FIN501

Assignment 1: 3,000 words

1. Introduction
The purpose of this report is to answer the main question: should the company, a
property developer in Malaysia, process to raise MYR50 million in China over next few
months; based on the concept and theory of capital structure.
The structure of report starts with the literature review about the Raising Moneys Concept
and Capital Structure Theory, clarifies selected theory, identifies factors that effect the
decision in raising money, considers the targeted country, and outlines the conclusion and
recommendation at the end.

2. Literature Review
In this section, I provide a theoretical discussion of the concept of Raising Money.
First, I present a Basic Concept of Raising Money and then descript the Cost of Capital.
Existing Capital Structure Theory is described in the last part of this section.
2.1 Concept of Raising Money
2.1.1 The Basic Concept
Money raising is the financial activities that every business has to deal with. For
example, a manufacturer may raise the money it needs to build new factory, or a property
developer raise the money to build new real estate development project. The amount of
that money can be called capital and the cost of raising that money can be called cost of
capital (,).
The cost of capital represents the firms cost of of financing and is also the
minimum rate of return that a project must earn to increase firm value (,). Typically, a
company capital can come from different sources such as equity shares, preference shares,
retained earnings and long-term debt.
2.1.2 Cost of Long-term Debt
The cost of long-term debt is the financing cost associated with new funds raised
through long-term borrowing (,). Typically, the funds are raised through the sales of
corporate bond.
The normal procedure for computing the cost of debt requires a forecast or
estimation of interest rates for the next few years, the proportions of various classes of debt
the firm expects to use, and the corporate income tax rate (,). The formula can be written
as:

ri = rd x (1 T)
where
ri = After tax cost of debt
t = Corporate tax rate
rd = Before tax cost of debt

And, the before tax cost of debt (rd) can be approximated by

rd =

where
I = Annual interest in RMs
Nd= Net proceeds from the sale of debt (bond)
n = number of years to the bonds maturity
rd = Before tax cost of debt

2.1.3 Cost of Preferred Stock

Preferred stock represents a special type of ownership interest in the firm (,). It gives
preferred stockholders the right to receive their stated dividends before the firm can
distribute any earnings to common stockholders (,).
The cost of preferred stock is measured by taking the annual dividend, then dividing
by the net proceeds from the sale of the stock. The formula can be written as:

rp = Dp / Np
where
rp = Cost of preferred stock
Dp = Annual dollar dividend
Np = Net proceeds from the sale of the stock
2.1.4 Cost of Common Stock
The cost of common stock is the return required on the stock by investors in the
marketplace (,).
Cost of common stock is defined using either the constant-growth valuation model
or the capital asset pricing model (,).
Cost of Common Stock under the constant-growth valuation model
Dividend discount model for estimation of cost of equity is useful only when the
stock is dividend-paying.
rs = (D1 / P0) + g
where
rs = Expected (required) rate of return on common stock
D1 = Expected dividends per share in the next period
P0 = Value of common stock
g = Expected rate of growth in dividends

In reality however, we have a lot of stocks that do not pay dividends. In such
situations, the capital asset pricing model (CAPM) are used (,).
Cost of Common Stock under the constant-growth valuation model
The capital asset pricing model (CAPM) approach is to define the cost of equity for a
firm by the following formula:
rs = Rf + [ x (rm RF)]
where
rs = Expected (required) rate of return on common stock
RF = Rate of interest on risk-free bonds (Treasury bond, for example)
= Coefficient of systematic risk for a firm
rm = Expected (required) rate of return on the market portfolio of stocks
2.1.5 Cost of Retain Earning
The retained earnings are a component of equity, therefore the cost of retained
earning (internal equity) is equal to the cost of an equivalent fully subscribed issue of
additional common stock, which is equal to the cost of common stock equity (,).
rr = rs

As explain previously, many companies use a combination of debt and equity as a

way to finance their businesses, and for such companies, their overall cost of capital is
derived from a weighted average of all capital sources, widely known as the weighted
average cost of capital (WACC) (,).
2.1.6 Weighted Average Cost of Capital (WACC)
To capture all the relevant financing costs, we need to look at overall cost of capital
rather than just the cost of any single source of financing (,).
A firm normally finds its weighted average cost of capital (WACC) by combining the
cost of equity with the cost of debt in proportion to the relative weight of each in the firms
optimal long-term financial structure. The formula can be written as:
ra = (wi x ri) + (wp x rp) + (ws x rr or n)
where
ra = Weighted average cost of capital
wi = Property of long-term debt in capital structure
wp = Proportion of preferred stock in capita structure
ws = Proportion of common stock equity in capital structure

2.2 Theory explaining Capital Structure

2.2.1 Capital Structure Irrelevant
The origin of Capital Structure was initiated by Modigliani and Miller (1958).
Modigliani and Miller states that in the perfect market, wherein the investors can borrow at
the same rate as the companies, no transaction costs, no taxes, no bankruptcy costs, no
effect of debt on a company's earnings before interest and taxes, and asymmetric
information, the market value of a firm is unaffected by how a firm is finance (,).
However, Modigliani and Miller (1963) expand research that if considered taxes, the
value of the company increases in proportion to the amount of debt used (,).
2.2.2 Trade-off Theory
The trade-off Theory refers to the idea of how a firm choose the capital structure in
order to find the balance between the benefit and bad result from debt financing (,). If the
increase of debt financing makes the firms get the benefits more than the bad result, firm
should increase the debt finance (,). The research by Kraus and Litzenberger (1973) explains
how to find the optimal point between the cost of bankruptcy, the bad result from financing
with debt, and the benefit, the good result from financing with debt, such as tax saving
benefits and increase of agency cost. Jensen and Meckling (1976) also propose the same
concept that the optimal capital structure come from the trade off between costs of agency
problem and benefits from debt financing.
2.2.3 Asymmetric Information and Pecking Order Theory
Myer and Maijuf (1984) opposes the traditional theory of Modigliani and Miller that
in the real market condition, the investors know less about the value, risks, and prospects of
the firm than the firms manager, the current stock price in the market therefore is not
precise to the real value. In the condition that the current stock is underpriced, if firms want
to obtain the capital for investing in the new projects by issuing common stock, it will result
to the former shareholder because the new entering investors will get the profit from these
new projects also. And even thought the current stock is overpriced, the manager should
avoid issuing common stock because it will cause Dilution Effect to the former shareholder
and also signal that share price is over-valued and then would lead to a drop in share price
(,). From the reason as mentioned above, we can see that if the stock price in the market is
different from its real value, the directors could deny the investment project even if NPV is
positive, it therefore causes the underinvestment problem.
Myers and Maijuf propose the Capital Structure theory been based on the signal
under the name of Pecking Order Theory where they argue that if a firm have the
investment project, a firm should begin with internal source in order to avoid the signal to
the market. If not sufficient, then choose acquired from borrowing and from issuing
common stock as the last resort.
2.2.4 Market Timing Theory of Capital Structure
The core concept of this theory states that firms will choose the Capital Structure
been based on both of bond and equity market conditions in a period of time.

When the equity market is suitable for equity financing such as period in which the
stock price is in upward trend and the stock has a higher expected (required) rate of return,
the value of common stock tends to increase and results to decrease the cost of equity. The
firm should, therefore, raise money thought issuing common stock. Likewise, when debt
market is suitable for debt financing such as period in which the interest rate is low, and the
risk premium on corporate debt issues is low, it results to decrease the cost of debt. The
firm should, therefore, raise money thought issuing bond.
If both markets are not in a proper condition to raise the capital, the investment
project may be postponed, or if the market condition in any period of time is suitable for
raising the capital, firms may finance the capital ahead of time even thought still have no
investment project (,).
2.2.5 Empirical Evidence of Capital Structure Theory
The Capital Structure Theory is one of main research that was studied extensively.
Bauer (2004) studied the Capital Structure of firms in Visegrd Countries during 2001 to
2002 founded that the result support Pecking Order Theory more than Trade-off Theory.
Al-Taani (2013) studied the Capital Structure of registered companies in Jordan during 2005
to 2009 founded that the result support Pecking Order Theory.
Fauzi et al. (2013) studied the data of registered companies in New Zealand. The study
founded the evidence support the Trade-off Theory.
Brendea (2012) tested the Market Timing Behavior of the Tehran stock exchange firms
founded the evidence support the Market Timing Theory
Zhao et al. (2004) tested the Pecking Order Theory and Signaling Theory of firm business in
the United State during 1995 to 2002. The result founded that the tested sample supported
both theory.
The studies of the Capital Structure Theory founded the evidence supported every abovementioned theory. Fama and French (2002) propose that no best or worst Capital Structure
Theory since each theory have the power in explaining the Capital Structure of real-life
companies.
3. Theory
For this report, I use Market-Timing Theory of Capital in explaining my
recommendation. Market-Timing Theory is a theory that can help firms and corporations
decide whether to finance their investment with equity or with debt instruments and, also
an applicable and useful tool for international financing in selecting a specific country.
In the tradition efficient and integrated capital markets world of Modigliani and Miller
(1958), the costs of different forms of finance do not vary independently and there fore
there is no gain from opportunistically switching among them (,) But, Baker and Wurgler
(2002), claim that market timing is the first order determinant of a corporation's capital

structure use of debt and equity in the real world situation. Graham and Harvey (2001)
show that market timing is a major concern of corporate executives: Two-thirds of CEOs
admit that timing considerations play an important role in financing decisions. In other
words, firms do not generally care whether they finance with debt or equity, they just
choose the form of financing which, at that point in time, seems to be more valued by
financial markets.
When the equity market is suitable for equity financing such as period in which the
stock price is in upward trend and the stock has a higher expected (required) rate of return,
the value of common stock (P0) tends to increase and results to decrease the cost of equity
(rs). The firm should, therefore, raise money thought issuing common stock.

rs = (D1 / P0) + g
Likewise, when debt market is suitable for debt financing such as period in which the
interest rate is low, and the risk premium on corporate debt issues is low, it results to
decrease the cost of debt (ri). The firm should, therefore, raise money thought issuing bond.

ri = rd x (1 T)
4. Factors that effect your decisions
4.1 Stock Market Condition
Stock market conditions refer to upward or downward trends in capital market. Both
these conditions have their influence on the selection of sources of finance. When the
capital market is dull right now or expected that it will fall in future, investors are mostly
afraid of investing the stock market due to high risk. In this market situation, firm should not
raise money by issuing stock because there is a high chance that a price of new issued stock
would go down and results to drop the value of the company.
On the contrary, when conditions in the capital market are cheerful right now or
expected that it will rise in future, firm treat raising money from the capital market as the
best choice to reap the fund because there is a high chance that a price of new issued stock
would go up and results to life the value of the company.
To summarize, a firm should raise fund through issuing stock when stock market
conditions is positive.
4.2 Interest Rate
Interest rate is simple the cost borrowing money. As with any good or service in a free
market economy, price ultimately boils down to supply and demand. When demand is
weak, lenders charge less to part with their cash; when demand is strong, they're able to

boost the fee. Demand for loans ebbs and flows with the business cycle. During a recession,
fewer people are looking for new mortgages or loans for their start-up businesses. Eager to
increase lending, banks put their money "on sale" by dropping the rate.
Supply also changes as economic conditions fluctuate. In this regard, the government
plays a major role. Central banks like the United States Federal Reserve tend to buy
government debt during a downturn, pumping the stagnant economy with cash that can be
used for new loans. The increase in supply, combined with diminished demand, forces rates
downward. The exact opposite occurs during an economic boom.
The change of interest rate has an influent on the decision to debt financing, especially
through the sales of corporate bond.
All bonds have a coupon interest rate, sometimes referred to as coupon rate or simply
coupon, that is the fixed annual interest paid by the issuer to the bondholder. A bond's
coupon rate is directly affected by national interest rates, and consequently, so is its market
price. Newly issued bonds tend to have coupon rates that match or exceed the current
national interest rate.
When national interest rates change, the coupon rates of newly issued bonds tend to
follow suit. When interest rates go up, so must coupon rates for new bonds to remain
attractive to investors. When rates go down, companies can issue bonds with
correspondingly lower rates without fear of being priced out of the market.
To summarize, a firm should raise fund through issuing bond when the interest rate and
the risk premium on corporate bond issues is low.
4.3 Exchange Rate
Because firm cannot control much or most of exchange rate, the firm faces potential
changes in exchange rates or currency fluctuations. These changes can, in turn, affect the
amount of money that firm will get and the amount of money that firm have to payback
such as, bond or stock issue cost expense, and annual interest expense. For example, the
Malaysian-based company raise money CNY50 million thought selling corporate bond at 4%
in China today. But in the end of the year, Malaysian Ringgit devalue, the Chinese Yuan
Renminbi to Malaysian Ringgit change from CNY1.65 to MYR 1 to CNY1.20 to MYR1. So, the
firm need to undertake more interest expense from MYR1.21 million to MYR1.67 million.
On the contrary, if Malaysian Ringgit appreciate or Chinese Yuan Renminbi devalue over
the next year, the Chinese Yuan Renminbi to Malaysian Ringgit change from CNY1.20 to
MYR 1 to CNY1.80 to MYR1. So, the firm undertake less interest expense from MYR1.67
million to MYR1 million
To summarize, a firm should raise fund from oversea in the period that have the lowest
cost of finance or least fluctuation.

4.4 Regulation
Another important risk, besides exchange rate risk, facing firms that raising money from
oversea is political and regulation. The decision to raising the capital is also influenced by
government regulations. For instance, banking companies can raise funds by issuing share
capital alone, not any other kind of security. Similarly, it is compulsory for other companies
to maintain a given debt-equity ratio while raising funds. Different ideal debt-equity ratios
such as 2:1; 4:1; 6:1 have been determined for different industries. For the property industry,
firms generally keep the debt-equity ratios at 2:1 (,).
In addition, firm also need to answer the basic essential questions such as, is it allowed
foreigner to issue bond or stock in that targeted country, and is it allowed to take the
money back out of that targeted country.
5. Country for consideration
5.1 China
5.1.1 Overview Business Environment

Since China opened its doors to foreign business in the late 1970s and officially joined
the World Trade Organization (WTO) in 2001, its transformation has been absolutely
remarkable. Over the last 25 years, China has transformed itself from a centrally
planned socialist state to a semi-market-driven, semi-command economy. For more
than a decade, Chinas GDP has grown over 9 percent each year. Not only economic
reformation, China has also been reformed its financial and monetary market. China
opened the bond market freely in 1988 (now China becomes the worlds 3rd biggest
bond market), founded the mainland stock market (Shanghai and Shenzhen) in late
1990s, and dropped the U.S. dollar peg by fixing the renminbis exchange rate to a tradeweighted currency basket in 2005 (now the renminbi becomes the worlds 5th most widely
traded currency).
5.1.2 Stock Market Condition
At the present, the China Stock market enter a bear market after the popping of the stock
market bubble on 12 June 2015. A third of the value of A-shares on the Shanghai Stock
Exchange was lost within one month of the event. Major aftershocks occurred around 27 July
and 24 August's "Black Monday". By 89 July 2015, the Shanghai stock market had fallen 30
percent over three weeks as 1,400 companies, or more than half listed, filed for a trading halt
in an attempt to prevent further losses. Values of Chinese stock markets continued to drop
despite efforts by the government to reduce the fall. After three stable weeks the Shanghai
index fell again on the 24th of August by 8.48 percent, marking the largest fall since 2007.
At the October 2015 International Monetary Fund (IMF) annual meeting of "finance
ministers and central bankers from the Washington-based lenders 188 member-countries"
held in Peru, China's slump dominated discussions with participants asking if "Chinas
economic downturn would trigger a new financial crisis."
By the end of December 2015 China's stock market had recovered from the shocks and had
outperformed S&P for 2015, though still well below the June 12 highs. By the end of 2015
the Shanghai Composite Index was up 12.6 percent. In January 2016 the Chinese stock
market experienced a steep sell-off and trading was halted on 4 and 7 January 2016 after the
market fell 7%, the latter within 30 minutes of open. The market meltdown set off a global
rout in early 2016.

From the Market Timing Theory, a property developer in Malaysia, should not process to
raise the capital through issuing the stock in China stock market over next few months.
5.1.3 Interest Rate
Because a slowing rate of China economic growth, not to a recession, the Chinese
government will process the policy for arousing the economics continuously. It is anticipated
that Peoples Bank of China will cut the policy interest rate by 0.5% and decrease the Banks
Reserve Requirement Ratio by 1.0% (,).
The decrease of interest rate and increase market liquidity is the factor supported firms
money raising through selling the bond in China because it decreases the cost of capital and
increase high chance that firm with get the targeted amount of money, at MYR50 million.
5.1.4 Exchange Rate
As a result of Chinas economic stimulus package and the remain in attempt of Chinese
millionaires to withdraw money out of the country continuously, the Chinese Yuan
Renminbi will further devalue.
The devalue of Yuan Renminbi is the factor that support firms raising capital in China.
5.1.5 Regulation
There is more lessening the regulation for foreign company in Chines last year. For example,
central bank had approved the foreign company to sell bonds in China and allowed
professionals in the securities industry to trade stocks themselves for the first time last year.
The lessening regulation is the factor that support firms raising capital in China.
5.2 Malaysia
5.2.1 Overview Business Environment
Malaysia has the target to become a self-sufficient industrialized nation by 2020 (,). One of
the Economic Development Plan is the finance and monetary system development in order
to support a business sector, especially role in supporting the new business investment.
Malaysian Government sets the proportion of Gross Nation Income (GNI) from financial
sector to increase to MYR121.5 million, 3 times of the present GNI, by 2020 and also push
Malaysia forward to become Global Islamic Finance Hub, including develop the potential of
commercial bank expanding to other countries, especially Asian countries, in order to be
ready for competition, treading, and investment that will increase from opening free trade
area. The following policy will go together with the financial institution development plan
phase 2 (2011-2020) continued from the financial institution development plan phase 1
(2001-2010) that promote the financial institution to merge together in order to create the
efficiency development, push them to adjust the risk management system and governance,
and increase the competition thought issuing the license to new foreign commercial banks.
Now, the Malaysian Financial Institutions system is various and have financial market that
can support the fundraising and risk management through varies of financial instruments.

5.2.2 Stock Market Condition

As a result of dull global economy, great plunge in oil prices, and in-house political affair, the
Malaysia Stock Market became gradually lower the middle of 2015, and suddenly dropped
200 point in September 2015. The Malaysian government solved this problem by inject
MYR20,000 million into ValueCap to support the stock that is too low. It results the stock
market to improve better to nearby the former point at this present.
To summarize, the Malaysia Stock Market Condition is mediocre.
5.2.3 Interest Rate
The Malaysia Interest Rate is quite stable last year, and went grow slightly in the past few
years as a result of increase in US bond interest rate.
To summarize, the interest rate in Malaysia is not bad due to the quite stable of interest
rate.
5.2.4 Exchange Rate
Last year, the Malaysia Ringgit devalued by 11%, the lowest level in 17 years since 1998 Asia
financial crisis, and the national reserve decreased to the lower level in 6 years period as a
result of the out flow of capital.
But in the last 3 months that financial market around the world is in a severe condition, it
become Malaysia Ringgit move up and been expected that will continually rise until back to
stand at the same point
To summarize, the rise of Malaysia Ringgit is the factor that support firms raising capital in
China.
5.2.5 Regulation
There is no difference of regulation about issuing bond or stock for local companies. The
local company can issue bond or stock as common in other countries.

After consider the targeted country for raising money, it can conclude that the firm, a
property developer in Malaysia, should process to raise MYT50 million through selling the
bond in China over next few months. This decision is supported by the lower interest rate in
China, and the devalue of China Yuan Renminbi and the rise of Malaysia Ringgit, including
the lessening regulation in China that allow the foreign company to sell bonds in China.
6. Conclusion and Recommendation
In this report to answer the main question: should the company, a property developer in
Malaysia, process to raise MYR50 million in China over next few months, I choose the
Market-Timing Theory to explain the answer because it is a useful tool to decide whether to
finance investment with equity or with debt instruments and, also an applicable tool to
select a targeted country for international financing.

The core concept of this theory states that firms will choose the Capital Structure been
based on both of bond and equity market conditions in a period of time. The firms should
choose the form of financing which, at that point in time, seems to be more valued by
financial markets.
Additionally, there are four main factors that could effect the decision such as, Stock Market
Condition, Interest Rate, Exchange Rate, and Regulation.
Finally, after analyze all factors that effect decision and consider the targeted country for
raising money, it can make the conclusion that the firm, a property developer in Malaysia,
should process to raise MYT50 million through selling the bond in China over next few
months. This decision is supported by the lower interest rate in China, and the devalue of
China Yuan Renminbi and the rise of Malaysia Ringgit, including the lessening regulation in
China that allow the foreign company to sell bonds in China. Specifically, the firm should
issue MYT50 million bonds in Shenzhen because there are a lot of financial institutions, and
finance market is very active.