Economic Theory


Economic Theory Essay, Research Paper

A small company will have to ensure its capability of all three in spite of the fact that in comparison to a larger company, it will be paying a higher interest rate, will be risking security based on the owner s personal assets rather than company assets and repayment terms will probably be more rigid rather than flexible as banks rightly see the small company borrower as a higher risk. (This is explained later on when discussing the problems faced by the small company in raising finance.)

There are sources of loans other than from banks. Companies usually resort to these financial institutions as a last resort because their interest payments are fixed and if inflation falls, this will make the borrowing very expensive. These financial sources can include pension funds, insurance companies, merchant banks, the European Investment Bank and the ICFC. (Investment and Commercial Finance Corp[oration)

There is also the medium term note open as an alternative which is a promisory note issued by the company promising to pay a specified amount on a specified date. The procedure is for the company to write the note and then to sell it in the market place. The interest rate can be fixed or may fluctuate and the maturity date of the note can be anything from under one year to as long as fifteen years.

The small company may issue a debenture, which is a document issued in return for money lent. There are various types of debentures but they all have some features in common. They are usually in the form of a bond, undertaking the repayment of a loan on a specified date and with regular stated payments of interest between the date of issue and the date of maturity. These dividends have priority to be paid before any other dividend is paid to any other class of shareholder. The Companies Acts define the word debenture as including debenture stock and bonds. Often the terms debenture and bond or loan stock are interchangeable although I shall mention Bond and Loan Stock a little later on.

There are a number of reasons why an investor would chose debentures in preference to other forms of company financing. The major factor has to do with risk. Debt financing usually has a fixed maturity. The investor enjoys priority both in interest and in the possibility of the company going into liquidation. In addition,debenture holders receive a fixed return on the investment and if the company does not make large profits, will continue to receive the fixed interest rate while the ordinary shareholders may have to wait the Board s decision on what and how much to pay out.

Now we must look at why a company would issue debentures. The primary advantage is that the cost of the debt is known and is limited. If the company makes greater profits, these are not shared out with the debenture holders. The cost of the debt is also limited because the risk of the debenture holders is lower than that of the shareholder. Also, and importantly, the interest payment that is made to the debenture holder is deductable against tax.

Debenture issues are not an unqualified benefit for the company. There are some disadvantages in that assumptions that were made ten years ago about the future trading position of the company might prove to be wrong and the decision for long term debt unwise. The company still has to repay the debt on the date of maturity.

A warrant, is in principle, a call option issued by the company on its own stock.The warrant holder is able to buy a specified number of shares at a specified price on a specified date. Problems that face the young company will be discussed later but for a company without a proven track record, raising finance can be difficult. The warrant can be used as an enticer. Debenture holders have no option to benefit from the company which performs well but companies can tempt investors to their debenture stock by issuing convertibles or warrents in return for lower interest rates in the immediate term. (a convertible is a bond which can be converted to ordinary shares) The most common issuers of warrants and convertibles are risky companies, young companies and those whose risk profile is difficult to estimate. In other words, those who may not fare so well in the credibility stakes at the bank.

The company can issue preference shares and holders are part owners of the company, but preference shares are closer to loan capital than to ordinary shares.In the heirarchy they come higher than ordinary shares and lower than debentures. The clear company advantage is that preference shares are a source of long term , though not permanent, finance and that the dividend does not have to be paid if company profits do not justify it. Preference shares are not really popular with companies or investors. In 1993 they were only 7.7% of the total.

There are a number of characteristics shared by small companies which make it difficult for them to obtain funds. Their shorter trading records means that less is known about them and their size often precludes fewer accounting skills in the company which are necessary to put over a strong case for financing. Small companies have limited access to markets for securities, and in particular, the Stock exchange, which is both difficult and expensive.It is a view widely held, that smaller companies are more likely to have to face liquidation and so potential lenders will be much harder to pursuade.

The Financial institutions which dominate the market for finance, usually seek to invest in such a way so as to ensure that their particular investment is unlikely to affect share prices. This is the strategy to invest small amounts in large companies. These finance Institutions obviously prefer stable long term growth and the most unlikely place to find this is in a young or small company.

These characteristics, combined with those already mentioned in earlier paragraphs, for instance, fixed transaction costs for raising finance putting the small company at a disadvantage, make the small companies more or less dependent on banks for finance. Institutions that invest in smaller companies will see a higher level of risk; as a consequence, the expected returns are higher and so the cost of the capital is raised.

Companies which find themselves in need of additional finance and look to the public for this via the Stock Exchange have access to variable income and capital investments and fixed income investments. The capital market offers three types of securities, Company securities such as loan stock, shares, and options; public sector securities, such as guilt-edged securities issued by governments and well established companies; and Eurobonds.

There are two facets to the capital markets and each has its distinct function. The primary market issues and deals in new securities. So, companies wishing to raise new equity on the Stock Market New Issues Market is dealt with by the primary market. The secondary market deals with existing financial claims. Dealing on the secondary market does not raise new finance for the quoted company, but it enables the lender to transfer the repayment rights to another, while the borrower remains unaffected.

The secondary market is important to the investor because it allows the initial investor to sell the investment as and when he chooses. Without the secondary market, companies would find investors less willing to tie up their money for any length of time so making the raising of finance by share issue more difficult.

The primary function of these markets is to match the lenders to the borrowers and effect the directing of funds between them.

Not all companies are in a position to use the Stock Exchange to raise finance. All companies wishing to enter the Stock Market must be quoted and this is a costly procedure. Many companies are either too small or too new to gain a listing full listing but they need not be excluded from this method of raising finance because there is then the Unlisted Securities Market where the requirements for trading are lower. Companies have to show a three year trading record and offer 10% of shares at the primary issue.

There are four major benefits to a company which can issue ordinary or equity shares. There are no fixed charges associated with ordinary shares. The company may pay a dividend if sufficient profit is generated but it does not have to do so. There is no fixed maturity date. If the company loses, the shares can be sold to increase the creditworthiness of the company and they can be sold more easily than debentures or preference shares because they carry a higher expectation of better returns and so represent a better hedge against inflation.

The downside for the company comes in the shape of costs and control aspects.

There is also the question of what does the firm want the financing for? . The reason can either be for the purpose of expansion or settling previously acquired debt. The truth is that even in the healthiest of cases, a small firm faces certain standard small firm problems such as the difficulty to diversify and transaction costs. For example, if a firm is small, this means that whatever it produces or trades is dealt with in much smaller quantities than a larger firm. Thus, the small firm s accounts read a higher cost in purchasing raw materials (per unit), than the costs a large firm has when purchasing the same raw materials at a much greater quantity.

Another problem on the top of the problem list of a small firm is its total worth. In order for the firm to enter into either a debt market or an equity market, it must be of a substantial value. For the case of the debt market, the small firm will not be able to acquire a substantial amount of capital through a loan due to its lack in required collateral. In the case of the equity market, it is difficult for a small firm to enter this market for the same reason, but not implausible.

The main concern for the small firm is the interest rate the debentures or loans it has issued carry. It is for this reason that these sources of finance are preferred to be used as short term solutions. In the case of a small firm though, these debentures or loans may be the only way to kick-start the firm into growth. There must be a source of finance for the firm to use in order for it to invest long term through short term financial sources.

Long term investments are an integral part of a small firm s growth. Investments in technology mainly, give a firm the potential to expand, provided that the new investment(s) are managed and utilized appropriately, and integrated accordingly into the previous assets of the small firm.

For the manager looking to raise finance for the company the Stock Exchange offers a number of possibilities, if the company is in a position to meet with the process of listing and the costs. If not, debt capital and its distinguishing features of being less expensive than equity capital, being of lower risk and therefore having a lower rate of return together with tax deductable interest payments, are commonly experienced by managers of small companies.

As an epilogue, an alternative to borrowing, the economic value of leasing is calculated by discounting the incremental cashflows of the lease over the borrowing alternative. In addition to the taxation benefits, leasing helps to preserve cash, varies the borrowing portfolio and provides a less restrictive form of finance. Its certainty and flexibility reduces risk and allows the small companies a greater freedom in their investment decision process because rentals are operating expenses.


International Economics: theory and Policy.

Paul R. Krugman, Maurice Obstfeld, Addison Wesley, 1998

Butterfly Economics: A new general theory of social and economic behaviour.

Paul Ormerod, Pantheon Books, 1999

Money Greed and Risk: Why financial crises and crashes happen.

Charles Morris, Times Books, 1999

Statistical Techniques in Business and Economics.

Lind Mascon, IRWIN, 1995

Economics, fifth edition.

David Begg, McGraw-Hill Book Company Europe, 1997

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