Finance For International Business - Essay Example

Finance for International Business Table of Contents Introduction 4 Overview of Fenland and Fresh Farm Foods Company 4 Foreign Exchange Exposure 5 Types of Foreign Exchange Risk Exposure 5 Transaction Exposure 5 Operating Exposure 5 Techniques for Managing Transaction Exposure 5 Forward Contracts 5 Future Contracts 6 Risk Shifting 6 Techniques for Managing Operating Exposure 6 Operational Strategies 6 Marketing Strategies 6 Sources of Financing 7 Equity financing 7 Options of Equity Financing 7 Debt Financing 8 Options of Debt Financing 8 Risk and Return 8 CAPM Model 8 Capital Budgeting 9 Methods of Capital Budgeting 9 Net Present Value (NPV) 9 Internal Rate of Return (IRR) 10 Payback Period 10 Net Cash Flows of Fresh Farm Foods Company 10 Cost of Preference and Equity Share Capital 10 Conclusion 11 Reference List 11 Appendices 13 Appendix 1: WACC 13 Appendix 2: Net Cash Flows, PV, NPV and Payback period 14 Appendix 3: IRR 15 Appendix 4: Cost of Preference and Ordinary Share Capital 15 Introduction Financing is required to commence a business or to undertake a project and slope it up towards profitability. The financing requirements of a company vary in accordance with the size and type of the company (Hofstrand, 2013). The processing businesses requires large sum of capital as they are capital intensive whereas, the retail businesses needs less capital. Equity and debt are two main sources of funding the project or business (Pike, Neale and Linsely, 2012). Fenland Foods was originated in the year 1970. The demand for their raw food was increasing and the company expanded rapidly but the family business still prevails. In the year 1980, it was reorganized as a limited company and then experienced quick growth till 1991. The business of Fenland Foods had reached the edge of development but then the future development needs large scale growth to contend with the producers of non-organic food. This needs a capital injection and it was unable for the company to generate themselves. So, the company directors are looking for other potentials for the future development. The main purpose of this essay is to evaluate the Fresh Farm Foods Company in order to make decision for Fenland Foods Plc whether they should undertake the project. It also requires identifying the utmost price Fenland should pay in order to acquire the Fresh Farm Foods Company. Overview of Fenland and Fresh Farm Foods Company Fenland Foods Plc was initially a family business and later on streamlined as a limited company. The financing is done through issuing debentures. At present, the current directors consider that their long term achievement lies in the expansion and diversification. The company needs to first evaluate its own financial position and then make necessary changes to reinforce its current financial situation. The director is concerned that the business should preserve sufficient liquidity as well as finance the assets in a favourable manner. The stock markets are extremely volatile and the uncertainty about the world economic development resulted in the lower trading of company’s ordinary shares. Fenland Foods Plc is thinking of a new venture to attain high return on the capital employed. They consider investing in Fresh Farm Foods Company because they have already analysed the trends of Fresh Farm’s financial ratios. Fresh Farm Foods Company is a flourishing family-owned business enterprise; the company requires additional capital to enhance its organic food network in Ireland. The share capital of Fresh Farm Foods Company is €550,000. They are deeming to sell all their shares to an appropriate company by 2014. Foreign Exchange Exposure It is defined as the sensitivity of actual domestic currency rate of liabilities, assets, and operating income towards probable changes in the exchange rates. Alteration in nominal exchange rate often are not compensated by consequent changes in domestic value of currency, this is called the actual exchange rate risk. The fundamental variables are neither successful in predicting the rate of exchange nor are the forward rates (Fordham, 2014). The risk associated with Fenland Foods Plc’s foreign exchange will be assessed by the discrepancy of the home currency value of liabilities and assets. Given the different market flaws in the world, evading exchange rate risk could lead towards an enhancement in the Fenland Foods Plc’s value. Types of Foreign Exchange Risk Exposure Due to the foreign exchange risk associated with Fresh Farm Foods Company, it can lead to operating and transaction exposure. Transaction Exposure Transaction exposure is referred to the sensitivity of real home currency price of liabilities and assets, when they are settled with respect to unpredicted changes in the exchange rates for importing, exporting, and import-substituting companies (Fordham, 2014). Operating Exposure Operating exposure is also known as economic exposure. It is defined as the sensitivity of real home currency price of liabilities and assets, and future operating profits to unpredicted changes in the exchange rates. It is the consequence of changes in the exchange rates on the company’s actual operation (Fordham, 2014). Techniques for Managing Transaction Exposure Forward Contracts When the companies have a contract to receive or pay a fixed sum of foreign exchange at some agreed future date, in most of the currencies they can get a deal today which specifies a cost at which they can sell or buy the foreign exchange at the agreed future date. This basically converts the undecided value of future home currency of this asset or liability into a definite home currency price to be obtained on the agreed date (Bodnar, 2014). Future Contracts They are generally exchange traded and thus encompass limited and standardized contract sizes, initial collateral, maturity dates, and various other features. Future contracts are generally available in certain sizes, currencies and maturities, so it is normally not possible towards getting an accurate offsetting position in order to totally eradicate the exposure. The exchange necessitate position user to posts margins or bonds based upon their positions value. This virtually eradicates the credit risk which is involved in future trading (Buckley, 2004). Risk Shifting It is considered as the operational strategy for controlling the transaction exposure. The most apparent way to decrease the transaction exposure is not to include an exposure. Through invoicing all deals in the domestic currency a company can circumvent transaction exposure (Shapiro, 2010). Techniques for Managing Operating Exposure Operational Strategies To manage the operating exposure, the first thing is to judge the operation responses towards the changes of exchange rates. The firms set up its production, sourcing, operations, and marketing so that they can respond towards the alteration in the actual exchange rates. It helps them to take benefit of the better competitive position or/and limit the damage caused by the lack of competitiveness. These might be either the ex ante actions which provide the company an operating choice, or marginal transformation in the activity intensity which try to diminish the unfavourable impact of fluctuations of exchange rate on company value (Bodnar, 2014). Marketing Strategies The marketing strategy includes the pricing policy of the company for managing the operating exposure. In response towards changes in the actual exchange rates, a company is required to make a choice regarding profit margin versus market share. Such a choice could be made through locating the price which maximizes the dollar profits. The decision of adjusting the price of foreign currency in relation to the changes in the exchange rates will be based on how long the change in the actual exchange rate is anticipated to persist. In opting to change the prices, a company should consider the consequence on the cash flows (Bodnar, 2014). Sources of Financing There are various sources of financing available to Fenland Foods Plc in order to undertake the project. The different types of financing options are: equity financing which incorporates venture capital, private equity, personal savings; and debt financing which includes bank loans and financial institutions (Bender and Ward, 2012). Equity financing Equity financing is defined as a method of raising the capital through auction of shares in a company (Arnold, 2007). The ownership stake which results from equity investment permits the financier to have a share in the profits of the Fenland Foods Plc. It entails permanent investment in the company and not reimbursed later by an organization or company (Shapiro, 2013). Options of Equity Financing Venture Capital: It is the amount which is invested through venture-capital organizations in small and start-up businesses with outstanding growth potential. The venture capitalists generally have rigid investment criterion and usually specialize in particular high-growth companies (Atrill, 2009). Private Equity: The private equity financiers make investment in those companies that are privately held. In the spectrum of risk-capital, venture capitalist takes high risks and therefore expects high return as compared to the private equity financiers/investors (Boakes, 2010). Personal Savings: It could be used towards creating ownership and rights in new company. This will facilitate to manage the decisions of the company (Ravindranath, 2011). Debt Financing It is referred to the money which is generally borrowed to carry out the business. Funding through debt creates cash through borrowing from Mortgage Company or bank, family and friends, or from the financial institutions. Debt should be compensated on time as discussed between the two parties in an agreement. It may be unsecured or secured. Secured debts comprise collateral whereas the debt of unsecured nature does not encompass collateral and eventually places lender in less secure situation (Neale and McElroy, 2004). Options of Debt Financing Bank Loans: Banks are normally referred as the main component of debt financing. They are generally attractive in nature because they do not require the industrialists to turn over company control. However, servicing debt could drain a new organization with inadequate cash flow. New firms might not even opt for bank loans if their operating history is bad as well as have no security to safeguard the loan. Bank loan need assurance of reimbursement by necessitating personal guarantees as well as secured interest, for example mortgage on the personal assets (Rao, 2010). Financial Institutions: The financial institutions for example IDBI, ICICI, and SIDBI fund the entrepreneurial ventures (Ravindranath, 2011). Risk and Return CAPM Model The CAPM (capital asset pricing model) framework helps the company to compute investment risk as well as the return on the investment they should expect. The notion behind this framework is that each investment includes two kinds of risk i.e. systematic and unsystematic risk (Fama and French, 2004). The systematic risks are the market risks which is almost impossible to diversify. The examples of such risks are: recessions, wars, and interest rates. Unsystematic risk is referred to the specific risk. It is diversifiable in nature and therefore could be diversified when the shareholders increases the amount of stocks in their portfolio (Perold, 2004). Beta is regarded as the only appropriate measure of the risk related to stock. The beta of the stock is one when the price of the share moves exactly with the market ups and downs. This model suggests that an investor could earn more only through investing in single stock. The capital asset pricing framework works because it is normally applied to estimate the suitable risk-adjusted probable return on investment and as a result helps in deciding the fair value of investment (Mullins, 1982). In this case, the risk free rate of Fenland Foods Plc is 1.8%, beta is 1.7 and expected market return is 5.3%. Therefore the risk premium comes at 3.5%, i.e. (5.3 – 1.8). This indicates that the financier will not assign funds to investment unless they expect to obtain at least a premium of 3.5% over the 1.8% risk free rate. Though, a 3.5% premium will not be sufficient if the investment is considered as more risky or variable than the whole market. The 3.5% risk premium must be increased 1.7 times to 5.95% or 6 % to attract the investors. Therefore, a stock with 1.7 betas must generate a return of 7.8% (6 + 1.8) or 8% to effectively recompense investors for the risk associated with the investment. It is analysed that the required return on financial asset comes at 12.25% which is good sign for the company to compensate the financiers (See Appendix 1). Capital Budgeting Capital budgeting is defined as the planning process which is applied by the managers of the company to decide whether the long term investments are worth the supplying/funding of money through the capitalization structure of the company. The main objective of capital budgeting is to raise the firm’s value to the investors (Arnold and Hatzopoulos, 2000). Methods of Capital Budgeting Net Present Value (NPV) Net present value is defined as the method of capital budgeting which is used to evaluate the projects of that company in which investment are to be made. If the result of the net present value is positive or if it comes at zero then the company should undertake the project or make an investment. It is calculated by dividing the investment cost with the present value or the cash inflows (Robinson and Thagesen, 2004). The present value of Fresh Farm Foods Company comes at £1267.49 and net present value comes at (£403,552.51) which is very low; therefore the Fenland Foods Plc should not make an investment in the company (See Appendix 2). Internal Rate of Return (IRR) Internal rate of return is a method used to estimate results of projected cash flow as well as to evaluate the investment or project feasibility (Ima, 2013). In order to make decision towards taking the project or making an investment, the most important thing to notice is the internal rate of return which should be more than the weighted average cost of capital (WACC). The IRR is 7.11 whereas the WACC is 12.25. According to this figure a lower internal rate of return indicates not to invest in Fresh Farm Foods Company (See Appendix 3). Payback Period Payback period signifies the time period when the project needs to recover the funds invested in that project. The choice to reject or accept the project relies on the payback period. The lower the payback period it is good for the company. According to this capital budgeting process, the project which promises a fast recovery of first investment is generally considered desirable (Siegel, Shim and Hartman, 1998). The maximum desired payback period of Fresh Farm Food Company is 5 years and the computed payback period comes at 13 years which is very less than the needed payback period. Therefore, Fenland Foods Plc should not consider undertaking the project (See Appendix 2). Net Cash Flows of Fresh Farm Foods Company The projected net cash flows of Fresh Farm Foods Company are positive for all the five years and it also keeps on increasing throughout the 5 years. The total net cash flows arrive at £1332.15 (See Appendix 2). Cost of Preference and Equity Share Capital The preference share capital cost is generally the dividend rewarded by the organization to the shareholders (Svtuition, 2010). For Fenland Foods Plc, it arrives at 10% which means that 10% of the profit will be paid to the shareholders. The equity share capital cost is 19.45% which means that 19.45% is the price to the company which will be paid to the equity share holders along with return they need on their investment (See Appendix 4). Conclusion Fenland Foods Plc should opt for debt financing method if it considers investing in the project in spite of the negative results of the Fresh Farm, because it does not require sharing the company’s part with the investor. Financing through bank loan will be the better option because raising loan through bank will give the freedom to Fenland to run the Fresh Farm Foods Company without any intrusion from the lender. By opting for the bank loan, Fenland could also enjoy the tax benefits as the interest paid on loans are generally deducted from the income before computing the taxable income. The capital asset pricing model provides a practical risk measure that helps the investors to resolve what return they actually deserve for placing their money or capital at risk. It is recommended that Fenland Foods Plc should not undertake the project as the NPV of Fresh Farm Foods is negative and also the payback period is more than five years which signifies that Fenland will not be able to quickly pay the finances. It is also advised that if Fenland considers undertaking this project in spite of its negative result then they may invest £400,000 which is less than the initial investment. Reference List Arnold, G. and Hatzopoulos, P.D., 2000. The theory-practice gap in capitral budgeting: Evidence from the United Kingdom. Journal of Business Finance and Accounting, 27(5). Arnold, G., 2007. Essentials of Corporate Financial Management. New York: FT Prentice Hall. Atrill, P., 2009. Financial Management for Decision Makers. 5th Edn. New York: FT Prentice Hall. Bender, R. and Ward, K., 2012. Corporate Financial Strategy. London: Routledge. Boakes, K., 2010. Reading and Understanding the Financial Times. 2nd Edn. New York: FT Prentice Hall. Bodnar, G., 2014. Techniques for Managing Exchange Rate Exposure. [pdf] Available at: < http://finance.wharton.upenn.edu/~bodnarg/courses/readings/hedging.pdf> [Accessed 3 Jan. 2015]. Buckley, A., 2004. Multinational Finance. 5th Edn. New York: FT Prentice Hall. Fama, E. and French, K., 2004. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspective, 18(3), pp.25-30. Fordham., 2014. Exposures of Foreign Exchange Risk. [pdf] Available at: < http://www.bnet.fordham.edu/goswami/FNGB7451FxExposure.pdf> [Accessed 3 Jan. 2015]. Hofstrand, D., 2013. Types and Sources of Financing for Start-up Businesses. [online] Available at: < http://www.extension.iastate.edu/agdm/wholefarm/html/c5-92.html> [Accessed 3 Jan. 2015]. Ima., 2013. Wiley CMA learning system exam review 2013. New Jersey: John Wiley & Sons. Mullins, D., 1982. Does the Capital Asset Pricing Model work? The Harvard Business Review, 1(1). Neale, B. and McElroy., 2004. Business Finance: A Value-based Approach. United States: Pearson Prentice Hall. Perold, A., 2004. The Capital Asset Pricing Model. Journal of Economic Perspective, 18(3), pp. 3-10. Pike, R., Neale, B. and Linsley, P., 2012. Corporate finance and investment: decisions and strategies. 7th Edn. New Jersey: Pearson Education Ltd. Rao, D., 2010. The 12 best sources of business financing. [online] Available at: < http://www.forbes.com/2010/07/06/best-funding-sources-for-small-business-entrepreneurs-finance-dileep-rao.html> [Accessed 3 Jan. 2015]. Ravindranath, S., 2011. CII Entrepreneurs Handbook. New Delhi: Westland Press. Robinson, R. and Thagesen, B., 2004. Road Engineering for Development. 2nd Edn. United States: CRC Press Publication. Shapiro, A.C., 2013. Multinational Financial Management. 9th Edn. United States of America: John Wiley & Sons. Siegel, J.G., Shim, J.K. and Hartman, S., 1998. Schaum’s quick guide to business finance. New Delhi: Tata McGraw Hill Professional. Svtuition., 2010. Cost of preference share capital. [online] Available at: < http://www.svtuition.org/2010/04/cost-of-pref-share-capital.html> [Accessed 3 Jan. 2015]. Appendices Appendix 1: WACC Weighted Average Cost of Capital Ra = Rf + βa (Rm - Rf) 12.25 Rf = Risk free rate = 1.8 βa = beta of security = 1.7 Rm = Expected Market Return = 5.3 WACC Mkt Value Weighting k Weighted Component Ke 0.7292 12.25% 0.0893 Kp 0.0865 10% 0.0087 kD 0.1843 7.11% 0.0131 ko 0.1111 Appendix 2: Net Cash Flows, PV, NPV and Payback period Appendix 3: IRR Cost of Debt Finance Current market price = £ 107.63 DCF Period (Yr) 0 1 2 3 4 Year 2014 2015 2016 2017 2018 Interest 9 9 9 9 Tax Saving 1.89 1.89 1.89 1.89 Tax given = 0.21 Redemption 100 Market Price -107.63 Total -107.63 7.11 7.11 7.11 107.11 After tax IRR = (1 - tax rate)(IRR before tax) % 7.11 Appendix 4: Cost of Preference and Ordinary Share Capital Read More