Cash, money, investment, funds, capital, whatever you want to call it, companies need it to survive and grow. There are three methods by which companies can raise money, retained earnings, equity capital and debt capital. It’s the job of the finance manager to make the decision of which option to choose, and which option is the best for the business.
Firstly we can look at a company that had a long history of using retained profit, Greggs PLC. They were one of very few companies on the FTSE to have no long term debt on their balance sheet at all, that was until 2009, which we will discuss later. Greggs’ growth had always been funded through profit, which to most companies is a dream come true, with retained profit the cost of capital is zero! Any return made on retained earnings is pure profit!
In 2009 Greggs appointed a new chairman, who took over when cash was running low due to dwindling sales figures in light of the recession. With no cash, expansion would grind to a halt. McMeikan was had to raise capital using one of the other methods, and he chose to take a loan from the government, which sits in the long term liabilities as debt. The advantage of taking on debt is obviously it injects cash when it’s otherwise not available, and also there is no dilution of control, the company gets cash and doesn’t release any shares. However the debt will come with interest rates attached, which reduces the rate of return. Greggs needed to ensure the investments were now making higher returns and so when negotiating property leases, they squeezed landlords to retain their margins and significantly slimmed their product range to reduce costs.
An option that Greggs didn’t choose to raise finance was through the issuing of shares. Companies can issue a batch of shares, which have to be offered to current shareholders first, and then to the mass market. Facebook, although it’s an initial public offering (IPO) rather than a share issuing procedure, are soon to be floating the company to raise money, and it certainly will raise significant amounts of money! The advantage to Facebook is there are no monthly payments or any obligation to pay back the capital raised or even to pay a dividend, which does lower the cost of capital. However it will come at a price to them, they will be losing a significant amount of control of the company and will be under increasing pressure to make returns for the shareholders. To issue shares or float a company is also very costly involving consultants, brokers and underwriters all taking a cut amount to between 10-12% of the finance raised.
Whichever option is chosen, only one thing is important! Return on the investment!! The option chosen should (usually) be the one that eats into the rate of return the least. Companies can calculate the cost of capital for each method and the expected cash flows (usually discounted as well) over the predicted life of the investment. Companies should then look to choose the project that pays the highest return. Seems simple enough, accept or reject projects. So why do companies take on projects that make a loss??
The internet is full of heavily discounted products that are clearly making losses such as airlines offering 99p flights. There are even sites such as Groupon that offer companies a marketing platform for low margin promotions. Surely the finance manager punches the numbers into the calculator and halts the project before a penny is ever invested? So why do they do it?
Sony’s Playstation has been entangled in a console war with Microsoft and Nintendo over the last decade, and has sold over 41 million of its Playstation 3 model (dated 11/05/11) but made a loss of £2bn on these!! However, making a loss on the consoles was all part of the plan for the Sony bosses. Playstation took the decision to install a blu-ray play in its consoles, which created a point of difference compared to the X-box and Wii, but even if they were sold at cost price they would price themselves out of the market. The decision was made to sell it at a loss to gain market share, which worked exceptionally well and PS3 sales overtook X-box 360 sales early 2011, and as the blu-ray market has continued to grow so has the sales of PS3. The gain in market share was vital to grow sales in the games market as well, margins are smaller on games but customers purchase more frequently and total PS3 games sales recently passed 500 million mark, helping boost Sony’s third quarter net profit to $559.7m. Proving projects that make a loss don’t always make a loss.
References:
Riley, A & Boome, A., Sex, religion and gossip fuels superbrands. BBC. Available at: http://www.bbc.co.uk/news/business-13416598 [Accessed February 19, 2012].
http://www.guardian.co.uk/technology/gamesblog/2011/apr/05/ps3-overtakes-xbox360
http://www.ft.com/cms/s/0/22ba711e-2f6e-11e0-834f-00144feabdc0.html#axzz1mqTNC5zY
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