Analysis of the Structure and Cost of Capital - Essay Example

Financial Management Submitted by: XXXXX XXXXXX Number: XXXXXXXX of XXXXXXXX XXXXXXX XXXXXXXX XXXXXX Date of Submission: XX – XX – 2009 Number of words: 1651 (Excluding Bibliography) Part A: The importance of capital structure and the cost of capital in the efficient financial management of large companies Financial Management: “Financial management entails planning for the future of a person or a business enterprise to ensure a positive cash flow. It includes the administration and maintenance of financial assets. Besides, financial management covers the process of identifying and managing risks” (Economy Watch, 2009) Objectives of Effective Financial Management: As understood financial management is a mode of right administration of the financial assets of a company. In the case of large companies the amounts of monies spent on the assets is very high. This requires highly effective financial management. The main objectives and requirements of effective financial management can be based on a few tips, i.e. need to have a clear and well planned budget, monitoring the performance and taking action whenever needed, focus should be placed on essential numbers like salaries, materials and also sales. A keen eye on these aspects of the financial management will lead to the better financial management in large companies (Brodie, 2009). Capital Structure: Choice of a determining the optimal mix of components of the capital structure is a very complex process and involves a number of different considerations. A number of different views of the capital structures need to be considered like the net corporate or personal tax, agency costs, bankruptcy cost and pecking order. There are a few components which build a company’s capital, these are: Ordinary shares, preference shares, debentures, and loan stock. Deciding the optimal mix is based on finding the right mix of long term funds which allow minimizing the cost of capital and helping maximize the value of the organization. This situation is referred to as the optimal capital structure. However, it is a known fact that gaining an optimal capital structure is not possible since, the changing of the mox of capital does not change the values. Views and Approaches to Capital Structure: A company can be financed by a number of different modes. The type of capital financing that has been chosen for the company is referred to as the capital structure of the company. A company can be financed using debentures, equity shares, long term loans, etc. These options however are based on the nature of risk the investors are willing to take. The following sections will discuss the various financing options that are available for investors to finance their companies and the factors that affect the choice have also been discussed. a) Equity Financing: This is the most common mode of financing used by companies. Here companies raise monies for the business by selling stocks of the company. These can either be preferred or common stock and can be sold both to individuals as well as investors. This is also referred to as the share capital of the company. These stocks provide the buyers with an ownership in the company. This is perceived to be ‘easy money’ as it does not involve any debt. Here the company does not require repaying the amount to the investors, as long as the business makes profits. Equity financing is best suited for people who are risk takers (J Ogilvie & B Koch 2002). b) Debt Financing: This type of financing is when a company borrows money from other sources like banks, etc, under an agreement to pay back within a fixed amount of time. Here the lenders do not get any ownership of the business and the relationship remains active until all the monies are paid back. This can be of two main types a) short term financing, where loans taken are for a period less than one year. These are mostly taken by people who are willing to take risks. b) Long term financing is when loans are taken for period higher than one year. This type of loan is best suited for investors who are risk adverse (J Ogilvie & B Koch 2002). c) Equity – Debt Financing: This is a combined form of financing. This is best suited for investors who prefer to be safe however are willing to take up a certain amount of risk. Here the combination of equity and debt is based on the amount of risk a company is willing to undertake (J Ogilvie & B Koch 2002). Company’s Cost of Capital (WACC): Definition: The average of the current costs of the sources of finance employed by the company is the WACC of the company (Samuels, et.al, 2000). Rationale for use: The main rationale behind the use of weighted average cost of capital is that the firms will be able to increase the market price of its stock in the long run by financing in proportionate amounts and by accepting projects that yield returns higher than the weighted average cost of capital. Assumptions: It is essential to understand that the correct cost of capital to be used for an investment appraisal is the marginal costs of funds used to finance the investment. As mentioned earlier the weighted average cost of capital can be considered as the safest and most reliable guide of marginal costs of extra funds, but based on the fact that the company would have to continue investing in the future: a) In projects with similar business risk as that of the existing projects b) Also by raising funds in a manner where the existing capital is not altered (GSW, 2008). Calculation of WACC: Weighted average cost of capital is also referred to as the overall cost of capital. The weighted average cost of capital is calculated using (12 Manage, 2008): Projects with higher values than the weighted average cost of capital should be accepted. This method has been very useful for companies to correctly and accurately use the weighted average cost of capital as the discount rate. There are a number of different methods that can be followed by companies to calculate the cost of capital to find the rate of interest. The most common of them all is the asset beta: CAPM and projects with different business risk profiles. Business and financial risks; business risks refers to the systematic risk of a company of its cash flows, in simple words , the business risk relates to the systematic risk of the net cash flows that results from the operation of the company’s assets. Both the equity and the debt holders in a company bear this risk. The financial risk however, refers to the additional systematic risk which is borne only by the equity holders of the geared company. There are two main factors that affect a company’s equity beta: a) the level of systematic risks of the company’s investments i.e. the systematic business risk and b) the level of the financial gearing employed by the company i.e. systematic financial risk (Encycogov, 2008). Part B: Discuss the motives behind corporate restructuring and evaluate the methods by which mergers and takeovers may take place Corporate Restructuring: Corporate restructuring refers to the process of redesigning either a part or the entire company. This process reorganises the company and can be implemented for a number of reasons like the positioning of the company may be competitive, adverse environmental and economical climate and or also the need for the company to move into a completely different direction. The motives for restructuring of businesses are quite vast and every company might have different reasons to do so. In some cases the restructuring is a necessity when the company have grown to points where the actual capital structure does not prove to be very beneficial and is not in the interest of the company. This can be done to gain a higher market share for the company and gain higher profits. However, restructuring can also be done to reduce the possibly dropping sales and sluggish performance of the company as well. This could mainly be caused due to the economy going down or even temporary issues in the environment. Company tend to restructure in these cases to survive in the markets more than any other reason. Another important motive of restructuring can be due to acquisition of the company or even mergers. If the restructuring is due to holistic takeovers the possible reason for the restructuring can be that the buyers feel that implementing a dismantle of the company will be more profitable. Types of Takeovers: There are four major types of takeovers. These include: a) Friendly takeovers: This is where the bidding company make an offer to the other company by informing the board of directors of the price. If accepted by the board of directors then the offer is recommended to the shareholders for their acceptance. In this case the bidding companies also have a chance to gain complete details of the accounts of the other business and this is referred to as a process of ‘due diligence’. b) Hostile Takeovers: This is where the suitors are allowed to bid on the companies even if the companies are unwilling for mergers and takeovers. These are referred to be ‘hostile’ if the bidders try to force the takeover despite the rejection of the company as well, or even if there is a continuous attempt made and offers made without the knowledge of the board. c) Reverse takeovers: This is a kind of takeover that is used mainly by private companies to takeover public companies. This is mainly done to reduce the time and energy on getting the private company to be floated out into the markets. d) Financing Takeover: When a company acquires another company, it would need to pay a specified amount for it. These funds can be raised in a number of manners. In most cases the funds are generally borrowed from the banks or even raised out of bonds. In this case the acquired company need to pay back the debt. This is mostly used by the private equity companies. Bibliography 12 Manage, 2008, ‘Analysing the cost of invested capital - Explanation of WACC’ 08 November 2008, Accessed on 7th July 2009, retrieved from http://www.12manage.com/methods_wacc.html Brodie, D., 2009, ‘7 tips of Effective Financial management’, Accessed on 6th July 2009, Retrieved from http://ezinearticles.com/?7-Tips-For-Effective-Financial-Management&id=785315 Economy Watch, 2009, ‘Financial Management’, Accessed on 6th July 2009, Retrieved from http://www.economywatch.com/finance/financial-management.html Encycogov, 2008, ‘Model CAPM’, Accessed on 6th July 2009, Retrieved from http://www.encycogov.com/A2MonitorSystems/AppA2MonitorSystems/AppBtoA2CAP_model/CAP_Model.asp GSW, 2008, ‘Weighted Average Cost of Capital’, Accessed on 7th July 2009, Retrieved from www.business.gsw.edu/busa/faculty/jkooti/Finance/Pres/Chap15/wacc.ppt Ogilvie, J. and Koch, B., ‘CIMA Study System Intermediate Level Finance’, 2nd edition, Viva Books Private Limited, New Delhi Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 2000, ‘Management of Company Finance’, 6th edn, Thomson Learning, London Read More