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How do Multi-national Corporations Raise Funds?
Sources of Finance
Multinational corporations have an array of methods they can utilise to raise capital as a means to fund different operational needs. This essay will critically analyse varied sources of finance, looking at their respective advantages and disadvantages.
One of the most common methods entails borrowing funds from a bank (Taylor and Thrift, 2012). Whilst this is one source, it consists of three forms, short, medium or long term lending (Gurkaynak et al, 2005). These different forms serve diverse needs and have different interest rates, which is an important business decision facet.
Short term lending represents a period under three years where the interest rate that is charged is conditioned on the credit rating of the company (Van Thadden, 2004). Multinational corporations are preferred clients for a bank, and the interest rates for different loans are negotiated as part of the agreement with the institution based on the company’s credit rating (Grubel, 2014). Loans for a medium term period are usually three to ten years and generally consist of a fixed interest, or variable rate (Graham et al, 2008). Under the latter, variable rate, the interest is adjusted at three, six, nine months and one year intervals periods in keeping with fluctuations of the Base Lending Rate (Goodfriend and McCallum, 2007). This rate is computed by banks under a formula that computes the cost of money to the bank along with its administrative overhead (Goodfriend and McCallum, 2007). As a means to understand the fluctuations in the Base Lending Rate among banks, the following table provides insight:
Table 1 – Base Lending Rate for Selected Banks
(realestateagent, 2015, p. 1)
As can be seen, there are variations in the interest rates, which depending on the size of the loan can amount to a significant difference in the interest to be paid. Short and medium term loans can also consist of a discounted loan rate where the interest and other charges are computed when the loan is approved and then subtracted from the face amount (Gambacorta, 2008). These types of loans are beneficial to the borrower as the payments go to principle as opposed to paying down interest and principle under conventional loan types.
Long terms loans are usually for a period over ten years, and can either be at a fixed or variable rate where the interest is progressively collected at the beginning stages of the loan, with more going to pay down the principle after the half way point (De Bondt, 2005). This kind of loan is usually for large amounts and banks usually seek collateral guarantees that tie up property or other asset forms. As can be deduced, regardless of the bank loan type, a multinational is paying out a significant interest charge for the cost of borrowing the bank’s funds. The other downside of any form of bank lending is that these show up on the multinational’s balance sheets (Berger et al, 2005). This impacts analyst’s ratings, depending on the size and term of the loan, as these types of events can negatively impact the stock trading price due to heightened liabilities. This can also affect the company’s shareholders and in some causes cause a selloff of stock or initiate short selling that drives down a stock’s price.
Another method multinationals use to raise funds is through capital markets (Brunnermeir and Pedersen, 2009). This entails the issuance of stock using the current stock price as the basis for putting more shares into the company’s public float. The negative impact of this approach is that it dilutes the holdings of existing shareholders if the stock price does not rise. The benefit of this method is that the corporation does not incur any debt as the money raised is from the sale of shares (Brunnermeir and Pedersen, 2009). This can be accomplished by a number of methods. Private placement is usually the preferred method large multinationals use. This consists of selling blocks of stock to pension funds, insurance companies, mutual funds or investment bankers (Kwan and Carleton, 2010). One of the negatives of raising funds in this manner is that private placement permits the buyers to acquire shares at a price lower than the current market (Ming and Siyong, 2009). This represents the incentive for purchase. The private placement includes a holding period where the buyers cannot sell these shares and sometimes limits the size of the blocks they can release. The company would need to work to raise the stock price in the interim period (usually one year) to absorb these stock sales when the waiting period expires in order to provide the buyers with an incentive to participate in future private placements (Cronqvist and Nilsson, 2005).
Essentially, the corporation is betting that the use of the funds raised will positively impact the stock price causing it to rise and stay at a heightened level. The negative aspect is that brokerage firms and investors are made aware of private placements, and if their reaction to this is negative, the company’s stock price might retreat (Cronqvist and Nilsson, 2005). This could potentially sour relationships with the buyers and cause short selling. The use of equity financing is a deft financial move by a multinational that can be beneficial in terms of the lack of borrowing costs (interest), but it also can negatively impact share prices if the use of funds does not garner positive revenue results or acceptance by the market.
Retained earnings are another method multinationals use for finance. This represents money the corporation has accumulated from past operations, which can be significant (Farma and French, 2005). The problem with the use of retained earnings as a source of finance is that it is a balance sheet item that analysts use to value the price of a company’s stock (Crawford et al, 2005). Drawing on funds held as retained earnings can sometimes impact the company’s stock price. This is not always the case as there are instances such as Apple, where shareholders have complained that some of the company’s massive retained earnings could be put to better use (Lax and Sabenius, 2006). Depending on the cash reserves a company has, if the amount of funds depleted from retained earnings is significant, it could cause the stock price to be revalued downward. Apple is an unusual example as the company’s retained earnings as of May 2015 was an astonishing $100,920 billion (Ycharts, 2015, p. 1).
Whilst this is not a UK company, it serves as an example of the power of retained earnings as companies doing business with Apple understand that it has the financial clout to cause deals to happen. It also means that Apple can negotiate for better terms. This is a critical aspect in financing as it can reduce the cost of the deal and thus add potential value from this stage in addition to projected earnings that will accrue (Lax and Sabenius, 2006).
Sources of Finance for a UK Company seeking to expand in Asia
In terms of a UK company seeking to expand its operations into Asia, there are a number of factors and considerations a multinational corporation needs to take into account in terms of the method used to raise funds. There are many forms such and expansion could take. These can be the UK company setting up a wholly owned subsidiary, to acquiring the operations of an Asian company as well as joint venture deals. Regardless of the approach, a UK company needs to be mindful that the company will be negotiating on some level with Asian companies, officials or agencies (Pruitt, 2013).
Another important consideration is that there are different cultural nuances in dealing with Asia. This is a highly important point in terms of negotiations for land, new facilities, suppliers, joint venture partners as well as labour. In an article by Benoliel (2007, pp. 2-4), he states that business practices and cultural values differ in Asia from the UK. This entails understanding the impact of Confucianism, Taoism, Buddhism and Hinduism (Benoliel, 2007, p. 3). A key underpinning of Asian cultures is “wu lun”(Benoliel, 2007, p. 3). Its relevance to this study is that the term signifies stability, which is a cornerstone of Asian values. Other Asian values include harmony, behaviour towards others, mastery, respect for traditions and reciprocity of favours (Benoliel, 2007, p. 3). These aspects have been mentioned because meetings and negotiations are a part of any process concerning a UK company expanding into Asia.
In terms of the sources of finances reviewed, the top selection represents retained earnings. This has been selected as the use of a company’s accumulated cash represents a wise use of funds where the anticipated return would be greater than the interest earnings from finance vehicles. More importantly, funds that a company invests in its operations, represented by expansion in Asia have other benefits. The first is control. The use of retained earning for investing in an Asia expansion project, regardless of the type (plant, new markets, production, new suppliers, or joint ventures), means the company has control over its funds. This is not the case in terms of investing in financial vehicles using idle cash.
Being able to finance a deal from internal cash means the company has the resources to weather unforeseen situations and circumstances that might occur. In selecting retained earnings, this assumes that the company’s cash hoard is sufficiently large enough so that the deal does not deplete all of the company’s financial reserves. A benefit of using retained earnings is that depending on the type of expansion area the projected earnings window concerning revenue generation and extent of company exposure is the question. If the percentage of retained earnings used allows for a good reserve, typically 60 percent, then the prospects of dealing with unforeseen events is heightened (Farma and French, 2005).
The second preferred method entails a mixture of retained earnings and equity financing. These two sources in combination represent a debt free approach when the company’s retained earnings are not large enough to finance the expansion project and leave a sufficient reserve against unforeseen events. Depending on the amount of retain earnings used, 40 percent of the total seems to represent a good figure if the company’s on hand cash is not large enough to underwrite the entire project. This would leave 60 percent in reserve. A private placement provides the means to secure the remaining financing. In some instances, the use of an equity and retained earning approach might have more benefits than simply using all retained earning funds. The basis for this statement is that if the company controls most of the critical aspects in the expansion plan, such as manufacturing, outlets, and control over supplies, then the use of part stock might be beneficial. This means that the UK company will have to plan effectively to cause the project to meet the targets set in order to minimise negative assessments by analysts.
The third choice would represent an all equity finance approach using private placement. As brought forth, this eliminates the need for debt and interest charges, but there are downsides to this approach. The first is the amount of projected funds needed to complete the project. Unforeseen events are always a risk element (Merna and Al-Thani, 2011). This means the company would need to add a contingency of at least 20 percent in the private placement in order to have a reserve. The problem with this is it means additional shares are issued. As these shares later become tradable, the company is taking the risk that if projections and target dates are missed, the impact of shares hitting the market in the future could negatively impact the share price. This represents the impact of share dilution that cannot be absorbed by the market when the project is not meeting projected results. This method represents more risk on the part of the UK multinational as it is betting its future stock performance against project results. The consequences could negatively impact present shareholders and institutional investors if the company’s opportunity does not go as planned. As mentioned, this can also include short selling.
Any form of bank borrowing is the least preferable of all the methods. This is because the company would be taking on debt. From a shareholder and analyst viewpoint, it could indicate that the corporation is not financially sound in terms of preparations for such an expansion because it did not accumulate the needed capital internally. There are instances where an attractive deal presents itself so that a firm has to act. This means that borrowing might represent a level of commitment. As indicated, the downside is the debt taken on to fund the deal. This places pressures on the corporation to the point where unforeseen circumstances could put the entire company in an adverse position.
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