Financing Strategy

The key issues to be addressed while formulating a financing strategy for a firm are:

• What should be the capital structure of the firm ?
• Which financing instrument should the firm employ ?
• What method of offering should the firm use ?
• Which market should the firm tap ?
• When & at what price should the issue be made ?
• What should be the distribution policy ?
• How should a firm communicate with its investors ?
• What should a firm do to improve the standard of corporate governance ?

These issues are inter related for pedagogic convenience we will discuss them sequentially.

1. Capital Structure:

           The two broad sources of finance available to the firms are the Shareholder's fund & Loan fund. Shareholder's fund mainly come in the form of equity capital & retained earnings and secondarily in the form of preference capital. Loan fund come from a variety of ways like debenture capital, term loan, deferred credit, fixed deposit & working capital advance.

Now what are the key considerations in determining the debt equity ratio of the firm ?

·         Earnings per Share

EPS which is simply equity earnings divided by the number of outstanding shares, is regarded as an important financial number that firm would like to improve.

Hence we need to understand how sensitive is EPS to changes in profit before interest & tax (PBIT) under different financing alternatives

·         Risk

The two principle sources of risk in a firm are business risk & financial risk.

Business Risk refers to variability of profit before interest & taxes, which is influenced by demand, price, input price variability & proportion of fixed costs.

Financial Risk represents the risk emanating from financial leverage.

·         Control

In the basic ways of raising additional finance i.e. right issue of equity capital, debt finance & public issue of equity capital carry the issue of control. As there can be dilution of control or carry high/low risk and costs.

·         Flexibility

Flexibility here refers to the ability of a firm to raise capital from any source it wishes to tap. It provides maneuverability to the finance manager.

·         Nature of assets

If the assets are primarily tangible, debt financing is more used. On the other hand if the assets are primarily intangible, debt financing is less used. The major explanation here is that lenders are more willing to lend against tangible assets than intangible assets.

2. Financing Instruments:

Equity & Debt come in variety of forms and are raised in different ways.

Sources of Capital:-

·    Equity:

1.      Equity Capital

2.      Preference Capital

3.      Internal Accruals

·         Debt:

1.      Term Loans

2.      Debentures

3.      Working Capital Advances

4.      Miscellaneous Sources

3. Methods of Offering:

There are different ways of raising finance in the primary market: Public offering, Right issue, & Private placement.

Public Offering:

A public offering or public issue involves sale of securities to the members of the public. The 3 types of public offering are the initial public offering (IPO), the seasoned equity offering, and the bond offering.

1.      Initial public offering (IPO):

The First public offering of equity shares of a company, which is followed by a listing of shares on the stock market.

2.      The seasoned equity offering:

As companies need more finance, they are likely to make further trips to the capital market with seasoned offering or follow on offering

3.      The bond offering:

Bond offering process is similar to IPO but have some differences like:

Prospectus of bond offering has company’s stable cash flows.

They are offered through 100% retail route as book building is not appropriate.

They are secured against the assets of issuing company.

Debt issue cannot be made unless the credit rating is done.

It’s mandatory to create debenture redemption reserve.

Right Issue:

It involves selling securities in the primary market by issuing rights to the existing shareholders. When company need additional equity capital it has to issue first to the existing shareholders on a pro rate basis.

Private Placement:

It is an issue of securities to a selected group of persons not exceeding 49. This can be done in two ways i.e. Preferential Allotment & Qualified Institutional Placements (QIP)

How do various Methods of Offering Compare

	Public Issue	Right Issue	Private Placement
Amount that can be raised	Large	Moderate	Moderate
Cost of issue	High	Negligible	Negligible
Dilution of control	Yes	No	Yes
Degree of Under pricing	Large	Irrelevant	Small
Market perception	Negative	Neutral	Neutral

4. Markets:

A firm planning to raise finance may tap one or more of the following capital markets:

Indian Capital Market:

A firm accessing this market has to conform to the regulations of the Securities and Exchange Board of India (SEBI).

Euro Capital Market:

The euro capital market is a global market beyond the purview of any national regulatory body. Firms get an access to this market through instruments like Global Depository Receipts (GDRs), & Euro Convertible Bonds (ECBs).

Foreign Domestic Capital Market:

Indian firms need to obtain clearance from Indian authorities as well as the regulatory bodies of the foreign country.

How do the three markets compare in terms of following points:

	Indian Market	Euro Market	Foreign Domestic Market
Access	Easy	Restricted	Highly Restricted
Market	Small	Large	Large
Cost of Issue	High	Low	Low
Disclosure & Transparency	Less onerous	Onerous	Highly Onerous
Price/Rates	Not so attractive	Attractive	More Attractive

5. Pricing & Timing:

The firm issuing securities has to determine when and at what price should its issue be made. Since pricing & timing are closely related they may be discussed together.

Following points are to be remembered while resolving this issue of pricing & timing:

Decouple Financing & Investing Decision:

Investing & Financing decision do not synchronise often so it is important to decouple them. As Warren Buffet says:”Therefore, we simply borrow when conditions seems non-oppressive & hope that we will later find intelligent expansion or acquisition opportunities, which as we have said are more likely to pop up when conditions in the debt market are clearly oppressive. Our basic principle is that if you want to shoot rare, fast moving, elephants, you should always carry a loaded gun”.

Never Be Greedy:

If present conditions are favourable for a certain type of financing, take advantage of it. Driven by greed, do not wait for an even better possible tomorrow. The advice of Bernard Baruch for the stock market investors “Leave the first 10 percent & the last 10 percent for someone else”.

Ensure Inter-generational Fairness:

Tapping the equity market when it is buoyant does not mean that the firm should price its equity issue far above its intrinsic value. If it does so, the existing shareholders will benefit at the expenses of new shareholders.

6. Distribution Policy:

It’s concerned with issues like how much of its earnings should a firm apy by way of dividend, what are the implications of bonus issues & stock splits, and when does it make sense to buy back shares

Key considerations Influencing Dividend Policy:

·         Earnings Prospects

·         Funding Requirements

·         Dividend Record

·         Liquidity Position

·         Shareholders Preference

·         Control

7. Investors Communication:

To ensure that the intrinsic value of the company reflected in its stock price, the company should communicate intelligently with the investors. What a company should do and should not do in this respect can be appreciated by understanding how the stock market really works.

As Bennett Stewart & David M Glassman put it:”Stock prices, like all prices, are set not by averaging investors; they are set ‘at margin’ by the smartest money in the game. The herd is led by influential investors-lead stress as we call them. They care about cash flow and risk; they are not fooled by accounting illusions”.

Given dominant role of ‘lead steers’, the company should bear in mind the following guidelines while communicating with the investors:

·         Deemphasise Financial Disclosure.

·         Avoid Financial Hype.

·         Cut ‘Lead Steers’ into the Planning Process.

8. Corporate Governance:

Corporate Governance is concerned basically with the agency problem that arises from the separation of finance and management, or refers to the constraints that managers put on themselves or those investors to provide funds ex ante and check misallocation of resources ex post facto by managers.

It covers issues like the legal rights of investors, role of large investors, the system of electing the board of directors, the composition of the board & various sub-committees etc

A great deal of concern has been expressed in recent years about the poor quality of corporate governance, in general, in India.

This was also echoed in the 1999 Budget speech of Union Minister Yashwant Sinha when he said” if investors have to be drawn back to capital market, companies have to put their houses in order by following internationally accepted practices of corporate governance. This is necessary to enhance investors confidence”.