MFRD task 2

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I. APPROPRIATE SOURCES OF FINANCE FOR BUSINESS ESPANSION

For business expansion, there are many options that help Xpresso raise capital.

Business expansion would require the issue of more share capital or more loans or based

on retained earning.

1. Retained earnings

Like any companies, Xpresso retains their earnings in order to invest them into

areas where the company can create growth opportunities. Using retained earnings to

expand market is much safer than other choices. The company does not have to pay

interest for others and get total benefits from their projects. They are also total

independent to set the strategy or control their capital without pressure from others

(interest, time banner).

However, using own capital cannot bring much more benefits than borrowing.

The company does not have much capital for other activities. Other thing is that using

own capital, Xpresso does not have reducible the cost of debt capital so the net income

will be influenced.

Retained earnings = Net income Dividend

Retained earnings are available to use and expansion is one of a part of businessso it must be thought when Xpresso wants to expand their market. However, using all

capital is not a good idea in business, the company has any other projects and they must

use their capital to balance their business operation.

2. Issuing new ordinary shares

To raise capital, Xpresso may issue new ordinary share in order to attract more

investors, who are willing to become new shareholders of the company. Issuing new

shares is suitable for raising large amount of cash because public ordinary shares of a

growth company will attract more investor if they feel the project can bring much benefit

for them. Moreover, this helps the company avoid the need to raise cash from existing

shareholders. It also reduces the risk of a future takeover taking place.

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On the other hand, existing holders may affect this option because it increases the

number of shareholders in the company, so the dividend which the company pays for

existing shareholders will be influenced and the control of them will be dilute. Besides,

most ordinary shares are irredeemable, in that the capital cannot be repaid to the

shareholder. It is also difficult in fixing an issue price, particularly in a volatile market

like Vietnam.

Xpresso Delight Limited need US$ 20 million dollar for the business expansion,

but in business, the company will not use US$ 20 million dollar one time. Xpresso will

divide the amount of money for five year. That means Xpresso will use US$ 4 million

dollar for one year.

For the option issuing new shares, Xpresso will pay flotation cost (17 %) and

dividend in the first five year. From the sixth year, Xpresso just have to pay dividend for

shareholders.

The cost that the company must pay for each year will follow.

Year 1:

$ %

For 1 share, the company issue (Proceeds) 1.50

The dividend the company pays for 1 share 0.20

Dividend/1$ (Dividend/Proceeds) 13.33%

Flotation cost for 1 share 17.00%Total cost for issuing ordinary share 30.33%

Dividend for existing shareholders 0.00%

Total cost 30.33%

Required fund 20,000,000

Dividend 13.33% x 20,000,000 2,666,667

Flotation cost 17.00% x 20,000,000 3,400,000

Total cost 6,066,667

Year 2

In year 2, Xpresso has two kinds of shareholders. One is shareholders, who bought

ordinary shares in year 1 and another is new shareholders, who buy shares in year 2. The

dividend in year 2 is not only $0.2/share, normally; it increases 0.2 x (1+15%).

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$ %


The dividend the company pays for 1 share 0.2 x (1 + 15%) 0.23


Flotation cost for 1 share 17%

Total cost for issuing ordinary share 32.33%

Dividend for existing shareholders 15.33% x 1 15.33%

Total cost 47.67%


Dividend 15.33% x 2 x 20,000,000 6,133,333

Flotation cost 17.00% x 20,000,000 3,400,000


From year 3 to year 5, the dividend follows the same formulae: A x (1+15%) with A is

the number of dividend in the previous year.

Year 3 $ %







Total cost 69.90%

Required fund20,000,000

Dividend 17.63% x 3 x 20,000,000 10,580,000

Flotation cost 17.00% x 20,000,0003,400,000

Total cost13,980,000

Year 4 $ %






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Total cost 98.11%


Dividend 20.28% x 4 x 20,000,000 16,222,667

Flotation cost 17.00% x 20,000,0003,400,000


Year 5 $ %







Total cost 133.60%


Dividend 23.32% x 5 x 20,000,000 23,320,083

Flotation cost 17.00% x 20,000,0003,400,000


In the year 6, the company just pay dividend for shareholders.

Year 1 Year 2 Year 3 Year 4 Year 5

Required fund 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000

Dividend 2,666,667 6,133,333 10,580,000 16,222,667 23,320,083

Flotation cost 3,400,000 3,400,000 3,400,000 3,400,000 3,400,000

Total cost 6,066,667 9,533,333 13,980,000 19,622,667 26,720,083

3. Issuing preference shares

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In order to raise capital but does not dilute the control of existing shareholders,

Xpresso may issue preference shares for existing shareholders. The shareholders, who

own reference shares, cannot effect the decisions of the company.

However, the company must pay dividend for reference shares before ordinary

shares. Sometimes, preference shares are issued in redeemable form. That means they

will be repurchased by the company which issues them at a specified date. Thus, this may

influence the plan of the company.

For reference share, the dividend of them does not fluctuate year by year, it is fix

at 9.52%/1$.

The calculation of preference cost as below.

Year 1 $ %

For 1 share, the company issue (Proceeds) 42The dividend the company pays for 1 share 4


Flotation cost for 1 share 10.00%



Total cost 19.52%


Dividend 9.52% x 20,000,000 1,904,762

Flotation cost 10.00% x 20,000,000 2,000,000


Year 2 $ %

For 1 share, the company issue (Proceeds) 42

The dividend the company pays for 1 share 4





Total cost 29.05%


Dividend 9.52% x 2 x 20,000,000 3,809,524

Flotation cost 10.00% x 20,000,000 2,000,000

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Year 3 $ %






Dividend for existing shareholders 9.52 x 2 19.05%

Total cost 38.57%


Dividend 9.52% x 3 x 20,000,000 5,714,286Flotation cost 10.00% x 20,000,000 2,000,000


Year 4 $ %




Flotation cost for 1 share 10.00%Total cost for issuing ordinary share 19.52%


Total cost 48.10%


Dividend 9.52% x 3 x 20,000,000 7,619,048

Flotation cost 10.00% x 20,000,000 2,000,000


Year 5 $ %




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Total cost 57.62%


Dividend 9.52% x 3 x 20,000,000 9,523,810

Flotation cost 10.00% x 20,000,000 2,000,000


In year 6, Xpresso only pay dividend.


Required fund 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000Dividend 1,904,762 3,809,524 5,714,286 7,619,048 9,523,810

Flotation cost 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

Total cost 3,904,762 5,809,524 7,714,286 9,619,048 11,523,810

4. Option 3: Borrowing

One of the optimum options for business expansion is borrowing from the banks.

With the same project, borrowing money brings more profit than using own capital.

Furthermore, Xpresso can use their capital for other business activities. The company can

control its own destiny regarding business and own all the profit it makes. They can alsoreduce the cost of debt capital by the tax relief; this is one of the most important things

that the company should consider carefully.

Nevertheless, borrowing brings more risky if the company cannot earn profits or

delay to pay interest for lender. This will broke the relationship with the bank and

influence future borrowing. The image in the public is also influenced, nobody believes a

company who cannot pay loan or delay too many times.

Interest rate 15%

Tax relief (tax rate 25%) 1 - 25% 75%

Debt 15% x 75% 11.25%

In the next 4 year, the debt will increase 2, 3, 4 and 5 times. Therefore, we can calculate

the amount of interest Xpresso must pay in five years for borrowing.

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Debt

% $

Year 1 11.25% 2,250,000

Year 2 11.25% x 2 22.50% 4,500,000

Year 3 11.25% x 3 33.75% 6,750,000

Year 4 11.25% x 4 45.00% 9,000,000

Year 5 11.25% x 5 56.25% 11,250,000

The table shows the costs/$1 that Xpresso must pay each year if they borrow


Fund1.0000 1.0000 1.0000 1.0000 1.0000

Debt

0.1125 0.2250 0.3375 0.4500 0.5625

Total cost1.1125 1.2250 1.3375 1.4500 1.5625

In the case borrowing, Xpresso needs $20,000,000 to open 20 cafes each year. We

can assume that now the company has 40 cafes so their equity is around $40,000,000.

That means their equity is double the total amount of money they need. Each year, they

need $4,000,000 so their equity is 10 times.


Debt 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000

Equity 40,000,000 40,000,000 40,000,000 40,000,000 40,000,000

Debt to equity 50% 100% 150% 200% 250%

According to rule of thumb, the Debt to equity ratio should less than 1. If not, the

company will not have enough money to pay for lender.

5. Comparison

To be easy to compare the three options, we may compare the cost that Xpresso

must pay for $1 each year. The cost that Xpresso pay for raising capital for each option

will be compared by the table below.

Year 1 Year 2 Year 3 Year 4 Year 5Total cost in 5

years

Borrowing 1.1125 1.2250 1.3375 1.4500 1.5625 6.6875

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Ordinary share 0.3033 0.4767 0.6990 0.9811 1.3360 3.7961

Preference share 0.1952 0.2905 0.3857 0.4810 0.5762 1.9286

We can see very clearly that the cost that Xpresso must pay for borrowing in 5

years is much more than others. However, it is because the calculation assumes that the

company has not paid for all debt yet for 5 years. If Xpressos business is quite good,

they can pay for debt early and reduce the total cost much. Currently, Xpresso Delight

Limited is growing up and they attract many investors (The earning growth projected at

constant 15% per annum; their ordinary shares have outperformed in the past four years

by an average of 40% per year). After paying all debt, Xpresso is free to do their business

and they have not paid for anything. This is one of the advantages if the company decidesto choose borrowing.

Furthermore, is the company issue ordinary or preference share, suppose that they

must pay dividends forever and this even increases the total cost much more than

borrowing option.

6. Recommendation

Compared any sources of finance for business expansion, we suggest Xpresso

Delight Limited should cooperate both their capital and borrowing to finance the project.

Firstly, they ensure that the flotation cost is not too big. Secondly, using their capital is

much safer than any other sources. Thirdly, borrowing can bring much more profits for

them than others as well as reduce the cost of debt capital. After paying all debt, the

company does not have to pay for long debt if comparing to dividends which Xpresso

must pay for their shareholders forever.

MFRD task 2

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