Report to CFO
FROM: Group Financial Manager of Woolworth Ltd
TO: Chief Financial Officer (CFO)
DATE: April 18, 2009
Subject: Choice of Financing Decision
The board of directors of Woolworth Ltd have decided to raise external fund of $800million over the next few month. They are considering three different funding options as follows: First, issuing ordinary share of $500milion and the rest $300million through retail offer with estimated market price of $25. Second, issuing a non-cumulative redeemable preference share of $800million ($80million preference share at $10 per share and 5% dividend per annum) and are convertible to ordinary share after five years. Third, to borrow $800million from the bank with interest rate expected to be 7% per annum and five years to maturity. The committed bank debt facility is $2.1billion.
The objective of this report is to determine the best choice of the three funding decision proposed by the board. To achieve our objective, a proper analysis of each of the funding decision is required.
Advantages and Disadvantages of each funding choice
Ordinary Share: This is one major source of long-term financing. It is also considered as equity finance, which is the investment in a company by the ordinary shareholders. This is represented by the issued ordinary share capital plus
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The advantages in issuing ordinary share capital include the following; first, it gives the investor (institutional) the right to vote in AGM. Second, issuing ordinary shares makes it easier to borrow money from financial institution because they are rank last for repayment. Third, issuing ordinary share is easily accessible when the company involved is listed. Lastly, issuing new shares would increase company’s total capital and reduce gearing (debt/Equity).
The disadvantages include the following; first, it is more costly to issue ordinary share capital compared to debt. Second, issuing additional ordinary share capital would dilute control of existing investors. Third, ordinary share capital are more risky since they are ranked last for repayment. Fourth, additional issue of ordinary share affects the company earnings per share (EPS), a market indicator.
Non-cumulative redeemable preference share: This is another type of share capital that can be issued by a company to raise fund. They are not considered as part of equity capital because their characteristics bear more resemblance to debt finance. Investors holding this type of share capital have limited right to vote at general meeting (except when their dividend has not been paid for three years), ranked after all creditors but usually before ordinary shareholders (Marks & Adelman, 2004)
It has the following advantages from the company point of view: first, dividends do not have to be paid in period of poor profit. Second, they avoid the diluting effect of control to existing shareholders since they carry no voting right. Third, the issue of this type of shares does not restrict the company borrowing power since they are not secured against the company assets.
The disadvantages of issuing cumulative preference shares include the following; first, they would increase the company gearing since they are considered as debt. Second, investors have limited right to vote during general meetings. Third, in situation where these shares are converted to ordinary share, it would have diluting effect of control to existing shareholders and would reduce the company EPS.
Debt financing: This is an alternative to equity finance and it represents long term debts (loan notes) in the form of debentures or bonds. Loan notes are written acknowledgment of a debt by an enterprise, which contains provisions as to payment of interest and term of repayment of principal (Arnold, 2005; Ross et al, 2002).
Debt finance has the following advantages; first, it is cheap compared to equity financing because it is less risky. And as a result loan note holder would accept a lower rate of return than shareholder. Second, debt has predictable flows and their cost is limited to stipulated interest payment. Third, there is no dilution of control when debt is issued.
It has the following disadvantages; it is inflexible, it increases the level of gearing for the company, stipulated interest cost must be paid whether the company makes profit or loss.
Implication of each funding choice in the company financial statement
Ordinary share capital: the issue of $800million ordinary share capital would have certain implication to the company statement of financial position (SFP) and statement of income. On the SFP, the ordinary share capital would increase by the issue amount. This would enable the reduction of the gearing level of the company. On the other hand, it would affect the EPS values in the income statement. Since the issue would increase the total number of ordinary shares, the new EPS value would reduce (a bad market indication)
Non-cumulative redeemable preference share capital: this would affect the debt component in the company SFP as the amount would increase by $800million. In addition, this figure would make the gearing level of the company to increase as the total debt value has increased. But in situation where preference shares are converted to ordinary shares if not redeemed, it would have similar implications like in share capital above.
Debt: this has similar implication to the company SFP like cumulative preference share capital mentioned above. But it has a different implication in the income statement because debt holders are entitled to fixed interest payment from the company regardless of its financial performance. This would affect the new EPS value since finance cost reduces profit before taxation.
Conclusion and Recommendation
Generally, considering the advantages and disadvantages of the three financing decision option, and their respective implication to the company financial statement, it is appropriate to mention that raising the $800million capital through borrowing is the best funding option. Therefore, in my opinion, I would recommend the CFO to adopt this particular funding choice.
ACCA official Textbook (2008/09): Financial Management (FM). Kaplan Publishing: UK
Arnold, G. (2005): Corporate Financial Management. Prentice Hill: USA
Marks, A. A. & Adelman, P. J. (2004): Entrepreneurial Finance: Finance for small Business. Prentice Hall, USA
Megginson, W. L (1997): Corporate Finance Theory. Addison Wesley: USA
Richard, S. & Janet, K. (2000): Entrepreneurial Finance. Wiley: USA
Ross, S., Westerfield, R., & Jaffe, J. (2002): Corporate Finance. McGraw Hill: USA