Financial Regulations in Financial Management - Assignment Example

Financial Regulations Q1 (i) A Company’s capital maintenance can be viewed from two perspectives: Financial Capital Maintenance (FCM) and Operating Capital Maintenance (OCM). OCM means the capability of the promoters to keep the system on going, so as to render productive services, and FCM, means adding to the Net Worth of the Shareholders’ Equity Capital Base. Under the OCM method, it is assumed that the operational capability of the company is maintained evenly from the beginning of the financial period to its end. At the termination of the operating period, the utility must have as much operating capital as it has had at the beginning of the period. Under this system, the difference between closing capital and opening capital is treated as profits, or surplus, after providing an adequate amount for operating costs, which is required for the maintenance of assets and other expenses. (ii) However, under FCM, the financial capital of the company is said to be maintained at present price levels; and if the shareholders funds at the end of the year is the same as that at the beginning, it is believed that capital has been maintained. Under the FCM, revenues become profits after adequate provision for the marketing of the financial values of the assets are maintained. (iii) During periods of technological shifts and rapid products changes, the asset value increases in real terms, but the working profits tends to reduce, due to increased incidence of depreciation charges. During this period, the shareholders’ equity would go up, because of the increase in retained earnings to the utility. Therefore, it could be said that the OCM method could best be adopted during periods of conspicuous technological and frequent product changes for the utility. (iv) Depreciation is a charge against profits to offset the fall in value of the assets, due to technological obsolescence, passage of time, wear and tear etc. The question of depreciation would normally occur only when the assets have completed their utility value and need to be replaced. When depreciation is charged against the revenues, a revenue advancement is created, and this occurs throughout the lifespan of assets. If the capital expenditure incurred on the acquisition of new assets is higher than the depreciation charged over the years, a revenue deferral would be created. In the long run, the effects of revenue advancement and revenue deferral would tend to even out and thus, would not have any long term impact of depreciation on the financial aspects of the utility. Q 2 (v) The Capital Asset Pricing Model (CAPM) is a single factor model. It analyses the risk element involved in the function of just one factor, i.e. its stock beta coefficient. But in the empirical models, the risk/return factor is far more intricate and intriguing, with a host of factors involved. Therefore, in situations involving more than one factor impinging on the returns, the CAPM model is not a very useful option. Moreover, if the stock holdings of investments are not fully diversified, that is, free of diverse risks, than the beta co-efficient would not be a sufficient indicator of risk and also, the SML would not be sufficient to set up the required returns. Further, if the cost of borrowings are more than the lending rates, the CML would not be constant and would show distorted results. Last, but not least, the inputs for the rate of returns are based on future projections, which may not be correct in all situations, since a lot of unforeseen factors could impact on future earnings. (ii) The other available methods of calculating cost of capital could be: 1. Arbitrage Pricing Theory 2 Dividend Yield + Growth rate (Discounted Cash Flow) 3. Weighted Average Cost of Capital. Arbitrage Pricing Theory: This takes into account several risk factors, since it is possible that required returns may be a combination of several factors and thus it allows several risk factors to be considered to compute stock risk and other options are available to the regulator to address the problem of risk/return, unlike CAPM Model. Further, it makes lesser assumptions than CAPM Model and therefore, could be more non-specific approach and also, it does not presume that the securities portfolios are all held by only investors, which is very practicable theory Dividend Yield + Growth rate (Discounted Cash Flow): This approach expresses the cost of common equity as a dividend yield and growth rate. The dividend yield can be estimated with a high degree of certainty. The DCF can be analyzed well through use of historical growth rate, retention growth rate, growth rate model and analysis forecasts. By far the analysis forecasts is the best method for computation of the DCF cost of capital. Weighted Average Cost of Capital (WACC): The utility’s weighted cost of capital is dependent on risks and overall levels of interest rates in the economy. The greater the risks involved, the higher is the general level of interest and consequently, the higher the WACC. “The correct weights are those based on the firm’s target capital structure, since this is the best estimate of how the firm will, on average, raise money in the future.” (Brigham F. Eugene & Ehrhardt C. Michael 2004. P. 435). (vi) Real option: According to the capital budgeting theories, the net present value of the project is the value of future projected cash flows, both inflows and outflows based on the current discounted rates. A negative NPV shall not be accepted. But now a question arises as to how action for increased inflows would be initiated after the project is on stream. Capital budgeting is important because there is also an element of risk involved. The chances of changing to varying circumstances, which are designed to change to suit varying situations and are based on real assets are called real options. An utility company should consider “input flexibility” (Brigham F. Eugene & Ehrhardt C. Michael 2004. P. 597) option because it offers multiple options for alternative cost reductions, rather than a single option for cost control management and increased profitability to stakeholders. Q3 The Return on Sales (ROS) depicts what proportion of the sales are available to the common stockholders as net income. The measurement is: Net Income available/Sales. And is expressed in percentages The Definition of Return on Equity (ROE) is the proportion of common equity which has been returned to stakeholders as Net Income. The measurement is: Net Income available/Common Equity. In my opinion, sales and equity do not have much in common. A company with a high equity base does not necessarily guarantee increased sales in proportion to the holdings. Consider the cases of utility companies which have large capital bases but comparatively make lower profits. Profits arise out of external factors like capitalising on. Market opportunities, strategic risk taking and highly diversified stock holdings in high yielding companies. The advantages of ROS and ROE are that they are amenable to comparisons studies with competition companies and industry standards. Their disadvantages lie that they are taken at Book values and may not be representative of, or in conformity with actual ground realities. The value to the owner in real terms means cost price, or the value at which the owner has purchased the asset. One of the basic tenets of management accounting, based on the law of conservatism , is the assts should be valued at cost price or market value, whichever is lower. Some assets ,especially land properties, goodwill and capitalized Software technology tend to increase over a period of time, but from the strict management accounting principles could only be taken at the cost of acquisition, or purchase costs. Therefore, since the costs of all acquisitions are documented, it would be reasonably accounted to have a true value of the business. (vi) Truncated Internal Rate of Return (TIRR) many companies prefer IRR over NPV The Truncated Rate of Return assumes that the cash flows from all the projects are reinvested at the cost of capital, while conventional IRR “assume that the cash flows from each IRR are reinvested at the projects’ own IRR”. Since the reinvestments at the cost of capital are fundamentally more accurate, the truncated IRR is considered to be a better option for measuring profitability. (Brigham F. Eugene & Ehrhardt C. Michael 2004. P 521). Q 4 (i) In the utility sectors, especially in the Electricity Companies, the tariffs are based on normative strictures rather than on performance benchmarks. This leads to a lot of distortion in the presented information to regulators which could lead to incorrect decision-making. Therefore, in order to make the benchmarks more performance oriented, incentive power methods are introduced for making efficiency improvements in the sectors and also for reducing the basic unit costs to the ultimate consumers. One example of incentive power measurement would be the calculation of energy tariffs in the electricity industry. The difference between company specific regulation and yardstick competition would be in terms of its scope and operational viability. Utilities need to work under regulatory methods, since being monopolistic in nature, they are prone to charge exorbitant prices without producing adequate results. Monopolies are in a position to charge high since the incidence of competition is minimal and they are absolute control over their products or services. The element of yardstick competition has been introduced with the ultimate aim of creating competition among monopolists in order to make their performance more competitive and transparent. This is also being done in order to disallow misuse or manipulation of market power which utility companies may enjoy. Therefore through yardstick competition the Regulators aim 1. To reduce costs 2. To make utilities more competitive and performance oriented 3. To discourage misuse of Monopolistic power. (ii) The advantages of yardstick regime when compared to company regulated regime is that while yardsticks are meant for the industry as a whole, company regulated regimes are company specific. The advantages would be in terms of better price management, more competitive environment and better service and value addition to consumers. The disadvantages are that consolidation among the monopolists themselves could vitiate the objectives of price controls and efficient business performance. Q5 Capital requirements are the essential requirements of any organization. The capital requirements are satiated either from debt or borrowed funds, or from raising equity, through Public issues, debenture Stocks, Bonds etc. The option whether a company should be highly geared (larger proportion of debt to equity) or lowly geared (lower proportion of debt to equity) is largely a matter of contextual interest and is best left in the hands of the governors of the company. However, it needs to be emphasized that a lowly geared company could withstand market pressures better and would have a better market resilience, during market slumps as compared to highly geared companies. The increased gearing to the company brings in its wake, higher fixed and compulsory interest costs and this could affect the profitability and shareholders’ returns, since the interests have to be paid, whether adequate profits are available or not. This is well during boom, but during slump, the company may not be in a position to pay the interests on debts, thus leading to possible bankruptcy. The effect of increasing gearing to the company would therefore be in terms of increased financial costs and capital payments of loans taken. High gearing in terms of its effects on the society would be that more and more companies would become insolvent and the stakeholders in these companies would lose a large portion of their investments in the event of dissolution of these companies. The factors that a utility company would take into consideration before deciding what kind of debt finance to issue would be: 1. Business risks. What kind of business risks are inherent in the utility’s business and what are the reasonable risks it could possible take. The least risk option would be issue of equities since there is no fixed interest burden and the question of repayment arises only after dissolution. However, an ideal mix would be of debt/equity/bonds and securities and Govt holdings. Tax Position: Debt capital is attractive because its interest is tax deductible and this reduces the cost of eventual debt. However, in the case of utility, there are other covers for taxes such as depreciation charges, interest on current debts and so, for utility companies, the aspect of tax benefits may not be very appealing. Financial flexibility which means that a company should be able to raise funds whenever it is required For a utility company, having a high debt equity structure is not effective for flexibility. Q 6 (i) Finance ability assessment could be done by analyzing the balance sheets of the utilities to ensure that all parameters of a strong financial capacity are present. It has to ensure that the cost of capital allowance is adequate, and that the utility need not have to undertake fresh capital requirements from the money market or capital markets or if this is not possible , whether it would be necessary to resort to debt for financing its projects. The utility’s current cash flow position, debt equity ratio, gearing analysis and RoE , among other parameters , would also have to be considered (ii) If the regulator has set the cost of capital in the price control at an appropriate level then the analysis of finance ability tests should not reveal any problem. Yes I agree to this statement because the cost of capital has been set after considering all the aspects of the business, and ,in a monopolistic market in which most utilities operate, the question of returns and liquidity and funding for future projects could be available from retained earnings (iii) The utility could use the following alternative sources of raising further capital to fund its projects: 1. Raising public equity through issue of shares and securities or from existing stockholders through rights issue. 2. Seeks loans assistance from financial institutions 3. Capital market borrowings 1. The advantages of public equity is that the returns to them are not fixed and can be varied depending upon profitability of the utility and also the payback is after the final dissolution of the company. Unlike secured creditors, equity stakeholders cannot exercise lien over the utility’s assets. The disadvantages are that public issue is a long and complex procedure invoking regulatory intervention, and to a large extent, depends upon current market trends and volatility 2. Seeking loan assistance from financial institutions against hypothecation of company’s assets, are an assured source, and rate of interest is comparatively and is low and well regulated. Bur it attracts a high degree of procedural compliances as per the norms and requirements of the lending authorities. 3. Borrowings from capital money markets – primary and secondary. They are good sources, especially for short and intermediate term borrowings. However, the attendant risks of repayment and debt servicing at high interests costs are also prevalent. To conclude, it could be said that the retained earnings and capital reserves could be the best way of meeting proposed project costs since external sourcing entails high risk factors in terms of interest commitments and loan repayment scheduling. . Works Cited Eugene, Brigham F., & Michael, Ehrhardt C. (2004). Financial Management: Theory and Practice. Singapore: South Western Thomson learning. Read More