Techniques Used to Aid in Deciding the Best Corporate Funding Options - Assignment Example

Financial Management Analysis By Techniques used to aid in analyzing and deciding the best corporate funding options.  Before embarking on sourcing for money to fund a project, a corporation like Biz Systems Consultants Ltd needs to look into the different types of finance in relation to the following underlying facts. They include; The required amount of capital – some sources of capital may fail to facilitate huge chunks of money while some other sources of money may fail to offer the flexibility that comes with facilitating small amounts of capital. In the case, the owners of Biz Systems Consultants Ltd need to look for sources of money that will facilitate the 1,700,000 Euros they need for expansion Their urgency to get the capital required – the more time a company spends while trying to come up with the capital required, the lesser the cost incurred by the company. It would however, have to incur a higher cost if it needed the money very quickly. In the case, the owners of Biz Systems Consultants Ltd need to embrace the likelihood of incurring a higher cost to get the funds needed The least expensive option – the company should determine the cost of finance in regards to the amount of money it will need to part with in order to secure the amount requested. The company has to decrease the typical cost (interest) by looking for a source of money that offers the least interest rate on the borrowed amount. The level of risk involved in the investment project – in the case of mutually exclusive projects, the company has to evaluate the projects to determine the project with the best chance of leading to a profit. The owners of Biz Systems Consultants Ltd need to realize that their potential sources of finance will require some sort of guarantee that their return on investment. They are likely not to lend money to higher risk business projects. How long the company needs the capital - a serious company should identify whether the capital required is for a long or short-term project. Biz Systems Consultants Ltd has a project that is both long and short term and therefore the project management team needs to decide the sources of finance that will be most appropriate for their project. (Crundwell,2008). Principles for analyzing corporate funding options. The process of determining the viability of an investment is called Capital budgeting. There are three popular decision making techniques: The first one is the Net Present Value, the second one is the internal rate of return and lastly, the payback Period technique. There however are, variations of these three most popular bring rise to the existence many lesser-used techniques. A company like Biz Systems Consultants Ltd has several projects and should measure each ones potential in relation to these three principles in order to make a comparison and choose the best project to undertake. 1. Internal rate of return. This technique is very user-friendly principle to follow. It is therefore the most commonly used technique. The company is more likely to use this principle because it is easy. It measures the returns a company will receive over the period of investment. We calculate (IRR) using the discount rate whereby Net Present Value is equivalent to zero. That is, to solve for r, we set NPV equals to 0. ‘r’ is represents a rate that equates the cash flow’s present value to the initial investment. Unfortunately, in most projects there is no easy way to arrive at ‘r’ without using a “guess and check” tactic. IRR is a rate mostly put in percentage in a similar manner to interest rate. We use it in the comparison of capital investment in relation to other different forms of investment. We find the ratio between the expected profit and the expected expenditure, arriving at a percentage of returns. To find out whether the project is acceptable or not, the owners of the company consider the following: Every project that incorporates the use of internal funds has a cost of capital. To determine whether to take up the project or not, we compare the cost of capital to IRR. Supposing the rate the project earns is more than the rate it costs us, the project is viable because it adds to corporate value. If the project earns the company less than what it cost us, then the project is a liability to the corporate, and should not undertaken (Moyer, Mcguigan, & Kretlow 2009). Among the shortcomings of this IRR principle that; This decision criterion works only when we have ordinary cash flows, that is, when we have net outflows early in the project and net inflows afterwards. If the company uses IRR with irregular cash flows, the results may be unusual, or sometimes multiple Secondly, it is more difficult than Net Present Value to get to by use of hands because we are calculating a rate of return. Our calculators or spreadsheets can only calculate one rate at a time for the interest rate. Therefore, for one to calculate, one should take iterations where one tries one interest rate at a time, (trial and error) see if the rate is too high or too low to reach at the results. IRR also fails to rank the mutually exclusive projects, properly. Due to these reasons, NPV is preferred to the IRR criteria, or is at least used to “double check” IRR’s credibility. 2. Net Present Value This technique puts together two value concepts. To begin with, it determines the cash flow from of the investment, and then compares that cash flow against the initial investment. Since these flows occur over some time or period, and mostly the investment does not pay off immediately, we also put into account the capital’s present value and future value. Money earned in todays Euros is worth more than the same amount in future, because of inflation. The NPV technique therefore, gets all of those cash inflows and outflows over that period, while considering both foreign exchange rates and inflation rates, while also expressing how the company is going to benefit eventually in terms of todays Euros. In order to find the net present value, the user of this technique has to discount all of the cash flows for an investment over the period of investment, adding inflows and subtracting outflows. More NPV translates into more financial value the project added to our company by the project undertaken; Net Present Value gives the project managers prospective amount of value that the project will add to the company. The owners of Biz Systems Consultants Ltd should accept projects that have a positive NPV and reject those with negative NPVs because they destroy value. Companies generally regard NPV as the best criterion for evaluating projects because it considers the time value of money. This technique discounts cash flows using the discount rate (firm’s rate of capital (r) or required return). This rate is the minimum return a project must earn to have the firm’s market value remain the same. Supposing the funds are unlimited then the owners of the company can accept any project with a positive NPV. In the case of Biz Systems Consultants Ltd we have mutually exclusive projects. Therefore, the project managers ought to select the project with the highest NPV or the least negative, if they need to pick one and they are all below zero (Heldman,2006). Shortfalls of NPV NPV is somewhat more demanding than payback period, thus it might be more complex to explain to others who are not as well familiar to concepts in finance. To use NPV the users needs a discount rate; if one does not have an accurate way to gauge of the cost of capital, it can be hard to calculate an NPV. 3. Payback Period This decision-making technique might be a very intuitive and very easy to calculate, but it might not tell the whole story. Payback period is very popular because it’s easy to explain and quick to calculate, but it is not always appropriate. It can also lead to the rejection of some viable long-term projects that add value. Therefore, companies will often use payback period on projects requiring smaller investments (where there is less risk). Payback period refers to the time between the initial investment and the recovery of the capital invested. The payback period shows the project manager how long it will take to recover the money invested into a project. For instance, the payback period is one, if it takes a year to make back the investment from revenues from the new project. However, I would not advice the owners of Biz Systems Consultants Ltd to use this principle because of the following Shortfalls; It does not consider the time value of money. The principle tends to oppose those projects that build momentum and have the ability to produce cash inflows over a long period. 4. Multiple Techniques In addition to the three most common principles discussed above, the company can also use the multiple techniques to supplement their capital budgeting decisions. There are several of minor methods, including sensitivity analysis and profitability index, which can assist the project managers at Biz Systems Consultants Ltd can in decision-making. Considering each technique looks into investment from a completely new perspective altogether, it is advisable to use multiple analyses and develop the project with the most promising returns after evaluating them using all the techniques (Longenecker, 2012). Factors for deciding corporate funding options. When a company is in the process of making decisions on matters finance, there are many choices to choose from when it comes to ways of seeking funds. There are also many lenders and investors from which to choose. Sources of funds come in two forms including debt or investment. There is a significant difference between the two. Key factors to put into account while choosing the ways of funding business projects are; a. Terms of Repayment The company should take into account the length of the financing arrangement. Longer loans can translate into significant amount of interest with time, while on the other hand, loans with shorter terms require larger periodic payments. The company management ought to consider the amount of the periodic payment requested by the lender. The owners of the company should also consider how often the company should make payments. The company should also consider the incorporation of principal and interest in each payment and look for sources that provide the highest allocation to principal in an effort to cut cost in total long-term. b. Fee and Interest Structures Before making a decision, the company needs to sum up all of the costs that come with every method of financing. Some costs for loans that are likely to pop up include interest rates and brokers fees. Different costs also come with seeking funds through investment. For instance, capital sourced from venture capitalists may not necessarily demand repayment in a number of years but the venture capitalist may demand repayment eventually at a very high premium at a go. Using stock offerings to source for capital has the ramification of change of the company’s strategic focus. c. Financing Requirements It is important for the company to take into account the personal requirements every lender and investor places on the company. The company should seek funds for the project from sources whose requirements the company can meet in full. Some financing requirements investors have include certain financial ratio tests like debt-to-equity ratio and credit score requirements. The top management at Biz Systems Consultants Ltd needs to make sure they can meet the requirements by every potential lender before taking the money from them. d. Additional Requirements If the owners of the company opt to finance their business projects through investment, they need to look into all the ramifications of their decision before going ahead. Venture capitalists mostly ask to take ownership stake in the company, expecting the company to buy it back at a premium past the period of rapid growth. Before the company buys the ownership stake back, however, the investor could have asserted huge influence on strategic and managerial decisions. Selling shares of stock to acquire funds for a project has its own set of important considerations, which include the possibility of future loss of managerial control or falling victim to a hostile takeover from a bigger company. Raising the 1,700,000: The three sources. 1. Debt capital To raise the 1,700,000 Euros needed for expansion, the company may borrow funds (debt capital) to fund its ongoing business operations or in the case of Biz Systems Consultants Ltd ,fund future growth. There are several forms of debt, for example, bank loans, or bonds issued to the public and notes payable. Biz Systems Consultants Ltd can borrowing from banks for a short term or medium-term. The company need a lot of money so short term borrowing may not be a good option. However, if the bank can grant the company a significant overdraft, then it can take a short-term loan to fund its expansion. A medium-term loan is appropriate because the loan is due for payment in three to ten years. This amount of time is sufficient for the company to finish its expansion and get returns from it, returns that are sufficient to facilitate the payment of the loan in full. The interest rate places on the company’s medium-term loan will be a set in accordance to the company’s credit standing or willingness to take the risk. In this case, the company looks decided on carrying on with the project, having set their most favourable interest rate at fixed rate of interest of 5%. The company can also purchase a bond that requires it to pay in regular amounts until the debt’s maturity date. 2. Ordinary (equity) shares, Equity capital and Preferred stock Owners of a company can decide to buy shares of the company, or sell the company shares to selected people or the public. If the company does not yet have shares to sell yet, it the owners can enlist it in the UK stock exchange and open an initial public offer for the public to buy shares in the company. When it comes to quoted companys shares, the market value of the shares is in no way related to the company’s real value. Ordinary shareholders can assist in funding the operations of the company through issuing new company shares to the public or investors, and by retaining profits. By withholding profits rather than paying them off as dividends to the shareholders, the company acquires a simple, efficient and cost effective source of funds. These funds can only supplement the fund got from other sources because they are not enough to finance the whole expansion project. Alternatively, the company can sell the company shares to investors to source funding. Investors, or shareholders, anticipate an upward trend in value of the company with the expansion of operations over time. If successful, the company projects will make their investment a profitable purchase because there will be more business for the company and hence more profits. Shareholder value increases when the company invests additional funds into projects that translate into more profits for the company. Investors or lenders would prefer to purchase shares of companies that promise a constant raise in the value of their shares going forward. This will in turn increase the company’s market value of the stock. It will be like killing two birds in one stone because the company will garner funds for successful completion of its projects while also increasing its attractiveness to investors. The company may also offer preferred stock is an equity security, that is a merger of the two discussed above. 3. Loan stock The company raise its long-term debt capital, and pay interest at a fixed rate, half yearly. This way, we consider those who hold the loan stock as the company’s long-term creditors. The debt owed by the company is the ‘face’ value of the Loan stock, and the coupon yield given on the amount, used to determine the interest paid. The company owners can choose to have debentures that have a floating rate of interest. With these types of debenture, t he issuer has the ability to change the coupon rate of interest, with respect to the discrepancies in market interest rates. Volatile rates of interest are, very compelling to investors and companies seeking funds a as well. Therefore, in the case of Biz Systems Consultants Ltd, loan stock and debentures are a good source of funding by the company. In terms of security, there are two ways of securing them; a) Fixed charge; Collateral for funds comes in form of tangible assets owned by the company. In case of default in payment, the lender has the permission to take ownership of any land or buildings or other physical assets owned by the company. The company is under no obligation to transfer ownership of its assets to a third party, up until all payment is made to the lender. The company can also not substitute the agreed collateral with other assets. b) Floating charge; Here, the collateral given to the lender is in form of assets of the company that are not necessarily physical. These assets include stocks and ownership of the company. The company is however free to dispose of its assets as it wishes until when they fail to pay the lenders. If there is a default in payment, the lender will most probably employ their own manager to take control the company as provided by the law compared to laying claim to a specific asset. These are the dangers that accompany the decision to raise funds through loan stock. The redemption of loan stock We redeem Debentures and Loan stocks immediately after the elapse of time issued. Ten years is the least amount of time issued and this period can stretch beyond twenty years all the way to thirty years. The redemption rate is normally equal or above the starting value. Most stocks feature the closest and furthest dates of redemption. Two major factors influence a company’s decision on what date to redeem the debenture or loan stocks (Clayman, Fridson, & Troughton, 2012). The company might not comfortably borrow additional funds to settle a maturing debt. The company ought to ensure one vital aspect works in its favour. This aspect is the date when current loans are scheduled for repayment on its balance sheet. Investors look into financial statements of companies in order to establish the amount of funds the company requires to complete the project, and when to facilitate these funds. An example of secured loan is mortgages. The company offer its title deed to a bank or lease its land to another company in order to receive money to fund its project up until a specific period. As far as Biz Systems Consultants Ltd is concerned, debt capital is a viable source to acquire funds for the project. It has great potential to generate a reasonable amount of funds because the interest charges on the profits reduce the amount of profits that can be charged corporation tax. References Moyer, R. C., Mcguigan, J. R., & Kretlow, W. J. (2009). Contemporary financial management. Mason, OH, South-Western/Cengage Learning. Heldman, K. (2006). Project Management JumpStartTM. Hoboken, John Wiley & Sons. http://www.123library.org/book_details/?id=11824. Crundwell, F. K. (2008). Finance for engineers evaluation and funding of capital projects. London, Springer. http://site.ebrary.com/id/10223434. Clayman, M. R., Fridson, M. S., & Troughton, G. H. (2012). Corporate finance: a practical approach. Hoboken, N.J., John Wiley & Sons. Longenecker, J. G. (2012). Small business management: launching and growing entrepreneurial ventures. Mason, OH, South-Western Cengage Learning. Read More