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8/23/2019 MFRD task 2
1/9
I. APPROPRIATE SOURCES OF FINANCE FOR BUSINESS ESPANSION
For business expansion, there are many options that help Xpresso raise capital.
Business expansion would require the issue of more share capital or more loans or based
on retained earning.
1. Retained earnings
Like any companies, Xpresso retains their earnings in order to invest them into
areas where the company can create growth opportunities. Using retained earnings to
expand market is much safer than other choices. The company does not have to pay
interest for others and get total benefits from their projects. They are also total
independent to set the strategy or control their capital without pressure from others
(interest, time banner).
However, using own capital cannot bring much more benefits than borrowing.
The company does not have much capital for other activities. Other thing is that using
own capital, Xpresso does not have reducible the cost of debt capital so the net income
will be influenced.
Retained earnings = Net income Dividend
Retained earnings are available to use and expansion is one of a part of businessso it must be thought when Xpresso wants to expand their market. However, using all
capital is not a good idea in business, the company has any other projects and they must
use their capital to balance their business operation.
2. Issuing new ordinary shares
To raise capital, Xpresso may issue new ordinary share in order to attract more
investors, who are willing to become new shareholders of the company. Issuing new
shares is suitable for raising large amount of cash because public ordinary shares of a
growth company will attract more investor if they feel the project can bring much benefit
for them. Moreover, this helps the company avoid the need to raise cash from existing
shareholders. It also reduces the risk of a future takeover taking place.
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On the other hand, existing holders may affect this option because it increases the
number of shareholders in the company, so the dividend which the company pays for
existing shareholders will be influenced and the control of them will be dilute. Besides,
most ordinary shares are irredeemable, in that the capital cannot be repaid to the
shareholder. It is also difficult in fixing an issue price, particularly in a volatile market
like Vietnam.
Xpresso Delight Limited need US$ 20 million dollar for the business expansion,
but in business, the company will not use US$ 20 million dollar one time. Xpresso will
divide the amount of money for five year. That means Xpresso will use US$ 4 million
dollar for one year.
For the option issuing new shares, Xpresso will pay flotation cost (17 %) and
dividend in the first five year. From the sixth year, Xpresso just have to pay dividend for
shareholders.
The cost that the company must pay for each year will follow.
Year 1:
$ %
For 1 share, the company issue (Proceeds) 1.50
The dividend the company pays for 1 share 0.20
Dividend/1$ (Dividend/Proceeds) 13.33%
Flotation cost for 1 share 17.00%Total cost for issuing ordinary share 30.33%
Dividend for existing shareholders 0.00%
Total cost 30.33%
Required fund 20,000,000
Dividend 13.33% x 20,000,000 2,666,667
Flotation cost 17.00% x 20,000,000 3,400,000
Total cost 6,066,667
Year 2
In year 2, Xpresso has two kinds of shareholders. One is shareholders, who bought
ordinary shares in year 1 and another is new shareholders, who buy shares in year 2. The
dividend in year 2 is not only $0.2/share, normally; it increases 0.2 x (1+15%).
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$ %
For 1 share, the company issue (Proceeds) 1.50
The dividend the company pays for 1 share 0.2 x (1 + 15%) 0.23
Dividend/1$ (Dividend/Proceeds) 15.33%
Flotation cost for 1 share 17%
Total cost for issuing ordinary share 32.33%
Dividend for existing shareholders 15.33% x 1 15.33%
Total cost 47.67%
Required fund 20,000,000
Dividend 15.33% x 2 x 20,000,000 6,133,333
Flotation cost 17.00% x 20,000,000 3,400,000
Total cost 9,533,333
From year 3 to year 5, the dividend follows the same formulae: A x (1+15%) with A is
the number of dividend in the previous year.
Year 3 $ %
For 1 share, the company issue (Proceeds) 1.50
The dividend the company pays for 1 share 0.23 x (1 + 15%) 0.26
Dividend/1$ (Dividend/Proceeds) 17.63%
Flotation cost for 1 share 17%
Total cost for issuing ordinary share 34.63%
Dividend for existing shareholders 17.63% x 2 35.27%
Total cost 69.90%
Required fund20,000,000
Dividend 17.63% x 3 x 20,000,000 10,580,000
Flotation cost 17.00% x 20,000,0003,400,000
Total cost13,980,000
Year 4 $ %
For 1 share, the company issue (Proceeds) 1.50
The dividend the company pays for 1 share 0.26 x (1 + 15%) 0.30
Dividend/1$ (Dividend/Proceeds) 20.28%
Flotation cost for 1 share 17%
Total cost for issuing ordinary share 37.28%
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Dividend for existing shareholders 20.28% x 3 60.84%
Total cost 98.11%
Required fund20,000,000
Dividend 20.28% x 4 x 20,000,000 16,222,667
Flotation cost 17.00% x 20,000,0003,400,000
Total cost19,622,667
Year 5 $ %
For 1 share, the company issue (Proceeds) 1.50
The dividend the company pays for 1 share 0.30 x (1 + 15%) 0.35
Dividend/1$ (Dividend/Proceeds) 23.32%
Flotation cost for 1 share 17%
Total cost for issuing ordinary share 40.32%
Dividend for existing shareholders 23.32% x 4 93.28%
Total cost 133.60%
Required fund20,000,000
Dividend 23.32% x 5 x 20,000,000 23,320,083
Flotation cost 17.00% x 20,000,0003,400,000
Total cost26,720,083
In the year 6, the company just pay dividend for shareholders.
Year 1 Year 2 Year 3 Year 4 Year 5
Required fund 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000
Dividend 2,666,667 6,133,333 10,580,000 16,222,667 23,320,083
Flotation cost 3,400,000 3,400,000 3,400,000 3,400,000 3,400,000
Total cost 6,066,667 9,533,333 13,980,000 19,622,667 26,720,083
3. Issuing preference shares
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In order to raise capital but does not dilute the control of existing shareholders,
Xpresso may issue preference shares for existing shareholders. The shareholders, who
own reference shares, cannot effect the decisions of the company.
However, the company must pay dividend for reference shares before ordinary
shares. Sometimes, preference shares are issued in redeemable form. That means they
will be repurchased by the company which issues them at a specified date. Thus, this may
influence the plan of the company.
For reference share, the dividend of them does not fluctuate year by year, it is fix
at 9.52%/1$.
The calculation of preference cost as below.
Year 1 $ %
For 1 share, the company issue (Proceeds) 42The dividend the company pays for 1 share 4
Dividend/1$ (Dividend/Proceeds) 9.52%
Flotation cost for 1 share 10.00%
Total cost for issuing ordinary share 19.52%
Dividend for existing shareholders 0.00%
Total cost 19.52%
Required fund 20,000,000
Dividend 9.52% x 20,000,000 1,904,762
Flotation cost 10.00% x 20,000,000 2,000,000
Total cost 3,904,762
Year 2 $ %
For 1 share, the company issue (Proceeds) 42
The dividend the company pays for 1 share 4
Dividend/1$ (Dividend/Proceeds) 9.52%
Flotation cost for 1 share 10.00%
Total cost for issuing ordinary share 19.52%
Dividend for existing shareholders 9.52%
Total cost 29.05%
Required fund 20,000,000
Dividend 9.52% x 2 x 20,000,000 3,809,524
Flotation cost 10.00% x 20,000,000 2,000,000
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Total cost 5,809,524
Year 3 $ %
For 1 share, the company issue (Proceeds) 42
The dividend the company pays for 1 share 4
Dividend/1$ (Dividend/Proceeds) 9.52%
Flotation cost for 1 share 10.00%
Total cost for issuing ordinary share 19.52%
Dividend for existing shareholders 9.52 x 2 19.05%
Total cost 38.57%
Required fund 20,000,000
Dividend 9.52% x 3 x 20,000,000 5,714,286Flotation cost 10.00% x 20,000,000 2,000,000
Total cost 7,714,286
Year 4 $ %
For 1 share, the company issue (Proceeds) 42
The dividend the company pays for 1 share 4
Dividend/1$ (Dividend/Proceeds) 9.52%
Flotation cost for 1 share 10.00%Total cost for issuing ordinary share 19.52%
Dividend for existing shareholders 9.52 x 3 28.57%
Total cost 48.10%
Required fund 20,000,000
Dividend 9.52% x 3 x 20,000,000 7,619,048
Flotation cost 10.00% x 20,000,000 2,000,000
Total cost 9,619,048
Year 5 $ %
For 1 share, the company issue (Proceeds) 42
The dividend the company pays for 1 share 4
Dividend/1$ (Dividend/Proceeds) 9.52%
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Flotation cost for 1 share 10.00%
Total cost for issuing ordinary share 19.52%
Dividend for existing shareholders 9.52 x 4 38.10%
Total cost 57.62%
Required fund 20,000,000
Dividend 9.52% x 3 x 20,000,000 9,523,810
Flotation cost 10.00% x 20,000,000 2,000,000
Total cost 11,523,810
In year 6, Xpresso only pay dividend.
Year 1 Year 2 Year 3 Year 4 Year 5
Required fund 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000Dividend 1,904,762 3,809,524 5,714,286 7,619,048 9,523,810
Flotation cost 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
Total cost 3,904,762 5,809,524 7,714,286 9,619,048 11,523,810
4. Option 3: Borrowing
One of the optimum options for business expansion is borrowing from the banks.
With the same project, borrowing money brings more profit than using own capital.
Furthermore, Xpresso can use their capital for other business activities. The company can
control its own destiny regarding business and own all the profit it makes. They can alsoreduce the cost of debt capital by the tax relief; this is one of the most important things
that the company should consider carefully.
Nevertheless, borrowing brings more risky if the company cannot earn profits or
delay to pay interest for lender. This will broke the relationship with the bank and
influence future borrowing. The image in the public is also influenced, nobody believes a
company who cannot pay loan or delay too many times.
Interest rate 15%
Tax relief (tax rate 25%) 1 - 25% 75%
Debt 15% x 75% 11.25%
In the next 4 year, the debt will increase 2, 3, 4 and 5 times. Therefore, we can calculate
the amount of interest Xpresso must pay in five years for borrowing.
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Debt
% $
Year 1 11.25% 2,250,000
Year 2 11.25% x 2 22.50% 4,500,000
Year 3 11.25% x 3 33.75% 6,750,000
Year 4 11.25% x 4 45.00% 9,000,000
Year 5 11.25% x 5 56.25% 11,250,000
The table shows the costs/$1 that Xpresso must pay each year if they borrow
Year 1 Year 2 Year 3 Year 4 Year 5
Fund1.0000 1.0000 1.0000 1.0000 1.0000
Debt
0.1125 0.2250 0.3375 0.4500 0.5625
Total cost1.1125 1.2250 1.3375 1.4500 1.5625
In the case borrowing, Xpresso needs $20,000,000 to open 20 cafes each year. We
can assume that now the company has 40 cafes so their equity is around $40,000,000.
That means their equity is double the total amount of money they need. Each year, they
need $4,000,000 so their equity is 10 times.
Year 1 Year 2 Year 3 Year 4 Year 5
Debt 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000
Equity 40,000,000 40,000,000 40,000,000 40,000,000 40,000,000
Debt to equity 50% 100% 150% 200% 250%
According to rule of thumb, the Debt to equity ratio should less than 1. If not, the
company will not have enough money to pay for lender.
5. Comparison
To be easy to compare the three options, we may compare the cost that Xpresso
must pay for $1 each year. The cost that Xpresso pay for raising capital for each option
will be compared by the table below.
Year 1 Year 2 Year 3 Year 4 Year 5Total cost in 5
years
Borrowing 1.1125 1.2250 1.3375 1.4500 1.5625 6.6875
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Ordinary share 0.3033 0.4767 0.6990 0.9811 1.3360 3.7961
Preference share 0.1952 0.2905 0.3857 0.4810 0.5762 1.9286
We can see very clearly that the cost that Xpresso must pay for borrowing in 5
years is much more than others. However, it is because the calculation assumes that the
company has not paid for all debt yet for 5 years. If Xpressos business is quite good,
they can pay for debt early and reduce the total cost much. Currently, Xpresso Delight
Limited is growing up and they attract many investors (The earning growth projected at
constant 15% per annum; their ordinary shares have outperformed in the past four years
by an average of 40% per year). After paying all debt, Xpresso is free to do their business
and they have not paid for anything. This is one of the advantages if the company decidesto choose borrowing.
Furthermore, is the company issue ordinary or preference share, suppose that they
must pay dividends forever and this even increases the total cost much more than
borrowing option.
6. Recommendation
Compared any sources of finance for business expansion, we suggest Xpresso
Delight Limited should cooperate both their capital and borrowing to finance the project.
Firstly, they ensure that the flotation cost is not too big. Secondly, using their capital is
much safer than any other sources. Thirdly, borrowing can bring much more profits for
them than others as well as reduce the cost of debt capital. After paying all debt, the
company does not have to pay for long debt if comparing to dividends which Xpresso
must pay for their shareholders forever.