Question

Buoyant business conditions in Australia has prompted the board of PKR Small Goods Pty Ltd, a third generation privately owned family business to look at expanding their operations. The board, which is made up entirely of family members, is looking to double the size of the business over the coming five years and has estimated that this will require an additional capital expenditure (CAPEX) of $225 million. There is considerable debate amongst board members as to how this expansion should be funded - some of the ideas that have been put forward include, raising equity by listing on the Australian Stock Exchange, issuing bonds, borrowing the funds needed from the firm’s banks, utilising retained earnings, or some combination of the preceding measures. In light of the debate amongst board member’s, they have sought your advice as a finance specialist and have requested that you write a report that:

Critically evaluates the perceived advantages and disadvantages to the firm of each of the preceding forms of funding. (1000 words)

Answer 1

The company may create required capital in combination of all the sources, like issuing new shares, use of retained earning, loan from banks. As the combination of different sources will help company to create an optimal capital structure, which will reduce the net cost to the company.

An optimal capital structure is the mix of senior debt, subordinate debt, retained earning, preferred stock, and ordinary equity shares to maximizes market value of the firm with minimum cost.Selection of optimal capital structure of a firm varies from firm to firm as per level of risk and expectation of return; analysts use the concept of weighted average cost of capital (WACC) to find the required level.

The net cost of raising debt is always less than the cost of raising equity due to level of risk. The expected return equity investors is higher than the expected return of debt investors, because debt holders have priority of payment over equity holders in dividend payment as well as the time of liquidations. The company may get tax relief on payment of interest on debt. The dividend is paid after tax.

The company should analyse all the combination of capital structure before taking any final decision.