Wooden Post Ltd - Assignment Example

Wooden Post Ltd (WP) Wooden Post Ltd is a company that operates in growing but very competitive environment. Its entrance to the Stock Exchange will create even more responsibilities for its shareholders. However, the profit which usually follows similar financial decisions can be a persuasive argument for the participants of the scheme. In this context and in order to design a profitable strategy for Wooden Post Ltd using one of the proposed strategies, we should first refer to the company’s financial results at their current level. The intervention of data related with the new organizational environment will be a basis for alteration and influence on the final decision. However, the use of the data should be examined under the scope of their suitability for the achievement of the targeted result. Of course, as in every relevant financial decision, there will be the element of the risk. However, the analysis and the presentation of the given options using accurate and effective financial and accounting methods will ensure the limitation of the risk to the lowest possible level. To a next level, the comparative analysis of the strengths and the weaknesses of each method will provide to the company the necessary information for the final decision. We should notice that the final financial decision will be influenced by a series of variables. According to the study of Bernard J. and Leroy S. (2004, 6) one of the basic characteristics of an investment decision is ‘the existence of a negative and significant correlation among uncertainty, risk aversion, and productive investment’. The investment decision is also likely to be influenced from the views stated in an applied investment theory, like the efficient market hypothesis (EMH) or the modern portfolio theory (MPT). The first of these theories states that ‘the market price of a stock, or any other asset, already takes into account all the known information and reasonable expectations about the future’. On the other hand, modern portfolio theory is more connected with the risk (i.e. the ‘volatility of the price of a security over a period’) and is constructed from several other ‘risk-related’ theories the most important of which is the capital asset pricing model (CAPM). According to CAPM ‘the return on a stock comes from two sources, the rise in the market itself and the return of the stock compared to the market, known as beta’. This theory leads to the assumption that in order ‘to obtain above average returns’ the investor needs ‘to take above average risks’ (Calverley, 1995, 120, 124). Under the above conditions, the final financial decision will have to take into account not only the data referring to the application of the proposed methods in practice but also to the general consequences of each method to the public as viewed from the theories that have been created on specific data and empirical analysis. This can be explained by the fact that the financial processes may produce specific results however the latter are likely to change when applying in practice. On the other hand, the theories that have proved their value in practice are mostly connected with long-term results which are more likely to appear as shown by the evidence produced from their empirical examination. Moreover, according to Bernard (2004) the analysis of firms investment decisions traditionally refers to financial concepts, notably notions such as net present value or the investment payback period; Reducing the investment decision to simple discounting and/or to a comparison between an immediate disbursement and future earnings may, however, oversimplify a far more complex reality’ (Bernard et al., 2004, 1). A very common problem when designing a financial strategy is the specific method for handling the cases of risk and uncertainty that they are very likely to appear during the corporate life. Drury (2001, 222) distinguishes between risk and uncertainty and describes their elements in order to explain their existence and their role in the business activities. According to him risk ‘is applied to a situation where there are several possible outcomes and there is relevant past experience to enable statistical evidence to be produced fro predicting the possible outcomes’. On the other hand, uncertainty ‘exists where there are several possible outcomes, but there is little previous statistical evidence to enable the possible outcomes to be predicted’. When referring to Wooden Post Ltd, the above views can be used in order to evaluate the possibilities and the level of failure regarding the corporate financial strategy, in order for the corporate members to be ready for such a situation. The relevant ‘precaution’ should not be taken only regarding a specific business activity but it should be incorporated in the everyday commercial transactions not as an obligation but as a necessary measure of financial protection. Presentation and analysis of the proposed methods Option 1 – General description The specific option which involves the acquisition of assets of competitors has as main aim to help the increase of the company’s UK market share. The target company is London Counties which is the most ‘powerful’ competitor of the market, holding the 28% of the total market (Exhibit 1) in the industry (whereas Wooden Post ‘holds’ the 21.2% of the market). The above figures show that Wooden Post by acquiring London Counties could have under its control a very important part of its industry (the 49.2%) having an important difference from the next (in market position) company which would have the 10% of the market. From that point of view the acquisition of London Counties could be considered as an important one for the improvement of the company’s financial performance. However, the above assumption should also be examined using relevant financial processes in order to achieve a more secure result. The above presentation of the market share that will result from the acquisition of London Counties is not the only element that should be considered regarding the specific business decision. Other important issues are also the growth of the company (as it will follow in real terms) and the following reduce of risk (as it should normally follow the acquisition of the main competitor of the industry). These elements combined with the increased earnings per share and the strengthening of management will lead to a significant increase of the shareholders’ wealth. It has also been stated that ‘in order to determine how much to pay for the acquisition, several concepts need to be defined; These concepts include the Net Present Value of the acquisition, the purchase price, the market value, and what we will call synergies, or organizational benefits that result from a relationship between the acquired business and the existing business of providing electric distribution service’ (Fricke et al., 2001, 2) According to the above, when examining the particular elements of the specific acquisition we should pay attention to synergy, i.e. the additional value that could result from ‘joining’ the two firms. From a first point of view the specific factor should be characterized as ‘priority’ regarding the specific acquisition. However it seems that it is rather difficult to create a secure image of the final result mostly due to the existence of a lot of variables that can have a significant influence to it. Moreover, according to Chandler (1996) when referring to a successful acquisition ‘task environment similarity appears to be positively related to firm performance; the strongest effects are evidenced in terms of venture growth’. However, it is noticed that ‘it may not be necessary to have experience in a highly similar business to gain familiarity with the task environment’ (Chandler, 1996, 75). Furthermore, it can be assumed that at a first level, the acquisition price could get higher from the price agreed between the parties. This can be the result of the market’s turbulences but also of the poor managerial planning regarding the specific acquisition. In these terms and in order to avoid similar situations we should proceed of a detailed examination of the companies involved in order to formulate secure assumptions (to the best possible level) regarding the specific business decision. Towards this direction, Damodaran A. (2001) created a diagram which presents the components of the acquisition price as can be viewed from the financial analysis aspect. This diagram is been exhibited in Figure 1.1 Figure 1.1 Components of the acquisition price (Damodaran, 2001, 837) Acquisition price of target firm ↕ Acquisition premium ↑ Goodwill ↓ Market price of target firm prior to acquisition ↕ Book value of equity Book value of equity of target firm Option 2 This option is mainly characterized by the upgrading of the company’s production capacity and distribution capacity in areas belonging to the west and east of United Kingdom. Under these terms, in order to achieve the targeted results, the company should acquire and develop knowledge related with its competitors. However, it seems that such kind of knowledge cannot be used without specific strategy. In this context, it has been stated that ‘for competitive intelligence to be used effectively, it must feed into a systems strategic planning; Competitor intelligence is needed to acquire foreknowledge of existing competitors and to predict future competitors’ (Luecal et al., 1995, 2). The success of such an initiative can be supported by the fact that the creation of a new and ‘strong’ company will put limits to the activities of competitors. According to Mirvis (1992) ‘mergers and acquisitions (M&A) are premised on the belief that the combined company will have greater value than the two companies alone; This added value - expressed as "synergy" between the firms- can be presented using as a ‘theory’ ‘where 1 + 1 |is greater than~ 2’. It is stated however that when controlling the merger planning and preparation most of the emphasis is on the numeric elements in the formula; less consideration is given to the complicated and elusive factor "+." (Mirvis et al., 1992, 69). Another possible solution is activity based costing (ABC). Kaplan and Cooper reiterate that ‘Activity based costing is not designed to trigger automatic decisions. It is designed to provide more accurate information about production and support activities and product costs so that management can focus its attention on the products and processes with the most leverage for increasing profits. It helps managers make better decisions about product design, pricing, marketing, and mix, and encourages continual operating improvements’ (Barnes, 1992, 18) Moreover, it is stated that ‘activity based costing’ approach (ABC) allows managers to vary the underlying activity drivers in business processes in order to study the impact of different levels in the process itself; Managers have the potential to learn much more about investment risks when they study the uncertainties in the business processes, rather than the traditional overview approach’ (Cook, 2000, 305) Option 3 According to this option, the company can decide to close its brands in the west of the UK. In terms of financial returns, this initiative can accumulate a significant monetary amount for the company. Although this option seems a rather effective solution, it is however connected with a relatively high risk of failure in case that the general image of the company is not positive (at least to the desired level). In the specific case it seems that such a decision may create severe problems to the company, as the latter faces difficulties to keep its performance to stable levels. In this case, the closure of the existing brands in a whole area can create the conditions of its general stop of working. Ballou (2004) examined the particular issue of auditing and of the client’s rights. In response ‘to criticism of traditional audits, public accounting firms have developed audit approaches focused on improving auditors understanding of client businesses and business risks at a global level’. Furthermore, ‘research regarding these audit approaches, termed strategic-systems auditing (SSA) by Bell et al. (1997), suggests that under certain conditions, SSA might lead to greater audit effectiveness and efficiency’ (Ballou et al., 2004, 71) Comparative analysis of the above three proposed projects The above mentioned projects can be analyzed using specific financial processes, like the payback and the net present value, as the two methods of financial measuring are presented below. A. Payback 1. Project A Cash flows 30* 74 70 73 76 79 85 91 97 103 109 0 1 2 3 4 5 6 7 8 9 10 │ │ │ │ │ │ │ │ │ │ │ * in million pounds 2. Project B Cash Flows 20* 16.6 16.6 16.6 31.6 46.6 61.6 76.6 91.6 106.6 121.6 0 1 2 3 4 5 6 7 8 9 10 │ │ │ │ │ │ │ │ │ │ │ * in million pounds 3. Project C 20* 30.4 40.8 51.2 0 1 2 3 │ │ │ │ │ │ │ │ │ │ │ From the above it is obvious that the 3rd project seems to be the most ‘productive’ in terms of profits made by the end of year 3 (of ₤51.2m). However, this project does not include provision for profits referred to its forwarded years (after the 3rhd year). On the other hand, the second project presents a high profitability (of up to 121.6 in the 10th year, whereas the first project has a ₤109m profit). As of the first project, this ‘produces’ ₤109m at the end of 10th year. These figures show that the project that should be chosen as most appropriate according to the payback method of financial analysis should be the second one. B. NPV 1. Project A NPV = (PV1 + PV2 + PV3 + PV) – initial investment = (74/0.10+70/0.10+73/0.10+76/0.10+79/0.10+85/0.10+91/0.10+ 97/0.10+103/0.10+109/0.10)-30= 740+700+730+760+790+850+910+970+1030+1090=8570-30=8540 2. Project B NPV = (PV1 + PV2 + PV3 + PV) – initial investment = (16.6/0.10+16.6/0.10+16.6/0.10+31.6/0.10+46.6/0.10+61.6/0.10+76.6/0.10+91.6/0.10 +106.6/0.10+121.6/0.10)-20 = (166+166+166+316+460+616+766+916+1066+1216)-20= 5854-20=5834 3. Project C NPV = (PV1 + PV2 + PV3 + PV) – initial investment = (30.4/0.10+40.8/0.10+51.2/0.10) – 20 = (304+408+512) – 20 = 1916 Although according with the payback period the project the most profitable for the company is the second one, it seems that when using the NPV method, the results present a significant differentiation. More specifically, regarding the results of this method the most appropriate project (in terms of profit produced) is the first one (with a NPV of 8540). At this point it should be noticed that the design and the monitoring of the financial decisions in any corporate environment should be made under the influence of the internal and external factors as well as the personal views of the person who has the responsibility for their application. As Hubbard (1995) states, ‘the "free cash flow" models of Jensen (1986) and others have suggested that observed links between investment spending and internal finance could reflect managers decisions to ignore signals from market valuation in favor of overinvestment in growth; Hence, a finding of a positive correlation between investment and cash flow need not be construed as evidence in favor of financing constraints’. Moreover, it seems that there is ‘very little empirical work that can be used to discriminate between the free cash flow hypothesis and the financing constraints hypothesis, even though both hypotheses start from a presumption that information and incentive problems are important’ (Hubbard, 1995, 684). Regarding the above, the first assumption made is that the final choice for the specific financial method that is going to be used in an organizational context belongs to the strategic management team. However, this decision is not out of control and each of the particular elements should be analytically explained and presented in order for all the participants to have knowledge on the strategy that is going to be applied. The above procedure although seems simple, is in real terms rather complicated since there are a lot of variables that can influence the development of the effort. Moreover, the structure of a given company tends to change in accordance with the aims of the particular corporation but also the aims of the company for the future. In the presentation above we can notice that the two methods, the NPV and the payback tend to give the superiority to different projects but when examining more analytically the methods and the theories used we can verify the credibility of NPV whereas net present value involves to more specific measures which can provide high protection for the participants. It’s for this reason that the result – and the indicator – given by the NPV should be preferred from that of payback period although the latter by its nature refers to less analytical business data. References Asano, H. 2002. Costly Reversible Investment with Fixed Costs: An Empirical Study. Journal of Business & Economic Statistics, 20(2): 227-241. Ballou, B., Earley, C. E., Rich, J. S. 2004. The Impact of Strategic-Positioning Information on Auditor Judgments about Business-Process Performance. Auditing: A Journal of Practice & Theory, 23(2): 71-241 Bernard J., Leroy S., (2004), Managers and Productive Investment Decisions: The Impact of Uncertainty and Risk Aversion, Journal of Small Business Management, 42(1):1-15 Calverley, J. Guide to Economics of the Global Investor, London, Probus Publishing Company, first edition, 1995 Chandler, G.N. 1996. Business Similarity as a Moderator of the Relationship between Pre-Ownership Experience and Venture Performance. Entrepreneurship: Theory and Practice, 20(3): 51-80 Coburn, S., Cook, T. J., Grove, H. D. 2000. ABC Process-Based Capital Budgeting. Journal of Managerial Issues, 12(3): 305-318 Dahl, P., Luecal, S. 1995. Gathering Competitive Intelligence. Management Quarterly, 36(3): 2-13 Damodaran, A., Corporate Finance – Theory and Practice, New York, Jon Wiley & Sons, Inc., second edition, 2001 Drury, C. Management Accounting for Business Decisions, London, Thomson Learning, second edition, 2001 Fricke, D., Luecal, S. 2001. Assessing the Value of a Strategic Acquisition. Management Quarterly, 42(4): 2-16 Hubbard, R.G., Kashyap, A.K., Whited, T.M. 1995. Internal Finance and Firm Investment. Journal of Money, Credit & Banking, 27(3): 683-700 Marks, M. L., Mirvis, P. H. 1992. The Human Side of Merger Planning: Assessing and Analyzing "Fit". Human Resource Planning, 15(3): 69-94 Read More