International financial management (2014, 2000 words) This report explores 2 financing sources in China and evaluates their

merits and ris s as well as their impact of capital structure of the firm!

Table of Contents
TABLE OF CONTENTS........................................................................................................2 EXECUTIVE SUMMARY ....................................................................................................3 INTRODUCTION..................................................................................................................3 EQUITY FINANCING SOURCE ........................................................................................4 DEBT FINANCING SOURCE..............................................................................................6 CONCLUSIONS.....................................................................................................................8 REFERENCES.......................................................................................................................9

EXECUTIVE SUMMARY This "usiness report aims to present a critical evaluation of relative merits (#ualities$worth) of and ris s associated with the various sources of finance availa"le in China to the glo"al manufacturing compan% under discussion! The report also criticall% evaluate and appraise the effect the different sources of finance would have on the compan%&s cost of capital through ma ing appropriate references to the theories! INTRODUCTION 'hen an organi(ation ta es a strategic decision to involve in international "usiness through engaging in the international financing activities, additional ris financing and de"t financing in China! RELATIVE MERITS AND RISKS ASSOCIATED WITH THE VARIOUS SOURCES OF FINANCE AVAILABLE IN CHINA Transforming from export) driven to a sustaina"le consumer)driven economic development, China exerts emphasis on its national demand to improve consumption! *t the same time, the econom% also decreases its reliance on exports and foreign investment! *n important perspective in terms of growth of foreign invested enterprises such as our glo"al manufacturing firm or Chinese su"sidiaries, the structural reforms are li el% to result in greater foreign capital control s%stems that demand foreign invested enterprises to cautiousl% valuate their financing situation for potential operations in China! +iven the option of financing through de"t as a source of financing within China as compared to the ,-, wouldn.t "e much eas% (Chang et al!, 2000, p! 1/02)! The compan% would "e su"1ect to the strict financing regulations in China that are stringentl% applica"le after the assessment and consent of authorities in China (2erding3! 4! +rand, 2015, p! 1)! The de"t would "e limited "% the manufacturing and opportunities are inevita"le! This report evaluates 2 financing sources i!e! e#uit%

compan%&s registered capital and the worth of the compan% would "e as much as the worth of cash held "% the compan% in China! The situation slows down the capa"ilit% of the compan% to use financing for its expansion in China! In addition, the local "an s in China would necessitate securit% arrangements such as guarantee from other compan% in the ,- or "an guarantee, which can "e a hurdle in the process of eas% financing (Chamle%, 2004, p! 126)! * usual practice for the foreign investors in China in accordance to the 2erd "ehaviour (7aner1ee, 1662, p! 868) is to raise initial funding for their direct investment from sources external to China and then in1ects the funds into the countr%! In accordance to the 9ec ing :rder Theor%, these funds are invested into China as a! e#uit% financing, "! ;e"t financing and $ or c! com"ination of "oth (<e%ers and <a1luf, 16=4, p! 1=6)! EQUITY FINANCING SOURCE >#uit% financing is means of raising capital through selling compan% stoc to the investors! In return for the investment, the shareholders o"tain ownership interests in the compan%! 3ome examples of e#uit% financing are ?enture Capital @unding and *ngel Investors! >#uit% financing as the second source of financing option that can "e considered "% the manufacturing compan% can "e a length% process, which would ta e a"out 5 to 4 months for clearance and approval (S. J. Grand, 2013, p. 1)! It is recommended that since e#uit% financing from overseas investors is one of the common wa%s of raising funds for the Chinese su"sidiar%, therefore this financing option should "e strongl% considered! 3econdl%, the advantage of this option is that the compan% can convert the in1ected capital into A<7 that can "e utili(ed for developing the "usiness in China (7reale% et al! 200=, p! 54)! Bevertheless the ris is that the foreign capital can onl% "e utili(ed for the specified purposes as well as within the approved a "usiness scope of the manufacturing compan% ('and and Chu, 2015, p! 526)! The 5rd disadvantage is that, with a su"stantial #uantit% of documented capital the compan% would involve massive well)timed investments within 1ust fairl% short period of time (3! 4! +rand, 2015, p! 1)! *pparentl% other complications that will "e o"served in repatriating the exceedingl% in1ected amount from China afterwards

should also "e considered (7oort( et al!, p! 5D 7an1er1ee, 1662, p! 86=)! <oreover if the su"sidiar% is "uild with lowest registered capital during the initial phase and demands more financing at some later period of time, extra capital can "e arranged onl% after acceptance has "een ac#uired from the appropriate authorities to maximi(e the compan%.s lawful capitali(ation (3u and 3un, 2011, p! 566D S. J. Grand, 2013, p. 1) ! This means that the entire process of funding authori(ation is fairl% prolonged and ma% ta e a"out three to four months for approval and acceptance (@ama and @rench, 2002, p! 52)! Therefore, anticipating a timeframe when the funding will "e accessi"le to the compan% is "e%ond its control departing from a choice "ut to thin a"out other options for financing as discussed "elow (<arciu ait%te and 3(ewc(% , 2011, p! 66D Chen et al!, 2010, p! 161)! RISKS AND MERITS OF EQUITY FINANCING 'ith this financing option, the compan% can utili(e its cash and investors& cash at the time of esta"lishing the su"sidiar% in China rather than ma ing huge loan pa%ments to the "an s or the private investors or lenders! This wa% the compan% wouldn&t "e under the "urden of de"t (@ama and @rench, 2002, p! 52)! 3econdl%, provided that the compan% clearl% explains its investors a"out the ris of their investments in the compan%, investors would understand in case the su"sidiar% fails to return the investments! ;epending upon the investors, the% could offer valua"le "usiness assistance in China that.s the principal compan% ma% not have "ecause of spea ing a foreign compan% in China (7reale% et al! 200=, p! 54)! This is a ver% important aspect of e#uit% financing! The ris of e#uit% financing is that the compan% would "e giving up some of the control onto the investors! The reason investors would invest into the su"sidiar% is that the% would expect to see return on their investments (<arciu ait%te and 3(ewc(% , 2011, p! 66)! In case the% couldn.t see the return, the% would demand and suggests for example strategic decisions that ma% not "e via"le for the compan% according to the parent compan% or the owner (Chen et al!, 2010, p! 161)! The investors could also demand increased returns on investment in case the% are getting returns, and in some extreme cases the owner of the compan% could "e even forced out "% their own investors ('and and Chu, 2015, p! 526D 3u and 3un, 2011, p! 566D 7an1er1ee, 1662, p! 86=)! 0

THE IMPACT OF EQUITY FINANCING ON THE COST OF CAPITAL OF THE COMPANY *ssuming that the su"sidiar% is choosing the e#uit% financing option, the cost of capital will get more complicated "ecause the compan% is now pu"lic and has investors (7oort( et al!, p! 5)! If the su"sidiar% were onl% using funds offered "% the investors, then the cost of capital would "e the cost of e#uit% (Chamle%, 2004, p! 126)! Bormall%, the su"sidiar% will have de"t "ut e#uit% financing or the mone% supplied "% the investors also funds it! In this case, the cost of capital would "e the cost of e#uit% and the cost of de"t! :wing to the Traditional Theor% of Capital structure, which explains that, wealth is not 1ust formed through investments in assets that produce return on investmentD rather purchasing those assets with a "est possi"le "lend of e#uit% and de"t is e#uall% important, the impact of cost of capital should "e considered such as sta e of ownership (Chang et al!, 2000, p! 1/02)! DEBT FINANCING SOURCE +enerall% spea ing, de"t financing relates to a financial loan, which finances a "usiness devoid of granting possession of rights! 3ome examples are lines of credit, issue "onds etc! In this case the compan% will "e re#uired to sustain the lowest percentages of registered capital to its complete investments (this is also called as de"t)to)e#uit% ratio) (7reale% et al! 200=, p! 54)! The distinction in "etween the registered capital and total investment is the highest possi"le amount the compan% that can finance "% overseas "orrowings, which includes related part% loans and foreign "an loans (3! 4! +rand, 2015, p! 1)! The loan applied for in China could possi"l% "e affected "% "orrowing gap rule as discussed earlier! 'ith the increase in capital, a financial loan re#uest in foreign currenc% also involves authori(ation from Chinese authorit% prior to each and ever% cash in1ection in China! This process can consume up to 5 months! Considering that a relevant part% financial loan is sought, the arm&s length theor% should "e o"served within exchange pricing rules (@ama and @rench, 2002, p! 52D 'and and Chu, 2015, p! 526)! 9rovided that the efficient taxation rate of the funding source or compan% is greater than the domestic financing compan%, then the interest rate wouldn.t "e tax) deducti"le amount! The interest will onl% "e tax deducti"le provided that the de"t$e#uit% ratio is no higher than 2E1! (0E1 /

for financial Institution), and for that reason, adheres to the thin capitali(ation rule offered "% the 9AC corporate income tax regulation (3! 4! +rand, 2015, p! 1)! *nother financing option can also "e considered which is nown as mixed financing! It is the colla"oration of e#uit% (registered capital) and de"t (shareholder loan) financing as it could possi"l% offer higher returns on investment! 9lanning for financing demands cautious organi(ation to protect against cash shortages (7oort( et al!, p! 5D)! The general taxes on interest are usuall% reduced than the tax on dividends! 2owever prior to deciding upon a mixed financing it is important to consider the impact of following on the cost of capitalE a! tax agreements and taxation of income from interest and dividends, "! possi"le tax credit on dividends and interest in the ,-, and c! decreased corporate income tax (CIT) rate for particular "usiness activities or across certain region (3! 4! +rand, 2015, p! 1)! RISKS AND MERITS OF DEBT FINANCING ;e"t financing allows the compan% to have a control although the ma1or "usiness decisions of the "usiness! In this case investors and partners are not involved and the decisions and profits aren.t shared (7oort( et al!, p! 5D 7an1er1ee, 1662, p! 86=D Chamle%, 2004, p! 126)! Through financing the "usiness "% using de"t, the interest paid "% the su"sidiar% on the loan is tax)deducti"le! This means that part of the "usiness income will "e secured from the tax along with reducing tax lia"ilit% of the su"sidiar% ever% %ear in China (Chang et al!, 2000, p! 1/02)! 2owever the ris s involved in de"t financing is that the su"sidiar% will have to pa% large loan pa%ments at the same time it will "e esta"lished (3u and 3un, 2011, p! 566D Chen et al!, 2010, p! 161)! This also means that in case of failing to ma e loan pa%ments on time to the creditors or the "an s, the credit rating of the "usiness will "e similarl% affected and would further impact future "orrowing of mone% for the second round of investments in the "usiness!

THE IMPACT OF DEBT FINANCING ON THE COMPANY'S COST OF CAPITAL

Aeferring to <iller)<odigliani theor%, in an environment, where there are no taxes, 8

default ris or agenc% costs, capital structure is irrelevant! *nd second, the value of a firm is independent of its de"t ratio and the cost of capital will remain unchanged as the leverage changes (7reale% et al! 200=, p! 54)! 2owever in our example of prospect Chinese su"sidiar%, the real world has taxes, default ris and agenc% costs, which means that it is no longer true that de"t and value are unrelated! In fact, increasing de"t can increase the value of some firms and reduce the value of others! This also means that in case of de"t) financing option, de"t can increase value up to a point and decrease value "e%ond that point! 2ence, for the discussed Chinese su"sidiar%, the impact of cost of capital would "e realised in the form of large "onds or loans and the interest rate paid "% the su"sidiar% on the de"t!

CONCLUSIONS Comparing "oth, e#uit% financing and de"t financing, de"t financing is relativel% a lot more desired financing source for raising funds "ecause of man% reasons such as ownership, financing costs, less time and cost consuming, tax efficient and flexi"ilit%! 'hen it comes to ownership issue, compared to e#uit% financing, de"t financing doesn.t demand the compromise of ownership interest of the "usiness in return of the funding "ecause the fund would "e paid "ac (Chamle%, 2004, p! 126D Chang et al!, 2000, p! 1/02)! 'hen it comes to financing costs in de"t financing option, cost of de"t financing is prett% much resolved and expected "ecause of set interest rate, and therefore, turns out to "e less ris %! *nother merit of de"t financing is its less time and cost re#uirements! ;e"t financing is comparativel% less time and cost consuming in comparison to e#uit% financing which demands more trader.s involvement, greater degree of trac ing and much more strict regulating specifications (<arciu ait%te and 3(ewc(% , 2011, p! 66)! @urther on, de"t) financing option is more tax efficient, which means that interest incurred on the de"ts is usuall% tax deducti"le, while dividend as cost of e#uit% financing is not tax deducti"le (7an1er1ee, 1662, p! 86=)! Fastl%, it is the flexi"ilit% that inherits less ris and higher merit when it comes to de"t financing (3u and 3un, 2011, p! 566)! 2ence it is evaluated that once the capital of the manufacturing compan% is invested in Chinese su"sidiar%, it would "e complicated to get acceptance from Chinese authorities to pull awa% $ lessen in1ected capital and repatriate to the ,- (Chen et al!, 2010, p! 161)! 2owever, if the manufacturing

compan% is expecting to pull out of its investment in China in the future, the financing the compan% through de"t) financing source is considered as a more appropriate choice (3! 4! +rand, 2015, p! 1)!

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