Corporate Finance-Financial Strategy - Coursework Example

Corporate Finance- Financial Strategy Introduction Lenovo Group Ltd is a reputed PC manufacturing and distributing company. The company follows a financial strategy that is very specific to this industry. The strategy aims at a negative debt policy to keep the debt less than zero. The capital structure of the company is highly volatile. There are no long term strategic financial plans. Keeping these facts in view an analysis is made of this financial strategy of the company making a comparative study of other firms in the industry. In this study not only impact of the strategy is analyzed, but various aspect of financial management have been looked into in order to make a prudent suggestion to the company. 1. Evaluation of financial strategy of Lenovo Cash management is an integral part of financial policy of any company. This is because “short term funds are typically less expensive than long term funds. Under an aggressive funding strategy, the firm funds its seasonal requirements with short term debts and its permanent requirements with long term debts. Under a conservative funding strategy, firm funds both its seasonal and its permanent requirements with long term debts.” (Lawrence J. Gitman, page 634)i Lenovo Group Ltd. kept $1863m cash balance in 2009 against its total bank borrowings of $685m; and in 2008 bank deposits and cash were $2191m against the total bank borrowings of $561m. In other words the company was keeping net cash reserves of $1178m in 2009 and $1630m in 2008 and not paying of the debts. It seems that objective is to pursue a negative debt policy, as company intends to meet short term requirements internally. There is a general belief that debt capacity of a company evaporates when business turns unprofitable. Business starts drawing debts on its short term debt capacity than a long term debt capacity. With Lenovo Group Ltd the situation is that company suffered losses in 2009, and it intends to improve its performance by following such a financial policy where in huge cash is lying idle. It can be seen from the financial results that the company suffered losses to the tune of $226m in 2009 when compared to profits of $484m in 2008, and then interim results of 2009-10 revealed profitability after big losses in 2009. Comparative EBIT or operating profits for interim 6 months ending 30 Sep 2009 are 1.20% as compared to 1.97% for 6 months ending on 30Sep 2008. This may support the financial policy of the company of pursuing a negative debt policy, provided cash funds are not kept idle. At the same time the company has shown less dependency on short term debts that came down to $20.293m as on 31 March 2009 from $61.130m as on 30 March 2008; but again risen to 33.946m as on 30 Sep. 2009. The company is trying to pursue the policy of achieving a state of negative debts but has to bow down against the needs of rising business. At this state, keeping huge cash idle and allowing debts to rise is not the right approach to achieve a status of negative indebting. Under corporate structure high value sustain only under the conditions when debts and distress risk are reduced after the initial structuring of capital. Lenovo is a seasoned campaigner and debt/ equity ratio for last two years is calculated as under: Debt ratio is rising after a little dip in 2009. In fact it has risen to 82.85% in interim results for 2010 from 77.59% in 2009, and79.2% in 2008. The indication is clear that negative debt levels need not be achieved to attain high value for the firm. The approach should be to increase profitability. Negative debt policy may help when idle cash is used to reduce the debts. At the same time positive debt policy will augment the borrowings and a rising debt ratio. Rising debt ratio indicates rising cost of borrowed capital and a reduction in the value of the company. Multinational operations certainly affect the financial strategy of a company. With multinational operations the company gets involved into variety of exposures affecting the financial strategy. There are translation or accounting exposures. Changes in exchange rate affect the financial strategy a lot. With the result, outstanding transactions on the balance sheet may get changed. This is called transaction exposure. The third type of exposure is called economic exposure that has potential effects on product and capital markets. All these exposures, occurring because of multinational risks, are bound to affect the financial strategy of Lenovo Group Ltd and ultimately the value of the company. 2. Accounting figures do not help much in arriving at market value of a company. However financial strategy certainly affects economically the value of company. Market value is arrived at by multiplying outstanding shares with market rate per share. Accordingly the MV of Lenovo and its competitors is calculated as under: Market values calculated above reveal that other companies are commanding a better value than the Lenovo as on that date. It is observed from the balance sheets of peers that all of them believe in keeping cash balances as a matter of financial strategy. Hewlett Packard has cash of $13279m as at 31.10.2009. Similarly Dell Inc kept $8352m as per its 2009 balance sheet. Keeping large cash balances is a strategy in the industry to reduce the borrowings, which in turn affect the debt equity ratio. Debt equity ratio plays an influencing role in determining the market value of the entity. The comparative financial metrics of Lenovo and its peers are computed as under: Enterprise value, calculated below for Lenovo and its peers, “represents the theoretical price that an acquirer would have to pay (excluding takeover premium) to buy the entire firm”(Tortoriello, page 113)ii In fact it is market value of the company plus total debts reduced by cash, cash equivalents, and short term investments. The above calculations explain that Hewlett Packard stands on priority so far as enterprise value is concerned. Enterprise value (EV)coupled with other financial metrics is used for a number of valuation purposes in many industries. EV divided by EBITDA (Earnings before interest, taxation, depreciation, and amortization) is a “valuation tool to compare the relative value of one company’s earnings stream to another’s (Tortoriello, page 113)iii. Comparative EBITDA and other matrix are calculated as under: P/E ratio “measures the amount that investors are willing to pay for each dollar of a firm’s earnings. The level of this ratio indicates the degree of confidence that investors have in the firm’s future performance” (Lawrence J. Gitman, page 70)iv It may be noted that P/E ratio is the figure currently available on the site of Yahoo.com and not based on 2009 financial statements. However Acer’s calculations are based on 2009 balance sheet figures converted into US dollars. Accordingly at present investors are ready to pay $40.93 for each dollar of earnings of Lenovo Group Ltd. Acer stands next in the eyes of investors, followed by Dell and Hewlett Packard (HP). EBIT and EBITDA calculated above can be used as multiple for valuing equity of a firm, but this has to be done carefully if valuation is done on a prospective basis. This is because “if the capital structure changes, the multiple chosen may turn out to be entirely inappropriate and even highly unfair” (Robert B. Dickie, page 197)v Return on equity is a measure that evaluates profits of a firm earned on per dollar of investments as owned capital of equity holders. On the other hand ‘Return on invested capital’ measures earnings on the basis of total owned as well as borrowed capital. Return on invested capital “allows us to assess a company’s return relative to its capital investment risk, and we can compare return on invested capital to alternate investments” (Bernstein, page 236)vi. These financial measures are calculated hereunder comparatively for three years for Lenovo Group Ltd and other companies: Both ratios reflect that Lenovo’s earning are erratic during the three years, but it slipped down heavily in 2009 when compared with 2008.The trend is same for the competitors but Dell has shown a remarkable return on equity in 2008, though its return on total capital employed improved marginally in 2008 as compared to 2007. However, ACER has shown a continuous slide in return on equity and return on capital employed as well since 2007. 3. Impact of financial strategy of Lenovo on its value Capital structure of Lenovo as at 31st March 2009 is highly geared. Out of total assets of $3787m, $1310m have been equity financed and rests $2477m are financed by debt capital. It is a highly geared structure. With debt ratio of 77.59% in March 2009, Lenovo is getting a loss per share of - US2.56 cents. The financial strategy of the company is to keep cash balances for short term needs and not to reduce debt investments. The purpose is to increase short term profitability in order to increase EPS. The strategy has worked for the short period for Lenovo. The company has converted itself from net loss in 2009 to a profitable entity in the interim results of 2009-10. EPS as per interim results for 6 months ending 30th Sep. 2009 is US0.42 cents, which is an increase of 116% over the negative EPS in 2009, But this strategy may not work for long time. There are no long term plans to reduce debts, and the strategy of keeping large cash balances is working for short term only. In fact debt ratio has risen to 82.85% in the interim results of Sep. 2009. Cost of servicing debts has been rising; otherwise the profitability would have been higher than shown in interim results. Short term financial strategy of keeping large cash under such a capital structure will not serve the cause of increasing the value of the company in the long run. The company will have to plan on long term basis. It is true that the market price of shares of Lenovo is rising, and this rise is partly because of financial strategy adopted by the company; but the capital structure is highly geared and the company has to bring it down by say repurchase of its own shares with available cash balance. Dividend policy adopted by the company has also played its role in increasing the prices. The company is declaring dividend even on the face of losses in 2009. In nutshell keeping huge idle cash is not a wise financial strategy unless that is used to pay off debts. 4. Financial Strategy Options If Lenovo pursue the present policy of keeping cash, the situation will get worsened on long term basis, as there is no strategy to reduce the debt capital. Profits available for shareholders will come down because of servicing the debts with highly geared capital structure. There may be temporary rise in share prices but ultimately the wrong policy will have an impact on the earnings per share as well as on the P/E ratio of the company. The other alternative of distributing $500m for repurchasing the shares of the company will help the company in increasing the value of its shares as depicted in the estimated financial statements (abridged) for the coming periods: The increase in estimated EPS on basis of repurchase of shares will help in increasing the market value of shares of the company. 5. Summary and conclusion Lenovo Group Ltd is following the financial strategy of keeping large cash balances at the cost of increasing debts. The interest on debts is rising as the capital structure of the company is highly geared. The company earned losses in 2009 and that were converted into profits as per results shown in the coming interim period. The policy might have worked for short term whereby EPS and market price of share have risen. Regular dividends may also be the cause of rise in prices of shares of the company. But pursuing a highly geared structure and keeping large cash balances is not a prudent policy. Such financial strategy, if not rectified in the due course, may prove costly to the value of the firm. The cost of servicing the debt will be a burden on otherwise good operating results. It is recommended that company should change the present financial strategy and reduce its long term debts, in order to increase the value of the firm. Word Count: 2147 References Read More