In this assignment, there are six learning outcomes:
In this view, various financial books, journals and electronic sources are used to address the above learning outcomes. Eager, a fictitious company, and Esprit, a global company, are used for more detailed discussion.
Learning Outcomes 1 and 5
A firm’s capital structure is usually a mix of financing alternatives generally classified as debt and equity financing ( 1999). The latter refers to long-term borrowings while the former refers to long-term funds. Optimal capital structure is achieved when the firm’s cost of capital is minimized and its market value is maximized (). In the case of ACME, the 0M cost of new production facility in the US has several financing sources to consider before arriving at a specific capital structure. In the case of acquisition, seller financing is possible when ACME has a target company with goals suitable with ACME’s pursuits (2006). Aside from ease of preparing a contract, ACME can readily start operating the new plant and derive potential benefits. The problem, however, is the obligation of ACME for periodic payments or face litigation as well as the probability of being in default in case the acquirer found reasons to withdraw the acquisition due to internal problems or absence of synergy (1996).
The plant acquisition can also be financed through the aid of government programs ( 2006). It is coined as the most popular federal program that offers up to seventy percent of business acquisition. In the contrary, the offer is intended for small business targets and requires applicant-acquirers to obtain 25%-33% of the loan in cash or cash equivalents ( 2006). ACME’s 0M facility seemingly is under medium to large business. On the other hand, there are commercial banks that can be an option at times of huge financial requirement. However, unlike the government, banks do not aspire to be looked by the society as charity organizations. Rather, they have almost the same objectives with business borrowers, that is, to profit. Due to the conflict of interest, banks demand rigorous loan requirements from applicants like financial strength, cash flow, debt and equity ratio and collateral (1993). The bigger the loan, the more stringent screening will take place.
There is a way to get-off this through mezzanine financing. The borrower will finance the deal with the bank and secure the loan with “ballooning” equity ownership. The drawback, however, lies in the idea that when the business started to earn positive cash flows, its distributable profits is largely attributable to the bank in question due to exhaustion of ownership use to survive the business during the early days of the project’s financing ( 2006). Asset-based lenders (ABLs) is a fragment of mezzanine financing because the commercial banks does not take ownership to fulfill the obligation of the lender but only some assets of the business like plants, A/R or inventory ( 2006). This is less risky than the preceding option but can dissolve the working capital of ACME use to calm shareholders and other creditors about its future prospects.
Further, luring private investors or requesting additional funding from existing shareholders is a lucrative strategy when a firm is on the verge of acquisition. This is because there is a higher probability that it can obtain equity investment in this particular engagement than start-up setting (UAEP, 2006). This can be in the case of initial public offering (IPOs) in which there is a stock sold to investors giving them the right to receive dividends or payback after every profitable periods. Even though this is a simple and ready strategy for ACME, the firm should take caution for investors who are just “playing” in the stock market as well as internal processes that lead it to Enron-like scandals. This difficulties as well as monitoring costs can be minimized if venture capitalists will be entertained. The strength of such strategy is that they have long-term perspective for applicants who have passed screening. However, ACME may loose control of its operations as venture capitalists typically assist the loan grantees to develop new products ( 2006).
As a conclusion, ACME should use the aid of commercial banks mixed with IPOs. IPOs can serve as a platform for ACME to leverage the risk of varying interest rates of commercial banks. Of course, the size of ACME is also an incentive for commercial banks to expedite investigation and granting of the necessary funds. The 0M acquisition cost can be financed through 60:40 equity-to-debt ratios. It is to be noted that high equity capital structure is less risky than debt financing because the firm should pay banks even though there is no profits. However, too much equity financing can destruct the ownership structure of the firm which can be harmful for major stakeholders. In addition, debt financing can also be used to maximize the performance and size of ACME as well as a tool to lure more investors or partners due to high credit rating.
Learning Outcome 2
Cash flows are the lifeblood of a corporation and inability to maintain in a manageable level will lead bankruptcy (1995). This admonition is supported by their study and found that cash flow is a more superior measure to predict bankruptcy than accrual accounting. As a result, for beneficial change in payment term, the company should keep separate cash and accrual records. This is especially significant as accounting policies are changed and the previously profitable companies that have substantial cash flows were tamed due to policy changes. As long as every cash flow decision is indeed analyzed within the boundaries of real cash assets, changes in payment term will continuously beneficial on its part. Non-cash transactions such as deferred taxes or depreciation are excluded from analysis. The potential cash flow increases will easily be reflected by actual cash flow increases from beneficial change in payment term.
Cash flow is equal to the sum of operating profit and depreciation plus or minus other non-cash transactions (1999). This means that cash flow is actually a measurement of a firm’s capability to generate cash asset and is the true test of the firm’s performance and long-term survival and growth. On the other hand, cash flows are not really free which give rise to measurement of free cash flows (FCF). FCF is the real cash flow a company has after making necessary investments in fixed assets, distribution of dividends and tax payments (1999). As observed, either free or tied cash flows are concern, it is necessary for a firm to continuously increase its cash flows because they are not only used for day-to-day expenses but can also be utilized for other significant costs if cash flows are fairly substantial.
Learning Outcome 3 and 4
As shown in table 1, Eager has an elapse time of 297 days (its operating cycle) in 2005 between the periods raw materials are delivered and when payment for the finished product manufactured from those materials is received from customers. However, Eager cannot operate its day-to-day activities within this 297 days cycle without the 77 days spontaneous financing received from its suppliers. The net financing requirement of 221 days is the period that is used to compute the required funds that should be available to bridge the financing gap otherwise Eager cannot continue to operate. Table 1 show that the firm should have access to short-term financing of approximately 45M and essentially having to finance 221 days worth of sales valued at their cost price.
In 2006, Eager has prolonged its financing gap to 270 days perhaps by having attractive contracts with longer payment dates (56 days, in terms of credits) and also with shorter ones (in terms of debts). However, it increased the required short-term financing at 53M. This situation is the usual tenet of financial management which is the trade-off of returns to risks. As financial risks decrease due to longer credit days, returns decrease due to longer operating cycle (at 327 days), longer debtor days (at 100 days) and slower inventory turnover (at 226) which affect availability of stocks and payment of debtors which reduce working capital. It is therefore apparent that for the succeeding years it is important to effectively market the product (for faster inventory turnover), efficiently produce the product (for faster semi-finished inventory turnover) and creation of harmonious relationship with both debtors and creditors (to obtain reconciliation settlements in times of working capital bottleneck).
Since Eager has high beta, it is ideal to use equity financing. Investors require a rate of return higher than the market average and a beta of 1.5 is simply an indication that Eager shares provide returns 50% higher on every dollar return in the market average. Complementarily, debt refinancing can be obtained easily as the company has historically no loan renewal problems but the firms should be able to settle a fixed-interest rate. Refinancing is common in mortgages and the competition result in offering fixed-interest rates in which Eager can exploit when it has ongoing obligation over a fixed asset. This will lessen interest payments and increase working capital momentarily.
The decline in 2006 EBIT indicates that the company is having difficulty in selling its products as well as the major costs associated in producing and distributing them. Investments should be made in product development and product diversification rather than marketing. Borrowing costs is increasing which could mean that the firm is not shielded with interest rate fluctuations and transaction costs. Equity financing should be focused. Since ordinary share capital is not increased for two consecutive years, the firm can issue additional shares to mitigate rising borrowing costs. A fall in income tax is a supportive account in equity financing but the firm should study because this would be the effect of tax-deductible debt which is mitigated herein. Retained profits on the other hand support product diversification and development. Using Du Pont analysis and strategy, product development is rationalized. Du Pont intends to focus on science-based innovation wherein returns are expected to kick-off in 2010. With this mindset, Eager can use its substantial assets and retained earnings to finance product development without the worry of timing of money even it takes five years at most. Commercialization of the developed/ diversified product is also easy because the company do business virtually.
Table 1: Cash Cycle for Eager
Cash conversion cycle formula = (Average Inventory Days + Average Debtor Days) – Average Credit Days
Average inventory = (Average Stocks/ Cost of goods sold)* 365 days
Average Debtor = (debtors/ credit sales)* 365 days
Average credit = (creditors/ purchases or COGS)* 365 days
For 2005
220.73 or 221 days
297.3673
=operating cycle
76.64
81.67
215.70
For 2006
credit days
debtor days
inventory days
270.14 or 270 days
326.7344
=operating cycle
56.59
100.28
226.46
Approximate amount of financing required
=(cost of goods sold/ 365 days)* 33 days
For 2005
45,939,542.47
For 2006
53,680,438.36
Learning Outcome 6
Supposed that Esprit condition assumed in the preceding examples do not hold. The global firm will be viewed by investors as a good investment destination but there is the need to determine the expected rate of return from the cost of capital. Using CAPM, the following Esprit information can be calculated: risk-free rate of 3%, beta (risk measure) of the stock is 2 and the expected market return over the period is 10%. The stock is expected to return 17%. This can be then used by investors in assessing the profitability of Esprit investment and in turn used by Esprit to entice capital into its coffers ( 1999).
As CAPM is useful for Esprit to determine the level of performance investors are expecting, WACC aids the firm to select the most efficient combination of capital structure by reflecting in the computation both equity and debt financing options. For example, Esprit is contracted with a project that has internal rate of return (IRR) of 9% with initial investment equivalent to million, 15 years life span and interest rate on debt at 8%. However, the firm has its broker who offers an alternative investment with the same initial outlay and life span but with IRR of 12% and required rate of return of 13%. Using WACC, the original 8% debt rate is down to 4% (8% x 0.50) while 13% equity rate is down to 6.5% (13% x 0.50) with a total WACC of 10.5%. In effect, the move to mix debt and equity in computation makes IRR of option one rejected (9% < 10.5%) while IRR of option two accepted (12%>10.5%) wherein initially option 1 is more worthwhile in absolute terms than option 2.
Not all firms particularly the new players can obtain its beta coefficient easily or its stocks are not traded in Hong Kong Stock Exchange (HKSE) making CAPM and WACC infeasible. Due to this input problem, there is a need to resort to other methods. First, the pure play approach (p. 442) requires a firm (say, confronted with new investment option that is never tapped before) to based its beta and financial structure strategy to a firm that is registered and traded in HKSE. Research is important to complete the missing inputs for either CAPM or WACC derivations. Ideally, the basis firm should be aligned with the same business as the nature of the new investment option. The objective of such is to determine a suitable venture match and to have profile of an experienced and relevant firm. Second, the subjective approach can guide the firm although with lesser concrete results than the first alternative. Managers will simply make a project risk classification subjectively in which beta can be derived. For example, routine replacement projects is classified as low risk with beta 10%, projects maintaining current operations as average risk with 14% beta and so on
Credit:ivythesis.typepad.com
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