Spry Plc

1.0 Introduction

Spry Plc. as a large listed company, the directors identify that there are some large projects which have great chances for success if the company has enough of funds to take over it. The estimated finance needed for the projects is approximately £200 millions; the company has to search for outside sources in order to reinvested profits in existing undertaking. There are some subjects to be reported on this piece of work is either debt or equity to be issue on the stock exchange to raise funds, discover the differing sources of finance available in current markets and their relevant information, and how it may effect the cost of capital of the company after recognizing the impact on risk of the new finance. The following also included the nature of the capital markets and the theories of the efficient market hypothesis. This report will be divided into three main structures to cover all elements, which is first The Capital Markets surrounding Spry Plc. and EMH, Source of Finance and Long Term Financing Decision to Spry Plc., and last part is The Cost of Capital and the Capital Structure of Spry Plc.

2.0 The Capital Markets surrounding Spry Plc. and EMH

2.1 Capital Markets

‘In its broadest sense capital can be defined as accumulated wealth that is available to create future wealth. It is wealth that is engaged in a reproductive process. The capital markets are meeting places where those who require additional capital seek out others who wish to invest their excess.' (Andrew M. Chisholm 2002: pg. 1) The Capital Markets is basically a financial relationship created by public, institutions, and governments with more funds (known as funds supplier or funds investor) transfer those funds to public, institutions, or governments who have a shortage of funds (known as funds demanders or funds borrowers) to make transactions. Apparently, the importance of capital markets is actually to promote economic efficiency by investing funds from those who do not have immediately productive use for it to those who do. For an organization it needs to be listed to trades its securities, thus, Spry Plc. as one of the listed companies are allowable and should raise funds from the capital markets.

2.1.1 The structure of Capital Markets

Generally capital markets are divided into primary and secondary markets, where the main function of primary market is to issues new securities of equity and debt funding for funds demanders. The secondary market is where the outstanding securities are resold. The potential investors must first engage in the primary market place before they engage in the secondary market. These are the markets where Spry plc. will be involved in the future when the decision is made.

2.2 The Efficient Market

In an efficient market, investor would want to obtain securities as cheaply as possible and seller will try to obtain the highest price they can for their securities. In this case, investors want to maximize their payback but the companies are looking finance as cheaply as possible. Therefore, securities are fairly priced by reflecting all available information in an efficient market. There are three forms of efficiency: * Allocation Efficiency : Ability of the market to allocate scarce resources to those companies which able to leads to these scarce resources being used most productively. * Operational Efficiency : Refers to the operations of the market, the costs of transaction determined competitively, reducing barriers to trade and trading rapidly. * Pricing Efficiency : Also known as Informationally Efficient, in a pricing- efficient market, shares price are fully reflect based on instantaneously all relevant available information.

2.2.1 Efficient Market Hypothesis (EMH)

This hypothesis is actually derived from the Pricing/ Informationally Efficiency which can be define as, share prices are fully and fairly reflect by the all relevant available information. It means that the prices of securities are always equaled based on the ‘good news' or ‘bad news' for the shares. There are three levels of market efficiency which categorized by E.F. Fama: * Weak form of Efficiency : The hypothesis states that the share prices fully reflect included past history share price movements and patterns. But some of the traders believe that the future share prices might be predicted by using technical analysis to analyzing historical data. * Semi-Strong Form of Efficiency : The hypothesis states that the share prices not only historic patterns but also all publicly available information about the shares. If this hypothesis is true, then the share prices will be rapidly incorporated when new information becomes public. * Strong Form of Efficiency : The hypothesis states that the share prices not only reflect by the historical patterns and current relevant available information but also all possible information included inside available information. This meant that the markets respond so rapidly that not even the inside traders who have the most valuable information could profit from their activities. When Spry Plc. involves in the markets, they are actually facing risk that they might got loss as markets cannot be extremely efficient or wholly inefficient in the real world, share price will follow a so called “random walk” (for further explanation please refer to Appendix 1), a theory created by Louis Bachelier. This means that the only thing that can change the share prices is a new piece of information occurs, as discuss before share prices will accurately reflect on all relevant available information. But the future information is unknowable; it might be a good or bad news for a particular share. Therefore, as share prices reflect so quickly on new information, no one could predict the share price by only considering current or historical information. Spry plc. has to understand that the financial market is actually mixture of both efficient and inefficient, sometimes it will returns fairly while some other times it may generate more than average returns too. (David Blake (2000) Financial Market Analysis. Second Edition. United Kingdom: John Wiley & Sons, Ltd, pg.389-405.) 3.0 Source of Finance and Long Term Financing Decision to Spry plc. For many business or companies, most are funded through a mixture of equity (share) capital or debt capital. Apparently, the concern of how and where to get funds to starting up, develop or expansion can be a key for the success of the business. It is so important, so, Spry Plc. must understand that which of the source of finance available to the business are the most appropriate or in relation to the needs of the business. From directors' decision, the discussion will be more into debt and equity (share) finance.

3.1 Option of choosing Equity Finance

Equity capital or known as share capital is actually an ownership capital, provider of the shares is the shareholders from those who are part-owners of the company. Shares counted in units, are the investment in a limited company, either it to be a public or private limited company. They are numbers of advantages if company chooses equity financing, like no repayment required for the capital which invested by the shareholders, no agreement for a fixed payment of dividend and the payments are determined by the Board of Directors. Equity financing able to decreases the gearing level of company, and pay zero dividend when profits are low or nil. These advantage all gone if considering on debt financing side.

3.1.1 Ordinary Shares

Ordinary shares are the most common shares available in the United Kingdom (UK). The owner of ordinary shares has the voting privileges, and to share profits (dividends) of the company. This share can be defined as the riskiest share as the profits of company can differ wildly in years, therefore, in good years the ordinary shareholders may receive substantial dividend but in bad years they may receive nothing. (For example please refer to Ryanair Holdings Plc, Appendix 2) In additional on that, these shareholders have the lowest ranking in the capital structure means that other investment (example: Bond) must be paid out first before them. Ordinary shares can be said the most expensive to serve because the shareholders requires higher returns to compensate the high risk. Spry Plc. has a choice of two ways to issuing the shares; one is New Issue of shares. Normally, it can issue by offer for sale as the company sells the new shares to a financial institution or an issuing house then they will sell the shares to the public. Or, not issued to the public but arrangements are made to sell large ‘block' of units of shares to small number of investors like for example to insurance companies, this type of issuing named as Placing. Another way of that is Right Issue of shares, raising funds by selling shares to existing shareholders to subscribe to new shares in ratio to their current holdings. The existing shareholders are offered to buy at a discounted price which means lower than the market price, they has the rights to sell if the shareholders not exercising the rights.

3.2 Option of choosing Debt Finance

Debt capital is a non-ownership capital providers by a bank or investor who buy bonds issued by the company, or by trade suppliers who offer terms of credit. It has lower risk as they are the first and must to be paid no matter the company make profits or not, as compensate to the lower risk, the interest paid is cheaper than shares' dividends and involved just a single payment at maturity on a fixed rate. The advantages of choosing debt financing are the interest payment is tax deductible, and free from dilution of the control of the existing shareholders. It is cheaper and also a straight forward contract between the lenders and borrowers, the issuing cost is lower compared to issuing of new shares. Normally debt holders do not have voting rights. These advantages do not exist on equity financing. Mainly, debt finance is broken down into two categories which are Term Loan and Bonds.

3.2.1 Term Loan

Term Loan or Long-Term loan is a loan offer by a financial institution (Bank) to a business or company, and having more than one year initial maturity. Mostly this loan is made to finance capital needs, often for permanent work like purchasing equipment or machinery. In a term loan agreements normally will specify payment dates in monthly, quarterly, semiannual or annual loan payments. Over the life of the loan, the interest and the principles are fully repaid according to the agreement states. There are also restrictive covenants in the agreements that limit the borrower in order to protect the interest of the lender. Like constraint on Subsequent Borrowings and the Usage of the Loan Proceeds, also working and fixed assets restrictions, in this case because of the liquidity of a company maintain on a certain level and some fixed assets cannot be sold.

3.2.2 Bond

“A corporate Bond is a certificate indicating that a corporation has borrowed a certain amount of money from an institution or an individual and promises to repay it in the future under clearly defined terms.” (Principles of Managerial Finance, pg495) This simply means a form of loan stock where an individual or company gives a written acknowledgement of the debt where the payment of interest and the repayment of the provision are stated. Face value in bond feature is the principal sum owed by the firmed. Coupon Rate is the contractual rate of interest, and Redemption Date is the date the firm must payback and last but not least is Call Feature, where the company reserves the right to retire the bond earlier before the maturity date at a premium. There are there types of unsecured bonds, which are debentures, subordinated debentures, and income bonds. While the secured bonds included mortgage bonds, collateral bonds, and equipment trust certificates. Other contemporary types of Bonds are zero coupon bonds, junk bonds, floating rate bonds, extendable notes, and putable bonds. (Lawrence J. Gitman (1994) Principles of Managerial Finance. Seventh Edition. New York: Harper Collins College Publishers, pg 488-603.)

4.0 The Cost of Capital and the Capital Structure of Spry Plc.

After discovered the sources of finance and also long term finance to Spry Plc, this part is actually discussing about the impact based on the decision making. Cost of Capital is a long term financing decision-making that will affecting the capital structure of the company, in any companies the capital structures must be a combination of both equity and debt capital. Different sources has different cost, overall cost can be measure by using Weighted Average Cost of Capital (WACC). The results must at least has fair return or most likely greater to the contributors.

4.1 Importance of the Cost of Capital

A progressive management will always put most of the concern on the cost of capital and the fluctuation of the capital market when doing any financing decision in order to achieve economical or optimal capital structure. This move is so important because it is a significant factor that will impact directly to firm's capital structure. Cost of capital can be used to deciding which method of financing are the most suitable for the company; a good financial officer will be able to identify normal dividend rates and the rate of interest on loans in times. Also, when a company requires additional finance like Spry Plc. is facing now, the first concern in choosing is which where bears the minimum of the cost of capital, at the same time considering the relating control and avoiding risk as well. Cost of capital is actually evaluating the performance of the financial of the top management. (Free MBA.in (2008) Importance of Cost of Capital in Decision Making .[Online] Available From: https://www.freemba.in/articlesread.php?artcode=343&stcode=10&substcode=22)

4.2 Optimal Capital Structure and the Weighted Average Cost of Capital (WACC)

Capital structure refers to the combination of different types of capital which a company uses to finance its activities. While a ‘good' of capital structure of a company can be defined as which a low overall has cost of capital, means that also has a low overall rate of return that has to be paid to finances providers. Capital structure also known as capital gearing can be categorized into high gearing and low gearing. Where high gearing means the proportion of debt capital is higher relative to the equity capital, and low gearing refers to the proportion of debt capital is lower than equity capital. Spry Plc. should find the optimum capital structure, which is a combination of debt and equity finance that has the minimum cost of financing, to reduce the WACC. Lawrence J. Gitman (1994: pg.474) states: ‘Optimal capital structure has strongly related to the WACC, in this area it can be explain by using a graphic view of company's equity, debt and WACC functions along with a modified form of the zero growth valuation model. The zero growth valuation model can be used to define the company's value as its after-tax earning before interest and tax (EBIT) divided by its WACC. Assuming that EBIT is constant, the value of the company is maximized by minimizing the WACC. The optimal structure is therefore the one that minimizes the WACC. Graphically, although both debt and equity costs rise with increasing financial leverage, the lower cost of debt causes the WACC to decline and then rise with increasing financial leverage. As a result, the company's WACC exhibits a U shape having a minimum value, which defines the optimum capital structure-the one that maximizes the owner's wealth.' Many people are wonder in the real world is there an optimum capital structure? Actually there is two main views are debating on this issue which is Traditional View and the Modigliani and Miller's View (M&M). Where the traditional view states that when a company involves debt capital into its structure, the overall cost of capital drops. This is because the cost of debt is cheaper than cost of equity, but beyond a certain level the ordinary shareholders will requires higher return to compensate the extra risk that they are facing to. For further explanation and graphs please refers to Appendix 3. While the M&M states two theories, one M&M Model 1958 with taxation which said that the total value of the company or the WACC will nit change when the gearing level changes, this is because the way income is depends on the future operating generated by assets, so it makes no difference to the total value of the firm. Next theory is M&M with taxation 1963, said that the cost of capital will decrease with increased in debt capital, this is because the interest paid are tax deductible. Thus, tax relief on debt interest is an extra advantage for shareholders. For further explanation and graphs please refers to Appendix 4. Lastly, there is one thing that the director should understand that the testing on these theories are complicated in practice and as such the optimal level of is an unsolved issue, but we can try to minimize the WACC as much as possible by balancing all the theories stated above.

5.0 Conclusion

In conclusion, there is no specific ways or solution to guarantee maximum profits gain by the analysis or planning of the sources of financing, cost of capital or even capital structure. As Ball (1994), pg. 33 stated that ‘The answer is both yes and no. On the one hand, the research provides insights into stock price behaviour that were previously unimaginable. On the other hand, the theory of efficient markets (like all theories) is an imperfect and limited way of viewing stock markets, as research has come to show.' Well, each company like Spry Plc. has its uniqueness with its own structure and development; cost of financing is just one of the ways to gain money besides debt and equity finance. A good financial planning must to consider other factors to find the most appropriate option such as the ability of company to generate cash flow, the duration of borrowing, the current gearing level, any restrictive covenants, and so on.

6.0 Appendix

Appendix 1

Random Walk Theory

A Random Walk Down Wall Street, written by Burton Malkiel in 1973, has become a classic in investment literature. Random walk theory jibes with the semi-strong efficient hypothesis in its assertion that it is impossible to outperform the market on a consistent basis. Malkiel puts both technical analysis and fundamental analysis to the test and reasons that both are largely a waste of time. In fact, he goes to great lengths to show that there is no proof to suggest that either can consistently outperform the market. Any success outperforming the market with technical analysis or fundamental analysis can be attributed to lady luck. If enough people try, some are bound to outperform the market, but most are still likely to underperform.

Newpont Mining Corp. (NEM) random movement chart from Stockcharts.com

The basic random walk premise is that price movements are totally random. Judging from the chart, the price movements of Newmont Mining (NEM)[NEM] over this 5-month period would appear to be quite random. Prices have no memory, therefore past and present prices cannot be used to predict future prices (as implied in technical analysis). Prices move at random and adjust to new information as it comes available. The adjustment to this new information is so fast that it is impossible to profit from it. Furthermore, news and events are also random and trying to predict these (fundamental analysis) is also a lesson in futility. Malkiel maintains that a buy and hold strategy is best and individuals should not attempt to time (or beat) the market. Attempts based on technical, fundamental or any other analysis are futile. Admittedly, he does have a point. Statistics have shown that the majority of equity mutual funds fail to outperform the market, as measured by the S&P 500. Investors can easily buy index-based securities with very low transactions costs. (https://stockcharts.com/school/doku.php?id=chart_school:overview:random_walk_theory)

Appendix 2

The Ryanair and Marconi' share price chart and explanation

Ryanair share price

Data source: Yahoo Finance The Ryanair share price fell so dramatically in mid-January 2004 because the company announced that its profits for the current financial year would probably be worse than they had previously expected. Marconi corporation plc suffered a similar fate in terms of its share price which suddenly collapsed following announcements of serious financial problems within the group. Take a look at how their share price has since recovered:

Marconi share price

Data source: Yahoo Finance Don't forget that the stock market is actually just a second hand share market so even though no company ever wants its share price to collapse in the ways that we have just seen, these share price catastrophes do not directly affect the business. However, with such a depressed share price, companies might find it vey difficult to raise additional finance or reassure existing creditors that they are a worthwhile risk. If you look at the share price pages in newspapers such as the Financial Times, The Times, The Guardian and so on, the prices you will see there are mainly ordinary share prices. The importance of share prices to a business is that it gives an indication of the value placed on the company by the market - for example if a company has 10 million shares and the current price is 500p each, then the value of the company - its market capitalisation - is £50 million. If the share price plummets to 200p the company would only be 'worth' £20 million. In such cases, companies become possible targets for takeovers. (https://www.bized.co.uk/learn/accounting/financial/sources/ordshares.htm)

Appendix 3

WACC and traditional view of capital structure and cost of capital There are different ideas with regards to the impact of capital structure change on valuation and cost of capital. *The debt to equity ratio (B/S) influences V and WACC. Increase in V causes decrease in WACC and vice versa. In the range 0 to CS, as debt B increases, WACC falls, despite rising debt carries with it risk of residual income, shown in the increasing cost of equity, k. However, when the debt increase beyond CS, the continue increase effects of k now starts to offset the effects of a falling S/V, resulting a rise in WACC. This highlights an essential condition for shareowners profiting from capital structure optimisation, i.e. the firm's ability to borrow on terms not available or attractive to individuals. Thus a target ratio of debt to equity finances is an important resource allocation for many firms. WACC stands for (market value) weighted average cost of capital, which can be express as equivalent to the valuation ratio Q/V Q/V = (S/V)k + (B/V)i = WACC, where Q=division of expected earnings; S=equity capital; B=debt; V=market value; k=expected return of equity S; i=interest rate on debt B. This concept of WACC is that cost of each component of the firm's capital structure is weighted relative to the overall market value, V. With this concept, finance managers by maximising overall market value, they will invariably minimise the weighted average cost of capital, creating a favourable financial position for investment in the future. Increase in V -> decrease in Q/V -> decrease in WACC (Odd Ball (2009) Discuss the impact of taxation on company capital structure decisions. Weblog. [Online] Available From: https://rg328.blogspot.com/2009/05/discuss-impact-of-taxation-on-company.html)

Appendix 4

Modigliani & Miller (M&M Propositions I & II) - Capital Structure of Corporations

If you read the chapter on Weighted Average Cost of Capital (WACC), you know that the best capital structure for a corporation is when the WACC is minimized. This is partly derived from two famous Nobel prize winners, Franco Modigliani and Merton Miller who developed the M&M Propositions I and II.

M&M Proposition I

M&M Proposition I states that the value of a firm does NOT depend on its capital structure. For example, think of 2 firms that have the same business operations, and same kind of assets. Thus, the left side of their Balance Sheets look exactly the same. The only thing different between the 2 firms is the right side of the balance sheet, i.e the liabilities and how they finance their business activities. https://www.financescholar.com/m-m-proposition1a.jpg https://www.financescholar.com/m-m-proposition1b.jpg In the first diagram, stocks make up 70% of the capital structure while bonds (debt) make up for 30%. In the second diagram, it is the exact opposite. This is the case because the assets of both capital structures are the exactly same. M&M Proposition 1 therefore says how the debt and equity is structured in a corporation is irrelevant. The value of the firm is determined by Real Assets and not its capital structure.

M&M Proposition II

M&M Proposition II states that the value of the firm depends on three things: 1) Required rate of return on the firm's assets (Ra) 2) Cost of debt of the firm (Rd) 3) Debt/Equity ratio of the firm (D/E) If you recall the tutorial on Weighted Average Cost of Capital (WACC), the formula for WACC is: WACC = [Rd x D/V x (1-5)] + [Re x E/V] The WACC formula can be manipulated and written in another form: Ra = (E/V) x Re + (D/V) x Rd The above formula can also be rewritten as: Re = Ra + (Ra - Rd) x (D/E) This formula #3 is what M&M Proposition II is all about.

Analysis of M&M Proposition II Graph

- The above graph tells us that the Required Rate of Return on the firm (Re) is a linear straight line with a slope of (Ra - Rd) - Why is Re linear curved and upwards sloping? This is because as a company borrows more debt (and increases its Debt/Equity ratio), the risk of bankruptcy is even more higher. Since adding more debt is risky, the shareholders demand a higher rate of return (Re) from the firm's business operations. This is why Re is upwards sloping: - As Debt/Equity Ratio Increases -> Re will Increase (upwards sloping). - Notice that the Weighted Average Cost of Capital (WACC) in the graph is a straight line with NO slope. It therefore does not have any relationship with the Debt/Equity ratio. This is the basic identity of M&M Proposition I and II, that the capital structure of the firm does not affect its total value. - WACC therefore remains the same even if the company borrows more debt (and increases its Debt/Equity ratio) (FinanceScholar.com (no date) Modigliani & Miller (M&M Propositions I & II) - Capital Structure of Corporations. [Online] Available From: https://www.financescholar.com/modigliani-miller-propositions.html)

7.0 References

Andrew M. Chisholm (2002) An Introduction to Capital Markets: Products, Strategies, Participants. United Kingdom: John Wiley & Sons, Ltd David Blake (2000) Financial Market Analysis. Second Edition. United Kingdom: John Wiley & Sons, Ltd Eddie McLaney (2009) Business Finance: Theory and the Practice. Eighth Edition. New Jersey: Pearson Education Ltd Lawrence J. Gitman (1994) Principles of Managerial Finance. Seventh Edition. New York: Harper Collins College Publishers Biz/ed (2009) Sources of Finance. [Online] Available From: https://www.bized.co.uk/learn/accounting/financial/sources/index.htm FinanceScholar.com (no date) Modigliani & Miller (M&M Propositions I & II) - Capital Structure of Corporations. [Online] Available From: https://www.financescholar.com/modigliani-miller-propositions.html Free MBA.in (2008) Importance of Cost of Capital in Decision Making .[Online] Available From: https://www.freemba.in/articlesread.php?artcode=343&stcode=10&substcode=22 Free MBA.in (2008) Mode of Measuring Cost of Capital. [Online] Available From: https://www.freemba.in/articlesread.php?artcode=345&stcode=10&substcode=22 James Woepking (2007) International Capital Markets and Their Importance. The University of Iowa Center for International Finance and Development. [Online] Available From: https://www.uiowa.edu/ifdebook/ebook2/contents/part3-II.shtml Odd Ball (2009) Discuss the impact of taxation on company capital structure decisions. Weblog. [Online] Available From: https://rg328.blogspot.com/2009/05/discuss-impact-of-taxation-on-company.html Reem Heakal (2009) What is Market Efficiency? Investopedia. [Online] Available From: https://www.investopedia.com/articles/02/101502.asp?viewed=1 Richard Loth (2009) Evaluating A Company's Capital Structure. Investopedia.[Online] Available From: https://www.investopedia.com/articles/basics/06/capitalstructure.asp?viewed=1 StockCharts.com- Chart School (2009) Random Walk Theory. [Online] Available From: https://stockcharts.com/school/doku.php?id=chart_school:overview:random_walk_theory Wikipedia (2009) Capital Market. [Online] Available From: https://en.wikipedia.org/wiki/Capital_Markets Wikipedia (2009) Capital Structure. [Online] Available From: https://en.wikipedia.org/wiki/Capital_structure Wikipedia (2009) Financial Market Efficiency. [Online] Available From: https://en.wikipedia.org/wiki/Financial_market_efficiency

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