There are two major ways in which companies can raise finance. These are Debt and Equity finance. There is also a third method of using the retained earnings the company already has. This is a method most companies initially try to use as retained earnings are dividends which have not been paid out to the shareholders, but retained within the business. With this form of finance the cost of finance is the expected return required by the shareholders and the cost of accessing the funds is minimum.
Equity finance involves issuing new ordinary shares, but is only a good choice if a large amount of finance is required due to the high charges involved. Through issuing new shares they are diluting the control of the business and again the cost of finance is the required return demanded by the shareholders. Regular repayments do not have to be made and dividends to shareholders are not legal requirements. Shareholders just expect to gain dividend from their investment.
Finally debt finance involves loans and debt securities. This is a cheaper method than issuing shares, but does involve regular repayments. If large amounts are required then syndicated loans are an option, due to many banks lending to spread the risk and one bank taking overall responsibility for the entire loan amount. Currently there are limits to the amount as Glencore and Xstrata are finding out, due to them both being among the biggest borrowers of syndicated loans. The two companies are merging and both have high amounts of syndicated loans which will need to be restructured to remain in these limits set out by the banks involved.
Companies sometimes offer products at a loss or below the required rate of return. They do this for many reasons such as gaining awareness of the product or to gain market share. An example of this is the Amazon Kindle Fire.
Amazon in 2011 released their Kindle Fire for $199 in the US which was $300 cheaper than the basic iPad. Through this low price Amazon were not even covering the cost of the components, never mind the technology and research that went into producing this. They were happy to sell the Fire as a loss leader in order to gain potential iPad customers and to be able to enter the tablet computer market.
When Amazon released their figures in October 2011, profit figures were down 73% due to the heavy investment in the Fire. They have had high cash reserves in the past which will have been used to fund investment for the Fire. But after the figures were released the share price fell 12% as a consequence, which shows that the shareholders expect high returns from using retained profits to finance projects and were not satisfied with the profit figure and profit warning for the Christmas period. The return on capital for the Fire will be unsatisfactory due to the loss they are making on each device. But Amazon will make very high returns on other devices such as the basic Kindle which will help overall figures.
Amazon can sell the Fire at a loss due to the requirement to purchase ‘apps’ and e-books to be able to use the Fire to its full potential. With the e-books certainly in the UK sometimes it is cheaper to buy the paperback version instead, although some are free or heavily discounted. I myself have a regular Kindle and sometimes the prices of e-books are significantly higher than the paperback on Amazon itself. If that is the case I purchase the proper book instead of the download option. But Amazon is able to charge the high prices as some consumers do not think of checking the paperback price. This is where Amazon makes a great deal of money allowing the Fire to be sold at a loss.
In the past three months, Amazon has sold 3.9 million Fire’s making them the worlds second largest tablet maker. This seems impressive but compared to Apple who sold 15.4 million iPads the figure seems quite insignificant. Will the Kindle Fire become as successful as the iPad and create the returns required by Amazon or will the next iPad which is rumoured to be smaller, mean the Fire project ultimately fails? Amazon is confident that the Fire offers something different to the iPad and I would definitely consider a Fire due to the premium price you pay for an Apple device. If the Fire can compete with the iPad then surely it will gain a different audience who do not require everything they own to be an Apple device. Globally people do not have as much disposable income so maybe the Fire will become an alternative to the iPad for many. If demand for the Fire declines and can not compete with the iPad, then unfortunately for Amazon it could become a failed project losing them and the shareholders a lot of money.
(Sources: Corporate Financial Management – Arnold, The Financial Times, Reuters, Amazon.com, BBC news)
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