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QUESTION You are the Investment Manager of Mambo Mingi Ltd.

The Board of Directors has requested you to give them a decision on the following issue. The Company would want to expand and they have an option of either floating shares at stock exchange or taking a loan from a financial Institution. In your own opinion, whi ch one of the above options should be taken and why. ANSWER Mambo Mingi Ltd can use debt or Equity depending on the prevailing circumstances of the company and its current capital structure (we don t have this information). There are reasons, advantages and disadvantages of using either debt or equity. According to capital structure theories that have been put forwa rd by several economists and scholars, you can use debt and equity up to certain level where the value of the firm is at the maximum and cost of capital at the minimum. In this case where I need to advise Mambo Mingi Ltd, more information is required to categorically say that taking a loan or issuing shares is the bes t option. I will therefore argue the case for and against each option at this poin t. According to the Pecking Order Theory of capital structure, it assumes that companies do not have specific debt-equity ratio but instead companies use external financing only when internal funds are insufficient. The theory maintai ns that the company will prefer internal financing like retained earnings to the co stly external financing. The company will come up with an order if raising funds from the cheapest source to the most expensive source. Once internal sources are exhausted (I assume Mambo Mingi Ltd are in this situation) they should select debt financing as opposed to issuing new shares which. This is the reason why: Taking a loan from financial institutions: A loan is an arrangement in which a lender gives money to a borrower, and the borrower agrees to repay the money, along with interest, at some future date. There is an agreed time for repaying the loan and the lender has to cover the ri sk that the borrower may not repay the loan. The interest rate charged on the borrowed funds reflects the level of risk that the lender undertakes by providin g the money Case for using debt It has been proved by Net Income Theory and Net Operating Income Theory of capital structure that incorporating debt in the capital structure increases the value of the firm to a certain extent. Although this theories were later challen ged by Mordigilliani & Miller (MM) Proposition, MM later incorporated taxes into the ir model and proved that a debt raises that value of the firm Capital structure theories have also shown that levered firms enjoy tax shied benefit. This result into less weighted Average Cost of Capital (WACC). It has also been shown that in the absence of taxes, WACC remains slightly lower in the levered firm. Today banks are offering competitive interest rates and flexible repayment terms due to stiff competition in the market. Obtaining a loan is much easier and fast er that issuing shares. The requirements of obtaining loans have been reduced and approval periods are much shorter normally a day or two. Good lending terms and relations with the bank: If the company meets the bank s lending criteria to the letter, it could benefit with a lower rate of interest a nd 2

relaxed and easy repayment terms. This is a bonus of having a good working relationship with the bank. If a loan application is backed by good collateral and other assets, the company can raise any amount it may require for expansion. The owner/entrepreneur does not lose control of the business. Profits are not shared with the lender. However, the business owner suffers alone when business records a loss during any period. Case against use of debt It should be noted that, advantages of lower WACC and increased value of the firm can go up to a certain level. It is not always the case that overall cost o f capital will drop and value of the firm increase. Capital structure theory shows that there is an optimal level of debt-equity ratio where cost of capital is at its lowest and value of the firm at its highest. If Mambo Mingi Ltd debt-equity rati o is very high, debt may not be the ideal option. Presence of debt in the capital structure exposes the company into financial ris k. This makes creditors more skeptical and this may result to more financial difficulties in the future. Interest on borrowed funds as well as part of principle amount is payable to the lender whether the company makes a profit or not. It is assumed that funds borrowed are invested in projects with positive net present value. Sometimes projects fail to perform as expected. This may plunge the company into a financi al crisis. If the company is not in good financial and relationship standing with the bank, there is always a case of rejection when applying for a loan. This may be as a result of poor credit history, inadequate past incomes and lack of tangible asse ts that the bank can attach the loan to. If the bank decides to the offer the loan anyway, the company may have to pay more to cover the risk. Loan alone may not be enough if a company requires a large sum of money for expansion. For instance if a company needs Kenya shillings in terms of billions for expansion, it may not secure a loan to cover the entire requirement. Conclusion Mambo Mingi Ltd should evaluate the terms and conditions of the loan and decide whether it is appropriate for expansion. If expected returns and lower that the cost of debt, another financing like issuing of shares should be considered. If the cost of debt financing outweighs the return that the company generates on the debt through investment and business activities it may become too much for the company to handle. This can lead to bankruptcy. 3 If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount th an the debt cost (interest), then the shareholders benefit as more earnings are spread among the same number of shareholders. Issue shares Share Capital is the fund raised by a company through the issuance of common/ordinary or preferential shares to individuals / institutional investors for the growth and expansion related aspects of the company. It is also known as Equity Financing through which the shareholders of the issued capital receive rights of ownership in the concerned company by buying shares of the same. Buyers of the Share Capital become owners of the company in accordance to

their stake in the same and hence possess certain degree of control over its operation. Amount of share capital a company possesses is a variable. As a company issues more and more shares to the public in lieu of fund, the amount of share capital increases. Mambo Mingi Ltd can opt to raise additional capital through issue of shares if funds raised through a loan were not enough or if the company failed to secure a loan. The company will have several options here. If the company is not listed i n stock exchange, the company can prepare for an initial public offering (IPO), in which it will be valued and an opening price will be set for its shares when the y are released onto the market. How much finance can be raised through an IPO depends partly on the perceived value, and thus share price, of the company, and partly on how much interest there is in the shares when they are released on the market. For a company that is already listed on stock exchange, an alternative route is to launch an additional share issue or a rights issue. A rights issue permits exist ing stockholders to purchase a designated number of new shares from a company at a specified price within a specified time. The offer may be rejected, or accepte d in full or in part by each stockholder. Rights are usually transferable, meaning that the holder can sell them on the open market. The additional shares in a rights issue are generally issued to stockholders on a pro rata basis for example, in a two-for-five rights issue stockholders are offered two shares for every five they already hold. Renounceable rights are rights offered by a company to existing stockholders to purchase further stock, usually at a discount. These rights have a value and can be traded. If rights are to be issued, the company has to set the price of the n ew shares, determine how many it will sell, and assess how the current share value will be affected as well as the effect on new and existing stockholders. Non renounceable rights are not transferable and cannot be bought or sold; these rights must be taken up or they will lapse. 4 Case for use of share capital For a company that has reached a certain size and has a strong reputation, an IPO can be a good route to raising a large sum of capital that will enable it to expand, or invest in assets that will enable it to grow in the future. The company does not need to repay this share capital, but instead agrees to distribute future profits to stockholders in return for their investment. If the company to record a profit in any particular year, it is not will not have to pa y any dividends. However, if a company records a loss, this affects it share price in the market. Once listed, a company can periodically issue further shares via a rights issue, raising yet more capital for expansion without running up debt. Being in a posit ion to raise capital from the stock markets, rather than privately from individual investors, is a major incentive for many companies to issue shares on an exchange. The right business investors can bring valuable skills, contacts and experience to your business. They can also assist with strategy and key decision-making. In common, these investors have a vested interest in the business' success, i.e. it s growth, profitability and increase in value. Investors are often prepared to pro vide

follow-up funding as the business grows. Case against use of share capital to raise funds Raising equity finance is demanding, costly and time consuming. The business may suffer as before shareholders begin to purchase the shares. Potential investors will seek background information on the business - they will closely scrutinize past results and forecasts and will probe the management team. However, many businesses find this discipline useful regardless of whether or no t they actually receive any funding. There can be legal and regulatory issues to comply with when raising finance, eg when promoting investments. According to Pecking order theory issue of shares is normally the last option to be considere d since it is the most expensive. The main disadvantage of issuing shares is that a company s owners no longer have full control of the business and become accountable to stockholders. Stockholders can block plans if they believe they pose too great a risk to their investment. Any issuance of further shares dilutes the holdings of existing stockholders as a proportion of the company s total shares. This can lead to dissatisfaction from minority stockholders, who have the most to lose. Conclusion Careful considerations should be brought forth to decide which option is more appropriate for the company. If a loan for the required amount is accessible and within acceptable debt-equity ratio, it should be preferred against issuing shar es. 5 References: I.M pandey, Financial Management Hussein Ashig, Business Finance, Revised Edition www.bizfinance.about.com accessed 20 t h September 2011

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