Funding Alternatives and Managing Foreign Exchange Risk … Essay
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A company based in the United Kingdom is seeking to generate additional funding of £500m for the next stage of developing its business operations. The company is currently listed with 100 million shares at a current market price of £10 per share. Given that the company is listed with a huge number of shares that are relatively performing well in the stock exchange, all avenues of funding are available to it. However, the process of raising additional finances for the company requires consideration of various funding options in order to select a suitable alternative that will be beneficial for the business. The evaluation of these funding options will involve a critical review of each of them with regards to their advantages and disadvantages. Notably, these different funding options that are viable for the company are available through equity and debt markets.
Funding Options in Debt Markets
One of the available funding options for this UK-based company is funding through debt markets, which is also referred to as debt funding that is usually carried out through intermediaries. Debt funding basically means borrowing money from an external source with the promise of repayment of the borrowed amount and interest at a later date (Palermo, 2014). For the UK-based company, there are several debt financing options available for raising additional funds for business development including conventional secured loans. These secured loans are relatively similar to those offered by banks and are usually repaid in monthly installments in addition to requiring a personal guaranty on the borrower's part. Some of the items that can be used as guaranty include inventory, insurance policies, accounts receivable, and equipment. In case the borrower defaults, the collateral or guaranty is used to satisfy payment. The advantages of conventionally secured loans include easy access to capital, flexibility for use in any size or type of business, offers more options than normal bank loans, and does not give lenders a say in business operations. However, these loans are disadvantageous since they are characterized by high interest rates, require sufficient collateral, and may eventually be expensive for the firm.
The second alternative in debt financing is syndicated bank lending, which involves the issuance of loans by banks through providing bonds utilized in the capital market. This bank-intermediated loan is usually given to large globally-active companies by a group of banks. This group of banks divides the loan among themselves depending on their abilities and expertise in relation to the various tasks the money will be utilized to conduct. These banks earn money from the syndicated loans through interest income and fee income. The major advantages of syndicated bank lending include competitiveness of price of the funds, a single negotiation and set of documentation, ease in arranging the amount of funds, and confidentiality in dealings. However, the disadvantages include the involvement of many banks, high costs of loans because of involvement of more banks, and preference for large international companies or national government (Pettigrew, 2014, p.63).
The third debt financing option for this UK-based company is securitization, which is a term that was originally used to refer to the process where a borrower substitutes bank-intermediated funds with provision of financial securities like bonds or commercial paper. In the modern business environment, securitization has been modified to include a wide range of assets, structures, and participants. In this case, the originator of the lending transfer rights to flow of future income from the receivables to a special purpose vehicle firm (SPV). Upon receiving these rights to the receivables, the firm provides rated debts securities to investors. Funds raised through this process are in turn used to pay the originator of receivables' rights while future payments generate interest. The major advantages of this debt funding option include distribution of roles to capable parties or entities and provision of a more efficient result for end users. However they are disadvantageous with regards to the involvement of many intermediaries and likelihood of being more costly.
The UK-based firm can also consider note issuance facilities or and the international bond market. Note issuance facilities entail providing short-term notes by a borrower in their own name but guaranteed by bank credit arrangements or underwritten by a group of banks. The advantages of this option include involvement of few intermediaries and guarantee of provision of funds by banks while disadvantages include banks only demonstrate commitment when NIF is agreed upon rather than provide money and need for detailed terms and conditions. Bond markets are advantageous since they have fixed redemption value and date and fixed interest rates though their rigidity is relatively a disadvantage in relation to repayment difficulties.
With regards to equity markets, the UK-based company can raise additional funds through two major options i.e. ordinary shares and preference shares since equities are not debt instruments like bonds. According to Bolton & Freixas (2000), companies may opt for equity financing in order to avoid intermediation costs (p.325). For this UK-based firm, equity markets could be the most suitable way of raising additional funds for its business development initiatives since it has a huge number of shares that are seemingly performing well in the stock market.
Ordinary shares are suitable funding option for the firm since they grant the firm claims to variable future income streams, in dividends form. These dividends are simply payments to shareholders that are paid from the company's profits. However, these dividends are not guaranteed though shareholders have the right to a portion of the profits. The advantages of ordinary shares as a funding option for the firm include shareholders bear business risk, they never have to be repaid by the firm, and have no specified maturity date. Nonetheless, they are disadvantageous in the sense that shareholders have a say in the business and shareholders' entitlement of a portion of the firm's net asset value in case it's placed in liquidation.
Preference shares are different from ordinary shares since they provide their owners certain preferences or benefits. The firm should consider this funding option because it comprises various types of shares with different benefits and advantages to the company. Unlike ordinary shares, preference shares are cumulative, which implies that if dividends for the current year remain unpaid, they are carried forward to the next financial year. The advantages of this option include shareholders have no voting rights, comprises several alternatives for the firm to choose from on the basis of their suitability, and relatively stable price of stock. On the contrary, their disadvantages are fixed dividend payment, cumulative nature of the dividends, and shareholders claims of company's assets (Pettigrew, 2014, p.80).
Part B -- Use of Financial Derivatives
For this UK-based company, the additional funding for developing the next stage of the business will help promotes its success and profitability in the market. This extra funding will also enable the business to become more international since it creates an opportunity to develop a market in various countries with payments made in local currency. However, the company's directors are skeptical regarding risk despite the numerous advantages of this additional funding in relation to increased growth and profitability of the company. To this extent, it is increasingly important to critically evaluate alternative derivatives that are available in the market that could help mitigate risk. These alternative derivatives should be evaluated on the premise of their ability to lessen risk with regards to payment in foreign currencies. This will be crucial in order to ensure the company has established suitable risk mitigation measures, which will help in promoting increased growth and profitability of the firm.
Generally, foreign exchange risk emerges from the exposure of a business to assets, transactions and liabilities that are denominated in international currencies. The overall price of such a company is usually affected by fluctuation in exchange rates, which affect the value of the business' items. Notably, foreign exchange risk usually occurs in three different ways i.e. economic risk, transaction risk, and translation risk. Economic risk is considered as the long-term effect of exchange rates' fluctuations on the current value of future cash flows. Similar to other multinational corporations, this UK-based firm is subjected to changes in cash flows because of fluctuations in exchange rates. Transaction risk emerges when a business develops future receivables and/or payables that are denominated in international currencies. Consequently, the eventual value of the receivables or payables when they are gathered or paid respectively may vary from their initial value when created because of differences in exchange rates between currencies. On other hand, translation risk is generated when an international subsidiary' financial statements are translated into the parent firm's local currency in attempts to consolidate the entire organization's financial statements (Association for Financial Professionals, 2013, p.56).
Since this UK-based firm will be operating in international markets through this additional funding, it is increasingly likely to be exposed to these three different types of foreign exchange risk. Therefore, identifying suitable risk mitigation measures is urgent and more important in order to promote growth and profitability. One of the financial… [END OF PREVIEW]
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