Knowledge Holdings Limited

usiness in Vietnam because of some opportunities. First, Vietnam is one of the youngest populations in the world. The youngster is fond of reading book and thirsty for knowledge as well as quality books. Second, there has been increasing foreigners in Vietnam and their demand for quality books is high. Third, Vietnam government has many incentive policies for foreign business enterprises and Vietnam’s entry in to WTO in 2007 provides the necessary advantage for the company. The plan of the company is having no less than 12 mega-size bookstores in the various metropolis cities of Vietnam in the next four years. The business expansion plan faces capital challenges. The company needs at least US$ 27million dollars. There are various alternative sources of finance available to Knowledge Holding Limited. The basic sources of finance comprise equity and debt. Preference shares and ordinary shares are two kind of equity. Retained earnings and issue of new shares are two ways of investment after paying preference dividend and ordinary dividend. Short-term debt and long-term debt are two kinds of debt. 2.0 Sources of finance 2.1 Issued of debts Debt financing: When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. (  ) Interest expense is tax-deductible because interest expenses do affect the taxes payable. If the company borrows more money from debt holders, the company will incur more interest expenses; therefore, taxes payable will reduce. If company borrows less, the interest expense will be less and the taxes payable will increase. In short, with debt, the company will incur higher interest expense, but this being reduced by tax savings The after- tax cost of debt, kd (1-T), is used to calculate the weighted average cost of capital, and it is the interest rate on debt, kd, less the tax savings that result because interest is deductible. This is the same as kd multiplied by (1-T), where T is the firm’s marginal tax rate After-tax component cost of debt = Interest rate - Tax savings = kd - kdT = kd (1-T) Based on the formula above, the higher tax rate, the lower cost of debt, therefore the company should issue more debt. The lower tax rate, the higher cost of debt, the company should issue less debt. The present tax rate is 30%, the cost of debt after tax rate is 5, 6%. The corporate tax rate for foreign is expected to go down, hence, the tax rate will decrease and the cost of debt after tax will increase. For that reason, the company should issue less debt. Control implication Knowledge Holding Limited is majority owned (52% stake) by her Chief Executive Officer (CEO), Mr Stanmore. Mr Stanmore has effective control in the company because his stake is more than 50%. He has the highest voting rights in the company. Every company’s business decisions have to be made with the acceptations of Mr Stanmore. Definitely, Mr Stanmore does not want to share his voting rights with other people. Issued of new debts is a way for companies to raise capital without giving up ownership in their company because of debt holders having non- voting right. Risk implication: In the event of winding up the company, debt holders will have the first claim on company’s assets. Shareholders will bear the financial risk which is the additional risk as a result of the decision to finance with debt. If the company’s business are not well , the company still have to pay interest rate for debt holders If the company issued debt, the company have to incur business risk which is inherent in a business for any companies as well as financial risk ;debt holder does not have to bare any of the business risk. Because interest expenses which the company have to pay for debt holder are fixed. Legal implication Interest payments are mandatory. If bankruptcy occurs, the debenture holders are considered creditors and must be paid back by the companies remaining assets. Shareholders do not have to share their profits if the business is extremely successful. Financial cost implication: Ked = 5, 6 % Tax rate = 30% Kd = 8% Because interest is a deductible expense, it produces tax savings which reduce the net cost of debt, making the after-tax cost of debt less than before tax cost. With debt, the company will incur higher interest expense, but this being reduced by tax savings 2.2 Issued of new ordinary shares: Taxes implication Ordinary dividends are not tax-deductible because ordinary dividends are paid out from the earnings after taxes. Thus, tax adjustment is not required when estimating the cost of ordinary shares. There is an advantage of issue new ordinary shares: payment of ordinary dividends is at the discretion of the company, therefore, ordinary dividends are variable. Control implication: Stake is ownership in an enterprise that one company acquires in another that represents less than 100 percent ownership. The stake holders have voting right in making business decisions of company. The more percent of stake stakeholders owned, the more voting right they have. In Knowledge Holding Limited Company, the CEO owned 52% stake. He has the most controlling stake. If the company issue ordinary shares, CEO’s stake and other existing shareholders’ stake will be diluted. Risk implication: Knowledge Holding Limited faces with both financial risk and business risk. If the company is wound up, ordinary shareholders’ voting right will rank after debt holder and preference shareholders respectively on the claims of company’s assets on liquidation. That is financial risk of issue ordinary shares. The business risk is uncertainty in the projection of future operating income. In Vietnam, fake-books and contraband books are quite familiar. That is an disadvantage that lead to business risk for the company to penetrate in Vietnam market. Issue of new ordinary shares will send a negative “signal” to investors. Legal implication: Ordinary shareholders and CEO will propose the ordinary dividends pay-out. The ordinary dividends in common does not stable because the company earnings fluctuate from year to year. The shareholders have the right to share in the company's profits. The more money the company has left after it has paid all its debts, the more shareholders share of the company will be worth. It is not mandatory for the company to pay ordinary dividends. If the company fails, shareholders could lose all of their investment. When a bankrupt business is wound up, shareholders are last in line to get money out of what is left. Financial cost implication: The factors which are influence the cost of ordinary shares are ordinary dividends, ordinary issued price, flotation and growth rate in earnings. Earnings per share (EPS) are equal to earnings available to shareholders divided by number of outstanding shares. When the company issues ordinary share, the earning available to shareholders will remain but the number of outstanding shares will increase. Therefore, (ESP) will be diluted. If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings 2.3 Issued of new preference shares: Beginning with Tax implication : preference dividends are paid out from the earnings after taxes. Hence, preference dividends are not tax deductible. A tax adjustment is not required when estimating the cost of preference shares because there is not tax saving here. The preference share price (Pp) is $54, preference share’s flotation cost (Fp) is 6%, and constant preference dividend (Dp) is $4 per year. Applying to the formula, the cost of preference share (Kp) is 7.88%. About the control implication of issued of preference shares, ordinary shareholders’ stakes would not be diluted that is because the preference shareholders have no voting rights in the company. As a result, 52% stake by CEO will be maintained when the company issued of preference shares. Risk implication: Preference dividends are paid out after paying interest expenses. That is financial risk to preference shareholders if the company’s business operation is not good. To deal with the risk, the company has to support preference shareholders with legal obligations. “If the company goes bankrupt, you'll likely lose money on your preferreds, but likely less money than if you'd bought the firm's common stock. Preferreds entitle you to a set amount of money if the company goes bust. However, you'll only be paid after bond holders and other creditors have been paid, which might mean there won't be much left”. Obligation to pay the preference dividends are not mandatory, however, most preference share issues are cumulative. Unlike common shares, preferred shares don't give preference shareholders the right to share in a company's fortunes. Preference shareholders have preferential claim to the profits ahead of common shareholders if the firm goes out of business. “Only if the company misses a set number of dividend payments do preferred shareholders have a right to vote in the company's affairs. If the company earns a profit again, preferred shareholders are usually entitled to get all the missed dividend payments paid to them before common shareholders get any”. Company will not be forced in to bankruptcy because of non-payment of preference dividends Cost implication: The cost of preference share is 7.88%. There, flotation cost is a component which makes the cost of preference shares increase. Besides, issued of new preference shares leads to the increasing of number of outstanding shares. Otherwise, earnings available to shareholders do not change. As a result, earnings per share (EPS) are diluted. If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 2.4 Retained earnings Retained earnings are earnings not distributed to the shareholders as dividends. “Retained earnings refer to that part of the current year’s earnings not paid in dividends, hence available for reinvestment in the business this year”. ( Brigham and Houston 1996) Tax implication is a signal which is appearing when tax payable is reduces. There is no tax implication here because retained earning is the firm’s after tax earnings. “The firm’s after tax earnings belong to its stockholders. Management may either pay out earnings in the form of dividends or else retain earnings and reinvest them in the business.”( Brigham and Houston 1996) . The ordinary share price (Po) is $12.40, growth rate (g) is 20% per annum, and expected dividend (D1) is $0.10. Applying to the formulae in appendix, the cost of retained earning is 20, 81%. There are some advantages of using retained earning. First, absence of flotation cost will help company reduce cost for investment bankers. Second, Capital will be available when company wants to invest a new project .It makes raising capital become easier. There are no direct costs associated with raising retained earnings. The capital still has opportunity cost. “Stockholders could have received the earnings as dividends and invested this money in other stocks, in bonds, in real estate, or in anything else. Thus, the firm should earn on its retained earnings at least as much as the stockholders themselves could have earned on alternative investments of comparable risk”. “If the firm can not invest retained earnings and earn at least (Ks), it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return”.( Brigham and Houston 1996) In control implication, the existing shareholder stake is no change; therefore 52% stake of CEO will be maintained after issued of new preference share. In legal implication, the approval of shareholders and debt holders for the use of retained earnings is necessary because shareholders and debt holders have the priority of claim. “All earnings remaining after interest and preferred dividends belong to the common stockholders and these earnings serve to compensate stockholders for the use of their capital.” If the company decides to choose retained earnings and reinvest them in other business, the company has to explain the prospect of the retaining clearly and persuade shareholders to approve with this decision. If the company decides to retain 100% earnings, credit risks and bankruptcy risk will occur. There, interest expense is tax-deductible. If the company do not issue debts, there will not have tax-savings (credit risk). Moreover, 100% of retained earnings also mean no shares are issued. In case of making loss, the company cannot share their loss to its shareholders (bankruptcy risk). 3.0 Assess on the costs of various sources of finance The cost of debt is less than the cost of equity due to some reasons. First is risk implication: in the event of winding up the company, debt holders will have the first claim on company‘s assets. Second is return implication: debt holders will receive fixed interest payments which is mandatory whereas shareholders will receive dividends payment which is at the discretion of the directors. Third is security implication; debt holders’ investment are secured by the company’s mortgage on fixed assets whilst shareholder’s investments are not secured by company fixed assets. Here, although cost of debt. “The cost of new common equity or external equity , is higher than the cost of retained earning because of flotation costs involved in issuing new common stock”.( Brigham.E , Houston. J ,1996) Appendix D1 $0.10 Ke = + g = + 20% = 20.88% Po(1 - F) $12.40(1 – 0.08) D1 $0.10 Ks = + g = + 20% = 20.81% Po $12.40 Dp $4 Kp = x 100% = x 100% = 7.88% Pp(1 - Fp) $54(1 – 0.06) Kde = Kd(1 – T) = 0.08(1 -0.3) = 5.6% References Brigham.E , Houston. J (1996) Fundamentals of Financial Management , Harcourt Brace college Publishers, USA Fabozzi, F.J. and Peterson, P.P. (2003) Financial Management and Analysis, Wiley.J & Sons, Inc, America Debt financing [online], Available from: [Accessed 21 April 2008] 4. Common share [online], Available from: 1_navCode- 10093_navCodeExTh-0,00.html [Accessed 25 April 2008] 5. Preferred share [online], Available from: ._.