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Borrowing
Agency Theory: Although it might be cheaper, shareholders are not very keen to
increase very much the company`s exposure to loan debt as they prefer to use its
own resources. Although not efficient, this attitude is still strong at management
level.
Borrowing
It will be in the company`s interest to increase the amount of loan debts because it is
cheaper than equity debts. Both the traditional and MM views support this in lower
levels of the debt/equity ratio. In this particular case though, this might not be true
because the usage of the loan to pay shareholders would be considered as a risky
activity by the bank and as a result it would ask for a higher interest rate.
Issuing new shares
The advantages of issuing shares as a mean of financing would include the shares’
acting as a shock absorber, meaning that in the event of losses the company is able
to decrease paid out dividends at any time. Also, shares have no redemption date to
be paid off such helping the cash flow of the company. On the other hand issuing
shares brings two types of additional costs. Administrative and legal costs and an
additional premium requested by investors since they are the last being liquidated in
case of bankruptcy (Arnold, 2007).
Financing
The company would be able to borrow only at high rates from banks if the funding
was to be used for dividend payout. On the other hand, shareholders might not
approve an issue of ordinary shares since they might lose control over the company
in this case.
To avoid these problems the CEO might propose to issue new shares in two
categories. First, to avoid the dilution of power, shares would be offered to existing
shareholders (right issues). If existing shareholders would not be able or willing to
raise the needed amount than a second round of shares would be issued to external
investors. These shares should be preferential in order to avoid the equity risk (which
makes this kind of financing more expensive) and hold one or some of the following
features according to their costs:
o No voting rights. This is the usual form of preferential shares (Arnold
2007) and avoids the problem of power dilution.
o Redeemable. The company might like to have this option in order to buy
back these shares if and whenever it does not need these funds any longer.
Since the company is rated as “A” by Value Line the issuing cost will most likely be
lower than most competitors. Issuing new shares would also improve the debt-to-
equity ratio leaving open the opportunity to take loans for expansion purposes in the
future.
References
Arnold, G. (2007) Corporate Financial Management, 4 Ed., FT Prentice Hall,
th
Harlow.
Atrill, P. (2003) Financial Management for Non-specialist, 3 Ed., FT Prentice Hall,
rd
Harlow.
Brealey, R.A., Myers, S.C. & Allen, F. (2006) Principles of Corporate Finance, 8 Ed.,
th