Introduction to Financial Management of A Company - Research Paper Example

Business Finance Introduction Corporate restructuring involves a fundamental change in the financial structure of the company for maximising the value of the business to the shareholders. This can be of two types- operational restructuring and financial restructuring. Financial restructuring entails a change in the capital composition of the company. Like for companies that are overleveraged the financial restructuring involves a rescheduling of debt by swapping equity for debt. Similarly for the underleveraged companies it is the reverse where the companies add more debt to lower the cost of capital (Sherif, n.d.). Financial restructuring plan laid out for the bankrupt firms is referred to as reorganization. Operational restructuring involves improving the economic value of the company by acquiring new business through mergers and takeovers; divesting the unprofitable business divisions (Giddy, n.d.). Techniques of financial management The management of the company acts as a representative of the shareholders in the management of the business activities. Its goal is to maximize the wealth of the shareholders. To achieve this they have to ensure an optimum utilization of the available funds. This is possible if the returns earned by the company on the investments are more than the cost of fund acquisition. The business generally has a number of investment opportunities. Due to paucity of funds it cannot invest in all of them. Therefore it has to use the financial techniques of investment appraisal to decide about the investment project that can enhance the value of the company. These techniques include the Net Present Value (NPV) and Internal Rate of Return (IRR). Under both these techniques the investment project that yields the highest surplus cash flows is selected for investment. The selection of the investment project is the first step of the financial manager. For the successful execution of the project a business needs funds. The companies do not generally have huge cash surpluses that can be used for funding the investment. For this reason the financial managers have to decide the sources from which the required funds can be raised. It can be either through debt or equity offer or a combination of both the strategies. The decision in this regard is based on the capital structure of the company. The financial managers have to be careful with respect to overreliance on any one source. In the recent takeover of Cadbury Plc by Kraft Inc the management of the company will use the combination of debt and equity for financing the takeover. With this Kraft Inc also plans to dispose of its North American pizza unit to Nestle for funding its transaction. Other than the evaluation and funding programs the financial management of the company is also entrusted with the task of dividend declaration. This is a crucial decision as both under and over declaration of dividend is not in the interest of the company. Under declaration of dividend may not be viewed positively by the company shareholders and result in a fall in the share price of the company. But over declaration means erosion of business profits thus leading to deterioration in the retained earnings position of the company. The retained profits of the company are crucial for financing investments and in its absence the company has to make use of external sources of funding. So the financial managers have to make important business decisions all of which are interlinked. A reduction in the rate of dividends may provide the necessary funds for financing the investment but this comes at the cost of dissatisfaction of the shareholders. Therefore the financial managers have to be careful as one wrong decision will have a negative impact on the company’s value. Methods of restructuring In their pursuit of growth, the businesses engage in a broad range of restructuring activities. Actions that expand or contract the basic operations of the business or bring about a fundamental change in its assets or financing structure are called corporate restructuring activities. Corporate restructuring is a wide area covering many things. One of them is the merger or takeover. From the point of view of the buyer, merger and acquisition relates to business expansion and from the view point of the seller it refers to a change in the ownership that may or may not be voluntary. Other than mergers and takeovers the other forms of corporate restructuring include divestiture, spin off, split off, equity carve outs and split up. Business expansion is a type of restructuring that increases the size of the business. This can be in the form of merger, acquisition, etc Merger- Merger refers to the combination of two or more companies into a single business unit. This can be in the form of Amalgamation or Absorption. In an amalgamation the two firms combine to form a new company. The two original companies lose their individual existence. This form of expansion is used for the companies that are identical in size. In absorption a small company is combined with a large company. After the merger the smaller company loses its individual identity. Takeover- When one company acquires another company it is said that the purchaser is taking over the acquired. Here the purchasing company is known as acquirer and the company being acquired is known as target and the process is known as take-over. Mostly the acquirer is larger than the target. The target may not be willing to the purchase and in such situations the purchase is referred to as hostile takeover. Takeover can be friendly when the acquirer makes an offer to the Board of Directors of the company expressing his interest of acquisition. If the Board feels that the offer is in the interest of the company shareholders it accepts the offer. But if the Board feels otherwise, then it rejects the takeover. In this situation if the acquirer pursues with the bid then it is referred to as hostile takeover. The acquirer then makes a public offer to buy the shares from the public at higher than the prevailing market price. This is known as tender offer (Schnitzer, 1994). A tender offer is a means of achieving what an acquirer could not obtain by negotiation (Lipton & Steinberger, 1978, pp. 2). Contraction is a form of restructuring that reduces the size of the business. When the current business structure fails to stand at par with the market expectations then this necessitates this form of restructuring. This is done when a division of the company does not fit in the plan of the management. The various forms of this type of restructuring are- Divestiture- A divestiture is the sale of a portion of the firm to an external party. This results in am infusion of cash into the business. Here the firm basically chooses to sell the division that is undervalued and is not related to the core business of the company. The money realised from the sale is then used for funding business opportunities that yield high returns. Like the disposal of the North American pizza unit to Nestle by Kraft Inc for financing its takeover is a for of divestiture where the company is selling its assets to fund the acquisition of Cadbury Plc. Equity carve-out- In an equity carve-out the firm sells its equity interest in a subsidiary to an outsider. The parent company retains control over the subsidiary. This may create a new legal entity. The shareholding pattern in the new company may not be similar to the parent company. In the corporations the funding of new ventures becomes difficult. This difficulty is meted out through equity carve-out. This raises the necessary funds for financing the projects. The investors are also benefited by getting a share ownership of distinct businesses. Spin-off- A spin-off is a transaction where the company distributes on pro-rata basis the share ownership in the subsidiaries to its existing shareholders. Here the proportional ownership of the stockholders in the new legal subsidiary is the same as the parent firm. The new subsidiary has a separate management and is run independently. This differs from divestiture in the sense that it does not provide any additional funds to the business. This is also used by corporate as a method of defence against hostile takeovers. Split-off- In a spin-off a new company is formed to take over the operations of an existing unit or division. The shareholders of the company receive shares in the new subsidiary in exchange of the shares in the parent company. The main reason behind split-off is that the equity base of the parent company is reduced. This does not result in any cash receipt to the parent company. Split-up- In a split-up the entire business entity is broken into a number of spin-offs such that the parent company ceases to exist and only the off-springs survive. This involves the creation of a new class of stock for each of the subsidiaries of the parent and then dissolving the main company. The shareholders of the new company may be different as the shareholders of the parent company may exchange their stock for shares in one or more of the spin-offs (Ramu, 1999, pp. 84). Issues relating to long term investment strategies The limited availability of funds and abundance of investment opportunities make it necessary for the business managers to make a careful analysis of the worthiness of the investments. To do this they make a projection of the project cash flows, income statements and balance sheet. In doing this they have to make certain assumptions about the demand pattern, price level, interest costs and exchange rates. The above assumptions are placed prominently in the spreadsheet and are used for carrying out sensitivity analysis. This analysis is generally carried out by the project manager initiating the new investment. The results of the analysis is presented in front of the top officials of the company like CEO, Chief Operating Officer, directors, treasurer and the department heads. This kind of presentation is important as proposed mergers and acquisitions; and investment projects involve huge expenditure and can significantly impact the business profitability and strategy. These financial projections guide in making decisions relating to the proposed investment (Marthinsen, 2008, pp.6). In the case of multiple projects the investment decision is based on the Net present Value (NPV) of the project. This is calculated by discounting the expected cash flows with an appropriate discount rate. This discount rate is also termed as the “hurdle rate”. It is the minimum return desired from the investment. Therefore this must take into account important factors like inherent project risk, volatility in cash flows and the funding mix. If the project is risky then a higher discount rate must be used. Also the returns earned from the project must be higher than the cost of capital. After the selection of an investment the next step for the management is to decide about the source of funding. The decisions relating to capital investments are long term based. It relates to choice of project and decisions regarding the source of financing i.e. whether there will be an offer of fresh equity or additional debt will be raised through bank loans. As the long term investments have longer gestation periods therefore the use of long term funding sources like debt and equity is recommended. If the short term sources are utilized then the business comes under the pressure of repayments. It takes time for the long term investments to reach the profitability stage. In the initial years of the investment they may not yield substantial results. But the payment on the short term loans starts immediately and creates a financial pressure on the company. For this reason the management must use only the long term modes like debt or equity for funding the long term investments. The choice between debt and equity is a crucial business decision. At times the company use a combination of debt and equity for funding the investment projects. Like in the funding of acquisition of Cadbury Plc, by Kraft Inc, is being done by the floatation of equity and cash raised through bank loans and disposal of its North American pizza unit to Nestle. This is a good funding source as there is no overdependence on one particular method of funding. The management of Kraft Inc must be careful about the excessive use of debt in the capital mix. An excessive exposure to debt is not in the financial interest of the company as this creates fixed financial burdens. At the same time the issue of fresh equity dilutes the ownership structure of the company. The cost of equity is higher as compared to debt making it a costly instrument of financing. Therefore the use of equity raises the cost of capital of the company. Ideally the companies must first use the internal sources of funding like reserves for financing the investment projects. As per the Pecking order theory equity must be used only as a last resort. According to this theory debt is preferred over equity due to low interest costs and the interest tax shield. The reserves are generated by apportioning certain percentage of business profits every year and hence do not entail any new costs to the business (Leonard N. Stern School of Business, 1996; Oregon State University, 2006). Other than this the other method of financing an investment is by disposing of the unprofitable or non-core division of the business. The same is being done by Kraft Plc which is disposing off its North American pizza unit for raising the money for the Cadbury acquisition. This relieves the management from the headache of managing losses from a division and concentrate on the core business activities. The financing plan of Kraft Plc includes a combination of bank loans, equity and asset sale. With the issue of fresh equity the ownership of the company will get diluted and the high cost of equity will raise the cost of capital of the company. The use of bank loans in the funding program will add to the financial burden of the company. There will be a rise in the annual debt servicing payments. The leverage position of the company will increase leading to a fall in the credit ratings. A highly leveraged business becomes risky prompting the credit rating agencies to downgrade the company. As a low rating means high default risk the company will have to pay higher returns for generating funds from the market (Tall, 2010). Impact on future performance Warren Buffet, the largest shareholder of Kraft Plc opposed this takeover as he considers it a threat to the shareholders value. This deal is also criticised on account of high risks associated with funding. The takeovers are not considered to be in the interest of the shareholders of the acquirer company. This is because the takeover bid consists of high premium. For this reason there is a fall in the share price of the company immediately after the announcement of takeover. One of the reasons behind takeover is the synergy realized from the acquisition. It has been seen that the integration of two large sized businesses results in low operations costs and raises business revenues. But the gains from the takeover take time to materialize as initially the management of the company is burdened with the repayment of the acquisition. Therefore the gains from an acquisition are not immediately visible. So initially Kraft Inc has to bear the burden of increased debts in the capital base for funding the takeover of Cadbury Plc. Role of treasury management The international transactions expose the company to exchange related risk and the aim of treasury management is to reduce the costs and manage the risks arising from the overseas exposure. The treasury department’s function comprises of improving the liquidity of the company and lowering the financial risk (KPMG, n.d.). With the growing complexity in business operations and the rapid globalization has magnified the role of the treasurers in the areas like mergers & acquisitions, funding, capital structure and non-financial risk (HSBC, 2007, pp. 138). The role of this department has evolved over time and its functions are no more confined to control of the monetary cash flows. Due to globalization and deregulation in the currency market there has been a rise in exchange related risk and interest rate fluctuations, necessitating the need of credit risk management. This has extended the role of treasury management to managing investment, varying financial risks and treasury deficits. Under the advanced cash management techniques the treasury management helps in hedging the risks relating to exchange rate fluctuations and interest rate risk that arising on account of interest rate fluctuations (Jose, et al., 2008). The overseas acquisition of the companies result in receipts and payments denominated in the foreign currency. This is subject to fluctuations due to the movements in the exchange rate market, thereby impacting the business costs and revenues. To hedge against any movements in the currency the treasury department of the company takes the necessary exposure in the financial instruments like currency options, forwards etc. By way of this the cash inflows and outflows of the business remain protected from the exchange rate risks in their foreign dealings. Appraising international capital investment The capital investment appraisal of the foreign countries gives rise to difficulties that are not encountered in the domestic projects. The cash flows arising from the overseas investments are subject to risk of adverse movements in exchange rates. Its overseas operations are considerably influenced by the attitude of the host government in the investing country. The government of the host country may impose penalties; impose restrictions on the cash flow remittances; etc (Lumby, 1988, pp.418). This shows that the government plays a crucial role in encouraging or dissuading foreign investment. The political policy of some countries facilitates international investments whereas that of the others impedes the same (JSTOR, n.d.). For this reason before investing in a foreign country the business must make an assessment of the policies of the existing government. An initiative must be taken only if the government has a friendly business policy. Investments must be made only if the government undertakes to provide a favorable business environment. Other than this the level of development in the country is also a factor that influences investment decisions. Infrastructure facilities of the country must be in place. If there is a lack of proper infrastructure then the business may face difficulty in its operations. The laying of infrastructural network may add to the operating costs of the business eroding the business gains from the overseas venture. Another aspect that deserves consideration is the level of advancement in the country. Like the sales of the company may get hampered, if the mind-set of the people, is such, that they do not support foreign products. Besides this the management has to consider whether there is an adequate supply of skilled man-power in the overseas country. Unavailability of workforce is a deterrent to business activities. This means that the company has to arrange for labor force from outside the country thus raising the cost of funding to the business. Conclusion A company should adopt a careful approach in financing its acquisitions. Over reliance on any particular source should be avoided. As far as possible the funding should be through internal means and if needed debt should be used as the debt mode of funding is favorable to equity on account of low cost. However care must be taken regarding over leverage as this exposes the company to financial obligations and downgrades its credit ratings. Reference Giddy, H.I. No Date. Corporate Financial Restructuring. Leonard N. 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Steinberger, H.E.1978. Takeovers and Freezeouts. Law Journal Press. Lumby, S. 1988. Investment appraisal and financing decisions. Taylor & Francis. Marthinsen, E.J. 2008. Managing in a global economy: demystifying international macroeconomics. Cengage Learning. Oregon State University. 2006. Pecking Order Theory. Capital Structure. Available at: http://classes.bus.oregonstate.edu/spring-06/ba340/Mathew/Power%20Point%20Slides/Chapter12.ppt#1 [Accessed on March 30, 2010]. Ramu, S.S. 1999. Restructuring and break-ups: corporate growth through divestitures, spin-offs, split-ups and swaps. SAGE. Schnitzer, M.1994. Hostile versus Friendly takeovers. JSTOR. Available at: http://www.jstor.org/pss/2554633 [Accessed on March 30, 2010]. Sherif, F.K. Financial Restructuring in corporations. Available at: http://lnweb90.worldbank.org/ECA/eca.nsf/Attachments/Financial+Restructuring+in+Corporations/$File/fin+restr.ppt [Accessed on March 30, 2010]. Tall, S. 2010. When should the state intervene? 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