Raising Capital Cost Of Issuing Securities

Table of Contents

Section-1: Aims & Objectives
1.1. Background Context
1.2. Problem Statement
1.3. Research Aim
1.4. Research Objective
1.5. Summary

Section-2: Literature Review
2.1. Capital Structure
2.1.1. Trade-off Theory
2.1.2. Static Trade-off Theory
2.1.3. The dynamic Trade-off theory
2.1.4. Agency Theory
2.1.5. The Pecking Order Theory
2.1.6. The Marketing timing theory
2.1.7. Modigliani-Miller Theory
2.2. Equity Securities
2.2.1. Ordinary Shares
a) Advantages
b) Disadvantages
2.2.2. Preference Shares
a) Advantages
b) Disadvantages
2.3. Debt Securities
2.3.1. Debentures
a) Advantages
b) Disadvantages
2.4. Asset-Backed Securities (ABS)
2.4.1. Securitisation
a) Advantages
b) Disadvantages
2.5. Summary

Section-3: Case Studies, Analysis & Discussion
3.1. Case Studies
3.1.1. Case Study on Equity Security
3.1.1.1. Company Profile
3.1.1.2. Raising of Capital from Ordinary Shares
3.1.1.3. Findings
3.1.2. Case Study on Debt Security
3.1.2.1. Company Profile
3.1.2.2. Raising of Capital from Ordinary Debentures
3.1.2.3. Findings
3.1.3. Case Study on Asset-Backed Securities (ABS)
3.1.3.1. Company Profile
3.1.3.2. Raising of Capital from Securitisation
3.1.3.3. Findings
3.2. Analysis
3.3. Discussion
3.4. Summary

Section-4: Conclusion & Recommendations
4.1. Conclusion
4.2. Recommendations

Section-5: References

Executive Summary

The central focus of this research project is to guide the relatively medium sized car dealership company towards making decision on the appropriate security financing option so that it would permit the given company to expand its operation while minimises its cost and maximises its profitability. In general there are three types of security financing (Equity Securities, Debt Securities and Asset-Backed Securities). Security Financing is also considers being a good financing source which involves the issuance of securities either in the stock market or in the capital market. In general, the companies’ financial decision subject to the composition of its Capital Structure. The Capital Structure is made up of two factors: debt & equity. The trade-off theory was originated out of debate over the Modigiliani Miller theorem. The term trade-off theories was been used by different authors to state different group or similar related theories. The static trade-off theory confirms that the firm has perfect capital structure which they gain by trading off cost from the benefits of the use of equity and debt. The dynamic trade-off theory relates to the role of profit, role of retained earnings and path dependence. The concept of agency theory is emphasised more on the approach of concentrating on the nature of relationship existing between the company’s shareholders (Principal) and their managers (Agents). Pecking order theory stressed that the company should first prefer to use internally generated income for the purpose of raising as it would restrict the company to expose itself towards financial leverage. The marketing timing theory state that firm value their equity in the way that when the stock price is perceived to be overvalued then they issue new stock and gain their share back. After the careful analysis of all possible options, it seemed better for the medium sized Car Dealership Company to go for option of debt security instrument known as Debentures for the purpose of pursuing expansion.

Section-1: Aims & Objectives

1.1. Background Context

In actual term, the security financing is considered as the way of financing through which a company could permit itself to expand its existing operation. For this purpose companies can have both options either to issue these securities in the stock exchange or to go for initial public offering. But before considering this option of raising funds through this source the underlying company must has to make decision regarding the following aspects: i) the amount of capital company wanted to raise, 2) how much would be the time period, 3) deciding over the pattern of offering and 4) either to go for equity, debt or asset-backed securities. In general, the company’s competency to make decision on these points enables them towards the making right financial decision. The central focus of this research project is to guide the relatively medium sized car dealership company towards making decision on the appropriate security financing option so that it would permit the given company to expand its operation while minimises its cost and maximises its profitability.

In general there are three types of security financing (Equity Securities, Debt Securities and Asset-Backed Securities). The option of equity securities would only be availed by listed companies. In this regard, there are two most commonly used instruments: Ordinary Shares and Preference Shares. It is considered to be convenient way for listed company to raise capital and experiencing the expansion and growth process. It has been observed that in the result of such funding, the company is entitled to make payment of dividends to the lenders of the fund as a reward and also these lenders would have given the rights of taking part in company’s decision making process as they also authorised for the voting rights. The second course of securities is debt securities which could be raised in stock exchange or through the Initial Public Offering (IPO). On these securities’ issuance, the issuing company must have to make interest payment along with the principal amount in the specified time period. In this regard, Debenture is the prominent instrument which is usually issue by the company for raising funds for the longer time period. This security cost less than the other securities but it is considered to be a riskier source from the lender point of view as it is only backed by the credibility of the firm. The company has to expose itself to the solvency risk with the use of this security. The last set of securities is named as Asset-Backed Securities. The issuance of these securities obliges the company to secure these securities against the receivable portfolio or against its revenue producing assets. Normally these securities are raised by the companies that have poor credit rating and thus facing difficulty in raising cash at short hand.

1.2. Problem Statement

Business expansion has been perceived to be as the process which usually undergone by the companies in quest of increasing their profitability and turnover. But this process is directly linked with the companies’ financial aspect. So it means that in order to consider such option the specified company must have to make financial decision and on the basis of which its future prospect would be decided. In the current era of knowledge economy, the companies have multiple options to choose from it so it means that the companies usually evaluate all of these options mainly on the base of two perspectives: Cost of Capital & Time Period.

Security Financing is also considers being a good financing source which involves the issuance of securities either in the stock market or in the capital market. In regard to the given case study, it has been determined that the medium sized car dealer is considering to expand its operation so in the given consequences what are the different security financing options are available to given company and which typical option is best for the company in order to minimise its cost or maximise its profitability (or turnover).

1.3. Research Aim

The ultimate aim of this study is to signify the role of security of financing in relation to the car deal’s potential expansion and also is to realise the signifies the importance of financing decision especially when it comes to raise capital from the external source which could also raise question mark on the sustainability of company’s existing management.

1.4. Research Objective

The major objective of this research report is to explore the importance of security financing in accordance with the process capital acquisition and company’s expansion. And also is to determine the which particular option is best fit with the company’s approach of minimising its cost of capital and maximising its profitability which then would be resulted in shareholders’ wealth maximisation which is believe to be a main objective of corporate finance manager. Additionally, other objectives of this report are listed below:

- To identify that what sort of aspect which the underlying company (non financial company) consider when it comes to make decision regarding the business expansion.
- To learn about the different modes of security financing and evaluate its impact on the company’s financial aspects: cost of capital and profitability.
- To make final decision about the concern that which particular form of security financing instrument assist the company to successful pursue the expansion process while keeping its cost of capital at lowest possible and its profitability as higher as it is possible.

1.5. Summary

The central focus of this research project is to guide the relatively medium sized car dealership company towards making decision on the appropriate security financing option so that it would permit the given company to expand its operation while minimises its cost and maximises its profitability. In general there are three types of security financing (Equity Securities, Debt Securities and Asset-Backed Securities). Security Financing is also considers being a good financing source which involves the issuance of securities either in the stock market or in the capital market. In regard to the given case study, it has been determined that the medium sized car dealer is considering to expand its operation so in the given consequences what are the different security financing options are available to given company and which typical option is best for the company in order to minimise its cost or maximise its profitability (or turnover).

The major objective of this research report is to explore the importance of security financing in accordance with the process capital acquisition and company’s expansion. And also is to determine the which particular option is best fit with the company’s approach of minimising its cost of capital and maximising its profitability which then would be resulted in shareholders’ wealth maximisation which is believe to be a main objective of corporate finance manager.

Section-2: Literature Review

2.1. Capital Structure

In general, the companies’ financial decision subject to the composition of its Capital Structure. The Capital Structure is made up of two factors: debt & equity. This theoretical concept is helpful for the financial analysts and outside investors to observe the company’s existing leverage and also for examining the company’s approach in regard to employ outside investment in the company’s fund in order to expand its operation for the purpose of attaining potential growth and also to maximise its shareholders’ wealth which is determined to be a major task of financial manager. The theories which are directly related with this concept are briefly discussed thereafter.

2.1.1. Trade-off Theory

The original version of theory was originated out of debate over the Modigiliani Miller theorem. The term trade-off theories was been used by different authors to state different group or similar related theories. All of these theories the decision maker has the ultimate power to take decision. He decides or evaluates the various cost inquired for different plans. By use of these theories we get the interior solution which balances the marginal cost and the marginal benefits. The original version these theories exploit the firm and the business the gain earned from the tax. And have created a shield to serve from earning shares. It saved them from the financial distress and bankruptcy. The firm and business opt for debt capital other than equity because it shields protection as the tax is calculated after deducting the interest given for debts so the firm’s better option is the debts. The Haugen & Senbet (1978) provide important discussion about the bankruptcy cost. The tax code makes it more complicated than the assumed theories (Haugen & Senbet, 1978)

A popular defense has been argued as follows “while the Modigiliani- Miller does not provide a realistic description of how firms finance their operations, it provides a means of finding reason why financing may matter” this quote describes the interpretation about how much of the theory of cooperation related.

Has the author mention different type of similar theories in a group. From this different the theories we can conclude that interiors are solved by keeping the marginal benefit. This helps the companies to earn cent percent on debt financing

Second the tax code is much more beneficial and complex than the theory mentioned earlier. Graham (2003) gives a better insight on these factors and a substantial theory on the literature review (Graham, 2006).

2.1.2. Static Trade-off Theory

The static trade-off theories confirm that the firm has perfect capital structure which they gain by trading off cost from the benefits of the use of equity and debt. The tax shield is the advantage of using the debts. And there is also disadvantage for using the debts. The disadvantage is that the cost of potential finance is high when the firm depends more on the debts (Hirshleifer, 1966). But there is other cost and benefits come up when the firm use the debts and equity. A lot of cost turn up when the company dealing with the debt and equity. Then occurs when the company deal with the debt and equity are agency cost for debt and equity and cost varies when deal with different agency. The firm should adapt in a way that the firm can brings back the leverage ratio to optimum level. When the firm brings back the leverage ratio back the firm make the profit and functioning of the company will steady and achieving the aim or target of the company.

All the authors got inspire by the Modigliani-Miller theories. Al most the theories of capital structure originated from his theories. The Modigliani-miller thinks that every company has particular cash flow, when they decide to deal with the debt and equity or with their asset which divide the cash flow of the company to the investor. The firm and the investor get equal right to access the financial markets which gives homemade leverage (Stiglitz, 1988). In this case the firm or the investor can create any leverage but it is not necessary the investor should accept the firm leverage or the firm should accept the investor leverage. As result of this the leverage of the company won’t affect the market value of the firm.

There are two different type of capital structure irrelevance proportion. The classic arbitrage-based and the irrelevance proposition are the different types. The classic arbitrage –based irrelevance proposition in way that it provide the perfect setting in which the arbitrage by the investor keep the independent value of the firm. In the Modigliani-Miller paper there is an important content which include paper by Hirshleifer (1966) and Stiglitz (1988). The second irrelevance proposition says that firm has given an investment policy, in which the investment policy the firm chooses to follow will neither affect the current price of its share. As per the Modigliani-Miller the firm and debt are affected by the factors like profit, collateral and the growth opportunities. The theory makes it seem that it is not unlikely for the real business.

2.1.3. The dynamic Trade-off theory

The first dynamic model considers the tax saving bankruptcy cost trade off are Brennan & Schwartz (1984). Constructive model recognize the role of time and specify some factors which are ignored in the single model. Dynamic trade-off model can be used to consider the value differing leverage decision to coming period. Pierre, et al. (2001) observation states that the firm which has lower leverage have the option to increase the leverage nowadays (Pierre, et al., 2001). Under this assumption the option to increase the leverage in future will reduce the optimum level of leverage today. The dynamic Trade-off theory much recent and so the judgment made on this theories result somewhat like experimental. This theory relates to the role of profit, role of retained earnings and path dependence. Recently this model is becoming the relevant model to be trusted.

2.1.4. Agency Theory

This concept is emphasised more on the approach of concentrating on the nature of relationship existing between the company’s shareholders (Principal) and their managers (Agents). It has been discovered that the shareholders usually appoint managers for the purpose of performing day to day operations (Pratt & Zeckhauser, 1985). And on the other side the shareholders are only interested in getting the dividend payment on time and also to conduct their management performance evaluation activity at the end of every financial period. Shareholders are also conscious in term of bonuses paid to these management members (Holmstrom & Milgrom, 1991). In short, if they found something wrong at the monitoring time then it would direct the company towards the agency problem which could be ended as the firing of specified managers or resolved through the intervention of external auditors.

In regard to the acquiring funds from the external sources, there would be a chance that the agency could occur as it would make negative impact on the amount of dividend paid to the shareholders or it would increase the risk of transformation of wealth from the existing shareholders to the lenders of the funds (Holmstrom & Tirole, 1988). So, it meant that the management of the company is intended to make decision to raise capital from external sources after getting the green signal from their shareholders in order to keep the company away from the agency problem which could raise the company’s existing agency cost as well.

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