Capital Structure and Corporate Financing Decisions - Essay Example

TASK Part A a) Sources of Finance Emaar Properties Plc. may have different options for financing the hotel project in addition to the indicated source of finance in respect of pre-sales of serviced apartments. The following discussion highlights those four areas which can contribute finance the hotel project of the organization. Internally generated funds The first and foremost choice that any company wishes to finance a project is the utilization of its internally generated funds. These internally generated funds are channelized though appropriation of retained earnings. Those companies which do not pay dividends wait for such types of investment areas, so that they can invest in those projects in their own standalone capacity (Baker and Martin, 2011). Long-term Borrowing Long-term borrowing is another option that Emaar may use especially when it assesses that it can no more acquire substantial financing through internally generated funds. However, long-term borrowing has to be repaid at a certain future date as well as the regular and timely interest payments to the lenders. The good thing of this financing option is that it can provide a specific amount of interest to the lenders whereas the profits obtained from this hotel project would definitely exceed substantially as compared to interest payments payable to the lenders (Brigham and Ehrhard, 2008). Venture Capital Venture capital is another type of financing that Emaar Properties Plc can pursue such that it can attract few large business groups which are likely to invest their money to establish the business for a specific period of time, include in the management decision making, earn profits and then erode their equity when the project is completed and delivered to the end customers. Issuance of New Equity Issuance of new equity may be one of the least preferred areas of financing available to Emaar Properties Plc because the company may want additional financing but not at the expense of losing their control on the company or even on a specific project. This option of financing can act as a last resort to Emaar but Emaar should approach once it gets through all other available financing options. The following are the three factors which an organization must take into consideration when deciding for an appropriate source of financing. Cheap or Expensive Source of Financing All sources of finance do not have the same capital costs as all the options have different features such as maturity, legal status, amount of finance etc. Internally generated funds of the company, is obviously the lowest cost based source of finance followed by the long-term borrowing which provides the tax shield to the company. However, issuance of new capital and venture capital scheme are the expensive sources of financing. Capital Structure Capital structure is one of the core factors which an organization must consider when deciding the appropriate source of finance. Company needs to keep an eye on the capital structure to see whether the company can be exposed to high risk due to inclusion of high debt into capital structure. Urgency of Funds Urgency is also another factor which company must account for as not every source of finance provides instant finance to the company. Internally generated funds, is the quickest source of finance as they are readily available to the company, whereas all other external sources of finance take substantial amount of time in arrangement, availability and usability of the funds. b) Evaluation of Dilution of Control, Legal Status and Tax Effects upon the decision of making finance sources Dilution of Control The organization must assess whether it would have substantial control over the management and decision-making process of the company or it may lose such control. Under venture capital and issuance of new equity options of financing, the organization would be exposed to the risk of dilution of control. As the number of owners is increased in the business, the highly diluted will be the company in terms of the control that it can have over the decision-making and management of the operations of the business (Watson and Head, 2009). Legal Status The legal status associated with each are of financing counts a lot especially to the organization raising funds. Long-term borrowing creates lending claims to the investors being creditors of the company and their invested money is taken as debt. On the contrary, all other three sources of finance create ownership right to the company and their invested money is referred as equity. Tax Effects Tax plays a key role in deciding the appropriate source of finance to the company. Since interest payments are tax deductible before the computation of profits and income tax liability, therefore the resultant tax liability is reduced which results in lower tax payments or tax savings. However, in respect of equity-based sources of finance, the dividend amounts are not tax deductible which means that total profit is computed first followed by deduction of tax liability which results in net profit after tax. That net profit after tax is then applicable for the dividend distribution unlike interest payments which are deducted from profits before computing tax liability (Brigham and Ehrhardt, 2008). c) Evaluation of Pre-Sales Serviced Apartments Besides the other four sources of finance that Emaar currently has, the existing source of finance in the form of pre-sales serviced apartments is indeed a handful source of finance even before providing the occupation of the apartments of their owners. This method of generating finance does not include any cost of raising the capital, nor does profit distribution become necessary for the company to make. At the same time the company can also make funds readily available due to which the construction of those apartments can commence a bit earlier than usual due course. However, until all the sales of apartments are completed, the company has to arrange other sources of finance so that the remaining unsold apartments can be constructed without any delays. In this way, this scheme of finance through pre-sales of apartments can provide Emaar another convenient and timely available of finance. Part B 1) Cost of using debt Debt is considered as the cheapest source of funding any project. This is possible because the interest payments associated with the debt are tax deductible due to which tax liability is decreased. However, it increases the overall risk of the organization and the bankruptcy chances may increase (Brigham and Ehrhardt, 2008). Cost of using equity Equity is the prime source of funding hotel project but its associated costs i.e. dividends are not tax deductible. This is why the company has to pay additional tax. However, it decreases the risk of bankruptcy. Issuing new equity to new owners carry a risk of dilution of control over the management decisions. 2) Importance of Financial Planning For every project, financial planning is necessary-perform activity as it provides the future projections of the business operations of the company especially in respect of using cash. Cash budget is the primary statement that is prepared to provide a better view of the cash inflows and outflows during specific time (Brigham and Ehrhardt, 2008). 3) Characteristics of Information Needs There are various characteristics of information needs especially applicable to CEO, project manager and the construction supervisor. Those characteristics should include timeliness, accuracy, appropriateness, conciseness, completeness. For instance, information related to availability of funds at a specific time, with specific terms and conditions showing accurate amount for apartments only include the characteristics of timeliness, accuracy, completeness and appropriateness. 4) Impact of Different Financing Options Long-term Loan When a company obtains long-term loan, it increases the portion of non-current liabilities in the statement of financial position. Not only this, interest is also charged on the amount of long-term loan which is recognized in the statement of financial performance. Equity Shares Equity shares issue is taken into equity portion of the statement of financial position. Dividends associated with share capital, is not mandatory for payment as it is purely based upon the discretion of board of directors of the company. They are shown in statement of changes in equity. Finance and Operating Lease Assets acquired under finance lease are disclosed in the statement of financial position and their interest payment is charged in the statement of comprehensive income. Assets acquired under operating lease are not capitalized and their rentals are charged out in the statement of comprehensive income. TASK 2 The above cash budget does not provide any value addition to the organization as the organization would end up on a similar footing where it started in Quarter 1. The organization has relatively larger amounts of cash balances during the first two quarters. However, the projections of the organization are quite depressing in the third quarter. The major reason behind such compromising projection is likelihood of purchasing new machinery especially when the organization would not have sufficient funds. Besides that, the operating performance of the organization may not provide a satisfactory outlook as the organization seems to have the sales of around 80,000 but the total material and labor costs amount to around 95,000. This shows that Quarter 3 may become quite challenging for the organization to meet the cash requirements and thus would end up having negative cash balance.   Quarter 1 Quarter 2 Quarter 3 Opening Cash Balance 5,000 51,000 115,000 Expected Cash Receipts   Cash Revenue 90,000 80,000 60,000 Receivables 54,000 57,000 20,000 Loan 10,000 5,000 - Total cash available 159,000 193,000 195,000     Disbursements   Material 20,000 30,000 55,000 Labor 30,000 35,000 40,000 Administrative 2,000 2,000 3,000 Machinery Purchase 45,000 - 90,000 Income Tax 11,000 11,000 12,000 Total Disbursements 108,000 78,000 200,000 Closing Cash Balance 51,000 115,000 (5,000) TASK 3 The product manufactured by Q Ltd currently has the variable production cost of $1.2 and the associated fixed cost per unit of around $5. These two costs amount to $6.2 which is the production cost of the product. However, there are selling costs associated with the product but they are not absorbed into the specific cost of the product due to which they are not included in the unit cost. Since Q Ltd has spare capacity of producing 2,000 units, therefore it should accept the offer from Z Plc. if Z Plc. is agreed to pay a price of above $6.2. The following table shows the computation of unit cost: Variable Production Cost   1.2 Total Variable Cost per unit 1.2 Fixed Production Cost ÷ 40,000   Number of Units Produced 8,000   Total Fixed Cost per unit 5 Total Unit Cost 6.2       TASK 4 EPG Ltd is considering two projects i.e. Housing and Home. However, the company has the choice of accepting a single project out of the two. The decision for selection of the project is based upon the investment appraisal criteria. Investment appraisal is an approach to evaluate the various investment opportunities available to any firm. This approach has various techniques such as Net Present Value, Payback, Internal Rate of Return, Accounting Rate of Return etc. For EPG Ltd, Net Present Value (NPV) and Payback are used, as the mainstream investment appraisal techniques to decide as to which of these two projects have to be selected (Brigham and Ehrhardt, 2008). The results of NPV show that the Housing project is going to provide NPV of around $52.62m whereas for Home project, NPV is found to be $32.73m. The criterion used for NPV calculation is to check the NPV value that should be greater than zero and higher than the other project’s NPV. In this way, the NPV of Housing project is greater than zero as well as higher than that of Home project, thus Housing project would likely be more beneficial than Home project. Besides NPV, Payback is another technique that provides the estimated time in which the capital outlay of the project would be recovered from the upcoming cash inflows. The earlier the capital outlays are recovered; the beneficial will be the project. Under existing scenarios, it can be clearly observed that the capital outlay of Housing project would be recovered in around 2.96 or 3 years whereas the same would be recovered in respect of Home project would take around 3.28 years. In this way, Housing project would recover its capital outlays earlier than that of Home project, and as a result, it should be considered for acceptance by the Board of Directors of EPG Ltd. Another investment appraisal technique is Internal Rate of Return (IRR) which is highly effective as it provides a basis of comparison of the two projects having different size of cash flows. IRR is actually the rate that makes the net present value of the project zero. In other words, the difference between the cost of capital that a company used to discount its cash flows and the internal rate of return (IRR) is the excessive return that finance providers earn on a given project. The higher the difference between the cost of capital and IRR, the beneficial will be the project (Brigham and Ehrhardt, 2008). The following table provides the computation of NPV and Payback period for both Housing and Home projects: Housing           Years 0 1 2 3 4 Capital outlay -100   Net cash flows 60 30 40 80 Residual value 10 Total cash flows -100 60 30 40 90 Cost of Capital - 15% 1.000 0.870 0.756 0.658 0.572 Discounted cash flows -100.00 52.17 22.68 26.30 51.46 Cumulative cash flows -100.00 -47.83 -25.14 1.16 52.62 Net Present Value 52.62   Payback 2.96   IRR 37.54%         Home           Years 0 1 2 3 4 Capital outlay -150   Net cash flows 60 60 60 60 Residual value 20 Total cash flows -150 60 60 60 80 Cost of Capital - 15% 1.000 0.870 0.756 0.658 0.572 Discounted cash flows -150.00 52.17 45.37 39.45 45.74 Cumulative cash flows -150.00 -97.83 -52.46 -13.01 32.73 Net Present Value 32.73   Payback 3.28   IRR 24.96%         TASK 5 Financial statements mainly consist of five individual statements such all those statements are jointly known as financial statements. The names of the sub-categories of financial statements are as under: 1. Statement of Financial Position 2. Statement of Comprehensive Income 3. Statement of Cash Flows 4. Statement of Changes in Equity 5. Notes to the financial statements Since EPG Ltd is a corporation therefore as per the requirements of the applicable accounting principles, the company is obliged to prepare all these financial statements. Statement of financial position will allow the company to keep a close look at the overall position of the company. This statement shows the value of assets deployed in the business and the financing side in the form of debt and equity for those assets (Watson and Head, 2009). Statement of comprehensive income provides the entity a mechanism to consider the performance of the company in a given period. This statement contains the revenue it generated from the ordinary business operations and the associated expenses. The most important head covered in this statement is the profitability figure that sums up the overall financial performance of the company in a given year. Statement of cash flows provides a system to the company in respect of the areas from where the cash is generated as well as the areas where the cash is put into use. There are three main heads covered in statement of cash flows i.e. operating, investing and financing. Statement of changes in equity shows the changes that have been made in the equity side of Statement of Financial Position such as net income taken to retained earnings, deduction of dividends from retained earnings etc. Notes to the financial statements is actually not a financial statement of a category thereof but these are the supporting notes that provide explanations of the figures that have been arrived while preparing the other financial statements. Comparison of Formats of Financial Statements Statement of Financial Position In this statement, a sole proprietor shows retained earnings and the capital. For partnership, the individual capital accounts of every partner are disclosed. Under corporation setup, the equity side contains share capital, share premium, reserves etc. Statement of Comprehensive Income For sole proprietorship, the basic heads are included in the statement of comprehensive income. For partnership, profit attributable to each partner is located at the end of the statement whereas for corporations, earnings per share, other comprehensive income etc. are the additional heads that included in the given statement. Statement of Changes in Equity Sole proprietors prepare this statement by simply adding up the net profit in opening capital balance and deducting the drawings, if any. For partnership firms, the effect of changes in the ratios of capital along with share of each partner’s capital etc. are included in this statement. Corporations provide a detailed disclosures in respect of appropriation of net profits, cash and bonus dividends, share capital, share premium etc. (Watson and Head, 2009). TASK 6 If the financial position and performance of Grappa and Merlot is analyzed based on financial ratio analysis, Grappa has outperformed Merlot in almost every area. Return on capital employed of Grappa is 4% greater than that of Merlot. However, net assets turnover of Merlot is quite high that shows that the company has efficiently used its net assets to generate its existing sales level. Gross profit margin and operating profit margin of Grappa is higher than that of merlot but to a substantially marginal level. Current ratio of Merlot is a bit higher as compared to Grappa which is a sign of improvement for Merlot. Merlot has reflected less number of days for inventory, trade receivable and trade payable as compared to Grappa. However, less number of day for accounts payable is not a good sign to Merlot because it can create cash flow problems to higher frequency of payments in a year. Gearing ratio of Merlot is worst as compared to Grappa as Merlot is highly risky. Not only this, it has few profits before taxes to cover the interest expenses as compared to Grappa which has even higher amount of profits for covering interest expenses. In this way, Merlot has low level of profitability and highly riskier capital structure as compared to Grappa therefore, it is advised to EPG to consider Grappa for acquisition. Ratios Grappa Merlot Return on Capital Employed 14.80% 10.99% Net assets turnover 1.2 2.25 Gross profit margin 12.50% 12.20% Operating profit margin 10.50% 9.76% Current Ratio 1.2 1.28 Closing inventory holding period 70 64 Trade receivables collection period 73 66 Trade payables payment period 108 77 Gearing 35.5 81.08% Interest Cover 6 2.3 References Baker, H. Kent . and Martin, Gerald S., 2011.Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons. Brigham, Eugene F. and Ehrhardt, Michael C., 2008. Financial management: theory and practice. 12th ed. New York: Cengage Learning. Watson, Denzil. and Head, Antony., 2009. Corporate Finance Book and MyFinancelab Xl. 5th ed. New York: Pearson Education, Limited. Read More