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Recommendation To Improve Financing And Investing Decisions Finance Essay

To : Board of Director

From : Senior Management Accountant

In Glee plc, the company is facing the profit problems and new projects are not going as well as the Board of Director hopes. In between, the Board do not seem to appreciate the importance of having a balanced capital structure to achieve a low cost of capital and the company have no structured approach to appraising investment opportunities. Therefore, this report will represent the review and recommendation to improve financial and investing decision which the key areas that underperform by the company.

Term of reference

As a Senior Management Accountant, need to prepare a report of review and recommendation to improve the financing and investing decisions of the company. The first issue is to achieve low cost of capital, if the rate of return to maintain market value or stock price of the company is low, then the company enable to compete effectively. Next issue is the structure approach to appraising investment opportunities, without a structure approach, a company will fail to evaluate the opportunities. The risk is the manager may make the wrong investing decision.

Relationship between Capital Structure and Cost of Capital

Capital structure refers to the way a corporation finances its assets through some combination of equity and debt. Most companies use a mixture of debt and equity to finance their business. Thus cost of capital involves a mixture of the cost of equity and the cost of debt. In this case, the cost of capital for a company is the required rate of return that the company needs to earn in order to pay the debts and to meet the expectations of the rate of return required by the investors. (Connect code, 2009)

Investors have different habits and temperaments. Some want to take lesser risk and and some may take greater risk in anticipation of huge profits in future. In order to tap the savings of different types of people, a company may issue different types of shares. These are preference shares and ordinary Shares.

Preference Shares are the shares which carry preferential rights over the equity shares. On the other hands, ordinary shares are shares which do not enjoy any preferential right in the matter of payment of dividend or repayment of capital.

Much theoretical work characterizes the choice between debt and equity in a trade-off context in which firms choose their optimal debt ratio by balancing the benefits and costs. Traditionally, tax savings that occur because interest is deductible have been modelled as a primary benefit of debt (Kraus and Litzenberger, 1973). Other benefits include committing managers to operate efficiently (Jensen, 1986) and engaging lenders to monitor the firm (Jensen and Meckling, 1976). The costs of debt include financial distress (Scott, 1976), personal taxes (Miller, 1977), debt overhang (Myers, 1977), and agency conflicts between managers and investors or among different groups of investors.

The cost of equity (Ke), often referred to as the required rate of return on equity, is most commonly estimated using CAPM. It is also implicitly estimated when using valuation ratios, as differences in the cost of equity is a key component of differences in the ratings at which different companies and sectors trade.

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital represents the overall cost of capital for a company, incorporating the costs of equity, debt and preference share capital, weighted according to the proportion of each source of finance within the business. The models used to calculate the cost of each source all start from the premise that the required rate of return is a function of the investors’ expectations of future cash-flow returns, expressed as a percentage of the current value of their investment.

The weighted average cost of capital measures the cost of capital of a company based on two elements. One is the cost of debt and the other is the cost of equity. If a company has a market value of say one hundred million and the level of debt is fifty million and the equity is the same, then the gearing is 1:1. The cost of the debt is taken by the Net Present Value of the debt interest and repayment schedule and the cost of equity can be calculated by using the capital asset pricing model. (Helium, 2009)

So in understanding the weighted average cost, this is to say that the cost of debt is lower than the cost of equity. Obviously the lower the weighted average cost of capital the less risk is attached to a company’s stock. Also where a company has a low level of debt the implications could indicate that borrowing money is good for the business. The first step in developing an estimate of the WACC is to determine the theories of capital structure for the company or project that is being valued.

Theories on Capital Structure

Capital structure theory suggests that firms determine what is often referred to as a target debt ratio, which is based on various tradeoffs between the costs and benefits of debt versus equity. It is expected that firms with lower leverage would tend to issue debt rather than equity. (Graham and Harvey, 2001)

Traditional View

The traditional view argues that when gearing ratio is too low, the company loses cheap debt but if it’s gearing ratio is too high, financial risk together with WACC will increase and subsequently shareholder value will drop. This signifies that when financial risk increases, shareholders will demand high required rate of return. It can be concluded that under the traditional view, to increase debt is welcomed but if it is too high, then the company has to face financial distress. In short, the guiding principle is that debt should be handled with great caution. (Myers and Majluf, 1984; Kester, 1986; Friend and Lang, 1988; Majumdar and Chibber, 1999)

Modigliani and Miller (without taxation)

In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring taxation, the WACC remains constant at all levels of gearing. As a company gears up, the decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset by the increase in the WACC caused by the increase in the cost of equity due to financial risk. The WACC remains constant at all levels of gearing thus the market value of the company is also constant. Therefore a company cannot reduce its WACC by altering its gearing. The cost of equity is directly linked to the level of gearing. As gearing increases, the financial risk to shareholders increases, therefore Keg increases.

Modigliani and Miller (with taxation)

In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their conclusion altered dramatically. As debt became even cheaper (due to the tax relief on interest payments), cost of debt falls significantly from Kd to Kd (1-t). Thus, the decrease in the WACC (due to the even cheaper debt) is now greater than the increase in the WACC (due to the increase in the financial risk/Keg). Thus, WACC falls as gearing increases. Therefore, if a company wishes to reduce its WACC, it should borrow as much as possible.

Pecking Order Theory

According to Myers and Majluf’s (1984), firms prefer to raise capital by internal financing instead of external financing. Assuming that the firm’s managers always obtain better information than investors which will generate adverse selection cost and to dominate the cost and benefits so they raise capital from retain earnings, then riskless debt, followed by risky debt and equity. With better information, they can avoid issue equity in order to maximize the market value. The preferences order reflects the costs of different capital financing option.

Cost of Capital and Value of Company

Given the premise that wealth is the present value of future cash flows discounted at the investors’ required return, the market value of a company is equal to the present value of its future cash flows discounted by its WACC. The formula is:

It is essential to note that the lower the WACC, the higher the market value of the company. Hence, if we can change the capital structure to lower the WACC, we can then increase the market value of the company and thus increase shareholder wealth.

Improve structure approach to appraising investment decision

Structure approach is important to an investor when making the decision making, the need for a structure approach to opportunities is to reduce the risk of making wrong investing decision. A wrong investing decision will face the consequences of high percentage of loss and gain lower potential return.

Attributes to good projects

Opportunity evaluation

The Opportunity Evaluation process can be excellent help to focus on key issues in develop invention and challenge thinking of how to develop it further. There are no right or wrong answers in an opportunity evaluation, only informed evidence that an invention will succeed or fail.

Feasibility Studies

Business feasibility study can be defined as a controlled process for identifying problems and opportunities, determining objectives, defining successful outcomes and accessing the range of costs and benefits associated with several alternatives for solving problem.

Technical feasibility

Technical feasibility is established upon completion of a detailed program design or a working model in regards to setting standards for software accounting. Once the technical feasibility is established, it is important to consider the monetary factors also. Since it might happen that developing a particular system may be technically possible but it may require huge investments and benefits may be less.

Financial feasibility

Financial feasibility studies often involve a market study or demand analysis to help determine and support assumptions regarding anticipated revenues. This helps company management decide whether or not to commit additional resources or borrow funds to finance a venture.

Project Evaluation

The project evaluation using appropriate tools and techniques for capital budgeting including Net Present Value (NPV), Internal Rate of Return (IRR) and Payback.

Implementation

At this stage, responsibility for the project is assigned to a project manager or other responsible person. The resources will be made available for implementation and specific targets will be set. It covers project management to management structure such as resource management, organizational structure and management of change.

Monitoring and Control

Now the project has started, progress must be monitored and senior management must be kept informed of progress. Costs and benefits may have to be re-assessed if unforeseen events occur.

Post Completion Audit (PCA)

At the end of the project, an audit will be carried out so that lessons can be learned to help future project planning.

Project Evaluation

Project Evaluation is a step-by-step process of collecting, recording and organizing information about project results, including short-term outputs (immediate results of activities, or project deliverables), and immediate and longer-term project outcomes (changes in behaviour, practice or policy resulting from the project).

Tools and technique in cash flow based approach

Net Present Value (NPV)

Net Present Value (NPV) is used in capital budgeting to analyze the profitability of an investment or project. Each cash inflow and outflow is discounted back to its present value (PV). Then they are summed. The advantages of net present value is able to takes account of interest rates, can looks at the profitability of the project and allows for the fact the future returns may be less valuable than current returns and so takes account of the opportunity cost of the money.

Payback

Payback method refers to the period of time required for the return on an investment to repay the total initial investment. The advantages of Payback which it is simple to use and gives an immediate view on how long it will take to recoup an investment and helps to identify how quickly the cash flow might become positive on the project, useful where firms have cash flow problems.

Internal Rate of Return (IRR)

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or simply the rate of return. The advantages of IRR are takes into account the time value of money, which is a good basis for decision-making and results are expressed as a simple percentage, and are more easily understood than some other methods.

Tools and technique in profit based approach

Accounting Rate of Return (ARR)

The rate of return on an investment that is calculated by taking the total cash inflow over the life of the investment and dividing it by the number of years in the life of the investment. The ARR can clearly shows the profitability of the investment and take account of interest rate changes. It can also used to compare with alternative investment projects to see how rates of return differ.

Constraints of these approach

Net Present Value (NPV)

A disadvantage of NPV is that it does not account for flexibility or uncertainty after the project decision.

Payback

A simple payback does not take into account the time value of money and the overall profitability of the project. Also, payback ignores cash flows received after the end of the payback period.

Internal Rate of Return (IRR)

IRR cannot be use to rate mutually exclusive projects and the usual manner for projects that start with an initial positive cash inflow.

Accounting Rate of Return (ARR)

ARR does not take into account the time value of money and it is based on accounting profits and these are subjective.

Practical aspect of making investing decision

Financial investment decision making in the stock market is extremely difficult due to the inherent complexity of the domain, many factors could affect the future prices. The decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Real investments must be accepted only if they yield positive NPVs when discounted at the unlevera­ged discount rate, that is, without accounting for the tax shield. WACC enters the picture only to assess the impact of a new project on firm value, once it has been accepted, and when a fixed debt ratio policy is in place. (GCG, 2009)

Conclusion

In overall, financial management is important for organisation when decision making. Having a well financial management can protect the business from pre-carious and mismanagement of money. Besides that, financial management can also maximize shareholder wealth, where having well financing decision and investing decision is able to manage well to the debt and equity of cost of capital in the company, and also can handle well to the risk in the investment. Therefore, manager must understand well to the financial management before make the decisions.

Appendix

Formula of WACC

Example of WACC

The 7% debt which has fifty million is averaged against the cost of the equity which tends to be much higher than the cost of debt. Let’s say the cost of debt is 12%. The weighted average would then be half of the cost of debt and equity and then added as a sum to give the answer of 3.5% + 6% = 9.5%. The 7% cost of debt is 3.5% as a weighted average and also the cost of equity is half of the figure calculated using the capital asset pricing model, because of the average fifty versus fifty split. 

Formula of NPV

t - The time of the cash flow

i - The discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)

Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t. For educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus) the investment

Formula of IRR

Where A is the lower discount rate and B is the higher rate, a is the NPV at the lower rate and b is the NPV at the higher rate.

Example of Payback Formula

Formula of ARR

Estimated average profits x 100%

Estimated average investment

Average investment is calculated by adding initial investment cost to the residual value. This gives the total amount of money tied up and it should be divided by two to find the average.


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