In order to expand internationally, there are two main financing alternatives that Jeremy must take into consideration. First, raising the money through an IPO is the first alternative of which, according to the underwriting group from Morgan Stanley, estimates that the IPO will raise $110 million. The cost of equity for the four million shares amounts to $60 million, the same amount of money that will be raised in the equity markets alone. This will leave a total of $50 million to be used on the expansion program overseas that will have been raised from the bond markets.
The other financing alternative available to Jeremy, if he decides against the IPO, is taking a loan from a financial institution. The IPO certainly appears to be more favorable because with a company beta of 1.8%, it is likely that the cost of the loan will exceed the amount needed to successfully expand overseas. Therefore, with the option of issuing corporate bonds with a coupon rate of 8%, the IPO will leave the company with a $50 million amount to conduct the expansion overseas, and this will provide a much cheaper deal than taking a loan from another financial institution.
The first advantage of debt over equity is that the interest charged on the debt can be deducted via the company’s tax return (Lioui & Poncet, 2005). This means that the actual cost of the loan will be lower as a result, especially compared to equity where the cost of the loan will be higher as it will not be based on the company’s tax return. Therefore, relying on debt will result in more money being available to conduct other business activities in the organization. There will be a significant reduction in the expense of the loan as a result, and the company will be able to save up on the extra expenses.
Another advantage of relying on debt over equity is that the lending institution (a bank, in this case) will have no say over the affairs of the business (Morewedge, Tang & Larrick, 2016). The business will be able to operate independently of the lending institution, as compared to equity where the lending institution will have a say in the affairs of the business.
WACC for debt = $50 million
WACC for equity = $60 million
One financial instrument that Jeremy could use in order to ensure a stable supply of oil for his operations and to protect his firm from currency translation losses are loans. Loans are agreements between a lender and a borrower stipulating a certain amount of money to be paid at a certain period of time with an interest payment on top (Oltheten & Waspi, 2012). This financial instrument is very useful to Jeremy because he will be able to secure a stable supply of oil for his operations because any price increases can be addressed with the loan amount. This will prevent any delays in the execution of the project and ensure that there is adequate capital to guarantee the success of the international expansion.
The loans will last for a certain duration of tie, and the specific instrument that Jeremy should take is a short-term loan. A loan that is payable within a short time will be easier to estimate, and it is likely to have a far more reaching impact. A short-term loan, in this instance, will help Jeremy avoid extra costs during the expansion process and also avoid the effects of inflation in the future. A short-term loan will guarantee success for Jeremy’s plan to expand overseas.
One approach that Jeremy can use to hedge his currency translation and transaction exposure to the Yuan is employing forward contracts. This is an informal agreement between a broker and a dealer to sell and purchase specific currencies at a determined price at a future predetermined date (Jorion, 2009). This strategy would be quite useful for Jeremy because it would help him circumnavigate the problems associated with currency exchanges when dealing with two different currencies. In the course of the international expansion, it is likely that Jeremy will need to alter the amount in dollars he will have to pay in exchange for the Yuan, and forward contracts will be a good way of hedging the currency translation.
This means that a definite price will be set for the currencies regardless of the changes that will have occurred in the future. This is particularly important if there are drastic changes to the value of the Yuan that will require Jeremy to raise the amount in dollars he will have to pay for in exchange. Therefore, forward contracts will be an excellent way of avoiding the problems associated with the cyclical increase and decrease in value of currencies that will otherwise determine the company’s expenses.
Jeremy should buy the plant as opposed to leasing it because, over the long term, the expenses will be far smaller as compared to the lease expenses. The inflation rate in China has been set at 6% per annum, meaning that the overall business costs associated with the leasing process will have correspondingly increased by the same percentage in ten years. With a plant life of 15 years, the expenditure that Jeremy would incur would be great because he will spend $30 million per annum to conduct his business in this plant in China.
Comparatively, buying outright will cost him $50 million, and the maintenance expenses will end up being far lower than the leasing costs. Exponentially, buying would significantly bring down the costs to ensure that the business operating expenses are at their lowest. At fifty million, the expenditure of maintaining the plant from the beginning will keep dropping to an all-time low after 15 years. In the case of leasing the property, the expenditures will be increasing exponentially during the same period resulting in a much higher expense for Jeremy considering he will be operating in China.
I would want to participate in the IPO because the financial statements from the company indicate that success is inevitable in the future under the current strategy. From the information provided with regard to the WACC, the debt margins are lower than the equity margins, meaning that the company has a good credit rating and can access additional funds in the future if need be. In addition to this, the decision to outsource means that the production expenses will eventually decrease, offering a chance for the company to be more competitive in the market by lowering its prices (Jorion, 2009).
Consequently, all indications show that the company will be able to attract a large number of customers in the future, thereby boosting its income. Further, a risk-free rate in the U.S. is 2%, and the expected return on the market is 14% is an excellent investment because it guarantees the investor good returns in the short-term. Therefore, participating in the IPO would be a good idea because there is a short pay-back period that will not exceed three years after operations begin in China. The company will be in a position to guarantee good returns within a short period of time.
The expected returns will exceed the WACC within three years after the operations in China begin. This is because the steady tax rate of 28% will not alter the returns that the company has been earning, and expansion will only increase the expenses for the company or two years. Prior to the move to China, the company will be incurring losses for the first two years, attributable to the costs associated with the expansion into China. However, the benefit of outsourcing will exponentially reduce the expenses incurred by the company to the extent that it will be able to guarantee high returns (Hull, 2006). Therefore, the production costs will drop, allowing the company to reap a greater income as a result of outsourcing and expanding overseas to explore other markets.
The expected return on the market of 145 will exceed the current expectations that are under 10%. Therefore, in the short term, the WACC will be less than the expected returns, turning a profit for the investors primarily because of a reduction in business expenses incurred. The IPO will be a source of capital that will adequately suffice for the entire expansion of the company and allow it to expand into new markets. The strategy of relying on forwarding contracts will be extremely useful, particularly against countering the anticipated loses likely to be incurred by transacting in the Yuan.
The company should proceed with the IPO because it will result in more benefits and advantages for the company both in the short-term and in the long-term. The terms of the IPO will allow the company to raise adequate capital for the important, strategic actions that have to be taken for the company’s future. The IPO will be directly related to a reduction in the business expenditures because several different strategies will be undertaken in the process of increasing the company’s visibility in the industry. Therefore, the IPO will be a route for which the company can explore to reduce their expenses and attract even more investors to the company in the future.
Hull, J. C. (2006). Options, Futures and Other Derivatives (6th edition). Prentice Hall: New Jersey.
Jorion, P. (2009). Financial Risk Manager Handbook (5 ed.). New Jersey: John Wiley and Sons.
Lioui, A. & Poncet, P. (2005). Dynamic Asset Allocation with Forwards and Futures. New York: Springer.
Morewedge, C. K.; Tang, S. & Larrick, R. P. (2016). Betting Your Favorite to Win: Costly Reluctance to Hedge Desired Outcomes. Management Science.
Oltheten, E. & Waspi, K. G. (2012). Financial Markets: A Practicum. Albuquerque, NM: Great River Technologies.