Pros and Cons of IPO
An initial public offering will involve Galaxy International selling its shares to the public for the first time (Moles, 2011). The stocks of the firm will be available for the members of the public through the stock markets. An IPO is undertaken with the assistance of an underwriting firm.
Pros of IPO
An IPO can help Galaxy International raise a substantial amount of capital it requires for expansion into the international market (Moles, 2011). The company is able to raise the required amount of capital through an IPO, unlike borrowing where the lender sets the cap. If the underwriter and the company uses a suitable strategy, all stocks offered by Galaxy International can be subscribed.
Secondly, an IPO will give Galaxy International a continuous access to the stock market. After a successful IPO, the firm will be able to raise more capital by issuing new shares (Moles, 2011). It will be easier to issue new shares once it has gone public. Besides, there will be alternatives for raise capital such as rights issue, among other means. Besides, publicly traded shares can be used as a source of finance. Galaxy International can repay its debts by converting them to equity.
An IPO will also enhance the visibility of the company in the market. Information about the performance of the company will be publicly available, and analysts will focus on its stock performance (Brigham & Gapenski, 2010). Enhanced visibility will enhance the reputation of the company that may, in turn, boost its sales. It also increases the credibility of Galaxy International. A successful IPO is a vote of confidence by investors on the prospects and financial stability of the company. This may increase its access to other financing alternatives. It also provides a valuable exit option for the founders of the company. For instance, a venture capitalist can easily exit a firm through an IPO and gets the return on the initial investment.
Cons of IPO
Galaxy International will have to incur direct and indirect costs of IPO. Equity has high floatation costs hence, the direct costs of the IPO will take about 10% of the proceeds. Galaxy International will also incur compliance costs after the IPO (Brigham & Gapenski, 2010). Furthermore, it will take a long time for the corporation to undertake the IPO due to lengthy procedures and several pre-conditions it has to meet.
The company will also be under increased public scrutiny. Corporations whose stocks are publicly traded must file reports with the relevant authorities such as the Securities and Exchange Commission. This implies that competitors will be able to learn more about the corporation.
An IPO will also lead to the loss of control of the company (Brigham & Gapenski, 2010). Jeremy will have to surrender some of its power in the running of the company since a board of directors will run the company. Besides, the IPO will increase the number of the corporation’s shareholders thus diluting the control of Jeremy and existing shareholders. This further leads to a reduction in earnings per share. The company will also be subject to corporate governance and other regulations. The shareholders will have the power to elect the directors of the company. Furthermore, company directors and managers will be liable for mismanagement. Shareholders can sue Jeremy and other directors for breach of fiduciary, among other duties.
Financing alternative and strategies
Bank Loans
Jeremy can borrow a loan from Galaxy International’s bank as well as other financial institutions. The bank would require a disclosure of the purpose of the loan and assess the creditworthiness of the corporation. However, this strategy is unlikely to succeed since the bank may not be able to provide a large amount of capital required for going international. Besides, the bank will require collateral for the loan which the company may not have considering the amount of capital required.
Bonds
Galaxy International can issue bonds in the bond market to raise the funds required for international expansion. Investors in the bond will provide the corporation with the funds, but it will have to pay regular coupon interests irrespective of its profitability. Galaxy International will repay the face value of the bonds upon the expiry of the term (Moles, 2011). This alternative is viable, but it will depend on the financial stability of the company. Investors will not acquire the firm’s bonds unless they are satisfied with the firm’s ability to honour its obligations.
Angel investors
Angel investors contribute capital to the company for improving equipment, expansion, among other uses, in exchange for a small portion of the firm’s equity. They invest in firms whose return on investment is above average (Moles, 2011). They, however, provide small financing and may not be adequate to finance Galaxy International’s plan of going international.
Venture capital
Venture financing involves a venture capitalist who provides substantial financing to companies with growth prospects for a substantial ownership of the company (Moles, 2011). Venture capitalists acquire substantial ownership in the target company and actively take part in the running of the company. They also provide managerial expertise and improve the performance of the company. They later sell their interest in the company at a profit.
Best alternative
Among the financing alternatives discussed above, venture capital financing best suits Galaxy International. It can raise a substantial amount of capital from the venture capitalist and benefit from the managerial expertise (Keown, 2011). Although Jeremy would lose some control of the company, he will be able to acquire it once the venture capitalist decides to exit.
Advantages of debt over equity
Using debt is advantageous since it does not lead to the dilution of control of the company. Holders of debt instruments are not shareholders of the company and do not participate in managerial decisions on affairs if the company (Helbæk, Lindest & McLellan, 2010). On the other hand, using equity financing dilutes control since the new equity holders have the right to participate and influence the decision process.
A lender does not share in the profits of the company. The creditor is only entitled to the principal of the debt plus agreed interests. Equity holders share in the profits of the company hence Jeremy’s profit share would reduce if Galaxy International uses equity financing (Helbæk, Lindest & McLellan, 2010). Debt financing also facilitates planning. This is because interest rates and the date of interest and principal payments are specified in the contract. The company can plan for these payments. It is also cheaper to issue debt than equity. The cost of debt is usually less than the cost of equity. Furthermore, issuing debt instruments such as bonds involve lower floatation costs than issuing equity.
Using debt also has tax advantages since interest expense is a tax deductible expense. This reduces the firm’s income tax expense thus improving profitability. Dividends paid to equity holders are not allowable expenses for tax purposes. There is double taxation since the company’s income is taxed and then shareholders are taxed on dividend income received. Although using debt increases the company’s leverage, it is beneficial so long as the company uses the borrowed funds efficiently.
Besides, dent is not a permanent source of financing. The company can repay the debt when it no longer needs the capital (Brigham & Gapenski, 2010). The company can also convert debt into equity upon the expiry of the term. Equity capital is a permanent financing, and the company can only dispose of equity when it is winding up.
Weighted average cost of capital
Debt = $50 million
Equity = $60 million
Total capital = $110 million
Cost of equity
K = Risk-free rate + Beta (Market return – Risk free rate)
= 2% + 1.8 (14 – 2)
= 23.6%
Cost of debt (coupon rate of bonds) = 8%
After tax cost of debt = cost of debt (1 – tax rate)
= 8% (1 – 0.28)
= 5.76%
WACC = (60⁄110 × 23.6%) + (40⁄110 × 5.76%)
= 12.87 + 2.09
= 14.96%
Financial instrument to ensure stable supply of oil
Jeremy can use futures contracts to ensure a stable supply of oil. A futures is a contractual agreement to buy or sell a commodity at a future date at an agreed price (Berk & DeMarzo, 2007). Jeremy can buy futures contracts in the futures market. Such oil futures contract will oblige the seller to supply Galaxy International with a specified quantity of oil at a future date. The seller will have to supply the specified quantity thus protecting the company from shortages when the market supply of oil falls (Eun & Resnick, 2007).
Approach for hedging currency translation
Jeremy can use options contracts to mitigate foreign currency risk. Options contracts will grant him the right but an obligation to exchange foreign currency such as the Japanese Yen to the US Dollar at a future date at an agreed exchange rate (Madura, 2014). Thus, the writer of the option will have to exchange the currencies at the agreed rate irrespective of the movements in the exchange rate (Madura, 2014). If the exchange rate movement is unfavourable, Jeremy would have the option of not exercising the options contract and exchange the currency at the prevailing rate exchange market.
Lease or build the plant in Japan
PV of leasing
Free cash flow 12,000,000
Lease cost (10,000,000)
Tax shield (28% of lease cost) 2,800,000
Cash flow 4,800,000
Real discount rate = 1.1496⁄1.06 – 1 = 8.45%
PVIFA8.45%, 15 years = 8.329
PV of leasing = 4,800,000 × 8.329
= $39,979,200
NPV of building
NPV = (12,000,000 × 8.329) – 50,000,000
= $49,948,000
Galaxy International should build the plant since the NPV of building the plant is higher than that of leasing (Bekaert & Hodrick, 2009). Furthermore, Japan’s economy is stable hence, the expansion would be profitable.
Participating in the IPO
I would participate in the IPO since the planned expansion is expected to be profitable. The company shows growth prospects hence the stock will earn a good return on investment.
Expected return on stock = Risk-free rate + Beta (Market return – Risk-free rate)
= 2% + 1.8 (14 – 2)
= 23.6%
Expected return and WACC
Galaxy International’s expected return would exceed the WACC. The company uses debt hence the WACC is lower than the cost of equity. Besides, the expected return on the plant is higher than the company’s WACC.
References
Bekaert, G., & Hodrick, R. (2009). International financial management. Upper Saddle River, N.J.: Pearson Prentice Hall.
Berk, J., & DeMarzo, P. (2007). Corporate finance. Boston: Pearson Addison Wesley.
Brigham, E., & Gapenski, L. (2010). Financial management. Chicago: Dryden Press.
Eun, C., & Resnick, B. (2007). International financial management. Boston: McGraw-Hill/Irwin.
Helbæk, M., Lindest, S., & McLellan, B. (2010). Corporate finance. New York: McGraw-Hill.
Keown, A. (2011). Financial management. Upper Saddle River, N.J.: Pearson/Prentice Hall.
Madura, J. (2014). International financial management (11th ed.). New York: Cengage Learning.
Moles, P. (2011). Corporate finance. Hoboken, N.J.: Wiley.
