Background
The decision on where to obtain money in businesses affects many investors. Therefore, capital scrutiny measures need to be in place to prevent loss and influence the decision-making process. The investment choice relies on different factors, including the potential income from the business operations and the size of the risk associated with the activities within the organization. Businesses use various sources of investments, including debt financing, equity capital, and retained earnings.
The source of investment capital influences the amount of money the firm is exposed to, and hence its efficiency in achieving its aims and objectives (Shad et al., 2019). The company is currently trading at £10 per share and has 10 million shares in issue. The total market value of the issued share capital is £100 million. Our company now aims to raise an additional £50 million to fund the next stage of development in the international project. This funding will enable the company to expand globally and conduct business in multiple countries where payments can be made using the local currency.
This report provides a critical assessment of alternative derivatives, including forwards, futures, options, and swaps, available in the market to minimize risk associated with payments in international currencies. A critical analysis of the advantages and disadvantages of the main financing options enables us to consider the various options available in the equity and debt markets, as well as to determine the benefits of interest rate swaps in reducing financing costs and mitigating interest rate risk. It will help find the most optimal ways to raise an additional £50 million with minimal risk and maximum benefit for the company.
Retained Earnings
One of the sources to raise the required £50 million could be retained earnings (RE). RE is a portion of the profits that a business does not distribute to its shareholders to aid in maintaining its operational efficiency by increasing capital investment or addressing emergencies (Lessambo, 2021). The accounting department records retained earnings on the balance sheet under the shareholders’ equity section at the end of every financial period to track their changes (Phan & Archer, 2020).
The initial RE balance is added to the net income, the net loss is subtracted, and dividend distributions are subtracted when calculating at the end of the financial period. After recording the amount in the balance sheet, the company must keep a summary report identified as a statement of retained earnings that summarizes the changes in the amount of RE at each given accounting period.
The retained earnings are helpful since they link income statements and balance sheets, and accountants record them as shareholders’ equity, thereby merging the two statements. Their purpose can vary depending on the company’s current needs. The primary purpose includes purchasing and acquiring new machinery and equipment, funding organizational research, or any other activity that potentially generates business growth. The company’s retained earnings are reinvested to increase future profitability (Kanakriyah, 2020). Suppose the company does not believe it can earn a sufficient return on investment from those retained earnings. In that case, it can distribute those RE to shareholders as dividends or conduct share buybacks.
Advantages
Retained earnings are advantageous to raise part of the £50 million needed, as they are readily available, and the firm does not need to regularly seek assistance from shareholders or lenders in case of urgency. These finances are available in the company’s coffers at the end of each financial period. The retained earnings are easily available to the company, improving its business image and capacity to raise immediate funding (Van Doorn & Badger, 2020).
Using retained earnings to finance corporate endeavors reduces the cost of issuing external equity and eliminates the losses incurred by the company due to underpricing, thereby maintaining organizational performance. In addition, using retained earnings as a source of funds to manage operations ensures that the company does not suffer from dilution of control and ownership, as shareholders do not gain different powers once management utilizes the money to run organizational developments. Generally, the stock market views the equity issue as doubtful; therefore, RE does not have a negative connotation.
Disadvantages
However, despite the several advantages retained earnings offer to the business, there are also some disadvantages. The amount raised through retained earnings may be limited, as it is derived solely from the company. Furthermore, a consistent dividend policy can complicate the usage of retained earnings (Kliestik et al., 2018).
Under this approach, the company pays out a proportion of its earnings as dividends yearly. This exposes investors to the whole range of earnings volatility. If earnings rise, investors receive a higher dividend; if earnings fall, they may not receive a payout. Under such conditions, it can be challenging to convince investors of the feasibility of reallocating a portion of RE to the company’s global expansion and doing business in other countries’ markets.
Another challenge is that the opportunity cost of these earnings is relatively high, as it represents the number of earnings that have been foregone by the equity shareholders and may draw the owners’ attention. Some companies do not give much importance to the opportunity cost of these earnings and invest them in sub-marginal projects, which ultimately hurts the net profit value. Thus, this option can be effectively applied to attract only a part of the required amount of 50 million. This is an effective approach, but the consequences of reallocating large volumes of RE can be negative for the company’s image and impact its financial statements.
Dept Capital
Another source of attracting resources to finance the next stage of an international project’s development is debt capital. It includes the money a business borrows from lenders to fund its operations. Unlike equity, which is an investment in the company through the purchase of ownership rights, debt capital is a liability to the business. It must be repaid within a specific timeframe. Borrowed capital is a corporate loan; therefore, it has consequences for the corporate image. The company may face difficulties in debt capital management in the long run if it obtains numerous creditors.
When selecting this source as the primary one, the company should consider that debt capital management poses an operational challenge for many businesses. Companies frequently face challenges in clearing it within a limited timeline despite these types of companies’ growing need for higher capital debts (Badi & Ishengoma, 2021).
The firms face the risk of failing to fulfill their responsibility to eliminate debts when necessary, jeopardizing their access to capital. Effective debt management requires a central system of records and clear scaling plans to help the company comply with credit agreements. Therefore, enterprises manage to control their debt capital, regardless of whether positive or negative implications arise for average business profits.
Advantages
The debt capital offers the company a wide range of benefits, such as retaining business control. The lender does not impact the company management process after providing the loans. The lenders will allow the firm to make independent decisions by waiting for it to run its operations and repay the loans without interference from management (Ignasiak-Szulc et al., 2018). The company’s management continues to run the business and make significant decisions, as the relationship with the lender ends once the debt is fully paid. They have no mandate to control business operations, as they shift their attention to other activities while awaiting repayment (Raimo et al., 2021).
The business relationship ends once the company has fully repaid the loan. Additionally, this method offers a tax advantage, as the amount paid in interest is tax-deductible, thereby reducing the firm’s net tax obligation. Moreover, it is more manageable to pay off the debt capital every month, making it easier to plan since one knows the amount of principal and interest they will pay back each month, thereby facilitating easier budgeting and financial planning.
Disadvantages
However, debt financing has limitations and drawbacks, including stringent qualification requirements, discipline, and collateral. If a company decides to receive financing from lending companies, it must have an excellent credit rating. It should indicate the ability to cater to the debt when the repayment period arrives.
As a result, the company must have alternate sources of funding in case earnings are inadequate to cover the debt (Dommes et al., 2019). In addition, the industry requires discipline to make loan repayments on time. The company must refrain from delaying payment of the debt, as this would result in higher interest and negatively impact its financial stability.
Proper debt management and excellent financial judgment are essential for a company since they limit the risk of failing to access financing in the future. Furthermore, businesses face challenges in formulating loans, as they need to place some assets at risk as collateral in the event of failure to meet their obligations. Thus, this source can become one of the most effective for obtaining the necessary capital of 50 million with comparable risks. However, this method requires good debt management, careful planning, and forecasting to minimize potential risks.
Equity Capital
A company’s primary capital, to which debt financing can be added, arises from investors providing money to the company in return for regular or preferred shares. These funds are at risk once invested because investors will not be refunded in the case of a company liquidation until all other creditors’ claims have been satisfied (Afzal & Hassan, 2018).
Despite this risk, investors are willing to provide equity capital for one or more of the following reasons: owning a sufficient number of shares gives an investor some degree of control over the business in which the investment has been made, the investee may issue dividends to its stockholders regularly, and the price of the shares may rise over time, allowing the investor to profit from the investment.
Equity capital is the net amount of any cash that would be returned to investors if all assets were liquidated and all corporate liabilities were satisfied. In certain situations, this figure may be harmful since the market value of the company’s assets may be less than the total amount of obligations. For instance, the amount of money that the U.K.-based company raises in equity capital by selling 10 million shares at £10 million (see Table 1).
Advantages
Equity capital is less risky for businesses since they do not have fixed monthly loan payments; hence, the general profits for the specific period are intact. This is particularly important for startup firms that experience negative cash flows during their early months. Therefore, businesses can operate freely without much stress since they do not owe any lender. In addition, equity financing is beneficial to firms since it does not take funds from external sources (Dowling et al., 2019). Debt financing requires firms to pay both the principal and interest every month, thereby interfering with their cash flow and reducing the available funds for financing growth.
Equity capital is critical for long-term planning in the business. Equity investors do not expect immediate returns on their investments, as they have long-term views and face the possibility of losing their money if the business fails. As a result of equity financing, the organization incurs no additional financial strain, as its owners can access the necessary funds through their personal finances. The firm obtains the necessary resources for its operations and enhances corporate growth, as equity financing requires no monthly payments.
The advantage is that the company receives the money immediately, which will allow a much faster start to finance the next development stage in the international project. Since the development project is global, the choice of capital source must consider the long-term perspective. With the support of investors, the company will be able to plan the project in the long run.
Disadvantages
One of the disadvantages that the business faces after incorporating the equity financing strategy is the cost. Equity investors expect to receive returns on their capital, and the business owner must be willing to share a specific amount of profit with their financiers. Another risk for the business is failure to implement all investors’ decisions in management and planning within the organization (Messlier et al., 2020).
Not all partners will always agree when making decisions. These conflicts can arise from differing visions for the company and disagreements over management styles. An owner must be willing to deal with these differences of opinion. However, given the advantages and potential to attract significant financial resources, this source of capital should be considered one of the highest priorities. It is the safest in terms of risk assessment. In the long term, equity capital is the most suitable option and should comprise the majority of the required $50 million.
Equity Financing
Equity financing involves selling a share of the company’s equity in exchange for funds. For instance, the U.K.-based company sells 10 million shares for £10 each, raising a total of £100 million through the sales of the shares to shareholders. The primary benefit of equity financing is that the company has no obligation to repay the funds obtained, as they are provided by the company’s owners (Afzal & Hassan, 2018).
The shareholders’ enthusiasm for the company’s success motivates them to engage in more capital-generating activities, thereby strengthening the company’s financial position. The company owners wish for its success and delivery of a high return on investment to its equity investors, but without incurring mandated payments or interest costs through debt financing.
As a result, because there are no required monthly payments with equity financing, the firm has more money to dedicate to its operations, improving corporate growth (Meslier et al., 2020). This is not to say that equity financing is without risk. One must offer the investor a stake in the company to secure the funding. They must divide their earnings and consult with the new partners when making business decisions. The only option to eliminate investors is to purchase their share value, which often costs more than the initial investment.
Interest Rate Risk
Interest rate swaps are forward contracts that exchange future interest payments for others with a specified principal amount. They are primarily involved in the bandying of fixed interest rates for floating rates. The move aims to minimize or maximize the exposure to fluctuations in the interest rates by obtaining marginally lower rates than the swap can manage (Ponder & Omstedt, 2019).
The process alternatively comprises a basis swap that exchanges one form of floating rate with another. Interest rate swaps are tradable over-the-counter instruments that exchange a specific set of cash flows for another (Chatziantoniou et al., 2021). They cater to several parties that select the ones to trade based on their specifications and preferences, which are customizable in unique ways.
Reducing Financing Costs and Eliminating Interest Rate Risk
When considering the various financing options available in the equity and debt markets, a company should consider the interest rate risk associated with an interest-bearing asset such as a loan or bond. Changes in the value of the asset are conceivable as a result of interest rate volatility, which can. A corporation can manage interest rate risk in various ways by utilizing different interest rate derivatives. Changes in the absolute level of interest rates cause a change in risk.
The value of fixed-income assets is directly affected by interest rate risk. Because interest rates and bond prices are inversely related, an increase in interest rate risk leads to lower bond prices, and vice versa (Sensoy & Serdengecti, 2019). When interest rates increase, the cost of borrowing money for a company also rises (Ruf & Wang, 2019). This may cause the company to delay borrowing, resulting in lower expenses. These cost-cutting measures may hinder company growth and result in decreased profitability.
To lower financing costs and mitigate interest rate risk, interest rate swaps are a viable option. They consist of counterparties agreeing to trade sets of future cash flows. The simple swap is the most frequent form of interest rate swap, in which one party pays a fixed interest rate and receives a floating rate. In contrast, the other pays a floating rate and receives a fixed rate.
Currency and interest rate swaps can help the company traverse global markets more successfully. Currency and interest rate swaps bring together two parties that have a competitive advantage in distinct markets. An interest rate swap is a transaction in which two parties exchange cash flows based on interest payments for a defined principal amount (Fabozzi & Vohra, 2022).
The principal amount on both sides of the currency is the same, and the fixed payment is often replaced with a flexible payment tied to the interest rate. A currency swap includes exchanging the principal and interest rates in one currency for the equivalent amount in another. The exchange of principal occurs at market rates and is typically the same for both the contract’s commencement and maturity.
With the effective use of these instruments, a company can reap several benefits, including reduced financing costs and the elimination of interest rate risk. Our company may engage in an exchange with a company in another country to take advantage of the fact that each company has better rates in its respective country (Lim et al., 2021). This provides an opportunity to save on interest rates by combining the privileged access that we and a partner company have in our own markets.
Forwards
Derivative financial instruments, when employed correctly, can help the company minimize different financial risks to which it may be exposed. Forwards are bilateral agreements between two parties to purchase or sell a specific quantity of a currency at a specified rate on a specific future date (Dorofeyev et al., 2018). The depreciation of the currency receivable is hedged by selling the currency forward.
If the risk is related to currency appreciation and the firm needs to acquire this currency in the future, such as for imports, it can hedge by purchasing currency forward. The key advantage of the forward is that it can be tailored to our company’s specific needs and provide an effective hedge. The fact that these contracts are not marketable and cannot be sold to another party when they are no longer necessary and mandatory is a considerable drawback.
Futures
A futures contract is similar to a forward contract, but it is more liquid because it is traded on an organized exchange, known as the futures market. Futures are standardized contracts that enable the purchase or sale of a currency on a predetermined date, time, and contract size. These contracts are exchanged on one of the world’s several futures markets.
Unlike forwards, futures contracts are openly traded, non-customizable (standardized in contract size and settlement processes), and credit losses are covered by an intermediary known as a clearinghouse (Sensoy & Serdengecti, 2019). A company may use futures contracts to mitigate the risk that an adverse price change in the underlying asset will result in unexpected costs or losses in the future.
Futures contracts can enable a company to hedge against adverse price changes in the underlying assets. In the context of foreign exchange transactions, this may enable a company to secure a better price in advance of a future transaction (Al Sadawi et al., 2021). Their advantage is that there is a central futures market, which eliminates the problem of double matching. They require a small upfront cost (a fraction of the future cost) that can generate significant amounts of money through actual forward price fluctuations.
However, futures do have some drawbacks that lower their standards as a hedging practice. The process contains a legal obligation to complete the activity within the agreed timeframe (Lund et al., 2019). In addition, futures are expensive to access due to their daily valuation (Pradeepkumar & Ravi, 2018). Futures can be expensive options, but the company can hedge a currency depreciation by selling futures, and an appreciation can be hedged by buying futures.
Options
When working with different currencies, an option can also become an effective hedging tool. It grants the right, but not the obligation, to purchase or sell a specific quantity of one foreign currency in exchange for another at a predetermined price. Because the exercise price is predetermined, it lowers the unpredictability of exchange rate swings and limits losses on open currency holdings. As with trading methods, the corporation may employ them as a contingent cash flow hedge (Menegaki, 2020).
If the risk is a price increase, call options are utilized, while puts are used if the risk is a price decrease (Zimon & Tarighi, 2021). If the exchange rate fluctuation is advantageous, the corporation can purchase the currency at the spot rate. Otherwise, if the rate rises from the current spot rate, the corporation may exercise an option to purchase it at the agreed-upon strike price.
Trading options involves applying a diverse range of tactics accessible in the markets since options are based on the underlying currency pairings. The strategy is dictated by the type of option chosen, the platform via which it is made available (Blankespoor et al., 2020). The options market is decentralized and varies significantly more wildly than options in centralized exchanges, such as stocks and futures (Sensoy & Serdengecti, 2019).
Options are utilized less frequently than forwards and are mostly used for long-term exposures. Because of the expenditures a corporation may pay to get the options, option exercise is less prevalent. There are also alternative technologies that are better suited to these hazards. The primary purpose of these derivatives is to control foreign currency risk (Pagano et al., 2020). The primary goal of a corporation using these contracts to manage foreign currency risk is to reduce the volatility of cash flows.
Swaps
Swaps are contracts in which the buyer and seller swap equal quantities of two distinct currencies at the spot rate. For the term of the contract, the buyer and seller exchange fixed or variable interest rate payments in their respective currencies. At the conclusion of the period, the principal is exchanged at a preset exchange rate, resulting in the return of the parties’ original currencies.
The benefit of swaps for international currency payments is that a corporation may switch to a wholly or partially hedged position using a currency swap mechanism without changing the underlying loan (Carlisle et al., 2019). The swaps will enable the corporation to hedge against floating interest rate risk, in addition to mitigating exchange rate risk. This is very useful in export activity.
An agreement between two foreign parties to exchange interest payments on one currency’s loan for interest payments on another currency’s loan entails the principal exchange. The swap is reverted once the agreement expires. However, most swaps involve notional principal, which is solely used to calculate interest and is not exchanged (Zhang & Chen, 2021). One reason for engaging in a currency swap is to get loans at lower interest rates than would be available if borrowed directly in a foreign market (Sensoy & Serdengecti, 2019).
Currency swaps vary from interest rate swaps in that principal exchanges can occur. Currency swaps are classified into two categories. Exchanging fixed interest payments in one currency for fixed interest payments in another is what a fixed-for-fixed-rate currency swap entails. Fixed interest payments in one currency are swapped for floating interest payments in another in a fixed-for-floating rate swap (Sensoy & Serdengecti, 2019). The principal amount of the underlying loan is not swapped in this trade. Businesses utilize the currency swap strategy to secure more affordable employment debt options and mitigate exchange rate risks.
Swap contracts are among the most recent international trade methods that significantly impact solving economic problems in various countries. Contracts have become widely used in international trade practices, as they enable traders to effectively hedge the risks associated with foreign exchange transactions. Swaps aim to mitigate the adverse effects of price changes on asset value by hedging against risks associated with commodities, currencies, and interest rate fluctuations (Almaskati, 2022).
These derivatives, with respect to payments in international currencies, will enable the company to reduce the time and costs associated with transferring items and currency, thereby boosting the country’s transportation and eliminating intermediaries that use the national currency. Swaps enable parties to explore the comparative advantages of one party over the other, providing them with information to facilitate effective interaction with their partners, thereby obtaining funds from the best alternative source at relatively lower rates (van Houwelingen et al., 2019).
Despite swaps being positive for development, they have disadvantages such as counterparty risk. It is the risk that a swap counterparty will default and be unable to satisfy its obligations under the swap agreement. The holder of the fixed rate is exposed to changes in the interest rate agreement if the holder of the floating rate is unable to make payments under the swap agreement.
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