RETAINED EARNINGS
Another sources of equity capital is retained earnings (Reserves or Surplus). Retained earning is defined as the income left to a company after taxes and dividends have been paid out of profits. Retained earnings are a major source of funds for a firm’s expansion without increasing its long-term debt obligations or further diluting its ownership by issuing more common stock.
The amount of retained earnings depends on the dividend policy of the firm. In theory, dividends are considered as residual payment to stock holders of those funds not needed within the firm at a particular moment of time. Contrary to this view, studies by John Lintnec8 suggest that dividend payments in listed stocks are not just a residual paid out after the need for retained earnings have been met. There is astrong tendency to maintain a particular level of dividend payment and to make a change in the level only when management is convinced that a new rate can be maintained for a reasonable period of time. The target pay-out ratio seems to vary from 20 per cent to 80 per cent with most common rates being from 40 percent to 60 per cent. This is because directors believe that stockholders are willing to pay higher prices for those stocks with a record of stable dividends.
As a result, retained earnings in most firms whose stocks are listed in the stock exchange approximate 20% of the net profits after taxes. This has been the case in the U.S. between 1962 to 1970.4
(b) Debt Capital
Debt includes any legally binding obligation of a firm to pay a fixed amount of principal or interest for a specified period. Thus, debt capital is funds provided by borrowing. Sources of debt financing include bonds, notes, mortgages, drafts, trade credit and trade acceptances.
Debts will be classified in this paper under the following headings: Short-term debts. Short-term debts have a maturity of less than one year. Examples include trade credit, trade acceptances, bank loans, commercial paper.
Intermediate term financing includes debts that mature in one to ten years. Examples include bank term loans, equipment financing loans, Conditional Sales Contracts.
Long-term debt financing includes debts whose maturity is ten years and over. Examples are bonds and variations thereof, such as bonds, collateral bonds,.mortgage bonds, debenture bonds and so on.
Each of these sources of debt financing will be discussed briefly in this section. The relative attractiveness of each type will be emphasized.
(i) Short-term Debts
The major sources of short-term debt financing include:
a. Trade Credit
b. Bank Loans
c. Commercial Paper
d. Promissory Notes (Notes Payable)
e. Commercial drafts
f. Bank Acceptances. •
Trade Credit
When a manufacturer, wholesaler or retailer buys materials, equipment, supplies and merchandise from a supplier with the implied obligation to pay the invoice at a later date, a trade credit is created. A trade credit may take any of the following forms:
i. Open-book Account
ii. Trade Acceptances
iii. Promissory Notes
Open-book Accounts
Open-account is the most common type of trade credit. In this arrangement, the buyer sends the supplier a purchase order, a document describing the types of goods the purchaser wishes to buy. When the supplier ships the goods, it sends the purchaser an invoice – a document detailing the items shipped, their destination, and the selling price, which has been previously negotiated. The supplier retains the original purchase order and a copy of the invoice in which the purchaser acknowledged receipt of the goods delivered.
Trade Acceptance
Trade acceptances are essentially cheque payable to the supplier at the future date noted on the cheque. In this type of trade credit, the supplier will submit through a local bank in which the purchaser has opened a letter of credit the shipping documents and a draft – an order for the purchaser to pay it the amount owed. When the purchaser signs this draft, he accepts it; that is, it formally acknowledges adebt to the supplier payable at some specified date.
Promissory Notes
A promissory note is an unconditional written promise made by one person to another to pay on demand or at a specified time, a certain sum of money to order or to bearer. As used in tradescredit, promissory notes almost always call for a payment at some future date. A supplier may request for a promissory note when he finds that a customer is well over-due in his open-account credit. Promissory notes are commonly used for consumer. installment purchases and for transactions between individuals.
Advantages and Disadvantages of Trade Credit
Advantages
(a) Cost – Since the supplier does not levy a specific additional charge for the use of trade credit, it follows that it ordinarily costs nothing additional to use trade credit.
(b) Convenience – Another advantage is that very little effort is made to get trade credit. Usually, there are no formal applications to fi II out, no notes to sign and no rigid repayment dates. Thus, it is convenient and easy to obtain.
(c) Flexibility – Trade credit is also useful because we can use it when we need it. For example, accumulation of inventory to meet a seasonal increase in sales can be financed by an immediate increase in trade credit during Christmas season.
Disadvantage
Excessive use of trade credit may lead to business failure. This is because it is easy to obtain in relation to other forms of credit.
Bank Loans
Bank loan is another useful source of short-term financing. It is the most widely used formof short-term borrowing. It may take the form of a single loan, a line of credit, or revolving credit.
Single loans are made by banks for specific maturity, amount and purpose. This type is used by firms with infrequent need for borrowing.
The Line of Credit involves an unsecured loan with a maximum amount the bank is willing to lend over a period of time. It is a continuing borrowing relationship. Under the arrangement, the bank agrees to loan the firm up to a maximum amount during a certain time period when the firm calls for the money. The firm draws the loan from time to time without exceeding the maximum amount approved by the hank. The firm is usually required to repay all outstanding take-downs during one 30-day period each year.
A Revolving Credit Agreement is a commitment by the bank to loan a specific maximum amount over a specific period as required from time to time by the firm. In addition to interest payment on the amount drawn by the firm, an additional commitment fee is paid by the firm when the loan is originally negotiated. Usually, repayment on revolving credit is in one lump sum at the end of the commitment period.
Commercial Paper
A commercial paper is a short-term promissory note of highly reputable business firms. Though unsecured, these notes are backed by excellent credit ratings and therefore are eminently negotiable. Normally, a firm sells its commercial paper to a dealer who in turn sells the notes, most often to commercial banks after deducting interest at the current rate, plus a small commission. Most commercial papers represent liabilities of N50,000 to N1 million or more, payable in less than 90 days. Commercial paper is traded in the Money Market.
Promissory Notes
Promissory Note is a credit instrument, consisting essentially, of an unconditional promise to pay a sum of money at some specified future date and place to a named person or to order or to bearer. The note mayor may not be secured and it may be payable on demand. Some notes are negotiable, that is, transferable to another person by endorsement. They are commonly used for consumer installment purchases and for transactions between individuals.
Commercial Drafts
Commercial draft, also called bill of exchange is a credit instrument similar to a Promissory Note except that it is created by the person who is to receive the money. It is an unconditional written order addressed by one person to another, calling on the person to whom it is addressed to pay, on demand, or at a fixed or determinable future time, a sum of money to the order of a specified person or to bearer. Other forms of a commercial draft include Acceptances and cheques.
Bank Acceptances
Bank Acceptance is a draft or bill of exchange of which the acceptor is a bank or trust company. It provides a method ofborrowing from a bank that has the advantage of securing only those funds actually needed and at the time of need.
(ii) Intermediate Term Sources
Unlike short-term financing which by custom tends to either liquidate or renew within the course of one year, intermediate-term financing usually matures in one to ten years.
The common intermediate term financing sources are:
i. Bank term loans
ii. Equipment Financing Loans
iii. Conditional Sales Contracts
iv. Insurance Company Loans v. Development Bank Loans
Bank Term Loans
Bank Term Loan is a form of business loan from banks or other lending institutions for a period of more than one year pay but usually less than ten years.
The repayment provision of most term loans calls upon the firm to amortize the principal over the life of the loan. That is, the firm is required to repay in installments over the term of the loan. Most bank term loans are written with maturities in the one to five-years range. The interest rates are generally higher than the rate on a short-term loan.
Advantages of Bank Term Loan
Van Home points out that the principal advantage of bank term loan is its flexibility? As the borrower deals directly with the lender, the loan can be tailored to the borrower’s needs through direct negotiation.
Disadvantages
An important limitation of bank term loans lies in the restrictive provisions of the loan agreement. These provisions limit the firm’s ability to manage its resources.
Equipment Financing Loans
Equipment financing loan involves the use of a term loan to purchase a particular equipment, which is pledged as an collateral for the loan. Such loans are made only on equipment that has high marketable and resale values.
The amount of the loan is usually less than the market value of the equipment which leaves the lender: a’ safety margin if the borrower defaults. The repayment of the loan is usually related to the expected cash inflows generated by the equipment over its expected life.
The principal advantage of equipment loan is that security provision is minimal compared to other term loans except for the pledge of the specific equipment.
Conditional Sales
Conditional sales contracts are agreements between the buyer and -seller of an equipment in which the seller retains title to it until the purchaser has satisfied all the terms of the contract. The buyer, after an initial down payment, agrees to make periodic installment payments to the seller over a specified period of time. The seller receives a promissory note for the balance of the purchase price. The note is secured by the contract which gives the seller the authority to repossess the equipment ifthe buyer does not meet all the terms of the contract.
Insurance Company Loans
Insurance companies, particularly Life Insurance Companies, extend intermediate term loans to companies in business. Often such loans are made through the commercial banks. Both the bank and the insurance company may jointly finance an installment loan to a business. Under this arrangement, a bank might take the intermediate-term notes maturing the first five years while the insurance companies would take the balance which might extend up to ten or more years.
Development Bank Loans
Nigerian Development Banks grant intermediate term loans to businesses. These banks are government financial institutions. The three development banks are: The Nigerian Industrial Development Bank (NIDB), the Nigerian Bank for Commerce and Industry (NBCI) and the Nigerian Agricultural and Cooperative Bank (NACB).
The main function of these banks is to finance industry through loans and equity share participation. They make medium and long-term loans to non-petroleum mining and industrial projects including hotel projects.
(iii) Long-Term Debts
As defined earlier, long term debt financing includes debts whose maturity is ten years andover. Examples are bonds and variations thereof such as collateral bonds, mortgage bonds, debenture bonds and so on.
Bonds
A bond is a long term promissory note evidencing debt on which the issuer (borrower) agrees to pay the lender a specified amount of interest for a specified period of time, and then redeem the bond at a specified future maturity date.
There are many kinds of bonds, depending on whether and how they are secured, who issues them, how long they run, how and when principal and interest are paid, the currency of payment, the purpose of their issue, etc.
Examples of secured bonds are mortgage bonds. These are bonds backed by mortgages on real property; when movable property is pledged they are called chattel mortgage bonds. When the bond is secured by rolling stock of railroads, it is called equipment trust certificates. On the other hand, when stocks or bonds of other companies are pledged, as security, the bonds are collateral trust bonds.
An example of an unsecured bond is the debenture bond. This is a bond backed only by the good name of the debtor.
Bonds may be issued as registered or Coupon bonds. They are registered in the books of the issuing corporation. Interest and return of principal are automatically mailed to the registered address.
Coupon (bearer) bonds are bonds in which ownership is evidenced by possession rather than record. Interest is paid by the firm upon presentation of appropriate coupon which is attached to the bond.
Advantages and Disadvantages of Long-term debt
Advantages
It has a lower, after tax cost ·of capital. Interest payment on bonds are tax-deductible. Traditionally, debt is less expensive than common stock.
Long-term debt is usually easier to sell and has low flotation costs than common stock.
The use of bonds as a source of funds does not dilute present stock holders, control.
The use of long-term debt opens the possibility of positive financial leverage and increased earnings per share.
The permanency of long-term bonds over short-term sources facilitates long-range planning and consolidation of the firm’s short-term indebtedness.
Disadvantages of Long-term debt
The most important disadvantage associated with long-term debt is the increased financial risk. This is the risk that the company’s cash flow may not be enough to meet its debt obligations due to variability in its earnings.
A second major disadvantage in the use of long-term debt is the restrictive nature of the indenture covenants.
Another disadvantage is the larger cash-flow requirement to meet the sinking fund. As the cash needed increase, the financial burden and chance of insolvency also increase.
OVER AND UNDER CAPITALIZATION
This section will deal with over- and undercapitalization. Its purpose is to explain the concepts of over- and under-capitalization with special emphasis on the measurement or valuation ‘technique. The effects of over and under-capitalisation will also be discussed. Capitalisation deals with the capital structure of a business in relation to the amount of equity, its composition and changes in it.
1. Valuation Technique
The procedure for determining the value of a firm is known as the capitalization – of – income method of valuation. It is a method of calculating the present value of a stream of earnings.
The following terms are commonly used in the valuation process:
(a) Par Value: This is the face value at which shares are issued. It is static and not affected by business oscillation. Usually, it does not reflect various business chances,
(b) Market value: This is the price at which shares are sold in the stock exchange or in any other organized stock market. It is affected by the demand and supply conditions in the market.
(c) Book Value: The value at which the asset value of shares are carried in the company’s account books. It is calculated by dividing the aggregate equity capital item such as share capital, surplus, reserves or retained earnings by the number of outstanding shares.
(d) Real Value: This is the capitalized value of earnings divided by the number of outstanding shares.
Example:
Balance Sheet of Ndukauba Company as of December 198X
| Paid Capital | Sundry | ||
| 1000 shares at | Asset | ||
| each fully paid | |||
| Reserves/Surplus | 25,000 | ||
| Sundry liabilities | 50,000 | ||
| 175,000 |
(a) Par Value of the shares is – N 100, the price at which the shares were issued originally.
(b) Market Value: This is not given in the Balance Sheet. This may be assumed to vary between N90 and N120.
(c) Book Value:
| Paid up Capital | |
| Reserves/Surplus | 25,000 |
| Total |
= N125
(d) Real Value: Suppose the average earning of the Company over 8 years is N7,500. Present average rate of return or capitalization rate is 6%. Then the capitalized value is = P =
P = Present Value i.e. Price
A = Average earnings for say 6-8 years
i = Capitalization Rate
P = = 125,000
Real Value = = N125
Note: Real Value is dependent on two variables;
(a) the earnings of the firm
(b) the capitalization rate
The earnings may represent dividend payments for the common stock. The formula assumes that the future growth of dividend is zero.
The capitalization rate is derived from the industry earning capacity. Thus, the real value takes into account the earnings capacity of the firm in relation to the earnings capacity of similar firms in the industry.
2. Over Capitalization
A firm is said to be over capitalized when the book value of the firm is greater than its real value. In other words, capital employed in the business is not being justified by earning capacity of the enterprise. The earning capacity warrants the investment of lesser amount of capital than actually employed in the company.
Thus, if BV > RV, it indicates overcapitalization, where
BV = Book Value RV = Real Value.
Causes of Over-Capitalization
Over-capitalization may be caused by the following events:
(a) Promotion with InflatedAssets: Conversion of Private Company to Public Company with inflated assets which do not bear any relationship with the earnings capacity may cause over-capitalization.
In Nigeria many government-owned business firms tend to be over-capitalized due to high cost of promoting such firms as well as inflated contract prices on the construction work, and feasibility studies.
(b) High Promotion Expenses: In the case of new public limited liability companies, the cost of floating its shares and other promotion expenses may be too high. For business mergers and purchases, payments on goodwill, and patent rights etc. often tend to be too expensive and may cause over-capitalization.
Effects of Over-Capitalization
Over-capitalization has the following adverse effects.
(a) On the Company
The shares of the Company may not attract investors in the stock market due to reduced earnings.
(b) On the Shareholders
Over-capitalization increases the business risk of the shareholdersdue to reduced earning of the company. Speculation is encouraged under this situation.
3. Under-Capitalization
A firm is, on the other hand, said to be under-capitalized when the real value is more than the book value. It is the opposite of over-capitalisation. In this case, capital employed in the business is earning far more than is warranted by the capital investment. The earnings capacity warrants the investment of a larger amount of capital than actually employed in the Company.
Causes of Under-Capitalisation
Under-capitalization may be caused by the following factors:
(a) Under-estimation of earnings. If the earnings are higher than these estimated, this will lead to under-capitalization.
(b) Unforeseeable increase in earnings such as increases that occur after a depression.
(c) Conservative dividend policy may lead to high earnings and increase in the real value of the company.
(d) Maintenance of high efficiency in production and sales often leads to under-capitalisation. Real value tends to exceed the book value due to improved efficiency.
Effects of Under Capitalization
Under-capitalisation may cause wide fluctuations in the market value of shares because of manipulation on the part of the company’s management.
Remedy for Under-Capitalisation
A possible remedy often adopted by some companies is the splitting-up of the shares in order to decrease the rate of earnings per share. This measure reduces the par value of the stock.
The real remedy is the capitalisation of reserves or surplus by issuing share dividend or bonus shares.