Financial Requirements of Merchants Plc - Essay Example

Finance and Accounting, Essay a) The Merchants PLC is a very old investment trust which aims to give the shareholders good income which goes on increasing over the passage of time. The objective of the company is to offer growth in income along with long term growth of capital by making investment in Hungary. There are several demerits in raising fund only locally by a company. It has to raise fund by other methods from outside sources also. The company can raise capital for various reasons depending on the time periods ranging from extremely short to rather long period. The sum quantity of financial requirements of a company depends on the size and nature of the business. The capacity of raising funds depends on the resources from which funds might be accessible. The company forms of partnership and sole proprietor have limited chances for raising funds. Banks will generally only desire to finance businesses where there is a revenue stream or short risk assets i.e., assets which can safeguard loans. The company can raise money by several ways by increasing short- term and long-term capital; they can also include -issue of shares and debentures, loans from financial institutions, loans from banks, public deposits. “Capital may also be raised by development taxes levied on either developers or households, or both. For example, a value-capture tax may be levied on the estimated increase in land value due to the development of related infrastructure.” http://www.appliedeconomics.com.au/pubs/papers/pa03_trans.htm The main benefits of the sources of finance for the company includes decreasing the reliance on outside sources of finance; it raises the credit value of the company, allowing the company to withstand complicated circumstances and allowing the company to accept a constant dividend policy. “Merchants has for many years focused on a simple proposition, to deliver a high and rising income stream, together with long term capital growth through investing predominantly in large UK companies.” http://www.alliancetrustsavings.co.uk/resource/taking-stock/june2012/merchants-trust-plc.htm In any company, there must be a number of financing sources, sometimes one has to choose debt over equity. Though debt can be considered as a method of cheap fund raising, there is an involvement of risk in it. The amount will have to be given back along with the interest to the party from whom it has been taken irrespective of whether profit or loss is made. But in the case of equity, huge amount of capital can be raised within a short span of time. The risk can also be shared by different persons. There are costs involved in equity because there is expectation from the part of the shareholders since they are also involved in taking part of the risk. If the business goes on well, the market value of the equity will rise to a higher level and it decreases if the business is dull. Equity financing is different from cost financing. In equity financing, there is no direct obligation to repay the amount. But instead, the equity investors will become owners in partnership and therefore will be in a position to have some degree of control as to how the business is run. Therefore, the founders are at a disadvantage as they will have to give up a little control over the business which in turn could create a problem to the entrepreneur. b) Country risk means the risk of investing in a country, reliant on variations in the business surroundings that can negatively influence operating profits or the cost of assets in a particular country. In Hungary, financial factors such as devaluation or regulatory alterations, controls of currency or stability factors for example civil war, mass riots and other probable events could contribute to operational risks for the Merchants PLC. “Country risk assessment can be placed under surveillance to warn that there is a possibility of a short-term modification. It does not mean however that it is inevitable and that it goes to the announced direction.” http://www.coface.com/CofacePortal/COM_en_EN/pages/home/risks_home/country_risks Country Risk forecasts and analyses the credit risk created by Hungary and it provides a frequently reviews of the risk involved in the country. “In addition to the currency, sovereign debt and banking sector risks posed by Hungary, the service also looks at political, economic policy and economic structure risks. You also receive short- and medium-term economic and political forecasts for the country.” http://store.eiu.com/product.aspx?pubid=1010001101&pid=60000206&gid=1010001101 Country risk reviews by analyzing the economic and political constancy of countries around the world. Euro money Country risk estimates the investment risk of a country, for example risk of evasion on a bond, risk to international business relations, risk of losing direct savings etc. “The country analyses are based on comprehensive source material from institutions such as the International Monetary Fund, the World Bank, credit rating agencies, consulting firms and Export Credit Agencies in the OECD.” http://www.ashra.gov.il/Eng/?CategoryID=869 The main factors of the ranking of countries by risks includes- political risk, structural assessment, economic performance, credit ratings, debt indicators, access to capital markets and access to bank finance. All extra countries are categorized into one of eight classifications during the purpose of two-step methods. They include, “the Country Risk Assessment Model (CRAM) produces a quantitative assessment of country credit risk based on three groups of risk indicators. A qualitative assessment of the CRAM results by country risk experts from OECD members, considered country-by-country to integrate political risk and/or other risk factors not taken into account by the CRAM.” http://www.rmicri.org/about/Credit%20Research%20Initiative_English_March%202012.pdf Euro money Country Risk (ECR) is an online society of political and economic experts that give actual time scores in about 15 groups which connects to the structural, economic and political risk. “The consensus expert scores, combined with data from the IMF/ World Bank on debt indicators, a survey of debt syndicate managers at international banks on access to capital and Moodys/Fitch credit ratings create the Euromoney Country Risk score (100) for 187 individual countries.” http://www.euromoneycountryrisk.com/Documents/fac29cf8-35d6-4520-8479eb1677cdc5cb/whitepaper/CEE/ECR%20Turkey%20Country%20Report%202013.pdf To discover the common ECR country risk score, Euro money allocates a weighing to six groups. The three qualitative specialist attitudes are political risk is about 30% weighting, the performance of economic is about 30%, and structural assessment, debt indicators, credit ratings and entrance to bank finance are about 10%. “The Country Risk Assessment Model (CRAM) produces a quantitative assessment of country credit risk based on three groups of risk indicators. A qualitative assessment of the CRAM results by country risk experts from OECD members, considered country-by-country to integrate political risk and/or other risk factors not taken into account by the CRAM.” http://www.rmicri.org/about/Credit%20Research%20Initiative_English_March%202012.pdf Political risk analysis providers and credit rating agencies use various methodologies to evaluate and rate Hungary’s comparative risk experience. Credit rating groups tend to utilize quantitative econometric types and concentrate on economic analysis, while polical risk contributors tend to utilize qualitative approaches, concentrating on political study. The qualitative average is formed by merging assessments of economic, political and structural evaluations from experts around the world. When applying economic, political and structural evaluations to a 100 point level for the qualitative average weighing is used about economic 43%, political 43% and structural 14%. The groups of financial risk scored include bank stability, unemployment rate, GNP outlook, and monetary policy and government finances. The group of structural risk scored contains demographics, labour market, hard infrastructure, soft infrastructure. The groups of political risk scored are corruption, government non-repatriation, government stability, information access, policy and regulatory environment and institutional risk. Within all sub factors, ECR also asks experts for extra data on the causes following each person score, and these drop under the group of connected factors. These are further like poll points, and do not straightly influence the score. c) The main factors included to undertake country risk analysis are political risk, structural assessment, economic performance, credit ratings, debt indicators, access to capital markets and access to bank finance. “Hungary’s economy, an open market with high-quality institutional infrastructure, benefits from a thriving private sector. Commercial law is well developed, with improvement needed only in judicial and administrative enforcement.” http://www.heritage.org/index/country/hungary The economy of Hungary is small but still open, diversified and the labor force there is very skilled. However, policy making is not predictable and has an impact on the business atmosphere. It can also be said that this will be harmful to the confidence of the investors in the country and hence, also to the flow of foreign direct investment and reflecting on the growth prospects of the economy. “S&P said that economic risks for Hungarys banks have increased incrementally as a downturn drags on.” http://online.wsj.com/article/BT-CO-20121219-710993.html Since the creditworthiness of corporations, households and public bodies are deteriorating; problem may arise in form of loans for the banks. The following are factors of country risks in Hungary: Political risks: Political risk is the risk of aggressive episodes causing losses of income or assets for a foreign agent in Hungary. This risk stems from political events and might lead to physical injure of economic losses. The political risk of Hungary will not affect the scoring of financial resilience. Simultaneously, it has been believed that the policy structure is not predictable in Hungary. Structural assessment Risk assessment gives an aim, technical estimation of the likelihood of impacts which are not acceptable to the environment and to the human health. The objective is to ascertain the necessity for protective measures because a particular risk assessment is a pre- requirement for such protective measures. “Risk assessment can be regarded as a pre-decision, decision support method.” http://www.eugris.info/EUGRISmain.asp?Ca=1&Cy Debt indicators Debt indicators are the main part of the present economic debate as on the recent financial crisis. “Debt indicators; including maturity profiles, reimbursement schedules, sensitivity to interest rates, and debt’s composition in foreign currency. Ratios of external debt or exports to GDP are useful indicators to define debt’s evolution and reimbursement capability.” http://www.issai.org/media%28925,1033%29/ISSAI_5411_E.pdf This crisis has been started with the explosion of housing loans and the disproportionate indebtedness of households in Hungary. It later spread throughout the world by making use of novel financial structures and thus, affected the public sector. This crisis started in the beginning years of the 21st century, for the policy makers to manage these reserves and debts; better guidance might be useful in this particular area. Credit rating A credit rating will evaluate the credit worthiness of a particular debtor, specially a government or a debtor. Here a credit rating agency will evaluate the ability of the debtor to repay the debt and also the possibility of default payment. There are credit rating agencies to determine the credit ratings. “The country risk classifications are not sovereign risk classifications and should not, therefore, be compared with the sovereign risk classifications of private credit rating agencies (CRAs). Conceptually, they are more similar to the "country ceilings" that are produced by some of the major CRAs.” http://www.oecd.org/tad/xcred/crc.htm The evaluation of the credit rating agency of the quantitative and qualitative information is represented. There is no mathematical formula to find out the credit ratings. The credit rating agency will use their experience and judgement to find out which private and public information has to be considered while providing a rating to a company or to the government. The credit ratings are made use of by the entities and the individuals who purchase the bonds which are issued by the governments and the companies to find out the possibility of the government repaying its bond obligations. The credit rating agencies make use of the primary and secondary information’s which it has gathered in order to find out the ability of the individuals and of the government to repay its loans. Access to bank finance The lending of money by banks has been reduced in many member States. There is a possibility to subdue because of the combined effect of lower demand and strict bank credit conditions. But Euro area banks have got prominent support of funds from the ECB which has sought to make a stronger balance sheet for regaining the access to market funding. “The Small Business Act (SBA) Fact Sheets suggest that Hungary performs in line with the EU average with regard to access to finance for SMEs. “On financing through private bank loans, most indicators are on par with the EU average.” http://ec.europa.eu/enterprise/policies/finance/data/enterprise-finance-index/situations-in-member-states/hu/ The lesser landings by banks weighs on the economic growth, however, the whole impact may even depend on other factors such as alternative funding sources and the policy responses. Access to capital markets: The European venture capital markets cannot be access to directly and the European capital market is mostly under developed therefore, SMEs has been mainly affected by financial instability and from tighter credit conditions. Capital markets play an important role in promoting economic activity worldwide by facilitating and diversifying firms’ access to finance. http://www.accaglobal.com/en/research-insights/access-finance/capital-markets.html In Hungary, debt financing has become more expensive and difficult to obtain, especially in countries under market force, and for high risk projects and borrowers. Savings and innovation are not probable without sufficient entrance to economics. Public resources have previously been mobilized to maintain investment in novelty, especially by SMEs. On the other hand, only by unlocking personal funds one may ensure the stage and sustainability which is essential to the finance savings by EU firms. “Improving access to capital markets is therefore another crucial challenge to increase our competitiveness.” http://ec.europa.eu/europe2020/pdf/themes/08_sme_access_to_finance.pdf Undertaking this problem is quite necessary to restoring expansion and improving competitiveness. Enhancing access to economics desires a synchronized attempt by the Member States, particularly learning from high-quality practices, and continually monitoring performance with the purpose to shift funds to those that work best. d) The net present value is a time series of cash flows, both outgoing and incoming, which is described as the total of the present values of the person cash flows of the similar unit. In the case, when every future cash flows are incoming and the simply outflow of cash is the purchase price; the NPV is simply the PV of future cash flows minus the purchase price. “The NPV calculation establishes what the value of future earnings is in today’s money. To do the calculation you apply a discount % rate to the future earnings. The further out the earnings are (in years) the more reduced their present value is. NPV is at the heart of securities analysis.” http://www.finance-glossary.com/define/net-present-value/1801 NPV is a central tool in discounted cash flow analysis and is a normal technique for using the time value of money to assess the continuing projects. Net present value is one of many capital budgeting methods used to evaluate physical asset investment projects in which a business might want to invest. Usually, these capital investment projects are large in terms of scope and money. Net present value uses discounted cash flows in the analysis which makes net present value the most correct of any of the capital budgeting method as it considers both the risk and time variables. The annual value of return that an investor imagines to earn when investing in shares of an industry is known as the cost of equity. Those earnings are composed of the dividends paid on the shares and any decrease or increase in the market price of the shares. Cost of equity refers to an investor required return rate on equity savings. It is the value of return that could have been earned by putting the similar money into a various savings with equivalent risk. “The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.” http://www.financeformulas.net/Capital-Asset-Pricing-Model.html The CAPM supposes that shareholders hold completely diversified portfolios. This means those shareholders who are assumed by the CAPM to desire a return on an investment basis are on a regular risk alone than on its whole risk. The amount of risk utilized in the CAPM, which is named Beta, is a measure of the systematic risk. The formula of calculating in cost of equity using the CAPM model as follows “E(ri) = Rf+ βi (E(rm) - Rf) E(ri) = return required on financial asset i Rf = risk-free rate of return βi = beta value for financial asset i E(rm) = average return on the capital market.” http://www.accaglobal.com/content/dam/acca/global/PDFstudents/2012/sa_jan08_capm.pdf In this case the risk free rate is 2%, Equity risk premium is 13% and the Beta value of Merchants Trust (The) PLC is 1.3. Using the CAPM: 2+ (1.3*13) = 18.9%. The CAPM forecasts that the cost of equity of Merchants Trust (The) PLC is 18.9%. Weighted average cost of capital is the standard price of return a firm imagines to recompense all its various investors. The weights are the proposion of all source of financing in the industries target capital structure. The essential formula for WACC as follows: “WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)] E = Market value of the companys equity D = Market value of the companys debt V = Total Market Value of the company (E + D) Re = Cost of Equity Rd = Cost of Debt T= Tax Rate.” http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/weighted-average-cost-capital-wacc-2905 The Merchants Trust PLC’s Equity market value E is $4 billion, Market value of debt D is 1.1 billion, total Market Value of the company is $5.1 billion, cost of equity 4/5.1 = 0.784 and cost of debt is 1.1/5.1 = 0.215. WACC= 0.784(15.35) +0.215(6.67) =13.48%. So the WACC of Merchants Trust PLC is 13.48%. In the above given calculation, we can find out the cost of capital and weighted average cost of capital. It has been provided that 18.9% is the cost of capital and 13.48% is the weighted average cost of capital by doing the calculations. So the Merchants Trust PLC is getting higher amount of weighted average cost of capital. The net present value and the capital asset pricing model techniques are not always suitable for assessing the potential target companies. By using the net present value we can identify only the cost of equity. But in order to find out the potential target companies other factors should also be given relevance. Read More