Sources Of External Finance Available To Public Listed Company And Weighted Average Cost Of Capital

Government Grants for Raising Finance

In terms of Commercial Company Law, a public listed entity is an entity which is trading on a recognised stock exchange of a country like Dubai Financial Market (DFM). The public company has its share trading and there is no restriction on share transfer of the company. There are various sources through which a public listed entity can raise finance from the market. The same has been highlighted here-in-below:

• Government Grants;
• Debt Financing;
• Venture Capital;
• Business Angels;
•  

The detailed analysis of the aforesaid five external factors of finance has been presented here-in-below:

• Government Grants

Grants are financial aid or help that are provided by the government to promote a particular type of business or activity in a particular area or to promote industrialisation in the country. They are provided to support core activity of business and is intend to improve the bottom line of the business. The aid is provided to ensure employment growth, creation of job opportunity in the economy and improving the standard of living. Further, the grant is also provided to promote Medium and Small sized enterprises in the economy.

Advantages of Raising Finance through Government Grants  

The chief advantage of raising finance through government grant has been highlighted here-in-below:

• Huge monetary awards are received at proposal without any return requirement, or lower rate of interest is offered;
• Funds raised through this medium aids in procurement of loan through other private or government sources;
• Support from Government in investment projects

Disadvantages of Raising Finance through Government Grants  

• It is time consuming and costly affair;
• Redtapism , Bureaucracy delays and stalls the project;
• Not suitable for large projects.

When to be Sought

• When other sourced of finance are readily available on account of poor credit rating, duration of debt and terms of repayment.

• Debt Financing

This mode of financing is one of the most common form of external financing in the investment world. This is used to procure funds when credit rating are good and the debt to equity ratio is low. Further, the interest on debt is tax deductible and is commonly used for trading in equity. Debt financing can be available for short term and long term as per need of the organisation. Further, debt can be raised from public or banks depending on needs of the organisation. (Entrepreneur Media, Inc., 2018)

Advantages of Raising Finance through Debt Financing

The chief advantage of raising finance through Debt Financing has been highlighted here-in-below:

• The company can retain control over the company by issuing debt as the debt holders do not have say in the decision making of the company. Further, the ownership of the company is not diluted as they are entitles to a fixed rate of return on the amount lent.
• The payment of interest is tax deductible and thus the payment of interest adds to tax benefit of the company. Thus, company prefer issuing of debt over equity;
• It eases financing as the company is aware of the amount of interest and principal to be repaid over the period. Thus, it eases planning of cash flows.

Disadvantages of Raising Finance through Government Grants  

• Debt can be converted into equity in case of default;
• Debt carry a fixed rate of interest which needs to be repaid irrespective of the profit or loss situation of the company;
• Issuing of debt has covenants associated with it which may restrict additional finance;
• Good Credit rating is required to procure funds from the market;
• Collateral needs to be provide for procuring funds from the market by the company;

When to be Sought

• Company has good cash flows and is ready to make regular payments for cash and principal;
• Company is earning profits and expected to maintain it over a steady period. 

• Venture Capital

Under a Venture Capital, a public listed entity not only receives financial support in the form of funds for procurement of assets or expansion of business but also non-financial support in the form of advisory and technical knowledge and skills. (EduPristine, 2017)

Advantages of Raising Finance through Venture Capital

The chief advantage of raising finance through Venture Capital has been highlighted here-in-below:

• Availability of Business Expertise: When a Public Listed entity opts for Venture Capital, expert advise and consultation shall be available to the company to make a well balanced decision for utilisation of procured funds for growth of the company. Venture Capitalists aid in financial management, human resource management and business decisions;
• Key Support is provided in the areas of tax, legal and personnel matters and helps in providing support service at each stage of growth of the company;
• Venture capitalists have good connection with business community. Exploring those business connections can help business to reap tremendous benefits in the long run;

Disadvantages of Raising Finance through Venture Capitals

• While procuring funds through Venture Capital, Company can loss its control over the business as it is similar to equity financing. The deep involvement of Venture Capitals in the day to day business of the company on the basis of the stake they acquirein the company;
• If the stake of Venture capital is greater than 50% of the voting rights of the company, the same shall result in the loss of control to the venture capital.

When to be Sought

• Openness of the Public Listed entity to take active support from the Venture Capitalist;
• Need for expertise and resources from a Venture Capitalist by a Public listed Company;
• Ready to share or give up control of the company.

• Business Angels 

Advantages and Disadvantages of Raising Finance through Government Grants

Under this method of financing, company typically stake in the assets of the company by selling equity to business angels for funds. The amount raised through this medium is modest (typically ranging from Sterling 10,000 to Sterling 5,00,000/-)

Advantages of Raising Finance through Business Angels

The chief advantage of raising finance through Business Angels has been highlighted here-in-below:

• It strengthen the business Balance sheet;
• Bank shall be willing to provide additional finance on account of strengthening of financials;
• Bottom line can be maximised by maintain a personal relation with the angel investor;
• No repayment of interest or capital is required.

Disadvantages of Raising Finance through Business Angels

• Share of equity interest is required to be given up.

When to be Sought

• Huge time involvement in finding a suitable angel investor;
• Public Listed Entity shall be ready to give ownership interest.

• Leasing

It is a medium term of finance that helps business to procure assets without outlaying a huge sum of money upfront. This helps business to maintain its working capital requirement. (efinancemanagement.com, 2018)

Advantages of Raising Finance through Leasing

The chief advantage of raising finance through leasing has been highlighted here-in-below:

• It helps business to get ace up without new technology/ equipment immediately;
• Since repayments are pre-determined it helps in proper budgeting and timely repayment;

Disadvantages of Raising Finance through Leasing

• If the profits of the company are uncertain, payment of lease rentals can be a problem to the company;
• In case of operating lease, asset belongs to the finance company.

When to be Sought

• Cash Crunch;
• Need to be updated with technology;
• Position to make payments of lease rentals;

Weighted Average Cost of Capital

The term Weighted Average Cost of Capital can be defined as the hurdle rate or the minimum rate of return required by the seeders of finance to the project of the company. It may be also be defined as the compensation rate desired by all investors of the project. The computation of Weighted Average Cost of Capital is computed on the basis of return required and the weight of the factors. (CFI Education Inc., 2018)

The formula for computation of Weighted Average Cost of Capital has been presented here-in-below:

WACC= ((E/V)*R_e)+ [(D/V)*R_d)*(1-T)]

E= Market Value of the company Equity;

D= Market Value of Debt;

V= Total Market Value of the company;

R_e= Cost of Equity;

R_d= Cost of Debt;

T= Tax Rate

The WACC of capital is influenced by the source of financed is explained here-in-below through an example presented here-in-below:

Suppose XYZ wishes to raise funds through the market to the tune of Sterling 1 Million. The same shall be funded through issue of equity and debt. The proportion of debt and equity in the proposed funding has been taken at 60% and 40% respectively. The cost of debt is taken at 6% and the cost of equity is taken at 18%. Further, let us assume the tax rate prevailing in the economy is 25%.

As interest on debt is tax deductible, the cost of debt shall be 6% *(1-25%)= 4.5%.

Further, the cost of equity is not tax deductible and the same shall be taken at 18%. The computation of Weighted Average Cost of Capital is detailed here-in-below:  

WACC= ((E/V)*R_e)+ [(D/V)*R_d)*(1-T)]

E= Market Value of the company Equity;

D= Market Value of Debt;

V= Total Market Value of the company;

R_e= Cost of Equity;

R_d= Cost of Debt;

T= Tax Rate

WACC= 4.5%*.4 + 18%*.6=1.8% +10.8%=12.6%

If the proportion of debt is increased to 50%, then Weighted Average Cost of Capital is presented here-in-below:

WACC= ((E/V)*R_e)+ [(D/V)*R_d)*(1-T)]

E= Market Value of the company Equity;

D= Market Value of Debt;

V= Total Market Value of the company;

R_e= Cost of Equity;

R_d= Cost of Debt;

T= Tax Rate

WACC= 4.5%*.5 + 18%*.5=2.25% +9%=11.25%

Thus, the WACC is reduced as more debt is added to capital. Hence the above deduction is proved.

References:

CFI Education Inc., 2018. Definition of WACC. 

EduPristine, 2017. Venture Capital. [Online]
Available at: https://www.edupristine.com/blog/venture-capital
[Accessed 13 November 2018].

efinancemanagement.com, 2018. What is a Lease or Leasing?. [Online]
Available at: https://efinancemanagement.com/sources-of-finance/advantages-and-disadvantages-of-leasing
[Accessed 13 November 2018].

Entrepreneur Media, Inc., 2018. Debt Financing. [Online]
Available at: https://www.entrepreneur.com/encyclopedia/debt-financing
[Accessed 13 November 2018].