Financing Basics: Debt vs. Equity
In this case study, Jute Plc intends to finance the development of a revolutionary new product which it plans to enhance its competitiveness in the economy. Jute plc only relies on two available options. The options available for the company are equity financing and debt financing. To start with, there is a financial connection between profits and funds for Jute plc investment. Jute plc markup and investment plans are inextricably linked in one direction or the other, and perhaps in both. Thus, the markup plans should be strategic in order to provide a clear vision of how the company's capital structure should be planned in order to effectively realize the desired goals for investing in the underlying investment.
In this case, the leveraging effect' is necessary to the creation of a financing structure of Jute plc. Furthermore, it is not an easy task for the company's management since many factors have implications on its operations. Such factor comprises of price factors, as well as, efforts to eliminate liquidity from the available capital sources. With regards to Jute plc, the revolutionary new product will either be financed by equity or debt financing option; this will depend on management's discretionary decision, however, the underlying features for these options are having already been analyzed.
Equity financing has become more and more important especially in difficult situations for instance in the elimination of credit capital in the economy, and the continuous strengthening of competitiveness as well. Hence, in Jute plc, equity capital provide give reference to the company's long-term capital. As such, it doesn't have any set period for the refund as it applies to the credit capital. According to Bossert "the issue of the long duration that equity capital takes implies to a company's security, that is, in the case of Jute plc, and its esteem creditors". As the company is currently being funded by £500M equity financing, the additional equity to finance the investment will mean that the company's liquidity will be affected in the long run.
Unlike the case of debt capital, the interest rate to be charged to the invested amount as it is not legally binding or they have no legality of being repaid in a stipulated time period. As such, the 6% coupon interest available to the Jute's investment cannot be applicable and it will only increase the amount for instance in debt financing. Return based on equity financing is paid as dividends; consequently it only depends on the profitability and growth of the business operations. Indeed, the management of Jute plc will not be under pressure to repay the amount that was raised by the investors when investing on the £100M revolutionary product but will have to delay the reimbursements until the investment reports a growth.
In regard to the underlying project, Jute plc management's scrutiny on the reliability of the project and the need to select the financing option articulates to the financial well-being of the company. For instance, where the company is not able to effectively repay the loan plus interest accrued will advertently lead to equity financing. In the case of Jute plc, the company had realized Earning before Interest, Tax, Depreciation and Amortization (EBITDA) of £110M and the available cash that was generated from the operations being £100M implying that raising equity of £100M for financing the operations will make the company forego a certain percentage of the business operations to the investors.
Generally, equity financing is considered sometimes appropriate in financing Jute plc's investment as the finances are always geared towards the business and the projects they are meant for. Individuals intending to invest in the company may achieve this through their businesses basing their attention on revolutionary new product, when the business is performing well either through flotation in the stock market or when it is valued by new investor who wants to purchase it. The investors that were preoccupied with the company's investment in the new product will ensure that they offer valuable contacts, skills and experience to Jute plc with an aim of ensuring success of the business. Such a strategy will enhance the realization of the strategic goal for the company and in turn increase the revenue outlay, as the investors are known to have a vested interest in the operations of the business through profitability, value increase and growth.
However, Jute plc management should analyze the financing option's drawbacks. In reality raising equity financing is always demanding, time-consuming and costly. Business operations of the company may ultimately suffer as the managerial team devotes most of its time to equity financing deal. The potential investors will be able to access the private and relevant information that are not intended to be exposed to the public scrutinizing the financial statements and forecasts of Jute plc by probing the management team. This will expose Jute plc to unintended rivalry and competition from the close competitors as their strategies will be exposed to them. Equity financing projects are dependent on the common mid in decision making. The management depended on the existing investor will ultimately make the management loose a certain amount of power they are vested within making relevant decision concerning the new product.
Debt financing is another option that is available for Jute plc to finance its operations. Debt is considered to be the total of finances acquired through borrowing from an outside source whereby the promise is the return of the initial principle with the accrued interest thereon. Although debt is perceived to possess negative connotation, new ventures and organization usually rely debt financing to fund their operations. Indeed, the most "healthy" balance sheets have always reported debt in their financial statements. Jute plc can rely on this financing option of the revolutionary new product. Currently, the management is being financed by debt of £200M and upon incorporating another investment, it will push up the interest that will be charged on the amount borrowed.
However, this option of financing an investment has numerous benefits to the management of Jute plc. It ensures that the share holders of Jute plc are maintained by the current management. In the case where the amount is borrowed from lending institutions like bank, Jute plc will only be obligated to make payments up to the agreed period of time. Upon completion of the payments, the management has the right to run the business undertakings on the way it wants without any interference from the outsiders. In addition, the payments that are made on the business loan; that is interest and principal, are considered being business expenses and are deducted from the taxable income of the entity. This will increase Jute's Earning after Tax (EAT) hence enhancing their profitability in the economy.
Despite these advantages that surround the financing strategy of Jute plc, the option has its underlying drawbacks in the realization of the strategic goal and overall success of the entity. The repayment of the debt is constant and cannot be altered to suit the entity's needs. In the case where Jute plc's performance is at stake, the payments of interest accrued and principal should be met in due course. As such, where the organization is declared insolvent, the claimants will be prioritized in regard to the equity investors. Even though, the option may report a lower discounted interest rate, Jute plc will be faced with an increased interest rate which is dependent on the change in the economy. The macroeconomic conditions prevailing in the economy will ultimately have an impact on the interest rates, Jute's history with the financial institutions, and the entity's credit rating.
Jute plc is currently having a debt financing of £100M which it is re-servicing, addition of another credit will mean that the credit rating of the firm by the financial institution will be lower. Levering up increases the risk of the financial institutions or the lender and with the available EBITDA of £110M, Jute plc cannot effectively re-service the debt that it aims to undertake. Currently, Jute plc is generating cash flows of £100M and this will is not sufficient when repaying the debt. Jute plc needs to ensure that it generates sufficient amount of cash from its operations before the repayment of the loan commencers.
Effects of EBITDA on the Investment option
Financial leverage is a financial index that is to measure the degree of the use of debt and other fixed-cost of the fund to finance an asset that has been acquired by Jute Plc. If Jute plc is highly leveraged, it is likely to go bankrupt due to its inability to achieve its debt requirements. It is also highly likely that Jute Plc might find it rather difficulty to raise funds at a future date. The use of debt as a magnifying effect on the earning per share ensures that the investment portfolio is articulated to by the management. Financial leverage has an identifiable relationship to the provision of capital of finance in a company. It is based on the availability of fixed financial "fixed financial charges such as interest on debt and dividend on equity/preference shares" (Leverage Analysis n.d). Because these types of expenses do not change with operating profits, financial leverage is mainly concerned with the effects on the changes in EBIT in relation to the earnings available to equity-holders. The firm may be able to meet its financial charges in order to magnify its effect of changes in EBIT on the earning per share (EPS).
Jute plc EBITDA is at £110M implying that any decrease in the value will have negative implications to earnings that a firm has on her equity holders. Thus, EBITDA tries to indicate the entity's operating performance and it cannot be effectively relied upon by the investors in the analysis of choice to invest in a company or to take an alternative option. In reality, the expenses are not necessarily operating and recurring and may include asset impairments and restructuring expenses. Jute plc can only increase its EBITDA by purchasing or leasing another company in the same line of operation.
By completing the financing scenario that Jute Plc is faced with, I am able to understand that there are two methods that the company may use to capital in order to finance its projects. These two methods are equity and debt financing. According to this case study, equity financing is more appealing to Jute Plc sine it is taken to mean "free" money and there are no obligations attached to its repayment because of the presence of equity investors.
Another aspect that I have learned is the use of the financial leverage to determine how Jute Plc is utilizing borrowed funds. If Jute Plc is highly leveraged, if debt obligations cannot be achieved rendering it to be bankrupt. It is also highly likely that the company might find any lender and therefore, it is imperative that the company's managers maintain a low leverage.
The value of Jute Plc depends on its capital structure and entails debt, equity, and is focused on other financial resources that are required for all assets to be held for long time duration. A major balance in the capital structure lies between debt capital and equity capital. From this case, following the determination of exact optimal capital structure, factors that firms require to target an optimal capital structure involves of more debt risks in returns or earnings and high debt that lead to higher returns. These cause greater debt and lower the stock's price.
When Jute expects high rates of return, this may cause investors to be more attracted. In such a scenario, the capital is weighted to the lowest average in a specified time, hence the value of the enterprise is in a maximum necessary to create a balance between risk of a firm and return to enable it achieve its main goal to achieve maximum prices for the commodities. The capital structure of Jute comprises of the long-term financial sources incorporating long-term assets and stocks that are preferred and earnings retained. When the company need additional funds for such things as acquisitions, new product offerings, and to enlarge their market share, Jute will have to shift to capital markets. The stock market refers to capital market, as well as the bond market. Thus in equity financing Jute Plc will be able to access the stock market whereas for debt financing, firms shift their attention to the bond market.
In debt financing, the advantages include the ability of a firm to maintain the overall control of the business enterprise and the accrued interest over debt financing which is taxed, however, it faces some setbacks in that much debt can make Jute Plc to encounter problems when it begins to depend on it so much and lack revenues to offset the debts. Furthermore, if Jute has too much debt, this will mean that it become unattractive to investors due to the belief that the company will be at high risk.
In the case of Jute Plc, equity financing will be emphasized since the company's management will have no worries concerning the traditional ways of repayment. This is because when Jute records good returns, banks will be paid finances that he company (Jute Plc) owe them; hence, assisting investors and the firm be realistic and attract more attention from banks.
Based on the functions outlaid I am able to identify the disadvantages of equity financing that includes the risk of Jute Plc's shareholders to lose overall control and become more dependent. Hence, investors will be responsible for the decisions they make. Furthermore, overreliance on equity financing may confirm to banks and other potential lenders that Jute Plc's management is willing to take control over any potential risks, thus, in such a situation, Jute Plc will lose its credibility. Analysis can be made to indicate that the firm can be operated in a sensible manner without relying on a particular institution.
In Leasing, the government has to withdraw market management in jute plc as well as other related markets. However, the importance of the involvement of the governments in the trade is the role it provides in relieving Jute Plc individual from potential risks. In addition, it also means that Jute is protected from exposure to potential risks in the market.
Preference share holders
In Jute plc, quite a good percentage of cumulative preference share have been offered for sale at par, Preference shares contains rights of a third of the profits that are distributed exceeding the dividends subjected to a maximum return. Thus, in jute plc, preference shares are important since the share holders are entitled dividends yearly. Hence, in Jute plc, the share holders are assured of a dividend yearly. In addition, the share holders are entitled to obtain a priority over ordinary shares. Thus, the preference, share holders are accorded the first priority.
Preference shares are also very safe, for instance in a situation which may lead to Jute plc being wound up, and the company's assets are being sold, the income obtained is shared among the shareholders. The preference shareholders will have an advantage of getting their share first. However, preference shares are not available easily since they are commonly issued by companies to affiliate institutions. Further more, the preference shares are not traded in the stock exchange market.
Through this analysis, I may consider developing my future career plans since there is a need to focus on future business motives such as the level of control needed, as well as designing firm's long-term goals. As a future bank manager or investor, from the above case, I am able to identify that with equity financing, a firm's owner and the funders or investors may not come to terms on the evaluation of the most important business decisions. Thus, this provides firms owners with an idea to allow investors to drive operate their businesses without the depending so much on financing institutions. Different approaches to debt financing should be explored in order to retain control and to maintain the best direction for a business enterprise.
In order to determine optimal structure, firm's trade off their costs as well as benefits, hence, have the option to make a choice on the appropriate debt, as well as, equity depending on the firm's life cycle. Debt financing and equity financing methods are sensitivity analysis, in which debts factors and associated effects of debt and equity are mostly based upon. With reference to this case study of Jute Plc, it is important to support the company's financial decision that are based on the belief that most important information is vested on firms management and lenders such as banks. In this case, I support a theory that makes emphasis on the reason why firms' managers are fond of using miscellaneous income to finance their targeted projects. This also emphasizes the need of a signal in debt issuance. When analyzing management this explains the reason why managers with low ability face a challenge of repaying debts which are at a higher level and may be at risk of being bankrupt. Hence, skilled managers will face no difficulty in repaying the debts. Consequently, with regards to equity financing, any investments in buying a firm's shares makes the shareholder or investor to be entitled to a share of the firm's equity. In such circumstances an investor forms part of a company's equity, as the share holders use their funds to finance the venture.