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Running head: FUNDAMENTALS OF CORPORATE FINANCE 1

Fundamentals of Corporate Finance

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FUNDAMENTALS OF CORPORATE FINANCE 2

Fundamentals of Corporate Finance

Question One

Abeer Inc. has debt claims of $400 (market value) and equity claims of $600 (market

value). If the after-tax cost of debt financing is 11 percent and the cost of equity is 17

percent, then what is Abeer’s weighted average cost of capital?

Any corporation having debt claims worth $400 and equity claims worth $600 is said to

be 60% equity-financed and 40% debt-financed. Abeer Inc. cost of capital will be calculated

using WACC formula which considers both the cost of equity and that of debts.

WACC = (equity cost * weight) + (after tax cost of debt * Weight of debts) where cost of

equity is 17%, weight of equity is 60%, cost of debt after tax is 11% and weight of debts is given

by 40%

WACC = (0.17 * 0.6) + (0.11 * 0.4) = 0.102 + 0.044 = 0.146

Therefore, Abeer’s WACC is equivalent to 14.6%

Question Two

What is the strategic role of venture capital in developing entrepreneurship in Saudi

Arabia?

Venture Capital (VC) consists of private equity financing that financiers extend to small

businesses and young entrepreneurs having great potential to grow. Saudi Arabia is a nation

currently a hub for attracting young entrepreneurs. According to Ashri (2019), 76.3 percent of

adult Saudi Arabians are now starting businesses. Venture Capital is playing a significant role in
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promoting entrepreneurship in Saudi Arabia. VC compliments debt financing through the

provision of equity investments to startups that require a venture partner.

The established VC firms in Saudi Arabia are geared towards extending assistance to

SMEs with the primary goal of advancing economic growth in the country. They invest their

time to understand the various needs of the entrepreneurs; these firms are aiming at not only

profit but also on the creation of sustainable jobs and economic diversification in the country,

thus having the interests of the whole country at large. In other countries, Venture capitalists are

only concerned with the firm making a profit.

Question Three

Under what conditions do you think that the finance manager does not have to think about

capital structure issue?

Financial management is the process that is concerned with sourcing funds and the

utilization of such funds to meet the goals of the company. Capital structure decisions are

essential for finance managers at this stage. Capital structure helps in identifying the required

mix or combination of debt and equity as sources of financing. Managers need to depend less on

debts, thereby maximizing shareholders' value. However, there are some conditions in which the

manager does not care about the considerations for capital structure.

The first condition is when the firm is making enough revenues to meet the operations of

the company. An organization can be generating enough cash flows, which can cater to all the

activities of the company ranging from all expenditures and financing assets acquisition. For this

reason, the manager will be unmoved concerning the distribution of debt and equity financing,

and since there is no debt financing, the manager only has one function of maximizing the

shareholders' value by paying them retained earnings at the end of the year.
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Another condition is when the new project being launched by the company is not likely

to change the company's capital structure. An organization may wish to implement a new project

that will not require sourcing for financing. In a University setting, for example, where a new

program on entrepreneurship is established to sponsor SMEs, where the source of funds was

through the sale of books and fundraising. Then this will not require giving considerations on the

capital structure of such an institution since the implementation of that project does not need

funds either in equity or from debts.

Lastly, almost all small companies usually have hard moments to acquire debt financing;

hence, they mostly prefer equity financing to meet the companies' business operations. Getting

debt financing for small companies, especially from banks, is a very long process. Lenders often

require a guarantee from management. In such a case, the Finance Manager will not be required

to make any decision based on the capital structure since only one source of financing is applied.

Question Four: Discuss the various modes of recent issue of IPO by Saudi Aramco

Company?

Aramco management intends to raise 5percent after the Initial Purchase Offer (IPO.

There are various modes that the company used to issue the recent IPO.

Public Issue and Rights Issue

The first mode is through the public issue. This is the most commonly used method that

several companies use to issue securities to the public. Through its IPO, Aramco intends to raise

funds by listing itself on the Riyadh stock exchange for trading purposes. The second mode is

through a rights issue to existing and new shareholders. Aramco will sell 1-2 percent of its shares

to personal and institutional retail investors after the Initial Purchase Offer (IPO) to raise an

estimated amount ranging between $20 billion and $40 billion (Aljazeera, 2019).
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Preferential Allotment

Lastly, the company also used the preferential allotment method to issue the IPO. This

method concerns the issue of shares to specific few individuals at a price that does not

necessarily match with the market price. Aramco intends to issue 1% of bonus shares for Saudi

Arabian nationals. The company aims at giving the individuals one hundred bonus shares for

every ten shares allotted to them, therefore raising an amount estimated to be 15 billion dollars

from the Saudi investors.

Question Five: Discuss the various factors affecting the capital structure decisions giving

appropriate examples.

There are several factors affecting capital structure decisions. These factors range from

internal to external factors, as highlighted below.

Weighted Average Cost of Capital (WACC)

The cost of capital is one of the factors influencing decisions on capital structure. The

company in question such as Amazon must project an earning ability to generate profit to cover

all the costs of capital and to finance Amazon's future growth. To maximize shareholders' value,

the cost of equity must be higher as compared to debts after tax. If Amazon decides to change the

structure of capital to maintain reasonable risks for both liabilities and ownership, then they will

realize a lower cost of capital.

Company Size

The size of the company is another factor affecting capital structure decisions. Small

companies, especially sole proprietorship or partnership type of companies with low capital base,

tend to rely more on equity financing (funds from the owner(s)). On the other hand, big

corporations must rely on the stock market to raise funds by issue of securities and bonds. These
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large companies listed on the capital market, such as Aramco and Bank of America, need more

capital. Therefore, to raise enough funds, they must consider several options, and hence they

adopt a highly flexible capital structure.

Retain Control

Additionally, retaining control is also another factor affecting capital structure decisions.

The management's attitude to maintain the power of a firm influences capital structure. In the

case where the company's current shareholders are not willing to change their holding, they will

refuse to provide additional equity shares. This will reduce the company's interest rate and

holding. The company will be unable to raise finances through equity shareholding. Thus the

only option will be through the issue of debentures and preference shares, which will be

determined by the reputation of the company.

Cash flows for the company

The capital structure of a company is affected by its cash flow capacity. A company's

cash flow capability increases the financial manager's flexibility in deciding on its capital

structure. Cash produced by a company improves a company's reputation. Cash flows help the

firms to fulfill their short-term liabilities. A company will be required to pay dividends to

shareholders of equity, interest to bankers, and debenture owners. A firm's cash flow generation

capacity helps to meet this obligation. Consistent cash flows make it easier for finance managers

to raise funds via borrowing.

Interest rates

Lastly, the lending rate within the market directly affects borrowed funds. If the banker's

expectation is high, a company can withhold fund mobilization or use retention earnings. It,

therefore, influences the composition of capital.


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References

Aljazeera. (2019). Ready, get set - Saudi Arabia approves Aramco IPO. Retrieved 28 November

2019, from https://www.aljazeera.com/ajimpact/saudi-regulator-approves-aramco-share-

listing-request-191103060527522.html

Ashri, O. (2019). On The Fast Track: Saudi Arabia's Entrepreneurship Ecosystem. Retrieved 28

November 2019, from https://www.entrepreneur.com/article/336766

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