Chuyên đề Corporate Financing – Theories in Vietnam Realities

inancing, this essay focus on the theory and reality of the problems in Vietnam in five parts as follows: Part I: Introduction Part II: Background – General Concepts Part III: Development – Theories in Vietnam realities Part IV: Conclusions and recommendations Part V: Appendix  II. BACKGROUND - GENERAL CONCEPTS When financing the capital demand, a company can rely on internal capital (current equity plus retained earnings and depreciation) or external capital (borrowing or issuing more stock). For the internal capital, it is the most convenient way to for the financial manager to have enough capital for operating his company. Obviously, the financial manager shall consider the internal capital prior to any other capital sources. However, the internal capital is hardly enough for new investment as well as other new capital demanded because they have been divided into many current as fixed assets of the company. If the company has enough internal capital for its operation, the problem of financing may can be solved by itself. Therefore, it is customary to classify external sources of finance as debt or equity. When the firm borrows, it promises to repay the debt with interest. If it doesn’t keep its promise, the debt-holders may force the firm into bankruptcy. However, no such commitments are made to the equity-holders. They are entitled to whatever is left over after the debt-holders have been paid off. For this reason, equity is called a residual claim on the firm. Equity If a company wishes to raise more money, it can sell more shares or stock. However, there is a limit to the number that it can issue without getting the approval of the current-share. Normally, this limit is approved in a General Shareholder meeting. Nevertheless, the proposal to issue more share is not always passed easily by the meeting. A company, pursuant to the approval of General Shareholder meeting, can issue common stock or preferred stock. In general, a joint-stock corporation is owned by its common stockholders. Some of this common stock is held directly by individual investors, but the other proportion may belong to financial institutions such as banks, pension funds, and insurance companies. Common stock, also referred to as common or ordinary shares, is, as the name implies, the most usual and commonly held form of stock in a corporation. Common stocks are units of ownership of a public corporation. Owners typically are entitled to vote on the selection of directors and other important matters as well as to receive dividends on their holdings. In the event that a corporation is liquidated, the claims of secured and unsecured creditors and owners of bonds and preferred stock take precedence over the claims of those who own common stock. For the most part, however, common stock has more potential for appreciation. Some other companies also have preferred stock or preferred shares. They are the shares that have preferential rights to dividends or to amounts distributable on liquidation, or to both, ahead of common shareholders. Preferred stock is given preference over common stock. Holders of preferred stock receive dividends at a fixed annual rate. The earnings of a corporation are applied to this payment before common stockholders receive dividends. If corporate earnings are insufficient for the fixed annual dividend, the preferred stock will absorb the total amount of earnings, and the common stockholders will be precluded from receiving a dividend. When corporate income exceeds the amount that is needed to pay preferred stockholders, the remainder is generally paid to common stockholders. Preferred stock can be cumulative or noncumulative. If it is cumulative and if the fixed dividend remains unpaid, it becomes a debit upon the surplus earnings of succeeding years. Accumulated dividends must be paid in full before common stockholders can receive dividends. When preferred stock is noncumulative, its preference is extinguished by the failure of the corporation to have sufficient earnings to pay the fixed dividend in a given year. Some preferred shares have special voting rights to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights associated with them. Some preferred shares only gain voting rights when the preferred dividends are in arrears for a substantial time. Besides, there are some other kinds of preferred stock such as convertible preferred stock, exchangeable preferred stock, participating preferred stock and perpetual preferred stock. A company also can buy back the stocks issued by itself to reduce the number of outstanding stocks on the open market. These stocks are call treasury stocks, treasury shares or reacquired stocks. In case of necessary, the company can sell its treasury stocks at market value to finance its operation. However, the selling or buying of treasury stocks still depend on the limit set by company charter as well as other regulation set by the General shareholder meeting, Board of management and other relevant authorities. Debt In order to raise money for operation, a company can also borrow capital from different sources in different forms. When companies borrow money, they promise to make regular interest payments and to repay the principal. However, this liability is limited. Stockholders have the right to default on the debt if they are willing to hand over the corporation’s assets to the lenders. Clearly, they will choose to do this only if the value of the assets is less than the amount of the debt. When companies borrow money, they promise to make regular interest payments and to repay the principal. However, this liability is limited. Stockholders have the right to default on the debt if they are willing to hand over the corporation’s assets to the lenders. Clearly, they will choose to do this only if the value of the assets is less than the amount of the debt. In general the mixture of loans that each company issues reflects the financial manager’s response to a number of questions: 1. Should the company borrow short-term or long-term? It depends on the characteristics of the capital demand and current financial situation of the company. Normally, short-term loan is to finance current assets and long-term loan is for fixed assets. However, depend on the financial balance of the company, the financial manager can decide to finance long-term investment by sort-term loan or finance current assets by long-term loans. Obviously that this decision must be accepted by the bankers. 2. Should the debt be fixed or floating rate? The interest payment, or coupon, on long-term bonds is commonly fixed at the time of issue. However, most bank loans and some bonds offer a variable, or floating, rate. For example, the interest rate in each period may be set at 1 percent above LIBOR (London Interbank Offered Rate), which is the interest rate at which major international banks lend dollars to each other. When LIBOR changes, the interest rate on your loan also changes. 3. Should you borrow in domestic currency or some others? The financial manager shall decide the problem base on the interest rate, exchange rate, source of revenue and forecast of above-mentioned factor. 4. What promises should you make to the lender? Lenders want to make sure that their debt is as safe as possible. Therefore, they may demand that their debt is senior to other debt. If default occurs, senior debt is first in line to be repaid. The junior, or subordinated, debtholders are paid only after all senior debtholders are satisfied (though all debtholders rank ahead of the preferred and common stockholders). The firm may also set aside some of its assets specifically for the protection of particular creditors. Such debt is said to be secured and the assets that are set aside are know as collateral. Thus a retailer might offer inventory or accounts receivable as collateral for a bank loan. If the retailer defaults on the loan, the bank can seize the collateral and use it to help pay off the debt. 5.Should you issue straight or convertible bonds? Companies often issue securities that give the owner an option to convert them into other securities. These options may have a substantial effect on value. The most dramatic example is provided by a warrant, which is nothing but an option. The owner of a warrant can purchase a set number of the company’s shares at a set price before a set date. Warrants and bonds are often sold together as a package. A convertible bond gives its owner the option to exchange the bond for a predetermined number of shares. The convertible bondholder hopes that the issuing company’s share price will zoom up so that the bond can be converted at a big profit. But if the shares zoom down, there is no obligation to convert; the bondholder remains a bondholder. Other sources Besides above mentioned sources of financing, a company also can look for other capital sources based on specific cases. Leases come in many forms, but in all cases the lessee (user) promises to make a series of payments to the lessor (owner). The lease contract specifies the monthly or semiannual payments, with the first payment usually due as soon as the contract is signed. The payments are usually level, but their time pattern can be tailored to the user’s needs. For example, suppose that a manufacturer leases a machine to produce a complex new product. There will be a year’s “shakedown” period before volume production starts. In this case, it might be possible to arrange for lower payments during the first year of the lease. When a lease is terminated, the leased equipment reverts to the lessor. However, the lease agreement often gives the user the option to purchase the equipment or take out a new lease. Some leases are short-term or cancelable during the contract period at the option of the lessee. These are generally known as operating leases. Others extend over most of the estimated economic life of the asset and cannot be canceled or can be canceled only if the lessor is reimbursed for any losses. These are called capital, financial, or full-payout leases. Financial leases are a source of financing. Signing a financial lease contract is like borrowing money. There is an immediate cash inflow because the lessee is relieved of having to pay for the asset. But the lessee also assumes a binding obligation to make the payments specified in the lease contract. The user could have borrowed the full purchase price of the asset by accepting a binding obligation to make interest and principal payments to the lender. Thus the cash-flow consequences of leasing and borrowing are similar. In either case, the firm raises cash now and pays it back later. A large part of this chapter will be devoted to comparing leasing and borrowing as financing alternatives. Most financial leases are arranged for brand new assets. The lessee identifies the equipment, arranges for the leasing company to buy it from the manufacturer, and signs a contract with the leasing company. This is called a direct lease. In other cases, the firm sells an asset it already owns and leases it back from the buyer. These sale and lease-back arrangements are common in real estate. In short-term, a company can use delayed payment for account payables. Delayed payment is sometimes called stretching your payables. Stretching is one source of short-term financing, but for some firms it is an expensive source, because by stretching they may lose discounts given to firms that pay promptly. A company also can ask their partner for deposit or payment in advance. These payments are important source of financing, especially for small companies. However, except for the case of monopolistic companies, these methods usually associated with the conditions in prices and other term. Furthermore, the sustainability of the company corresponding to the source of financing is a very important factor greatly effecting the decision in choosing financial source. PART III: DEVELOPMENT – THEORIES IN VIETNAM REALITIES Economic aspects: If firms were all-equity financed, then calculating the cost of capital would be as simple as applying one of the approaches we've already covered, though with some changes in the necessary assumptions underlying the pertinent formulas. However, when firms use multiple sources of capital, including not only equity but also debt and preferred stock, with possibly multiple classes of each, determining the cost of capital gets more complicated and a Weighted Average Cost of Capital (WACC) must be determined. However we must note one complication here: Interest paid on a firm’s borrowing can be deducted from taxable income. Thus the after-tax cost of debt is RD (l _ Tc), where Tc is the marginal corporate tax rate. When companies discount an average-risk project, they do not use the company cost of capital as we have computed it. They use the after-tax cost of debt to compute the WACC: The formula for the WACC is: (1) where E,P,D = market values of equity, preferred stock, and debt in the capital structure of the firm or project V = E + P + D, the total market value of all capital in the firm or project RE, RP = after-tax costs of equity and preferred stock, respectively RD = before-tax cost of debt Tc = firm's marginal tax rate At this point in most finance textbooks, the In order to simplify the formula of WACC, in the case of the company has no preferred stock, a very popular case in Vietnam, we can shorten the formula as follows: (2) In the case of the company have different debts with different interest rates, The RD shall be weighted interest rate: Where: - Ii: Interest paid for debt No i Di: The debt No i (ΣDi=D) However, the problem Companies in Vietnam are different. According to the figure issued by the General Statistics Office of Vietnam in 2005, 54.9% of the total capital owned by State Companies. For the State companies, all the companies are owned by the State. To some extend, we can consider they are company with 100% shares owned by the State. However, these companies have no rights to issued more equity to the public. The only feasible way to increase their equity, if they do not transform into Joint-Stock companies, is to apply for being provided more capital, a very difficult method for most of State companies now because the State obviously do not have enough capital to provide for all such required payments. Furthermore, for the State companies, the WACC can not be calculated with correct manner. All the capital in this company can be use without any cost because they do not have to pay dividend to their shareholders. Previously, the state applied tax on capital provided by the State to these companies. However, the regulation has ended its validity and now the State companies have no responsibilities to pay anything for this State equity. Therefore, the WACC of State companies shall be very low compares with other company. This fact shows the inefficient distribution of national capital. On the contrary, the number of joint- stock companies, which fully applicable to the formula of WACC are small compared with other kinds of companies. In 2005, only 10.3% of total numbers of Vietnam enterprises are Joint stock companies (The General Statistics Office of Vietnam). To some extend, the formula of WACC can be applied to the limited company. However, the above figures show that we can not calculate correctly WACC for the whole economies. Figure in table 1 show us most of companies in Vietnam are in serious lack of capital. They must try to operate their enterprises by debts. In the whole economies, the equity capital only takes a third of total capital. On other words, Vietnam companies, in general, have very high debt ratio, especially in Joint stock Companies. The high debt ratio in joint stock companies may be have advantage as well as disadvantage aspects. It is very risky for any enterprise to maintain a high rate of debt in its operation because it will not have enough financial powers to protect itself against unfavorable changes in the business. Particularly, during the time of economic recession, the companies may go to bankruptcy easily. On the other hand, this financial leverage can help the companies to improve its return on equity ratio (ROE), an important factor to raise their share price in the security market. Transform the formula (2) we have (2) (3) (4) (5) Because RD, TC, V are out of the control of financial mangers or exogenous for financial manger. The only way to minimize to WACC is to choose the financing source to minimize WACC by adjusting the capital structure. On the other words, under fixed requirement on financing the corporate operation, the financial manager only decides to choose the source from equity for debt in order to minimize WACC. Formula (5) show that if RE < RD x (1-TC), it shall be better for the company to issue more equity than take more debt because the cost of capital shall be lower than the case of borrowing. The stock market in Vietnam has developed rapidly recently. Within 2006, the Vn index increased by 4 times. This is one of fastest increasing speed in the world stock market. Therefore, the P/E ratio increases sharply with the growth of Vn index. Now, the average P/E of all list securities in the stock market, including Hanoi Stock market as well as Hochiminh Stock Market, fluctuate between 25 and 30, some good companies even have P/E ratios of 60-80. For the international standard, only the companies with very good prospect have P/E ratio (Price – Earning ratio) above 25. And the normal companies usually have P/E of between 10 and 20. This phenomenon shows us the fact that the price of stocks in Vietnam may be too high compared with their real value. However, it may also lead us to another unpleased conclusion: the current businesses of most listed companies are too low compared with their potentials. Between those two conclusions, the latter seem more reasonable because those prices are accepted widely, by both domestic and foreign investors. For many investors, these potentials are strictly related to the value of land rights arising that these companies had before the time of equitisation. Such high P/E in the Vietnam stock market now suggest that a company obviously should better issue more equity than borrow to finance its operation. For the average company with P/E ratio of 25, its earning/price ratio is only 4%. This ratio is even lower than the inflation rate of in Vietnam. When comparing with the borrowing interest rates, which are originally stable at 12-14%/year, or 8.6% -10.1%/year after deducting corporate income tax. The problem even clearer when we compare the RE with RD because only a part of net profit is paid as dividend, the other parts shall be kept at the companies as retained profit and distributed to appropriate funds. In general, the average dividend per par value of stock in Vietnam is about 20%. When the Vn index stand around 1100points, RE now is even less than 2%, which much lower than interest rates after deducting corporate income tax. This RE rate is even much lower than long-term deposit interest rate declared by all of the banks in Vietnam. This is the reason to the fact that many joint stock corporations even issue more equity with no specific expansion plan. In many cases, the companies issued more equity only for the purpose of reduce the debt from banks and other business partners. However, although issuing more equity is generally more economical than borrowing at the current market, it has a side effect of changing the company’s capital structures. In economic side, the change has little effect on operation. However, the change in capital structure may cause changes the structure and proportion of shareholder, which may lead to a changes in General Shareholder voting rights, Board of Management and/or Board of Directors, which greatly effect the company’ management. Therefore, economic sides in not the unique problem should be considered when finding the sources of financing. Beside WACC, we also analyze other factors for the best decision in corporate financing. Legal and customary aspects: Vietnam is one of the countries with least economic freedom. According to Heritage Foundation and the Wall Street Journal, the Vietnam’s index of economic freedom in 2007 is 50.00 ranking 138th among 161 countries. Therefore, corporate financing in Vietnam is strongly affected by the government. Under current regulation, in general, all the companies have right to find the capital source to finance their operation. However, similar to other governments, the Vietnam government, through Stave bank control the credit that banks given to enterprises by regulating compulsory reserve rate. Furthermore, the State bank also regulates maximum permissible of debt capital from the bank financing for each project. Besides, the government also uses its budget to finance directly to many projects, which many of them are infeasible or inefficient, mostly the project invested for State owned companies. In the recent years, investment made by State companies has taken more than 50% of total investment. Furthermore, these companies have many advantages over other type of enterprises. However, the contribution of State Companies to State budged and GDP as has no significant access over companies in other economic types. Moreover, some other results of State Companies such as employment is minor compare with the other. Beside, enterprises do not have full right in issued equity and bond. For the equity, all the listed companies in stock market must ask for approval from the State Securities Commission of Vietnam after getting the permission from the General shareholder meeting. Furthermore, enterprises are only able to issue bonds to a small number of buyers. If the enterprises offer their bonds to more than 50 buyers, they must ask the State Securities Commission of Vietnam for permission and have guarantee from sufficient security companies or banks according to the Law of Securities. Therefore, the complicated in procedures and guarantee fees prevent enterprises from issuing bonds to the public, which is a important source of financing. In fact, most of the bonds issued in Vietnam are government’s bonds or local authorities’ bonds. We hardly find any corporate bonds existing in the security market. Despite the strict control of the Government on financial market, the legal environment in Vietnam is far from competence, especially the validity of economic courts and law enforcement. In Vietnam, many companies try to finance their operation with unpaid- payables, even for over-due payables. This method is unacceptable for international practice but very popular in Vietnam. The debtors, in most of the case, are benefited from that financing source with zero interest rate. The creditors in this case hardly can call for the economic courts, not only because of high expenses but also of low effectiveness of legal economic sentences. In additions, although all the economic types of enterprises are equal, it is customarily more favorable for the State own companies to access to State funded capital. It is obviously that most of investment made by the State is for the State enterprises. However, most of Development Assistant Fund and other domestic investment incentives, which were established to support the investment of all enterprises, also disburse to the State companies. Similarly, as a habit, is shall be easier for the State commercial banks to finance state companies, especially in case of having approval from any relevant authorities. Even joint stock companies equitized from State companies have easier access to credit from state commercial banks. The legal frameworks are on the way of amending to suitable for the economic realities in Vietnam. Furthermore, the remaining of centrally planning system still has strong effect in the financing sector. Therefore, the shortcoming of financial system in corporate financing is unavoidable and can not be overcome in short time. CONCLUSION Any enterprises in the economics need to find sources to finance its operation. However, it is not easy for any company to be succeeded in this unavoidable works. During the booming of security market today, it seems to be more economical for the company to issue more equity than borrowing. However, beside the economic side, the problems of capital structure also need considering when deciding the source of corporate financing. In developed financial markets, there are many sources of corporate financing. However, due to the restriction of the government as well as customs of Vietnam enterprise