week 4

As a student studing in finance, I cannot imagine the difficulty for a company to raise capital for some projects. The financing process is complicated which involves many factors. 

When a company grows rapidly, for example when contemplating investment in capital equipment or an acquisition, its current financial resources may be inadequate. Few growing companies are able to finance their expansion plans from cash flow alone. They will need to consider raising finance from other external sources to achieve their objectives (Arnold G, 2008).

Before raising capital, an important term needs to be addressed is the rate of return (Arnold G, 2008). If the rate of return is too close to the cost of capital, it risks profitability of the project if any unforeseen circumstances arise. As the example of Sky, after they released their broadband package in 2006, they predicted a post tax return of 15% by 2011. It would be expected that to ensure profitability, the return however shrinks to 10.5 per cent post tax, compared with Sky's group weighted average cost of capital (WACC), estimated at about 9 per cent. The new investment that does little more than meet its cost of capital in five years is hardly compelling - particularly given that Sky's assumptions on further price deflation in broadband provision may prove conservative.

Another important issue is to find the best method to fund these returns. The two main methods are debt and equity. In debt, bankers request interest payments and capital repayments, while in equity, the borrowed money is usually secured on business assets or the personal assets of shareholders and/or directors. It should be noted that bank also has the power to place a business into administration or bankruptcy if it defaults on debt interest or repayments or its prospects decline. In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation in increasing levels of profits and on the eventual sale of their stake (McNulty, J., Yeh, T.D., Schulze, W. & Lubatkin, M, 2006). 

Today, the most popular and secure method is selling its shares on a stock exchange. Usually there is no obligation to pay dividends. Additional, the capital does not have to be repaid. However, this method suffers limitations that the return required to satisfy shareholders, moreover, it may loss of control and dividends cannot be uses to reduce taxable profit. If the company can give up an amount of ownership in the business, raising finance through equity is an optimal choice. It is should be note that raising equity finance need a long time, and the cost of listing shares on the stock market, you have to plan a hell of a long way in advance (Brealey, Richard, Myers, Stewart & Allen Franklin, 2006).

The main source of business finance is venture capital (Lumby S, 2003). It is a general term to describe a range of ordinary and preference shares where the investing institution acquires a share in the business. Venture capital is intended for higher risks such as startup situations and development capital for more mature investments. Replacement capital brings in an institution in place of one of the original shareholders of a business who wishes to realize their personal equity before the other shareholders. There are over 100 different venture capital funds in the UK and some have geographical or industry preferences. There are also certain large industrial companies which have funds available to invest in growing businesses and this 'corporate venturing' is an additional source of equity finance.

Raising finance is often a complex process. Business management need sto assess several alternatives and then negotiate terms which are acceptable to the finance provider. During the finance raising process, accountants are often called to review the financial aspects of the plan. Their report may be formal or informal, an overview or an extensive review of the company's management information system, forecasting methods and their accuracy, review of latest management accounts including working capital, pension funding and employee contracts etc. This due diligence process is used to highlight any fundamental problems that may exist.

Reference

Arnold, G. (2008). Corporate financial management (4th ed.). Harlow: Financial Times Prentice Hall

Brealey, Richard, Myers, Stewart and Allen Franklin (2006). Principles of Corporate Finance, 8TH Edition

Lumby, S. and Jones, C. (2003) Corporate Finance- theory and practice, 7th ed. Thompson.

McNulty, J., Yeh, T.D., Schulze, W. & Lubatkin, M. (2002) What's Your Real Cost of Capital? Harvard Business Review.