Financial Management - Essay Example

Introduction Capital structure of firm is one of the important aspects of deciding how the firm can actually create value for itself. Careful utilization of equity as well as debt allows the firms to not only tap into the sources available for expanding the business but also allow firms to maximize the value. The firm’s capital structure therefore defines how the firm actually plans to finance its assets and what percentage of debt and equity has been used in financing these assets. (Bierman) Organizations require maintaining effective capital structure in order to ensure that they maximize their value and minimize the cost of capital. However, in order to achieve a balanced capital structure, it is important that different sources of financing are achieved in a balanced mix which can maximize the value for the firm as well as minimizing the cost of capital. Thus having a balanced capital structure is essential for the firms to maximize their value and reduce the cost of capital.( McLaney). It is also critical for the organizations to also utilize different models available in order to properly evaluate the investment opportunities. The use of different investment appraisal techniques such as NPV, IRR and other methods provide a methodological and logical approach towards evaluating the proposed investment opportunities and than deciding which one to choose from based on the objective results provided by these tools. This report will outline as to how Gee Plc can utilize the balanced capital structure as well as different investment appraisal methods to make better investment decisions. Capital Structure and cost of capital Capital structure actually defines as to how a company finances its assets by utilizing different financing resources. Most of the organizations use two different sources of the financing in order to finance their assets – equity and debt. Equity is what is being contributed by the shareholders of the firm whereas the debt is the source of finance which is acquired from external sources such as bondholders. In order to decide upon the overall capital structure of the firm, a finance officer or CFO may need to focus on some important aspects related with the capital structure. One important issue is how the overall cost of the capital can be changed by changing the mix of the capital structure. The quantum or the weightage of the debt is another important component which needs to be considered. Since debt has the higher risk associated with it therefore higher the debt, more risk the firm assume therefore deciding upon to manage a balanced mix of the debt in the overall capital structure is important for the firm. (Arnold) Firms therefore obtain mostly three types of financing in order to finance their assets. Equity is raised from either through the existing shareholders or through the floatation of new shares in the capital markets. Debt however, can be either by issuance of the bonds for a fixed period of time against a fixed or variable rate of interest to be paid to the bondholders. Finally, firms also obtaining preferred shares as the source of financing whereas preferred shares is a hybrid type of security having the characteristics of both the debt as well as the shares. It is important to note that each component of the capital structure has the relative costs associated with each of the component. Firms usually pay to the shareholders the dividends and raising the equity also require some initial costs to be incurred in order to raise the equity. Similarly, firm have to pay to the bondholders the agreed rate of interest during the duration of the bonds and therefore debt carries the cost also. Same is the case with the use of hybrid securities such as preference shares wherein firm agree to provide a fixed percentage as a return to the holders of preference shares. The weighted average cost of all the components described above therefore determine the total cost which firm has to pay in order to achieve such mix of the capital structure. Cost of capital is the cost which a firm has to pay in order to obtain the funds to be used for the expansion and other purposes. It is however, important to note that the decision to obtain any form of the capital therefore depends upon the relative cost the firm has to pay. For example, many firms may prefer debt over the equity because debt is relatively inexpensive to obtain as compared to the equity. Firm Value and the Cost of Capital Firm value is defined as the sum of all of the future cash flows which the firm can generate in the future. It has been generally accepted that the firm’s capital structure has the impact on the value of the firm. Since debt carries the risk therefore higher the quantum of debt in the capital structure of the firm, higher the risk firm can run. Due to this reason, it is believed that the shareholders willing to invest into the firm will demand the higher rate of returns and therefore increasing the overall cost of capital for the firm. In order to arrive at the firm value, the future cash flows of the firm are discounted back with the cost of the capital of the firm- higher the cost of capital lesser will be the value for the firm. The famous Modigliani and Miller theorem however, defines that under certain conditions, the firm’s capital structure will have no effect on the firm’s value. This theorem however, outlines certain conditions such as the presence of the perfect capital markets, absence of taxes and the bankruptcy costs. However, under the imperfect market conditions, the firm’s value is affected by the firm’s overall approach towards the maintaining a balanced mix of the capital structure. Optimal Capital Structure It is important to note that the basic responsibility of the management of the firm is to maximize the value for the shareholders. The maximization of the shareholders value however has a critical link with the weighted average cost of capital. It is within this context that the overall financing mix of the firm’s capital structure can play significant part in deciding how the firm’s value will be maximized. Considering the risks associated with the each of the component of the capital structure as well as the cost involved in obtaining each of the components, a balanced capital structure can be achieved. Balanced capital structure can be achieved at a point where the firm’s value is maximized and the cost of capital is minimum. However, in order to achieve such combination, firm has to go through the trial and error method to find out the right mix of the debt and equity. It is however, generally believed that a combination of 60:40 i.e. 60% debt and 40% equity can be an effective mix of capital wherein the weighted average cost of the firm is minimized. Achieving such combination of debt and equity however, depends upon certain factors which need to be taken into considerations. Taxes, risk associated with obtaining debt, the cost of financial distress as well as the type of assets to be financed is some of the important factors which firms need to take into consideration. It is also important to note that the overall cost of capital of the firm has a critical link with the investment decisions to be made by the firm. This is because cost of capital serves as the hurdle rate which is used to evaluate the investments which firm proposes to undertake. Investment Appraisal Techniques Having effective investment appraisal system helps organizations to make more informed and accurate decisions while deciding upon making an investment. As discussed above that the firm’s capital structure define as to how the firm is going to finance its assets however, in order to make a conscious choice between different investment opportunities, it is important that the firm’s financial managers must use different investment appraisal techniques in order to decide upon the correct investments. It is important to note that most of the investment appraisal techniques depend upon the time value of money- a concept which outlines that the money looses value over the period of time. Therefore in order to make a choice between two investments, firms have to look into how the future cash flows which will be generated from the proposed investment will add to the value of the firm now. Therefore the concept of present value is one of the key to most of the investment appraisal techniques. As discussed above that the firm’s cost of capital has a critical link with the investment decisions because most of the important investment appraisal techniques use the cost of capital as the base rate which is required by the investors to invest into the firm. Any investment opportunity which can provide the rate of return which is at least equal to or greater than this rate of return is considered as the acceptable investment opportunity.( Watson & Head) The next section will discuss some of the investment appraisal techniques. Net Present Value Technique Net Present Value or NPV technique is one of the widely used investment appraisal techniques used by the firms. The basic idea behind the net present value technique is that it discounts backs all the cash inflows and outflows of a particular project with the rate of return i.e. weighted average cost of capital. The first step in utilizing this technique therefore is to assess and identify the cash flows which will be generated from the proposed investment activity and once the cash flows are assessed and calculated, they are discounted back with the appropriate rate of return to find out a combined present value of all the future cash flows. This sum of all the present values of the cash inflows is then deducted from the present value of all the cash outflows which are incurred on the project and the net value is determined. If the net difference between the firm’s cash outflows and inflows is positive, that project or investment is considered as viable because the net present value will add value to the firm to that extent. However, if the difference between the two is negative than that investment opportunity will be discarded based on the principle that it will not add value to the firm.( Levy. & Sarnat ) The major strength of this method is the fact that it takes into account the time value of money concept and recognizes the importance of how the future cash flow streams will value today if the firm decides to make an investment into that project. It is also however, important to note that the NPV is considered to be risk in-sensitive i.e. it may not allow the firm to adjust for the risks associated with the projects which can emerge in future. Since NPV considers a certain rate of return at a particular period of time therefore subsequent changes in the risk profile of the firm are not adjusted into the calculations once the firm decides to make an investment decision based on NPV.( Brealey, & Myers,) Internal Rate of Return Internal Rate of Return or IRR is another method for comparing investments and deciding upon choosing a particular investment. The IRR is considered as that rate of return which basically makes the NPV as zero. This means that IRR equals the sum of present value of all the cash inflows of the firm with that of the present value of the cash outflows. The result is therefore zero wherein both the cash inflows and outflows are equal. (Lumby & Jones) Firms therefore decided based on the IRR criteria when the IRR is greater than the required rate of return. if any investment opportunity offers IRR which is greater than the required rate of return, the firm can actually choose that investment opportunity over other investment opportunities. IRR is an alternative method to NPV as it outlines as a particular rate of return which investors or shareholders of the firm will earn if the firm decides to make an investment into a particular project.( Haugen) It is important to note that IRR is mostly found with trial and error method wherein the firm tries different rates to find the exact rate which can match the present value of all the cash inflows with that of the cash outflows. The major problems or weakness of this approach is that it cannot be used for mutually exclusive projects. It can only offer insight about the profitability of one single project as compared to the mutually exclusive projects.( Copeland, & Weston) It is also important to note that since IRR does not take into consideration the cost of capital therefore it may not be an effective measure to evaluate the projects of different duration. Further, there can be multiple IRRs for the same projects if the cash flow pattern of the project is not smooth. In cases where there are more than one cash outflows, IRR may not provide accurate description of the profitability of a particular project.( Megginson) Conclusion Firm’s capital structure as well as its investment decisions play important role in deciding how the firm will generate value for itself in the future. Maintaining a critical balance of the capital structure will allow firms not only to maximize their value but also reduce the cost of capital. Similarly, adapting a comprehensive investment appraisal technique, firms can actually make more informed and right investment decisions which can help them to add value. Investment appraisal techniques such as net present value methods, internal rate of return are some of the tools which firms can use to make better investment decisions. Bibliography 1. Arnold, Glen. Corporate Financial Management. 3rd. New York: Financial Times/ Prentice Hall, 2005. 2. Bierman, Harold. The capital structure decision. New York: Springer, 2003. 3. Brealey, R.A. & Myers, S.C., Principles of Corporate Finance, 7th ed., McGraw-Hill., (2002) 4. Copeland, T.E. & Weston, J.F. Financial Theory and Corporate Policy, 3rd ed., Addison-Wesley.(1988) 5. D Watson & A Head, Corporate Finance – Principles and Practice, 4th edition, Financial Times- Pitman Publishing. (2004) 6. E J McLaney, Business Finance for Decision Makers, 2nd ed., Financial Times- Pitman Publishing. (2001) 7. Haugen, R.A., Modern Investment Theory, 5th ed., Prentice-Hall. (2001) 8. Levy, H. & Sarnat, M. Capital Investment & Financial Decisions, 5th ed. Prentice Hall. (1999) 9. Lumby, S. & Jones, C. Investment Appraisal and Financial Decisions, Thompson International Business Press, 6th Edition.(1999) 10. Megginson, W.L. , Corporate Finance Theory, Addison-Wesley. (1997) Read More