Capital Structure and Cost of Capital and Financial Performance Analysis - Abu Dhabi Islamic Bank - Case Study Example

Capital Structure and Cost of Capital and financial performance analysis Students Name: Institutional Affiliation: Department Course: Date: Introduction One of the most imperative financial assessments and which financial managers come across in their professions is evaluate whether the enterprise should devote huge sums of capital in a given outlay. The judgment may impact the corporate managers in either a manner that is directly or indirectly. For instance, the manager may come up with a scheme to take over or combine with a different concern and it would encompass the appraisal of possessions that are maintained by the target entity and a resolution made to either maintain or close a specific section of the target entity. These decisions are accompanied by financial analyses that are complicated setting out a justification on the proposal. There are various methods used to gauge the worth of investments that are new or projects with the most demanding and steady encompass projecting the cash flows of the future and subsequently discounting the projections at a proportion to of interest that is appropriate in arriving at the present worth. The reaction is normally accessible as a ratio of the rate of return. The inference is that the frequency of return for the a project that is identified should on the higher perspective of the cost of capital of the enterprise for the plan to be acknowledged. Managers even though it seem familiar have the vaguest of ideas of how the rate of discounting that is appropriate is chosen. Moreover, even if an enterprise calculates correctly the cost of capital a different cost of capital is used. It seems therefore there are many practical and conceptual problems that face managers when queried to appraise verdicts in capital budgeting. The research sets to highlight how Abu Dhabi Ship Building PJSC can evaluate the cost of capital that is suitable. The best valuation for an enterprise is replicated in the market worth of the stocks and liabilities for the long period it has allotted. The manager cannot regulate the engagements of the market but they can have a sway on the score which is assumed by the market of stocks. The criterion used to seek regulation on the perspective to finance a sum of capital in a scheme is whether the market price of the share decreases or increases. The concrete result is that the manager should prognosis the cash flow that is expected from a project being reviewed and pragmatically value them by discounting at a cost of capital that is appropriate. If the remaining outcome is optimistic and adopted the price of the share increases. If it gives a negative cash flow the share price decreases. Capital structure The whole issue on the capital structure relies on cost of equity and debt. The formulae for determining the cost of capital is articulated as; The implications for the principle are that the maker of decisions should use it to assess the projects worth that meet the company risk and only assent project that produce a yield that is higher. There is no argument that if the debt level increases the holders of equity will demand higher returns. An issue arise on whether the increase exceeds the outcome of appropriating more capital at lesser interest charges from holders of debt. The argument is inherent on the net outcome of solvency on the average cost of capital. Three views are articulated as follows to describe the argument I. Traditional- as the extent of solvency increases, the cost of capital will decrease at first then rise that is there is a peak. II. MM articulate as the gearing amount increases, the cost of capital remain consistent except on the perspective there is an effect of shield on taxation and in this scenario, it is decreased by the tax shield quantity. III. Modified M&M heightens that limits exit because of insolvency costs and the ambiguity of preserving the tax shield. An optimum may occur but it may be subjected to all categories of preference and biases from the institutions. Although arguments persist between scholars as to the extent for a phenomena like bankruptcy or the tax effect, a common agreement accentuate that average cost of capital is adjusted by at minimum of the effect of the tax shield on commitment. Entities can claim legitimately that the payment of interest is an operating cost, the tax amount that is due is reduced by payment of more interest. In this paper the assumption is on the long term debt and equity. Cost of debt The modest tactic for appraising the obligatory yield on commitment is to use the yield for redemption. In financial description, it accentuate the internal ratio of profit that pragmatically parallels the bond contemporary price to the cash flow. However, the redemption can overestimate the bond return if there is any unplanned default. The assumption also articulate the rate of interest are continual during the lifecycle of the bond. The cost of debt for ADSB IS 1 month EIBOR plus 1%, which represents 2.8% Cost of equity It is rather problematic to appraise the yield on equity. There are two method that can be used. The dividend discount model values the stock by supposing that the dividends propagate at a continual rate. The lead of DDM is that it is modest to evaluate. The cons for the method is that it is not an approach that is consistent. The use of CAPM is rather a demanding source and is broadly encapsulated in calculating the required return for equity. The key assumption of the model is that the investors articulated to be efficient are at present differentiated. The investors can this ignore the sum of the ambiguity and ponder on influence of their assortment of investment on the action of the company. The pros for CAPM articulates that it can be encompassed to consistently fine-tune the risk. The procedure of appraising and expending cost of capital encompasses 1. Appraise the cost of equity The assumptions accentuate that the risk premium of the market has generally been in the region of at 7% and for the risk free rate, it is about 4%. The beta for the firm for the fiscal year 2015 was 0.19. The calculation to estimate the cost of equity will be K = 4% + 0.19 (7%-4%) K= 0.457 or 4.57% 2. Estimating the comparative weights of equity and debt Component Amount in AED'000 Proportion Debt 34304 0.09 Equity 367852 0.91 402156 1 3. average cost of debt estimation The cost of debt for ADSB IS 1 month EIBOR plus 1%, which represents 2.8% 4. Assumption of an effective marginal tax rate The assumption in the paper encompass that ADSB does not pay any tax hence there is no effective marginal tax rate. 5. Using the WAC equation to calculate the cost of capital WACC= (9%x2.8%) + (91%x4.57%) Cost of capital = 4.41% From the calculation, the company minimum required return should be 4.41%. Hence a project that is below the rate should be rejected given that it decreases the value of the firm. For a project that return exceed the proportion, they are accepted because the share prices would increase. Matters that cannot be determined in exercise. There are a number of concrete hitches in the estimation and use of cost of capital. Amongst the most important include The frequency on the calculation of WACC. According to norms, the calculation should as frequent as an assessment is essential. Concerns infrequently convert the cost of capital more repeatedly than after a quarter and particular entities do it only every twelve months. Should the book worth or the ongoing rates be used? The market value is used if it is possible. How is he bank loans, loans that are convertible and preference share taken into account? The current liabilities and assets are netted out as the cost of capital predominantly reflect financing in the long-term. What is the risk free rate? It encompasses a proportion of the yield of a stock that is assured for the period endowed. The risk free rate in assumption is the rate of the Reserves Bill which has no intention of being defaulted and the profit over the era of a month or three months is defined unerringly by the purchasing price. Although many entities are conversant with the ideologies delineated in the paper, it is extensively acknowledged the use of capital budgeting in construction of decision infrequently uses the NPV concept. Scholars have also established that entities use an interest rate that is pointedly on the upper side than the cost of capital. Part B Financial performance analysis Bank Selected (Abu Dhabi Islamic Bank) Company overview Abu Dhabi Islamic Bank is a well networked multinational bank operating through 88 branches in the United Arab Emirates as well as 3 overseas branches based in Qatar, Iraq, and Sudan. The Abu Dhabi Islamic Bank is head quartered in Abu Dhabi United Arab Emirates. The company provides banking services financing as well as investing solutions to SME’s, individuals and the corporate customers. Abu Dhabi Islamic Bank is strategically equip with diversified different account that enhances the all based on customer from students to corporates bodies. Further, Abu Dhabi Islamic Bank provides mobile, Internet as well as telephone banking services and ATM deposit machine which enhances preference and client efficiency in using the banking services. Return on assets (ROA) Return on Assets ratio is utilizes in measuring the percentage of profit that the banking will earn on the assets invested[Nex07]. Return on Assets is a major financial profitability ratio that evaluates the amount of profit the banking business makes per dollar of each assets invested. Return on Assets is a highly valuable ratio which also reveals the management efficiency in utilizing the company’s resources to generate profits. ROA = Abu Dhabi Islamic Bank 2015 2014 EBIT 1,940,358 1,754,216 Total Assets 118,397,662 111,903,803 Return on Assets 1.64% 1.57% Abu Dhabi Islamic Bank return on assets accentuates an increasing trend in utilizing its assets to generate income attributable to the company’s shareholders. The company’s pragmatic policies in consideration to the rate of return on the company’s asset is properly managed and utilized in generating income for the business. Hakman (2006) heightens that the company’s unveils increasing assets return from 1.57% in 2014 to 1.64% financial year 2015. However this describes that management are efficient in substantiating the policies of utilization of assets to generate revenue and income. Profit margin ratio Profit margin is a profitability ratio accentuating the company’s effectiveness in making use of its investments to generate earnings which is relative to the sales[Nex07]. Profit margin unveils the firm’s financial ability to gather for its operating expenses as well as generating surplus earning from sales of goods and services[Hak06]. The higher the company’s profit margin indicates viability of the company in converting its sales into actual earnings. Net profit margin = Abu Dhabi Islamic Bank 2015 2014 EAT 1,934,043 1,750,690 Sales 5,751,003 5,211,270 Profit Margin 33.63% 33.59% Abu Dhabi Islamic Bank profit margin describes an emergent trend in the company aptitude to generate financial earnings for the shareholders through turnover[Ali13]. The company’s reveals increasing trend from 33.59% in financial year 2014 while increase to 33.63% in the subsequent year 2015. This shows that the company management has enhance quality control initiatives to enhance profitability. Asset turnover Asset turnover ratio refer to the efficiency ratio describing the company’s efficiency in utilizing its assets investment to increase its earning in product or service sales[Cha10]. The asset turnover ratio measures the company’s management efficiency in utilizing its assets to vitalize the company’s sales in relation to the competitors. (Manuchehr Shahrokhi (2008) accentuates that asset turnover ratio enhances an analytical measures of the assets productivity of the company to the interested users such as potential investors as well company’s stakeholders. Assets Turnover ratio = Abu Dhabi Islamic Bank 2015 2014 Sales 5,751,003 5,211,270 Total Assets 118,397,662 111,903,803 Assets Turnover 0.05 0.05 Abu Dhabi Islamic Bank Assets turnover ratio accentuates a stand efficiency in making use of the financial assets to make revenue. Based Allen and Gale (1997) According to the graph above Abu Dhabi Islamic Bank describes that an increase from 2014 assets turnover of 0.05 while in 2015 the company averages at 0.05 efficiency in making use of the financial assets to make revenue. This shows that Abu Dhabi Islamic Bank management need to but more emphasis on financial stringent procedures heighten in ensuring the assets turnover ratio is enhanced at acceptable increasing trend. Conclusion Abu Dhabi Islamic Bank financial ratio analysis describes that the company’s management are sensitive in enhancing the company’s profitability, as well as substantiating the company’s sustainable efficiency financial measures. According to Abu Dhabi Islamic Bank profitability ratios describe by profit margin as well as the return on assets indicates that the company has substantive profitability growth towards 2015. The efficiency ratio’s indicates that Abu Dhabi Islamic Bank need to establish the improving financial ability to increase the amount of cash available to meet the financial obligations. References Nex07: , (Earl, 2007), Hak06: , (Hakman, 2006), Ali13: , (Manuchehr Shahrokhi, 2008), Cha10: , (Gibson, 2010 ), Appendix Read More