Financial Managment - Coursework Example

? Financial Management Table of Contents Table of Contents 2 QUESTION 4 4 a)Argument for and against Costof Capital Reduction an Financing through Debentures 4 b)Factors to consider when raising capital through preference and Debentures 5 i.The Board Operation 5 ii.Working practices and employees 5 iii.The plan monitoring and management information 5 iv.Margins and cash flows 6 c)Factors affecting level of debt financing 6 i.Tax Exposure 6 ii.Financial flexibility 6 iii.The stage of Growth 7 iv.Market Conditions 7 QUESTION 6 7 a)The expected share price, total value of equity and value of the firm under the two financing options and a commend on the best financing option 7 b)The value of equity and the firm in the event that company is financing the expansion by (i) equity or (ii) debt 8 c)Basic assumption of Modigliani and Miller 9 QUESTION 7 11 b) Comment upon the nature of the company’s dividend policy prior to the listing and discuss whether such a policy is likely to be suitable for a company listed on the Stock Exchange. 11 QUESTION 8 12 a)Arguments for and against the directors’ views on dividend discharge 12 b) Factors should be taken into account when determining the level of dividend payment 14 i.Industry patterns 14 ii.Firm ownership structure and capital size 14 iii.Firm’s asset structure and size 14 MERGERS AND ACQUISITIONS 14 a)Classification of acquisitions or take over’s 15 b) Economic justifications of acquisition and mergers 15 c)Financing of the acquisition process 15 List of References 15 QUESTION 4 a) Argument for and against Cost of Capital Reduction an Financing through Debentures A capital structure of any corporation may be lowly geared or highly geared. In the event that, a corporation has much more ordinary shares compared to other capital forms such as debentures the company is usually believed to be low geared. The company’s capital gearing creates dividend charges or fixed interest on the income of the company; thus it has a key impact on the feelings of shareholders and prospective investors. Generally, potential shareholders prefer a corporation with much higher equity participation (Modigliani & Miller, 1958). On the other hand, a corporation with much high stock of debentures is usually considered unattractive to invest in for the reason that it has a higher risk especially in the times of financial volatility since only holders of debenture have priority over the company assets in such circumstances. Prudent financial management stipulates that, a business should not depend much on loan capital and debentures compared to equity capital unless it is only being employed for a very short period of time. However, these kinds of ascertaions are highly challenged by Modigliani and Miller (MM). In fact their basic hypotheses states that, in an efficient market, the nonexistence of bankruptcy costs, asymmetric information, taxes and agency costs, the business’s value is not affected by the manner in which that business is financed. According to MM, it doesn’t matter whether the capital of the firm is raised through selling debt or issuing stock. They further state that, the dividend policy of the firm also does not affect its value. Actually, the argument of MM is straightforward; the cash flows that a corporation can make for all investors are all the same despite the capital gearing. According to them, changing the capital gearing does not in any way alter the firm’s general cash flows (Modigliani & Miller, 1958). b) Factors to consider when raising capital through preference and Debentures i. The Board Operation Although preference shares do not have much effect on the company’s management, debentures do have. This is based on the fact that, a business with external investors needs to be run in a manner that goes in line with the aspirations of debenture holders. With this in mind, it may be quite impossible to manage a company where the lifestyle of directors is the only central part behind the business deliberations. Instead, the business might be forced to adopt a proficient board whose directors, that will only be seeking to capitalize on the business profitability so that investors can get their money back (Neale & Pike, 2009). ii. Working practices and employees When seeking out on external sources of finance, the directors need to assess the effect it will impact on employees and the company’s working practices. In circumstances where the company is resorting on a high financing level, it will imply that some changes within employee section and working practices will have to be re looked into. This is always the case as the management must oil around to attain the greatest possible commitment and productivity from its workforce to enable it to make good its debts in good time. To attain this, the management might employ redundancies and reorganization. In addition, some employees will be forced to operate on the directives of debenture holders and might as well affect their working practices. A part from being forced to work to the tune of investors especially in financial reporting, some of them may as well force the management to set up some share option schemes for the employees. This aspect does not affect the investments and returns to the investors but generally reduces the company’s income. iii. The plan monitoring and management information Lenders have been found to insist on information systems that are highly effective so that they can be served with the company’s performance normally within the last two weeks of every month. As well, this goes in line with continuously reviewing the performance of the business against the arrangement that may have been agreed upon with the debenture holders. This does not seem problematic at all, but the aim of the company is to make business and not always making investors records. iv. Margins and cash flows Normally externally financed businesses are always under pressure to maintain margins and cash-flows. Cash-flow is a critical aspect that shows the ability of the business to pay interests to the debentures, and margins on the other hand, are critical as they show the business’s profitability which is a determinant of shareholders returns. This aspect will reduce the business’s management into machines making them to sideline other company responsibilities. c) Factors affecting level of debt financing i. Tax Exposure Tax regulations and laws play a significant role in capital gearing deliberations. Given that payments of debt are tax deductible, in the event that the tax rate of a corporation is too high, it means that the company may be in a position to use debt financing. The debt payments tax deductibility protects some revenue from taxation. Because Kipling plc is already having some level of gearing it must first assess its feasibility to add on another debt. ii. Financial flexibility Normally, the lower the debt ratio of a business is, the more flexible the business will be in hard economic times. This aspect shows the ability of the business to raise capital in times of slow growth. iii. The stage of Growth The capital gearing of a firm may as well rely upon its existing growth stage. A business in its early growth stage might tend to rely more on debts in order to pick up. Nonetheless, some times businesses might develop too fast, which makes their growth highly volatile. In fact, a business that is more stable generally calls for less debt, because of its stable stream of revenue. iv. Market Conditions The existing conditions in the market are an important aspect in making capital gearing deliberations. In a low performing market for instance, investors may not be willing to invest, as a result, rates on interest may be considerably higher. During this time, businesses might tend to stay away from high debt ratios. QUESTION 6 a) The expected share price, total value of equity and value of the firm under the two financing options and a commend on the best financing option With new investment with new Current and equity investment and ____________________________ (?m) (?m) debt (?m) EBIT 79.500 85.2001 85.200 Interest ___ 0 0 (4.560)3 EBT 79.500 85.200 80.640 Tax @ 33% (26.235) (28.116) (26.611) Ord. shares of ?1 each 50.000 54.6572 50.000 EPS 107p 104p 108p P: E ratio 9.0 9.5 8.5 Share price (pence) 963 988 918 Market value equity 481.500 540.011 459.000 Market value debt 0 0 38.000 Market value firm 481.500 540.011 497.000 Notes (1) ?79.500 + (?38.000 ? 15%) (2) ?50.000 + [?38.000/ (960p ? 85%)] (3) ?38.000 @ 12% Apparently, using equity is preferable because of the expected adverse impact of gearing on the P: E ratio. b) The value of equity and the firm in the event that company is financing the expansion by (i) equity or (ii) debt (i) MV of equity = MV of ungeared firm (Vug) = (?85.2m ? 1 – T)/0.14 = ?407.7m (ii) MV of geared firm = Value of ungeared (Vug) firm + tax shield (TS) – financial distress cost (FD) Vug = (85.2 ? 1 – T)/0.14 = ? 407.743 TS = (?38m ? 0.12 ? 0.33)/0.12 = ? 12.540 FD = ?5 million = (? 5.000) = ? 415.283 Note that, in the geared case, the value of the equity is given by: [Value of firm – Value of debt] = [?415.3m – ?38m] = ?377.3m c) Basic assumption of Modigliani and Miller Modigliani and Miller (1959) assume: neutral taxes; the financial policy of the firm reveals no information; symmetric entry to credit markets (investors and firms can lent or borrow at the same rate) and no capital market frictions (no bankruptcy costs, asset trade restrictions and no transaction costs). % Ks Ka Kd Source: (Neale & Pike, 2009) Debt/Equity According to MM, law of price is the one that is at the center of a perfect market especially one that is dominated with homogeneous capital. Basing on their argument, if equity and debt are just dissimilar packages of homogeneous capital, and with no market limitations, then to them the one price law holds because of to arbitrage. During this time, investors only engage in arbitrage to the point where the deviations in the value of the two capital forms is reduced (Neale & Pike, 2009). Since no taxes have been assumed, the EBIT or operating revenue is the same as the net revenue which is all given out as dividends. Therefore, the firm’s value is equivalent to Since the firms value is equivalent to the value of the equity and debt, Solving for Ks the last equation is replaced into the preceding one. Hence, ks goes up as more debt is injected to the capital structure. Graphically it will be like. Ks Dark red: Ka Blue line: Ks Ka % Red line: Kd Kd Debt/Equity Source: (Neale & Pike, 2009) QUESTION 7 b) Comment upon the nature of the company’s dividend policy prior to the listing and discuss whether such a policy is likely to be suitable for a company listed on the Stock Exchange. Years prior to listing No. of shares Total dividend Payout ratio 21.33m ?768,000 42.7% 4 21.33m ?1,024,000 42.7% 3 26.67m ?1,642,860 42.7% 2 26.67m ?1,750,000 42.7% 1 26.67m ?1,898,000 42.7% Current 40m The number of shares is found by working backwards from the present figure of 40m and adjusting by the two specified new issues (50% at listing and 25% three years previously). The total dividend paid is found by multiplying the dividend per share by the number of shares and the payout ratio then follows. The company’s declared objective is to maximize shareholder wealth. In principle, a variety of dividend policies is consistent with this aim depending on factors such as the tax position of the clientele and whether dividend policy has been used to convey information to the market. Pavlon has followed a remarkably consistent dividend policy, adhering to a constant payout ratio. At the time of listing, it would presumably have stated its dividend policy in its prospectus and unless specified otherwise, shareholders would have been justified in expecting continuation of this policy. A switch in dividend policy so soon after listing is certain to offend at least some portion of its clientele. However, whether the pursuit of a constant payout ratio is rational is debatable. As long as earnings are increasing, the company is able to continue to increase dividends, but should earnings fall, adherence to a constant payout implies lower dividend per share and possibly lower share price. It is more usual to follow a dividend policy incorporating a stable dividend per share, with ample dividend cover, to allow earnings fluctuations to be smoothed out. QUESTION 8 a) Arguments for and against the directors’ views on dividend discharge Director A: His proposition to expend dividends to the company shareholders is based on two reasons: financing and investment decision of a company. Given that, the investment decisions of the company took into account the investors position then his decision to give out dividend would be in line with fulfilling the shareholders requirement. The other reason is that, the more the shareholders get returns on their investments, the more they will be willing to inject in the company. Besides, shareholders usually rely on the dividends for their daily up keep, denying them the chance to reap on their investment might make them with draw their shares. However, this argument has been challenged. Businesses that boast of a long-standing record of constant dividend payouts most likely would be affected negatively by omitting or lowering dividend distributions (Arnold, 2007). The argument of Director B seems to be much in line with the assumptions that were put forward by Miller and Modigliani. MM established that, with some restrictive market aspects, dividend policy becomes irrelevant. MM shows that dividends actually have effect on location as compared to investment of the shareholders. Besides, they stated that the values of the shares will always be affected by divided levels but on condition that retained earnings are safely injected. However, the MM arguments on dividend irrelevance consider assumptions that are highly challenged. Some of these assumptions include: neutral taxes; the financial policy of the firm reveals no information; symmetric entry to credit markets and no capital market frictions. The assumptions he made are practical in real world hence his arguments cannot heavily relied upon (Modigliani & Miller, 1958). The stand point of Director C is based on the argument that all shareholder amounts and returns on investments should always be ploughed back to create more wealth. Besides, his argument to maintain dividend is aimed at boosting more capital for the company and evade on paying taxes on some taxable dividends. For instance, the Director seem to have considered the rate of taxes on both capital gains which at times is not taxed and dividends which are usually taxed at the incomes marginal rate. However, with this process shareholders stand too loose more than if they were given the dividends. First, continuously retaining shares in the company without a close follow up on the performance (dividends indicate the company’s performance) of the company may create a scenario where the company managers will be having easy cash at their disposal to squander. b) Factors should be taken into account when determining the level of dividend payment i. Industry patterns Several studies on dividend policy emphasizes that businesses usually increase dividends, but only when the management considers that the company returns have permanently increased. This means that when dividend increases it depicts a rightward move in the earnings distribution (Neale & Pike, 2009). ii. Firm ownership structure and capital size According to the theory of agency cost, the separation of control and corporate ownership generates the chance for the business leaders to rally behind their own interest and not the interest of shareholders. Dividends can be the best way of reducing the unrestricted (discretionary) resources available to business leaders for perquisite utilization. iii. Firm’s asset structure and size High business risks usually leads to a reduction in the willingness of a business to give cash via dividend payment. High business risks create the projected direct link between expected and current profitability less assured. In other words, the more the business risks, the more uncertain the company will be in making profit, hence less tendency to discharge dividends. MERGERS AND ACQUISITIONS The phrase acquisition and mergers is the characteristic of corporate management and finance, corporate strategy, dealing with the selling, buying and aggregating of different businesses that can finance, aid, or assist a growing business in a particular industry to grow fast without necessarily creating another business entity. a) Classification of acquisitions or take over’s Horizontal takeover: businesses in the same stage and line of production unite into a single business entity Vertical takeover: This occurs when tow businesses in the industry but at different level of production combine into one entity. This process can either be backward towards the supplies or forward towards the distribution. This is majorly aimed for securing vital outlets their finished products (Neale & Pike, 2009). Conglomerate acquisition: This comprises companies that come from different industries b) Economic justifications of acquisition and mergers Economies of scale, normally the larger the business the more it can sale and gain on big profits to offset the overheads. Acquisition also takes place when a particular company wants to enter in the new markets. Also market power has been identified as a driving force behind acquisitions where businesses aim at increasing the market share hence developing ability to earn more. c) Financing of the acquisition process This has mostly taken place through the use of debentures which are long term loans, preference shares and convertible bonds. Also to some extend loan stocks have always been employed. List of References Arnold, G. (2007). Essentials of Corporate Financial Management With Companion Website With Gradetracker Student Access Card. New York: FT Prentice Hall. Modigliani, F., & Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review , 48, 96-261. Neale, B., & Pike, R. (2009). Corporate Finance and Investment. Decisions and Strategies. New York: Financial Times (FT)/Prentice Hall. Read More