Maximizing Shareholders’ Wealth Financing Alternative Research Paper

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Updated: Mar 4th, 2024

There are many financing alternatives available for a company in the US planning overseas investments. Lester Electronics is faced with the same problems as other USA companies while planning to acquire Shang-wa electronics. The sources of financing available for international expansion of USA companies are as follows;

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Common Stock

This is where funds are obtained by issuing shares to the public for subscription. It can also be obtained through a rights issue. New shares can be issued by private negotiations, placing, or offer for sale, or by a rights issue.

Private negotiations – is where unquoted companies obtain funds from owner proprietors or rich patrons, merchant banks, finance corporations who are prepared to take risks in order to show above-average returns.

Placing – is a form of financing used for smaller issues of shares. They choose certain Institutions in which they place or sell to.

If the general public wishes to subscribe to the shares, they do so from those institutions.

Offer for sale – is an invitation to apply for the shares in a company based on information contained in the prospectus.

Offer for sale by prospectus-This is where shares are offered to the general public to subscribe at a fixed price. The prospectus gives the company information regarding past performance, future prospect as specified by the stock exchange rates.

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Offer for sale by tender-Shares are offered to the public at no fixed price. Investors bid for the shares at the price of their choice hence the striking price at which the shares are sold depends on the demand of the shares.

Rights issue – is an offer to the existing shareholders to subscribe for fore shares in proportion to their existing shareholding. It is a limited source of finance. An ordinary resolution must be passed allowing the offer.

Characteristics of Equity financing :

  • Usually have voting rights in general meetings of the company.
  • Rank after all creditors and preference shares in liquidation.
  • Dividends are payable at the discretion of the directors out of undistributed profits after senior claims have been made.

Advantages of Equity financing:

  • No provisions are made for repayment of dividends as they are only paid if profits are available.
  • Not limited – depending on the size of the investment, the company can quote as many shares as it likes.

Advantages of Equity financing:

  • Expensive – there are many cost reasons required to raise these finances for example advertisement.
  • Dilution of control as most of the shareholders have voting rights in the control of the company.
  • Not tax-deductible since retained earnings are taxable.
  • Not liable since not all companies can access this form of financing.
  • Risky – as large amounts of equity finance may increase the rate of return and reduce the earnings per share.

Long-Term Debt

Is a source of financing whereby funds obtained can be repaid back after a long period normally from eight years and above. The company pays interest and principal or dividend at the stated or prescribed period. Examples of this are; Debentures; Is a written acknowledgment of a debt by a company containing provisions of interest and the terms of repayment of principal. This can be secured, unsecured, irredeemable, or redeemable. It is a secured debt that carries charge on one or more specific assets or all assets of the company such that on default of repayment of interested principal, the debenture holder will appoint receive to administer the assets until the interest is paid eventually they can sell the asset to repay the principal.

Preference shares: This is a form of financing whereby shareholders are paid a fixed rate of the dividend after creditors but before ordinary shareholders. This can be Cumulative preference shares where shareholders are paid a fixed amount of dividends and arrears accumulate or non-cumulative where they receive fixed rates of dividend but arrears do not accumulate.

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Advantages

  • Cheap – because is less risky, debenture holders can accept a lower rate of return.
  • Cost is limited to the stipulated interest repayment.
  • There is no dilution of control where debt is offered since no voting rights.

Disadvantages

  • Interest is a compulsory default that will mean selling the company securities or the company will go under receivership.
  • It is limited since the shareholders are concerned that a geared company can not pay its interest and still pay its dividend and raise the rate of return that they require from the company to compensate for this risk.
  • Provision must be made for the repayment of debt with a fixed maturity rate.
  • If the general interest rates fall, fixed-rate interest payments may prove to be a burden.

Before advising Lester electronics on the best capital mix for the new venture, I will need to analyze the capital structures and their average cost of capital. The weighted average cost of capital is derived as follows:

WACC = wdrd(1-T) + wprp + wkerke

Whereas WACC= weighted average cost of capital

wdrd(1-T) = weight of debt X cost of debt.

wprp = weight of debt X cost of preference share.

wkerke = weight of debt X cost of common share

In order to get the weights, we have to determine the capital structure.

Lester Electronics.

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Capitalamount (a)Proportions (b)cost capital (c)Weighted (b) x ( c)
EQUITY161699.50.9918.56%18.37%
Long-term debt16880.015%(1-0.4)0.03
Total163,387.51.0018.4%

The average cost of capital based on the assumption made is 18.4%

Assumptions

The following assumption has been made for this case the long-term debt is a bond that is being sold in the stock exchange market and the rate applicable is 5% and this rate is applicable for companies.

The year of the investment is 2005 and the corporate taxes are 40% at the time.

Cost of common stock

I will recommend Lester electronics to choose 40% long-term debt and 60% common stock issue.

This will ensure the company does not risk liquidation and the annual financial commitment is not very high.

The common stock issued should be from the right issue. If the right issue fails then they will float the shares in the stock exchange. The 40% should cover the bond issue and preference shares. From the financial statements, the company is doing well and the interest is low as compared to other companies. The proposed capital structure will have the following weighted average cost of capital.

CapitalProportions (b)cost capital (c)Weighted (b) x ( c)
equity0.68. %4.8
Long-term debt0.45%(1-0.4)1.2
Total1.006%

Avra Electronics

Capitalamount (a)Proportions (b)cost capital (c)Weighted (b) x ( c)
EQUITY1,434,5110.5073.25%1.648
Long-term debt1,392,4940.4935%(1-0.4)1.479
Total2,827,0051.003.127%

I will recommend Avra electronics to choose 40% long-term debt and 60% common stock issue. This will ensure the company does not risk liquidation and the annual financial commitment is not very high. This will reduce it from almost 50:50. The proposed capital structure will have the following weighted average cost of capital.

Transnational Electronics corp.

Capitalamount (a)Proportions (b)cost capital (c)Weighted (b) x ( c)
EQUITY7093610.36210.28%3.917
Long-term debt1,252,4670.6385%(1-0.4)1.914
Total1,9618281.0005.831%

I will recommend transnational electronics to reduce their debt to 30% through conversions or issue of shares to pay off. The company currently not consistently performing well and they risk technical default which is very dangerous. This will ensure the company does not risk liquidation and the annual financial commitment is not very high.

Shang-wa Electronics corp.

Capitalamount (a)Proportions (b)cost capital (c)Weighted (b) x ( c)
EQUITY36,414,7500.30930%9.27%
Long-term debt81,622,0000.6915%(1-0.4)2.073%
Total118,036,7501.00011.343%

I will recommend transnational electronics to reduce their debt to 40% through conversions or issue of shares to pay off. The company currently is consistently performing well and there is no risk of technical default. But the debt ratio should be reduced.

DuPont analysis for the companies that is ROE and ROA for year 2004.

RATIOAvral ElectronicsLester ElectronicTECShagwa
ROE
(Earning after tax and interest)/ Equity
46,217×100
1,434,511
=3.22%
30,010 X 100
161,699.5
= 18.56
72,897×100
709,361
=10.28%
10,921.8×100
36,414.75
= 30%
ROA
(Earning after tax and interest)/ Total Assets
46,217×100
4,638,015
=1%
30,010 X 100
252,948.5
= 11.86%
72,897×100
3,675,893
=1.98%
10,921.8×100
142,292.7
= 7.68%

All investments have various risks associated with them. But this kind of investment faces various risks among them foreign exchange risks, political risks, operating risks, financial risks, and other risks.

Foreign exchange involves things like currency shortages, depreciation, and increase of public debt or exchange rate fluctuations. Proper strategies should be adopted to mitigate this risk. if the risk is not well covered it will affect the cash inflows and outflows and eventually profitability or even operations of an enterprise. Strategies adapted can be Strategic actions, operational tactics, and financial tactics.

Dividend Policy

Dividend policy based on value management can realize the final goal of maximizing enterprise value thus leading to shareholder wealth increase. While making the distribution policy of the dividend, emphasizing the goal of maximizing the enterprise value, we will overcome the defect in the policy of maximizing the shareholder’s wealth with profit. It pursues a balanced and effective cash flow in a long period and promotes the enterprise’s value.

The essence is to make the enterprise more adaptable to future changes of environments and realize value creation and sustainable increase. As value creation is a starting point of value management, so the main characteristic of dividend policy based on value management is to pay attention to creating firm’s value and increasing it to realize the maximum of enterprise value and promote enterprise’s long-term development when considering the dividend policy (Wang X, Zhang Jand Man H; 2006).

References

Carlson S; (1969) International Financial Decisions; North Holland Pub.

Lindsay R; (1967) Financial Management, An Analytical Approach; R.D Irwin.

(2004) Capital Budgeting and Long-term financing Decisions; Thomson Learning.

Unidas N; (1993) Transnational Corporations & Management Division; International Financial Management; Routledge.

Wang X, Zhang J and Man H; (2006);The Influences of Value-Based Management on Dividend Policy; Journal of American science.

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