Financing the Long-Term Needs of Large Organization - Example

Financial RUNNING HEAD: Financial Management Financial Management of Introduction This paper consists of two parts. Part A discusses the range of sources available to large companies, long term projects and evaluates the relative merits and limitations of such finance. Part B will compare and contrast at least three techniques of investment appraisal to aid decision making to major long-term projects and critically evaluate their usefulness. 2. Part A The possible sources could basically come from equity and debts. Each is discussed below with its respective merits and limitations 2.1 From issuance of stocks Large companies, since they are publicly listed can have the long-term external source of finance to finance their long-term projects issuing shares of stocks to investors. When s company issues shares it may do the same the first time or it can do additional new ones to new investors or to existing investors. Corporations as the publicly listed companies including that could generally source the long-term source of finance from original issue. In fact a corporation is required to have original issue of share based on authorized share to be able to keep the organization running that would make it as corporation. A corporation could be distinguished from other business organizations like a partnership or a sole proprietorship. The latter two organizations do not issue shares of stocks but the capitalization could come directly from owners. As business expands more capital is needed so companies eventually have their stocks listed in the stock exchanges for them to be able to raise capital. More it can be argued that a company is presumed to be a going concern based on accounting assumptions. This would connote also assuming long-term life that would entail long-term source of capital (Van Horne, 1992; Brigham and Houston, 2002; Brealy, et al, 2007) for the said company. The result of the issuance of shares is to entitle make the holders of shares as owners to the business entitled to manage the corporation either directly or indirectly. These stockholders would be able to elect their board of directors who will manage the corporation or just some of them will become members of the corporate boards. It can therefore be deciphered that the purpose therefore of original new share is to launch the corporation and if the new shares are add-ons to the original, the purpose may be different but in most case it would be to address and expansion plan of the company (Kotler, 1994; Pearce, and Robinson, Jr., 2004; Massie, 1987; Pearson, 1999; Plunkett and Attner, 1985). Some reasons could include the need to match requirements by other stakeholders like creditors to increase capital. Some creditors would like a higher investments from stockholders since technically the creditors now becomes the principal and the stockholders the agents of the corporation. For the shareholders to be trusted as agents of the total assets of the corporation as shared by owners and creditors, these shareholders need to show that can take risks by additional investment. It may be further asserted that the durations of original and additional issue of share may be viewed or considers as permanent in natures or while the corporation exists and until the owners will transfer them to new owners. Moreover, the corporation may decide to get the most out of profitability. As such some, the corporate board who make many of the decision and sometimes share with the shareholders, may reduce outstanding shares in form of reacquisition. This would be followed by placing the reacquired shares in the treasury or just retire them (Van Horne, 1992). AS to why the company board decide to do this may have something to do with increasing earnings per share of the corporation to enhance the marketability of existing shares. This is in furtherance of the wealth maximization objectives by corporations (Weston and Brigham, 1993; Baker and Powell, 2005; Meigs, Meigs, & Meigs, 1995). After the issuance of shares, the risks are created if taken from the points of view of original founders of the business and the corporation itself (Ketz, 2003). One of the risks would include the possibility of not recovering the amount invested because of business reversers. Original owners may also consider the selling additional new share to have the potential to dilute the ownership of the corporation and may result to lose of control of the business. This would necessarily affect the pleasure of being the founder of a corporation. It may be deduced that to find a company is to have the power to influence its growth but selling new share may decrease this power. This must be however admitted as a result of the decision-making process in corporations which could be described as democratic with power exercised directly on the basis of stock ownership (Van Horne, 1992). Wanting not to lose power, the original owners may plan to protect the dilution of ownership control. They can do this by offering first the new shares to the original owners ahead of all non-existing shareholder. This is normally termed as the right of pre-emption in corporations. Of course there is another risk on the part of original owners if the corporation sell new shares. This would have the effect of increasing the number of outstanding shares that would subsequently reduce the earnings per share that could affect the market price per share of the stock. However, the advantage would be to make the price per share more affordable to other investors. It can therefore be observed that the permanent nature of the stock ownership control may not be supported all the time if the corporation has to be flexible at times to survive the external pressures. This also with the economic reality that some periods could come when expansion is not encouraging as in times of recession (Slavin, 1996; Byars, 1991; Carroll, 1983; Churchill, Jr. and Peter, 1995; Dornbusch & Fischer, 1990). However the need to keep stockholders to enjoy an acceptable level of dividend some of the shares may need to be reacquired in the meantime 2.2 Issue bonds An alternative from stock or share issues that may have been used by corporations is to issue bond or through debts. This may be accomplished in form of debenture that can be taken out by a public listed company. The amount that a corporation may need to finance its long-term needs for capital is normally determined first before sourcing the capital. Bonds are not the same as stocks in the sense that the former makes the buyer a lender or creditor while the second makes the buyers as shareholders or owners as discussed earlier. It may therefore be argued that a corporation not craving to have its ownership control diluted may just have to issue bonds rather than sell shares of stocks. However a disadvantage of issuing bonds is must be accepted as well. One consequence is that that it would make the leverage position (Van Horne, 1992; Brigham and Houston, 2002) of the company higher and therefore less desirable if taken to the extreme. The need to balance equity of owners from equity from creditors becomes a matter in deciding the weighted average cost of capital for any given corporation (Droms, 1990; Helfert, E. 2001; Higgins, 2007; Johnson, et al, 200). While some corporations may benefit from less equity at some point, for others this would be making the company more risky by having a less desirable leverage position at some point. To sell additional new shares compared with of selling bonds may also lesson earnings per share, but this may not attain a desire optimum capital structure. Thus companies aims for that capital structure that would lessen the stock price per share. It is not therefore difficult to see excessive sale of new share may deny the corporation to maximize earnings which become clear when the same will increase earnings per share or price per share. The reason behind is that issuing bonds may entitle the company to deduct interest expense for tax purposes from the debts which simply remain not attainable when dividends are given to shareholders. The wise for corporate decision therefore is still to keep a balance between the two possible sources of external financing for long-term needs of the business. A source of long-term financing has its own advantages and disadvantages (Bernstein, 1993; Bodie, Kane and Marcus, 2007) relative to the other which should explain the need to avail both with the objective of keeping the proper balance. To decide to have common share alone without resorting to debt may mean the stockholders may have all the gains from the business. Nevertheless, business realities would tell otherwise that there are times that that business could have its business reverses such in in times of financial crisis or recession (Slavin, 1996; Samuelson and Nordhaus, 1992). A decision to become profitable does not necessarily means going all the way even extending the most liberal credit to customer as this may result to failure to collect receivables. The same can be said in the trade-off between bonds and stock issuance. In other words, one cannot exclusively want to have all the profits in the business to common shareholders since the company has also increased its chance of losing all the money of shareholders in managing the risks of business or by failing to minimize its cost of capital. The business environment must still be thought as uncertain at one point although the promise of more profits or more wealth is there. This precisely explains the need for effective management of the business (Atkinson, et al (2005). To summarize the points in sourcing for large corporations, their best course of action would not to treat one source as exclusive of the other. There must be a combination of both in order to maximize the wealth of shareholders (Higgins, 2007) in the unavoidable act of balancing returns and risk. A business viewed as nothing more than using sources to produce value but there are risks that must be avoided or reduced to maximize the value generated. 3. Part B. This part compares and contrasts three techniques of investment appraisal available to aid decision making with regard to major long term projects and critically evaluate their usefulness. This part therefore seeks to evaluate the similarities and differences investment appraisal methods available to decision making in relation to long-term projects and to critically evaluate their usefulness. These investment appraisal methods include Payback, ARR and NPV and IRR methods and this part will include firm recommendation on a hypothetical long-term project that a company should adopt based the advantages and disadvantages of the various investment appraisal methods used and current/future requirements of the firm. 3.1. Evaluation using a hypothetical project using Payback, ARR and NPV and IRR methods. This part need to assume the choice of having to acquire a machine from that could be termed as Machine A as option A and Machine B and option B. To decide which project should be accepted using the NPV method will be compared with e other methods. See Appendix A for the computations. Option A should be the assumed project that should be accepted using the NPV method over the other methods. Although it has lower IRR than Option B, Option A has higher NPV, and the latter method should prevail in case of conflict between the two (Brigham and Houston, 2002). Average ARR per year is also higher for Option A than B and this should be an added advantage. This issue would essentially highlight the real conflict between discounted cash flows and non-discounted cash flows and the first should be chosen over the second method because of the time value of money. Between NPV and IRR, NPV should be given preference on theoretical grounds. This is based on the assumption that the money is reinvested as cost of capital than at reinvestment rate. The principle should support the use of NPV or IRR in case of mutually exclusive projects (Brigham and Houston) as this as explained further in following paragraphs. 3.2. The advantages and disadvantages of the various investment appraisal methods as used and current/future requirements of a hypothetical firm Appreciating the advantages and disadvantages of the investment appraisal methods is easier when the proper or best method is found the most accurate or most logical basis for decision making. Since the methods are basically divided into discounted and non-discounted cash flow methods that which is the most logical to reason should be upheld. By grouping the methods by having the first group with the NPV and IRR as those belonging to the discounted cash flow methods and the ARR and PB as generally belonging to the non-discounted cash flow methods, analysis could be made easier Since NPV and IRR belong to the DCF methods, they generally should have the same endorsement as far as choosing among projects which are not mutually exclusive. In other words, what NPV says to be accepted, the IRR must usually agree. This is on the principle that the computations under the two methods consider the time value of money. This is actually verifiable as when NPV is set to zero. Finance theory would agree that the implicit rate is actually the IRR of the project proposal. The two methods however will have to different when they part ways regarding mutually exclusive projects or when the acceptance of one will result to the rejection of the other. What is created as decision to be made, a choice between two options must be made and either option causes the rejection of the other. Thus, deciding in favour of NPV method over that of the IRR should be in order because of the reinvestment rate at cost of capital which is more realistic than at IRR as the latter method assumes (Brigham and Houston, 1992). Between DCF and non-DCF, the better choice should go to the first because it is more scientific and logical than the first. This is justified by the use of the time value of money concept. The time value of money concept assumes that a thousand British pounds received today is different from one thousand dollars that will be received in the future. Thus, the concept assumes the money in the future should be brought its present value in order to allow comparison of the two values. This would assume as well a discount rate, which is normally equated with the cost of capital. 3.3 Applying the four investment appraisal methods using assumed data The assumed data and case facts as provide in Appendix A provides for better way to know which the most logical method is. XYZ is assumed to have s return on capital employed (ROCE) has been 20%. If it wants to maintain the same if doing future projects as presented in Appendix, the 20% ratio should be made comparable with average ARR of the two options. Option A has average ARR of 20% while option B has 27%. Since Option B has a higher rate than 20% recent capital employed, this would mean other two projects are acceptable, but option B is better on the basis of said criteria but then the case assumes a choice to be made as which would give wealth to stockholder. See Appendix A. Option A may have a longer period to recover at 2.71 as against 1.67 for option B but I the company can accept project with pay back of three years or less then both of them are acceptable. However Option A should be finally chosen over Option B because of higher NPV. In other works, choosing option A complies with the company’s requirements. It must be noted that 20% ROCE was higher than the 12% cost of capital since the former does not consider also the time value of money and for simple decision making. 4. Conclusion Financing the long-term needs of large organization requires a balancing act. A company cannot just select one to the exclusion of the other since the same could come in conflict with its need to maximize wealth of stockholders. This was seen in choosing between common shares and bonds during the life of a corporation including the early part. In analysing the different appraisal methods, it was necessary to a hypothetical company with a hypothetical project with options A and B and then applying the appraisal methods. Option A was found to be better than option B. It was found beneficial to the company in terms of generating more wealth as measure by NPV The investment appraisal methods used were analysed and considered for purposes of establishing the basis for analysis and it was found that NPV was the best method among the four and the same was used for recommending option A over option B. The decision maker may be given freedom to decide but his or her use of the proper method would most likely lead to better decisions for the business. Appendices References Atkinson, Anthony, et al (2005). Management Accounting. New Jersey: Person Custom Publishing Baker and Powell (2005). Understanding financial management: a practical guide. Wiley-Blackwell Bernstein, J. (1993). 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