Economic Principles on Shareholder’s Equity

The Board of Ethical Trading Group has asked you to prepare a report on current economictrends and evaluate the impact of these on their proposed plan to move into small scale sustainable manufacturing.

Introduction

Ethical Trading Group plans to move into small scale sustainable manufacturing business which would require a capital of $22,500,000. This amount of capital can be raised by the company through equity or debt financing or through a combination of both. But in order to understand, what would be the best option for the company we need to first understand the following.

Types of Debt, their valuation and rating

Companies can raise the required amount of capital through issuing debt to individuals or institutions. For this, the individuals or the institutions are the creditors who expect an interest on the capital invested. Some of the debt instruments which can be used are:
Bonds – These debt instrument have fixed period of time for maturity and carry an interest rate which is fixed or either variable. Bonds of the companies are rated by the credit rating agencies which give the trust and confidence to the investors against the risk associated with these instruments.
Bills- Bills are the bonds which matures in less than a year. These are generally issued by the government in order to decrease the money supply in the economy.
Notes- Notes are also debt instruments which are generally issued by the government in order to finance any new project. These are very highly rated by the investors as it is backed by the government and hence there is no default risk.
Short-term- Short term debts are generally issued by companies for raising money for new ventures. These are backed by the interest which the companies pay from its profits. 
Long-term- Long term debts span for longer period of more than five years and cannot be diluted before the period. However, discounting can be done in informal market for lower returns.

Shareholder’s Equity

Type of shares and their implication for the company in terms of risk
•  Ordinary Shares – These are the most ordinary shares with no special rights to the shareholder in terms of dividend. Though these shares have voting rights which is not             given to the preference shareholders.
•  Deferred Ordinary Shares- These types of shares would be paid dividend once all other class of shares have been paid with a minimum dividend.
•  Non-voting Ordinary Shares- These shares have no voting rights in the general meetings
•  Redeemable Shares- In this type of shares, the company has right to buy back in future but this can be only from the profits earned by the company or from the proceeds of       the issuance of new shares.
•  Preference Shares – This type of share has right to a fixed dividend every year and need to paid before any other type of shareholders are paid from the profits of the                 company. 
•  Cumulative Preference Shares – This type of shareholders will be receive all the dividends which were missed or was short the previous year.
•  Redeemable Preference Shares- Redeemable preference share has the characteristic of both redeemable shares and the preference shares. These shares can be                     redeemed  by the company prior to the fixed period and if not redeemed these shareholders are eligible for dividends before any other shareholders are paid from the profits       of the company.

Economic and Political Climate of financial service industry (using Keynesian economics)

•  Economic growth outlook- According to the Keynesian theory economic growth is directly related to the growth in demand in the economy.
•  Interest rate outlook- The rate of interest in a Keynesian model is the cost of borrowing money.
•  Unemployment outlook- Keynesian economy establishes that there cannot be a situation of full employment in the economy and there would be some unemployment at the        current wage rate.
•  Inflationary outlook- According to Keynes, inflation is positively related to the amount of money supply in the economy.

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Micro-economic principles of debt and equity market

In the debt market, the return is calculated by the dividend yield which is the dividend when expressed as a percentage of stock price. The return from equity is calculated by price-earnings ratio which is stock price as a percentage of Earnings per Share. Mathematically these can be expressed as
Return on Debt =   Net Income / Long term debt
Return from Equity = Net Income / Shareholders Equity

Statistical Ratios used in financial service industry

Quick Ratio- This ratio indicates to the investors about the capability of the companies to meet its short term liabilities. Thus while investing in a company, the individuals or the institutions analyse the balance sheet to calculate this ratio. A financially strong company would always have this ratio above one.
Leverage Ratio- This ratio analyses the capability of the company to meet its long and short term debts. For companies who are financed by both debt and equity capital, it becomes important for investors to know the proportion of debt and equity. Too much of debt financing would indicate that the company is using its profits to pay-off the loans instead of investing in the company for earning future profits.
Working Capital Ratio- It indicates the ratio of current assets to current liabilities and how well the company can pay of its current liabilities with its current assets. This indicates the liquidity of the organization. 
Debt-Equity ratio- This ratio is similar to leverage ratio and indicates about the proportion of debt and equity in the financial structure of the company.
Interest Coverage Ratio- This ratio indicates the ability of an organization to pay interest expenses on its debts. In case of solvency, this ratio provides the quick view of the return to shareholders.

Application of financial modelling techniques

•  Payback period before financing – This indicates the amount of time required to fully cover the cost of investment. This is a strong indictor which helps decision maker to             determine whether they should undertake a certain project. Here in the above case, Ethical Trading Group need to determine the payback period for the current project of           small scale sustainable manufacturing business. The biggest shortfall of this financial modelling technique is that it ignores the time values of money.
•  Yield curves- The yield curve shows the yield over a period of time through the economic expansion or depression. This financial modelling technique
•  Rate of return – The internal rate of return helps in estimating the profit potential of a business venture and also considers the time value of money. A high internal rate of             return would mean the particular business venture is highly profitable and should be undertaken by the company. Ethical Trading Group should use this method for                       determining whether they should undertake the new business venture of sustainable manufacturing business.

Asset and debt pricing model

Valuing debt – Valuation of the debt securities as these capital instruments have a predictable cash flow and a definite life. Hence the approach of discounted cash flow is used for valuing these documents. Investors often face the credit counterparty risk, interest rate risks. In order to safeguard the interest of the investors, the credit rating agencies often give ratings to the companies indicating their credibility. These rating are very important for the companies for raising huge capital through debt as it wins the trust of the investors.
Valuing equity- Valuation of equity securities is slightly complex than the debt securities. Some of the technique used for its valuation is top-down approach. This approach first analyses the economy in which the company is operating. Then the investor analyses the performance of the industry in that economy. Then the equity is compared with the equities of the other companies operating in the sector. Based on this analysis a relative valuation is done which help the investors take decision about the investment.

Source of financial service information

As the company Ethical Trading Group is operating in Australian Market, it need to comply with the laws and policies in that country. Apart from being influenced by the external political, economic, social, and technological environment, the company also need to consider the interest rate, inflation rate, etc. of the country. The most reliable and authentic source of information for calculating the viability of the project would be the banks and institutions governing the financial aspects of the country. Such institutions where Ethical Trading Group can find data on important statistics of the economy would be Reserve Bank of Australia, Australian Securities Exchange and Australian Bureau of Statistics. These institutions can give reliable data from which the company can predict the economy. These institutes would also help in providing the average cost of debt and equity which can help company in taking important decisions.
Apart from this, Ethical Trading Group need to adhere to the statutory requirements of Australia where it would start the operations. These might include obtaining various certificates like certificate of inception and commencement. Other legal formalities and paper work also need to be completed and compiled with in order to successfully start operations.

Best option regarding capital raising

The best option regarding capital raising for Ethical Trading Group would be a combination of the debt and equity financing. The company anticipates a return of $5,750,000 from the capital investment of $22,500,000 which mean yield of 25% return. The weighted average cost of capital of the debt and equity financing should be less than this return for the new business of small scale manufacturing to be viable. The weighted average cost of capital is the expected payment to be made in order to finance this business venture and raise the capital of $ 22,500,000. The company would only be creating value for its investors when this cost is less than the estimated return. In this methodology of calculating the cost of capital, each of the capital whether debt or equity is proportionally weighted. Mathematically it can be calculated as follows:
      WACC = E/V * Re + D/V * Rd (1- tx)
where, E= Equity Value
               D = Debt Value
               Re = Cost of Equity
               Rd = Cost of debt
               Tx = Tax rate
This is widely used by managers in companies to take important decisions and understand the proportion of debt and equity which would be suitable to the company needs. If for any company, the rate of return is less than the WACC, then it indicates it’s better to invest in some other project. One of the major drawback of this methodology is the cost of equity capital which is dependent on a number of factor and hence may vary. But if all source of information for such metrics is reliable, then companies can appropriately estimate the viability of a project.
Before taking decisions for operating in the economy, it is vital for any company to understand the current and determine the future economic trends. Economic trends shows the direction of a nation’s economy like recession or boom. These trends affects most of the companies operating in it. In case of a recession, the overall demand in the economy is very low and hence starting a new venture would be difficult for customers to accept and sustain. Whereas in case of a boom, Companies can easily find sufficient demand for their new products. Apart from the acceptance of the products by the customers, the economic trends also determine the cost of capital to be raised for financing the new venture.

Conclusion

As the board of Ethical Trading Group, it is important to analyse all the aspects of the project before taking the decision for start of this business venture. As the amount of capital involved is huge, the risk factors and the cost of the capital become important aspects to be determined. There are certain uncertainty in very business and even after the most researched analysis, the success of this business venture would depend on many economic variables.

References

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Gurvits, V. (2004). Practical guide to financing a new or small business. [Boston, MA]: MCLE.
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Why Australia Prospered. (2012). Princeton University Press.
Smales, L. (2012). Non-Scheduled News Arrival and High-Frequency Stock Market Dynamics: Evidence from the Australian Securities Exchange. SSRN Electronic Journal.
Trading ASX CFDs, options & warrants. (2008). Milton, Qld.: John Wiley & Sons Australia.
Australian equity market structure. (2010). [Melbourne]: Australian Securities & Investments Commission.
Armitage, S. (2005). The cost of capital. New York: Cambridge University Press.
Bhattacharyya, N. (1990). Interpreting internal rate of return. Calcutta: Indian Institute of Management.
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