Introduction 1
Company Background 1
Discussion Questions 2
1. The Various External Sources of Finance Available to the Company 2
a. Issuance of Common Shares 2
b. Corporate Bonds and Preferred Shares 3
c. Bank Loans 3
2. The Possible Considerations that may have been taken into account by the management when choosing the type of finance. All the relevant considerations explained and placed clearly in the context of the particular circumstances of the chosen quoted company. 4
3. The calculation of the Weighted Average Cost of Capital (WACC) appears to be straightforward in theory but difficult in practice. Using all available information, calculate the WACC of the chosen company. Evaluate the information available to calculate the WACC and the practical problems and difficulties that may be encountered for the chosen company. 5
Discussions, Conclusions and Recommendations 7
References 10
Introduction
The objective of this paper is to review the financial management and capital structuring options available for a publicly listed company. Several discussion questions focusing on financial management analysis and capital structuring options and decisions will be answered. The publicly listed company that has been chosen to be discussed in this paper was Wal-Mart. The primary metric that will be used in this paper would be the chosen company’s Weighted Average Cost of Capital. As mentioned earlier, there are many ways how businesses can generate cash as a form of capital.
The fact of the matter is that generation of capital is a costly process; it involves a lot of requirements, processes, and expenses, especially if there is going to be accreditations, investigations, and financial organization due processes involved. Another important note that businesses such as Wal-Mart must be aware of is that if there is one best form of capital raising strategy, that would be raising capital using the income that the company generated from its core business operations itself. However, businesses indeed face situations wherein the current level of cash reserves is too low to support major operation and infrastructure expansions. In such cases, they may really have to tap other options to raise capital aside from relying on the profits they generated themselves.
Company Background
Wal-Mart is one of the largest multinational corporations in the world. First things first, Wal-Mart is a publicly listed company. This means that shares, which represent ownership of the company, are available to both retail and institutional investors in the various bourse houses (i.e. stock exchanges) where the company’s shares are being bought and sold. Wal-Mart operates in the general retail industry. Its major source of revenue is it large and multinational chain of discount stores, department stores, and warehouse stores. For one to understand how Wal-Mart generates a gigantic income just by simply opening up more and more stores and making sure that there are merchandises placed in them for people to purchase, one has to understand the business model and even the business life cycle of companies operating in the general retail industry.
The company is currently headquartered in Bentonville, Arkansas, United States. According to the results of an analysis published in Fortune’s website in 2014, Wal-Mart has been identified as the holder of the first (i.e. top) spot in the Global 500 list of the largest multinational companies in terms of revenues. The company was founded by Sam Walton in 1945, when he purchased one of the for-sale branches of Ben Franklin Stores from the Franklin brothers, the owners and operators of one of the popular chain of retail stores back then. The first official Wal-Mart store, however, was opened only in 1962. The company grew from having only one store to several stores in the city of Arkansas and later on in other states in the U.S. The company, after experiencing a long stretch of success in its business campaign, was incorporated in 1969 as Wal-Mart Stores Inc. That time, the company was operating 38 stores and employing 1,500 employees, with overall sales revenue worth 44.2 million USD.
Discussion Questions
The Various External Sources of Finance Available to the Company
This section will be comprised of three subsections, each of which focuses on the discussion of one external source of finance that Wal-Mart may tap for the purpose of raising capital.
Issuance of Common Shares
Common shares or common stock (can be used interchangeably) represent a certain percentage of ownership of a corporation. This type of shares is tradable; which means that it can be purchased directly from an existing shareholder for a certain agreed price; and it can also be purchased from the secondary market such as in stock exchanges or in the case of Wal-Mart, the NYSE. Holders of common shares of a corporation have control and voting rights, although this mostly apply to the people who hold a significant percentage of the available shares for the public and this also depends on the prospectus of the common share issuance that the company has released; as well as on the by-laws of the company that issued the shares.
The shareholders’ voting rights may be exercised during the election of board of directors and when it comes to voting for or against new corporate policies. Since Wal-Mart is already listed in the NYSE, it would be safe to assume that it already got its profits from selling a certain percentage of ownership of the company. Additionally, all the shares that it issued to the public, via an investment bank, is already owned by the public (e.g. institutional and retail investors) so there is no way for it to profit from its shares already available in the market; unless of course if the company would approve a share buy-back program wherein it will acquire its own shares by buying it from the public and selling those acquired shares for a higher price later on. This route would take a lot of time though because change in fundamentals takes time to be counted in by the market.
Corporate Bonds and Preferred Shares
Corporate bonds are like loans only that instead of banks, they would be issued to investors, although banks, via their trust departments may also avail of corporate bonds and make profits from it. Bonds are practically debts because the total amount of principal owed generates interest which the company that issued the bonds would have to pay for as well.
One important factor to look for when it comes to corporate bonds is the coupon or discount rate. This rate describes the interest rate that the issuer has to pay for every year until the bond’s date of maturity, or until they get redeemed by the issuer—by means of a buy-back. It is also important to note that preferred shares are practically the same with corporate bonds only that they are traded in the stock exchanges and on a per-share basis. Preferred shares are also valued based on their coupon rate.
Naturally, the higher the interest rates, the more expensive the WACC of Wal-Mart would be. Currently, the baseline interest rates are down to near zero levels. This has been the case for quite a number of years now. This makes it cheaper to issue debt instruments that generate interest and this may indeed be an advantage for firms that are planning to issue debt for capitalization purposes such as Wal-Mart.
Bank Loans
Of the three external finance sources, bank loans are the least desirable because the allowed margin of error for the debtors (i.e. Wal-Mart) would really have to be small. Whenever a corporation loans money from a bank, the bank always has to make sure that the debtor would be able to pay for what it borrowed one way or another. So, collateral has to be offered and this often comes in the form of company assets. Bank loans also generate interest; the rates of which are often similar to the coupon rates of corporate bonds, but in most cases, higher by several basis points. Additionally, there are processing fees and long approval processes involved.
The Possible Considerations that may have been taken into account by the management when choosing the type of finance. All the relevant considerations explained and placed clearly in the context of the particular circumstances of the chosen quoted company.
There are two primary considerations that an issuing company may factor in whenever they are going to make a decision related to capital financing and these two would be the total size of the capital they would be able to raise, and the risks involved in being able to raise that capital.
In the case of issuing common shares, for example, there are two ways how Wal-Mart can profit and generate capital. They can buy back their shares now and wait for some time until the share prices go higher and then sell the shares that they bought back for a profit. This option takes a lot of time and often does not work especially if the overall economy and performance of the company are on a downtrend.
The only viable option that Wal-Mart can choose if it wants to raise additional capital without having to wait for a considerable amount of time is to issue new shares. This process is often referred to as an FOO or a follow on offering. This is one of the best ways to raise cash for capital because unlike debts, companies that issue new shares to the public are not obliged to pay whatever the total amount they get from the issuance. They, however, are expected to use the raised capital responsibly because investors use metrics (e.g. return on equity) to check whether it is wise to invest in a certain company or not.
The size of capital that the issuing company would get depends on two things; the price per share of the company and the total number of shares that will be issued. Some important notes to be familiar of about issuing common shares include: an issuance of shares where a larger volume of shares were issued means that a larger percentage of the company’s ownership was sold to the public; and that the higher the price per share is, the larger the capital that can be raised in an FOO.
In Wal-Mart’s case, they have an advantage if ever they are going to issue new shares to the public to raise capital today, should the need to do so arise, because its share price is already quite expensive and because of the high price of the company’s stock, it would not have to issue a lot of common shares and lose a percentage of the company to the public in the process. As of June 19, 2015, Wal-Mart (Stock Symbol: WMQ) shares were trading at $72.88 per piece. This means that if, for example, the company decides that they want to raise $300 million worth of capital for expansion purposes for example, the company only has to issue around 4.1 million common shares to the public via an investment bank.
Wal-Mart may also issue corporate bonds, preferred shares, and bank loans. It is important to note that these three individual finance options share one common thing: they are all debt instruments and they all generate interest annually. Because they are a debt instrument, the company is required to pay for what they owed the creditors regardless whether the company’s expansion brought in revenues and profits for the company that it could then use to repay its debt obligations or not. To establish a line of comparison with common share issuance, the first option, suppose Wal-Mart has to raise $300 million worth of capital too for an expansion and the board of directors decided for some reason that they would want to issue debt.
The current interest rates for debt instruments today stand between 4% to 6%, depending on the stability and integrity of the debt issuer (in this case, the higher the stability, the cheaper the credit would be and the lower the stability, the higher the risk, and so the more expensive it will be to borrow money and issue debt). So assuming the debt that will be issued will generate an interest rate of 6% per annum with a re-computation and initial tenor (for bank loans) or redemption date (for bonds and preferred shares) of 10 years, Wal-Mart would have to make an annual interest payment (principal payments not yet included for bank loans) of $18 million per year. So, between common share issuance and issuance of debt, the first option would naturally turn out to be the safer option.
The calculation of the Weighted Average Cost of Capital (WACC) appears to be straightforward in theory but difficult in practice. Using all available information, calculate the WACC of the chosen company. Evaluate the information available to calculate the WACC and the practical problems and difficulties that may be encountered for the chosen company.
According to the report “the retailer (pertaining to Wal-Mart) has ramped its international focus; with Doug’s start as CEO in 2014, the company has underscored its desire to expand further overseas; prior to taking the helm, he headed Wal-Mart International from February 2009 to February 2014; as a whole, Wal-Mart serves more than 100 million customers in 26 countries per week; in fact, the company said that net sales overseas, which accounts for more than 6,000 stores, climbed 4.6% to 140.9 billion USD from 2013” . These pieces of information only highlight Wal-Mart’s financial status, health, and capabilities as a multinational corporation and a leader in the world retailing industry. It became a publicly listed company in 1970, a year after it got incorporated. The decision was based on the company’s chairman and board of directors’ belief that they need enough exposure to the financial and capital markets in order to fuel the company’s rapid expansion in the U.S. and later on overseas. It took two years for the company to be listed in the New York Stock Exchange (NYSE); that was on 1972.
In Wal-Mart’s case, it has already been forty three years since it conducted its initial public offering at the New York Stock Exchange. It is important to note, however, that equities will not only be the focus of this paper. Other capital financing options will be discussed as well such as bank loan financing, and debt-financing (e.g. corporate bond issuance), including their pros and cons, and whether it is advisable for the company to subscribe to these options considering their current capitalization structure and financial situation.
In Wal-Mart’s case, it has already gone through the hardest part of raising capital and that is being accredited by the SEC and being listed in one of the largest capital markets in the world, the NYSE. With their shares being listed in the NYSE, Wal-Mart can have its shares bought by retail and institutional investors who are almost always looking for the highest yields. Long-term investors often base their share purchase decisions on fundamentals and one of the most important fundamental measures they use when it comes to buying a stock is the company’s WACC or weighted average cost of capital.
The formula to compute for the WACC is WACC = [((E/V) (Re)) + ((D/V) (Rd))] [1-Tc] where Re is the cost of equity; Rd, the cost of debt; E, market value of the firm’s equity; E/, percentage of the firm’s debt that is equity; D- market value of the firm’s debt. D/V, percentage of the company’s financing that is debt; and TC, the corporate tax rate . Unfortunately, this information are unavailable for non-stock holders of the company and so for the purposes of demonstration, hypothetical values for Wal-Mart will be used to show how to compute for the WACC.
All values are in Millions of USD. All values with * are Wal-Mart’s real values; all figures without * are hypothetical values that were used to demonstrate computation of WACC .
Re = 10%
Rd = 10%
E* = 238,606
D* = 50,581
V* = 289,187
D/V* = 0.175
E/V* = 0.825
TC = 6%
Using all the above figures and the formula for the WACC, the answer would be 9.90%
Discussions, Conclusions and Recommendations
Capital, from an economics and investment banking perspective, pertains to the resource required to purchase or generate (depending on the existing business and organizational model) the products and or services that a company offers to sell to its customers. In the case of a business involved in the general retail industry, the capital may be used to purchase the merchandises that the company would display in its stores and sell to its customers for a profit. Capital is different from money in the sense that money is simply an instrument used to purchase goods or services whereas capital is an instrument that is used to generate revenue and therefore wealth by making an investment. This means that whenever the term capital is used, the decision to make a purchasing decision is motivated by the idea of ultimately making a profit in the end.
This is specifically where the investment part, which differentiates capital from money, comes in. The most common form of capital is cash. Cash is what companies use to purchase equipment, real estate and infrastructures, goods and merchandises, among other things that can be sold for a profit. The thing is that there are numerous ways how to generate cash as a form of capital. The process where cash is generated for investment-related purposes is operationally called capitalization. Some of the most common ways how businesses generate capital (i.e. capitalize) include but may not be limited to issuing common and or preferred shares to institutional and retail investors, issuing corporate bonds, borrowing money from the bank, and selling unused, unprofitable, and underperforming assets.
Between the three options discussed, it would easily turn out that the issuance of new shares would be the safest and most profitable option for Wal-Mart for two major reasons. Firstly, for a company as large and as stable like Wal-Mart, there will always be investors who would be willing to buy the securities and financial instruments that it offers. When it comes to investing, there is no other way for investors to plunge in than to place their investment funds in companies that are known to deliver; those who know how to turn debts and equities into profits and cash, which would later on go back to the investors in the form of dividend yields for their holdings and if the growth in earnings is continuous and significant, capital appreciation.
Wal-Mart so far satisfies all of these criteria. It has managed to issue shares and the company’s shareholders, especially those who have been long time holders, have so far been handsomely rewarded thanks to the huge gains in capital appreciation. Dividend yields have also been stable so far, with the company offering annual dividend yields of between 2% to 5% sometimes even higher. The company has also issued a lot of debts before, especially during the time when the company was ramping up its plans to expand into the international market. It needed a lot of capital and one of the options it tapped to increase the amount of capital it could raise was the debt market. It issued corporate bonds, preferred shares, and loaned from banks.
So far, Wal-Mart has never missed amortization and bond and preferred share dividend payments. Its creditors have so far been happy lending their money to a safe company such as Wal-Mart. It is a win-win situation for everyone. Wal-Mart is a stable and profitable company. It is continuously growing in terms of market exposure, size, and earnings. However, between the three capital financing options discussed in this paper, the one that Wal-Mart can really take advantage of would be the capital markets, specifically the common share issuance option. This is because of the fact that there is limit of how much the company can take advantage of the current high price for its shares.
As mentioned earlier, the company can take advantage this valuation by issuing new shares now. The only negative effect of this would be a dilution in their stocks. Dilution of shares often lead to lower valuations because more shares get circulated in the market; practically leading to an increase in supply in a market—this drags down the price of the shares. So, in a way, this may be seen as an option that benefits the company because it gets to find a safe and virtually risk-free source of capital to finance its expansion or other programs; but not the investors, at least just over the short term.
In the long run, the investors would benefit from the follow on offering because when the expansion plans of the issuing company gets finished, that would most likely translate to higher earnings and earnings growth rates, leading again to a significant increase in valuation and share prices, and dividends. Now, Wal-Mart may also consider tapping the debt market but the reward to risk ratio is simply too low to even consider taking advantage of.
References
Farber, A., R. Gillet and A. Szafarz. A General Formula for the WACC. International Journal of Business. 2006.
Fortune. Global 500. Fortune. 2015.
Stock Analysis. Wal-Mart Stores Inc. WMT. Stock Analysis. 2015.
Yahoo Finance. Wal-Mart Stores Inc. WMT . Yahoo Finance. 2015.
