REPORT ON BENITEZ PLCFINANCIAL PERFORTo conclude I defiantly think GNCC Capital shouldreduce their weighted average cost by utilising more debt financing as it ischeaper and will allow GNCC Capital to obtain more ownership of the companyhowever they have to beware of not becoming too over geared as it can createrisk.
With saying that I don’t completely think GNCC Capital should stop usingequity financing, just reduce the amount as it could potentially create lowerrisk of GNCC Capital becoming bankrupt. Alternatively, if GNCC Capital decide they prefer touse equity capital over debt financing I think the company should firstly tryto increase their market share value by improving managerial decisions such asprofit maximisation and sales maximisation, as a higher market share price willpotentially lower their cost of equity capital and attract more and cheaperinvestors due to a lower risk associated with the firm’s operations.However, too much debt financing can make the company overgeared and increase leverage creating some risk for GNCC Capital, because if thereis a change in the company’s financial position for example the company’sprofit somehow reduces or interest rates suddenly increase, the company isobliged to follow repayment schedules or could face bankruptcy. Regardless ofthe company’s financial position lenders will not change interest rates tocompensate which could potentially end a whole projectAdditionally, debt financing has the benefit ofallowing the GNCC to preserve full ownership without any outside interference ofmanagerial decisions made by GNCC which will reduce conflict within the firm.It also means they don’t have to share as much of their profit withshareholders as lenders receive only the sum of interest agreed on, unlikeequity capital with profits being shared.Discovering that information has led me to theconclusion that for GNCC Capital to reduce their weighted average cost of capitalthey could should issue more debt financing and reduce the amount of equitycapital they use. The main reason why I suggest GNCC use more debt financing isbecause it is considerably cheaper than equity capital it also may help thefirm recollect more profit within the company as with debt financing GNCC Capital’sinterest payments are tax deductible reducing the firms net duty unlike equitycapital when dividends is paid out of profit after tax, beneficially fixedmonthly or annual payments make it easier for the firm to budget and plan theirfinances.
According to Arnold (2012 p 773) “financing a businessthrough borrowing is cheaper than using equity capital. This if first becauselenders require a lower rate of return than ordinary shareholders” I found thisto be certainly true as when calculating the capital structure and the weightedaverage cost of capital for both GNCC Capital and Magnet Financial services asshow in table 1 and 2, I found the cheapest source of capital for both firmswas bank loan, (debt capital) costing only 7.5% which was cheaper thanpreference shares and considerably than equity capital.I think GNCC Capital should definitely aim at reducingtheir weighted average cost of capital and opting for a cheaper source ofcapital as it has benefits such as attracting investors as it increases thevalue and reputation of firm and furthermore will widen their businessopportunities by allowing them to accept low return projects and still increasevalue. CHEAPER SOURCES OF FINANCEAND IDEAS ON REDUCING WEIGHTED AVERAGE COST OF CAPITAL To conclude, aftermuch analysing it is almost certain that GNCC Capital, concerns for capital iscorrect and should immediately aim at changing their capital structure toreduce their weighted average cost of capital. The negatives of utilisingequity capital most defiantly outweigh the positive, such as issues likeconflict with in the firm due to outside forces influencing decisions also thehigher cost of burden and potential reduction in profits for GNCC Capital.
However, having too much equity capital may not alsobe a completely bad idea for GNCC Capital, as a high amount of use of equitycapital ensures a lower risk of bankruptcy for GNCC Capital. This is becausedividends payments can be deferred if the firm is having some financialproblems and any form of cash flow can be directed into improving the firm’soperation to relieve themselves from a financial crisis. Your worries of Magnet financial services attractingcheaper sources of finance is very accurate.
This is due to Company Capital’sweighted average cost of capital being 1.34% higher than their competitorsMagnet financial services meaning there is a higher risk associated with thefirm’s operation which may be deemed unattractive to investors and lead themmore towards their competitors. Moreover, Magnet Financial Services may beattracting cheaper sources of finance because they have a higher market shareprice by £15 in comparison to GNCC Capital, meaning a lower risk is associatedwith Magnet Financial Services operation meaning the required rate of returnwill be significantly lower making there cost of equity capital cheaper andreducing the companies weighted average cost of capital.
Additionally, an important disadvantage or equityfinancing is the share in profit. according to Modigliani and Miller (1958 p 263) “Inparticular, the use of debt rather than equity funds to finance a given venturemay well in- crease the expected return to the owners, but only at the cost ofin- creased dispersion of the outcomes.” Which supports my theory that if the company has a great turnover and takesoff they will have to share a proportion of the earnings with its shareholderswhich could potentially lead to the dispersal of profits over the long termexceeding what GNCC Capital could have repaid on a loan. Another flaw of GNCC Capital using equity capital as aform or capital financing is the expected pressure applied by shareholders. Asmentioned before because of the uncertainty and risk investors hold they mayapply pressure on the firm on achieving a high rate of return on thereinvestment which may cause conflict with management as it could affect GNCCCapital’s goals and plan.
I think the main cause of GNCC Capital’s high weightedaverage cost of capital is there flawed capital structure, they are simplyusing way too much equity capital. Equity capital is money that is investedinto the business by investors in conversion of a share of the company with anexpected rate of return normally set by investors. If you look in table 1, wecan see that equity capital (earning shares and retained earnings) is astaggering 64.7% proportion of GNCC capital structure and cost the highestamount (14.8%) in comparison to the other sources of capital in the structuresuch as bank loan (7.5%) and preference shares (7.
62%). The reason why equitycapital is typically more expensive is because its holds a higher risk forshareholder, the definite return of the investment is uncertain for investorsin comparison to a fixed obligated amount earned by debt financers if GNCCCapital was to go bankrupt equity shareholders would be the last to get theirmoney back with debt lenders and preference shares being a priority. Furthermore,financing through equity also necessitates other expenditures such asunderwriting fees, brokerage and a merchant banker which just adds to GNCCCapital’s expenditures.