About the report
The report is commissioned to discuss the possible financing options for Outdoor Limited which is currently seeking external funding for expansion purpose and is also likely to face liquidity issues once three of its five investors, liquidate their holdings. Henceforth, each of the possible sources of funds will be evaluated considering the present situation of the company
The second part of the report will be used to discuss the tools of foreign exchange risk management as the company is exposed to FX risk, citing an outward transaction as part of which it will be paying $2 million in six months.
Part A: Evaluting sources of funds
Every established entity in this corporate world has an appetite for an additional capital in order to supplement the need for expansion. Outdoor Limited, which for years has been a private entity and has been operating with equity investment made by the five shareholders and marginal bank loan secured against the minimal asset our company owns, is now facing the situation where it is seeking aggressive expansion, but is feeling capital-crippled as three of its shareholders are willing to liquidate their investments Henceforth, it is extremely important that in order to ensure the survival and to fund the expansion, the company should seek other sources of raising capital, but in a way that suits its organizational architecture. Accordingly, to assist my owners with the understanding of various sources of capital available to fund the expansion, we have prepared this report. As part of this report, we will be evaluating all the available sources meticulously and will also judge the suitability of each source. Below we have discussed such sources:
-Initial Public Offering/Equity Issue
Generally abbreviated as IPO, Initial Public Offering is the first step of a private entity to go public. IPO marks the first ever sale of a stock of a company in the financial markets.
It is considerable that Outdoors Limited has been operating as a private entity, however, considering the need for a high amount of additional capital, an entry into the financial markets will be a suitable step for the company. Important to note, raising capital through the equity issue involves numerous pros and cons and before we undertake any final decision, it is crucial that we understand these considerations:
Advantage of equity issue
i) Access to huge amounts of capital
Equity issue processed through popular investment bankers, who act as underwriters for the issuing firm, can popularize the issue amongst the suitable investor and can assist in raising a huge amount of capital required for expansion purpose. Important to note, the investment banking firms charge flotation cost in lieu of their services while in many cases, they also guarantee the minimal amount they will arrange for the firm issuing equity. Since, these firms have access to a wide array of investors around the globe, they are able to arrange the capital at least cost possible or with acceptable terms.
ii) No fixed obligation
Unlike debt borrowing, where the borrower has a fixed obligation to repay the interest and principal portion through monthly instalments, an equity issue relieves the borrowing company from any such obligation. Important to note, an equity issue entitles the investors to become the proportionate owner of the company in lieu of the amount invested. Accordingly, they are only entitled to claim share of profits in the form of dividends, and even dividend declaration policy is not an obligation to the company as in the initial years, the company may want to retain the profit rather than distributing it back to the shareholders.
In short, once the entity issues equity, it will have more time to grow the business before worrying to repay any amount back irrespective of the financial standing of the company. And, if the business fails, the entity will not pay anything to any investor. Hence, investors sink or swim alongside the business owners
iii) Corporate recognition
At the time of IPO issue, the investment bankers plan marketing strategy to spread the news of the IPO amongst the investors. Moreover, the kind of media attention received at the time of IPO issue and thereafter, enhances the corporate image of the entity. This publicity allows the company to reach for wider scale of community rather being recognized by a handful of people.
iv) Access to managerial talent
Once an entity goes public, it gains recognition amongst the experienced managers of the industry. Unlike a firm which is trading with a handful of capital, equity issue allows the company to hire best and most productive managerial talent from the industry and these personnels can then assist the company in achieving its objectives at the time of expansion.
Disadvantage of equity issue
i) Dilution of ownership
As stated earlier, equity issue allows the investor to gain a proportionate ownership in lieu of the amount invested. Henceforth, once an entity decides to issue equity, it should be ready to face the dilution and associated disadvantages. For instance, outside investors may not agree with the managerial decisions that existing owners are willing to take, and this altercation will result in a delay in the decision making process. Most importantly, if any investor owns more than 50% of the equity ownership of the company, he can succumb the original owners and can take full control of the company.
ii) High cost of capital
Unlike debt borrowings, which are obtained against a lien on the assets of the company, equity issue is an unsecured borrowing and accordingly, equity investors presumes a higher level of risk. Henceforth, equity financing is sourced at a higher cost compared to debt financing.
iii) Following regulatory procedures and release of financial documents publicly
Once an entity is privately owned, it remains behind closed doors with no obligation to disclose its financial results to the general public. However, once it raises equity capital from the common investors, it is under the obligation to release the annual report describing the financial position of the company and other operational aspects.
Suitability of the equity issue for Outdoor Limited:
Considering the present situation of Outdoor Limited where three of the present investors are looking to liquidate their investment and the company is seeking capital for expansion purpose,equity issue will be a suitable option for it. Raising additional capital through equity issue will allow the company to focus exclusively on its business goals rather than bearing the pressure of making timely payments. At the same time, the company has a vintage presence of being a private limited company, therefore, leaping forward and obtaining a public listing through equity issue will provide a corporate recognition and access to the managerial expertise.
At the same time, the management of the company should also weigh the limitation of dilution of ownership against the above stated advantages. It is considerable that since its establishment, Outdoor Ltd has been under a private ownership by a family who are taking the decisions on their own. However, equity issue will bring outside investors to the board and the existing owners will have to develop a camaraderie with them. Moreover, management should also be aware that any equity related payment do not provide the tax benefit and from now on, they will be under the obligation to report their quarterly and annual earnings to the general public.
On the whole, we do recommend that issuing equity to raise the additional funds required for expansion will be a prudent step. At the same time, funding the expansion projects entirely with 100% equity capital will involves high cost and a significant dilution. Henceforth, the need for expansion related capital needs should be met through a mix of equity issue (80%) and unsecured debt(20%) . More discussion on unsecured debt is explained in the next section of this report.
-Unsecured debt financing
Another point of consideration while evaluating the source of capital available is the lack of asset base available with the company. Important to note, Outdoor Limited has already raised a bank loan mortgaged against the available asset base and since the company do not have any other asset available (The company does not own land and buildings to offer as security and the manufacturing plant has been leased), the only option available with it is to rely on unsecured debt channels such as a line of credit or overdrafts. Below we have discussed the pros and cons of an unsecured line of credit for the company:
Advantages of unsecured debt:
i)No dilution
Outdoor limited can arrange unsecured line of credit from the bank in order to meet with its working capital needs. This will also save the company from diluting the ownership in order to raise funds for meeting working capital needs related to the project.
ii) Tax benefits
The entity is eligible to include the interest paid on debt related funds as an expense, and accordingly gain from the tax shield in the form of lower tax bills.
Disadvantages of unsecured debt:
i) Expensive source of finance
Since unsecured debt is funded without any mortgage arrangement,financial institutions charge a high rate of interest from the borrowers. However, interest in these types of loans is charged on a daily basis as the interest amount is calculated daily outstanding balance of the borrower account.
Suitability of the unsecured debt issue for Outdoor Limited:
As already explained earlier, arranging capital for expansion purpose entirely through equity issue will raise the risk of dilution for the management. Therefore, the working capital needs of the expansion project should be met through unsecured lines of credit as doing so will preserve a representative ownership with the owners themselves and will also provide a tax shield advantage.
On the whole, we recommend that 80% of the amount required should be raised through equity issue and remaining 20% from debt sources.
Part B:
Foreign exchange transactions involve the risk factor of the volatility of exchange rates and this is often overlooked by small and medium scale companies. However, with growing globalization, many small and medium scale entities are being regularly exposed to such transactions and if the accompanied risk is not managed properly, this can cost million dollar losses to an entity. The situation which Outdoor Limited is facing is a simple illustration of foreign exchange risk as the entity which is liable to make the payments in USD six months from now is citing euro depreciation relative to USD. Henceforth,it is important that the company understand the risk scenario involved and opt or appropriate hedging techniques. Below we have explained two such techniques that can be considered by Outdoor Limited with the view to manage the exchange risk involved:
a)Forward Currency Hedges
Forward currency contracts are one of the most simple methods of hedging foreign exchange risk as it enables one party to buy the set amount of foreign currency at a fixed exchange rate at a pre-decided rate. For instance, in the given situation, Outdoor Limited is required to make a payment of $2 million six months from now while its base currency is pound sterling. However, since the company is foreseeing a dollar appreciation, this means that at the time of payment, it will need to spend more sterlings to purchase $2 million. Therefore, to manage the currency risk, the company can enter into a forward contract of six months and lock in the exchange rate at six month forward rate of $1.5433/£1. This contract will ensure that Outdoor Limited will need to spend £1295924.31 to purchase $2 million, regardless of what may happen to the USD-GBP exchange rate over the six months period.
Important to note, Forward contract is an agreement between two parties and do not involve regulators or clearing house to eliminate the default risk. Therefore, it is important that Outdoor Limited should enter into a forward contract with a credible party and should pick forward delivery dates conservatively. Secondly, there is no fee of entering into forward contracts since one party is making a spread by buying at one price and then selling it to another party at a higher price.
b) Foreign Exchange Option Hedge
Another option and a popular way to hedge the foreign exchange risk is Foreign Exchange Options. In case of Outdoor Limited, which is a small and privately owned entity and can face the default on forward contracts, currency options are worth considering. Important to note, currency options is a derivative contract that grants the right to the holder, not the obligation, to buy or sell the currency at a specified exchange rate at a given period of time. However, unlike forward, entering into an option contract attracts fees in the form of premium paid to the broker.
In the given situation, Outdoor Limited is considering a possible appreciation of USD relative to Pound Sterling. In this case, the company should buy a call option on USD/GBP so that it should stand to gain profit from the increase in the exchange rate in the favor of USD, i.e. when USD appreciates. In order to enter into option contract, the company will need to pay the call premium relative to to size of contract, i.e. $2 million* 0.0427= $85400.
Accordingly, if the spot rate of currency rises above strike price+ call premium, the company can exercise the call option and purchase the currency at the price lower than the market price. Similarly, if the spot rate of the currency is lower than strike price+ premium, the company can purchase the currency at the market rate and the option ends worthless.
Another point of consideration while trading in currency options is that while these derivative instruments do offer a high degree of flexibility, but they can be more expensive than forward hedges.
Conclusion
Considering both of the exchange risk management tool, we believe that for a small scale company like Outdoor Limited, Currency Options will be the appropriate tool of managing the foreign exchange risk as with a minimal premium amount, the company will be able to off-set any risk related to volatility of exchange risk and that too without any risk of default on behalf of the counterparty.
Bibliography
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Madura, J. (2015). Currency Derivatives. In J. Madura, International Financial Management (pp. 128-156). Cengage Learning.
Motley Fool. (n.d.). The Advantages & Disadvantages of Bonds Over Stock For Long-Term Financing. Retrieved February 16, 2016, from http://www.fool.com/knowledge-center/2016/01/16/the-advantages-disadvantages-of-bonds-over-stock-f.aspx
