Initiatives Taken by Thomas McGill and Improving Financial Position of Star Bay Company - Assignment Example

Insert your name here] [Insert professor’s name here] [Title of the course] [Date of submission] Question 1 Executive vice presidents, finance and managers at every level must make some technical financial decisions at a given part of their profession. One thing though that remains poignant is that the decision might have disastrous impact on the company. To underscore the above statement, thorough evaluation of Thomas McGill’s financial decisions needs to be related. Executive Vice President’s financing decisions taken from 1990 to 2007 has much to query and admire at the same instance. Case of 1990 In 1990, Thomas McGill made to critical decision in the name of issuing stock and obtaining of $10 million in form of long term bonds. To begin with is assessment of the decision to issue stock. There are some pressing circumstances when such decision as issuing of company’s stock may be acceptable. If there is a belief in the future that stock prices will inflate thus generating some extra income then managers may make such decision(s). The second option is when the company is in dire need of external finance and cannot raise from within. The third option is that a company can do this if it wants to make a change in its debt-to-equity ratio which it can thereafter uses to assess its bonding rating. It is from the above premise that I am going to refute or take in decision made by Thomas McGill. Assessing circumstances at hand in 1990, there were two pressing issues and a decision by McGill to issue shares was the best decision any manager working at such circumstances would have been advised to do. Star Bay Company was supposed to increase net assets by 30% which translated that the asset be moved from $80 million to $104. Out of $24 needed, McGill could only obtain $4 through retained earnings with no idea where to get $20. Again, though financial analysts may have argued that there was a 5% increase rate in sales between 1986 and 1989, there were other dragging expenditures such as the new plant facilities required to produce the products developed by the running R&D programmes. This and other expenditures made the company require a substantial amount of external funds. Any auditor expecting books of account would have concurred that the decision made was proper. With regard to the decision to obtain $10 million in the form of long term bonds, the bottom line of the idea is that any company who tries to sell their long time bonds before maturity may have a problem with their finances as these bonds will be affected with heavily discounted markets. However, as the case with their shares, there was a compelling circumstance which was the need to realise a capital gain. This is so because as the case stands, the prevailing rates have declined while the value of the bond has gone up. It therefore remains that the decision made by McGill was not against the policy. Case of 1992 The Star Bay Company Cash Budget For the Year Ended December 31, 1991 QUARTERS Q491 Q192 Q292 Q392 Q492 Cash balance, beginning 5,000 5,000 5,000 5,000 5,000 Add sales 21,000 29,000 44,000 51,000 54,000 Total cash available 26,000 34,000 49,000 56,000 59,000 Less purchases 22,500 37,500 37,500 45,000 22,500 Less expenditures 4,500 3,600 4,500 4,500 5,200 Cash balance ending -1000 -7100 7000 6500 31300 Cash balance ending $36,700 As the balance stands, the company indeed needed a minimum cash balance of $25 million. Therefore borrowing must be sufficient to cover cash deficiencies of the $25 million. Case of 1995 In the year 1995, Thomas took an initiative of reducing the debt ratio of the company. Based on this decision, analysis of the subsequent financial impacts will help to determine his take in the then financial turmoil of the company. As the matter stands, the intention of McGill was to reduce the debt ratio of the company’s long term debt. He intended to do this by repaying $25 million of 5% loan principal and the interest accrued. It must be understood that his decision was done as a result of economic conditions which were favorable and funding costs were lower. Just like a situation when a borrower may repay a loan if the interest rates in the market are lower as compared to those of the existing loan. As opinions from analysts and Wall Street experts argued, inflationary pressures translated that there would be a decrease in the exact value of the circulating money which will ultimately discourage investors and other companies willing to save. On the other hand, this status would have also forced central banks to re-adjust their nominal interest rates in an attempt to avert the situation which would of course encouraged other investors especially from non-monetary capital companies. Therefore decision by McGill to defer the refunding proposal was for the best interest of the company and its financial position because he was hoping to invest the supposed $25 million in order to take advantage of the initiative the central bank was to take to avert the situation. Basically offsetting long term loan with short term one is a clear effort in an attempt to reduce debt ratio of the company. This was a good idea as short term loans carry low interests rates which could not have strained financial position of this company. On the other hand, long term loans may be bonds or loans carrying higher interest rate which Mr. McGill wanted to avoid. Case of 1999 The manager’s decision of issuing long term convertibles at 6.5% interest rate expected to be converted to stock at $40 for each share was a wrong decision. There are two major variables the manger ought to have looked at before making such decisions; the financial position of the company at that particular time and the impacts of issuing long term convertibles with regard to the financial environment in and outside the company. Though the company needed $15 million, there was clear indication that the stock split was selling for $35 and earning $2.20 per share, a favorable condition for this company to finance from within. Besides, Star Bay Company had a policy of retaining its earning which enhanced its debt ratio even though it was lower than that of the industry average. These are exactly what Mr. McGill failed to look at. On the other side, Mr. McGill did not evaluate the impact the company will have if long term convertibles at such a rate are issued. Though there is a possibility of reduced cash interest payment when such bonds are issued, Mr. McGill did not know that at such a situation when the industry average price-earnings ratio was just 16, there was no need to rush into such decision for the sake of getting reduced interest payment as the truth of the matter was that the company on the other side got a reduction on the value of shareholder’s equity during the time a stock dilution was expected due to bondholders making new shares out of the bond. Case of 2002 (Efraim and Eyal1) argue that “Short term financial debt without doubt exposes borrowers to roll-over risk and therefore has the potential of causing an amplified financial turmoil.” Indeed the basic concept is that with short-term liabilities, companies can fund ever growing illiquid investment projects especially when economic conditions melt. Taking this in account, the decision by Mr. McGill to refund short term debt with the long-term debt was an idea destined to positively shape financial position of the company. Most financial managers will try hard to eliminate short-term debts as many learnt from the recent crisis whereby asset-backed commercial paper market collapsed. The other reason is that it can be beneficial to any company trying to avoid fragility embedded in short-term debt and rollover risks associated with it. Moreover, (Diamond and Rajan 40) add that “There is higher likelihood of crisis stems, not from the short-term debt, but from the illiquidity and potentially low creditworthiness of the investment being financed.” From the other side, taking long-term debt was ideal for McGill because (a) there was going to be a rise in interest rate due to inflationary pressures (b) there was to be a tax deductibility of interest payments which would have result in the risk-adjusted component cost of debt being lower than that of the stock. Case of 2004 Tough decisions as that of McGill have to be based on the returns which that investment will earn. It is unwise to consider investing in a project that will strain the company financially. Therefore these kinds of decisions need to consider the difference between the value of cash inflows at the beginning and the value of cash outflows at the onset. In such a situation, I will use Net Present Value in this capital budgeting to scrutinize the profitability of the project the company wanted to undertake. Using: = the N.P.V= -11 + (summation) O.C.F/ (1+R(r))t + T.C.F/(1+R(r))n -II= initial investment McGill is planning to put = $12.5 million (payable immediately) O.F.C= the cash flow operating within the year (t) = year 1 $8.0, year 2-9 $2.5 year 10 $3.0 t is the year (n)= years of the project = 10 years Rr = rate of return =10% Solution: NPV= -12,000,000 + (8,000,000/1.10) + (2,500,000/1.10^7) + (3,000,000/1.10^10) 11,678,005 – 12,000,000 = -321,995 The expansion project initially started by McGill should be given consideration if the value is positive and turned down if the figure is negative. I can therefore infer that the project was not profitable and no value could have been added to The Star Bay Company (SBC) and as it stands, severity measure to be taken to satisfy McGill’s proposal was to look into a self financing model. Case of 2007 The decision to now want to engage in the proposal abandoned couple of years ago is not economically viable. It was an idea that should not have been welcome as the basis of his decision was merely on anticipation. Besides, if selling a 25 year old bond which had a floating rate set at three quarters of 1% above the prime rate is core basis of his reconsideration, it will be misleading as there was other market fluctuations that could arose since he only based his judgment on anticipation. Question 2 From general analyses made, initiatives taken by Thomas McGill are destined to help improve financial position of Star Bay Company (SBC) over years to come. For instance, the decision to abandon expansion project was pivotal as it could have strained the finances of the company. Question 3 Before making a recommendation about the future of McGill we need to consider that some of the decisions made by him were external (external financing operations) and he could not influence the outcome. It therefore stands that his general performance was good as he was always sensitive about external market fluctuations before making decisions. He should be given more time to work with the company. Works Cited Efraim, Benmelech and Eyal, Dvir. “Does Short-Term Debt Increase Vulnerability to Crisis?” Evidence from the East Asian Financial Crisis, 2011. Print. Diamond, D.W., and Rajan, R.G. Liquidity risk, liquidity creation and financial fragility: a theory of banking. Journal of Political Economy 109, 287–327, 2001. Print. Read More