LDM | Risk Management

Background

Every business will need finance from its commencement and through its development and growth. There are varieties of sources for raising finance for the business from its commencement and through its development as well as growth. The various sources of raising funds can be classified as follows:

• debt financing (e.g., bank loan, leasing, debt factoring, venture capital, debentures, bonds, etc.),
• equity financing (e.g., issue of shares, retained earnings, venture capital, etc.), and
• hybrid securities (e.g., convertible bond, preference shares, option-linked bonds etc.).

A company needs right combination of such sources of finances to maximize the shareholders value. To achieve this objective, a company has to resolve various issues like income, financial flexibility, control, risks, timing and so on.

Financing Strategy: Debt vs Equity

Raising debt finance increases the income of the company. This is because the interest on debt finance is a deductible expense for the purpose of computing taxable income. Therefore, debt financing provides tax shelter to the company. This ultimately increases the net profit and consequently, the shareholders value.

The tax benefit from debt financing can be measured in two ways. Firstly, tax benefit is measured by computing the present value of tax savings arising from the payment of interest. Secondly, such benefit is measured by computing the difference between the pre-tax rate of borrowing and after-tax rate of borrowing. Debt financing also enhances discipline on the management by having to make payments on debt. On the other hand, if the required fund is managed by the issue of equity shares, it will result in lower earnings per share (EPS) of the company. However, a lower EPS may bring down the price of shares in the market.

Financial Flexibility

Another consideration on selecting appropriate financing strategy is financial flexibility. As such, financial flexibility refers to the capacity of the company to meet any foreseen contingencies. Such contingencies may arise that may arise due to changes in government policies, recessionary conditions in the market place, disruption in supplies, decline in production and take advantage of unanticipated opportunities such as profitable projects. Also, financial flexibility provides the finance managers more room and power of availing the debt finance.

Financial flexibility is a powerful defense against financial distress and its consequences to the company. Generally, the value of financial flexibility depends on three factors. There are the availability of projects; excess returns on projects; and uncertainty about project needs and cash flows. So, loss of financial flexibility of a company having growth potential may cause hurdle in enhancing its shareholders value.

Control

The promoters wish to have better control on the company. They may not like the dilution of controlling interest. Procurement of additional funds may have implication on the controlling interest in the company. If a fund is raised by way of debt financing or by the issue of preference shares, there will not by any dilution of control in the company. But, the company will have to undergo constant scrutiny or monitoring of the banks or lending institutions. Issue of right shares also will not dilute the controlling interest of promoters in the company. On the other hand, issue of equity shares to general public dilutes the controlling interest of promoters in the company.

Risk

While debt finance enhances the earnings, it also attracts financial risk to the company. When a company employs a high proportion of debt financing in its capital structure, it results to higher burden of fixed financial commitment. This may lead the company to financial distress. Financial distress occurs when promises of the company towards the parties providing debt funds are broken or honoured with difficulty. Financial distress may lead the company towards bankruptcy. As equity shareholders have residual interest in the income and assets of the company, they will be the sufferers in case of financial distress. Since the overall risk is the product of the business risk and financial risk, increase in financial risk may lead to increase in overall risk of the company. Therefore, a company should be cautious on excessive leverage in order to reduce its overall risk.

Timing

While raising some particular source of financing, timing plays a crucial role. For example, when there is depression in the equity market, debt financing will be the only alternative for raising funds for the company. On the other hand, when there is a boom in the equity market, the company may opt for raising funds by the issue of equity shares. Therefore, the management of the company may want to resort to timing based on their assessment on the conditions of capital market.

Strategy to Maximize Shareholders’ Value

When a growing company requires additional funds to finance long-term projects, it should opt for raising debt over the issue of equity and utilization of retained earnings in order to avail tax shelter on interest payments and maximize shareholders value. But according to pecking order theory, the management of the company prefers internal financing rather than raising debt or issue of equity to finance new project. Therefore, companies with high growth potential tend to retain larger portion of profit and adopt lower dividend pay out ratio. Dividend policy also has signaling effect on the value of equity shares of the company.

Finding the appropriate financing strategy is a complex task. A company should always consider for the maximization of shareholders value while formulating financing strategy. To achieve this objective a proper trade-off among various factors like income, financial flexibility, control, risks, timing is required.