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This report has been intended for module tutor. It has been asked to carry out research into the financial management issues that have to be taken into account when raising finance. The aim of this report is to critically assess why and how companies issue shares and to evaluate the investment appraisal techniques available. Finance manager will also provide recommendations to the module tutor on matters concerning raising finance, issuing shares and investment appraisal decisions. References are provided according to Harvard Referencing System.
3. Research Methodology
Different data collection tools and techniques are considered. Fast but cheap methods are applied to obtain maximum information in little time. Specific but relevant research is focused to minimize collecting irrelevant data and save time. Journals and books are the back-bone for the literature. Library catalogues and indexes are used to scan for secondary data. Journals and newspaper articles, books and magazines are searched online as well as in the library. It is ensured that the procedures adapted are relevant, systematic, justified and appropriate. The researcher also ensured that the research conclusion is viable and verifiable. The research findings are examined for reliability and validity.
The finance manager is responsible for the finance function of a business including the investing and financing decisions (Why and what for the company needs finance and where it can raise finance from). A finance manager needs to assess sources of finance based upon criteria: amount of money required, how quickly it is needed, the cheapest option available, amount of risk involved, the cost of finance and the time of the requirement. The finance manager can raise finance internally from the company’s cash flow or externally from the capital market. A finance running a company is one of the most critical aspects of a business. The organization must procure the fund needed for the business especially in the initial stages. This fund can be generated from variety of sources but organizations are initially financed by debt or equity. External funds are made available through capital markets to companies which require outside capital infusions. Selling shares involves important strategic and practical considerations as well as legal compliance concerns.
(i). Equity markets are the means by which company can raise capital by selling portion of its ownership and control. Selling stock or shares is the most common method to generate finance. Company has the advantage of having a much larger investment market from which it can receive investors. Investors provide investment capital to the company in exchange of part of rights of its ownership. Companies that are raising capital by creating and selling new shares, do so to improve the financial health of the business. It is usual for the company to issue shares at some stage of their business. Shares are issued for variety of reasons apart from raising finance e.g. it can be issued as part of a director or employee bonus scheme or to distribute equity to new investors so that they can benefit in the organisation’s future success. Although a company may also raise finance through other sources like borrowing, equity can be raised without much complication and procedures. Equity has few advantages over loans or any other form of debt as it does not have to be repaid nor are there regular payments to be made and dividends are paid at the option of the directors. It is much easier to get finance for the organisation when compared to borrowing from bank or any other lending source and more amounts can be raised than borrowing. In general, capital is raised in order to generate cash for business expansion of the company and/or to reduce the debt level (leverage or gearing) of the organisation. The capital derived from selling shares can also be used for growth purposes and for future commercial ventures. It may be utilised to target a new market or to market a new product or to acquire a new business. Other advantages of shares issue include: Company can keep funds indefinitely, there’s no cost or payment on the funds as dividends are only on earnings and no collateral is required for equity investment. Companies like Bowleven Plc can raise finance easily by issuing shares when their quest for seeking partners bears no fruit and they are in desperate need of cash. Besides, the companies cannot borrow a huge amount such as £71 million when their financial position is not good as large sum of money is not available through some sources. They have to provide information regarding company’s assets, gearing levels and cash flow (projected and current). Securities need to be provided as well as restrictions are applied on company’s functions, decision making, policies and procedures. Shares issue on the stock market can resolve many of the problems companies face. The companies also need to take into account issues relating to shares issue like shared control of the organization, tax deductions, cost of equity, profit sharing and restrictions.
(ii). Most companies contact a broker when they want to make an investment decision especially when issuing shares in the stock market. This is sometimes necessary to do as it is not possible to execute stock trades without having the membership of a stock exchange. However, there are some instances Bowleven Plc can sell shares to investors without needing assistance from Royal Bank of Scotland and Merrill Lynch as their brokers. Although there are many ways, each method requires some measure of work and minor expenses. In addition, the company will have to locate the buyer itself. To sell shares without a stock broker, Bowleven Plc can open its own brokerage account or get registered as a member of a stock exchange. In this way the company can directly sell shares to the investors. This is the easiest way to sell stock on the market. Bowleven Plc can also introduce company’s personal purchase plan for investors in which the investors can directly contact the company. Bowleven Plc can offer something called Dividend Reinvestment Plan (DRIP) as many large companies offer, in which all dividends are reinvested in additional shares rather than being deposited into current shareholder’s account. The other option available for Bowleven Plc without using a broker is to appoint company’s stock transfer agent who track and process the stock. It is cheaper than taking help from a broker. Equity finance can be generated by sale of ordinary shares to new investors through the stock market or it can be a sale of shares to existing shareholders by means of a rights issue. The company can sell shares to existing shareholders to raise capital in proportion to their existing shareholdings at a specified price within a specified time. This is a good way of issuing shares to shareholders without engaging a broker and it helps protect the ownership of the company as it remains in the same hands. Another method accessible for Bowleven Plc is to issue preference shares. Preference shares have fixed dividend rate and is paid to shareholders before any other dividend is paid and it is only paid if sufficient profits are available. By issuing these shares, Bowleven Plc can retain control of the company as these have no voting rights. From the company’s point of view, preference shares are advantageous as it does not restrict the company’s borrowing power, at least in the sense that preference share capital is not secured against assets in the business and it does not lower the equity/debt balance. Other ways that Bowleven Plc can apply consists of online shares trading which is cost effective and time efficient. With the access to internet, the company can set up online brokerage account and sell stocks to investors without ever having any contact with a stock broker. The company can also sell stock through an in-the-money covered call. This means writing an option below the current share price. This is a popular method used by large institutions to sell large quantities of stock. The company can also use ‘Trade points’ which allows it to sell shares to bypass the usual system of going through the broker. Other techniques include selling rights and warrants which are securities that grant the right to buy shares at specified price for a specified time.
There have been many changes and innovations in the financial markets over the past few years regarding which shares to trade and how to trade these. Whatever method Bowleven Plc adapts, it should take into account the cost of capital (equity), issue costs, administrative, legal and all the related fees.
(iii). Investment appraisal is a planning process used to determine a firm’s long term and short term investments which are the major issue for financial managers. This area is extremely important, because the decisions made involve the direction and opportunities for the future growth of the firm. Investment decision making is of vital importance to a company and to support this decision making process, effective appraisal techniques are most valuable tools. When a company like Bowleven Plc invest in the development or expansion of business, there are number of stakeholders involved. Investors and partners need to know how their money will be invested and how much profits will they get in return or how much will they gain in long term. Investment appraisal may follow a varied measures and standards depending on the decisions maker or stakeholder’s priorities. These differences in priorities are usually represented by long term growth versus short term profits. Study strongly directs that the investment’s feasibility research is mainly based on financial cost-benefit analysis, conducted using traditional capital investment-appraisal techniques. Most commonly used for appraisals are Payback Period, Discounted Cash Flow and Accounting Rate of Return/Return on Investment. Techniques such as Internal Rate of Return and Net Present Value are perceived as being more difficult and are used to a lesser extent. As traditional capital investment appraisal techniques are mostly used, one can assume that potential partners mentioned in the case study could use these to assess the viability of drilling wells off the Cameroon coast. These techniques are well known, well understood, easy to use and are focused on financial gains and are developed to maximise investor’s profits.
Discounted Cash Flow (DCF) is a capital investment appraisal technique of valuing a project or company using the concepts of the time value of money. Only cash flows related to the future profitability of the investing share are included in the decision analysis. Whether or not to invest, this decision is based on how the future discounted cash flow will impact the company’s present value. Once the company determines the net cash flows and establish the discount rate, it can apply this discounted cash flow technique for evaluation and ranking investment alternatives. Net Present Value (NPV) is the most economically-sound technique that involves discounting all future project cash flows into the present value using the company’s discount rate, then deducting the net cost of the investment project. The NPV method is consistent with the idea of company’s objective of maximising the present value of that is shareholders’ wealth. It takes into account of changing value of money over time and is useful for comparing similar projects. Drawback of NPV method is that it is difficult to determine the discount rate. Internal Rate of Return (IRR) method is another popular technique. It is a special case of the NPV method. The IRR is the distinctive discounted rate that associates the present value of the future cash flow stream to the project cost. IRR calculates an alternative cost of capital including an appropriate risk premium. It enables comparison to be made projects of different values. The project offers a chance to earn a profitable return on investment and should be undertaken if IRR is greater than the firm’s hurdle rate. The technique often used by many organizations, is the payback method. The payback method attempts to determine how long it will take for the project to retrieve the total investment costs. The payback method is not a measure of profitability, unlike the NPV and the IRR methods; instead, it is a measure of time. It is simple to use and is useful for short term decision making. Disadvantages of using this method can include an overly simplistic view of the situation, it doesn’t take account of the fact that future returns may be less valuable, it often ignores qualitative aspects of the decision, it takes no account for inflation, taxation or interest rates.
Apart from the above mentioned capital appraisal methods; there are few other techniques available that the potential partners can adapt e.g. Average Rate of Return (ARR) in which profit generated by the investment is compared with the cost of the investment; Adjusted cost-benefit method in which cost and benefits of the investments are analysed; strategic fit which proposes investments be evaluated primarily in function of their contribution to a firm’s competitive advantage; option models and balance scorecard by taking into account different views and perspectives. Despite the existence of a wealth of literature, capital investment appraisal for investments like Bowleven Plc’s, it is hard to appraise. Since all techniques have their drawbacks, reliance on a sole technique may lead to sub-optimisation or even failure. Therefore it makes sense to use a mixture of techniques, eliminating or diminishing the weaknesses of each of the techniques used. Multi-layer evaluation process is highly recommended. A multi-layer evaluation process uses different evaluation techniques, which are more or less ordered in a hierarchical manner. Other issues should also be considered when selecting an appropriate appraisal method: costs of investment, inflation, depreciation, opportunity cost, ease of use of method, degree of simplicity, adjustment of taxation, capital allowances and risks and assessing uncertainty
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