A few days ago a friend of mine, Frederik Rasali (Analyst – PT. Minna Padi Investama), brought up an interesting discusion on why did so many of Indonesian companies do right issue lately. This was discussed in a group growing in numbers and quality, namely Investor Muda ( facebook & instagram : @investor.muda ).
According to finance theory, issuing equity is the most expensive way to raise funds. Companies usually prefer bank loans or issue bonds simply because they can still retain the ownership (control and influence) and eventually, they share less of their profit. Investors usually use CAPM ( capital asset pricing model ) to determine the expected return while at the same time companies use CAPM to calculate the cost of equity. Before we move on with the discussion, let’s take a look on CAPM formula.
Source : Investopedia
The formula is pretty straight forward. First, the expected return (investor) / cost of equity (company) of the stocks must be greater than the risk free rates (rf). Second, the beta times market risk premium (rm – rf) estimates the risk associated with the stock. So the expected return/cost of equity has to be greater than risk free rates plus extra return for taking extra risk.
If cost of equity is the most expensive why did companies do rights issue?
When economy is in bad condition banks are unwilling to lend and at the same time companies minimize and delay its capital expenditure. The main reason why lending rate has to come down is not to stimulate capex but to help companies refinance their debts first. S&P failed to grant Indonesia the investment grade status because of this refinancing risk issue. In this Q1 2016 not only that NPL kept rising but bad debt writeoffs also picked up. Not to mention the crowding out effect that worsened the situation (shift of deposits from banking system to government bonds). This situation prevented banks from lowering lending rates despite 3 x 0.25% rate cuts each in January to March 2016. 7day reverse repo policy (effective 19 Aug 2016) was introduced to replace BI rate as a short term benchmark rate was expected to lower the lending rate. Moreover, in this kind of situation companies will not be able to meet bank’s requirements to get the loan eventhough the rate is cheap (7day reverse repo implementation). Banks simply don’t have the right reason to lend since companies profitability is doubtful and most importantly banks only have little liquidity left. Lending nowadays is like taking more risk for less return which doesn’t seem to be attractive. Without tax amnesty i just don’t see how credit growth can go north.
It will also be difficult to issue bonds because of two main reasons; 1. The size of the bond market investor is still very small. Most of the investors are institutional investors. Retail investors don’t have enough exposure and knowledge to invest in the bonds market. 2. The debt covenants are just too hard to achieve. Profitability ratios, debt ratios, liquidity ratios, performance ratios are very likely not in a good shape. In fact in general they are bleeding. We know that institutional investors are more sophisticated and careful with their investments. It’s absolutely not going to be easy to sell bonds to them.
The most expensive way to raise funds ironically becomes the cheapest way simply because it’s the only way available to raise funds. It needs no debt covenants,no difficult requirements, it only cost you investor’s trust. Since Indonesia stock market is not yet efficient, the size is considered small, and the investors rarely perform fundamental analysis which makes them way more eager and easier to invest, there is actually opportunity for companies not just to raise funds but also make profit from selling their stocks instead of generating profit from the business. Since many of Indonesian investors don’t care or know much about fundamental analysis, CAPM as another filter(treshold) which calculates expected return/cost of equity is not an issue for companies looking for funding. So you if could get easy funding (at least from the retail investors), you have no obligation to pay interest or coupon (promised return), you may or may not pay dividends as long as the stock price goes up significantly in short period of time, you also don’t have to worry about the influence and control eventhough you issue more stocks, then why would you not do rights issue?
Disclaimer : This note is not a research report. It doesn’t represent any company, institution, or individual. This is not a recommendation or suggestion. Information and data are collected from various public sources. Reader should be able to distinguish between fact on opinion.