BUSINESS FINANCING
Introduction
Business owners and managers seeking financing encounters an essential decision regarding choice of whether to borrow money or to make use new equity capital. Given that equity and debts have very varied characteristics, each of them has different effect on cash-flow, earnings, and taxes as well as on balance sheet. They also have different impacts on any company`s dilution, leverage as well as a host for other financial metrics by which companies are measured. Lastly, each business financing options presents a different kind of relationship in relation to the financing source. Thus, a company`s plan on how to use funds, the relationship they desire to have with the source of capital as well as stage/type of a company shall greatly determine the best form of financing. In that respect, this analysis evaluates the financing alternatives available for Outdoors Ltd that has a need to raise £2M for business expansion purpose. With that, the report presents a recommendation on the most suitable option considering the business status and stakeholders’ interests.
Discussion
Pecking order of Financing
Given that all business financing emanates from debts, new funding and internal funding, how to raise capital would requires Outdoor ltd’s consideration of the suitability of all the methods in priority beginning with internal financing, the debts, as well as issuing of new equity, respectively. The raising of equity in such a case may be viewed like the final resort. The theory of pecking order was made popular by Stewart Myers by arguing that it would be less preferred to raise capital since managers issues some new equity (with an assumption that they well know about a company`s true condition than the investors). The investors have the belief that the managers tend to overvalue a firm and take advantage of that over-valuation. Consequently, the investor places a lower value on a new issued equity. The theory maintain the fact that businesses tend to adhere to the financing sources hierarchy and prefers the internal financing whenever it is available, while debt is more preferred than equity if an external business financing is needed (Arnold, 2013).
Alternatives for raising additional capital
The outdoors Ltd has various options for raising the needed capital. The options falls under two categories of debt and equity funding and their suitability is discussed as follows.
Debt financing
Debt:
Debts are in two forms: subordinated and senior. A bank’s senior debt is not as expensive as subordinate one but has covenants that are more extensive that provide leader with given remedies in an event that satisfaction of the covenant is not met. Additionally, majority of senior lenders expect the company’s debt to be collateralized by the account receivable, personal guarantees, real estate, other assets of the company, or other sources of secondary repayment in case the flow of cash proves insufficient in servicing that debt. In event of liquidation, obligation of senior debt takes the priority over the other obligations of debt as well as equity positions; thus the referred to as “Senior Debt”. Senior debt in most of the cases is less expensive alternative of financing, and most of the companies therefore prefer financing much of the capital needs using it, typically from the banks. Nevertheless, for most emerging growth, balance sheet as well as high-growth “light” companies, financing available by senior debt is inadequate for all their needs, leading to them turning to other two forms that are most common for additional capital: equity and mezzanine (Nilsen, 2002). However, this option would not be a priority for the Outdoors Ltd given that it already has a loan that is secured by a floating charge on its assets.
Lease financing
Lease financing as source of long- and medium-term financing is important. It involves the asset owner giving the right of using an asset to another person against payments that are periodical. In that case, the asset owner is referred to as lesser while the lessee is the user. The payments that are made periodically by the lessee to lesser are known as the lease rental. In the lease financing, the right of using an asset is given to the lessee but ownership remains with lesser and when the lease contract ends, the asset in consideration is given back to the lesser. However, an option can be given to the asset lessee to either renew the agreement on lease or purchase that asset. In that view, had the Outdoors being in need of an asset in its expansion program the lease financing advantages are that the business would not have to spend a lot of money in acquiring the asset but the same will be used by the business by paying yearly or monthly payments that are small. Also, the company could enjoy tax advantage through deductions for the payment regarding the lease as they are deductible expenses for taxation purposes. Further, the leasing is financing would have been a less expensive option compared to the other financing sources. Also, the lessee gets technical support in respect to leased asset from lesser. It is also notable that, the method is more inflation friendly as the lessee pays fixed rental amount each year regardless of the fluctuation in the asset cost or inflation rate. Finally, after expiry of the primary period, the lesser could offers Outdoors Ltd the opportunity to buy that asset – through payment of significantly low price compared to the market price (Ayyagari, Demirguc-Kunt & Maksimovic, 2010).
Equity financing
The equity financing is capital investment into a company through ownership of the business share. However, the methods would dilute the existing family ownership of the Outdoors Ltd. Typically, equity investors identifies their capital is required to drive growth in business and does not need monthly or even quarterly interest rate payments. Additionally, the equity terms would be flexible more than for the debt financing given that the equity has got fewer covenants, as well as fewer remedies that are defined in an event that an organization does not operate according to its business plan. Further, equity investors could seek to align the interest rates as per that of management team; always not possible with the debt and would work closely with the company’s management in assisting it maximize on the ultimate business value during the investment period; typically between 3 and 5 years (Arnold, 2013).
That very value added component of the equity investors tend to be one reason as to why equity would be more expensive than the mezzanine debt. Another primary reason regarding why equity would be more expensive for Outdoor Company is that the equity always resemble mezzanine debt with respect to the capital structure, hence 100 percent of the a Company’s returns would be normally shifted backward to an investment period, leading to a security that is more risky. Thus, the equity financing would have to be pricier than the debt so as to offer an appropriate return for risk-adjustment to investors.
Further, the equity capital normally is a solution that is good for the companies that are looking to finance the shareholders equity; as it allows business owners as well as other investors to be able to take some cash from the business. Thus, it is also the most preferred solution in firms at the point of inflection of increasing growth and firms looking for more management support as well as board-level management (Arena, 2011). In that view and considering the family involvement in the Outdoors Ltd management as well as the planned expansion, various equity options would be worth considering as follows
IPO
The stock market option also known also as IPO would involve publically offering shares in order to raise capital. This may be a very complex and expensive option and would have the risk for not raising the required £2M because of poor markets circumstances.
Preference Shares
The preference shares tend not to be included in the equity share of capital since they have different rights to those of the ordinary shareholders. The preference shareholding normally do not provide the holder with a right for voting and the preference shares issuer would not snatch a company`s control from the original shareholders. However, the shareholders would have a right to fixed dividends and they do not benefit when a company`s profit goes up. On other hand, holders of the preference shares are normally entitled to dividends prior to the holders of the ordinary shares; hence they are most likely to get paid even when a company does not do well. Additionally, in case a firm is wounded up, the holders of preference shares are commonly repaid their shares’ values before the holders of the ordinary shareholders get their money back. In view of the Outdoors Ltd case, the alternative would be applicable given that three non executive directors have offered to liquidate their preference shares (McLaney, 2009).
Retained Earnings
A business growth funding through the retained earnings may be a very powerful strategy. That is because it does not increase the business debt profile or even sap the profits through payments of interests. This option that is conservative would also allows the family members to maintain the full control over their business without outside investors or new partners (Arnold, 2013). That is because involving the outsiders such as lenders, partners or even angel investors would provide them with some influence on how the management operates the business. However, the funding would also mean reduced funds availability; hence possibility of missing out on some opportunities as the business would be required funds. That is also given that the business also requires cash for its ongoing activities. So, if a lot of cash is directed towards the growth funding, the company would be starving of cash that is required to keep its liquidity at a suitable level. Finally, although the outside funding means surrendering some control, one may benefit from insights and experience of the new players in the business.
Venture Capital
The venture capitalists generally are huge co-corporations investing huge sums of money in businesses that are starting and having a potential for significant profits and high growth. Typically, they require huge control of a business and mainly provide industry or management expertise (Brealey, Stewart and Franklin, 2010). Thus, given the family interest in retaining full control and decision making in the Outdoors ltd, the method would be less attractive.
Conclusion
In view of the shareholders needs and the various alternatives effect on the company, the best financing alternative to raise the £2m should be retained earnings use following the pecking order of financing that requires the earnings to be the first option. In that respect, the earnings should be the first and given that the business has already had debt and also seeks to protect family interest, the use of the earnings would be the most suitable (Kim and Hyun, 2007).
B. Managing foreign market risks
Introduction
Multinational firms use different strategies to hedge against the exchange rate risk depending on the specific currency risk they face. In that respect, this report presents a summary of the risks that the Outdoors Ltd would be subject to in its international operations. The report also analyzes the alternatives that the business has in managing the foreign exchange risks given that it has an agreement with a US based company to share development costs for a new line of clothing that will transmit location data to rescue services in the event of getting lost or in case of accident. The agreement requires a payment of $2m due in 6 months’ time.
Discussion
Risks of expanding into foreign markets
Currency risk
With the business seeking possible expansion to a foreign market, it would be exposed to various risks including the risk on currency fluctuation. Thus, the international market approach would increase complexity and possibility of losing the investments value if the local currency gained against the foreign currency (McLaney, 2009).
Country risk
The country risk would involve dealing with monetary restrictions that are imposed by the foreign governments regarding key business aspects such as taxations and funds repatriation.
Economic Risk
An economic risk is the unfavorable economic environment in sellers and buyers country that can affect the two parties in the fulfillment of their obligations. At the side of a buyer, an economic risk can result into buyer`s inability or insolvency to accept goods or even services. At the other side, a seller can experience hardship in producing or even shipping goods as such (McLaney, 2009).
Transaction risk,
This basically is the risk related to cash flow and it deals with effect of the exchange rate movements in a transactional account in relation to the receivables (the export contracts), the payables (the import contracts) and the dividends’ repatriation. The exchange rate variation in the denomination of a currency of such a contract leads to a direct risk of exchange rate transaction to a firm (Lumby and Jones, 2011).
Translation risk
This basically is a balance sheet risk of exchange rate and it relates to the moves by foreign subsidiary in valuing their investments and returns for purpose of consolidating the balance sheet of the original parent company. The risk of foreign subsidiary transaction is normally measured by exposure of the net assets (the assets minus liabilities) to potential moves of exchange rate (Lumby and Jones, 2011).
Political/Sovereign Risk
The sovereign/political risk does refer to complications that sellers and buyers can be exposed to because of unfavorable political change and decisions that can change the outcome that is expected for a contract that is outstanding. An example of a sovereign/political risk is the changes in monetary/fiscal policy, riots, and war or trade embargoes (McLaney, 2009)
Evaluation of exchange risk hedging strategies
In view of the various risks that the Outdoors ltd would be exposed to in expansion to international markets, the following are some of the key measures that could be applied in managing those risks.
Agree on payment method that is more secure such as an open account or documentary credit. That would be suitable for managing the country risk in view of the different policies and requirements such as policies on taxation.
Deal with a seller who has a good reputation or whose track record is established as well as request for guarantee on performance to avoid risks that are non-performance. That would be key in managing the economic risk that could arise in event of insolvency of a business partner.
Respect and acknowledge cultural differences with seller. That would be appropriate for managing the country risk that relates to the differences in the ways of doing things.
If there is need for financing, enter into loan whose interest rate are fixed or an agreement on swap of the interest rate. That would be suitable for addressing the currency risk that relates to the exchange rate fluctuation.
Sell and buy in the same currency in order to minimise risk in foreign exchange. Alternatively, buyer may hedge against risk of foreign exchange through entering option or forward contract on foreign exchange with bank. That would be appropriate for hedging or managing the currency risk as well as the economic and translation risk. The rationale is that all those risks relate to the fluctuation in the value of the foreign currency.
Having an emergency plan against any unfortunate events. That would be suitable for addressing the political/sovereign risk that could affect a business and its operations or performance.
Ensuring sufficient insurance against the transit risk. The insurance would also be a crucial measure to address the sovereign risk in event of an uncertain event.
The two swaps of cross-currency that are commonly used are basis cross-currency and coupon swaps cross-currency. The coupon swap cross-currency is defined to mean currency swap buying and at that time receive floating and pay fixed interest payment. The advantage of this is that firms are allowed to manage the rate of their foreign exchange as well as risks in interest rate, as they like, but firms that purchase these instruments are left vulnerable to interest rate and currency risks. Basis cross-currency swap means buying currency swap as well as paying interest that are floating in one currency and in another currency you receive floating interest. This instrument, while the same risk in currency is being assumed as the currency swap standard, has advantage in that firm is allowed to capture the prevailing differential of the interest rate. However, its main disadvantage is that firm’s primary risk is risk on interest rate rather than currency risk. For instrument of currency hedging that are exchange traded, the currency future and currency options are the main one (Hagelin and Pramborg, 2004).
Various currency structures options’ development has been very swift, and has been attributed with their nature which is very flexible. Most common option structure type is – 12 – plain call vanilla, defined as upside strike buying in rate of exchange without obligation to the exercise. These methods advantages are its simplicity, lower cost compared to the forward, as well as maximum loss that is predicted which is premium. However, this method’s cost is more than for other options that have structures which are highly sophisticated such as the call spreads which is to buy at-the-money call then sell the low call delta. The currency future is a contract of traded exchange specifying particular currency’s standard volume that is to be exchanged at settlement date that is specified. They are the same as forward contracts by the fact that a firm is allowed to fix prices for given currency that will be paid at given time in future. Yet, there is difference in their characteristics with those of forward rates, in both available currencies that are traded as well as typical (quarterly) date’s statement. However, the currency future price will in general be similar with forward rates of given currency as well as settlement date. Currency futures and currency forward market comparing, the contract size and date of delivery are individual needs tailored in forward market i.e. resolute between the firm and the bank, centrally to contracts of currency futures that are guaranteed and standardized by some exchange that are organized.
Whereas there is a no separate function of clearing-house for the forward markets, clearing operations for the future markets are all handled by exchange clearing operation house, with the daily settlements of mark-to-the-market. In the terms of the liquidation, whereas many of the forward contracts get settled by an actual delivery as well as only some through costs-offset, in contrast, many of the future contracts are all settled via offset as well as just few through delivery (Alayannis, Ihrig and Weston, 2001).
Additionally, prices of a future contract vary over time as a reflection of future market anticipated spot rate. In case of a firm that is holding a currency future agreement decides prior to the date of settlement that it does no longer require to maintain that position, it may close out that position by selling identical future contracts. But this may not be exercised with a forward contract. In conclusion, since the currency hedging is mainly costly, an organization can first put into consideration the natural hedging, like matching that involves pairing most suitably the international firm`s outflows and inflows of foreign currency with the respect to timing and amount; netting that involves consolidated settlements for receivables, payables as well as debt among firms subsidiaries; and the invoicing in foreign currency that reduces the transactions risk that relates primarily onto imports and exports (Albuquerque, 2007).
In view of the above, there are various alternatives that the Outdoors Ltd could apply in hedging against the possible gain in the dollar against the pound. The hedges are summarized as follows.
FX Swap hedge
The business can hedge against the future commitment in money market by taking a loan in local currency and investing in the currency it will be paying. The method’s application is dependent on the interest rate differential.
Given the current spot rate of $1.5352 the $2,000,000 to be paid would currently equal (2,000,000/1.5352) = £1,302,761
Then a hedge would involve borrowing the money in the UK at 3.5% that equals 1.75% for six months and investing it in GBP at (5.3/2) = 2.65%.
Thus, the amount would be worth = £1,302,761* Interest differential
Where interest differential equals ((2.65-1.75)/100 +1) = 0.009 +1 = 1.009
The amount would be worth 1,302,761*1.009 = £1,314,485
That would mean that they would be successfully hedged against a currency fluctuation up to
(2,000,000/1,314,485) = $1.5215 and any fluctuation to $1.5433 would mean a gain to them, while a fluctuation below the $1.5215 would mean a loss to them.
In that view if the pound gained in value to $1.5433, where they would have to pay (2,000,000/1.5433) = £1,295,924, then the gain would be (£1,314,485 – 1295924) = £18,561 and that is the amount they would pay less compared to no hedge.
FX Forward hedge
The most definite method for hedging forex exchange risk tend to be a forward contract that helps exporters to make sales at a set foreign currency amount at an exchange rate that is pre-agreed having a delivery date that ranges from 3 days to 1 year in future. Therefore, when making use of forward contracts in order to hedge forex exchange risk, the US exporters tend to be advised to be able to pick the forward dates of delivery conservatively. If foreign currency get collected sooner, the exporter may hold to it till when the date of delivery reaches or may “swap” the older Forex contract for that which is new having even a new date of delivery at the most least cost. It should be noted there is no any charges or fees for the forward contacts because the lenders does hope to create a spread through buying at a certain price as well as selling to somebody at a price that is higher. In that respect, the business would have an option of offering to deliver the $2m at the current spot rate and would not change the rate even with an appreciation of depreciation of the pound. In an event of a pound gain, the business would lose an equivalent of the value between the new rate and the spot rate. However, in an event that the pound would lose value against the dollar, they would gain as they would pay a less amount by that difference (Alayannis and Ofek, 2001).
If the Outdoors offered to buy the pound at the current spot rate of $1.5352 they would eventually have to pay (2,000,000/1.5352) = £1,302,761
However, if the pound gained instead meaning the dollar lost the value to $1.5433, then it means they would have paid (2,000,000/1.5433) = £1,295,924 without the hedge
That means that had they not hedged they would have paid (1,302,761-1,295,924) = £6,837 less, hence the hedge was not effective.
FX Options hedge
If a serious doubt concerning whether sale of a foreign currency shall actually be collected and completed by any precise date, a forex option can be worth a consideration. Under a forex option, exporter or option holder earns the right, but not obligation, to make delivery of an agreed foreign currency amount to a lender in the dollar’s exchange at a rate that is specified before or on the date of expiry of options. Contrary to the forward contract, the FX options tend to have an explicit charge that is alike to the premium that is paid for any insurance policy. In case the foreign currency value goes up significantly, exporters may sell option back into a lender or even simply let the expiry by foreign currency selling on market spot for dollars that are more than the originally expected, though the fee could be forfeited. Whereas forex options option hedge offers a high flexibility degree, they may significantly be more expensive than forex forward hedges (Wong, 2003).
Given the spot exchange rate of $1.5433/£1 in 6 months
2,000,000 = £1,295,954
1.5433
£1,295,954 = 21 contracts
£62,500
Premium (0.0427 x 62,500) x 21 = 2,668.75x 21 = £56,043.75
In six months spot rate @ 1.5433
Hedge position 21 x £62,500 = £1, 312, 500
Therefore 1.54 x £1,312,500 = $2,021,250
Balancing $US: $2,000,000-$2,021,250-$56,043= (77,293)
77,293 = (£50,190)
1.54
Overall hedge position
£1,312,500-£50,190 = £1,262,310
If Outdoors didn’t hedge
2,000,000 = £1,298,701
1.54
In this case the hedge was successful given that Outdoors ltd would have paid £36,391 more if they had not hedged.
Conclusion
In view of the analysis, businesses operating in foreign markets are subject to various risks than need to be managed. Those include the market risks as well as the risks related to the foreign exchange fluctuations. In that respect, recommendations have been made on various ways of addressing the risks. Regarding the evaluation of the hedging techniques and given that the dollar value changes to the $1.5433/£1, which indicates that the pound would have gained, the business would be better off with the option hedge as it would help them pay much less even compared to the swap hedge while a forward hedge would involve a loss.
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