Financial Management: the Debt Mode of Funding - Case Study Example

Financial Management: the Debt Mode of Funding Introduction In the modern scenario the core business of a company is no longer limited to a single product... Rather the companies are engaged in the production of non-related goods and services. With the aim of maximizing shareholders wealth, the companies diversify their business operations across various industries through mergers and acquisitions. Considering the abundance of such opportunities it is important that a company makes a careful assessment of these opportunities. A number of investment appraisal techniques are available that can facilitate the process of appraisal. Besides the selection process another area that needs to be considered is ‘financing’. The funding of the investment can be done through debt or equity. The debt mode of funding consists of loans from the financial institutions, bond issue, overdraft etc. Under the equity mode of funding if the company is already listed then it can opt for rights issue. In the rights issue the company offers shares to its existing shareholders. The debt mode of funding is preferred by the managers due to low cost. An equity issue on the other hand is time consuming and costly. Issue of new shares dilutes the ownership of the company. This leads to interference by the investors and delays crucial management decisions (Department for Business, Innovation & Skills, n.d.). The debt mode of funding too has its own set of limitations. An excessive exposure to debt is not in the financial interest of the company. It can create bankruptcy problems and increase the insolvency risk of the business. For this reason the financial managers in the company thrive to achieve the optimal capital base, with an ideal mix of debt and equity. This enables the company to enjoy the benefits of both without risking the loss of power or rise in the financial burden. Takeover Jebb Plc is planning to takeover its rival company for raising its market share in the core business. In a takeover the acquirer makes an offer to the directors of the company stating his intentions to acquire a controlling interest in the company. By way of this the acquirer becomes the majority shareholder in the company. Here the company that acquires another company is known as “bidder” and the company being acquired is known as “target”. The takeover of the rival company can bring in business gains for Jebb Plc. This kind of business deal is initiated for a number of reasons like economies of scale, market position, synergies etc. Reasons of takeover This kind of acquisition entails a number of financial benefits. Firstly the acquisition of the rival firm eliminates business competition and makes the company the undisputed market leader. By virtue of its new position the company can raise business profits by charging higher prices. The combined operations of the two entities results in economies of scale thereby lowering the cost of business output. This benefit can be passed on to the consumers in the form of low prices or if the company wishes to keep the prices unchanged then there will be a rise in business profitability. With the advancement in globalization the business can acquire a stake in off-shore businesses. This helps the company to establish itself in the foreign market. Other than raising business revenue the business of the company gets a global dimension. With the integration of the cost centres of the two businesses there will be a reduction in the business costs. The company will be able to negotiate favourable terms of credit with the suppliers on account of bulk purchase of materials. There will be a reduction in the research and development costs with the combination of the research units of the company. Besides there will be a considerable amount of savings in the administration costs with the redundancy of certain positions of the target like human resource, accountant etc. The takeover provides an expansion scope to the companies that are in the maturity stage. In this stage the companies find it difficult to grow internally. Therefore the takeover of a growing company opens up new sources of revenue to the company. By way of this the company will acquire an access to speedy streams of revenue which would not have been possible through internal business growth. It may also be possible that the target company enjoys certain privileges in the form of patents. Thus the takeover of the target company will entitle the acquirer to the exclusive rights of the target company. A conglomerate takeover results in diversification of the core business. With the diversification in the business products and services the company will remain immune from the downturns in the core business. Therefore the acquisition of Jebb Plc will result in various economic as well as business benefits. This will eliminate the market competition for the company and will lower business costs. Besides this, Jebb Plc will be able to acquire a dominant market position. The business prospects of the company will improve in terms of business contacts. Apart from catering to its own customers Jebb Plc will become the preferred choice for the customers of the rival company. This will raise the business revenue and strengthen the market position of the company. Methods of takeover When the acquirer makes a friendly offer to the directors of the company expressing his interest of acquisition it is referred to as Friendly takeover. If the board views the takeover to be in the interest of the business they accept it. However if the board does not consider the offer to be lucrative they reject it. As the owners and shareholders in a private company are mostly the same the takeover is usually friendly. But this is not the same in the case of takeover of a public company. In a hostile takeover the bidder continues with the offer despite the rejection by the management of the target company. Here he bypasses the decision of the company’s management and makes a public offer to the shareholders of the target company, at higher than the market price of the company’s share. This is known as tender offer. In a reverse takeover the private company acquires controlling interest in a public company. Here the private company is larger in size and initiates the takeover with the aim of floating itself in the market without bearing the time consuming process of the conventional IPO. Depending on the stage of production and industry there can be horizontal, vertical and conglomerate takeover. In a horizontal takeover the two companies belong to the same industry and are in the same stage of the production. In a vertical takeover the first condition is the same except that the two companies operate at different stages of production. A conglomerate takeover involves the merger of companies belonging to different industries. The takeover of Jebb Plc is a type of horizontal takeover as the company that it intends to acquire is its rival. This means that the two companies are in the same stage of production and therefore the takeover will bring in additional business revenues for the company. Effects of takeover The takeover is not generally considered favourably by the investors of the acquiring company. Often the bid amount contains a large amount of premium making it unattractive to the shareholders of the investing company. For this reason there is a fall in the share price of the acquirer company due to investor sentiments. On the other hand there is euphoria among the shareholders of the target company and this is reflected in the form of rise in its share price. This does not mean that the takeover does not yield any benefit, rather the synergies from the takeover get reflected in the long run. Initially the company has to burden the financial cost of the takeover. The takeover results in loss of employment in the target company. As some of the departments like Human resource, accounts etc are common to both the businesses; it results in job cuts in the target company due to redundancy of some of the positions. Often the culture of the two companies is different posing difficulty in the cultural integration in the combined entity. Investment Appraisal The limited fund supply and abundance of investment opportunities make it necessary for the company to evaluate the returns of the proposed investment project. Like in the case of Jebb Plc the company has a number of investment prospects but the limited availability of funds makes it important that the company makes a thorough investment appraisal of the proposed investments. This can be done with the help of various techniques like Net Present value (NPV), Internal rate of return (IRR), Payback method and Accounting Rate of return (ARR). The merits and demerits of these methods have been discussed briefly. Payback- This is mainly the time taken for the project cash inflows to equate with the project outflows. Here the company chooses the project with the shortest payback time period. Merits and limitations- The simplicity of the method makes it popular among the UK firms. In the rapidly changing business environment new technological advancements necessitate faster payback on the investment. The main limitation of this method is that it lacks objectivity. The choice of the optimal time period is not based on a concrete base. It classifies the cash flows as post-payback or pre-cash back ignoring the cash flows beyond this period. This method does not incorporate the time factor in the cash flows. Accounting rate of return (ARR) - This method states the investment profits as a percentage of the invested capital. The profit figures may include the amount of depreciation. This data is obtained from the Income Statement of the company. Merits and limitations- This method is simple to understand and interpret. As this method is similar to the Return earned on Capital Employed it is relatively easier to understand for the business planners. The criticism against this method is that it ignores the cash flows timing and project duration. Moreover this method does not give any definitive signal that can assist the managers in project selection. This makes the investment decisions subjective. Net Present Value- The NPV is based on the opportunity cost of capital in the valuation of the project cash flows. Under this technique the cash inflows expected to arise in the future are ‘discounted back’ to the present date. This discount rate is based on the cost of obtaining the capital invested in the project. Merits and Limitations This method is most reliable as it incorporates the time value of money aspect in the project cash flows. Unlike Payback, this method considers the cash flows for the entire project duration. It is more realistic as this is based on the core concept of finance which states that the value of money today is not the same as at a future date. The limitation of this method is that it is difficult to understand for the people from the non-finance background. Internal rate of return (IRR) - IRR is the discount rate at which the present value of the cumulative cash inflows is the same as the amount invested in the project. This can be interpreted as the discount rate equating the NPV of the project to zero. Merits and Limitations- Like NPV this method considers the timing of the cash flows and considers all the cash flows relating to the project. Its limitation is that it cannot be used in the case of mutually exclusive projects. Jebb Plc can use either NPV or IRR for assessing the project viability. Both the methods take into consideration the time value of money in estimating the net cash flows from the investment. This will give a better picture to the company about the project profitability. It is important for the company to ensure that the funds committed to the investment give surplus returns. Other than the return aspect, Jebb Plc must consider the risk inherent in the project. Higher the risk higher is the return expected from the project. This factor must be incorporated in the discount rate to obtain a true picture of profitability of the proposed investment. Gearing The gearing refers to the leverage position of the business. This refers to the amount of debt employed by the business. A highly geared firm is one which has high levels of debt in the capital structure. It is also referred to as overleveraged. On the other hand the firms with low debts are said to be low geared firms. They are also referred as underleveraged firms. Both high gearing and low gearing are not in the interest of the company. Jebb Plc plans to fund its acquisition through debt. This will affect the gearing position of the company and raise it to high levels. This will raise the debt burden of the company further, exposing it to financial risk. Effects of high gearing The managers of the company prefer to use debt for financing the investments. This is on account of low cost of debt procurement. The interest payment on debt is a tax deductible expense. For this reason the managers prefer to use more of debt in the capital base. Unlike debt the dividend payment on equity is not a tax deducible expense. Due to this the company managers try to use more debt to avail the interest tax shields. But the use of debt is not without limitations. High amount of debt in the capital base raise the fixed obligations of the company. This does not create a problem during good economic times. But during troubled times when the companies find it difficult to stay afloat the burden of honouring the interest payments creates pressure on the earnings. To pay the fixed contractual amounts the companies often forego lucrative investment opportunities. This results in stagnation, a stage which is least desired by the investors. A rational investor invests in the avenues that yield high returns. As growth prospects get limited in a stagnated company, he withdraws the funds resulting in a fall in the share price of the company. The reason for the increased use of debt in the capital base is the low cost. It has been seen that this is valid only up to certain levels of debt. Initially the low cost of debt reduces the weighted average cost of the capital (WACC) for the business. The WACC is the weighted average cost of funds deployed by the business in the capital base. As the cost of raising equity is high the financial managers in the company prefer debt over equity. For this reason the costs of capital falls initially with the rise in the debt in the capital structure. But beyond a point the inclusion of debt raises the cost of capital of the company taking the sheen off the debt investment. With the rise in the debt burden the lenders become cautious of lending and demand for higher returns. The lenders like financial institutions base their decisions relating to loan advancement on the gearing ratio of the company. A highly geared company is viewed to be a risky investment and hence they raise their required rate of return. Even though the lenders do not have any right to control the business affairs they interfere in the management decisions. This gives rise to conflict of interest. For financing its prospective investment Jebb Plc wants to raise more debt. This will raise the gearing ratio of the company. A rise in the debt component can threaten the financial solvency of the company. The excessive use of debt can increase the bankruptcy costs. As the investors prefer to invest in safer companies with ideal debt margins, Jebb Plc may lose its attractiveness to the investors. In the future the company may face difficulties in raising finance for expansionary purposes. This will impact the profitability position of the company. With the rise in debt the company might get overburdened with servicing the repayments. So the managers of the company must weigh all the pros and cons of using additional debt in the financing program. Conclusion The limited availability of resources makes it necessary for the financial managers of the company to scan through the investment projects. A number of investment appraisal techniques can be used for assessing the worthiness of the proposed investment. As most of the projects have a long gestation period it takes time for them to yield significant gains. For this reason the managers must use only the long term sources for generating project capital. This can be in the form of long term loans as well as equity. As both the sources have their own set of merits and limitations the management must be careful in the capital mix. Raising additional debt will raise the gearing of Jebb Plc to higher levels, endangering its solvency position. Instead of issuing new debt the company can rely on internal financing. This can be in the form of reserves generated by the company over the years. Unlike debt the use of reserves does not create new costs foe the company. The takeover planned by Jebb Plc may not yield any immediate benefits due to investor sentiments. But the acquisition of the business rival will lower the research & development costs of the company. The combined business operations of the company will bring in economies of scale and generate additional business revenues. The positions having overlapping business responsibilities can be removed thus reducing the operating costs of the company. Reference Department for Business, Innovation & Skills. No date. Advantages and disadvantages of equity finance. Equity Finance. Available at: http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1073789573’ [Accessed on April 2, 2010]. Read More