Discussion on the Working Capital Policies of Companies - Term Paper Example

?Corporate Finance Assignment Table of Contents PART A: INVESTMENT APPRAISAL 4 Introduction 4 Capital Budgeting 4 Capital Budgeting Techniques 5 Popularity of the Techniques Reviewing Relevant Publication 12 Conclusion 13 PART B: DIVIDEND POLICY 13 Introduction 13 Factors Affecting Dividend Policies of a Firm 14 Theories of Dividend Policy 16 Dividend Policies of Tesco Plc 17 Conclusion 18 PART C: WORKING CAPITAL POLICY 18 Introduction 18 Factors Considered for Working Capital Policy 19 Trade-off Relationship between Profitability and Liquidity 20 Conclusion 21 References 23 Bibliography 25 PART A: INVESTMENT APPRAISAL Introduction Most of the organizations nowadays utilize capital budgeting to evaluate the investments of different projects and compare between them so as to chose the right project for investment. There are various capital budgeting techniques namely Net Present Value analysis, Internal Rate of Return, Payback Period Method and Profitability Index Method. These four capital budgeting techniques have been discussed in details in Part-A. This study would assist the junior staff members of MyCompany Plc and would also increase the performance of the company. Capital Budgeting Investment judgments, dividend and financing are critical areas of financial management which needs to be addressed by any organization like that of MyCompany Plc The primary goal or objective of a profit making company like MyCompany Plc is to maximize the wealth of its shareholders. The decisions related to financing refer to the development of an optimal capital structure of the business firm (Clayman, Fridson, and Troughton, 2012, Capital Budgeting). Dividend decision includes the ways in which the profits generated by the business firm are distributed to its shareholders. Lastly, investment decisions refer to the means by which funds are raised by the organizations which are utilized in various operational activities performed by the firm so as to achieve the overall objective of the business firm (Clayman, Fridson, and Troughton, 2012, Introduction). The organizations are involved in activities which require investments in different types of assets characterized as being both long term and short term. Capital budgeting primarily deals with investments made by the companies which are long term in nature and in larger volumes. These long term investments made by the firms would help in the determination of the strategic position of the firm in future. It has a considerable effect on the cash flows generated by the firm in future. All these facts imply that decisions regarding capital budgeting taken up by firms have an impact which persists for a long term and it is critical to the failure or success of a business firm like MyCompany Plc (Dayananda, 2002, p.1). Capital Budgeting Techniques There are different capital budgeting techniques which are employed by business firms universally. The four capital budgeting techniques have been described in details here. All of the capital budgeting techniques would help the financial manager of the company to choose the best project and suitable for the firm to invest. There are certain factors which are analyzed before taking the decision, for which the capital budgeting tools are used. They are: a) Generating the cash flows, b) Risk associated with the cash flows generated by the firm in future, and c) The calculated worth of the cash flows which also involved the uncertainties of future (Peterson, & Fabozzi, 2002, p.57). The capital budgeting techniques described here are explained with the help of numerical examples. The projects have been named as Project 1 and Project 2. Both the projects are considered to be mutually exclusive to each other and only one project can be selected out of the two by the company management. Other assumption related to the projects is that both of the projects have a five year lifetime. The initial cash outflow in the year zero is considered to be ?100,000 for both the projects. Moreover both the projects are considered to have similar risk characteristics and the cost of capital of the projects is assumed to be 10%. The subsequent yearly cash inflows for Project 1 are assumed to be ?30,000, ?50,000, ?70,000, ?80,000, and ?90,000 for the five consecutive years respectively. Similarly the cash inflows for Project 2 are considered to be ?70,000, ?60,000, ?50,000, ?35,000 and ?20,000 for the consecutive five years respectively. The cash outflow is assumed to be zero in all the cases. The cash flow of Project 1 is assumed to be increasing over the time and the cash flow of Project 2 is assumed to be decreasing. Net Present Value (NPV) The Net present Value (NPV) can be defined as the difference between the cash inflows and outflows, and the sum to be discounted. It is utilized to calculate the present value of money in comparison to the present value of money in the future. NPV is utilized as an indicator in deciding how much the project or investment would add to the company or be profitable for the company. If the NPV is greater than 0, then the project or investment would add value to the company. When the NPV is equal to 0, then the investment or project would neither be profitable nor is a loss for the firm, and if the NPV is below 0, then the company might have to incur losses for the project. In such case the project should be rejected. The project should be only accepted when NPV is greater than zero. In case of equal results, indifferent decision can be made. Net Present Value (NPV) is considered to be one of the most widely used capital budgeting techniques by the business firms worldwide. It is defined as the present value of all the cash flows that are generated in future through the investment in a particular project by a company. The cash flows are discounted at a rate equal to the cost of capital assigned for the project (Brigham, & Houston, 2011, p.371). Table 1 Net present Value Project 1 Project 2 Year Cash Flow Discounting Factor (@10%) Discounted Cash Flow Year Cash Flow Discounting Factor (@10%) Discounted Cash Flow                 0 -100000 1.0000 (100,000.00) 0 -100000 1.0000 (100,000.00) 1 30000 0.9091 27,272.73 1 70000 0.9091 63,636.36 2 50000 0.8264 41,322.31 2 60000 0.8264 49,586.78 3 70000 0.7513 52,592.04 3 50000 0.7513 37,565.74 4 80000 0.6830 54,641.08 4 35000 0.6830 23,905.47 5 90000 0.6209 55,882.92 5 20000 0.6209 12,418.43                     NPV 131,711.07     NPV 87,112.78 An example of the NPV calculation is stated above, which is described with the help of two fictitious projects, Project 1 and Project 2. The cash flow amounts have been assumed for 5 years. The calculations in table 1 show that the NPV of Project 1 is higher, than Project 2. So the any company opting for Project 1 and 2 should accept Project 1. Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the annual rate of compounded return on the investment or the project that the company undertakes. According to theory, all those projects should be accepted, the IRR of which is more than its cost of capital. IRR is considered as the rate to ascertain the efficiency, yield or quality of the project or investment. IRR is a contrast to NPV, which is useful for estimating the value of the project. Those projects or investments can be considered whose IRR is greater than the cost of capital or the minimum set level of IRR by the company. So if among two projects, the IRR of both of them is higher than the cost of capital, then the higher IRR percent project would be chosen. Internal Rate of Return (IRR) is another technique of evaluating an investment project. It is the rate of return which is equal to the rate of return as expected from the undertaken project by the organization. If the IRR becomes equal to the cost of capital of a project then the corresponding NPV of the project becomes zero (Finnerty, 2011). Table 2 Calculation of Internal Rate of Return (IRR) Cash Flows   Project 1 Project 2 Year     0 -100000 -100000 1 30000 70000 2 50000 60000 3 70000 50000 4 80000 35000 5 90000 20000 IRR 45% 48% With the same example as mentioned in table 1, IRR has been calculated here in table 2. According to the IRR calculated for both Project 1 and Project 2, the IRR of project 2 is higher, i.e., 48 %. So Project 2 is the best investment among the two. Payback Period Payback period is also one of the capital budgeting techniques. It is defined as the time period calculated as number of years in which the initial investment that is recovered from the invested project Payback period is a tool which involved calculating the time period required for paying-off the amount invested for the project. The payback period helps to determine the time frame within which the company can cover its investments through revenue generation and start earning profit. Payback period tool is very useful because it is easy to understand and even without specific training in the field of finance, one can easily calculated payback period of an investment (Baker, and Powell, 2005, p. 249). The shorter the payback period of a project, the more acceptable is to the company. When the management uses payback period method, they should first set a standard payback period or cut-off period, so that it can be utilized as a base. In such cases the managers utilize their knowledge and experience to set the base payback period for the company. This benchmark varies between the different companies. In case of independent projects, those investments should be accepted whose payback period is lesser than or is equal to the highest payback period. In case of mutually exclusive investments, the project with the shortest investment period should be accepted. The concepts behind the payback are easily understandable and intuitive. The companies utilize the theories of payback period for screening the minor decisions in investment in which detailed analysis is not required to be done. This tool acts as an indicator of risk calculation and liquidity for any small project or investment (Crosson, & Needles, 2010, p. 449). Table 3 Calculation of Payback period Project 1 Project 2 Year Cash Flow Cumulative Cash Flow Year Cash Flow Cumulative Cash Flow             0 -100000 -100000 0 -100000 -100000 1 30000 -70000 1 70000 -30000 2 50000 -20000 2 60000 30000 3 70000 50000 3 50000 80000 4 80000 130000 4 35000 115000 5 90000 220000 5 20000 135000 Payback Period 4 Years Payback Period 3 Years The calculation of payback period for two projects has been shown in table 3. The initial investment was 100,000. The payback period for project A is 4 years and Project B is 3 years, so Project B should be selected over Project A. Profitability Index Profitability Index (PI) is another measure used to undergo capital budgeting decisions made by an organization. It is similar to the technique of calculating the present value of the cash flows generated from the project. PI can be defined as the ration of the benefits or cash inflows from a project calculated in present value terms to the costs incurred while undergoing the project also measured in the terms of present values (Droms, & Wright, 2010, p.197). Profitability index is an index that assists in identifying the correlation between benefits and costs for any proposed project through the usage of a ratio which can be calculated as: Present Value of the future flow of cash Initial Investment The lowest acceptable point of the ratio is 1.0. If the value is lower than 1.0, then the investment would be regarded as less profitable than the initial investment. The increase in the profitability index signifies higher financial attractiveness of the investment. So when the profitability index is higher than 1, the project should be accepted. In case it is lower than 1, the company should reject the project (Keown, Martin, Petty, and Scott, 2005, p. 298). Table 4 Calculation of Profitability Index Project 1 Project 2 Year Cash Flow Discounting Factor (@10%) Discounted Cash Flow Year Cash Flow Discounting Factor (@10%) Discounted Cash Flow                 1 30000 0.9091 27,272.73 1 70000 0.9091 63,636.36 2 50000 0.8264 41,322.31 2 60000 0.8264 49,586.78 3 70000 0.7513 52,592.04 3 50000 0.7513 37,565.74 4 80000 0.6830 54,641.08 4 35000 0.6830 23,905.47 5 90000 0.6209 55,882.92 5 20000 0.6209 12,418.43 PV of Cash Inflows 231,711.07 PV of Cash Inflows 187,112.78 Initial Investment 100,000.00 Initial Investment 100,000.00   Profitability Index 2.32 Profitability Index 1.87 Table 4 shows the calculation of profitability index for two projects, Project 1 and Project 2. For calculating the profitability index of both the project, the present value has to be calculated and divided by the initial investment. In this case both the projects have a profitability index above 1, so both are good, but Project A has a higher profitability index, so Project A should be selected. Weighted Average Cost of Capital Weighted Average Cost of Capital (WACC) is regarded as the rate of discount for the different components of the capital structure. The weights are ascertained to the different portion of the capital structure on pro rata basis. The weights assigned should be at their market value. It is impossible to finance a firm entirely on the basis of equity, so firms employ several capital components such as preferred stocks, debts, or common stocks for financing their projects or company. Most of the capital components are supplied by the investors who expect high returns on their investments. If the investors of the company were only the stockholders holding common shares, then the cost of capital could be calculated by assuming the rate of return on the equity shares, but firms do not employ capital from a single source generally, so the rate of return is assumed from the entire capital component through a weighted average method. This is the basic idea behind WACC. The basic formula used for computing WACC: WACC = (Ke * We) + (Kd (pt) [1-t] * Wd) Here, Ke = Cost of capital from equity We = Weight (equity) Kd (pt) = Cost of capital for debts before tax Wd = Weight (debt) t = Tax rate Popularity of the Techniques Reviewing Relevant Publication Two surveys, namely “A Survey of the Capital Budgeting Techniques Use by Major U.S. Firms, Financial Management”, and “The Theory and Practice of Corporate Finance: Evidence from the Field, Journal Of Applied Corporate Finance” focuses on the three areas such as capital structure, capital budgeting and the cost of capital. A group of MBA students were chosen to conduct the survey. The respondents for the survey were mainly the CFOs of the companies. The motive was to evaluate the significance of different financial and capital budgeting tools in the organization. The ratio calculations were also considered as a part of effective calculation tool. It can be concluded that NPV method is the most user friendly and transparent capital budgeting tool, that is popular among investors and investment managers. Conclusion As evident from the results of the utilization of different capital budgeting techniques, all of them do not correspond to the same result. The four Capital Budgeting techniques that have been discussed in this study gives different conclusive results for the same projects 1 and 2. All the four techniques that have been discussed in this study have its own advantages and disadvantages. The payback method is more of a traditional method which is not used much by the companies now. Its major disadvantage is that it does not consider the cash inflows after the payback period. It has been argued that NPV method of evaluating an investment proposal is the best option for selecting any one investment project for a company out of two projects which are mutually exclusive (Ryan, P. A., & Ryan, G. P., 2002, p.2-3). Thus, project 1 can be considered to be the best option for the company. However, the NPV method of evaluation of an investment project has its limitations too like the use of cost of capital in its calculation which is an estimated figure and cannot be ascertained with certainty (Drake, n.d.). PART B: DIVIDEND POLICY Introduction A firm’s dividend policy is a vital element towards determining the success of a firm. Dividends are paid out by different companies depending on various strategies followed by them and many factors have an impact on the dividend policy adopted by a firm. This study discusses about the dividend policy followed by Tesco Plc, as listed in The Telegraph: Tuesday 21st August 2012, Trusted brands “are best” dividend payers). Tesco is one of the leading companies in UK which is primarily engaged in the business of retailing. This part of the study aims at discussing the utility of the dividend policy of an organisation, the factors which affect the formulation of such strategies, and the theories designed for developing the dividend policies. In order to explain the practical implementation of such dividend policies and theories, the example of Tesco Plc has been used to evaluate their dividend policy. Factors Affecting Dividend Policies of a Firm The factors which affect the dividend policies of companies are stated below: Theories of Dividend Policy There are two major theories for dividend policy, which is sub-divided further into different other theoretical models. We would be including only the most used and applied ones only in this study. The two theories are: a) Relevance Theory, and b) Irreverence Theory. Within the relevance theory, the Walter’s model and the Gordon’s Model is viewed by both the firms and the investors as significant. Walter’s Theory The Walter‘s model was developed by James E. Walter to represent the importance of dividend policy and its behaviour on the worth of the company’s shares. The basic assumptions that are taken in case of Walter’s model are: a) there are no external financing sources involved. Only retained earnings are the sources for financing. b) There is no fixed life of the firm. c) The rate of return on the investment (r), and the cost of capital (Ke) are constant. This means that the risk would remain the same. The concept utilized in this policy is that the shareholders reinvest the dividends that they derive from the firm. This is regarded as an opportunity cost for the firm or Ke. In another situation, the firms do not pay dividends because they want to invest it in profitable ventures. In such cases the rate of return (r), must be at least equal to cost of capital. So the Walter’s model suggests that if r< Ke, then the profit should be distributed as dividends. If r> Ke, then the investment is profitable, and when they are equal the firm should be indifferent. Gordon’s Model The Gordon’s Dividend Model was formulated by Myron J. Gordon. According to this model it is assumed that the dividends paid by a company have a constant growth rate (Pinto, 2010, p.97). Mathematically, dividend payable by a company in the year t, (Dt) is given by the formula: Dt = Dt-1 (1 + g), Here, Dt-1 = Dividend paid by the company in the year (t-1) g = Constant rate of growth of the dividends This model can be utilised to calculate the cost of equity of a company by using the concept of time value of money (Gallagher, & Andrew, 2007, p.236). Hence, the cost of equity, (Ke) is given by the formula: Ke = (D1 / P0) + g, Where, D1 = Dividend on common stock that is payable in the next period P0 = Common Stock’s current price g = Constant rate of growth of dividends Dividend Policies of Tesco Plc Dividends are payments made to all the shareholders of a company. The level or amount of dividend payments made by a company depends on its dividend policy. Currently Tesco pays dividends to its shareholders twice a year. Tesco also gives an option to its shareholders about reinvesting the dividends received by them on the ordinary shares issued by Tesco. As observed from the dividend per share figures of Tesco, it can be observed that Tesco follows a progressive dividend policy and it has been steadily growing over the past 5 years. This trend was observable even during the years of Global Financial Crisis (GFC) during 2008 and 2009. When the dividend pattern is compared with the earnings of Tesco, it is observable that the dividend payments were in line with earnings generated by the firm over the past 5 years. The steady growth in the earnings of the company indicates that the progressive dividend policy followed by Tesco Plc. was quite successful. Although the share prices of Tesco are a bit volatile in nature but it follows a strong and steady dividend policy. The dividend yield for the company has been quite high during the past 5 years. Hence it can be concluded that the dividend policy of Tesco is quite effective in its continued growth in the market (Tesco, 2012). Conclusion The firm pays its shareholders the part of their yearly profit, based on the number of unit each shareholders posses, this profit is called dividend. There is a fixed slab or policy according to which every company pay dividend to their shareholders. The dividend policy of every company is formulated based on certain factors or firm’s working conditions and the theories developed for dividend policies. The most popular dividend policy models are the Walter’s model and Gordon’s Model, which most companies and shareholders trust. In this study the example of a well-know company, Tesco plc from the retail industry, is discussed to understand their dividend policies. PART C: WORKING CAPITAL POLICY Introduction Working Capital policies are developed to maintain the stability between the current liabilities and the current assets of the firm. The goal in such case is to see that the company can continue its functions and operations and there is sufficient flow of cash in the firm to manage the operational expenses of the firm. The important aspects that are considered in working capital policy consist of investment, time, growth and credibility. The most significant reason why the balance sheet is viewed is for seeing the working capital position of the company. It reveals about the actual status of the financial condition of the company, than other financial calculations. The working capital depicts that if the company utilizes all its current resources to pay off its short term debts, what would remain with the company. More is the working capital with the company, less the liquidity pressure the company has to face. Factors Considered for Working Capital Policy The working capitals of any firm are influenced by many factors such as: a) The nature of the business, b) The Production Conditions, c) The Market Conditions, d) Supply Conditions, and e) Seasonality of functions. These factors are explained below in details with respect to examples of two famous companies listed in FTSE250, and both are from retail industry, though they deal in two different type of product range. The companies are Debenhams and Home retail Group. Debenhams is a renowned garment retailer and Home retail group is into kitchen and home decor. Firstly, the working capital requirements depend on the type or nature of business that the firm is engaged in. Any service firm generally sells mostly on cash basis, so their working capital requirements are modest, while a manufacturing plant have longer operation cycle and goods are largely sold on credit. Both Debenhams and Home Retail Group belong to the retail industry that is into manufacturing and selling garments and the other is home decor items. So they need to maintain higher working capital for their longer operating cycle (Debenhams Plc, 2011). Secondly, In order to avoid seasonal fluctuations in sales and production, most of the firms develop a production policy, which helps in reducing sharp fluctuations. These sharp variations also affect the demand of working capital in the firm. The manufacturer can maintain a steady production rate all round the year to avoid fluctuations in working capital requirements. Thirdly, when the inventory moves out faster, the company can function with small inventory. However, in case of unpredictable supply, the firm has to ensure that they maintain an adequate stock of inventory. Fourthly, Lastly, the sale of woollen in winter months rises and sharply falls during the summers. However, the demand for home decor items or furniture would remain almost the same round the year. So the company has to maintain an adequate working capital to cushion the sharp variations in demand. Now, we would be discussing the concepts of working capital in terms of its relationship between profitability and liquidity. Trade-off Relationship between Profitability and Liquidity Efficient administration of working capital entails planning and immediate actions according to the fast changes in the business environment. Working capital management includes functions which concerns the sufficiency of current assets to meet the current liabilities. The firm must design its working capital policies to meet its three goals such as maintaining adequate liquidity, maximizing profitability, and minimizing the risks. In relation to trade-off among liquidity, profitability and risk, the company can utilize three types of policies for working capital: Conservative policy: In this case the company would maintain a high working capital among its total assets to be on the safer side. The rate of return on current assets is lower, but it would signify stable condition of the company to meet the current obligations. For example: Debenhams maintains a high working capital to meet its current liabilities or other short-term obligations. Moderate Policy: This is a middle path between conservative and aggressive policy. In this case the investment on current asset is neither too high nor too low. The liquidity, risk and profitability are moderate and balanced. For example: Home Retail Group focuses on the adequacy of working capital requirement, but their sustainability reports depict that they follow a moderate policy (Home Retail Group Plc, 2012). Aggressive Policy: In this case the firm opts for lower working capital policy. In such cases the profitability is high and the risk is also high. The liquidity position depends on the profitability and fluctuations or variations cannot be denied. Conclusion Part – C of this study includes a discussion on the working capital policies of companies. We have evaluated the factors based on which the firms take decisions regarding the implementation of working capital policies of the company. The examples of two FTSE250, companies are included such as Debenhams and Home Retail Group, from retail industry to discuss the nature of working capital policy these companies follows. The nature of working capital policies based on trade-offs between liquidity, profit and risk has been evaluated to understand which policies companies undertake with respect to working capital management and in which situations, with the help of those examples. References Baker, H. K., and Powell, G., 2005. Understanding Financial Management: A Practical Guide. New Jersey: John Wiley & Sons. Brigham, E. F., and Houston, J. F., 2011. Fundamentals of Financial Management, 7th ed. Connecticut: Cengage Learning. Clayman, M. R., Fridson, M. S., and Troughton, G. H., 2012. Corporate Finance: A Practical Approach. 2nd ed. New Jersey: John Wiley & Sons. Clayman, M. R., Fridson, M. S., and Troughton, G. H., 2012. Corporate Finance Workbook: A Practical Approach. 2nd ed. New Jersey: John Wiley & Sons. Crosson, S. V., and Needles, B. E., 2010. Managerial Accounting, 9th ed. Connecticut: Cengage Learning. Dayananda, D., 2002. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press. Debenhams Plc, 2011. Annual report 2011. [Online] Available at: http://media.corporate-ir.net/media_files/IROL/19/196805/agm2011/ar2011.pdf [Accessed 17 September 2012]. Drake, P. A., no date. The Theory and Practice of Corporate Finance: Evidence from the Field. [Pdf] Available at: [Accessed 17 September 2012]. Droms, W. G., and Wright, J. O., 2010. Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know, 6th ed. New York: Basic Books. Finnerty, J. D., 2011. Project Financing: Asset-Based Financial Engineering, 2nd ed. New Jersey: John Wiley & Sons. Gallagher, T. J., and Andrew, J. D., 2007. Financial Management: Principles and Practice. 4th ed. Minnesota: Freeload Press. Home Retail Group Plc, 2012. Annual report 2012. [Online] Available at: http://www.homeretailgroup.com/media/134116/annual_report.pdf [Accessed 17 September 2012]. Keown, A. J., Martin, J. D., Petty, I. W., and Scott, D. F., 2005. Financial Management: Principles and Applications. New Jersey: Pearson Education. Peterson, P. P., and Fabozzi, F. J., 2002. Capital Budgeting: Theory and Practice. New Jersey: John Wiley & Sons. Pinto, J. E., 2010. Equity Asset Valuation. 2nd ed. New Jersey: John Wiley & Sons. Ryan, P. A., & Ryan, G. P., 2002. Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? [Pdf] Available at: [Accessed 17 September 2012]. Seneque, P. J. C, no date. A Review of the Factors Affecting the Dividend Policy of the Firm. [Pdf] Available at: [Accessed 17 September 2012]. Tesco. (2012). Dividends. [online]. Available at: http://www.tescoplc.com/index.asp?pageid=48. [Accessed 17 September 2012]. Bibliography Graham, J. R., and Harvey, C. R., 2001. The Theory and Practice of Corporate Evidence from the Field [online] Available at :< http://118.96.136.228/ejurnal/JFE%202001%2060%202-3/JFE%2001%2060%202-3-%20The%20theory%20and%20practice%20of%20corporate%20finance%20evidence%20from%20the%20field.pdf> [Accessed 17 September 2012]. Read More