Corporate Financial Management - Assignment Example

CORPORATE FINANCIAL MANAGEMENT a) Evaluate the plans using four alternative capital budgeting techniques (paybackperiod, accounting rate of return, IRR and NPV assuming a discount rate of 10% and 35% alternatively), rank the plans accordingly and critically discuss the results and the applied methodology. Determination of yearly incremental operating cash flows Before any of the capital budgeting techniques could be employed, there is a need to define the incremental operating cash flows per plan for the net present value (NPV), internal rate of return (IRR), and payback period methods. On the other hand, the after tax accounting profits are needed to determine the accounting rate of return (ARR). These are done in Table 1 below. The depreciation was determined on the P10,000 initial investment using the straight-line method over the life of the project, and the tax rate is 45% as given in the case. Table 1: Computation of yearly operating cashflows per plan (40% tax rate, st line depreciation) The payback period capital budgeting technique The payback period method was used in computing the payback period in Table 2 following: Table 2: Computation of Payback Period per Plan The payback period computed for the four plans comes down to one year for both plans A and D, one and one-third years for Plan B, and 2.1 years for Plan C. The criterion for determining the attractiveness of investments on the basis of the payback period is the shortness of the period during which the investment is “paid back” by the operating cash flows. Based on this criterion, the best investments are plans A and D on the same level, then plan B and finally plan C. While plan A and D are evaluated to be similarly attractive, plan D has additional cash flows after the first year, while plan A does not, therefore plan D should be a better choice than plan A. The subsequent cash flows, however, are ignored in the payback period approach, so as far as the method is concerned, plans A and D are on equal footing. The accounting rate of return (ARR) capital budgeting technique The accounting rate of return, or ARR method, makes use of the after-tax profits of the plans instead of the operating cash flows. The average of after tax accounting profits are obtained, as well as the average investment which is half of the initial investment (Gitman & Madura, 2000). The accounting rate of return is the percentage ratio of the average accounting profits to the average investment. The ARR for each of the plans is computed below (plan A has zero profits – see Table 1). Table 3: Computation of Accounting Rate of Return per Plan The above method evaluates the alternative plans on the basis of the highest ARRs. On this basis, plan C is the most attractive plan with 60% ARR. It is followed by plan B (50%) and then plan D (45%). Plan A is not considered a viable alternative having 0% ARR. This thus presents a different hierarchy of evaluation compared to the payback period. The preceding two methods – payback period and accounting rate of return – are considered the unsophisticated capital budgeting techniques (Gitman & Madura, 2000). They are so called because they do not take into account the time value of money, and add cash streams occurring at different time periods as if they had equal value through time. The internal rate of return (IRR) capital budgeting technique The last two techniques to be discussed here are called the sophisticated capital budgeting techniques. They are so called because they acknowledge the differences in values of cash flows originating in different points in time. The time value of money makes possible the discounting and compounding of cash flows in a cash flow stream, to obtain their values as if originating at a single point in time. In the IRR, an appropriate discount rate is computed that would equate the sum of the present value of all future cash flows in the stream to the initial investment. This is obtained through a trial-and-error method, aided by an estimation of a virtual annuity. For the purpose of this paper, the estimation was done through computations on spreadsheet (i.e., manual step-by-step method rather than through programmed function). The results of the computation are presented in Table 4. Table 4: Computation of Internal Rate of Return per Plan Evident from the total present value of cash flows in the last column is that they approximate closely the initial investment of 10,000 euros. The final IRRs per plan are indicated in red. The present values of the cash flows were computed by discounting the cash flow (using the compound interest rate formula) to time zero, coinciding with time the initial investment was incurred. The IRR method specifies that alternatives are to be evaluated on the basis of the highest IRR downward. Thus, the most viable plan based on IRR is plan D (42%), after which is plan C (34%) followed closely by plan B (32%). Plan A is not considered a viable alternative under the IRR, because its single cash flow one year from time zero is exactly equal to the initial investment at time zero. This can be viewed as zero growth for the plan, and is not viable. Taken to a higher level, the IRR is considered acceptable or not depending upon the cost of capital of the firm. The cost of capital is the cost of alternative source of financing to the firm (Hirt & Block, 2006); or, simply put, this is the rate of return required by the investors out of the company’s performance which would justify their investment in the company. The cost of capital is higher than the risk-free rate (usually the rate of return earned by investing in government securities), because by investing in the company the fund providers forego the safety of risk-free instruments and choose to put their money in the firm, a risky investment. It is important for the firm to meet the return expectations of investors; otherwise, they would opt to transfer their investments to other alternatives. For this to be achieved, it is necessary that the projects embarked on by the firm should at least meet the expected rate of return of investors. Therefore, while the IRR method specifies that the rate of return be positive, it should also be equal to or greater than the cost of capital, or the expected rate of return by investors. The higher the IRR surpasses the cost of capital, the better choice the plan becomes. The net present value (NPV) capital budgeting technique The final method to be employed in this project is the net present value, or NPV, method. Table 5 below shows in spreadsheet form the computation of net present values for the four plans, using two alternative discount rates: 10%, and 35% (given by the case). Table 5: Computation of Net Present Value (at 10% and 35% alternatively) The net present value is also a sophisticated capital budgeting technique, and similar to the IRR requires the discounting of future cash flows to coincide with the point in time the initial investment is made. However, while in the IRR the discount rate is that which is the subject of determination, for the NPV the discount rate is known (or imposed) and the total present value of the future cash flows duly determined therefrom. After the present value of the cash flow stream has been determined, the difference between this and the initial investment is calculated. This difference is the NPV. If the present value of the cash flows exceeds the initial investment, then the NPV is positive and the proposed investment is justified. If the present value of the cash flows is less than the initial investment, then the NPV is zero and the proposed project is rejected. The relative viability of the alternative projects or plans is evaluated on the basis of the size of the NPV. Though the NPVs be positive, the projects with the higher NPVs are first accepted before those with lower NPVs. In the case given, two NPV schedules are drawn because two alternative discount rates are given – 10% and 35%. The NPV based on the 10% discount rate is shown in the upper part of the table. In this case, the most advantageous investment is plan C, with an NPV of more than 5,000 euros. It is followed by plan D with slightly less than 4,500 euros, and then plan B with about 3,000 euros. Plan A is not considered viable because it has a negative NPV, indicating a loss to the shareholders. The lower part of the table presents the computation of the NPV at 35% discount rate. Under this condition, only Plan D is considered acceptable, since it is the only plan that has a positive NPV. Plans A, B and C all have negative net present values at a 35% discount rate. It is interesting to note that, using the same NPV method but different discount rates, plan C is a better alternative at 10% while plan D is the better choice at 35%. The importance lies in the distribution of cash flows in the cash flow stream. When the larger cash flows occur sooner, this is of higher value to the investor, not only because he gets his returns sooner and thus the risk of loss is much reduced, but mathematically it redounds to a higher rate of return given the same initial investment (or viewed from another perspective, a lower initial investment is required to effect the same total cash flow stream, except for the more recent occurrence of the higher cash flows. The following, Table 6, summarizes the foregoing evaluation of the proposed plans. Table 6: Summary of evaluation and ranking of proposed plans b) Explain if your recommendations in the above part change if the firm operates under capital rationing. Extend your answer under the assumption that there is a capital constraint of 10,000 euros. The case states that the original capital availability is 40,000 euros, sufficient to fund all four plans if they prove to be viable. Based on Table 6, al 40,000 euros will be invested using the payback period technique, only 30,000 for the ARR, IRR and NPV (10%) criteria, and only 10,000 euros shall be invested for the single project considered viable based on NPV (35%). Under these considerations, the availability of capital is not an issue, only the viability of the project. Under conditions of capital rationing, the corporation has less money to invest than the total capital requirements of all the alternative projects with positive net present values under the firm’s consideration. Therefore, some projects that should be accepted are excluded because financial capital is rationed (Hirt & Block, 2006). If the amount of available investment capital is only 10,000 euros, this would change the number of projects that would actually be accepted, because only one project could be funded (i.e., initial investment of any one plan is 10,000 euros). Therefore, based on Table 6, plan C would be approved given ARR and NPV (10%); plan D, given IRR and NPV (35%); and a choice of either A or D for payback period (although realistically, A does not constitute a good investment since from the practical point of view, one ends up with only as much as he had put in a year earlier). A would only prove to be a good investment if there is a higher interest involved other than just the financial returns expected of the project – for instance, humanitarian, political, propaganda, or social reasons. c) Considering that the shares of the firm are not listed in any organised stock exchange and that the firm has to raise capital for the proposed investment(s), briefly outline the pros and cons of alternative financial instruments and methods that can be used by the firm for the financing of the selected investment(s). The fundamental alternative methods of financing, and a brief description of their advantages and disadvantages, are as follows: 1. Long-term debt, in the form of corporate bonds The basic long-term debt instrument representing long-term debt is the corporate bond. A bond is a contract of debt whereby the creditor provides a sum of money to the debtor, with the promise of the return of this principal after a determinate length of time. While the money is in the disposition and use of the debtor, the latter shall provide a fixed rate, usually on a periodic basis, to the creditor to defray him the use of his money. Floating of corporate bonds is advantageous to the firm in that it provide the firm financial leverage, or the enhancement of shareholder profitability through the employment of fixed-rate debt. Another advantage is that the cost of capital of debt (interest rate) is usually much lower than the cost of equity. Furthermore, interest paid on the debt is tax deductible, thus having the effect of lowering taxable income. The advantage is that too much debt increases the risk of default and of bankruptcy of the firm (Copeland et al., 2005). 2. Lease financing A lease is a long-term contract between two parties who are called the “lessor” or owner of the capital asset, and the “lessee” or the borrower of he capital asset subject of lease. In return for the use of the asset, the lessee makes periodic payments to the lessor in compliance with such terms as the parties may agree upon. Leasing is thus a form of rental. Leases are usually constituted on pieces of capital equipment such as machinery, plants, cars, office equipment, and the like. The two basic forms of leases are operating leases and finance leases. Leasing is popular because it has several advantages to the lessee. When the lessee is short of cash and could not obtain a bank loan to purchase an equipment, a lease would provide a means to obtain use of the equipment through rental. This thus precludes the huge capital outlay that would be entailed by purchasing the equipment, the lease fee being paid out from the revenues generated during operations. Furthermore, leasing relieves the lessee of the costs of obsolescence particularly of high-technology equipment. The lease payment is also tax-deductible, thus effectively minimizing the net profit taxable at the end of the year (FAO, 2009). 3. Internal financing – retained earnings The profitable would have accumulated past years’ earnings which it would have retained in its books. Retained earning may be declared and distributed as dividends, however, when the firm is in the process of expanding, earnings are retained for the purpose of providing financing for expansion. The use of retained earnings, also called internal financing, is quite convenient in that it is already in the company and does not have to be sourced, and tapping it for financing does not require bank approval nor costs of transaction or issuance. The level of retained earnings, however may be governed by the law through the Securities and Exchange Commission (SEC). Also, another disadvantage is that resort to retained earnings as a funding sources does not lead to acquisition of cash (Grinblatt & Titman, 2002). 4. External financing (common shares) External financing comes in the form of common shares, and such common shareholders are afforded the full benefits of business ownership. The advantage of financing through common stock is that unlike interest payments on debt that is mandatory whether the firm is profiting or losing, declaring dividends for stockholders only transpires when the firm is profitable. Common stock is not prone to default, as there is not fixed period wherein the common equity expires and the principal should be returned to the investor. Even then, dividend distribution may be effected without cash being released if the dividend were a stock dividend. The disadvantage of financing with additional common stock is that a stockholder’s proportional share of the company and it earnings is diluted with new issuances of stocks. 5. Hybrid sources of financing (preferred shares). There are some financing instruments that combine feature of both debt and equity. Preferred shares of stocks is one such instrument. Preferred shares are not debt, so there is not constraint upon the company to meet interest payments and return of principal upon arrival of a fixed date. What it does require is for a fixed percentage cash dividend to be distributed by the company to preferred shareholders before dividend may be distributed among common stockholders. Unlike debt, however, the distribution of dividends to preferred shares is not obligatory if the company is incurring losses. Thus preferred shares are a form of financial leverage, where additional productivity may result from additional financing at a fixed cost. d) Briefly discuss the theories and factors that affect the capital structure decision. There are many theories that have been proposed to provide an explanation for financial managers’ motivation to favor one source of capital financing from another. A few of them are presented here. The most popular model of capital structure decision-making is the Modigliani-Miller theorem. It was devised by Franco Modigliani and Merton Miller. In essence it states that in a perfect market, how the firm is financed is irrelevant to its value. MM, however, has been criticized for its assumptions concerning a perfect market. The assumptions were naturally unrealistic, such as the assumption that there were no taxes, effectively negating the distortionary effect of taxes; or the absence of transaction costs for raising capital through equity. Second is the trade-off theory of capital structure, which states that there is an advantage as well as a disadvantage when a company finances with debt. The advantage takes the form of tax benefits (i.e., the tax deductibility of interest expenses), while the disadvantage takes the form of bankruptcy costs in the case of default. The theory states that as debt increases, there is a trade-off between the advantages and disadvantages. The incremental benefit of additional debt falls, and the incremental costs rise, as the level of debt increases. Therefore, a firm that seeks to maximize the benefits and minimize the costs implicit in debt financing will seek to determine through the trade-off theory the proper mix of debt and equity. The following figure illustrates the trade off between the interest shield and bankruptcy costs as debt to equity ratio increases. (Source: Suicup, 2007 under the GNU Free Documentation License Third is the pecking order theory. This theory, developed by Stewart C. Myers and Nicolas Majluf in 1984, states that companies tend to finance their productive activity based on a hierarchy or order of priority. The firm’s first recourse is to source financing internally through the use of its retained earnings. Upon depleting internally generated resources, the firm then resorts to debt financing, and finally equity financing. The proponents point to the principle of least resistance, wherein the form of financing that is easiest to source is that which is resorted to first. Evidence is, however, not yet conclusive in the case of the pecking order and trade-off theories (Fama & French, 2002 and Frank & Goyal, 2000). Fourth is the relatively recent market timing hypothesis. This theory was developed by Baker and Wurgler in 2002. According to this theory, the relative proportion of debt and equity to total capital depends upon the relative value attributed to each of them by the market at the time they were sourced. Stated simply, firms do not care how they raise their capital, whether through debt or equity; they make their choice at the time the capital is sourced, based on which is better valued by the market (Baker & Wurgler, 2002), Finally (for this paper), the optimal capital structure theory states that the source of decision is chosen so as to minimize the weighted average cost of capital. The weighted average cost of capital: The computed cost of capital determined by multiplying the cost of each item in the optimal capital structure by its weighted representation in the overall capital structure and summing up the results (Hirt & Block, 2006). By employing the optimal capital structure, a firm is theoretically able to maximize the value of the firm’s stock by providing it the highest possible earnings per share. REFERENCES Baker, M & Wurgler, K 2002 Market Timing and Capital Structure, The Journal of Finance, vol. LVII, no. 1, pp. 1-32 Block, S B & Hirt, G A 2006 Foundations of Financial Management, 11th ed. McGraw Hill Bürgi, J; Meister, T; & Wyss, L 2009 Alternative financing sources. International Financial Law Review, 02626969, Oct2009 Financial Crisis Supplement Database: Business Source Complete Copeland, T; Weston J; & Shastri, K 2005 Financial Theory and Corporate Policy (4th edition), Pearson Addison Wesley, Boston Fama, E F & French, K R 2002 Testing Trade-Off and Pecking Order Predictions About Dividends and Debt. Review of Financial Studies. Accessed 20 January 2010 from http://rfs.oxfordjournals.org/cgi/content/abstract/15/1/1 Food and Agriculture Organization of the United Nations (FAO) 2009 Chapter 7 – Sources of finance. FAO Corporate Document Repository. Accessed 20 January 2010 from http://www.fao.org/docrep/W4343E/w4343e08.htm Frank, M Z & Goyal, V K 2000 Testing the Pecking Order Theory of Capital Structure. Social Science Research Network. Accessed 20 January 2010 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=243138 Gitman, L & Madura, J 2000 Introduction to Finance. Addison Wesley Graham, J & Harvey, C 2002 How Do CFOs Make Capital Structure Decisions? Journal of Applied Corporate Finance, vol. 15, no. 1, pp. 8-23 Grinblatt, M & Titman, S 2002 Financial Markets and Corporate Strategy (2nd edition.), McGraw-Hill Irwin, Boston . Read More