FINANCIAL MANAGEMENT
I. Apple Inc.’s Fundamental Risks
I. A. Business Risks
Variance in cash flows that Apple confidently mitigates due to its institutionalized innovation structure and market followers may emerge because of contentment (2006). Another, the changes of strategic outlook of Steve Jobs overtime may mean learning from past mistakes but the same attitude also imposes investment risks. For example, the historically high-end target market of Apple shifted to include middle and even low markets evidenced by lowering the price or increasing differentiation of its iPod, iTunes and other proprietary components to reach a wider market base. Lastly, as in the case of corporate leaders of Walt Disney, Hewlett-Packard and Sony, the longevity of Steven Jobs (i.e. prognosis of cancer) can also affect the strategic direction of the firm in cases of sudden leadership replacement.
I. B. Finance/ Leverage Risks
Apple efficiently uses object-oriented frameworks that reutilize established software as platform to develop new software (2003). In effect, there are fewer requirements to finance research and innovation efforts that positively contribute to the depth of company‘s leverage as well as speed of software creation/ upgrade. Venture capital, government sponsorship and mezzanine financing are widely used by hi-tech firms to reduce high investment risks that companies like Apple would face under equity issuing (2003). Apple receives leverage to finance R&D activities but grants have effects on decision-making particularly on how innovations will be managed.
I. C. Liquidity Risks
In high-tech firms, the only discernable collateral that parties can offer is their intellectual property that has a distorted and impractical value and difficult to transfer ( 2003). In the contrary, Apple has also financial framework of reducing the liquidity risk by pulling-down period of maturity of its short-term investments or limiting its holdings of long-term ones (). As a result, the company can offer higher liquidity but lower returns due to absence of interest rate gain for investors.
I. D. Exchange Rate Risks
Spot exchange rates and changes of these are risky for MNEs like Apple as this factor of host country demand depends largely on the price of its goods, services, labor and entrepreneurship. Especially on unstable currencies in merging economies, price competitiveness of an Apple exports are pegged on fluctuations of host country’s currency. As a result, the pricing of Apple’s products is more dynamic and unpredictable when the host economy is ever-changing. In its history, Apple uses financial instruments in the derivative market to reduce its exchange and interest rates risks through forward contracts and options (2003). Certain assets, liabilities and future cash inflows are also protected by this strategy to tally with forecasted revenues and expenditures.
I. E. Country/ Political Risks
In France case, over-success in host markets can impose adverse effects like regulation to the growth of Apple ( 2006). In the economic side, the demand for company’s products is also related to global economy where suppliers, distributors, resellers and end-users interact (2006). Several product and services to complete manufacturing and logistics activities are located in foreign countries through outsourcing. In effect, Apple minimizes the control over its supply chain through cost-effective means deepening the significance of cross-border political and economic events.
I. F. Credit Risks
To promote customer loyalty and satisfaction, Apple third-party distributors do not regularly apply collaterals for its debtors expect when substantial credit is at stake ( 2007). Trade receivables are usually without limit and the application of credit insurance exist only in isolated cases. However, as only their distributors are in direct contact with end-users, Apple prevents assumption of credit risk sharing because agreements between distributors and customers are remote without their intervention. If any, the doubtful accounts of distributors are related on their capacity to pay Apple and so the company adopts a dynamic framework to handle those accounts through analysis of debtor worthiness, economic situation and historical experience.
II. Apple’s Capital Structure
II. A. Impact of Gearing to Shareholder Wealth
In the traditional view of capital structure, the value of the company (e.g. the impact to shareholder) can be affected by managing the level of gearing. Also, this view supported that debt is more risky than equity financing because the organization is committed to pay a stream of amortization/ interest payments without surety of profits. Therefore, highly indebted companies are damaging to shareholders. Alternatively, the cost of equity capital also increases which results in higher required rate of return when gearing is continuously increased. This tendency is caused by the trade-off of cheaper debt financing with more expensive cost of equity. In this view, debt financing is deemed advantageous but such advantage is waived by higher expected shareholder returns.
According to Modigliani and Miller, when similar type of risks are classified and are capitalized, value of the un-geared and geared firms will not vary. Their methodology requires capitalization/ discounting of earnings before interest and taxes (EBIT) and its subsequent variability over an expected value. As a result of this analysis, the proponents build a linear function of capital structure which reflects the trade-off between yield in equity and risk incentives in debts. In their conclusion of a more real case, the proponents stated that benefits of tax shields from gearing is inappropriate to view as absolute gains to shareholders as they are tax allowable costs (e.g. interest payments). When capitalization is applied, the value of geared company will equal the un-geared company considering that tax shields will obtain their present values. It is to note that when debt-equity ratio is increased the financial risk of the firm also rises due to higher expectations from shareholders.
With this views and proponents, it is concluded that debt is a cheaper source of financing that equity primarily it is a tax allowable expense in its financial statements. In the contrary, the company has to pay principal and interest even in recession or poor performance which can affect its liquidity and other growth plans. Further, when there is a high-concentration of gearing, shareholder’s interests are undermined in favor of external creditors which can hamper the former claims at times of investment pull-out due to dissolution or winding-up. For un-geared companies (e.g. family-closed corporations), huge equity financing is intolerable as they may loose corporate control or incidentally enters a hostile takeover zone. Therefore, the impact of shareholder wealth under gearing is a function of shareholder’s overall outlook and preferences and there is no direct solution to say if gearing is good or otherwise.
II. B. Determinants of Capital Structure or Gearing or MVD / (MVD+MVE)
A firm’s CS is frequently a combination of different financing schemes and external creditors. To understand the concept of CS, three basic financing terms should be considered. According to (2006), debt financing is the act of providing capital by selling bonds, bills or notes to individuals or institutions while common/ preferred stock is sold through equity financing. Taken in simpler terms, the former refers to extended debt while the latter refers to internally-generated cash. Lastly, debt/ equity ratio is equal to their quotient whose answer is used as a measure of company’s financial leverage or gearing. The optimal structure of the capital is obtained if the expenditure in acquiring it is reduced considering that the proceeds are increasing the value of the firm.
Using the gearing ratio (), the level of a firm’s financial risk is assessable which means that the firm can identify if financial resources are able to pay planned or on-going financial commitments or not (Mcmenamin p. 453). In this way, the firm can make decisions and implement strategies according to its financing ability. This upper hand is worthy not only because it places the firm in a safer stance but more importantly it is able to control one side of the general risk confronting a business (financial side) which relaxes problems emerging from the uncontrollable business/ environmental risks ().
With this, the survival of the firm is protected by CS as internal consequences of a firm’s strategy are detected. Questions such as “Do we have enough money for the project?”, “Is there a need to borrow or issue shares?” and “What is the gearing ratio to be adopted to maximize the potential of the project?” This facility has also its implications on corporate ability to forecast, exploit and mitigate environmental changes and even apply influence over its gradual evolution. This can achieve merit by using the resource-based model of above average returns wherein core competencies are matched against the changing environment (2003).
III. Investment Appraisal Techniques and their Associated Risks
Payback period method is advantageous when a firm tightly adheres to the time value of money concept, that is, the money to be received in the future has higher risks and lower value than the same amount of money on-hand today. This becomes crucial when a firm is bound to be acquired in which its objective is not to maximize profits rather minimize the time required to recoup investments (say) for a period of two years in which it is also bound to be formally acquired. Alternatively, its computation ignores time value of money due to the absence of discounting cash inflows to find their present values (1999 ) unlike NPV or IRR. Nonetheless, it is used frequently because it is the most popular and easily understood investment appraisal techniques (). Easy it is because it is internally-driven from the view and subjectivity of the firm preventing technical calculations and market research in favor of the “fastest way to recover investment” rule.
Return on Equity (ROE) is an accounting ratio that shows how much the investors are earning in their equity investments making it a useful basis in investment decisions (1999). It is derived by dividing the profit of the company with the average common equity outstanding of the firm or simple Net Profit/ Average Common Equity (2003). With ROE, the investment decision-making of investors are focused on how to minimized the cost of equity investment and maximize the return in the form of dividends or capital gains. If ROE has risen, it indicates that the investment of shareholders improved its efficiency and implies that the company is avoiding wastage on its asset’s operations on the process of creating value-adding outputs. This investment situation makes investors sustain their capital in other investment destinations leading to flexible decision-making and depth
Internal Rate of Return (IRR) is another accounting ratio that is computed more complicatedly that ROE (c2000). For example, it attempts to convert the net present value of the cost of capital as a way to show that the discount rate is equal to investors and projects expected rate of return (1999). With IRR, investors can evaluate the level of their risk in the project because it shows the expected rate and the required rate of investors for comparative analysis. In this veil, IRR gauge the cash flows that may arise within the course of the project and viewed the company in question in separate case such as isolating its financing position. As the discount rate applied in IRR is very dynamic, it is efficient in analyzing the profitability of two or more projects. However, projects in question must have similar time horizons, discount rates, level of risks as well as their cash flows should be predictable (2006).
The upper hand of ROE is its ability to recognize the comparative benefits of investing in a company using the industry standard ( 2003). As an illustration, three global IT companies in 2003 posted ROE of 46%, 12% and 2.5% respectively which results in easy recognition of investors that Dell (e.g. ROE = 46%) is efficiently providing earnings to shareholders and also highlighted the strength of its direct marketing strategy. Although ROE can imply any business growth, the same firms can manipulatively dictate the level of ROE to attract prospective investors and maintain the loyalty of existing ones. In the accounting side, imposing too much write-downs on certain assets as well as implementation consecutive buyback programs can distort the structure of equity in the denominator resulting to soaring ROEs. In addition, financial reports may appear attractive as ROEs that are high can be affected primarily due to the existence of large and extraordinary debts for the operating year (2003).
The core advantage of IRR is its ability to analyze the income and cost features of corporate projects which leads to screening the relative profitability of one aspect of the company (1998). On the other hand, ROE’s holistic approach makes it weak in fragmented analysis of the business which IRR can resolve. In the contrary, IRR cannot analyze a combination of cash inflow and outflows over substantial investment projects because it cannot contain distortions that may impose by the open market where NPV can intervene (2006). Further, the determination of well-structured discount rate is difficult for the purpose of deriving IRR and without discount rate IRR is bound to failure. As a result, IRR is a simplistic investment appraisal tool requiring minimal assumptions as well as research compared to streamlined features of ROE and NPV (2006).
In cross-border investments, ROE is quite fitted to appraise equity assets as well as direct investments residing abroad because ROE can protect the relatively more costly, strategic and complex structure to obtained above-average returns. As corporations are existing and guarding those investments, ROE is always embedded in the ethical consideration and operational effectiveness of the organization. In contrast, IRR can maximize the potential of financial investments because it shows a simplistic technique to view environmental risks that are very unpredictable in the foreign country. Also, IRR can support in evaluating project-based strategies and implementations of the firm in the foreign land because it helps in planning, monitoring and evaluation for future consideration. As illustration, in the advent of expropriation of assets due to pending political conflict between two nations, the stakes of the shareholders can be extremely at risks. Since ROE utilizes the corporate-level information while IRR is to the project-level, investors can select the best tool for their reference in relation to the level of their risk-aversion, preferences and personal goals.
By discounting, the Net Present Value (NPV) of investment cash flows is obtained which makes it useful in the relatively vague long-term projects. The assumption of NPV is to accept project investments that have positive NPVs and reject those with negative. There are available net present value tables and other materials to guide the computation of NPV making it relatively simple. However, there are imperfections with this technique such as its inability in determining methods to minimize working and physical capital that can actually affect returns from the investment. It is a passive technique that is used merely as analytical tool. To be able to gain active analysis, NPV must be coupled with methods that can locate inefficiencies/ value-creating processes, postponement of projects and even their actual elimination as portfolio to locate opportunities to save or grow (1993). NPV is the sum of discounted yearly cash flows and discounting is applied after the net income is computed and other non-cash transactions are included in the potential discounting.
In these comparisons, IRR has the upper hand in analyzing cash flows between two projects simultaneously (1998). As ROE is an integrative technique, IRR is more dynamic and applicable in real decision cases where two or more investment options are appraised based on profitability and risks. In the contrary, IRR is based on past data which makes NPV more accurate to forecast future returns and basis for decision-making. IRR is not efficient in scheming the project’s combination of inflows and outflows as there are many results involved due to implications of environmental issues (2006). IRR has also the lack of formidable basis for attaching a discount rate. As mentioned in NPV, discount rate is crucial for investment appraisals that assumed time value of money and opportunity costs. As a result, IRR is a straightforward investment technique that requires minimal assumptions and research compared to ROE or NPV (2006).
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