Finance for Multinational
Financing a $500 million overseas production facility is a major undertaking and the consequences of the decision can dramatically affect the company for years to come. There are two main options — debt or equity — but within these options there are a wide range of options. This paper will compare the most likely options and provide the advantages and disadvantages of each.
Equity financing involves the sale of stock in the company. This has several advantages. An equity issue has no carrying costs; only the up front costs of the equity issue. It does not increase the amount of debt in the organization, which can be important depending on the organization’s liquidity situation. Equity also matches up well with the time frame off the new operation, as equity has no limit to its life and our operations in the new country are also intended as such.
Equity financing has a high initial cost, as the cost of equity issues can be steep. In general, because equity bears higher risk, the firm’s cost of equity will be higher than its cost of debt. The company needs to consider what it is willing to bear with respect to cost of capital. The relative cost of debt or equity must be weighed against the expected returns of the project.
Equity financing also has the disadvantage of diluting the value of ownership for the existing shareholders. The company can issue more common shares or can do a warrants issue. The former is simply creating and selling more common shares on the market. The latter involves selling warrants to existing shareholders that can be used to acquire more shares. The warrants issue gives existing shareholders better opportunity to avoid dilution, or the option to sell the warrants for a profit while retaining their existing shares. As such, a warrants issue gives existing shareholders more flexibility.
However, by issuing new equity, the firm is further diluting control of the company. The owners, be they existing or new, will claim an even greater stake in the firm’s profits (Hillstrom, 2009). They will also be better able to exert control over management, should they decide to do so. Debt issues are not subject to changes in control, although they are subject to covenants, which will be described below.
The use of external debt can come in different forms as well. The first main form is financing through a bank. This gives the firm some degree of flexibility with regard to the terms of the financing. However, bank loans are not typically used for amounts this great. A deal would likely be complicated, with many different banks involved. This will increase the cost of such a deal.
Another form of debt would be a bond or debenture issue. This would likely be placed by the underwriter with a range of institutional shareholders. Costs would be both up front, in the order of the cost of an equity issue, plus the interest payments. The company could issue a zero coupon bond to avoid interest payments, but this would be done at a discount. A bond or debenture issue can be structured to incorporate different maturities as well. This gives the company some flexibility with regards to matching the lifespan of the debt with the lifespan of the project. One major downside with respect to lifespan matching is that the interest payments would begin in a year but the revenues from the project are unlikely to be realized by that point.
The main advantages to debt issues are that they are easier to accomplish than equity issues, which are complicated and expensive (U.S. Legal, 2008). This is primarily due to the fact that unlike equity issues, they do not dilute shareholder’s equity or suppress share price. Debt issues are typically conducted with financial institutions only, rather than the markets. However, debt issues have several disadvantages. Debt is an obligation that must be paid. The obligation is both short-term (interest payments) and long-term (principle repayment). However, the payment of this obligation is tax-deductible, as it is in classified as an operating expense. This means that debt has an inherent tax advantage (Richards, no date), one of the main reasons why the cost of debt is typically lower than the cost of equity. There are other disadvantages to debt as well. Debt issues typically require collateral and/or restrictive covenants. For a greenfield investment, the firm would have to post existing fixed assets as collateral, not the new factory. Any restrictive covenants can impact management’s ability to run the company as they see fit.
There is a third financing option, mezzanine, but this is of limited appeal to our firm and is typically geared towards entrepreneurs. This form of financing is essentially debt without collateral. Very high interest rates are used by the lender to manage the risk. This is not appropriate for firms with better, less costly, financing options available to them.
When considering whether to issue debt or equity in order to finance this venture, we must consider the firm’s financial position in terms of both liquidity and capital structure. We must also consider how best to match the inflows from the project with the outflows for servicing the project. Other factors should also be considered, such as the current interest rates and the expected direction of future interest rates.
It is also worth considering that the project, being greenfield, is going to take at least a couple of years to start to generate revenues. Ideally, the choice of financing will defer the financing costs until they can be paid for with the revenues from the plant. With any option, there will be upfront costs. A debt issue, however, will allow for the plant to pay for future interest costs. The longer the term of the bond or debenture the greater the chance that the factory itself will pay for the principle repayment.
It is recommended that the plant be financed with long-term debt in the form of a debenture issue. The first reason is that because as a greenfield, the project has relatively high risk. Thus, the variability of the expected returns is high. The lowest cost of capital should be used in order to increase the likelihood that the project is profitable. Moreover, debt financing brings the time frame of the financing cost in line with the time frame of the project. A debenture, for example, will have the vast majority of the debt costs paid by the revenues generated from the facility, despite the long time frame until the facility generates revenue. Lastly, the dilutive effects of an equity issue would not be viewed favorably by our shareholders, in particular given the relatively risky nature of the project.
Hillstrom, Laurie Collier. (2009) Debt Vs. Equity Financing. eNotes. Retrieved July 9, 2009 from http://www.enotes..-equity-financing
No author. (2008). Equity Financing Law & Legal Definition. U.S. Legal. Retrieved July 9, 2009 from http://definitions.uslegal.com/e/equity-financing/
Richards, Daniel. (no date). Debt Financing — Pros and Cons. About.com. Retrieved July 9, 2009 from http://entrepreneurs.about.com/od/financing/a/debtfinancing.htm