Long-Term Financing
Introduction
Companies grapple with many investment opportunities, but the potential projects may be foregone due to capital limitations. Capital projects require a vast amount of funds, which is not always available, and companies weigh several options to identify appropriate sources of funds. In evaluating possible sources of funding available, companies still refer to their financing goals. Consequently, it is essential to look at the costs, cash flows, risk and control, availability, and maturity to ensure they are in line with the goals of the company. A company can choose between utilizing available cash, issuing new shares, or borrowing to satisfy its capital needs. Investing using retained earnings is the most convenient because it is readily available. However, it has its downsides as well and hence the need to consider external sources to ensure the best financing approach. There are four funding options Coca Cola should consider, including a bank loan, bonds, and issue of preferred and common stock.
Evaluating Financing Options
Companies retain a portion of their annual earnings to secure future investment opportunities. Retained earnings are among the least expensive options to finance a project, but it is not always available to many companies. Coca Cola has $65.8 billion in retained earnings and hence is a suitable option worth considering when choosing what to use in financing the capital project the company. Using retained earnings has no associated floatation costs, which is common in stock and debt issuance. However, the opportunity cost of the amount invested in the project is vital in the analysis of the option. Coca Cola can invest the retained earnings in an account earning 4%, which amounts to $37 million annually. The next available option after is common stock
Common stock is one of the most preferred options by many companies because it enables the company to avoid struggles with creditors due to non-payment. It is also available because investors in stock are not interested in short-term profitability hence would not focus their attention on short-term liquidity. Issuing stock suits Coca Cola given the company’s inferior liquidity, as demonstrated by its current and quick ratios, which show that current liabilities exceed current assets. Buying stock would secure an investor’s future because ownership in a company grants investors long-term benefits in the form of dividends and capital gains. Common stockholders are paid dividends, and the amount paid represents the cost to the company. Unlike debt instruments that pay a predetermined amount as interest, common stock is expensive because dividends are dependent on earnings. For example, shareholders can earn dividends four times bigger than the interest paid to debt holders in a single financial year. Generally, the cumulative dividends are more than interest expense on borrowed capital. Coca Cola can as well issue preferred shares that have both the features of common stock and debt.
Preferred stock is enticing for investors because, like debt, it pays constant amounts periodically. Preferred dividends are paid annually, unlike ordinary stock dividends, which are not necessarily regular. Accumulation of dividends is possible so that preferred shareholders are paid in profitable years to cover amounts not paid during loss-making years. Coca Cola can issue 8% preferred shares, which require a payment of $55 million in dividends at the end of every financial year. There is also an option to convert the shares to common stock at a favorable price. As such, compulsory dividends coupled with the convertible feature, is costly to the company because it requires constant cash flows. Its dilutive capabilities render preferred shares risky because common shareholders cede control upon conversion of the preferred shares. Such problems can be resolved by borrowing by selling bonds and issuing notes.
Borrowing capital is cheaper compared to the issuing of common and preferred stock. Also, a company relying on borrowed finances enables shareholders to retain control over the company. Issuing of notes payable and bonds has its own merits but also comes at a cost to the company. Note payable available for the company is a five-year term loan that attracts 5% interest payable annually. The interest expense of $46 million payable annually is the cost, and payment is a must irrespective of the profitability of the company. As a result, Coca Cola has to contend with the payment terms and be ready to pay the expense as and when it becomes due. The maturity of the loan is shorter than the economic life of the project and hence would require payment of the principal amount at the end of five years. Depending on the cash flows of the project, Coca Cola may have to resort to other sources of finances to pay the loan when it falls due. Alternatively, the company can issue bonds instead of the note payable.
Bonds are another approach companies rely on in financing their projects. Like most borrowed funds, issuing bonds to raise capital is inexpensive compared to stock. Coca Cola can issue a ten-year bond and has to pay an annual interest of 8% together with one-tenth of the amount borrowed until maturity, $166 million yearly payments. In terms of time value, the option is relatively expensive compared to most borrowed capital, which requires payment of the principal amount at maturity. Coca Cola’s short-term liquidity is in question and hence may be unable to meet its obligations as far as paying annual interest expense is concerned. Liquidity ratios indicate that the company is unlikely to meet its current commitments because its current assets are less than the current liabilities.
Recommendation
Based on the analysis, I would recommend retained earnings as a suitable financing option for the company. An optimal capital structure depends on specific company goals in matters relating to control and cost, cash flows, and availability, among other considerations. Coca Cola has a solid retained earnings record, and utilizing the available funds only is enough without having to borrow or issue more shares. Retained earnings also maintain the control the shareholders have, and it also protects the liquidity of the company from further deterioration. Issuing shares is the most expensive despite it being a lesser threat to the liquidity of the company. Common shares require payment of dividends. Preferred stock, note payable, and the ten-year bond require regular annual payments and hence exposes the company to more liquidity problems. Even though the debt instruments are cheap, the current financial position of the company will not withstand interest payments, especially in the short-term. Borrowing will increase current liabilities hence lowering the current and quick ratios. It also reduces times interest earned because it increases the company’s interest expense. In conclusion, earnings on savings notwithstanding, retained earnings is the most appropriate under the circumstances.