Introduction
The main objective of entrepreneurs is to achieve profitability and growth of their ventures. Most of the entrepreneurs who have saturated their domestic markets seek to globalize their operations to increase profitability and achieve growth (Vinturella & Erickson, 2013). Globalization of business operations involves various considerations to facilitate the assessment of the viability of business expansion. Primarily, organizations seeking to go international must consider their financial capabilities and the risks involved (Vinturella & Erickson, 2013). Entrepreneurs can expand their businesses by increasing production and exportation or establishment of operating plants in different countries. This paper will answer various questions regarding the feasibility of expansion of Galaxy International through an establishment of a plant in China.
Pros and cons of an IPO for Galaxy International
IPO (initial public offering) involves the sale of stocks and securities of an organization to the public to facilitate the raising of capital required for expansion of the business (Rothberg, 2012). A business entity seeking to expand may consider raising the required capital through various methods such as the sale of bonds and equity. Various advantages and limitations are associated with IPO, Some of which are discussed below
Taking an IPO will enable the company to get the cash it needs for expansion of its operations (Rothberg, 2012). Also by going public, a company becomes publicly traded and attains legitimate status. According to Grassman (1973), going public has the advantage of increasing company’s capacity to form acquisitions with its competitors, thereby strengthening its market position as well as achieving rapid growth (Vinturella & Erickson, 2013). Thus, Galaxy will be in a better position to conduct business with other institutions since its ability to finance its activities will increase after going public.
One of the main drawbacks to going public is the lengthy and expensive procedures involved (Rothberg, 2012). Besides, the conversion of private to a public entity is risky and will require Galaxy International to be reporting to many stakeholders on a more regular basis (Rothberg, 2012). Additionally, Galaxy may not benefit immediately from going public due to lock-up periods involved in the process of going public (Rothberg, 2012). Considering the pros as well as cons of taking an IPO, staying private is the best option. In addition to the cons of going public, institutions that are publicly owned tend to perform poorly due to lack of profit motive and bureaucratic managements. Therefore, I would recommend Galaxy to remain private since there are many benefits in operating privately owned entities. Furthermore, remaining private for a particular time does not necessarily mean that the company is not successful to go public.
Evaluation of appropriateness of financial alternatives and strategies available to Jeremy
Jeremy has two alternatives that he can use to raise the capital he needs to make his company grow to an international level. He can raise money through the sale of bonds or equity. The sale of four million shares each at $ 15 can raise $ 60 million. On the other hand, Jeremy can raise $ 50 million through the sale of bonds. The bonds are issued at the coupon rate of 8%, implying that bond owners will be paid back with an interest of 8%. Morgan Stanley estimated that Galaxy’s beta is 1.8% implying that if it trades its stock publicly, the variance between the interest on bonds and market returns will increase, and the company will have enough returns to cover the market risk. Sale of bonds would raise less capital than equity. The use of equity is more appropriate than the sale of bonds because it will allow the business to operate on private capacity (Mangelsdorf, 1993). Additionally, the company will not have the obligation to make interest payments, and it will be at lower risk of being declared bankrupt since equity investors do not have rights to declare a company bankrupt.
Advantages of debt over equity and cost of each after tax
When debt is used, the profits of the company go to the owner since the lender is only entitled to loan repayment and the agreed-upon interests. Additionally, raising capital through debt is less complicated since the company does not have to comply with regulations of the state (Khosa, 2013). Moreover, the cost of loan can be reduced by deducting the interest from the tax returns of the company. Also, the company does not have to consult shareholders when making decisions. The cost of debt after tax will be calculated as follows
Before tax rate (1-marginal tax) total value of debt
0.08(1-0.28)50=2.88
The after-tax cost of equity will be equal to
Cost of equity= risk-free rate+ (company’s beta*risk premium)
0.02+ (0.018)(0.122)60=1.332. Therefore, the after-tax cost of debt and equity are 2.88 million and 1.332 million respectively. The weighted average cost of capital then will be
(Cost of equity*equity’s portion of capital)+ (cost of debt*debt’s portion of capital)
(2.88*50/110)+ (1.332*60/110)=2.034
Financial instrument that Jeremy could use to ensure stable supply of oil and protect his firm from currency translation
Jeremy intends to establish an operating plant in China. As such, he stands a risk of currency translation since his assets will be denominated in Yuan. One instrument that Jeremy could use to protect the loss due to currency translation is to use financial derivatives to ensure standard prices for raw materials such as oil polymers. Derivatives are essential in the management of risks caused by currency translations as well as transactions (Hagelin and Pramborg, 2004).
An approach that Jeremy can use to hedge currency translation and transaction exposure
The conversion of US Dollar to Yuan involves the risk of the exchange rate (Berisha, Asllanaj & Shala, 2014). According to Allayannis and Ofek (2001), such risk can be neutralized by preparing invoices using the domestic currency. The use of invoices stated in Yuan will ensure that the exchange risk is shifted to customers who will be importing from China since they will use Yuan to pay for products.
Whether Jeremy should buy or lease the plant
The decision about buying or leasing the plant must consider the economic conditions in China. Other factors such as taxation system, consumer behavior, and business environment also require due consideration before setting up the plant (Jongen, Muller & Verschoor, 2012). The cost of building the plant is $50 million while the leasing cost is $10per year. Considering that the annual rate of inflation is 6% and the lifetime of the plant is fifteen years, it would be more profitable to set up the operating plant since the cost involved is far less than leasing cost (Funke, 2006). Also, due to high inflation, the leasing cost is likely to rise (Yueh, 2012).
If Galaxy International goes public, I would not want to participate in IPO if I am the portfolio manager. The issue of company’s stocks to the public involves brokers such as Morgan Stanley, who take a significant share of profit. Also, it is much easier to get one person to buy company shares than going public to look for many people to buy the same shares (Vinturella, & Erickson, 2003). Using the CAPM, the expected return on the stocks would be given as
Re=rf+ (rm-rf)* β where;
Re is the expected return
rf is the risk-free rate
rm-rf is the risk premium
β is the beta coefficient
Therefore, the expected return equals 0.02+ (0.14-0.02)0.018=0.022. This approximate to 2.2%. Weighted average cost is 2.034%. This implies that if the company participates in IPO, WACC will go higher than returns since the company will have to pay more interests in financing its assets.
References
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