Financial Management as a Very Important Tool for a Company - Assignment Example

Name University Course Tutor Date Financial Management Financial management is a very important tool to a company. Solid financial management is fundamental as it enables a company to use its resources well enough to achieve its desired results. This therefore calls for optimal financial performance and decisions concerning various sources of finance need to be checked properly before they are arrived at. Among the financial decisions is whether a company will be geared or not. Each of the decisions whether to be geared or not has its advantages and disadvantages (Brigham & Houston 2004). Question 1 By using net income approach theory which is one of the capital structure theories, it is noted that Green Limited is unlevered while Jones Limited is levered. The net income theory suggests that the cost of debt will often be less than the cost of equity. The following two reasons explain this (Carmichael, Whittington & Lynford 2007) The interest on debt is a tax allowable expense and therefore gives a company a benefit called interest tax shield. This expense is subtracted from earnings before interest and tax to arrive at earnings after before tax. The debenture holders have a certainty of income whereas the equity holders have uncertainty of income. Thus the equity holders will demand a risk premium because of the increased level of risk. Therefore the difference between the cost of capital of a levered firm and the cost of capital of unlevered firm is called the risk premium. To determine their cost of capital we shall use the value of firm formula as explained by Chandra (2008). Green Ltd: Value of firm = value of equity, Vu =  where EBIT = Earnings before interest & tax = £3m t = tax = 0 (we have ignored tax), keU = cost of ordinary share of unlevered firm. We make keU subject of the formula. keU = , Vu = No. of shares × MPS=7,500,000 × £2 = £15,000,000. =100 = 20% WACC = Weke = ×100 = 20%, WACC = keU, the unlevered firms have the cost of equity being equal to the weighted average cost of capital (WACC) (Shim & Siegel 2008). Jones Ltd: Cost of levered firm, keL= Value of equity = 3,000,000 × £2.8 = £8,400,000 Interest = 6%×£15,000,000 = £900,000 keL ==  ×100 = 25% To find WACC, we need to find the weights of capital structure of the firm that is, weight of equity and weight of debt for Jones Ltd. Value of Jones Ltd = value of equity + value of debt (bond) Value of a bond = price of a bond = == £7,500,000 or simply put if the yield increases by 50% that is, from 6% to 12% then the price must decrease by 50%, that is, from £15m to £7.5m so as to earn the same interest because the interest of irredeemable bond is constant to the bond holder. This means the bond is trading below its par price. Therefore value of Jones Ltd = 3,000,000×£2.8 + £7,500,000 = £15,900,000 WACC = weke + wdke(1-t) = + = 13.21 + 5.66= 18.87% The cost of equity for Green Ltd is lower than that of Jones Ltd because Green has a higher value of equity than Green even though Jones Ltd enjoys a deductible interest expense. However, the WACC of Jones Ltd is lower than that of Green Ltd since the debt has a lower interest rate which is again a deductible expense. This shows that there is an importance when a company is geared. In fact the benefit it gets is called a tax shield. Therefore this encourages companies to borrow funds as part of their capital structure. Question 2 This question is based on the arbitrage process. It is based on MM theory. It normally occurs between two companies in which one is geared and the other one not geared. Investors will be moving from the geared firm to unlevered one. Arbitrage process is analysed using the following steps (Fabozzi, Peterson & Habbegger 2004). The investor sells his ownership in the overvalued company and realizes the amount. This is because the investor believes that he/she will receive a higher return and that the levered firm is riskier than the unlevered. The investor will then borrow on personal account some amount equal to the percentage of ownership in the company multiplied by the debt in that company. This is due to the fact that the separate legal entity has been ignored. The investor will then buy shares in the company where his income shall be maximized which is the unlevered firm. The process keeps on until the values of both companies are at equilibrium. At this point investors would have settled and are satisfied. Therefore we shall analyze the process as follows: Jones Ltd has a market value of £15.9m and Green has market value of £15m. Therefore Jones is overvalued. This is illustrated as below: Green Ltd Jones Ltd £ 000 £ 000 Equity 15,000 8,400 Debt - 7,500 Total market value 15,000 15,900 Mr Grant has 30,000 shares in Jones Ltd. He will therefore sell them to realize funds. Amount he realizes = No. of shares × MPS (market price per share) = 30,000 × £2.8 = £84,000 He will borrow an amount equal to percentage of his ownership in Jones Ltd, that is: Percentage ownership == 1% Amount he borrows = Percentage ownership × market value of debt = 1% × 7,500,000 = £75,000. Total amount he has to invest = 84,000 + 75,000 = £159,000 He will invest the funds in Green Ltd with two options: Option 1: If he invests the whole amount his % ownership will be; 100 = 1.06% His ownership increases from 1% to 1.06%. Option 2: If he maintains his % ownership that he had in Jones Ltd, then he shall have a balance of funds as follows; £ Amount available 159,000 Amount spent 1% × 15,000,000 (150,000) Balance 9,000 Mr. Grant therefore can exercise one of two the options, since both have benefits as explained, one increase his ownership while the other leaves him with a balance but after attaining his percentage ownership that he had while at Jones Ltd. My reservations are based on the fact that this process is based on a number of assumptions which, in most cases do not hold. Brigham & Ehrhardt (2010) discusses the following assumptions: There is a perfect and efficient capital market. This may not be the case at all times. Corporate entities and individuals may borrow any amount of funds at the same interest rates. Interest rates for corporate sometimes differ from individuals. The separate legal entity is ignored, that is, individual borrowing and corporate borrowing have a similar financial effect. Normally corporate entities have a separate legal entity from the owners. Question 3 If other shareholders act in a similar manner like Mr. Grant, then there will be a change in financing policy. The other shareholders will want to sell their shares in the levered company, Jones Ltd in order to buy shares in the unlevered company, Green Ltd. As a result the prices of securities of Green Ltd will move up in the market and they will be more attractive. Hence more and more shareholders will be buying the securities. The shareholders will continue this process until values of the two companies are at equilibrium. At this point the cost of capital for the two companies will be the same. Therefore the value of equity of Jones Ltd will decrease and while that of Green Ltd will increase until they are equal. MM argued that this process is an ideal one and that no two firms that will have different values simply because one is levered. Therefore this process is temporal and it will only hold for a short time (Shim & Siegel 2008). List of References Brigham, H. 2004, Fundamentals of Financial Management, 10th edition, New York:John Wiley & Sons Brigham F. E, Ehrhardt C.M, 2010, Financial Management: Theory and Practice, United States of America: South Western Cengage learning. Carmichael, D.R. Whittington, R. & Lynford, G. 2007. Accountant’s Handbook, 11th edition, New Jersey: John Wiley & Sons. Chandra P. 2008, Financial Management, 7th edition, New Delhi: Mc Graw Hill. Fabozzi,F, Peterson, P. & Habbegger, W. 2004. Financial Management and Analysis workbook, 2nd edition, New Jersey: John Wiley & Sons Shim J.K,Siegel J.G. 2008 Financial Management, 3rd edition, New York: Barron’s Business Library. Read More