The Recent Credit Crunch Has Had a Very Significant Impact on the Firm’s Cost of Capital
Introduction
Every business endeavour or venture is constantly faced with financial management problems to which the owner or manager should be able to attend to in order to take the business to success especially during the times of crisis that the global communities are facing. Thus, key financial decisions normally confronts the managers in issues and problems that concerns financial investments they usually provide answer to the problems regarding the assets on which the company of firm needs to put money and how a chosen investment should be financed.
With this consideration, we may say that the current credit crunch or the so-called credit crisis is one of the problems experienced not only by some firms in the United States but also by the global economy since their cost of capital was affected. Basically, the current financial crisis of 2007–2009 which is classified by the general media as a “credit crunch” or “credit crisis” was started last 2007 of July. The crisis was triggered when most investors loss their confidence in the value of securitised mortgages in the United States. This development created a liquidity crisis that prompted an extensive inoculation of capital into financial markets by the United States Federal Reserve, European Central Bank and Bank of England (Norris, F. 2007).
For evidence of the emergence of this credit crisis, TED indicator spiked up in July 2007 and remained volatile for a year and again spiked even higher in September 2008 (see Figure 1). This indicates that the crisis deepened as of September 2008 in which the global stock markets worn-out and go into a period of high volatility, and a significant number of banks, insurance companies and mortgage lenders failed in the following weeks.
Figure 1. TED Indicator
Source: http://www.princeton.edu/~pkrugman/ted-spread-wsj.gif
As the nature of financial management becomes more and more complex in today’s business world, finance managers face a wide array of challenges, opportunities and options to enhance the investing and financing activities of the organisation as well as to minimize the inherent risks and circumstances of the financial decisions that will be made. The challenge now for the financial mangers is to explore the options and take advantage of the opportunities while taking caution in managing the business risks partially the credit crunch issue. “Experiences differ and common usage lack precision” (Calow, 1988) with regard to risk. From this statement, we may say that risk involves both hazards and opportunities to people/organisation who undertake changes and development. People/organisation evaluates result based on their evaluation of the situation based as guided by criteria of gains and losses. Furthermore, risks brought by credit crunch involves trade-offs in which there are some groups who may experience losses in exchange to others goals to profit. The trade-off influences the perception of people about the risk. Oftentimes, the risk issue revolves not on the scientific facts about the risks but the conflict of values and the acceptability of the risk of different groups with conflicting interests.
Theories and Discussions
Businesses are continuously evolving in order to meet the needs of its people. However, they should be cautious to the changes in order to maintain competitiveness. Therefore, they need to have a careful review of their financial status. Overhead costs and credit rating should be also reviewed carefully. Business companies around the globe should not rely alone on credits instead they should think of creative ideas to sustain their growth and development. Thus, if the financial crisis hit the country, they’ll be able to survive. Basically, the actual cause of the financial crisis or the emergence of credit crunch is that both Europe and the United States were living beyond their means for too many years. Since 2000 there was a major housing bubble and in the United States the banks were required to make high risk loans to people allowing them to buy too much house. When the housing bubble burst and variable rate mortgages tied to the labour average started to sky rocket people found out that they no longer could afford their houses.
Aside from this, the price of oil has also been diving very fast. And this is because of speculators who had driven it so unrealistically high before, have pulled all their money out of there as well. It was yet another bubble, an artifact of an unregulated market. With this development in the global economic market, credit lenders and other bank financial institution are now limiting companies to regulate the credits which are relatively play significant impact to the cost of capital of any businesses. Credit crunch actually controls the cost of capital that is more businesses around the globe are suffering from downturn. The next section will discuss how cost of capital or weighted average cost of capital (WACC) play significant role in business development and issues related to capital structure will be also discussed.
Weighted average cost of capital (WACC)
Weighted average cost of capital (WACC) aids the firm to select the most efficient combination of capital structure by reflecting in the computation both equity and debt financing options. It is posted that high equity capital structure is less risky than debt financing because the firm should pay banks even though there is no profits. However, too much equity financing can destruct the ownership structure of the firm which can be harmful for major stakeholders. Therefore, capital structure must be managed by combining financing alternatives in order to optimize a firm’s cost of capital that can contribute to increase in firm’s value.
Traditional model believes that capital structure is related to the value of the company wherein it is possible to reduce WACC (Mcmenamin 1999). The model held by following assumptions; namely, all earnings are distributed as dividends, earnings are expected to remain constant indefinitely, all investors have identical expectations about future earnings, taxation is ignored, business risk remains constant, capital structure can be altered immediately by exchanging debt for equity or vice versa and there is no transaction cost. The traditional model theorizes that the WACC of the firm is a source of useful information or signal to achieve an optimal capital structure.
Capital Structure Analysis
Credit practices of a business are important to their business processes. Thus it is crucial for them to identify their capabilities to loan or identify the amount they need to loan. Using the gearing ratio, the level of a firm’s financial risk is assessable which means that the firm can identify if financial resources are able to pay planned or on-going financial commitments or not (Mcmenamin 1999). In this way, the firm can make decisions and implement strategies according to its financing ability. This upper hand is worthy not only because it places the firm in a safer stance but more importantly it is able to control one side of the general risk confronting a business (financial side) which relaxes problems emerging from the uncontrollable business/ environmental risks.
With this, the survival of the firm is protected by capital structure (CS) as internal consequences of a firm’s strategy are detected. Questions such as “Do we have enough money for the project?”, “Is there a need to borrow or issue shares?” and “What is the gearing ratio to be adopted to maximize the potential of the project?” This facility has also its implications on corporate ability to forecast, exploit and mitigate environmental changes and even apply influence over its gradual evolution. This can achieve merit by using the resource-based model of above average returns wherein core competencies are matched against the changing environment (Hitt, Hoskisson & Ireland 2003 p. 22).
Using CS as the basis for project planning and implementation, the firm can enjoy the computed future earnings without interference from pending obligations to creditors or shareholders. This is important for project cash flows to be obtained all throughout its life span because creditors can sue a company when debt contract or shareholders’ expectation are not met. As an example, in the early years of US operations of News Corporation (the owner of Twentieth Century Fox), its CEO and financial officers faced difficulty to calm its creditors and defer lawsuit that can substantially disrupt its corporate life in the US (Hill, Jones & Galvin 2004 C101).
The company’s debt came from its huge acquisition costs on most American-owned media companies where some are unsuccessful to meet their expected earnings. This case shows how lack of financial planning can provide a big headache for (expanding) firms. However, through CS, this highly-owned family company may have give-up some of its control in favor of equity financing. Thus, it may have prevented the last minute plead and risky confrontations to its creditors.
In general, debt financing is cheaper than equity financing because it is a tax allowable expense (Mcmenamin 1999 p. 16). However, it is also more committed (thus, risky) because repaying includes the principal and interest and it is mandatory even if the company results to a loss. In addition, too much debt can discourage shareholder and their funds from entering the firm’s coffers because ordinary shareholder is only awarded with the profit residual after the creditors are paid (p. 16). In the contrary, focus on equity financing can be unacceptable (in the case of News Corporation) or not strategic because the firm can loose its identity as it also looses control to major corporate decisions. When company’s shares are concentrated to one entity on the market, it may also face hostile takeover. This literally is one way to say that the original company has already perished.
One would argue that a firm can certainly avoid debt/ equity dilemma by using its lone profits or retained earnings, thus, serving as a reduction for the need for CS consideration. However, in most cases, such idea does not hold. For example, Excite@Home is a daring internet service provider and an internet portal that decided to compete head-to-head with Yahoo! since its existence on 1999 (Hitt, Hoskisson & Ireland 2003). Two years later, it declared bankruptcy as customers are dissatisfied with the service.
The cause of its downfall is the lack of coherent and clear business plan on how to operate and implement strategies. Hence, an indication that shareholder and creditor emphasis is disregarded evidenced by lender’s demand for M payment on the verge of the corporate failure. This is a situation where CS is undermined in favor of exploiting the attractiveness of then booming internet/ hi-tech industry. In effect, the firm did not even get closer to Yahoo! or its profit target which ultimately explain how leveraging ratio should be used to protect the survival of the firm especially when profits is not flowing and financing entities are rigid or hostile.
With regards to specific types of debt and equity financing (as applied in US setting), CS consideration is also useful for the firm to achieve profitability. Seller financing is a debt facility in which the firm can readily use a certain resource like plant through acquisition under a seller contract (UAEP 2006). In effect, it can reduce the cost of construction and planning including shortening the time for cash inflows to pursue. However, the contract can be customized to seller needs in which periodic payments and litigation clauses can impede contingent actions from the buying firm that may arise due to resources problem or lack of synergy. The withdrawing aspect and ending the contract is tight which brings the acquirer in a risky position. To avoid this scenario, the acquirer can evaluate other debt financing options such as government programs, commercial banks, mezzanine financing and asset-based lenders.
On other hand, equity financing options can also provide more attractive profitability schemes than debt options. Initial public offering (IPO) is a financing option in which stocks are sold to investors giving them the right to receive dividends or payback after every profitable period (UAEP 2006). As observed, IPO does not limit the actions of the firm unlike seller financing but there are cautions in the stability of investor support as especially when they are just “playing” the stock market. Stocks are easily tradable and gains from the practice are fast. Similar to debt financing, equity option takes other strategies to prevent sudden loss of internal funding capability due to over-speculation. As a bottom-line, there are varieties of ways that the firm can manipulate its CS. It can choose between equity and / or debt financing and also choose between the combinations of different types and strategies involve in the broader genre.
The fundamental benefits of CS are derived in its ability to present numerical evidence as a basis of decision-making. However, even though there are many types of computing for the cost of capital, the firm should consider the method that best define its business and factors affecting its operations. One is the capital asset pricing model which is criticized by the weighted average cost of capital. Risk from a venture can also be attached to a single-asset or a portfolio of assets in which the method of getting the associated risk is different.
In addition, there are many ways for common stock valuation (e.g. freezing the complex content of preferred shares and the dynamic interest-bearing in debts). This various valuation techniques are related to the regularity of the firm to issue dividends. What if the company does not issue dividends for the current year? Well, it should use a more challenging platform for arriving at an accurate measure of pricing the stock. These overlapping techniques can create decision bottlenecks to the management which ultimately suggest the very important role of the underlying CS knowledge.
And based on the discussions, it is evident that debt and credit practices of any company are crucial to their operation. This means that in the time of credit crunch, businesses would have troubles not only in their current stance but also to the future of their business.
Evaluation
The general concept of credit crunch refers to the degree to which the credit capabilities of a firm or an industry are affected by the global financial crisis. Credit crunch imposed by lenders and other financial institutions can affect an individual investor who owns a portfolio; a company; an exporter and importer who concentrates on international trade and even a firm that has no direct international activities. Furthermore, credit crunch, through their impact on the costs of inputs, outputs, and substitute goods play a significant role in determining the competitive position of companies with no direct international operations relative to foreign firms (Joseph, 2002).
In the case of the current financial crisis and credit crunch, businesses should have careful assessment of their business process to avoid downfall. They should have risks management. The cost of indemnity had restricted management’s alternatives in dealing with the hazards faced by the organisation. One of the foremost problems was that insurers rated firms according to business in such a way that a fine run firm that had few losses were required to pay for the claims of poorly run firms within the same industry. With this, the role of risk management appeared. Management began to make out that abridged losses intended reduced cost of risk. If managers reduced losses they could hold them themselves without resorting to indemnity. However, it took some time for industries to settle in management.
The delicate inquisitiveness in management is the result of a number of instantaneous drifts. With the current economy, the trade and production has augmented financial and direct investment in unstable up-and-coming markets. With this we may say that risk management has also ensnared consideration as a result of the recurring and well-publicized breakdowns linked with its execution. Regardless of the amplified academic and specialized concentration paid to risk management, common instances still occur when classy investors or firms experience abrupt, unexpected, and devastating losses.
To an economist, risk is described as the survival of ambiguity about potential upshots like the emergence of credit crunch. Risk is a mean reason in economic existence for the reason that individuals and firms create immutable reserves in research and product improvement, inventory, plant and equipment and human capital, without knowing whether the potential cash flows from these funds will be adequate to pay off both debt and equity holders. If such genuine investments do not engender their necessary returns, then the financial claims on these returns will turn down in worth.
In addition to altering the extent of equity and debt in their capital composition, firms/business organizations can also influence their chance of liquidation by extenuating the risk disclosures they countenance. Firms/Business organizations come out to prefer between the types and degrees of disclosures, assuming those that they consider have an aggressive gain in supervision and laying others off into the capital markets (Stulz 1996). Other features of the firm’s processes such as the convexity of its tax lists, can also influence the amount to which administrators challenge to alleviate risks (Tufano 1996). Apparently, Besanko, Dranove and Shanley, (1996) believes that economists and strategic planners view risk management as being related to the issue of the boundaries of the firm. In this structure, the pronouncement to alleviate meticulous risks is comparable to the verdict to outsource a particular purpose. Thus, risk management, like technology, allocation, or level, is a basis of economical plus.
With respect to risk management as tool to counter credit crunch, we may also say that, corporate strategies used by the companies may contribute to the company’s possible success rate especially in the face of crisis that involves the financial aspect of the corporation. The presence of a these strategies may give the company a competitive advantage over their rival corporations through their scheme on how the organizations or departments that make up the industry are able to work together, and at the same time how they establish their reputation in order to continue giving their services to their clients. Here, the corporate strategies that companies use involve the corporate responsibilities and the brands that contribute to the performance of the company.
Lantos (2001) stated that corporations should have economic and legal responsibilities to the public at large due to the influence that they bestow upon the public. Because of their services and products which they distribute to their clients, the public have now irresolutely put their trust upon the Novak (1996) enumerated seven economic responsibilities of firms, which are: satisfy customers with goods and services of real value; earn a fair return on the funds entrusted to the corporation by its investors; create new wealth, which helps lift the poor out of poverty as their wages rise; create (and the writer would add, maintain) new jobs; defeat envy through generating upward mobility and giving people the sense that their economic conditions can improve; promote innovation; and diversify the economic interests of citizens so as to prevent the tyranny of the majority. Legal responsibilities, on the other hand, should be to follow the law or the rules that govern firms.
It is logical that those responsibilities, if exercised by the firm, can affect the firm’s operation in general, which includes marketing. The way firms handle and meet those responsibilities can be basically considered as corporate strategy, which can have numerous implications with the firms marketing strategy. Legal aspects of the firm is viewed as a part of its corporate governance and such rules will prevent them from exploring certain marketing strategies that are in conflict with their economic and legal responsibilities. These responsibilities can also be called as corporate citizenship, and be related with consumer marketing. A number of industry surveys suggest that consumers are willing to make an effort to support proactive corporate citizens. For instance, Cone and Roper’s study shows that 76 percent of consumers are prepared to switch to brands or stores that seem concerned about the community (Jones, 1997). Similarly, a Walker Information national survey showed that 14 percent of US households actively seek “do-gooders” when making purchases, while similarly, 40 percent judge corporate citizenship as a tie-breaking activity (Business Wire, 1997). On the contrary, Brown and Dacin (1997) demonstrate that negative corporate social responsibility associations can have a detrimental effect on overall product evaluation, whereas positive associations can enhance product image and value.
With regards to credit crunch as financial issue, financial evaluation and implementation of new strategies can be a demanding exercise. It can be difficult to foresee what the future holds (e.g. the actual future outcome may be entirely unexpected), i.e. to foresee what the scenarios are, and to assign probabilities to them; and this is true of the general forecasts never mind the implied financial market returns. However, this is an important procedure because it enables the organisation to make decisions that will be advantageous and beneficial to the company. In addition, organizations that are open to change and willing to counter the current financial crisis are generally more successful compare to companies that resist it. On the other hand, corporate leadership in accordance to their of power focuses on the techniques and expertise of efficient organisation, planning, direction, financial planning, credit assessment and control of the operations of a business is really vital. In this ever changing global business environment a company must be competitive and do everything it can to counter any threat from its competitors. Having a good leader gives the company some edge in facing competition in the business environment.
In examining issues of companies’ initiatives to counter financial crisis, we may argue that it is integral to any business’ success. We may also wonder how the economy would affect businesses if there is action towards the current crisis we are facing.
References:
Besanko, D., Dranove, D. & Shanley, M. 1996, Economics of Strategy. New York: John Wiley & Sons.
Business Wire 1997, “New report shows good citizenship is good for companies too’’, Business Wire, January 2 Issue.
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