Financial Management Degree - Case Study Example

I. In a takeover bid, a business may wish to adopt methods such as cash, loan or share exchange. Discuss the merits and demerits of each of these methods from the viewpoint of (a) the bidding business shareholders, and (b) the target business shareholders. A. Cash Cash purchase provides both advantages and disadvantages to both the bidding business shareholders and the target shareholders. From the perspective of the bidding business shareholders, its major advantage is the preservation of the level of control that they have prior to the acquisition. As the acquirer buys another company and pays cash to the target's shareholders, the bidding shareholders would be able to retain the same level of control in the company because their equity proportion is not diluted. To some shareholders, retaining the level of control over the whole entity after the target company has been acquired is one of the major considerations (McDougall & Chenhall). Another advantage of cash purchase to the bidding shareholders is that is is simple and straightforward. A cash offer would be more likely attractive to the target's shareholders especially when economic times are not so predictable, therefore the acquisition deal would prove to have higher success. A major disadvantage to the acquirer would be the huge sum of cash that it has to raise in order to fulfil the deal. While it is less likely for a company to raise such a huge amount of cash from its retained earnings, it is necessary for the company to raise it through other means, such as by incurring debt. The dilution of the capital structure of the company through higher debt, which affects its risk and credit rating, is a major disadvantage. If the company already has a high amount of debt, the acquirer's shareholders would find that the huge amount of debt to raise cash and pay for the acquisition would erode the company's credit rating, and would increase the risk of each share that they hold. From the point of view of the target's shareholders, the major advantage of cash purchase includes the opportunity to use the cash proceeds for a wider-ranging portfolio. Cash offers more security than other forms of payment, especially in volatile economic situations. However, the major disadvantage includes the capital gains tax that the target's shareholders would incur from the sale of the stocks. B. Shares exchange Another form of merger financing is shares exchange. Instead of paying cash, the acquiring company can issue more shares for the target's shareholders in exchange for the shares that they hold in the target company. From the point of view of the acquirer's shareholders, shares exchange is beneficial in such that the company would not have to be burdened to raise a huge amount of cash through other financing means such as debt, which could put pressure and increased risk on each of the shares they hold. The company's liquidity position would not be compromised in the process (McDougall & Chenhall). Shares exchange have been so attractive during the past decades because of its impact on the acquirer's price/earning ratio. If the target has a low p/e ratio, the acquirer can take advantage of it by issuing one share equivalent to more than one share of the target's. This can have a significant impact on the acquirer's own p/e ratio. However, one major disadvantage of shares exchange to the acquirer's shareholders is the dilution of equity due to the issue of more shares, which leads to the dilution of position and lower level of control over the company. With shares exchange, the target's shareholders will not incur capital gains tax because no immediate sale of shares has taken place. If the target's shareholders sell their new shares in the acquiring company, that is when they pay the capital gains tax. This is one of the advantages. Another advantage is that the target's shareholders will be able to maintain a position in the new combined entity. One disadvantage to the target's shareholders would be that, if the acquiring company fails to generate gain, the value of the stocks that they hold would be less than the value of the cash that they could have received instead. C. Other types of finance A merger can be financed not only by cash or shares exchange. There are also some alternatives which include debentures, loan stocks, convertibles, and preference shares (McDougall & Chenhall). While using these can be advantageous in that they offer more flexibility than cash and shares can provide, these types are rarely used by acquirers. From the point of view of the acquirer, these options would not provide good reasons, that is, it is difficult to establish a rate of return which could attract the target's shareholders into accepting the acquisition deal (McDougall & Chenhall). From the point of view of the target's shareholders, these options would have little advantages. Unlike shares exchange, the shareholders would have no voting right in the newly formed entity if these options are used for the deals. Because these securities are also less frequently traded, lack of marketability is also a disadvantage to the target's shareholders. II. The rationale of the portfolio theory is based on the notion of calculating risk returns trade off's of securities combined in a portfolio. Critically evaluate the merits and drawbacks of portfolio analysis as an approach to project appraisal. Portfolio theory is to analyse the company's portfolio in order to manage risk by diversification. In order for a company to manage risks, it has to look at the portfolio of industries where it plays, determine the relative beta which is a measure of the risk, determine the correlation of the company's returns and beta with those of the other portfolio, in such a way that in harsher times or the better times, the company would not face great trouble (Gressis, Philipatos, Hayya, 1976). This is the major advantage of the portfolio theory. When using it in project appraisal and capital budgeting, the risks and returns of a project can be easily gauged depending on its impact on the company's overall risks and returns. Since the finance function's aim is to maximise shareholder wealth, the company can protect its shareholder by incorporating portfolio analysis for every capital budgeting decision that it makes. By analysing a couple of projects to be undertaken and determining their risks in the form of beta and their covariances, the risks for the whole company is minimised. However, portfolio theory also has its limitations. One of the major limitations is that, since beta estimates are based on historical trends and data, it may not be a completely reliable estimate of the risks that the company can face when undertaking certain projects. Not only that, the standard deviation which is part of the portfolio equation. Also, the portfolio theory in project appraisal is used with scenario analysis in order to manage the risks and minimise losses during the harsher times. Because of this, the covariances between the risks and returns of the projects to be analysed are also based on statistical projections, which could change immediately depending on the external forces in the environment of the company. Another demerit of the portfolio theory is that the returns are based on the performances of firms as measured against the stock market. In cases where the project does not reflect the activities of a publicly listed firm, such as entrepreneurial ventures, the risks and returns are hard to estimate. Also, because data such as the beta and other measures of risks that are incorporated in the project appraisal with the portfolio theory are based on the performance of the companies may have different level of volatility than those of the project's, the firm would be toying with a lot of assumption (Gressis, Philipatos, Hayya ). This is another weakness of the portfolio theory. While the portfolio theory is helpful in order to assess projects, manage risks and spread it out especially during harsher economic climates, there are some limitations to the model as well. These demerits limit the ability of portfolio theory, and implies that the theory must be used not dogmatically in the case of project appraisal, but with caution and sensitivity to the data that is used as input for the model. III. Securities can be valued using a variety of methods including dividend growth model, earnings growth model, shareholder value added and market value added models. Compare and contrast these above mentioned methods. The logic behind the use of the dividend model in share valuations is in line with the financial concept of time value of money. The value of the stocks which is dependent on the future profitability of the company and ability to create value, is measured by the cash flows to investors. The time value of money states that there is an opportunity cost to holding money in the form of interests when investors place their money in the bank for a risk-free investment. Therefore, the cash flows derived from every investment, both in the present and in the future must be considered. Future cash flows, because of the time value of money, should be discounted in order to assess their net present values. Only with this, can the value of the investment be determined. These cash flows to investors come in the form of dividends. The dividends are then discounted depending on the required rate of return of investors. Because the cash flow that the investors would get from the stocks comes in the form of dividends, how much they expect the stocks to perform, at the least expectable level of return for them would determine the present value of the stocks. Therefore, the dividend growth model is a measure of the net present value of the company's stocks. The dividends growth model prices a share by dividing the expected dividend by the difference between the dividend growth model and the expected growth rate of the company. By computing this, the price of the stock is measured based on the expected future profitability of it as measured by the cash flow to the investors in the form of dividends (WallStreetModels.com). Another valuation method of shares is the earnings growth model. While it is partly the same as the dividend growth model that values the stock depending on its future profitability, the valuation is not based on the cash flows that investors receive, such as dividends. The valuation is based on the predicted earning of the company in the next couple of years (WallStreetModels.com). With the assumption that not all companies would be able to declare dividends soon, earnings growth model has been preferred by analysts as a valuation tool. The fact that some companies do not give dividends as well does not mean their stock prices cannot be measured. After all, dividends are part of the company's earnings which are distributed to shareholders. Even if there is no dividend paid to shareholders, the earnings growth rate could give a strong basis for the valuations. Market value added is computed by determining the market value of the firm's debt and equity and subtracting from it the value of invested capital (WallStreetModels.com). This market value of debt and equity are usually determined by the current market prices of these securities traded in financial markets. Invested capital is the sum of all the funds that are invested in the company. The concept behind this, is over some time, the market value of the firm through the perception that it has generated among the market in terms of its ability to create higher future earnings would be higher than its book value. Therefore, this difference is the added value. Investors use this valuation in order to see the firm's track record in creating wealth. The higher the market value added, the higher the wealth the firm has created for its shareholders. Unlike the dividend growth model and the earnings growth model, the market value added uses the market value instead of looking at the company's future earning potential. Shareholder value added, or another way to call economic value added is another valuation tool that is used to measure the economic profit of the company and measure the value of its securities. Shareholder value added is computed by subtracting the cost of capital from the after tax net operating profit (WallStreetModels.com). The cost of capital is computed by multiplying the invested capital by the weighted average cost of capital of the company. Using this, the economic profit which is added to the value of what the shareholders have invested in the company is looked into, in order to determine the value of the securities. Unlike the market value added, the shareholder value added uses the operating performance of the company instead of the market value in order to come up with valuation over the company's securities (Tasmanian Government). IV. An effective treasury management helps management helps improve and aid strategic management decisions of company's. Critically evaluate the role of the treasury department within a company. A. Financing One of the treasury department's tasks is to look into the financing options of the company (Philips). Because every financing need has to be addressed by different financing options, the treasurer has to make sure that the company considers the implications of every source of financing to the company's operations and financial position. Some of the areas that the treasurer should address include the amount of money that should be raised, the type of financing, the implications on the company's financial position, i.e. capital structure, and maintaining relationship with the entities in the financial community (Philips). As the company has both short-term and long-term needs, the treasurer should consider what are the most suitable sources of financing for all these needs. Because each has an impact on the company's financial position, may it be in liquidity, or credit rating, etc-the treasurer has to note that. Matching the cash needs to the sources of financing, the treasurer would know how much to borrow as well as the best instrument to use. For example, for short-term needs instead of borrowing for long-term, the treasurer can opt to establish a line of credit with a bank or consider arrangements in trade payables with suppliers. For long-term decisions, it would have a say on choosing between equity and debt, and the effect of the decision to choose one in fulfilment of the company's objectives. An effective treasury department, in order to avail of the most suitable types of financing, has to establish a good working relationship with other entities in the financial community such as shareholders, banks, investors, etc (Newman). B. Risk management Since businesses deal with uncertainty, every business is exposed to different kinds of risks. An effective treasury department must be able to manage these risks for every project that the company undertakes (Philips). Since the finance function is aimed to maximise shareholder wealth, when looking at returns, the company should be able to assess the level of risks as well and manage it. For most company these risks are classified into three types, which include business risks, interest rate risks, and currency risks. Business risks include risks that a company may incur either in its operations, its financial position, or anything about the business itself. This can be some credit risk in the case of defaults of customers, product risk in the case when some products fail to perform well in the market, or liquidity risks, which is the risk of running out of cash which could hamper its operations (Philips). Interest rate risks are risks associated with the company's borrowing. Since a company cannot entirely finance itself by equity, in most instances it is exposed to the risks of paying higher for the cost of capital that it employs (Philips). A sharp increase in the interest rates, which can be triggered by external forces in the environment of the company, can have a huge impact on the interest expenses of the company. Higher interest expenses mean lower net income. At the same time, because interest rates have an influence over the cost of capital the company employs, this can have some effect on the capital budgeting decisions. By looking at these risks, the treasury department can look for ways to come up with contingent plans that could minimise the risks. In the case of business risks, the treasurer can break down the risks and come up with individual plans to manage them. In the case of interest rate risks, the treasury department can protect the company's exposure through fixed interest rates agreements with banks and lenders, such for an example (Philips). Companies that do business outside their home countries are exposed to currency risks as well. The fluctuation in foreign exchange rates could have an impact on the company's incomes and expenses from its international operations. It can mean higher raw materials, if it imports them, or lower reflected revenues because of the higher exchange rates. Therefore, the treasury department can come up with strategies to combat it, such as hedging and coming up with options or derivatives in order to minimise this type of risk. C. Working capital and liquidity management Cash, or working capital as a whole is the life blood of the business. While capital budgeting decisions look at the long-term, working capital is crucial to the company's day to day operations. This includes ensuring timely payment to suppliers, management of collections, payment to employees, etc (Philips). Many companies, although profitable have collapsed because working capital was not managed properly (Newman). An effective treasury department must ensure that short-term cash needs are met, by planning in advance. Since a company's strategy is laid out in plans which include budgets, the treasury department has to ensure that these budgets are followed, and come up with contingency plans in case of emergencies. Working capital management includes management of cash, accounts receivable as well as inventory in order for the operations to run smoothly, and matching them with sources of cash through short-term bank loans, supplier credits, etc (Philips). Ensuring that budgets that reflect the plan and strategies of the company are followed, the treasury department plays a strategic role in the company's success. Works Cited Department of Treasury and Finance. "Shareholder Value Added." Tasmanian Government July 1999. July 20, 2009 McDougall, F. M. & R. H. Chenhall. "Shareholders and Share Exchange Takeover Offers." Abacus (December 1975): Vol.11 Issue 2, p. 122-135. Business Source Premier. July 20, 2009 Phillips, Aaron L. "Treasury Management: Job Responsibilities, Curricular Development, and Research Opportunities." FM: the Journal of the Financial Management Association (Autumn 1997): Vol. 26 Issue 3, p. 69-81. July 20, 2009 Read More