Memorandum on the Financing Options
This memorandum evaluates the different long-term financing options available to the company for the new project to manufacture new types of pipes as well as for future expansion needs of the Company.
Normally the guiding principle for deciding on the debt/equity mix is the maximization of the firm value in terms of the value of its stock. It is for the financial managers to arrive at a proper debt/equity mix and this decision is primarily affected by the funding needs of the firm in the context of the uncertainty of the future earnings of the firm. It also depends on the accessibility of the capital market by the firm. The financial manager has also to ensure that the shareholder value is maximized by borrowing at the lowest cost of capital. Thus the choice of the firm’s optimum financing mix is “based on a tradeoff between the benefits and costs of choosing debt versus equity.” (Business.UUC)
In the matter of financing the capital expenditure projects the firms are always confronted with the decision to choose from paying large dividends with the retention of lower profits leading to heavy external financing for future investments or to pay retain higher profits by paying lower dividend so that they need to resort to lower external financing for the future investments. Hence the dividend policy of a firm decided the debt/equity mix of the company’s capital structure.
Characteristics and Costs of Various Debt and Equity Instruments
The equity form of financing the long term needs of a firm involves the issue of different kinds of stocks. The equity form of investment allows the firm to reduce personal risks of the owners. Even in case the business fails, the firm has to repay the debts being the borrowings by the company or the firm has to get the loans reorganized the debt repayment under bankruptcy protection. The cost of financing through equity is the dividend that the firm has to pay to the investors. Equity is considered more expensive than debt as the equity investor usually undertakes more risk and hence expects more return on the investments. Thus the cost of financing with equity is usually significantly higher than financing with debt.
Another type of equity is represented by the preferred stock. The dividends are payable are in preference to the payment of dividends on the common stock. “The amount of dividends that will be paid to the holders of preferred shares may be stated as a percent of its par value, or as a flat dollar amount.” (Business Reference)
Debentures and bonds represent some of the debt instruments. In contrast to the equity form of financing debt instruments do not provide any ownership rights to the bondholders. The cost of long term debt is the after-tax cost of borrowing through the issuance of bonds. The proceeds of the bonds are reduced by the costs incurred to issue and sell the securities which are known as flotation costs. It is important to state the cost of financing on an after-tax basis. This is so because the interest payable on debt financing is tax-deductible.
Long Term Financing Alternatives
There are different alternatives available for funding the long term financing needs of the firm. The firm may decide to finance its long term needs through various alternative forms like equity, bonds or leasing.
Equity
Equity represents the fundamental ownership units of the corporation. The firm may resort to equity in the form of common stock or preferred stock. The common stocks provide ownership to the stockholders. Usually certain voting rights are attached to the common stock. The option of using equity as long term financing alternative allows the firm to sell its shares to the investors who provides the necessary funds for financing the long term capital investment needs of the company. By using the equity form of financing the firm can use the funds accumulated through the issue of equity to grow the business instead of spending the cash on payment of interest and repayment of the loan.
Bonds
A bond represents a debt security. The issuer of the bond becomes the debtor for the bond holder and the bond issuer is obligated to make the repayment of the principal and interest borrowed on an agreed future date. The bond should be considered as a loan covered with security. The issuer of the bond is the borrower and the bond holder is the lender. By issuing the bonds the firm should be able to finance the long-term investment with the funds from external sources. Although both bonds and stocks are considered as securities the bond holders are lenders to the issuing company but the stockholders represent the owners of the firm.
Changes in some of the associated factors will influence the value of the bonds as and when such changes occur during the currency of the bonds. Since the yield and the price of a bond have an inverse relationship the changes in the market interest rates affect the bond prices.
The various financing options for Rondos are presented in the following table:
In the case of common stocks with the issue of $ 15,000,000 million worth stocks, there is a higher level of dilution at 22% and more dividend payments to the new equity holders as the management is keen on maintaining the current rate of dividend. Therefore the Company can consider issuing a lower level of common equity.
In the case of mortgage debentures of $ 8,000,000 the cost of debt is only 9% which is less than the Weighted Average Cost of Capital of the company (WACC) which is calculated at 9.62%. The interest on mortgage debentures can also be charged off against profits for taxation purposes. However with a higher mortgage bond of $ 13,000,000 the company will become more geared and hence it is suggested to keep a lower level of debt.
In the case of convertible bonds though the cost of funds is low at 8.63% and the present value as is comparatively lower, there is the potential risk of the bond holders exercising their option when there are changes in the market conditions. Similarly issuing the preferred stock also is undesirable from the point of view of cost and dilution of ownership.
Considering all the issues discussed, it is recommended that the company issues common equity of $ 5,000,000 and obtain debt fund through the issue of mortgage bonds to the extent of
$ 8,000,000 to meet its acquisition of Poly Pipe and to meet the financial needs of the expansion plans. This way the company can maintain its gearing ratio as well as get the tax advantage from the interest payments on the mortgage bonds.
References
Business Reference ‘Cost of Capital’. Web.
Business UUC ‘The Firm’s Financial Policy’. Web.