This study reflects all the internal and external factors which company consider while determining while raising funds from external and external funds. Finance is important aspect for the economic growth of world. An organization typically goes from 5 stages in its life cycle such as start- up business, growth stage, maturity stage, decline stage and closing stage. Each and every stage of business requires high amount of capital for the effective running of set functions in business.
Purpose
Every organization use different source of finance at different stage of its business. In this report an adamantine study has been made to evaluate the financial resources available to organizations. Organization is comprised of several set of activities in which various functions are performed. It is observed that each and every organization needs capital requirement for the smooth running of their business.
Scope
There are several options which could be used by organizations for making arrangement of finance for its operating and capital expenditure such as internal funding and external funding. This study provides how company could use various internal and external sources of funds to reduce the cost of capital.
Methodology
In this study, various articles and finance books have been used to identify the number of external and internal sources of finance available for the company. However, these secondary sources are used to identify which sources of funding would be most suitable for the raising finance for company.
These are the sources of finance which helps organizations to raise funds for their business functioning. Ideally this type of funding is useful when company has strong brand image in market.
It is the most common step which is used by organizations having good brand image in market. Ideally, there are two options to raise capital from the market by issue of share such as initial public offering and further public offering. (Black and Gilson, 1998).However, only listed companies could issue shares in market at a certain level of price and it depends on the profit of the company and the ongoing market value of company. Therefore, amount of capital which could be raised by company from the market is based on company market value and company prospectus (Beck, 2016).
Advantages
The main advantage of issues of shares in market is that company could raise capital from the market without any obligation to pay any amount to its shareholders. In case of issue of shares in market, company is not bound to make payment to its shareholders or return back their share capital unless otherwise provided. For instance, if company wants to raise capital of USD $ 1, 00, 00,000 then it could raise by issues of FPO (Further public offer) (Roth, 2017). This method is useful to raise big amount of capital from the market.
Disadvantage
In comparison to other sources of finance it carries higher floatation expenses of brokerage and underwriting commission. However, the issuing expenses, brokerage and commission increase the overall costing of raising funds from the market. However, issues of shares in market are accompanied with cumbersome process in which organization has to comply with various applicable rules, regulations and legal formalities. In addition to this, if shares are issued in market then it will change the debt capital structure and result to destruction of optimum capital structure and increase the overall cost of capital. It is evaluated that fi company could not maintain equilibrium between debt and equity capital then it will increase the sustainability risk.
Debentures and bonds are the scriptures which are issued by organizations to its debentures holders and secured by physical assistance. These bonds are issued to bondholders as a promise to pay certain amount of money after a stipulated period of time. However, companies should evaluate its financial position and financial risk before issuing bonds and debentures to debenture holders. Interest payment and other amounts given to bond holders are charged against profit. It could be described with example, if company A issues debentures in market and find itself in hard position to pay off its debts and interest amount. In this case these debenture holders have right to fetch the company in winding up procedure. Therefore, before issuing debentures into market, company should gauge its financial risk and profit earning capacity in determined approach. Nonetheless, company should evaluate the cost of capital which could be in its weighted average cost of capital and determine whether issue of debts in market will result into lower down the cost of capital or not (Jansen, 2016).
Advantage
It is evaluated that if company issues debentures and bonds in market then it would not dilute the control of the existing shareholders of company. In addition to this, interest amount paid to debenture holders for their money is also considered low as compared to return available to shareholders.
Disadvantage
The main disadvantage of this source of finance is related to the sustainability of organizations in long run. For instance, if company fails to pay interest amount or due to its debenture holders then these debenture holders may take company in liquidation. It will pose high financial leverage on the company’s business functioning.
Preferences share are the shares which are issued by the company to provide certain preferences right to their shareholders. However, in case liquidation or winding up of company, these shareholders could ask for their invested money and dividend amount and other dues before money given to shareholders. Furthermore, if company has declared dividend in its general meeting then it needs to make pay its declared dividend within the given time manner.
Advantage
All the preference shares holders are given priority to take their dues before amount paid to equity shareholders.
Disadvantage
These preference shareholders are not allowed to vote in general meeting unless otherwise provided.
Banks and financial institutions are always ready to give loans to its clients either for short term or long term. Banks and financial institutions provide loans to company by creating charge on company’s assets. Ideally, Banks and financial institutions Analysis Company’s financial statement and its position in market before granting loan. There is another loan which is called term loan. This loan is given by Banks to companies for small period of time at high interest rate (Hanssens, Deloof and Vanacker, 2015). Banks also provides overdraft facility to companies which are used by company to raise short term funds. Overdraft facility is provided as facility or short term availability of funds to organizations when they are lacking with certain amount of payment. Banks and financial institutions charges interest amount on this facility (Knack and Xu, 2017). It could be defined with practical example that if Company A wants to raise capital from market then it could apply in commercial banks and other private lenders who provide money on the certain % of interest. However, the interest amount charged by these commercial banks is comparatively high and rate varied as per client credit rating in market. In addition to this, there is another option which is loan guarantee program. In this program, companies are given loans by banks and financial institutions on the basis of application supported by blocked amount. With the help of this funding companies places orders to buy products and other services from the market and payment amount will be supported by blocked amount in commercial bank (Pinto and Reis, 2017).
Advantages
If company raises funds as loan from the Banks then the interest paid on this loan amount would be tax deductible (Barton and Wiseman, 2014). In addition to this, there will be no dilutions of ownership control as lenders are not given any right to perform. It could be explained by simple example that if company raises money from banks and financial institutions then it would highly influence weighted average cost of capital and would decrease the overall cost of capital. Therefore, it could be inferred that if company wants to keep its average cost of capital minimum then it should be more inclined towards raising funds from banks and financial institutions (Turner, 2014).
Disadvantages
There will be creation of charge on the assets and if company fails to pay its due then these Banks and financial institutions would take company in winding up. However, if company raises funds from banks and financial institutions then it would increase the financial leverage and risk associated with it (Nizam and Hoshino, 2016). The cost associated with overdraft and other facilities of banks are very high which simultaneous increase overall cost of capital of company. If company fails to repay its debts then company could go in liquidation or winding up procedure (Nirajini and Priya, 2013).
The factoring of debt is process in which companies sell of its debtors to certain debt factoring companies at discounted amount. This is the easiest way to convert assets into cash. However, company should not provide high amount of discount to factoring company otherwise it would influence weighted average cost of capital and increase its average cost in determined approach (Zattoni, and Judge, 2012). Another one is related to letter of credit which is used to raise funds from commercialized activities. It is the most common funding for organization which works same like credit card to individuals. In this process company, takes loans from banks and financial institutions at present rate at any time without seeking loan approval each time. For instance, if a company takes a loan of $ 20, 00,000 at a rate of 8% and compensating requirement to pay off its debt is $ 15, 00,000. It provides that effective rate of borrowing amount would be 20, 00,000*8%/15, 00,000= 10.62 (Hirschey, 2008).
Advantages
It helps company to reduce the overall capital involved in value chain activities of organizations.
Disadvantages
It is costly process and increase the overall cost of productions.
There are following factors which influence the type of funding employed by listed company
Consistency- It is evaluated that company has to identify consistency of funds available for the organization (Routledge, Sargeant ,Jay, 2014).
Cost of capital- It is the biggest important factor for choosing the amount of funds for the organization. It provides how much money company has to leave for deploying investors funds in organization.
Life cycle of raised funds- Company measures the life cycle of funds and for how many times funds would be available for the organization such as lock in period and availability of funds.
Nature of source of capital- It is analyzed that company has to identify that once capital is raised from issue of shares then there is no requirement to pay off back until and unless company goes in liquidation (Arora, 2013).
Legal issues- These are the legal compliance issues. At the time of raising funds from banks and financial institutions, companies have to create charge against its assets. They have to register their charge with authorized agencies. This process is accompanied with long legal process. Therefore, companies have to take into consideration of all the legal factors before raising funds from the market (Frank and Shen, 2016)
Company should go for mix source of finance for raising capital from the market. It is evaluated that if company would take half money from issue of shares and half money from issue of debentures then it would reduce the cost of capital and will also help company to manage its financial risk in effective manner. For instance, if company A wants to raise $ 5 million then it should issue shares and debentures by calculating WACC methods. It would assist company to reduce its cost of capital and increase the efficiency of company (Minsky, 2015).
Weighted average cost of capital
It is evaluated that if company wants to raise finance from the market then in this case overall cost of capital should minimum (Brigham and Ehrhardt, 2016).There are mainly three source of finance available for company such as debt, common stock and preferred stocks. Weighted average cost of capital could be defined as cost of financing company’s assets which is estimated by multiplying each component weight by the component cost and summing up the products. It helps organizations to maximize its return. It is minimum acceptable rate of return that a company should earn on its investments for creating value of its invested amount. Weighted average cost of capital helps company to prepare its optimal capital structure. In this weighted average cost of capital, company could manage its resource in effective manner. There are following factors such as cost of debts, cost of equity, and cost related with retained earnings (Platon, Frone and Constantinescu, 2014).
This critical evaluation of weighted average cost of capital has been done to identify the best suitable sources of finance. There are several times when companies have to suffer from high gearing problems such as tax exhaustion, security issues and increment of cost of capital. Weighted average cost of capital could be defined by an example that a company wants to refinance its business assets by taking out single mortgage and paying off all other subprime and prime mortgage. There is example given as below (Minnis and Sutherland, 2017). The below given example would help in determining the methods to reduce the overall cost of capital by considering Weighted average cost of capital in raising finance.
Company takes loan of $ 2, 00,000 from American express, 3, 00,000 loan form considerate bank and then third loan is taken from commercial bank. Therefore in this Weighted average cost of capital would be computed as below (Cholakova and Clarysse, 2015).
|
Bank’s name |
American express |
$ 2, 00,000 |
7.5% |
|
Bank’s name |
Considerate bank |
$ 3, 00,000 |
8.5% |
|
Bank’s name |
Commercial bank |
$ 5, 00,000 |
9.5% |
Company’s weighted average cost of capital computation has been made as below (Minsky, 2015).
Portion of loan taken * Rate assigned to each loan by banks
è(2, 00,000/10, 00,000)*.20+ (3, 00,000/10, 00,000) *30+ (5,00,000/10,00,000)*.50
è 7.5*.20+ 8.5*.30+ 9.5*.5
è 1.5+ 2.55+4.75
è 8.80
Company’s average cost of financing for its resources is 7.825%. Any rate below 7.825% would be beneficial.
In order to determine the Weighted average cost of capital companies have to compute following things such as the relative weights of their loans cost of debts, preferred stocks and shareholders cost. It is evaluated that weighted average cost of capital provides a clear view point about the overall cost of capital of company. It could be classified with a simple example. Capital structure of three identical firms
It is clear to understand that if company does not maintain proper capital structure then it may result to increased financial risk in the company. For instance, if company is having 80% debt and 20% share capital in its capital structure then it would result to high financial risk. In this case, if company wants to raise funds from market then it should do it by issue of share capital to maintain optimum capital structure.
This will provide the capital structure of company which is used by company to finance its business functioning. Let’s just suppose if company has raised capital by issuing debts or loans from banks and financial institutions then in this case company would have to face high financial leverage in their business functioning. This level of financial leverage aroused due to high amount of debt portion in company’s capital structure. In addition to this, weighted average cost of capital assist organizations to evaluate the perfect capital mix which provides idea about how company could reduce its overall cost of capital in its business.
These There companies require $ 70, 00,000 for financing their new projects’
|
Particular |
Company A |
Company B |
Company C |
Cost of capital |
|
Amount of capital required |
USD$ 70,00,000 |
USD$ 70,00,000 |
USD$ 70,00,000 |
USD$ 70,00,000 |
|
Issues Of debts |
60% =42,00,000 |
40% =28,00,000 |
70% =49,00,000 |
10% |
|
Issues of share |
30%=21,00,000 |
40%=28,00,000 |
20%=14,00,000 |
12% |
|
Other sources |
10%=7,00,000 |
20%=14,00,000 |
10%=7,00,000 |
10% |
In this case as per the WACC, company would have 8.94%
In this case as per WACC, Company would have 8.94% Optimum level of capital structure helps company to reduce overall cost of capital. It is the minimum cost of capital which company could have if it issues share capital in market.
Total cost of capital for Company A= 4, 20,000+3,60,000+70,0000=9,50,000
Total cost of capital for Company A= 2, 80,000+3,36,000+1,68,000= 7840000
Total cost of capital for Company A= 4, 90,000+1,68,000+70,0000=728000
Therefore, it could be said that Company A has minimum level of cost of capital and optimum capital structure.
Weighted average cost of capital assist in gauging the weight of each financial component and divide these entire rate as per its assigned weight in organization. It provides accurate overall cost of capital of company and helps company to determine the minimum level of return which is need to be earned for creating value on its assets. In addition to this, WACC also provides views which reflect how company could reduce its overall cost of capital. It is evaluated that if a company has 80% funding from equity share and its own funding then as per WACC Company should go for debt funding. It is analyzed that amount of interest and other expenses on debts are tax deductible amount which would help organizations to save tax on its profit. In addition to this, interest rate charged on debts portion by companies are also lower as compare to other options. This WACC provides weight to debts portion according to its market value. Eventually, company reduces its overall cost of capital by using WACC method in cost computation. Long term funds could be raised through banks loans, issues of shares, debentures or letter of credit from commercial banks. WACC takes all these sources of finance into consideration for better managing the resources of organization and determining the overall cost of capital of organization. It also provides that if company raises funds at higher rate from the market then it would eventually increase the overall cost of capital of organizations. In addition to this, financial management should evaluate WACC before raising funds from the market. The true advantage of WACC in the business functioning of organization could be described with the given example (Davis and Davis, 2011).
Suppose that lenders who are providing money to organization requires 10% return on money they have lent to firm and assume that shareholders requires 20% return on their investment in order to retain holding in the same firm. By calculating average rate of return, projected funded form the company’s pool of money will have to return 15% to satisfy debts and equity share holders. This 15% is WACC of company. It assists organizations to choose right amount of long term funding.
There are several sources which could be used in this report to reflect various aspects of financial aspects while raising capital from the market. However, with the limitation of words and other details, only relevant and summarized form of this work has been given. There are several other options which are considered by listed company to raise funds from external sources such as use of factoring of debts and letter of credit but the best suitable course of actions depends upon the nature and working of company.
Conclusion
Company should go for mix source of finance for raising capital from the market. It is evaluated that if company would take half money from issue of shares and half money from issue of debentures then it would reduce the cost of capital and will also help company to manage its financial risk in effective manner. Now in the end, it would be inferred that each and every organizations needs to take care internal and external factors while raising fund from market.
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