Financial Management: Rolls Royce Company - Essay Example

? Financial Management [Supervisor Financial Management Introduction United Kingdom based, listed on London Stock Exchange the global business Company Rolls Royce works by providing interconnected systems of power to be used on sea, air, and land. In the year 1884, Rolls Royce was founded. The headquarter of the company is in London, United Kingdom. The company is operating worldwide since its existence and it is involved in developing, and manufacturing of civil aerospace, marine aerospace, defence products, Nuclear products, energy products and operates in 50 countries. It has been one of the most reliable, trust-worthy, and reputable companies in the industry it operates. Rolls Royce has chosen for the evaluation requirement of this report. (Rolls Royce 2012). Part 1: Capital Asset Pricing Model (CAPM] The Capital Asset Pricing Model has been developed to generate estimation over the capital assets of an organization. The model assists in evaluating asset’s generation of annual returns, and makes it possible for organizations to calculate the rate of return of an asset by incorporating non-diversifiable risk. The risk is usually a systematic risk or market risk, represented in terms of ? (beta) and the rate of return of asset when no risk is associated to asset. Capital asset pricing model therefore helps organization to maintain their portfolio of assets. There are two general concepts on which the model CAPM is based including the estimation of risk associated and time value of money to be invested (Amenc and Le Sourd 2003). The time value of money provides a way of estimating the value of money invested today for a specific period of time and it thus compensates the investors for holding their funds in any investment for that period. This concept is represented by the risk return that investors can expect and it is denoted as rf rate in the formula. The later part of the CAPM formula provided below is related to the determining level of compensation that investors would require from their investment in light of the risk they face. This is the represented by a risk measure known as beta (?) which actually compares the return expected from an assets with that from a market portfolio and also with market premium that is the difference between return on market and risk free rate (Rm-rf) (Pratt and Grabowski 2010). Valuation with the capital asset pricing model uses a variation of discounted cash flows, organisation use a varying discount rate that instead of giving organisation a "margin of safety" by being conservative in organisation earnings estimates, gets bigger to compensate for organisation investment's riskiness. There are different ways to measure risk; the CAPM defined risk in terms of volatility, as measured by the investment's beta coefficient (Apostolou and Apostolou 2005). Formula: Ri = Rf + ? (Rm-Rf) Ri = expected return on capital asset/ cost of capital Rf = risk free rate of return Rm = market rate of return ? = the sensitivity of the expected higher asset returns to the expected excess market returns (Pratt and Grabowski 2010). Limitation of Capital Asset Pricing Model The changes in the market based on past trends, cyclic variations and random variations that can help in estimating future possible changes in the market and risk associated to those changes but actual changes/swings in the market has seen to be quite different from that assumed one. This would lead to a change in the value of non-diversifiable risk and the whole computation of cost of capital. Capital asset pricing model does not provide any space for the fluctuations in these risks (Brigham and Houston 2009). It is assumed by the model that organization exists in a perfect market with no variations. However, in real, no such perfect market exists anywhere, perfect markets are the ideal markets, and pure from risk factors that is why assumptions and rates, which are being used in the calculations are only estimates and do not generate absolute results. Sometimes, it possible to use risk free rates for lending and borrowings; contracts may contain numerous covenants as well; this aspect of trading is not dealt under Capital asset pricing model. Capital asset pricing model is best suited for those organizations, which have a diversified range of assts; the organizations having similar natured assets are not recommended to use this model, this applies a doubt on the universality of model (Brigham and Ehrhardt 2001). It is presumed that the historic patterns of flow of benefit will continue to be the same in the future as well. This is not practically applicable on the assets as the indexes change significantly (Brigham and Ehrhardt 2001). Another assumption applied by the model is that all the stakeholders and investors have access to same information and agree about all the risk identified and returns of assets. This model does not explain the variations in the stock clearly and the factors that can cause a stock to vary. It is generally seen that low beta stock generate higher returns in the market, this somehow weakens the application of the model (Apostolou and Apostolou 2005). Generally, investors and shareholders, before investing and engaging their money make it sure that the investment is reliably secure with low risks. Lower risk will generate lower returns, but conversely management always want organization to grow and generate all possible maximum returns for shareholders and maximum returns demand high-risk engagements. This way it contradicts to shareholders expectations (Brealey 2007). An ideal portfolio includes in it all types of assets that are held by the entity; this includes works of arts, human capital, and real estate and internally generated intangible assets. In practice, such a market portfolio is unobservable. Substitution of such assets in the portfolio and application of capital asset pricing model over it is noxious and can lead to false validity of the model that is the reason capital asset pricing model is empirically not testable (Brigham and Daves 2009). Dividend Valuation Model (DVM): It is regarded as one of the efficient methods being used for the valuation of price of a stock by making use of estimated dividends and discounting them back to the present value. The core idea is that if the value obtained from the Dividend Valuation Model is higher than what the shares are currently trading at, then the stock is undervalued from their actual worth (Brigham and Daves 2009). This model does not work for companies that do not pay out dividends. Formula: P = D1/ (r-g) P = current stock price D1 = value of next year’s dividend r = constant cost of equity of organization g = rate of growth (Hirt and Block 2009) Limitation of Dividend Valuation Model: The applied/ assumed growth rate can over or under valued, variation in the growth rate are ignored, this on the other side means that company is not going to improve its performance in the future and will be moving with constant flows for ever (Brigham and Daves 2009). All of the dividends and prices used in the model are the investor's estimates and assumptions of the future based on the historic trends. The model assumes investors act rationally and take their decisions about share transactions based on financial evaluation. However, there could be other decision influencing reasons as well. The same case is with the cost of capital which is taken to be constant for every period, variation in the cost of capital can also effect the whole calculated and budgeted/ expected performance. If in a year the organization does not currently pay a dividend, like many growing organization do with a vision of reinvestment and business expansion, then more general and improved versions of the discounted dividend model must be used to value the stock. No external or internal environmental factors are considered and the effect of PESTLE (political, economical, sociological, technological, legal, and ecological) is ignored (Brealey 2007). The prices generated through this model are hyper- sensitive to the growth rate g. Inputs are very subjective and can result in adverse results. It is highly sensitive to all the inputs applied (Brigham and Houston 2009). Estimation of ? Beta can be calculated using the prescribed formula: ? = Ri – Rf/ Rm – Rf Ri = return on capital asset = Net income/ Total Assets Rm = market return Rf = risk free return Ri = ?848/ ?16423= 5.1% Rm = 11% Rf = 4.9% ? = (5.1-4.9) / (11-4.9) ? = 0.26/6.1 ?= 0.043 (Rolls-Royce, 2011) The value of beta is lower than one (1) and according to the above instructions, the assets of Rolls Royce are generation lower returns than the market returns other companies of the same industry are generating. It is earning only 0.043 returns and the figure is very sensitive. Measures should be taken to improve the returns earned. Estimation of Price using CAPM: Formula: Expected return = dividend paid+ capital gain/ stock price Expected return= 11% Dividend paid = 17.5p Capital gain = p1-p0/p0 = 845-840.5/840.5 = 0.0053 0.11=0.175+0.0053/stock price Stock price = ?1.64 (Rolls-Royce, 2011) Estimation of Price using DVM: P = D1/ (r-g) P = price D1 = D0 (1+g) r = 11% g = 7% P = 0.175(1+0.0938)/(0.11-0.0938) P= 0.191415/0.01615 P= 11.85p The value of dividend for the period is 11.85p where the actual share price of Rolls Royce in 2010 December was 9p (Financial Times 2012). Reasons for Differences There could be numerous reasons for the differences in the share prices of Rolls Royce and the market such as: The difference can be the result of demand and supply mechanisms, underlying demands can cause the price to reduce It can be assumed that quality of the product might have reduced and would have affected the price. There can be some global reasons for the reduction in prices such as the global crises that the whole world is going through. The estimations applied in the calculation can also impact the results as estimations are expected to vary from the actual results and cause variances. Management’s under standard performances and low sales can also hit the share price of company (Rolls Royce 2010). Part 2 The global recession generally termed as Great Recession has created a strain in the markets worldwide. It had affected small companies heavily but large corporations like blue chip companies and wealthy businesspersons had the minimal effect of the recession, and hence were the first to recover. Being a high profile company, Rolls Royce is one of the tycoons that have recovered and reached stability now. Company is planning for a business expansion in China, there would be some advantages of moving towards China, labour costs will get reduce and usage of energy in the production will be less then ordinarily. The quality and reliability of the products manufactured will be getting a question mark over them. As the industry is a pharmaceutical, intense care should be provided and it has to make sure that consumer can rely on the quality, as this decision is based upon an objective, that objective and the core matrix of this expansion plan is to increase shareholder’s confidence by diversifying the risk. Diversification of risk is one of the most popular methods to reduce the chances of occurrence of risk. This technique has a simple logic that the investment should not be made and the money should not be bounded in a single project, but multiple combinations should be made. Company’s Strategy While formulating a strategy to expand into China, company must include the following analysis, the analysis of the macro environment, which would include the: Political situation: stability in and decision making power of the government, how strongly government can influence the industry, how can political personalities can effect business, how much secure the business will be in that country. Ecological situations: what are the laws and regulations about the environmental sustainability, how much that country will be affected ecologically by this expansion plan, what could be the fines and penalties. Sociological issues and problems: up to what extent this expansion will affect the people living in China, their life styles. Economical conditions: how can expansion plan affect the economic conditions of China, what would be its effects on the GDP of China and earning per capita? Technological status: how China’s existing technology can help Rolls Royce to in the manufacturing and day-to-day proceedings, reaching its desired destination. Is the technology sound? Or it should be outsourced? Legal/ regulatory situation: what regulations are present there in China, regulations relating to health and safety, company act, corporate social responsibility, environmental management accounting, sustainability reporting etc? After considering these external factors, some inter organization factors are to be satisfied as well, that can be: Initial required investment levels: the amount of capital that is required to be invested for the expansion is monitored, its availability and composition (owner investment and borrowings) is then analysed. Required returns: the pay back periods are calculated here and the over all profitability of expansion is monitored. Required human capital, Staff capacity and capability: the strength and capacity of the staff required must be present there in China or else, should be out sourced, the cost of outsourcings and the limitations of outsourcing are also kept under consideration Shareholder’s satisfaction: overall objectives of many organizations are to provide a good product to its ultimate users and satisfy shareholders with good returns, keeping a major focus on maximizations of shareholder’s wealth. Resources: Availability of the resources is to be checked that all the resources, which company uses in manufacturing, such as, water, material, labour and supporting components. A plan to access to these resources is developed. Other related functional costs: other functional costs like, delivery, supply, holding and other related costs are identified and control over their drivers is planned. Potential challenges As discussed above, there would be some difficulties that Rolls Royce will be facing while expanding business in China The very first issue that would come across is the knowledge of laws and regulations of China and their compliance criteria. The standard of the qualification, education, and experience of the staff required there in China should harmonize with the existing staff of Rolls Royce worldwide. The foreign exchange rates and the worth of currency of China should also be taken under consideration, while evaluating the currency growth of China. The biggest potential problem with China is that, it has a pool of other environmental problems. Problems like, acid rain, serious soil erosion, deforestation, silted reservoirs, and growing carbon dioxide and sulphur-dioxide emissions. In addition, it is very frequently building dozens of coal-fired power plants that will increase carbon dioxide emission and make situation worst. There are some growing legal and social issues capturing China day-by-day, issues like growing corruption, at the level of government corruption is intensely increasing and decisions taken by government organizations are based on reasons other than merit, there is misallocation of resources as well. The following points are related to some of the major issues relating to China that are recommended through this report to be focused before any decision-making. Role of Managers The role of management is a vital role with respect to organizations. Managers manage the organization in the direction provided by the directors. There are numerous roles that a manager plays in an organization - one of those key roles is diversifying risk faced by the organization. Diversification of risk is possible in following ways: Organization’s portfolio should be spread among many different investment vectors such as cash, stocks, bonds, mutual funds, and perhaps even some real estate. Organization’s portfolio should be spread over several investment vectors which may include cash, stocks, bonds, mutual funds, and perhaps even some real estate. Organization’s securities should have varied risks. Considering various investments with varying rates of return will ensure that significant gains in some areas offset losses in other areas. However, it shall be kept in mind that this doesn't mean that organization needs to jump into high-risk investments. Organization’s securities should vary by industry, minimizing unsystematic risk to small groups of companies Conclusion Part 1: The analysis has shown that organizations can take help from different models to get their portfolios presented to shareholders, and other stakeholders. Capital Asset Pricing Model is one of those techniques. In portfolio management there are certain sensitive areas that needs to be dealt very carefully because every shareholder do not usually enters into the organization to see the reality of the work being processed and the management of assets. Instead, annual reports and portfolios provide a real image of organization to the shareholder that is why intense care has to be taken before providing any information to interest holders. Limitation of this model and its effects is also dealt in this part. The Dividend Valuation Model (DVM) also helps organizations to predict future year dividend prices this makes shareholders and investors to get a rough estimate of the future dividends. This model not only help organizations to provide shareholders an idea of an estimated return over their investment but also helps shareholders to plan for their future investments and other proceedings that are directly dependent on the returns of their investment. Factors that result in the failure of this model are also discussed and possible controls are identified. Based on some factual calculations, possible reasons for the estimated and actual results are suggested (Hirt and Block 2009). Part 2: This part relates to an expansion plan of Rolls Royce, company is planning to expand in China; the overall problems that are expected to come across by this expansion are taken under consideration and the strategy that would be used to identify and reduce these problem/ threats, is also designed. The role of managers in the maintenance of portfolio of the organization and the diversification of risk is witnessed with all the possible means a risk can be diversified. Overall, the expansion plan is beneficial for the organization as the global recession has caused companies to face economic challenges, but expanding in China has some more potential problems that will be causing and creating numerous bottle necks in proceedings of business. Resources are scarce in China. Another threat is of the corrupted government departments, this may cause difficulties in operations and unexpected influences and demands by the government, but these all problems can be handled with good planning and a strong control over activities. It will be providing a strength to the portfolio and create more attractiveness in the investments, fostering Rolls Royce’s global recognition. List of References Amenc, N., and Sourd, V. Le. 2003. Portfolio theory and performance analysis. New York: John Wiley And Sons. Apostolou, N., and B. Apostolou. Keys to Investing in Options and Futures. New York: Barron's Educational Series, 2005. Baker, H. K., and Powell, G. E. 2005. Understanding financial management: a practical guide. New York: John Wiley And Sons. Botosan, C. 1997. Disclosure Level and the Cost of Equity Capita. The Accounting Review, 323-349. Brealey, Richard A. Principles of corporate finance. New Dehli: Tata McGraw-Hill, 2007. Brigham, E.F., and Ehrhardt, M.C. 2001. Financial Management:Theory and Practice. Cinncinatti: South-Western Educational Publishing. Brigham, Eugene F., and Houston, Joel F. 2009. Fundamentals of Financial Management. New York: Cengage Learning. Brigham, Eugene F., and Daves, Philip R. 2009. Intermediate Financial Management. New York: Cengage Learning. Financial Times. 2012. Rolls Royce Holding. [Online] Available from [Accessed March 14, 2012]. Pratt, Shannon P., and Grabowski, Roger J. 2010 Cost of Capital: Applications and Examples. New Jersy: John Wiley and Sons, Inc. Hirt, A. G. and Block, S. B. 2009. Fundamentals of Investment Management. New York: McGraw-Hill Companies, Inc. Rolls Royce. 2010. Historic C share. [Online] Available from [Accessed March 14, 2012]. Rolls Royce. 2012. Rolls-Royce. [Online] Available from [Accessed March 13, 2012]. Rolls-Royce. 2011. Annual Report. Rolls Royce. [Online] Available from [Accessed March 12, 2012]. Read More