The Three Objectives of Food-For-Life Company - Essay Example

Corporate finance Task Word Count: 3,267 (without considering the cover page, the table of contents and the bibliography) Executive summary This report seeks to analyze the three objectives of Food-For-Life Ltd. The company plans to increase its sale levels for the next three years. The suitability of the objectives has been determined based on their influence on the company and its shareholders. The first objective, maintaining the profit margin around 24% is suitable since it simultaneously increases the level of retained earnings and the dividends paid to the shareholders. The second objective, maintaining the current financial position of the firm is suitable too. It would increase the availability of cash, thus facilitate the running of day-to-day activities of the company. Last, the third objective is to maintain a dividend payout ratio of 40%. The objective is suitable because it helps prevent agency problems and respond to the investors’ preference to certain earnings (dividends). The cash flow analysis indicates a strong financial position of the company. In addition, the financial plan takes into consideration the shareholders’ interest of wealth maximizing through payment of high dividends. Table of contents Executive summary 2 Table of contents 3 Introduction 4 The suitability of the Food-For-Life’s chosen objectives 5 Turnover ratios 5 Liquidity ratio 5 Gearing ratio 6 Profitability ratios 6 The growth and valuation ratios 7 The first objective 8 The second objective 8 The third objective 9 The dividend policies 9 Why to pay 11 A financial plan for the company 12 The cost of capital 13 Shareholder value analysis 13 Recommendation 14 List of References 15 Introduction Food for life, a company incorporated in the United Kingdom, operates locally. The company was established 25 years ago and since its establishment, it has been providing services to various customers such as schools, colleges, hospitals, businesses and retirement homes. The company faces strong competition from only one company, the Organic Foods. Its rival company is a much larger and has expanded into various international markets. The establishment of Food-For-Life was made by two young women who currently own 75% of shares, whereas, the other 25% of shares are owned by a venture capital firm. The end of the financial year 2014 is on the horizon and the customary board meeting is expected any time. Among the most critical issues to be discussed during the board meeting are the company’s objectives. The following are the three objectives to be reviewed during the meeting: first, the company wishes to maintain the company’s profit margin of around 24%. Second, the company seeks to uphold the current strong financial position. Last, in order to satisfy the interest of the shareholders, the company is planning to maintain the current dividend payout ratio of 40%. In addition, the company anticipates an increase in the sales levels to £ 270 million in 2015, £ 310 million in 2016 and £ 350 million in 2017. However, the sales growth rate is expected to be zero for the subsequent years. Based on the company’s financial objectives and other relevant information such as the financial statements, this report seeks to present a review of the company’s current objective, an opinion regarding the company’s 3-year plan, and an appraisal of the significance of the intended capital investment. The suitability of the Food-For-Life’s chosen objectives The company has three critical objectives whose appropriateness should be appraised. The objectives are as follows: to maintain the profit margin at 24%, to uphold the current strong financial position and to maintain the company’s dividend payout ratio of 40%. In order to determine the suitability of the objectives, a financial analysis using ratios could be useful. Turnover ratios Net asset turnover – this ratio indicates the efficiency with which the net assets are utilized to generate revenue. Concerning Food-For-Life Ltd, the asset turnover for the period is determined to be 1. The interpretation of the ratio means that every one pound invested in the company’s net assets was utilized to generate £ 1 toward the company’s revenue. Therefore, the company earns the exact amount invested in the net assets. This shows that the company is actively engaging the net assets in the revenue production process. Total asset turnover - this ratio indicates the efficiency with which the total assets are utilized to generate revenue. The total asset turnover of the company in question for the period was 0.625. The interpretation of the ratio states that £ 1 invested in the total asset generated £ 0.625 toward the company’s revenue. Based on the ratio analysis, the total assets generate less than the invested amount toward the company’s return (Sarngadharan & Kumar, 2011). Liquidity ratio Current ratio- shows the ability of a company to sufficiently meet the current obligation using the liquid assets. The current ratio for Food-For-Life Ltd for the period has been determined to be 1.667. The interpretation of the ratio states that for every £1 of current liability, the company had £ 1.667 of the current assets. The ratio depicts the capability of the company to completely meet its current obligations without fully exhausting the available current assets. Therefore, the company’s liquidity level is high (Sarngadharan & Kumar, 2011). Gearing ratio Debt/equity - ratio indicates the proportion of fixed charge capital in the capital structure of a company. Concerning the company under consideration, the debt/equity ratio for the considered period has been determined to be 0.66. The interpretation of the ratio states that for every £ 1 of total equity, the company had £ 0.66 of the fixed charge capital (Long-term liability). In other words, 66% of the company’s capital structure is composed of shareholders equity whereas; the remaining 34% was fixed charge capital. Based on the ratio, the company’s gearing level is low. In other words, the company’s reliability on external debt as a source of finance is low (Poston, Harmon & Gramlich, 1994). Profitability ratios Operating profit margin- the ratio shows the level of a company’s profitability after meeting the costs related to sales. It also shows the capability of a company to meet other critical obligations such as meeting the cost of capital and the payment of income tax. A higher operating profit margin signifies a higher capability to pay interest and taxes. Concerning the Food-For-Life, the ratio has been determined to be 20%. The interpretation of the ratio means that 20% of the company’s total sales are operating profit, whereas, the remaining 80% of the sales were used up in meeting costs related to the sales. Based on the analysis, the company’s selling activities are fairly efficient (Poston, Harmon & Gramlich, 1994). Net profit margin- this ratio shows how well a company manages its administrative and other operating expenses. The higher the ratio, the lower the operating expenses of a company. Concerning the company in question, the ratio for the period has been determined to be 14%. The interpretation of the ratio states that only 14% of the company’s sales constitute the net profit of the company whereas, the remaining 86 % were used to meet the administrative and other operating expenses. Based on the analysis, the company’s administrative expenses are fairly high. Therefore, stricter cost reduction policies should be implemented where appropriate (Poston, Harmon & Gramlich, 1994). The growth and valuation ratios The dividend per share indicates the dividends earned by investors from every share held. The dividend per share of the company for Food-For-Life Ltd for the period under consideration has been determined to be £ 0.56. The interpretation of the ratio states that shareholders were paid £ 0.56 for every share held. The division of earnings between payment to shareholders and re-investments are determined by the dividend policy implemented in a company. Therefore, dividend policy focuses on the following aspects: how much to pay, when to pay, why dividend payments are made, and how to make the payments (Osteryoung, Constand & Nast 1992). The earnings per share indicate the amount of a company’s profit attributable to every share held by investors. A high ratio indicates a higher earning power of a firm. Concerning the company under the consideration, the EPS for the period is determined to be 1.4. The interpretation of the ratio states that £ 1.4 is attributed to every share held by investors. The dividend payout ratio indicates the proportion of earnings used to pay dividends. Concerning Food-For-life Ltd, the dividend payout ratio for the period has been determined to be 40%. The interpretation of the ratio states that 40% of the company’s earnings were used to pay dividends, whereas; the remaining 60% were retained (Singh & Schmidgall 2002). The first objective The first objective of the company is to maintain the profit margin around 24%. From the above ratio analysis, the current profit margin is 14%. As discussed above, the ratio means that the administrative and other operating expenses of the company are very high thus eating away a bigger proportion of the company’s profits (Singh & Schmidgall 2002). The company will have to implement cost reduction measures in appropriate areas. Maintaining the profit margin at 24% means an increase in the company’s net profit from the current value of £ 35 million to (0.24*250) = £ 60 million. If this objective is achieved, the company would either increase the level of retained earnings or increase the dividend payment to the shareholders. An increase in the dividend payment would increase the attractiveness of the company to potential shareholders. Consequently, the market value of the company would increase. In addition, a company with high value receives lenient treatment from the lenders, thus increases the chances for qualifying for a loan. Therefore, this objective is suitable to the company due to the mentioned reasons (Osteryoung, Constand & Nast 1992) The second objective The second objective is to uphold the strong financial position of the company. Based on the above ratio analysis, the company’s liquidity level is high. A similar case applies to the net profit. The company is able to meet its current obligations such as payment to suppliers and meeting the utility bills. Creditors assess the capability of companies to meet such obligations when evaluating the credit worthiness of a borrower. In order to continue meeting the day-to-day obligations of the company, the current financial position should be maintained. Therefore, this objective is suitable (Osteryoung, Constand & Nast 1992). The third objective This objective seeks to maintain a dividend payout ratio of 40%. However, dividend payout ratio is a function of the dividend per share and the earning per share of a company. The function is expressed as follows: DPR = DPS/EPS. The DPS variable in the function is also a function of the number of a company’s shares and the amount of dividend paid to shareholders. Therefore, this objective will influence the company’s dividend policy. As briefly mentioned above, dividend policy focuses on the following aspects: how much to pay, when to pay, why dividend payments are made, and how to make the payments (Bai, Hunting & Paulsen 2012). Dividends decisions are essential part of a firm’s financing decision. It is therefore a plan of action adopted by the management. For instance, payment of high dividends means less retained earnings and the firm may have to go to the market to borrow for investment purposes. This will increase its gearing level. The dividend decisions made by a firm have a significant influence on the share value. Managers are, therefore, advised to formulate effective and optimal dividend policy, which creates value and maximizes the shareholder’s wealth (Bai, Hunting & Paulsen 2012). The dividend policies How much to pay: it overwhelming to determine how much dividend to pay the shareholders. As a result, there are various methods to simplify the process. Companies can use constant payout ratio, constant amount of each share, constant dividend per share plus a surplus amount, or the residual dividend payment method (Abbott 2001). Constant payout ratio alternative involves the payment of a fixed amount of dividend, usually a fixed portion of the company’s earnings. For instance, a company could decide that 30% of annual earnings is used for dividend payments. Under this method, the amount of dividends paid to the shareholders is directly dependent on the level of the company’s earnings. In addition, if a company makes no profit, the dividends earned by the shareholders is zero. Therefore, this policy creates uncertainty regarding dividend payments, thus has no significant contribution in shareholder value creation (Dhaliwal, Erickson & Trezevant 1999). An invariable amount per share is the second policy used to determine how much to pay. The dividend paid to shareholders is invariable regardless of the earning level of a company. Unlike the above policy, this policy creates a certainty of dividend payments. It, therefore, is the preference of the shareholders with heavy dependence on dividend income. By fixing dividend per share at a lower level, the policy safeguards the company during the seasons of low earnings. In addition, the policy offers the shareholders a preferential treatment by fixing the rate of return. The dividend per share is adjustable and could be increased or reduced depending on the levels and the sustainability of the earnings (Chawla 2008). Constant dividend per share plus extra involves the payment of a fixed dividend annually. However, shareholders receive occasionally payment of extra dividends when the company makes a supernormal profit. The policy allows for a flexible dividend payment. That is, it allows the company to increase dividend during high profitability seasons. It also gives the shareholders a chance to participate in earning of the supernormal profit. However, the surplus dividends are paid in such a manner that they are not perceived as a constant responsibility of the company. Therefore, the policy is preferable to firms whose earnings are highly volatile (Abdelsalam, El-Masry & Elsegini 2008). The residual dividend policy involves the payment of dividends out of the amount of money remaining after investment decisions have been financed. Under this policy, dividends will only be paid if there are no profitable investment opportunities available. Therefore, the policy is said to be in line with the shareholders’ wealth maximization objective (Setia-Atmaja 2010). Why to pay The following are the theories on dividend payment: the residual dividend theory, the Modigliani and Miller dividend irrelevance theory, the bird-in-hand theory, the information signaling effect theory, the tax differential theory, the clientele effect theory, and the agency theory. Since the company’s objective is to continue paying dividend, the following theories are discussed: agency theory, the bird in hand theory, and the information signaling effect theory (Chawla 2008). Agency theory – one method of solving the agency problem between the shareholders and managers is through the payment of high dividends. Managers will thus engage in activities that are consistent with maximization of shareholder wealth by making full disclosure of their activities. Dividend policy will have a beneficial effect on the value of the firm because the dividend policy can be used to reduce agency problems by reducing agency costs. The implies that companies adopting the higher dividend payout ratio will have a higher value due to reduced agency costs (La Porta, Lopez-de-Silanes, Shleifer & Vishny 2011) Bird -in - hand theory - this theory argues that stockholders prefer certainty due to their aversion towards risk. Dividend payments are more assured as compared to the capital gains, which depend on the market forces of demand and supply to influence the share prices. As a result, the bird in hand (the assured dividends) is better than two in the bush (capital gains). Consequently, the value of a firm that pays high dividends is likely to be high (Hunting & Paulsen 2013). Information signaling effect theory - the underlying concept of the theory states that, the management of a company can use dividend policy to send an important message to the market, which only they know the meaning, in an inefficient market. It is important to note that an inefficient market is characterized by severe cases information asymmetry. For instance, if the management pays high dividend, the message sent to the market is that of a possible high future profits in order to maintain the high dividend payment level (Hussainey, Chijoke & Chijoke-Mgbame 2011). Therefore, in order to prevent agency problems, respond to the investors’ preference to certain earnings (dividends) and to signal a message to the market, Food-For-Life Ltd should maintain the dividend payout ratio thus the company will have to implement a constant dividend payout policy. Consequently, the objective is suitable. A financial plan for the company The company plans to increase the sales levels to £ 270 million in 2015, £ 310 million in 2016 and £ 350 million in 2017. However, the sales growth rate is expected to be zero for the subsequent years. In order for the company to achieve the plan, the level of productivity must be increased. That is, the company must increase the number of catering services delivered annually. Therefore, more funds must be invested to facilitate the acquisition of the necessary equipments. Assume that the company has borrowed an additional loan £ 50 million at 10%. Therefore, a three-year financial plan for the company considering the objectives would be as below. Table 1: cash flow projections Year 2014 2015 2016 2017 £ millions £ millions £ millions £ millions Sales 250 270 310 350 Operating profit 60 64.8 74.4 84 Less interest (£ 100 m @10%) 10 10 10 10 Less interest (£50 m @ 10 ) 0 5 5 5 Profit before tax 50 49.8 59.4 69 Tax at 30% 15 14.94 17.82 20.7 Profit after tax 35 34.86 41.58 48.3 Dividend 14 13.94 16.63 19.32 Retained profit 21 20.92 24.95 28.98 The above table, the company’s operating profit, profit before tax, profit after tax, dividend payment and retained profit increase with an increase in sales. Based on the plan above, the company is not likely to experience any financial problem in the future. Therefore, the plan is suitable because it increases both the company’s financial strength (high profits) and maximizes the shareholder’s wealth (payment of high dividend). The cost of capital The company relies on three sources of capital, that is, equity, retained profits and debt. The cost of debt could be determined using the following formula: Kd = (interest * par value) / market value. In order to incorporate the rate of tax, the cost of debt with respect to the tax rate, in this case would be Kdt = Kd(1- t) where Kdt is the cost of debt with respect to the tax rate, Kd is the cost of debt, and t is the rate of tax. The cost of external equity could be determined using the following formula: Ke = {Do (1 + g)/Mv – f}+ g, where Ke is the cost of equity, Do is the dividend paid, g is the growth rate of dividend, Mv is the market value of shares, and f is the floatation cost. Last, the cost of retained earnings is determined using the following formula: Ke = {Do (1 + g)/Mv}+ g. In this case, there is no information about the market prices of the costs of capital (Ly 2010). Shareholder value analysis The shareholder value analysis using the net present value is not impossible in this case due to incomplete information about the market values of the costs of capital (debt and equity). Nevertheless, the shareholder value analysis is still possible. The company’s plan increases the dividend, the retained earnings and the sales, as indicated in table 1 above. Therefore, any strategy that increases a company’s ability to generate cash, increases the earnings to the shareholders and increases the level of retained earnings increases the shareholders’ value (Walters 1999). Recommendation All the three objectives of the company are suitable since they facilitate the creation of shareholder value. Based on the cash flow analysis conducted, the company’s revenue streams are increasing. Both the dividend and the retained earnings follow a similar trend. Therefore, the company’s objectives facilitates value creation, thus maximizes the shareholder’s wealth. Food-For-Life Ltd has broken down its objectives into clear and direct action plans. On the other hand, the objective of the rival company, Organic food, is too general thus scatters the resources of the firm. List of References Abbott, L.J. 2001, "Financing, dividend and compensation policies subsequent to a shift in the investment opportunity set", Managerial Finance, vol. 27, no. 3, pp. 31-47. Abdelsalam, O., El-Masry, A. & Elsegini, S. 2008, "Board composition, ownership structure and dividend policies in an emerging market", Managerial Finance, vol. 34, no. 12, pp. 953-964. Bai, L., Hunting, M. & Paulsen, J. 2012, "Optimal dividend policies for a class of growth-restricted diffusion processes under transaction costs and solvency constraints", Finance and Stochastics, vol. 16, no. 3, pp. 477-511. Chawla, G. 2008, "Dividend Policy Decisions", Journal of American Academy of Business, Cambridge, vol. 14, no. 1, pp. 42-47. Dhaliwal, D.S., Erickson, M. & Trezevant, R. 1999, "A test of the theory of tax clienteles for dividend policies", National Tax Journal, vol. 52, no. 2, pp. 179-194. Hunting, M. & Paulsen, J. 2013, "Optimal dividend policies with transaction costs for a class of jump-diffusion processes", Finance and Stochastics, vol. 17, no. 1, pp. 73-106. Hussainey, K., Chijoke, O.M. & Chijoke-Mgbame, A. 2011, "Dividend policy and share price volatility: UK evidence", The Journal of Risk Finance, vol. 12, no. 1, pp. 57-68. La Porta, R, Lopez-de-Silanes, F, Shleifer, A, & Vishny, R, W 2011, “Agency problems and Dividend Policies around the world”, The journal of finance, Vol. 55, No. 1, pp 1-33. Ly, K. 2010, "Investor relations level and cost of capital: evidence from Japanese firms", Asia - Pacific Journal of Business Administration, vol. 2, no. 1, pp. 88-104. Osteryoung, J., Constand, R.L. & Nast, D. 1992, "Financial Ratios in Large Public and Small Private Firms", Journal of Small Business Management, vol. 30, no. 3, pp. 35. Poston, K.M., Harmon, W.K. & Gramlich, J.D. 1994, "A test of financial ratios as predictors of turnaround versus failure among financially distressed firms", Journal of Applied Business Research, vol. 10, no. 1, pp. 41. Sarngadharan, M., & Kumar, R. S. (2011). Financial analysis for management decisions, Wiley, NY. Setia-Atmaja, L. 2010, "Dividend and debt policies of family controlled firms", International Journal of Managerial Finance, vol. 6, no. 2, pp. 128-142. Singh, A.J. & Schmidgall, R.S. 2002, "Analysis of financial ratios commonly used by US lodging financial executives", Journal of Leisure Property, vol. 2, no. 3, pp. 201-213. Walters, D. 1999, "The implications of shareholder value planning and management for logistics decision making", International Journal of Physical Distribution & Logistics Management, vol. 29, no. 4, pp. 240-258. Read More