Implications Of Raising Long Term Capital

Published Date: 02 Nov 2017

This report explains the implications of raising long term capital. It also takes into account the possible impacts of opting source of finance on financial health of a company. Engro Fertilizer is a Pakistani company which recently invested in World’s largest single train fertilizer plant. To complete this project, Engro raised substantial long term capital. Worth of this project was almost USD 1 Billion. This report first explains its aims. The technical points which are covered in this reposrt are briefly explained in aims of report section. Then there is a introductory section. In this section the selected company, Engro Fertilizer’s introduction is given and its need for long term capital has been explained. Then there is a description section about long term capital. It has been tried to cover all the aspects of long term capital in this section whether it is equity capital or debt capital. It starts with implications of raising long term capital. Then the process of raising long term capital is explained followed by benefits and costs to firm of raising long term capital. The analysis section is based on complete analysis of long term capital. Equity capital and debt capital are compared with different aspects in this analysis section. This report end with a conclusion reached after analysis of detailed knowledge of long term capital.

Aim of the Report:

The objectives of this report are explained with a few details as follows:

There are a number of securities issued by a company which can be categorized into debt securities and equity securities. The purpose of issuing securities is either to finance the company through debt or through equity. This report will analyze the securities issued by Engro Fertilizers Limited in order to raise long term capital. Securities underwriting points to the procedure in which investment banks bring up investment capital through those who look for investing in support of companies and legal authorities that are assigning securities i.e. equity capital and debt capital. The underwriting process for Engro Fertilizers Limited is discussed in the report. (Melicher and Norton, 2008)

The terms of arrangement refer to the way the capital is raised in order to finance the company i.e. the percentage of debt capital and the equity capital which means the identification of debt element in capital and the equity element. Furthermore, the long term debt and the short term debt are also considered. Details regarding Engro Fertilizers Limited’s are kept under consideration in the report. (Mohana, 1989)

Costs and expenditures associated with underwriting activity value a lot to the company. Underwriting expenses include a wide range of expenditures like legal and accounting fees. These expenses need to be cut short in order to increase the profitability and these factors are also kept under consideration in the report. (US, 2010)

Dilution of ownership occurs when the company issues capital and securities in order to finance its activities. The reason for dilution is the increase in shareholders and debenture holders of the company. Engro Fertilizers Limited issued the long term capital in the recent past. (Gladstone and Gladstone, 2002)

The aim of the report is actually to focus on the aftereffects of issuing bonds like Engro Fertilizers Limited did to raise investment for the financing the world’s largest single train urea plant. All details regarding the issue, its costs, dilution of ownership due to this, post issue performance and other factors of the company are discussed in the details.

Introduction:

Engro Corporation is a leading business in Pakistan which deals in different type of industries such as food, fertilizers and power generation. In 1957, when Mari gas field was discovered in Pakistan, Esso proposed the idea of a urea plant at Mari gas field which was later on named as Esso Pakistan Fertilizer Company Limited. In 1978, it was renamed to Exxon Chemical Pakistan Limited. In 1991, this was result of the most successful employee buyout in Pakistan’s corporate history. Later it became Engro Chemical Pakistan Limited. The 21st century era proved to be most successful for Engro Corporation and the company never looked back. (Ahmed, 1999)

Engro Fertilizers Limited started the operation of its largest fertilizer plant in the world at January 4, 2011. This plant is considered to be the largest single train ammonia-urea plant so far.

The plant has an overall capacity to produce urea at 1.3 million tons every year which increases the total per year production capacity of urea for Engro Fertilizers to a level of 2.3 million tons. The largest private based investment in industry of Pakistan has a value of 1.1 billion US dollars. It is an expansion project which is designed ultimately to fulfill up-to-date demands in industry. It is deemed to be the most energy saving fertilizer plant throughout the country with the lowest level of gas consumption in correspondence to one ton of urea. Engro Fertilizers has continued to follow the convention too maintain the highest standard of Health, Safety and Environment (HSE) through proper assurance of a perfectly complying with environmental laws and regulations and making a new record for the country by 29.8 million man hours being worked without any break. (Ashraf, Ozturk and Athar, 2009)

Description:

Implications of Raising Long Term Capital:

Long term finance means a longer repayment cycle; hence risk associated with both lender and buyer is high. Raising long term capital means than raising finance over a long period of time. Future uncertainties are hard to be predicted. The success of long term finance depends on the successful long term profits and future uncertainties would likely to impact long term profits directly. Another implication of raising long term capital is prediction of interest rates. Interest rates depend upon risk and uncertainties. Short term interest rate can easily be predicted as compared to long term interest rates as it is hard to foresee risk and uncertainties over a long period of time. (Khan, 2011)

Process of Raising Long Term Capital:

The process of raising long term capital depends upon the source of raising long term capital. Capital is made of two things, equity and debt capital. A company may raise long term capital by issuing shares. Raising capital through issuing shares is called equity finance. To raise debt capital, a company may either opt for issuing debentures or may opt for loan from financial institutions or commercial banks. Debentures are issued to aid long term financial need of a company. Investor is secured against property or any other asset of company and company has to pay interest on debentures even if it earned no profit and going in losses. Financial institutions and commercial banks lend money to companies to help them in raising long term capital. These loans are given on the security by way of mortgage of property of company. Other ways to raise long term capital are public deposits and reinvestment in profits. Funds are raised through public deposits by inviting shareholders, employees and general public to invest their savings in the company. This results as benefit to company as company pays a lower interest as compared to interest it has to pay on money borrowed from a financial institution or commercial bank. Reinvestment of profit means less distribution of profits as dividends and taking major portion of profit into reserves of a company. These are also called internally generated funds. (Keowin and Martin and Petty, 2008)

Benefits of Raising Long Term Capital:

Raising long term capital means ensuring stability. There will be no need to keep searching for short term financing and this will bring stability to company in every aspect. Interest expenses against the raised finance are known and it helps in future cash flows and profit projection.

Long term capital gives the best idea about long term cost of capital. This helps in better decision making when appraising different projects. If there is no long term financing, cost of capital will keep on changing with every negotiation of short term financing, hence the decision making process through appraising different projects will be in confusion. Long term financing is always flexible and many options are available to raise long term finance such as mortgages, reverse mortgages, leases, debentures, allowing more control over spending. Low regular monitoring is required for long term finance as compared to short term finance which keeps on changing. Long term capital is also linked with the productivity of the company unlike short term loans as long term finance is typically used for non-current assets which are directly linked with production of company. (Megginson and Smart, 2005)

Costs to Firm for Raising Long Term Capital:

There are two types of long term capital. One is equity capital and other is debt capital. Different costs are associated with these both types of long term capital. Issuance cost is common between both debt capital and equity capital. No matter how you raise finance, you will have to pay issuance cost whether finance is being raised through equity or through debt. If long term capital is being raised through equity, then firm will have pay dividends annually to shareholders according to their percentage of shareholding. These dividend could also be paid twice or thrice during a financial year, if not annually. If long term capital is being raised through debt capital i.e. debentures, bonds etc, the firm will have to pay interest on principal amount annually. These interest payments are mandatory even if company is not making profits and suffering from losses. If company is unable to pay interest to debt holders then it might face the liquidity issue. (Groppelli and Nikbakht, 2000)

Analysis:

Engro fertilizer planned for a bold step to fulfill its dream of World’s largest single train fertilizer plant. Remember that Engro belongs to Pakistan, a country where energy crisis (both electricity and natural gas) have turned economy worst. Natural gas is raw material for production of fertilizer. The dream of World’s largest fertilizer plant was not so easy and it was biggest challenge for Engro fertilizer. Engro financed this project through issuing bonds which were launched with successful advertisement on media. These bonds were named ‘Engro Rupiya Bond’. As country was facing economic challenges and energy crisis, inflation caused return on investments to increase which means a higher interest rate. So Engro had to pay higher interest on the bonds issued which was around 14.5%. Engro financed this project through bonds which is debt capital. (Ahmed, 1999)

As debt increases, it causes gearing ratio to increase which is sign of danger. This means that company has to pay interest first and after paying interest, very little is left for shareholders and company. Increase in gearing ratio pushes and tilt a company more towards financial problems. Increase in gearing indicates bad financial health of a company. Beside interest expense on debt capital, Engro also incurred money for issuing these bonds and also for running promotion campaign through press and electronic media. Even if a long term project is financed through equity, company still has to bear few costs like share issuance cost. Dividends are also paid to shareholders. Issuing new shares can dilute the shareholding of major shareholder which may have an impact on decision being made in general meetings of company. But equity capital is much cheaper than debt capital. Equity capital is also less risky than debt capital. Company has to pay fix interest payments on annual basis on debt capital while for equity holders, it depends on the management of company that how much they want to pay their shareholders as dividend and how much they want to retain as internally generated funds which company can use to invest further and hence to earn further. Internally generated fund is the cheapest source of finance for any company. Debt capital is riskier than equity capital as company has to pay interest payments to debt holders whether it is making profit or suffering from losses. Interest payments are fix percentage of principal amount and are costly than dividend paid to shareholders. Therefore after paying interest, company is left with quite low figure of net profit which is to retained and a portion of it also to be distributed as dividend to shareholders. A good mix of equity capital and debt capital indicates good financial health and prosperity of company. A good mix of equity capital and debt capital is when company has enough funds to retain as internally generated funds and to distribute as dividend to shareholders after paying interest to debt holders. (Ashraf, Ozturk and Athar, 2009)

Conclusion:

The conclusion that could be derived from the report is that when a company issues debt in order to finance its investments, it has to taken many points under consideration. One of the biggest factors is the gearing of the company. Engro Fertilizers Limited issued bonds named "Engro Rupiya Certificate" with the initiative for people to save money by investing in an organization they can trust on. While another side of the picture was that it increased the gearing of the company. As the amount of debt increases for a company, the gearing increases and it is not a good indicator for the potential investors and they feel like looking forward to organizations with less gearing ratio and financed more with equity. This could keep Engro Fertilizers Limited at stake and people might start taking their investments out from Engro Fertilizers. For making such huge decisions like financing the world’s largest urea plant through debt, companies should take into account internal and external analyses of all types in order to ensure profitability and security in terms of cash flows and company’s repute in the future. Though the project was good enough to make the company flourish and fulfill the demand of urea throughout the country, the company must have focused on the factors that will influence it regarding the ratio of debt and equity. (Butzen and Fuss, 2003)

Moreover, the companies have to take into account the cost/benefit analysis before raising investments in such a gigantic plant. Apart from this, the stake of shareholders also increases in the company as dilution occurs when investments are raised through equity and debt. The number of shareholders increasing dilutes the ownership of existing shareholders which means that they will no longer satisfied with the company’s performance as all of the profits generated need to be distributed amongst all shareholders of the company. It may be a question mark for the existing shareholders that whether the increase in proportion of shareholders will be in accordance with the increase in the number of shareholders of the company. If the answer is no, the company might not stay as attractive to the shareholders as when it had a lower number of shareholders to satisfy. (Construction Press, 1983)