Financial Management: The Spring Group - Essay Example

Topic: F M: T S G A (2007) Order: 165083 Deadline: 2007-04-21 15:02 Style: APA Language Style: English UK Pages: 10 Executive summary " Time value of money" which is given in Jovi's mission statement, as Tempus Fugit is very important term in this required problem. As Jovi's CEO is a busy lady, she is needed to a brief discussion about dividend and re-investment decisions. Conceptually, " time value of money" means that the value of a sum of money received today is more than its value received after some time. Conversely, the sum of money received in future is less valuable than it is today. In other words, the present worth of a pound received after sometime will be less than a pound received today. Since a pound received today has more value, individuals, as rational human beings, would naturally prefer current receipt to future receipts. The time value of money can also be referred to as time preference for money.this, then, constitutes the rationale of considering time value of money in financial decision-making. The main reason for time preference for money is to be found in the re-investment opportunities for funds, which are received early. The funds so invested will earn a rate of return which or more popularly as a discount rate. The expected rate of return as also the time value of money will vary from individual to individual depending on his perception, among other things1. The investment decision relates to the selection of assets in which can be acquired fall into two broad groups (i) long-term assets which will yield a return over a period of time in future, (ii) short-term or current assets defined as those assets which in the normal course of business are convertible into cash usually within a year.accordingly, the asset selection decision of a firm is of two types. The first of these involving the first category of assets is popularly known in the financial literature as capital bugeting.the aspect of financial decision-making with reference to current assets or short-term assets is popularly designed as working capital management 2. Working capital management is concerned with the management of the current assets. It is an important and integral part of financial management as short-term survival is a pre-requisite to long-term success. One aspect of the working capital management is the trade-off between profitability and risk (liquidity). There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, i.e. it does not invest sufficient funds in current assets, it may become illiquid and consequently may not have the ability to meet its current obligations and thus invite the risk of bankruptcy. If the current assets are too large, the profitability is adversely affected. The key strategies and considerations in ensuring a trade-off between profitability and liquidity is one major dimension of working capital management. In addition, the neither inadequate nor unnecessary funds are locked up. To summarise, the management of working has two basic ingredients, namely (i) an overview of working capital management as a whole, and (ii) efficient management of the individual current assets such as cash, receivables and inventory 3. The second major decision involved in financial management is the financing decision. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. The concern of the financing decision is with the financing-mix or capital structure or leverage. The term capital structure refers to the proportion of debt (fixed-interest sources of financing) and equity capital (variable-dividend securities/sources of funds). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. There are two aspects of the financing decision. First, the theory of capital structure which shows the theoretical relationship between the employment of debt and the return to the shareholders. The use of debt implies a higher return to the shareholders as also the financial risk. A proper balance between debt and equity to ensure a trade = off between risk and return to the shareholders is necessary. A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure.thus, one dimension of the financing decision is: Is there an optimum capital structure In what proportion should funds be raised to maximize the return to the shareholders The second aspect of the financing decision is the determination of an appropriate capital structure, given the facts of a particular case.thus; the financing decision covers two inter-related aspects (a) capital structure theory, and (b) capital structure decision4. One approach to determine the decision criterion for financial management is the profit maximization goal. According to this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, as applicable to financial management, the profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximization of profits. The rationale behind profitability maximization, as a guide to financial decision-making, is simple. Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be jugged. It is, therefore, argued that profitability maximization should serve as the basic criterion for the financial management decisions. In this problem, working capital management is necessary to explain how optimise credit terms materially influence demand and enhance future profitability. General exposition of how optimum credit terms (a departure from 3/7:40) within the context of efficient working capital management can materially influence demand and enhance future profitability: Working capital management refers to the administration of all aspects of current assets, namely cash, marketable securities, debtors and stock (inventories) and current liabilities .the financial director must determine levels and composition of current assets. He must see that right sources are tapped to finance current assets, and that current liabilities are paid in time. In this required problem, credit terms specify duration of credit and terms of payment by customers. Investment in account receivables will be high if customers are allowed extended time period for making payments. The stipulations under which the firm sells on credit to customers are called credit terms. These stipulations include (A) the credit period, and (B) the cash discount 5. A firm lengthens credit period to increase its operating profit through expanded sales.however, there will be net increase in operating profit only when the cost of expended credit period is less than the incremental operating profit. With increased sales and expended credit period, investment in receivable would increase. Two factors cause this increase:(a) incremental sales result in incremental receivable and (b) existing customers will take more time to repay credit obligation (i.e., the average collection period will increase), thus increasing the level of receivable. A cash discount is a reduction in payment offered to customers to induce them to repay credit obligations within a specific period of time, which will be less than the normal credit period. It is usually expressed as a percentage of sales. Cash discount terms indicate the rate discount and period for which it is available. If the customer does not avail the offer, he must make payment within the normal credit period. In practice, credit terms would include6: (a) the rate of cash discount, (b) the cash discount period, and(c) the net credit period. For example, credit terms may be expressed as '2/10, net 30'. This means that a 2% discount will be granted if the customer pays within 10 days; if he does not avail the offer he must make payment within 30 days. A firm uses cash discount as a tool to increase sales and accelerate collections from customers. Thus, the level of receivable and associated costs may be reduced. The cost involved is the discounts taken by customers. Derivation of a marginal cost of capital for the new investment associated with each financing option dictated by the finance director: Option (i): Marginal cost of capital of ordinary shares/equity= (DIV1/P0) +g Where, DIV1 =DIV0 (1 +g) DIV0 = dividend per share g = growth rate P0=price per share Since there is no information to calculate dividend and also it has no growth rate we can consider P/E ratio as cost of capital. So in this problem, ke=10 %( as P/E ratio is 10) After tax ke = ke (1-tax rate) =10 %( 1-.25) =7.5% Option (ii): Marginal cost of capital of irredeemable 8% loan stock issued at par (kd)=interest/bond value Here, interest rate =8% Suppose, face value of loan stock/debt=100 So, interest =1008% =8 Therefore, kd = 8/100 =0.08 =8% After tax kd = kd (1-tax rate) =8 %( 1-0.25) =6% Option (iii): In the cases of retained earnings, firms are not required to pay any dividends; no cash outflow takes place. Therefore, retained earnings have no explicit cost of capital. But they have a definite opportunity cost. The opportunity cost of retained earnings is the rate of return, which the ordinary shareholders would have earned, on these funds if they had distributed as dividends to them 7. Therefore, here marginal cost of capital of current retention is same as ke. So, marginal cost of capital of current retention plus a similar issue of loan stock = 7.5% + 6% =13.5% Explanation of the optimum financial option, based upon the assumptions and constraints that validate the application of any marginal cut-off (discount) rate for new investment: In this problem, optimum financial option is option (ii), i.e. financing by issuing irredeemable 8% loan stock issued at par. By following this option, jovi will finance by issuing this type of loan stock. The role of financing in this way in magnifying the return of the owner is based on the assumptions that the fixed-change funds (such as the loan from financial institutions and other sources or debentures) can be obtained at a cost lower than the firm's rate of return on net assets (RONA or ROI). Thus, when the difference between the earnings generated by assets financed by the fixed-changes funds and costs of these funds is distributed to the shareholders, the earnings per share (EPS) n or return on equity (ROE) increases. However, EPS or ROE will fall if the company obtains the fixed-changes funds at a cost higher than the rate of return on the firm's assets. It should, therefore be clear that EPS, ROE and ROI are the important figures for analysing the impact of financial leverage 8. The basic assumption of cost of capital analysis is that the firm's business and financial risk are unaffected by the acceptance and financing of projects. There are some other assumptions of cost of capital is: Firms employ only two types of capital: debt and equity The total assets of the firm are given. The degree of leverage can be changed by selling debt to repurchase shares or selling shares to retire debt The firms have a policy of paying 100 percent dividends.etc. The calculation of the cost of debt is relatively easy. The cost of funds raised through debt in the form of debentures or loan from financial institutions can be determined from the previous mentioned calculation.interst payments made by the firm on debt issues qualify for tax deduction in determining net taxable income.therefore, the effective cash flow is less than the actual payment of interest made by the firm to the debt-holders by the amount of tax shield on interest payment9. So, this option validates the application of any marginal cut-off (discount) rate for new investment. Reconciliation of the conceptual contributions of EVA, MVA and NPV analyses to corporate wealth maximization that embraces the stern-Stewart model: Economic Value Added The economic value added (EVA) is a measure of the dollar surplus value created By an investment or a portfolio of investments. It is computed as the product of the "Excess return" made on an investment or investments and the capital invested in that Investment or investments. Economic Value Added = (Return on Capital Invested - Cost of Capital) (Capital Invested) = after tax operating income - (Cost of Capital) (Capital Invested) MVA: Market Value Added, a measure created by Stern Stewart, is the difference between total market value--what investors can take out of the company--and the total capital invested. A positive MVA indicates that a firm has created wealth. Stern Stewart calculates MVA by adding the capital taken in by a company during its lifetime through securities offerings, loans, and retained earnings, then makes some EVA-like adjustments (such as capitalizing and amortizing R&D expenditures), and subtracts the total from the current value of the company's stock and debt 10. Economic Value Added and Net Present Value: One of the foundations of investment analysis in traditional corporate finance is the Net Present Value rule. The net present value (NPV) of a project, which reflects the Present value of expected cash flows on a project, netted against any investment needs, is a measure of pound surplus value on the project. Thus, investing in projects with positive Net present value will increase the value of the firm, while investing in projects with Negative net present value will reduce value. Economic value added is a simple extension of the net present value rule. The net present value of the project is the present value of the economic value added by that project over its life. This is true, though, only if the expected present value of the cash flows from depreciation is assumed to be equal to the present value of the return of the capital invested in the project. Where EVAt is the economic value added by the project in year t and the project has a life of n years. This connection between economic value added and NPV11 allows us to link the value of a firm to the economic value added by them. To see this, let us begin with a Simple formulation of firm value in terms of the value of assets in place and expected future growth. References: 1. Hill, R. A., Financial Management: An Active Approach (Part A), Leicester Finance Study Group, 2006. 2. Hill, R. A., Financial Management: An Active Approach (Part B), Leicester Finance Study Group, 2007. 3. Pandey, I. M. Financial Management, 8th ed. 2001, Vikas Publishing House Pvt. Ltd, p. 676, 808-876, 4. Khan. M. Y. & Jain P.K.," Financial Management", 2nd ed. 1999, Tata McGraw-hill Publishing Company Limited, New Delhi, p.9-12, 22-23, 317-346. 5. Introducing Compliance Management System Generation, Investment Goals and Decision Criteria, Chapter 14, 2007, DF Institute available at: < http://www.dearborn.com/download/Invanalysis/Chapter14Outline.pdf > 6. Margolis, D. (2007), Corporate Finance, Value Enhancement tools, Chapter 32, available at: < http://pages.stern.nyu.edu/adamodar/pdfiles/valn2ed/ch32.pdf > Read More