The Correlation between the Life Cycle of the Enterprise and the Cost of Capital
Ing. Natalia Mokhova
VUT vBrně, Kolejní 4, Brno, Czech Republic, Tel. 775088528,
Abstract
There are a lot ofresearcheson the theme of the life cycle of an enterprise. Almost of them are focused how to survive, how to increase output, how to manage the hazard and increase value of the firm, but a little was said about cost of capital in the context of life cycle of enterprise. This article is about correlation between the life circle of an enterprise and the cost of capital. It is important to determine the factors that have impact on the cost of capital and the changes of the expenses emergent on the different stages of the life cycle enterprise. Also the changes in economy influence on their relations and therefore on the strategy of the firm and its development.
Key words:the life cycle of enterprise, cost of capital, factors, changes in the external environment
Introduction
There are a lot of variations of the stages of the life circle of an enterprise. For the sake of simplicity let’s take into account five main stages: start up, growth, maturity, crisis and bankruptcy. Onthestageofstartupbasicsourceoffinancing is authorized capital.At the same time it is possible to draw the venture capital. Thoughprobabilitytoattractitisverylow. On this stage one of the main source is also banks loans. Buttheinterestratesareveryhighforyoung company and the credit conditions are very strict. Asaruletheprofitisverylowortotallylacking. Withdevelopmentthetoolsoffinancingarechanging. The cost of loan capital is decreasing and the share of equity capital is growing. On the stage of maturity all tools are available with less cost (bank loans, emission of bonds and stocks). The cost of equity capital increases (the growth of the profit sets the increasing of dividends). Though the possibility to attract strategy investors allow to use the capital with less expenses. (Otekina, 2007). On the stage of crises proceeds decreased and consequently net profit and dividends too. At the same time borrowed current assets are turning more expansive firstofallbecauseofreputation which is reducing, then because of lack of assets for credit security. Using capital by way of stocks also is limited because potential investors don’t want to invest money into a crisis firm. In order to avoid bankruptcy the firm has to get to another stage of the life circle – new stage of growth (it will be new round of the life circle of a firm). To lead this it is necessary to draw additional capital at the same time possibilities of the firm are limited. So it is necessary to manage cost of capital and the financial characteristics of the firm like financial leverage, ability to pay, liquidity and profitability. Having more of these qualities increases the firm's chances of survival, and firms with less have a higher chance of bankruptcy. Theproblemisthatthereisnoprovedmethod to adjust cost of capital in order to avoid bankruptcy of the firm. Certainly we have some expectations about the terms of bankruptcy and try to adjust that terms, but still there are a lot of factors that have got a big impact on it. So there will be some departures. (Morris, 2009)
Discussion
The expected life of a firm is potentially a very important factor in determining the firm’s value, which is close related with cost of capital. But there are a lot of other factors that have a big impact on the cost of capital. And thereupon that on the different stages of life circle different factors have different effects on the expenses of the capital formation the cost of capital is varied on that stages. Cost of capital on the different stages of the life circle of enterprise is different first of all because of different abilities on the every stage. It’s happened because of several factors. First is the information availability. Firms in the beginning don’t have long-term relations on the financial market, so don’t have opportunity to have capital with the same expenses as firms during its maturity. Thisfactorconnectswithdeterminationofthelevelofriskanditsmanagement, that in turn helps determine optimum relationship equity and loan capital, and consequently WACC.
In addition firm’s profitability connects with risk. Directly proportional correlation between these factors shows connection between cost of the capital and the life circle of a firm. Revenue increases with growth of the risk, in addition profit’s increase and its decrease connect with the life circle. Profitability of the firm favors the generation of net surplus, and therefore equity capital including free cash flow. The high economic efficiency and liquidity lead to the growth of the enterprise (a firm can move to the stage of maturity or growth and avoid crisis). Furthermore the cost of the capital also will be decreasing as a result of correlation of factors (for example, profitability influences on the firm’s reputation). Reputation also is very important factor. The company with positive goodwill and good credit reputation has less expensive money. And this could be on the stage of growth or maturity.
But the main factors which have big impact on the economic efficiency, ratio of capital turnover, cost of capital during the main firm’s activities - investment, operational and financial – on the every stage of the life circle are following: profit margin, growth, liquidity, reinvestment, profitability, financial leverage asset turnover earnings stability interest coverage, which in turn have impact on survival (so on the life-cycle of enterprise).
A lot of factors influence on the cost of capital, but a firm chooses a source of capital on the assumption of the ratio of two factors – price and availability. In addition the ratio and the preferences are changing subject to the stages of the life circle of the firm and its goal (further development or liquidation). If it is concerns not about liquidation, but about increasing of the equity capital in the issue of capital formation, the firm doesn’t need IPO. Andinthissituationitisbettertobe financed by using financial leverage and hedge the risks. And in the case of increasing of firm’s value the best variant is emission of stocks. In the case of wishing to be the leader on the market it can resort to the most expensive sources of financing.
In consequence of the global finance crisis many enterprises turned out on the stage of crisis. They faced with the problem of profit’s decreasing in the consequence of low buying attitude and also increasing of expenditures. Value of shares of most companies during the crisis decreased in several times, also their reputation was dropped that influence on the cost of the capital. Thus this type of the capital is not rational on this stage of the life circle. Furthermore even during normal conditions stock capital is one of the most expansive types of the capital, which can be attracted by the firm. Owing to the crisis many companies suffered additional losses, thus using this type of capital is unacceptable.
Bonds like a financial tool of the capital formation also underwent changes in its cost aspect. In the result of reputation’s fall the costs of using funds increase.
One of the most widespread types of loan capital is the bank’s loan. But in connection with bankruptcy of some banks distrust to it goes up. As was said reputation of many firms went down that make difficult to attract this type of resource. But in connection with reduction of refinancing rate bank’s loan is one of the cheapest sources. But using loan capital in the capacity of main can lead to decreasing of liquidity of the company, ability to pay, that will negative effect on the life circle of enterprise.
Profit as a source of equity capital is also decreasing. Free cash flow could be only during the stage of growth or maturity, when the profitability of the firm is maximal.
Conclusion
The correlation between the cost of capital and the life circle of enterprise is very close. Not only expenses of using capital influence on the life circle, in turn every stage has its own impact on the cost of capital, on the transition from one stage to another. And factors influenced on the cost of capital also have correlation with the life circle of enterprise. The opportune analysis of these factors furthers adjusting the cost of capital and therefore the life circle. Correct management of the cost of capital inclusive all factors leads to the development and preclude the bankruptcy.
One of the most important factors are financial measures as liquidity of the firm, but nowadays we can see that other external factors have a great impact on the cost of capital and the life circle of enterprise such as external environment.
In consequence of global crisis a lot of firms turned out to be on the stage of crisis. Thus nowadays the most urgent is the determination the cost of crisis in the crisis and post crisis period and search of the factors that have impact on it and the ways to adjust it.
Also in present conditions the influence of many factors on the cost of capital was changed, therefore expenses on it attraction were changed too. What is more the attitude to the capital was changed. Thecostofloancapital in form of banks loan considerable decreased and at first sight it is better to attract this type of capital. But according to the theory of financial leverage the firm couldn’t implicitly substitute equity to the loan capital. In spiteofthe fact that banks loan remains very cheap it is necessary to put the limit of the maximal eventual loan capital. But the cost of equity capital increased so it balances cheapness of loans. What is more every firm needs equity capital (internal resource) to survive with the defined level of confidence and also to make its financial measures higher (as liquidity and paying capacity)that provide development and deny bankruptcy as the last stage of life circle of enterprise.
Thus because of changes in the factors’ impacts, in the behavior of main players and state of financial market, it is essential to work out new methods of reducing the cost of capital, find out new approaches of determination of the cost of capital. And this is challenge for next researches.
References
Periodicals
Morris J. R., 2009Life and death of businesses: a review of research on firm mortality. Journal of Business Valuation and Economic Loss Analzsis.
Otekina E., 2007 Loans - for young, IPO – for maturity. Konsultant
Kuranov M. V., 2008 The analysis of the factors characterized the firm’s operation on the differnet stages of the firm’s life cycle. Analysis of economical activities: Theorie and practice.
Books
Mard M. J., Dunne R. R., Osborne E., Rigby J. S, Jr., 2009. Driving Your Company’s Value: Strategic benchmarketing for value. John Wiley and Sons, Inc., USA, pp 1 - 18.