Imperial Tobacco Group Plc and the Capital Structure With Financial Leverage - Research Paper Example

 Gearing is the financial leverage that measures the extent or degree of use of debt capital for the required financing of total assets of firm. Gearing or financial leverage results from the fixed financial cost to be incurred for financing the firm. Fixed cost is the cost of debt capital employed in the firm, and its presence directly affects the earnings before interest and taxes and the earning per share. In other words the gearing or financial leverage depends upon the employment of debt capital out of total funds employed into the firm. When debt capital exceeds equity funds employed the firm is said to highly geared and when the debt funds are lower than equity funds the firms is said to be low geared. Thus financial leverage or gearing is ‘the potential use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes and the firm’s earning per share.’(Lawrence J. Gitman, page 546)i The presence of financial leverage in a firm can be expressed in terms of degree of financial leverage (DFL). Financial leverage is present when the degree of financial leverage is more than one, i.e., when the ratio of percentage changes in earning per share to percentage of change in EBIT is greater than one. The presence of financial leverage in case of Imperial Tobacco is checked by calculating its DFL, at level of its 2008 EBIT, on basis of figures for 2007 and 2008 from financial statements in its 2008 Annual Reportii. DFL is 3.08, i.e. more than one. Therefore, gearing or financial leverage is present in the capital structure of Imperial Tobacco Group Plc. Also the DFL of 3.08 indicates a high financial leverage presence in its capital structure. The extent of financial leverage or gearing of capital structure can be measured in two ways. One is on the basis of stock terms and the other on basis of flow terms. Under stock terms the leverage can be measured either by using ‘debt ratio’, i.e., debt to equity or by the ratio of total debts (including preference capital) to total capitalization (i.e. total debts plus equity or total assets of the firm) On the basis of stock terms the gearing or financial leverage of Imperial Tobacco Group Plc is calculated hereunder: Debt capital employed to finance the total assets of the Imperial Tobacco is 87.33% in 2007 and 78.24% in 2008. As debt capital employed is more than equity capital, Imperial Tobacco is highly geared company in both 2007 and 2008 as well. That means fixed charge (interest) of debt capital creates the leverage that affects the earnings available to equity holders. The benefit of highly geared capital structure is that equity holders of Imperial Tobacco can trade on equity. In other words during the period of high earnings equity holders will have the benefit of increased earnings after meeting fixed charge of interest on debt capital. This is because equity holders are residual beneficiaries. Trading in equity is the result of risk taken by the firm in its capital structure. Higher risk exists when there is high debt ratio and the equity holders are taking higher risks as residual beneficiaries. In case of Imperial Tobacco, the financial leverage is quite high and thus the risk for equity holders for their residual earnings is also higher. Dividend Policy of Imperial Tobacco ‘A finance manager’s objective for the company’s dividend policy is to maximize owners’ wealth while providing adequate finances for the company’. (Jae K. Shim and Joel G. Siegel, page 338)iii It is a general feeling that if a company does not have sufficient profitable investment opportunities, it should distribute excess funds to shareholders. The firm need not pay the exact unused portion of earnings every year, but stabilization of amount of dividend paid from period to period is very important. Dividend policy adopted by Imperial Tobacco is maintaining stabilization of dividend pay outs as per its dividend policy analyzed in this write up. Dividend as a residual: Under residual theory of dividend, ‘the dividend paid is viewed as residual- the amount leftover after all acceptable investment opportunities have been undertaken.’ (Lawrence J. Gitman, page 594)iv As long as there are investment opportunities with returns exceeding the required rate of return, the firm will use retained earnings, and the increase in its equity base will support to finance these investment projects. This theory implies that dividend is irrelevant. If investments return is less than required rate of return, the investors prefer dividend. Residual theory of dividend does not necessarily mean that dividends need to fluctuate keeping in view investment opportunities from time to time. A firm may smooth out actual payments by saving some funds in surplus years, in anticipation of deficit years. Dividend relevance theory suggests that there is direct relationship between the firm’s dividend policy and its market value. The investors are not concerned with diversification of the corporation. If dividend is less than desired, investors can sell portion of stock held by them to obtain desired cash distribution. If dividend is more than desired, investors can use dividends to purchase additional shares in the company. Dividend payout is also affected by a number of factors like legal prohibitions, contractual constrains, liquidity available with the company, growth prospectus, market considerations, and many other factors. Besides cash dividend the companies also declare stock dividends. Sometimes companies indulge in stock splits to have desired effects of a dividend policy adopted by the company. Imperial tobacco has declared the dividends of £588m in 2008 making the total dividend of 63.1p on per ordinary share as compared to 60.4p per ordinary share in 2007. Imperial Tobacco is following a constant- payout policy instead of regular dividend policy. Under regular dividend policy a fixed amount of dividend is paid each year, and in constant payout policy the stress is on certain percentage earning being paid out to shareholders. There is another low-regular and extra- dividend policy where higher dividends are given to supplement low dividends in lean periods. It appears that Imperial Tobacco is following a constant payout policy, as is clear from following dividend pay outs per ordinary share of the company Year Dividend per ordinary share 2008 63.1p 2007 60.4p 2006 62.0p 2005 58.0p As per 2006 annual reportv of the company, record date for final dividend was 19 January 2007. The importance of record date is that dividend is paid to shareholders who are on the records of the company as at record date, that in this case is19 January 2007. Therefore ex dividend date, which happens to be two days earlier than record date, is 17 January 2007. “Purchasers of stock selling ex- dividend do not receive the current dividend’ (Lawrence J. Gitman, page 590)vi. The date of payment of dividend was 16 February 2007. The date of payment is date on which dividend payments are actually mailed to shareholders on record date. Accordingly the dividend announced between 9 Oct 2006 and 9 February 2007 will be treated as under: If the dividend announcement date is before final dividend record date, i.e., 19 January 2007, then this would be treated as announcement of an interim dividend, for which another record date and payment date would be announced. And if the dividend is announced after 19 January 2007, the final dividend for which record date is 19 January 2007 would be treated as interim date, and the final dividend would be the dividend announced after 19 January 2007. For this final dividend the company will have to declare new record date and date of payment. iii) Evaluation of management of working capital: Working capital is represented by the current assets of the company. “Working capital refers to current assets and current liabilities under operation and is normally related to level of sales. Current assets are cash and other assets that are expected to be converted into cash within one year. The major elements of current assets are cash, inventory and accounts receivable.Net working capital is defined as current asset minus current liabilities.”(Sophie Manigart and Miguel Mueleman, Page 24)vii Net working capital exists when current assets exceed current liabilities and negative working capital is the situation when current liabilities are more than current assets. Management of working capital is an important financial managerial activity that ensures the short term solvency of the company. A company is said to be short term solvent when it is in a position to meet its short term obligations when those become due. The financial statements of Imperial Tobacco depict a negative working capital as at the date of balance sheet as on 30 September 2008. This is because its current liabilities of £9658m exceed its current assets of £6579m. Under the situation of a negative working capital it becomes more difficult to manage it. Basically the management of working capital involves bringing about a tradeoff between profitability and risk. Profitability is the relationship between revenue and costs attained by exploiting both fixed assets and current assets. Profitability of a company can be increased by enhancing revenue and controlling the costs. Whereas risk in short tern context is the probability that company will not be able to meet its short term obligations. It is assumed that when working capital is positive and greater, it has more capacity to meet its short term liabilities. That is the more net working capital a firm possesses the more liquid it is said to be. Imperial Tobacco is having negative working capital and therefore that company would be finding very difficult to meet its short term obligations when those become due. As stated above working capital management is to bring about a tradeoff between profitability and risks. The risk and profitability factors are associated with investment of resources in current assets as compared to total assets, and incurring of current liabilities as compared to total liabilities. The company takes short term risks when its ratio of current assets to total assets decreases. The risk decreases when this ratio of current assets to total assets increases. Similarly when ratio of liabilities to total assets increases, the profitability increases and vice versa. In case of Imperial Tobacco the ratio of current assets to total assets and current liabilities to total assets for the financial years 2007 and 2008 are calculated as under along with its current ratios and operational profit margin ratios in order explain its working capital management strategy. Current ratios of the company suggest that the company is facing a great liquidity crunch. Optimum current ratio in any industry is 2:1, whereas Imperial Tobacco has only 0.87:1 in 2007 and 0.68: 1 in 2008. The company had very fragile liquidity during these years and it had to maintain the safe liquidity status by effectively managing its working capital. That is why the company tried to trade off by taken reasonable risks but at the same by not increasing its profitability in order to save its fragile liquidity, as is explained hereinafter. During the year 2008 the ratio of current assets to total assets has decreased to 22.52% from 30.56% in 2007. That means the company has deployed less financial resources in current assets in 2008 as compared to what were employed in 2007, and thus taken a risk on its liquidity position in 2008. The company would have faced difficulties in meeting its current obligations in 2008. At the same time its ratio of current liabilities to total assets has also come down from 35.21% in 2007 to 33.06% in 2008. This reduction indicates that company has also not tried to increase its profitability. The company was aware of its fragile liquidity status and therefore took risks not for increasing its profitability but for managing its short term solvency. The company was not in position to go in for an out and out risk to increase profitability. That is the reason the operational profits of the company come down from 11.49 % to just 5.64%. So the working capital management policy of Imperial Tobacco was controlled risk with less profitability tradeoff. Another aspect to analyze the working capital management is calculation of cash conversion cycle of the company. “The part of operating cycle that’s left after the average payment period is deducted, is the cash conversion cycle of the enterprise. So the cash conversion cycle is that period of time when your cash is tied up in inputs and debtors: you have paid for production inputs, but have not yet got the money from your debtors for sale of inventory.”(A Stoltz and M. Viljoen, page 317)viii This is natural that every company, particularly Imperial Tobacco with its fragile liquidity, will like to shorten this period. CCC for 2007 and 2008 is calculated as under: Cash conversion cycle of Imperial Tobacco is negative twenty days in 2008. That means the company is not getting any credit, on an average, from its suppliers and other creditors. Instead the company is providing advances, on an average, to receive supplies from creditors. This is a very delicate working capital position and even questioning the reputation of the company involving its credit- worthiness in the market. The position has worsened in 2008 when its CCC has come down to minus (–) 20 days from 15 days in 2007. The company has not managed its working capital effectively in 2008. That was the reason company was trading off by taking risks but not seeking high profitability while managing its working capital. The company is in deep trouble so far as its short solvency is concerned and need reasonable amount of working capital infusion to survive. Conclusion Imperial Tobacco Group Plc has highly geared capital structure with financial leverage going beyond one. This may provide shareholders an opportunity to trade in equity because of fixed costs of debt capital. The company has constant dividend pay out policy as it is maintaining a certain standard or percentage of dividend being declared every period. Imperial Tobacco has a very fragile liquidity position. The company is taking risks with deployment of current assets not for increasing profits but to sustain whatever liquidity position it has. The company is not at all enjoying the benefits of a credit period as its cash conversion cycle is negative in 2008. The company is facing serious short term solvency problems seeking an emergent solution. References Read More