Strategic Finance and Decision Making - Example

Name : xxxxx Tutor : xxxxx Title : strategic finance and decision making Institution : xxxxx @2015 Question 1: Al Araqi Trading Limited. A. Financial Performance Based On Financial Ratios 1. Profitability: it refers to the measure of a company’s ability to generate earnings taking into account expenses and other costs used to produce the profits. The appraisal of Al Araqi was done using; Return on Capital Employed (ROCE) 2012: 2013: Inference: The return on net assets (capital employed) rose from 16.2% in 2012 to 16.9% in 2013. The increase got attributed to both an active improvement of sales revenue and the fact that Al Araqi disposed of some items of Plant & Equipment in 2013. The debtors also paid part of their amounts meaning with the increase in sales and decrease in assets; the ROCE improved. Return on Equity (ROE) 2012: 2013: Inference: There is a decline in ROE from 27.7% in 2012 to 27.2% in 2013. The drop could be because, in 2013, there was an increase of retained earnings reserves by OMR 55,000, thus increase in reserves. The proportional increase in profits regarding the rise in equity differed during the two financial periods reviewed. Gross Profit Margin (GPM) 2012: 2013: The gross profit margin increased from 25.1% in 2012 to 28.3% in 2013. The increase was due to reduction in the cost of goods sold and an increase in sales revenue. Net Profit Margin (NPM) 2012: 2013: Inference: NPM showed evidence of a slight increase from 9.1% in 2012 to 9.6% in 2013. The rise can be attributed to increase in sales turnover in 2013 leading to higher profits that year. It could also mean that Al Araqi adopted better product marketing strategies with the aim of improving its performance for the imminent sale of the company. It is, therefore, evident from the ROE that Al Araqi no longer operated with going concern due to the imminent takeover by Ward. The profitability ratios showed moderate but stable state of affairs synonymous with companies facing takeover. 2. Activity Ratios: it measures the company’s ability to generate cash and sales from its accounts. It shows the level of efficiency that a corporation has in utilizing its assets, leverage and other balance sheet items. In the case of Al Araqi, the following activity ratios were used Net Assets Turnover (NAT) 2012: 2013: Inference The ratio remained constant at 1.8 over the period reviewed. It indicates that, for every OMR invested in assets, Al Araqi generated the same amount of revenue in both years. Inventory Turnover 2012: 2013: Inference In 2013, Al Araqi was less efficient in generating sales from its stock evidenced by the drop in the inventory turnover to 5.1 from 6.5 in the preceding financial year. The higher inventory turnover in 2012 indicated a better cash management regime compared to 2013. Stockholding period 2012: 2013: Inference There was an increase in the number of days it took Al Araqi to sell its entire inventory from 56 days to 72 days. In essence, it meant that it took the company 16 more days to sell its inventory. This is due to the increase in inventory in 2013 or a weak inventory management regime in 2013. 3. Gearing/Leverage ratios: It measures the degree to which a company’s activities gets funded by shareholders funds versus those of creditors. Al Araqi Trading Limited’s leverage got evaluated in terms of; Debt-Equity ratio 2012: 2013: Inference There was a slight decrease in the debt equity ratio of Al Araqi from 1.1 in 2012 to 1.0 in 2013. However, both years had relatively equal debt and equity evidenced by the ratio of 1. Gearing Ratio 2012: 2013: Al Araqi was highly geared in 2012 but reduced to 0.61 in 2013. Interest Cover 2012: 2013: There was a rise in the level of interest cover from 4.4 times in 2012 to 5.1 times in 2013 mainly due to increase in earnings in 2013. It indicates that debt-financed more of the earnings in 2013 compared to 2012. 4. Liquidity: it refers to a company’s ability to meet its short-term financial and other obligations as and when they fall due. Al Araqi’s liquidity was evaluated as follows; Current Ratio 2012: 2013: From the fact that Al Araqi had current ratios of more than one during both years, it is evident that it would be able to meet its short-term financial obligations. The increase to 1.6 in 2013 is a further indication that that ability improved. Quick ratio 2012: 2013: In both years, the quick ratio was below 1, i.e. 0.7 in 2012 and 0.6 in 2013. It indicates that Al Araqi was unable to meet its short-term obligations using its most liquid assets. The inability also worsened in 2013 because inventory formed the most portion of its current assets during that year. B. Valuation the Equity of Al Araqi Trading Limited Valuation refers to the process of estimating the net worth a firm for the purpose of decision making. It can be achieved using various models that put into account the firm’s financial items. For the case of Al Araqi, it can be valued using the following models; 1. Net Assets Method The net assets method estimates the value of the company as being worth the value of its net assets. There are three commons ways of valuing net assets; book value, net realizable values and replacement values. For the case of Al Araqi, the most useful of the three is the net realizable value since it presents the sellers with the lowest value they should accept. The valuation can be arrived at as follows: OMR OMR Non-current assets Land and buildings Plant & Equipment Motor Vehicles 715,000 230,000 45,000 990,000 Current assets Inventory Receivables Cash 260,000 150,000 8,000 418,000 Total value of net assets 1,408,000 Less intangible asset (goodwill) - Total Value of tangible assets (net) 1,408,000 Less: Accounts Payables Taxation Long term debt Net Asset Value of Equity 227 38 400 (665,000) 743,000 Number of Ordinary shares 100,000 Value per share OMR 7.43 The lowest value that Ward should accept as the value of Al Araqi is OMR 743,000. It represents the value after the non-current assets have got revalued. 2. Earnings Method It is an income base approach that mostly relies on finding listed companies in the similar industry to that of Al Araqi Trading Limited, and then evaluating their relationship in share prices and earnings. Using the relationship-based model the value of shares of Al Araqi was established. Price-Earnings Ratio P/E Company 2013 2012 Al Amal Ltd 8.5 8.0 Al Hassan Ltd 9.0 8.5 Al Hashar Ltd 10.0 9.8 Average P/E 9.2 8.8 Ward can use the above value as the starting point in negotiation 3. Dividend yield method (with no growth) In this case, the value of the shares of Al Araqi Trading was estimated by examining the expected profits to be earned. Dividend yield Company 2013 (%) 2012 (%) Al Amal Ltd 12 13 Al Hassan Ltd 11 10 Al Hashar Ltd 13 12 Average P/E 12 11.7 The price per share of Al Araqi was given as OMR 1; therefore the annual dividend is given by; 4. Dividend yield method (with growth) The valuation got on shareholders rate of return taking into account the annual growth in dividends. Where Do is the dividend at a given time. re is the rate of return/ cost of capital. g is the cost of capital 5. Discounted Value of future cash-flows method The present value of future cash flows got used as an indicator of the value of Al Araqi. It got obtained as follows; It can, therefore, get deduced that the management of Ward should base their decision on whether to acquire Al Araqi or not on the above present value of future cash flows. C. Alternative Sources of Finance. The Management of Ward Pursuant to the impending acquisition of Al Araqi Trading Limited, there are several other sources of finance available to the management of Ward apart from the shareholders’ funds of which ward had €5 million. The sources may include; 1. Bank Financing Bank financing is a viable option in case the management of Ward feel that Al Araqi has enough assets and a substantial profit margin. It is, however, subject to itself having a good credit score. The management of Ward ought to find a bank that can finance the kind of business that Al Araqi gets involved. To help improve the chances of obtaining the financing, Ward managers should have a good relation with the management of the Bank as this will enable them also to get safe payment plans and interest rates. 2. Seller Financing It is worthwhile that the management of Ward explores the possibility of Al Araqi financing part of the transaction. Ward could make a down payment and issue Al Araqi with a promissory note for the rest of the purchase price (Sherman, 2011). In that case, Ward could use a significant asset as the primary collateral for the note. The terms of the purchase will vary as negotiated. However, monthly payments usually begin a month from the date of the sale. 3. Asset-based financing It mainly refers to an asset-based loan where the asset gets used as the primary collateral. Regulations usually provide a range of 65 to 80 percent of the asset class as the maximum amount that can get borrowed. It is, however, important to note that asset-based financing involves high expenses due to the competitive nature of lenders. Interest rates could range from 15 to 30 percent depending on the prevailing economic conditions. 4. Debt- Equity hybrid financing It mostly gets referred to as mezzanine financing. Such a funding option involves a senior and subordinate debt, a private placement deal, and capital investment. The equity is usually in the form of preferred stock. However, Ward should look to ensure it does not give up control to Al Araqi Trading Limited, therefore, should restrict the ownership of Al Araqi to 20 percent. According to Kahn (2010), to ensure the best financing terms and improve the likelihood of success, Ward should present a well thought out business plan. Question 2: The Role of SME’s In the Development of Oman Economy Small and Medium-sized Enterprises SMEs are crucial to every developing economy. SMEs have an inherent flexibility and ability to adapt to any changes in the economic environment, making them the most adaptable form of business. As per the Oxford Business Group report (April 2012), the SME sector in Oman accounts for 16 percent of GDP and 90 percent of economic activities. The most significant contribution to the economy of Oman is job creation. A lot of people get employed by the SMEs than in other sectors. The form of employment includes both skilled and unskilled labor. The limited job opportunities facing Omani citizens in private and public sectors lead to increased competition for the few jobs. Most citizens end up being jobless. However thing looks to improve with the vibrancy of the SMEs. Statistics shows that more than 10,000 residents work in the SMEs compared to roughly 200,000 in other high-class firms. (Oman Observer, March 2013) Omani SMEs also act as a link between industries. For instance, food enterprise in Oman provides a connection between the Agricultural sector and other industries in which its customers work. The SMEs have also ensured ‘home’ ownership of business by Omani nationals meaning there are reduced loopholes in terms of taxation. Ordinarily, expatriate owners would be taxed in their home country leading to revenue loss by the Oman government. The current system would also result in high remittances and increased pressure on the labor market among the Omani nationals. The recent mandate by the Central Bank of Oman (CBO) to all banks to allocate at least five percent of their total credit to SMEs means that the Banks are now required to fund local SMEs. It further help to foster economic growth in Oman. (Muscat Daily, December 2013). One can deduce that SMEs are important for the economy of Oman, and the government has taken the following steps to promote their growth; i. Ensuring a free market-based economy by limiting destructive market powers such as monopolistic behaviors by big firms. ii. Putting in place policies that encourage investors to seek funding and operate as SMEs. For instance the CBO mandate on Banks of December 2014. iii. Funding incubation initiatives to provide investors with the necessary skills to compete in the local and global markets. iv. Ensuring access to markets by SMEs by improving national infrastructure, providing ease of access to information and doing away with biased policies. v. Developing risk management mechanisms for SMEs. vi. Governments in OECD member countries including Oman, are currently promoting the development of secondary stock markets with the aim of ensuring SME inclusion in financial markets. (OECD Policy Brief, June 2000) vii. By easing taxation on capital gains and dividends and also allowing SMEs to use stock options as compensation has also helped promote SME development. (OECD Policy Brief, June 2000). Question 3: Factors that contribute to low benefits to shareholders of predator companies. Evidence show that the shareholders of a predator company in any form of acquisition gain at most 30 percent of all the advantages that accrue as a result of the acquisition. However, these benefits are usually not clear-cut nor tangible for that matter. The gains are minimal and sometimes there is even a drop in share value after an acquisition. Factors have been put forward to explain the above phenomenon and includes; i. Overvaluation of a takeover by the predator firm. It means therefore that once the dust settles during the post-acquisition period, the apparent gains gets offset by rising expenses needed to stabilize the take over fully. ii. The managements of predator firms usually place more incentive in the expansion of the company as opposed to shareholders wealth. The evidence of this factor is rampant share splits by companies with the aim of obtaining more funding while devaluing the stock value. iii. The absence of a standard of measurement of the benefits means that it is difficult to account for the benefits. The management of the predator firm, therefore, may use the benefits in other areas as opposed to shareholder’s wealth maximization. iv. The acquisition of companies with small economies of scale results in the predator firm using up funds during the post-acquisition period to enhance the operations of the acquired company. Shareholders wealth maximization is therefore not given priority. v. Mismanagement of the takeover process and integrity issues by the management of the predator firm. Shareholders could lose benefits that could have accrued to them during such a process. It can, therefore, get concluded that a takeover process need to be managed accordingly to ensure that benefits due to the shareholders do accrue to them. Otherwise, the decline in the stock value after acquisition may be experienced. References: 1. http://www.readyratios.com/reference/profitability/ 2. http://thismatter.com/money/stocks/valuation/activity-ratios.htm 3. Russell James Lundholm; Richard G Sloan, 2013: “Equity valuation and analysis” 3rd Edition. 4. http://www.inc.com/guides/201101/business-acquisition-financing.html 5. http://www.muscatdaily.com/Archive/Business/SMEs-the-engines-of-economic-growth-2rl4 6. R. A Shick, (May 1972), “The Analysis of Mergers and Acquisition”, Journal of Finance 7. T. F. Hogarty, (July 1970), “The Profitability of Corporate Mergers”, Journal of Business 8. http://www.lexuniverse.com/merger-acquisitions/US/Benefits-of-M-&-A-to-Shareholders.html Read More