Finance for growth - Business Environment

Internal sources
A firm will generate income in the form of profitfrom its operation. Part of this profit will be distributed in the form of dividends to shareholders, the rest can be used for reinvestment and to finance growth. Although this is seen as a relatively easy and cheap source of finance, it does carry an opportunity cost and therefore should be judged on its rate of return like any other source of finance. Table shows that internal funds were the largest single source of finance for industry in 1990, 1994 and 1997. It also shows that the totals available and the pattern of sources vary a great deal from year to year. (This data is no longer compiled by the Office for National Statistics.)

sources of  funds-for-industry

External sources
As the size and availability of retained earnings will be limited, most firms will also have to seek other sources of finance for expansion. There are many external sources of finance and a typical firm’s capital structure will comprise a combination of these. The sources are as follows.
Banks provide short and medium-term finance to companies in the form of loans or overdrafts. The relative cost of these depends upon how the firm wishes to use the funds. Loans carry a lower rate of interest but the interest is paid on the whole amount, while the interest on overdrafts is only paid on the amount drawn. British banks have been criticized by many for failing to provide longer-term finance for business, as banks do in other countries.

Capital market
The capital market is the place where stocks and shares are traded and is therefore a key provider of long-term finance to firms. The main institution in the capital market is the Stock Exchange. The capital market is made up of two parts: the primary part which involves the buying and selling of new stocks and shares; and the secondary part which involves the buying and selling of existing stocks and shares.

It is therefore the primary part of the market that is the source of finance for firms.The secondary part of the market is, however, also important in this process as individuals and organisations are more likely to buy stocks and shares with the knowledge that there is a ready market on which they can be traded at a later date.

The main institutions that buy stocks and shares are the insurance companies, pension funds, investment trusts, unit trusts and other large financial institutions such as building societies. A new issue of shares takes place when an existing company needs extra finance or when a company becomes a public limited company.
Types of stocks and shares

  1. Preference shares. These are shares in a company which carry a fixed dividend. Holders have preference over other shareholders in the payment of dividends and on the liquidation of the firm. Preference shares usually carry no voting rights, and so holders have little influence over how the company is run.
  2. Ordinary shares. Ordinary shares are called the ‘equity’ of the company. They do not usually carry a fixed dividend; the company declares a dividend, depending upon its performance in that year. This means that in good years ordinary shareholders could receive high dividends, while in bad years possibly none at all.Ordinary shares are therefore more risky than preference shares, and in recognition of this they usually carry voting rights, so that holders can exercise some influence over how the company is run.
  3. Debentures:Debentures or loan stock are bonds which are given in exchange for a loan to the company. The company agrees to repay the borrowed amount at some date in the future and to make annual payments of interest in the meantime. Interest on debentures is paid before payment of any dividends and the interest is allowable against tax. A debenture holder is a creditor of the company,a shareholder is an owner of the company.

New issue of shares
A company will go to an issuing house or merchant bank which will advise it on the type and number of shares to issue, the price at which they should be offered and other matters. They will often carry out the issue of shares on behalf of the firm. A new issue of shares is not a big source of finance for growth as it is fairly expensive; retained earnings are more convenient and cheaper. Also the amount of information that is required from companies which issue shares to the general public can act as a disincentive.

It is worth noting that in the UK the Stock Market essentially comprises three main elements: the main market, the Alternative Investment Market (AIM) and off exchange share matching and trading facility (OFEX). The main market deals in the shares of the large and well-established companies. The Alternative InvestmentMarket provides an opportunity for growing smaller companies to raise capital and have their shares traded in a market without the considerable expense of a full market listing. OFEX tends to be used by companies seeking relatively small amounts of capital, mainly from private investors, and has to be seen as a stepping stone to a listing on a more senior market (e.g. the Official List, AIM, NASDAQ).

Money market
The money markets provide short-term finance for companies, often for as brief a period as overnight.
Government and other institutions
The government is a source of finance for firms. Through its regional policy it gives tax allowances, loans, grants and training allowances to firms in certain parts of the country. It has many schemes for helping business, particularly small businesses. This will be covered more fully later in this chapter.
Other sources
Other sources include trade credit and hire purchase (i.e. receiving assets now and paying later). This is only a small source of finance for companies. As Table shows, industry draws a fairly high proportion of its funding from overseas. This includes finance from many different sources, including individuals, governments, financial institutions overseas and companies.

Firms will typically go for a mixture of different types of finance. The exact combination will depend upon many factors, including their relative costs, their availability and the desired capital structure of the firm. A firm’s desired capital structure will largely depend upon the type of market in which it operates. The different types of finance are classified under the two headings of debt and equity.

Debt refers to all types of capital on which payments have to made each year regardless of how the firm has performed; this would include loans and preference shares. Equity refers to ordinary shares where the payment of a dividend depends upon the performance of the firm. As a source of finance, debt is generally cheaper but it is also more risky since in bad years the firm will have to meet the interest payments. The ratio of debt to equity is called the gearing of the company. Debt is not well suited to firms in industries where profits fluctuate and such firms will have lower gearing than those in more stable markets.

Limits to growth
Several factors tend to act as a limit to organisational growth:

  • To finance growth, excessive borrowing might have taken place and the firm may have trouble meeting debt repayments; therefore there is increased risk of bankruptcy.
  • A serious constraint to growth might be the abilities of management. As organisations grow in size they may experience dis-economies of scale, which are mainly to do with managerial problems, like communication and control.
  • If the size of the market for the product is stagnant or declining it may be both unnecessary and impossible for the firm to grow.
  • Government policies, too, can have an important impact on growth. Every government has policies on competition which seek to limit anti-competitive practices and which normally regulate merger activity.

Merger activity in the United Kingdom
There are two common ways of measuring the level of merger activity by the number of transactions or by the total value of the transactions. Figure shows the level of merger activity in the UK according to the number of companies acquired in the UK by UK companies. It can be seen that there was a sharp rise in merger activity in the mid-1980s and a downturn in 1989. The cyclical pattern continues into the 1990s but the amplitude is reduced. This cyclical pattern is repeated in other countries and in the EU as a whole and it implies that the level of mergers is in some way related to the state of the economy. The rise in the mid-1980s was due partly to an improvement in the state of the economy and partly to the liberalization of the financial markets, which made finance for takeover bids more freely available. The fall in 1989 was due partly to the recession and partly to the problems that some companies subsequently experienced by over stretching themselves in the mid-1980s. The subsequent rise in the level of merger activity was due to the restructuring which took place in many diverse industries in the 1990s like the financial services sector and the public utilities.

Merger activity in the United Kingdom

Merger activity by value in the United Kingdom

Figure shows the level of merger activity in the UK according to the value of the transactions, and the same cyclical path can be discerned although the peaks and troughs do not exactly coincide with the number of transactions. The use of the value of the transactions as a measure of merger activity is problematic in that it will be distorted by any very high-value deals that take place, as in 1995–7 and2000 when the number of transactions fell but their value rose.

Merger activity in Europe
Figure shows the number and value of cross-border mergers and acquisitions in the EU between 1999 and 2005. As in the UK, there was a fall in activity by both measures after 2001 but a sharp rise in the first half of 2005.

Cross-border mergers and acquisitions

The total value of cross-border mergers and acquisitions in the EU in the first half of 2005 was €286.6 billion. The most important acquirer was France (21 per cent of total) followed by the USA (19 per cent), Italy (10 per cent) and the UK (9 per cent).

Global merger activity
Table shows the value of outflows from and inflows to OECD countries for merger and acquisitions between 1999 and 2005. The pattern is the same as for the UK and the EU flows fell after 2001 and increased sharply at the beginning of2005. It is predicted that in 2006 the number of global cross-border mergers and acquisitions will be in excess of 700 and their total value in excess of $720 billion.

It can be seen that the same pattern presents itself for the UK on its own, the EU and the world as a whole a decline in merger and acquisition activity followed by a surge in activity in 2005. During the 1990s the boom in merger and acquisition activity was dominated by the telecommunications sector. In 2004/5 recovery activity was taking place mainly in the financial services sector the two largest deals were the takeover of Abbey National Bank (UK) by Banco Santander Central Hispano (Spain) and the takeover of John Hancock Financial Services (USA) by Manulife Financial Corporation (Canada).

Cross-border mergers and acquisitions from OECD countries

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