Performance Evaluating, Research Paper Example

Acme is multinational enterprise and its funding would be intricate, demanding and exhausting. Abroad Acme is exploring funding opportunities from Greenfield. There is variety of methods to attain capital funding. Acme is considering external sources for instance, growth capital equity, bank loans, lines of credit and mortgages. This paper will focus on debentures, lines of credit, long term loans and short term loans.

Capital structure

“Capital structure is the mixture of long term debt and equity that is used to finance the firm’s productive assets. Debt is a contractual arrangement between the firm and the debt holders that includes the principal, relevant interest and maturation date. Equity defines ownership where the holder has certain rights to the overall direction of the firm and the disposition of residual assets at the dissolution of the firm” (Swanson, et. al., 2003).

“Company’s optimum capital structure is the combination of debt and equity than reduces the firm’s weighted average cost of capital (WACC)” (Swanson, et. al., 2003. For many corporations, the after tax debt cost is less than the equity, so they use debt mostly.

Company’s tax liability decreased by debt because interest payments are deductible expenses, growing debt increase the equity cost and interest rate on debt due to the growing chances of bankruptcy. On the other hand it is obvious that rising debt means high risk for the company and risk reflected on different kinds of capital cost of the company. “Therefore, it is obvious that the relation of financial leverage and WACC stays U-shaped not straight line with a minimum of WACC between the extremes of debt utilization” (Kosi, et. al., 2011).

Apart from the risk allied with a firm’s primary operations known as operating risk. By the use of financial instruments, risks can be introduced which is commonly known as debt. The benefit of debt is lower cost but no profits. The limitation is the increase of financial risk.

Since, Acme has 500 million dollars to invest, so it has two options to finance. There are two capital funding components of the company: debt and equity. Capital invested by lenders and equity holders, they expect return on it. The expected return of shareholders, equity owners and debt holders is the cost of capital. In other words, WACC means investors’ opportunity cost by taking the risk of investing money in the company.

Various Options of raising finances

Issue of Equity Shares

“Equity shares of a company’s common stock are financial claims issued by the firm, which confer ownership rights on the holders. A share of stock represents the fundamental unit of ownership of a corporation, and all firms have at least one shareholder. Every shareholder is a part owner of the company. A shareholder’s stake in the firm is equal to the fraction of the total share capital of the firm to which he has subscribed” (Parameswaran, 2007). There are different ways to raise equity, by private placement and public.

Equity shares features

In the event of liquidation, equity shareholders are the last claimants to assets of the firm in the event of liquidation. After meeting all the obligation, if there is not sufficient income left then equity shareholders cannot receive any return.

Advantages of Equity shares

The following are the important advantages of equity shares:

Equity shares do not cause any economic burden on the resources of the company. Equity share capital is a form of permanent long term sources capital. Hence, the liability of repayment does not arise. The company can mobilize long term capital through equity shares without creating any charge on the assets of the company. Equity shareholders are the real owners of the company. They possess all the voting rights to participate in the affairs of the company. Equity share capital enhances the credit worthiness of the company.

Disadvantages of equity shares

Difficulty in trading on equity exists as the entire capital structure is composed of equity shares. Compared with preference shares or debentures, issuing of equity shares is highly expensive. Compared with preference shares or debentures issuing of equity shares is highly expensive. Rights issue may lead to concentration of control of the company in hands of a few persons. Higher dividends on equity shares during the period of boom results in appreciation of the value of shares which leads to ample speculation and equity shareholders have a residual claim to income as well as assets. Because of the un-assured return on the equity shares, the investors do not want to invest on equity shares.

Bonds

For raising capital, bonds are the important instruments issued for a period of more than one year. Different organizations, for instance central or state government, corporations sell bonds. Bonds can be defined as a promise of repayment the principal along with fixed rate of interest on a specified date which is called the maturity date.

Advantages and disadvantages are following:

Bonds are less costly. There is no ownership deletion, payment of interest is fixed. It also reduces real obligation. There are also some disadvantages, for instance obligation of payment, financial risks, and outflow cash and covenants restriction.

Debentures

The term Debentures is derived from the Latin word debars meaning to owe. A debenture is an instrument of acknowledgement of debt under the common seal of the company. Debentures and bonds are called as creditor ship securities. Debentures are one of the frequently used methods, issued by the company to procure long term funds to meet the requirement of a company’s initial needs, growth and modernization.

A debenture may be defined broadly as “an instrument in writing, issued by a company under its seal and acknowledging a debt for a certain sum of money, and giving an undertaking to repay that sum on or after a fixed future date and meanwhile to pay interest thereon, at a certain rate per annum of stated intervals” (Buccierei, et. al., 2011).

“Debentures do not form a part of the share capital, but are generally referred to as loan capital. Usually debenture provides for a charge on the company’s asset” (Esteves, et. al., 2011). Debenture holders are entitled to receive interest at an agreed rate periodically. They are entitled to redemption of their principal amount at the expiry of a definite period. Debenture holders also have priority over preference shareholders and equity shareholders in respect of their claim on assets at the time of winding up of a company.

Advantages

The company is able to raise a part of long term finance without giving any control of ownership and management of the firm. Interest paid on debenture is generally lower than the rate of dividend payable on preference and equity shares. Hence, capital is mobilized through debentures at relatively lesser cost. Flexibility in the capital structure is possible when debentures are issued on redeemable basis.

The company has the scope for trading on their equity. In this way, equity shareholders are able to enhance their total earnings from the company. Interest paid on debentures is deductible income in computing total taxable income because it is charged on income of the company. Debentures holders are entitled to claim on the assets of the company in order of top priority at the time of liquidation. Debentures have a great market response during depression, thus, the company can easily dispose of the debentures in the open marke3.

Disadvantages

“It becomes a permanent burden to the company, because interest has to be paid to the debenture holders regularly, whether the company earns profit or incurs loss” (Manian, et. al., 2011). Debenture financing increases the cost of capital because of heavy stamp duty, duty on transfer, commission and brokerage, etc. it becomes difficult in repayment of debenture capital during depression. From the company’s point of view, financing of debentures increases the financial risk, since interest on debenture is fully taxable on company’s income.

Recommendation

Our recommendation for the company should be our desire equity structure which supposes to be balance between the cost of capital and financial risk of the business. So our recommendation would be 1:1 ratio for debt and equity. The company can issue 250 million dollars in equity and rest can be issued through issuance of bonds.

References

Swanson, Z.; Srinidhi, B. N.; Seetharaman, A., (2003), The capital structure paradigm: evolution of debt/equity choices. Retrieved from http://books.google.com/books?id=U0ZWrqKLPG8C&lpg=PP1&dq=capital%20structure&pg=PP1#v=onepage&q&f=false

Parameswaran, S., (2007), Equity Shares. Retrieved from http://books.google.com/books?id=4BqefaE7_UkC&lpg=PP1&dq=Equity%20Shares&pg=PP1#v=onepage&q&f=false

Kósi, k., & harazin, p. (2011). Evaluating intellectual and environmental capital — the whats and hows — performance evaluation in the information era. International journal of management cases, 13(4), 233-241.

Buccierei, K. M., Brown, R., & Malta, S. (2011). Evaluating the performance of the academic coordinator/director of clinical education: tools to solicit input from program directors, academic faculty, and students. Journal Of Physical Therapy Education, 25(2), 26-35.

Esteves, A., & Barclay, M. (2011). New Approaches to Evaluating the Performance of Corporate-Community Partnerships: A Case Study from the Minerals Sector. Journal Of Business Ethics, 103(2), 189-202. doi:10.1007/s10551-011-0860-7

Manian, A., Reza Fathi, M., Karimi Zarchi, M., & Omidian, A. (2011). Performance Evaluating of IT Department Using a Modified Fuzzy TOPSIS and BSC Methodology. Journal Of Management Research, 3(2), 1-20. doi:10.5296/jmr.v3i2.640