International financial management

(2014, 2000 words)

This report explores 2 financing sources in China and evaluates their merits and risks

as well as their impact of capital structure of the firm.

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Table of ContentsEXECUTIVE SUMMARY................................................................................................................... 3

INTRODUCTION................................................................................................................................ 3

EQUITY FINANCING SOURCE........................................................................................................ 4

DEBT FINANCING SOURCE............................................................................................................ 6

CONCLUSIONS................................................................................................................................... 8

REFERENCES...................................................................................................................................... 9

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EXECUTIVE SUMMARY

This business report aims to present a critical evaluation of relative merits

(qualities/worth) of and risks associated with the various sources of finance available

in China to the global manufacturing company under discussion. The report also

critically evaluate and appraise the effect the different sources of finance would have

on the company’s cost of capital through making appropriate references to the

theories.

INTRODUCTION

When an organization takes a strategic decision to involve in international business

through engaging in the international financing activities, additional risk and

opportunities are inevitable. This report evaluates 2 financing sources i.e. equity

financing and debt financing in China.

RELATIVE MERITS AND RISKS ASSOCIATED WITH THE VARIOUS SOURCES OF FINANCE AVAILABLE IN CHINA

Transforming from export- driven to a sustainable consumer-driven economic

development, China exerts emphasis on its national demand to improve consumption.

At the same time, the economy also decreases its reliance on exports and foreign

investment. An important perspective in terms of growth of foreign invested

enterprises such as our global manufacturing firm or Chinese subsidiaries, the

structural reforms are likely to result in greater foreign capital control systems that

demand foreign invested enterprises to cautiously valuate their financing situation for

potential operations in China.

Given the option of financing through debt as a source of financing within China as

compared to the UK, wouldn't be much easy (Chang et al., 2000, p. 1652). The

company would be subject to the strict financing regulations in China that are

stringently applicable after the assessment and consent of authorities in China

(HerdingS. J. Grand, 2013, p. 1). The debt would be limited by the manufacturing

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company’s registered capital and the worth of the company would be as much as the

worth of cash held by the company in China. The situation slows down the capability

of the company to use financing for its expansion in China. In addition, the local

banks in China would necessitate security arrangements such as guarantee from other

company in the UK or bank guarantee, which can be a hurdle in the process of easy

financing (Chamley, 2004, p. 129).

A usual practice for the foreign investors in China in accordance to the Herd

behaviour (Banerjee, 1992, p. 797) is to raise initial funding for their direct

investment from sources external to China and then injects the funds into the country.

In accordance to the Pecking Order Theory, these funds are invested into China as a.

equity financing, b. Debt financing and / or c. combination of both (Meyers and

Majluf, 1984, p. 189).

EQUITY FINANCING SOURCE

Equity financing is means of raising capital through selling company stock to the

investors. In return for the investment, the shareholders obtain ownership interests in

the company. Some examples of equity financing are Venture Capital Funding and

Angel Investors. Equity financing as the second source of financing option that can be

considered by the manufacturing company can be a lengthy process, which would

take about 3 to 4 months for clearance and approval (S. J. Grand, 2013, p. 1). It is

recommended that since equity financing from overseas investors is one of the

common ways of raising funds for the Chinese subsidiary, therefore this financing

option should be strongly considered. Secondly, the advantage of this option is that

the company can convert the injected capital into RMB that can be utilized for

developing the business in China (Brealey et al. 2008, p. 34). Nevertheless the risk is

that the foreign capital can only be utilized for the specified purposes as well as

within the approved a business scope of the manufacturing company (Wand and Zhu,

2013, p. 329). The 3rd disadvantage is that, with a substantial quantity of documented

capital the company would involve massive well-timed investments within just fairly

short period of time (S. J. Grand, 2013, p. 1). Apparently other complications that will

be observed in repatriating the exceedingly injected amount from China afterwards

should also be considered (Boortz et al., p. 3; Banjerjee, 1992, p. 798). Moreover if

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the subsidiary is build with lowest registered capital during the initial phase and

demands more financing at some later period of time, extra capital can be arranged

only after acceptance has been acquired from the appropriate authorities to maximize

the company's lawful capitalization (Su and Sun, 2011, p. 399; S. J. Grand, 2013, p. 1).

This means that the entire process of funding authorization is fairly prolonged and

may take about three to four months for approval and acceptance (Fama and French,

2002, p. 32). Therefore, anticipating a timeframe when the funding will be accessible

to the company is beyond its control departing from a choice but to think about other

options for financing as discussed below (Marciukaityte and Szewczyk, 2011, p. 99;

Chen et al., 2010, p. 191).

RISKS AND MERITS OF EQUITY FINANCING

With this financing option, the company can utilize its cash and investors’ cash at the

time of establishing the subsidiary in China rather than making huge loan payments to

the banks or the private investors or lenders. This way the company wouldn’t be

under the burden of debt (Fama and French, 2002, p. 32). Secondly, provided that the

company clearly explains its investors about the risk of their investments in the

company, investors would understand in case the subsidiary fails to return the

investments. Depending upon the investors, they could offer valuable business

assistance in China that's the principal company may not have because of speaking a

foreign company in China (Brealey et al. 2008, p. 34). This is a very important aspect

of equity financing.

The risk of equity financing is that the company would be giving up some of the

control onto the investors. The reason investors would invest into the subsidiary is

that they would expect to see return on their investments (Marciukaityte and

Szewczyk, 2011, p. 99). In case they couldn't see the return, they would demand and

suggests for example strategic decisions that may not be viable for the company

according to the parent company or the owner (Chen et al., 2010, p. 191). The

investors could also demand increased returns on investment in case they are getting

returns, and in some extreme cases the owner of the company could be even forced

out by their own investors (Wand and Zhu, 2013, p. 329; Su and Sun, 2011, p. 399;

Banjerjee, 1992, p. 798).

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THE IMPACT OF EQUITY FINANCING ON THE COST OF CAPITAL OF THE COMPANY

Assuming that the subsidiary is choosing the equity financing option, the cost of

capital will get more complicated because the company is now public and has

investors (Boortz et al., p. 3). If the subsidiary were only using funds offered by the

investors, then the cost of capital would be the cost of equity (Chamley, 2004, p. 129).

Normally, the subsidiary will have debt but equity financing or the money supplied by

the investors also funds it. In this case, the cost of capital would be the cost of equity

and the cost of debt. Owing to the Traditional Theory of Capital structure, which

explains that, wealth is not just formed through investments in assets that produce

return on investment; rather purchasing those assets with a best possible blend of

equity and debt is equally important, the impact of cost of capital should be

considered such as stake of ownership (Chang et al., 2000, p. 1652).

DEBT FINANCING SOURCE

Generally speaking, debt financing relates to a financial loan, which finances a

business devoid of granting possession of rights. Some examples are lines of credit,

issue bonds etc. In this case the company will be required to sustain the lowest

percentages of registered capital to its complete investments (this is also called as

debt-to-equity ratio) (Brealey et al. 2008, p. 34). The distinction in between the

registered capital and total investment is the highest possible amount the company

that can finance by overseas borrowings, which includes related party loans and

foreign bank loans (S. J. Grand, 2013, p. 1). The loan applied for in China could

possibly be affected by borrowing gap rule as discussed earlier. With the increase in

capital, a financial loan request in foreign currency also involves authorization from

Chinese authority prior to each and every cash injection in China. This process can

consume up to 3 months. Considering that a relevant party financial loan is sought,

the arm’s length theory should be observed within exchange pricing rules (Fama and

French, 2002, p. 32; Wand and Zhu, 2013, p. 329). Provided that the efficient taxation

rate of the funding source or company is greater than the domestic financing

company, then the interest rate wouldn't be tax- deductible amount. The interest will

only be tax deductible provided that the debt/equity ratio is no higher than 2:1. (5:1

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for financial Institution), and for that reason, adheres to the thin capitalization rule

offered by the PRC corporate income tax regulation (S. J. Grand, 2013, p. 1).

Another financing option can also be considered which is known as mixed financing.

It is the collaboration of equity (registered capital) and debt (shareholder loan)

financing as it could possibly offer higher returns on investment. Planning for

financing demands cautious organization to protect against cash shortages (Boortz et

al., p. 3;). The general taxes on interest are usually reduced than the tax on dividends.

However prior to deciding upon a mixed financing it is important to consider the

impact of following on the cost of capital: a. tax agreements and taxation of income

from interest and dividends, b. possible tax credit on dividends and interest in the UK,

and c. decreased corporate income tax (CIT) rate for particular business activities or

across certain region (S. J. Grand, 2013, p. 1).

RISKS AND MERITS OF DEBT FINANCING

Debt financing allows the company to have a control although the major business

decisions of the business. In this case investors and partners are not involved and the

decisions and profits aren't shared (Boortz et al., p. 3; Banjerjee, 1992, p. 798;

Chamley, 2004, p. 129). Through financing the business by using debt, the interest

paid by the subsidiary on the loan is tax-deductible. This means that part of the

business income will be secured from the tax along with reducing tax liability of the

subsidiary every year in China (Chang et al., 2000, p. 1652). However the risks

involved in debt financing is that the subsidiary will have to pay large loan payments

at the same time it will be established (Su and Sun, 2011, p. 399; Chen et al., 2010, p.

191). This also means that in case of failing to make loan payments on time to the

creditors or the banks, the credit rating of the business will be similarly affected and

would further impact future borrowing of money for the second round of investments

in the business.

THE IMPACT OF DEBT FINANCING ON THE COMPANY'S COST OF CAPITAL

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Referring to Miller-Modigliani theory, in an environment, where there are no taxes,

default risk or agency costs, capital structure is irrelevant. And second, the value of a

firm is independent of its debt ratio and the cost of capital will remain unchanged as

the leverage changes (Brealey et al. 2008, p. 34). However in our example of prospect

Chinese subsidiary, the real world has taxes, default risk and agency costs, which

means that it is no longer true that debt and value are unrelated. In fact, increasing

debt can increase the value of some firms and reduce the value of others. This also

means that in case of debt- financing option, debt can increase value up to a point and

decrease value beyond that point. Hence, for the discussed Chinese subsidiary, the

impact of cost of capital would be realised in the form of large bonds or loans and the

interest rate paid by the subsidiary on the debt.

CONCLUSIONS

Comparing both, equity financing and debt financing, debt financing is relatively a lot

more desired financing source for raising funds because of many reasons such as

ownership, financing costs, less time and cost consuming, tax efficient and flexibility.

When it comes to ownership issue, compared to equity financing, debt financing

doesn't demand the compromise of ownership interest of the business in return of the

funding because the fund would be paid back (Chamley, 2004, p. 129; Chang et al.,

2000, p. 1652). When it comes to financing costs in debt financing option, cost of

debt financing is pretty much resolved and expected because of set interest rate, and

therefore, turns out to be less risky. Another merit of debt financing is its less time

and cost requirements. Debt financing is comparatively less time and cost consuming

in comparison to equity financing which demands more trader's involvement, greater

degree of tracking and much more strict regulating specifications (Marciukaityte and

Szewczyk, 2011, p. 99). Further on, debt- financing option is more tax efficient,

which means that interest incurred on the debts is usually tax deductible, while

dividend as cost of equity financing is not tax deductible (Banjerjee, 1992, p. 798).

Lastly, it is the flexibility that inherits less risk and higher merit when it comes to debt

financing (Su and Sun, 2011, p. 399). Hence it is evaluated that once the capital of the

manufacturing company is invested in Chinese subsidiary, it would be complicated to

get acceptance from Chinese authorities to pull away / lessen injected capital and

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repatriate to the UK (Chen et al., 2010, p. 191). However, if the manufacturing

company is expecting to pull out of its investment in China in the future, the financing

the company through debt- financing source is considered as a more appropriate

choice (S. J. Grand, 2013, p. 1).

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