SOURCES OF LONG-TERM FINANCING: A CASE OF LISTED FIRM
Introduction
Long-term financing involves huge amount of money (e.g. Billions of Pounds) and is required over a longer period of time (e.g. minimum of one year). With this consideration, financing corporate projects especially an expansion proposal is channeled through a combination of different sources. This section is intended to evaluate alternative financing methods that are available for a listed company facing long-term investment project.
Sources of Long-Term Financing
Share is the first option for a listed firm because it is cheap and quick way to raise funds. One of the benefits of issuing shares includes unlimited pool of investors in the capital market that can enhance the issuer’s flexibility. For example, if the project needs additional £300 Million to begin, the firm can simply issue 300 million, 150 million or 75 million of shares for £1, £2 and £4 per share respectively. It is also one way of reducing one of the disadvantages of share issue which is loss of control because the firm can regulate the amount of shares to be issued to protect the governance structure it targets.
Another advantage of shares is that the common practice of using the services of financial institution such as investment banks can strengthen the confidence of the issuing firm that the project will be financed whatever happened. Most institutions undertake underwriting services where they do not only try to sell the shares of the issuer in the capital market but more importantly will assure that such shares are good-as-sold. It means that these institutions will give the required funding of the issuer ever if there is a lack of share buyers. Apart from the primary benefits of shares, the aspect of going through public scrutiny and firmer regulatory demands can reduce the decision-making independence of the listed firm. This means that it has to acquire some ethical considerations as indirect payment of using unlimited public funds.
Entering a venture capital deals is also an alternative means of raising funds. This is especially true when the listed company is seen as holding a big potential of becoming profitable in the future by venture capitalists. As venture capital is supported by large companies and wealthy investors, they can easily supply required funds for a new project. The core strength of this financing option is the generous support that venture capital can give to prospective firms. Compared to financial institutions described in share underwriting, venture capital can even extend its funding to high risk projects with minimal guarantee from the listed company. However, the bottleneck is the same as share financing wherein there is a huge possibility that the original management of the listed company will loose control over governance. Not only this, venture capital also demands distribution of profits unlike share issue where dividends are not required.
Government funding can also be tapped but this is a slightly awkward source for some companies. One advantage is that the total cost of the project can be financed by the government through National Lottery, European Union and other organizations with similar functions. However, this extreme benefit may be outweighed by the expensive paperwork, monitoring and ultimately loss of control that underlie the contract. Another issue is that not all public or listed companies reflect public services and welfare within their objectives. As a result, it is difficult for firms to be included in key priority areas of government where total funding is possible. Lastly, if ever total funding is applied, the listed company has the tendency to be assumed as public asset because the project cost is funded by the government. Pricing strategies, quality and non-financing factors in its operations will be strictly monitored and regulated.
Perhaps the primary source of short-term financing, bank loans are also offered where payment can lasts up to 25 years. Due to the familiarity of the bank to the listed firm because it is the source of the latter short-term funds, application of long-term loan is accelerated. Paperwork and other slowdown are reduced due to relationship that is built in the course of business. However, unlike share and venture capital, loans must be repaid even without profits or else the listed firm will loose reputation and may not be accepted by institutions for future loans. With bad revenues and project returns, this restriction aggravates the problematic task of paying interests due to unpredictable rates. The ease of getting the loan is offset by the risk of default.
Common to small businesses, loan using mortgage can reduce the risk in bank loans. Mortgage is a property that serve as guarantee to the lender that the borrower can somehow pay what is due even if the project or expansion plans turn-out to be unsuccessful. In this case, the lender has the right to sell the property and turn it to cash. For the listed company, mortgage can be beneficial when it has “idle” assets that are not likely not a key to its strategic plans. Such assets can be mortgaged to raise a fund for more worthwhile and productive projects. Even if the project is a failure, the lender will pull-out idle assets that are not crucial to survival of the listed firm. It is important to note that the borrower should allow the drawing of the mortgaged asset as a last resort and continue paying the required interest payments periodically.
Retained profit is the idea behind the policy of a listed firm to delay payment of dividends. This option is attractive when the business is under start-up, growing and expanding stages. However, when it is matured, holding the dividends for so long can disrupt the loyalty of shareholders. For the listed firm eyeing a long-term project, retained profit is strategic source because it comes from the savings of the company and it need not to bother about loss of control, interest, default, and mortgaged. However, retained profits highly depend on the past revenue results of the firm which mean minimal value. This amount is insufficient to fully support a long-term project.
Selling assets can also be seen as source of funding. This is an advance version of mortgage option wherein assets are instantly sold to reduce concerns over interest payment and sudden closure of the mortgaged asset. Divestment is a good example of this type of financing where the company intends to take-off some of its low-performing business areas and divert the funds to potential business earners. In the case of a listed firm, subsidiaries can be sold in order to simplify the business and raise funds for the project. It can get away from disadvantages of external financing and retained earnings by simply creating money out of its own assets. These assets could likely be from business areas that generate low revenues for some time. In effect, the selling process can eliminate the problem of inefficiency and solve the issue of financing simultaneously. On the other hand, the listed company must find a generous buyer to suffice its needs for additional funds not to mention complete appraisal on both the financial and strategic value of the asset.
Conclusion
Different sources of long-term financing have their positive and negative impact to the listed firm. Therefore, the firm must use more than one of these sources to form an efficient portfolio of funding. To illustrate, when the firm feel that it will loose control of governance when it will continue to issue shares, it can stop the issue and even announce buy-back programs. The lacking funds can be then sourced from bank loans. Simply put, different sources provide the ability for the firm leverage its risks. If the firm is risk-averse on control/ interest payments, it will use interest-based/ share-based financing. Overall, the firm has options that are there to support during turbulent times (e.g. long-term project financing).
PORJECT APPRAISAL FOR AP LIMITED
Proj
Annual net cash flow
Initial investment
Cost of capital
IRR
NPV
1
£100,000
£449,400
14%
A = 18%
B = £72,200
2
£70,000
C = £293,440
14%
20%
D = £71,680
3
E = £38,343.56
£200,000
F = 10%
14%
£35,624
4
G = £60,000
£300,000
12%
H = 15%
£39,000
Assumptions
Solutions (Note: Look for red highlighted figures for final answer)
PV of an ordinary annuity (i.e. cash flows are received at the end of the year):
PVAn = PMT*(PVIFAr, n)
Where, PVAn = the present value of an n-year annuity
PMT = the constant annual amount invested
PVIFA = the present value interest factor for an annuity
r = the discount rate
n = the number of years of the annuity
NPV, therefore is NPV = PVAn – Initial Investment
For Project 1, NPV (Letter B) is computed as:
PVAn = 100,000*(PVIFA14%, 10 years)
= 100,000*(5.216)
= 521,600
NPV = 521,600 – 449,400 = 72,200
Note: See PVIFA table in the appendix
To find IRR of Project 1 (Letter A), use trial and error method where the NPV above must be equal to zero. This is done by using 18% as the discount rate. Thus,
PVAn = 100,000*(PVIFA18%, 10 years)
= 100,000*(4.494)
NPV = 449,400 – 449,400 = 0
To find the initial investment in Project 2 (Letter C), the IRR approach should be reviewed. This is important because the given IRR (i.e. 20%) represents the discount rate where NPV is equal to zero. Thus, the NPV that will be derived reflects the initial investment.
PVAn = 70,000*(PVIFA20%, 10 years)
= 70,000*(4.192)
NPV = 293,440 – Initial Investment = 0
So,
NPV = 293,440 – 293,440 = 0
To find NPV for Project 2 (Letter D), use the method in Project 1. Thus,
PVAn = 70,000*(PVIFA14%, 10 years)
= 70,000*(5.216)
= 365,120
NPV = 365,120– 293,440 = 71,680
To compute the annual net cash flow of Project 3 (Letter E), initially use IRR formula. Thus,
PVAn = unknown*(PVIFA14%, 10 years)
= unknown*(5.216)
NPV = 200,000 – 200,000 = 0
So,
unknown*(5.216) = 200,000
unknown = 200,000/ 5.216
= 38,343.56
Now that annual net cash flow is derived, find the cost of capital (i.e. discount rate and Letter F) using NPV formula. Thus,
PVAn = 38,343.56*(PVIFAunkonwn%, 10 years)
= 38,343.56*(unknown)
NPV = 235,624 – 200,000= 35,624
So,
38,343.56*(unknown) = 235,624
unknown = 235,624/ 38,343.56
= 6.145
Looking in the PVIFA table, discount rate should be 10% for 10-year project life to achieve PVIFA rating of 6.145.
To find the annual net cash flow (Letter G) for Project 4, NPV formula should be used. Thus,
PVAn = unknown*(PVIFA12%, 10 years)
= unknown*(5.650)
NPV = 339,000 – 300,000= 39,000
So,
unknown*(5.650) = 339,000
unknown = 339,000/ 5.650
= 60,000
To find IRR of Project 4 (Letter H), use trial and error method where the NPV above must be equal to zero. This is done by using 18% as the discount rate. Thus,
PVAn = 60,000*(PVIFA18%, 10 years)
= 60,000*(unknown)
NPV = 300,000 – 300,000 = 0
So,
60,000*(unknown) = 300,000
unknown = 300,000/ 60,000
= 5.000
A PVIFAunknown%, 10 years equivalent to 5.000 is approximately PVIFA15%, 10 years. Therefore, cost of capital or discount rate is approximately 15%.
Recommendation
Project 1 and Project 2 are both superior investment projects. Project 3 and Project 4 are inferior investment projects because of the acceptable but relatively low IRR and NPV. However, Project 1 has higher NPV compared to Project 2 but the latter has higher IRR compared to the former. This cause the bottleneck on what is the most worthwhile project and what is the priority project that AP Limited must sought.
The first consideration would be to look on the initial investment. Project 1 is riskier because it requires approximately 1.5 times more initial investment than Project 2. The risk is more on the financing aspect where initial investment is sourced by AP Limited from investors and the ability of paying the interests, dividends and other demands of investors. In the contrary, Project 1 has 1.4 times more annual net cash flow compared to Project 2 which means Project 1 can generate more profits in annual basis. Again, another way of saying that Project 1 and Project 2 are closest rivals in terms of project worthiness that further working is required.
In this case, there is one single method of appraisal that ultimately distinguishes between NPV and IRR. NPV is theory-based while IRR is more realistic and practical in decision-making. IRR can also be compared with industry percentages for ease of investment analysis. However, NPV has reinvestment rate assumption wherein AP Limited is assumed to reinvest its annual net cash flow into other projects. For example, Project 1/ Project 2 is assumed to reinvest its £100,000/ £70,000 in other projects with similar required rate of return/ cost of capital (i.e. 14% each). IRR, in contrast, suggest that annual net cash flows should be reinvested on projects that frequently have higher cost of capital.
In the preceding statement, it is clear that the reinvestment rate assumption of NPV is the preferred method especially for shareholders trying to maximize their investment. This is because IRR does not offer a comprehensive data on which AP Limited can maximize its “idle” funds from its annual net cash flow. Also, according to (1999), “when deciding among mutually exclusive projects, especially projects differing in scale, size and/or cash flow timings, the decision should be guided by the NPV technique” (p. 377). This admonition is a perfect guide in the case of AP Limited since Project 1 and 2 are mutually exclusive projects that differ in scale and size (i.e. Project 1 has higher initial investment) and cash flow (i.e. Project 1 has higher cash flow).
In the light of the analysis above, with higher NPV, Project 1 should be chosen over Project 2.
Credit:ivythesis.typepad.com
0 comments:
Post a Comment