Managing Financial Resources and Decisions
This report is to propose an appropriate capital structure for Xpresso Delight Limted’s business expansion with the minimum amount of capital as US$ 30 million. In order to achieve that goal, firstly, it is going to identify the sources of finance available for the business as debt financing which include loans, debentures and bonds; and equity financing, which includes common shares, preference shares and retained profit.
It is also to discuss advantages & disadvantages of each source, as well as to assess the implications of these different sources related to risk, legal, financial and dilution of control and bankruptcy. Based on those analyses, it is to select the appropriate sources of finance for the project including retained profit, common and preference shares and loans. What’s more, the costs involved with each source will be assessed and compared in order to form the best alternative of capital structure.
There are three options of capital structure proposed:
50% debt financing; and 50% equity including
80% common share and 20% preference shares
25% debt financing; and 75% equity financing including 80% common shares and 20% preference shares
10% debt financing; and 90% equity financing including 80% common shares and 20% preference shares Besides, this report is also to mention and explain the importance of financial planning for Xpresso Limited.
Xpresso Delight Limited is a publicly listed company in Australia Stock Exchange with the headquarter is based in Hanoi, Vietnam. Xpresso Delight Limited is majority owned (51% stake) by Chief Executive Officer (CEO), Mr.
Nguyen Dong Khoa. The company has 30 cafes concentrated mainly in big cities in Vietnam like Hanoi, Ho Chi Minh City, Hai Phong, Da Nang, Can Tho and so on. With many advantages such as the growing affluence of coffee culture, the increasing expatriates population in Vietnam, and even the government’s pro-business policies; Xpresso limited believes that there is an immense market potential in the emerging Vietnam, which encourages it to embark on an ambitious plan of expanding, opening at least 20 cafes each year for the next five years in the various parts of the country.
The company issues two kinds of share including ordinary shares (par value US$ 1 per share), which are currently traded at US$ 2. 50 per share; and preference shares, which are currently traded at US$ 52 per share in Australia Stock Exchange. Its corporate tax rate is 25% at present but is expected to go down. With strong earnings growth projected at a constant 15% per annum in the future, Xpresso Delight Limited is expected to pay out US$ 0. 30 per share as ordinary dividend in the next financial year while a constant preference dividend is US$ 5 per share per year.
The average flotation cost for the new issue of ordinary shares and preference shares are 17% and 10% of the gross proceeds respectively. For new issue of ordinary shares and preference shares, Xpresso Delight Limited’s issue price will be set at their respective current market price as traded in the Australia Stock Exchange. Xpresso Delight Limited’s before-tax cost of debt is 15%. 4. MAIN BODY: 1. Available various sources of finance: In the case of Xpresso Limited, as a large company with stable profit growth looking for capital to expand, it is only necessary for long-term financing to be taken into account.
Therefore, there are two principal sources of finance available to Xpresso Limited including debt and equity financing. 4. 1. 1. Debt financing: In regards to debt financing, the simplest meaning is borrowing money on credit with a promise to repay the amount borrowed, plus interest18. There are many types of debt financing, including borrowing from banks in terms of loans; or borrowing from investors in terms of debentures, bonds. Loans: A loan is a financial transaction in which one party – the lender – agrees to give another party – the borrower an amount of money which must be paid back in full16.
With a good finance profile and the support of Vietnam government pro-business policies, it is easier for Xpresso Limited to borrow from commercial banks such as Vietcombank, VietinBank and so on. For example, the supportive interest rate of loans in Vietnam at present is fluctuating between 5 and 6 percent per year14, therefore if Xpresso Limited. borrows US$ 10,000, the interest it has to pay back will be between US$ 500 and US$ 600.
Debentures: It is a channel for Xpresso to mobilize capital from investors setting out the terms of loans, backed by its reputation but not collateral12.
Investors can be individuals, Vietnam and foreign financial institutions such as VinaCapital, BankInvest and so on; and even Vietnam commercial banks are the main investors in organizational debentures. Because of its high standing in the market, investors and other creditors are willing to purchase once Xpresso Limited issues debentures. As in the Vietnam present market , the common interest rate of debentures issued by enterprises is 12. 5 percent per year11, if Xpresso issues debentures of US$ 10 million for 5 years, it has to pay investors the total interest of US$ 6. 5 million.
Bonds: Bonds are large debts which are usually paid off over a period of 10 to 35 years1. Simply explaining, in bond financing, Xpresso mobilizes capital from investors instead of banks by selling bonds to them with a promise to pay back with interest, according to specified schedules8. As an example, if Xpresso issues bonds at an interest rate of 6%, the interest over 20 years would be about US$ 0. 73 for each dollar borrowed.
In terms of equity financing, equity capital generally is composed of funds that are raised by Xpresso in exchange for an ownership interest in the company17. Since it is owner’s equity, the company does not have to worry about any liability to repay interest or loans for other parties. There are two major sources of equity financing including issued share capital and retained profit & other reserves12. Issued share capital: Issued share capital is capital that is subscribed by shareholders when they purchase shares Xpresso Limited issues, including common and preference shares4.
Common shares are shares issued to the general public in the stock market, while preference shares are shares issued to some special people (for example, banks or specific institutions)
Retained profit & other reserves: Retained profit is simply profit that has been kept within Xpresso Limited rather than paid out to shareholders as dividends. Assessment of the implications of sources of finance to Xpresso Delight Limited related to risk, legal, financial and dilution of control and bankruptcy:
As being categorized in debt financing, those various types including loans, debentures and bonds have some implications to Xpresso in similarity, which are going to be discussed below. There are many advantages of Xpresso Limited for using debt financing. There is no dilution of control since the creditors have no authority in running the company but just involve in the money they invest; and they usually do not participate in the superior earnings of the company either as the cost of debts is limited 13. The most important advantage is tax relief on interest as it is considered one kind of expenses3.
For example, if Xpresso Limited borrows US$ 10,000 at the interest rate of 5%, it will have to pay the interest of US$ 500 but will be reduced US$ 500 in the tax-incurred income. What’s more, in time of inflation, debts may be paid back with “cheaper pesos”13 since the money becomes worth less. To the existing shareholders, one advantage is when Xpresso Limited unfortunately goes broke, they may lose their investment but other personal possessions are safe 2. However, using debt financing also has disadvantages. Obviously, debts add risk to the company12.
There is a risk of not having enough money to pay by the maturity date or if the earnings of Xpresso Limited fluctuate 12; either of which easily makes the company become bankruptcy. To add more, the legal of debt financing in Vietnam is relatively complicated 2, and certain managerial prerogatives are usually given up in the bond’s indenture contract (for example, specific ratios must be kept above a certain level during the term of the loan)13. Besides, debentures and bonds also have their own characteristics.
One advantage of using debenture financing is that Xpresso Limited does not have to give collateral9. However, it also has disadvantages as it must compete with government loan stocks (gilts), what are the dominant type of debentures in Vietnam market, so the company must generally offer a higher rate of interest than the one on gilts to attract investors4. The legal issue of debentures that Xpresso Limited has to concern is that if a bond defaults, investors are entitled to the liquidation proceeds of property bought with the money they invest (by purchasing debentures)
Bonds: Bonds have fixed interest and are issued for long-term1. One advantage of using bond is that substantial flexibility in the financial structure is enhanced by debt through the inclusion of call provisions in the bond indenture13. In case of financial distress, bondholders have greater claims of the issuer’s income than shareholders6.
Issued shares: The legal aspect involved is that shareholders are also owners of the company.
Therefore, the business ownership is diluted and it is possible to lose the control of the business for investors. However, there is also an advantage that there is large potential membership to provide capital and to share risks of loss, bankruptcy and so on. There is a part of profit of the company distributed to shareholders as dividends. One significant advantage of using issued share capital is that Xpresso may withhold the dividend if profits are insufficient. One disadvantage is that cash dividends are not tax deductible. 13) Besides, each type of shares also has its own characteristics.
Common shares: The advantages of using common shares are that common dividend is based on profits when so that Xpresso Limited is free from worrying about not having enough money to pay; there is no fixed maturity date for repayment of the capital; and the sale of common shares is frequently more attractive to investors than debts as its value grows with the success of the firm11. However, there are disadvantages as well. Shareholders ave right to vote, therefore the shareholders’ control and share in earnings are usually diluted13. If Xpresso decides to issue common shares, the stake of CEO (51% at present) will be reduced as the number of shares increases. In terms of finance, issuance of common shares requires higher underwriting costs; and the average cost of capital may increase above the optimal level when too much equity is issued13.
Preference shares: Legally, like common share, preference shares represent a part of ownership or equity of Xpresso Limited4.
What’s more, in case of financial distress, claims of preference shareholders must be satisfied before common shareholders receive anything13. There is no default risk since non-payment of dividends does not necessarily mean bankruptcy. Preference dividend is fixed so that the company can plan to pay. Preference shareholders have no voting rights except in case of financial distress, which means there is no dilution of control. Call features and provision of sinking may be included so Xpresso may replace the issue if interest rates decline.
There is one disadvantage that preference shares involve cumulative feature, which means in case Xpresso Limited does not have money to pay dividends in a particular year, the dividend keeps getting added to the next years’ dividend until the it is able to pay. (13)
Retained profit: There are advantages to using retained profit as a form of finance due to the absence of brokerage costs (for example, merchant banks’ fees), its simplicity and flexibility, and all gains from investment will still ultimately belong to existing shareholders13.
Besides, there are disadvantages as shareholders’ expectation of dividends may present a problem or insufficient earnings may be available
Selection of appropriate sources of finance for a business project & assessment and comparison for various cost involved for each sources:
Appropriate sources of finance: As discussed above, it is proposed that Xpresso Delight Limited should use equity financing in forms of retained profit, issued share capital and debt financing in forms of loans in the capital structure.
The main source that should be included is retained earning since it is the solidest source and has the least risk to the firm3. Issued shares and loans are the next choices as they bring many opportunities and a relatively reasonable number of risks as well as liabilities.
Costs of sources:
Retained profit: Costs of retained earnings include fixed expenses such as wages, rent, materials, electricity and so on; tax cost; dividends (dividends are a cost of retained earnings as well as a cost of share capital); certain costs if invested in the short term as not needed immediately; and also opportunity costs.
Issued shares: Costs of the issued share capital include flotation costs, dividends (cash dividend and scrip dividends- dividends in the form of new shares); cost of providing shareholders or owners with information about the performance of the business such as the cost of glossy financial reports, Annual General Meetings, audit fees and the administrative costs of company with legal and Stock Exchange requirements for disclosure of information to shareholders; and also certain costs associated with investing them if not needed immediately
Loans have interest as the main cost. The rate of interest may either be fixed or variable but in the case of Xpresso Limited it is fixed. There are also other costs including an initial arrangement fee to cover lender’s administrative costs on setting up the loan (checking references, setting up data on a computer system and so on); factors charge commission for advancing funds; non-financial costs involved in the relationship between the company and creditors (for example, Xpresso will be required to provide the creditor with regular information about the performance of the business)4.
That kind of non-financial cost may create the uncomfortable feeling of being watched for the owner. Opportunity cost is also included in this case as well. For instance, instead of paying interest of US$ 10,000 a year the business could do something else with that US$ 10,000 that might help generate income.
Options of capital structure: There are three alternative capital structures that could be taken into account. Based on the comparison between their advantages and disadvantages, the most appropriate structure would be chosen.
First structure: For the first structure, it is to use 50% debt financing; and 50% equity including 80% common share and 20% preference shares. That means US$ 15 million of debts, and US$ 15 million of equity including US$ 12 million of common shares and US$ 3 million of preference shares. The costs of sources are: Rf = US$ 0. 167 million Rc = US$ 1. 84 million Rd = US$ 1. 69 million The total cost is: 0. 167 + 1. 84 + 1. 69 = 3. 697 (US$ million) 4. 3. 3. 2. Second structure:
The second structure is to use 25% debt financing; and 75% equity financing including 80% common shares and 20% preference shares. That means US$ 7. 5 million of debts, US$ 22. 5 million of equity including US$ 18 million of common shares and US$ 4. 5 million of preference shares. The costs of sources are: Rf = US$ 0. 25 million Rc = US$ 2. 81 million Rd = US$ 0. 84 million The total cost is: 0. 25 + 2. 81 + 0. 84 = 3. 9 (US$ million)
Third structure: The third structure includes 10% debt financing; and 90% equity financing including 80% common shares and 20% preference shares.
That means US$ 3 million of debts, and US$ 27 million of equity including US$ 21. 6 million of common shares and US$ 5. 4 million of preference shares. The costs of sources are: Rf = US$ 0. 3 million Rc= US$ 3. 32 million Rd = US$ 0. 34 million The total cost is: 0. 3 + 3. 32 + 0. 34 = 3. 96 (US$ million) As comparing the costs and the advantages & disadvantages of the three structures, it is to be said that the second structure is the best capital structure to apply for Xpresso Limited.
Because although it does not has the lowest cost, the proportions of sources of finance included are the most appropriate option as the percentage of debts used (25%) is not too high for adding risks to the company but also ensures for the financial leverage (the tax relief) to be used. In addition, the cost of finance in this structure is still relatively low.
The financial planning:
Definition: In general, financial planning is the process of developing strategies to help you manage your financial affairs so you can build wealth, enjoy life and achieve financial security5. .
Importance for Xpresso Limited: Financial planning involves achieving a balance between the requirements to minimize the risk of not having cash to pay creditors and the requirements to maximize the earnings made by using assets. It plays a very important role in helping Xpresso co-ordinate and organize the internal system, set up detailed plans for using resources, as well as for paying debts and liabilities, develop strategies, and finally prepare for any potential incidents in the future7. For Xpresso, every transaction has to be well-planned to run the business efficiently.
Shortage & surplus of capital: Capital surplus- the amounts of directly contributed equity capital in excess of the par value13 – has a large impact on Xpresso Limited as it can be used to distribute as bonus dividends to shareholders, to reinvest as owner’s equity and it also helps to reduce the cost of capital mobilizing9. It helps gain more prestige for Xpresso but also gives more pressure on the management as they have a duty to use it effectively. Capital is one factor of production, therefore its shortage makes difficulties for Xpresso to operate and develop efficiently.
Even it can lead to bankruptcy if capital shortage is too large.
It can be said that each and every source of finance has both advantages and disadvantages. The aim is to make use of the advantages and also to avoid the disadvantages of all sources. The best capital structure is to combine the appropriate sources to make the best use for the company. To conclude, the capital structure proposed is to use 25% debt financing and 75% equity financing including 80% common shares and 20% preference shares in estimated US$ 30 million of capital.
The cost of finance is US$ 3. 9 million. The structure has a relatively cost of finance and also ensures to make use of all advantages as well as minimizes all disadvantages of sources of finance used for expansion. As preparing a detailed and well-organized financial planning, there is a high rate of success for the expansion and other further developments of Xpresso Delight Limited Company.
Appendix 1. Formula of cost debts: + Before-tax cost: Rdt = debts x 15% + After-tax cost: Rd = Rdt x (1 – t) Rd : After-tax cost Rdt : Before-tax cost t : Corporate tax rate (t = 25%) . Formula of cost of issuing shares: 1. Cost of issuing common shares: Rc = Dc / Pc (1 – ec) + g Dc : dividend per share (Dc= US$ 0. 3) Pc : value per share (Pc= US$ 1) ec : flotation cost for ordinary share (ec= 17%) g: rate of earnings growth (g= 15%) 2. Cost of issuing preference shares: Rf = Df / Pf (1 – ef) Df : dividend per share (Df = US$ 5) Pf : value per share (Pf = US$ 1) ef : flotation cost for preference (ef= 10%)
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