Strategic and Financial Decision Making - Essay Example

Strategic and Financial Decision Making Section A a) Thecapital investment decision making process involves determination of the composition of various sources of finance. It helps us in identifying various the various merits and demerits of various sources of finance. A project can be solely financed through borrowings from outsiders or shareholders funds or with the combination of both in different proportion. Borrowings include loans from financial institutions; corporate bonds etc. while shareholders funds include equity share capital, preference share capital, accumulated profits. However, the amount of risk involved in both the sources of financing differs. The cost of financing through equity is more than that of debt. The bond holders are paid fixed rate of interest every year, hence they bear no risk. The equity shareholders do not receive any fixed income every year; it is dependent on the profits of the company. Hence, there is a risk involved in holding equity shares as compared to debt capital. Therefore the equity shareholders require more return as compensation to the extra risk borne by them. On the factors discussed above, debt financing would seem more attractive as compared to equity financing. But decision cannot be made solely on the cost factor. One also has to look into the risk involved in different sources of financing. Since there is a fixed obligation every year towards interest payment, it is considered to be more risky than financing through equity on which no risk is involved. Thus, a company has to decide upon the level of debt on the basis of the risk it can undertake. Eugene, Houston (2007:1).The following steps involved in decision making process are: Existing capital structure: One has to evaluate the existing capital structure. In case the company has too much debt already it is not advisable to issue more debt. It can also maintain the existing debt equity ratio or change the ratio. Desired debt equity mix: The company should decide upon the desired level of debt equity ratio on the basis of the risk appetite and the cost involved. Dividend payout policy: The dividend payout ratio should be decided be the firm, so as to maintain the same every year. This is because fluctuating dividend payout ratio would reduce the confidence of the shareholders towards the company. Effect of return: The company has to analyze the effect on return because of the cost of capital. It has to ensure that it is able to earn the desire level of return of the investors. Effect of return: In order to reduce the cost of the capital a firm might take debt equity mix. However, it should first analyze the risk involved in using debt as a source of capital. Effect on cost of capital: The effect of desired level of debt and equity on the cost of capital of the company should be evaluated. Excess debt can lead to increase in cost of capital after a certain point of time because of the high risk involved. These decisions should be based after careful study of the market. The risk appetite, the required rate of return of the shareholders, the effect on market value of the shares due to change in the capital structure of the company should be studied. Hence, these factors have to be taken into consideration in order to arrive at a sound decision. b) The investment proposal involves an initial investment of 3,000,000 along with cost of forecasting of 100,000. The proposal is expected to be financed at the existing debt-equity ratio of 2:3. It is assumed that the return required by equity investors is 10.5% (real). Therefore nominal return (inflation adjusted) expected would be 10.5% + 5% (inflation) that is 15.5%. The rate of interest payable on corporate bonds (debt) is 6% p.a. We have to now compute the weighted average cost of capital which would be the discount rate used to compute the NPV of the project. Shannon (2008:2)The weighted average cost of capital (WACC) is determined by the following formula D/(D+E) X Kd(1-T) + E/(D+E) X Ke Here, Wd = Debt Weight We = Equity Weight Kd= Interest rate on Debt T = Tax rate applicable (nil, as no rate is given) Ke= Rate of return required by equity shareholders Therefore, the WACC for the firm is: (40%X 6% + 60% X 15.5%) X 100 =11.70% Therefore, the firm needs to earn at 11.70% p. a. to satisfy the owners. The WACC would be used to discount the cash flows to calculate the NPV of the project. Net Present Value The net present value is the present value of future cash flows minus the initial investment. The cash flows would be discounted at the cost of capital or the kc. If the NPV of the project is positive then it should be accepted or else rejected. Groppelli, Ehsan (2000:3). The NPV of the project is given by- NPV = I1/(1+ kc) + I2/(1+ kc)2 + I3/(1+ kc)3 + ..+In/(1+ kc)n - Initial Outflow Where, I = Cash inflows during the life of the project. Kc = Cost of capital (11.70%) Net Present Value Amount In Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Initial Investment 3,100,000 Sales 1,854,000 2,227,890 3,933,817 1,519,437 Less: Variable costs 748,800 908,544 1,619,804 631,724 Operating Income 1,105,200 1,319,346 2,314,013 887,713 Less: Fixed Cost 265,200 275,808 286,840 298,314 Profit 840,000 1,043,538 2,027,173 589,399 NPV= The NPV of the project is given by- 840,000/(1+0.117) + 1,043,538/(1+0.117)2 +2,027,173/(1+0.117)3 + 589,399/(1+0.117)4 -3,100,000 =321,563.90 As the NPV is positive that is 321,563.90, hence, the project should be accepted. Notes: Sales for the First year = 30X1.03X60000; Variable Costs = 12X1.04X60000 Sales for the Second year = 30x1.03^2X70000; Variable Costs = 12X1.04^2X70000 Sales for the Third year = 30X1.03^3X120000; Variable Costs = 12X1.04^3X120000 Sales for the Fourth year =30X1.03^4X45000; Variable Costs = 12X1.04^4X45000 Fixed costs for the First year = 255000X1.04 Fixed costs for the Second year = 255000X1.04^2 Fixed costs for the Third year = 255000X1.04^3 Fixed costs for the Fourth year = 255000X1.04^4 It is assumed that there are no taxes. The fixed costs includes depreciation for the year. Calculation of Internal Rate of Return: The Internal Rate of Return is the rate of interest at which the net present value of the project is zero, in other words, it equates the present value of cash inflows with the cash outflows. If the IRR of the project is greater than the cost of capital of the project then the project should be accepted or else it should be rejected. Robert (2001:4) The IRR is given by r in the following equation- Initial outflow = I/(1+r) + I/(1+r)2 + I/(1+r)3 + ..+I/(1+r)n Where, I = Cash inflows during the projected life r = Internal Rate of Return n= Life of the project 3,100,000 = 840,000/(1+r) + 1,043,538/(1+r)2 +2,027,173/(1+r)3 +589,399/(1+r)4 Therefore, solving the above equation we have r at 16.37%. Since, the IRR is greater than the required rate of return that is 11.70%, therefore the project should be accepted. The project is considered to be financially viable. Calculation of Accounting Rate of Return: The accounting rate of return of an investment is the average net income as a percentage of the investment. It is given by- ARR = Average Annual Net Income/ Investment The Average Annual net income for the project is- = (840,000+ 1,043,538+2,027,173+589,399)/4 =1,125,027 Therefore ARR = 1,125,027/3,100,000 =36.29% This is greater than the targeted rate of return on capital employed (30%). Hence the project should be accepted. Calculation of Discounted Payback Period: The payback period is the length of the time required to recover the initial investment of the project. In discounted payback period we first discount the cash flows at the cost of capital, to determine the time required to recover the investment. Years Net Cash Flow PV @11.7 PV of Cash Flow Cumulative CF 1 840,000 0.90 752,014 752,014 2 1,043,538 0.80 836,377 1,588,391 3 2,027,173 0.72 1,454,559 3,042,950 4 589,399 0.64 378,614 3,421,564 We find that the time taken to recover investment lies between 3 to 4 years. Therefore the discounted payback period = 3 + {1/(3,78,614) X (3,100,000 - 3,042,950)}= 3.15 years. This means that the investment would be recovered in 3.15 years. Since the cut-off period of the project is not given therefore we are unable to draw a conclusion. c) Martyn Vershinina recommended the use of Accounting Rate of Return for the purpose of appraisal of the project. However, decision should not be based on this criterion as it ignores the time value of money. It ignores the fact that immediate cash flows are more valuable than cash flows in the later years. It gives equal weightage to cash inflow in Year 1 and cash flows in Year 4. This is not correct as the value of money today is more than 4 years hence because of the inflation factor involved. It also advocates the use of Internal Rate of Return for the purpose of inference. This is also not a suitable criterion as it assumes that the immediate cash flows are reinvested at the IRR itself. On the other hand NPV assumes that future cash flows are reinvested at the discounted rate which seems a more logical assumption. Moreover, the projects with heavy cash inflows in the earlier years would be favored when compared to projects with heavy cash flows in the later years. Hence, we conclude that NPV is the most suitable criterion on which appraisal decision can be based. Section B d) Julia Dobbin suggested the issue of corporate bonds in order to finance the investment. However, she is thinking only in the context of reduction of cost of capital. She is not looking into the risk involved in issuing too much debt into the capital structure. Excess debt in the capital could become risky for the firm as there is a fixed obligation towards interest and principal payments. Firstly, the probability of bankruptcy in case of levered firm is higher when compared to unlevered firm because of the fixed payment obligations. Secondly, the probability of bankruptcy increases with the increase in the gear ratio. Thirdly, the investors require higher rate of return from companies which has the prospect of being bankrupt. Fourthly, if the firm is highly geared then investors would not be ready to purchase the bonds. Fifthly, after a certain point of time the issue of corporate bonds would no longer reduce the cost of capital, as investors would start expecting more returns because of the prospect of bankruptcy. e) Natalia Pointon suggests the use of only corporate bonds as a source of capital. This will reduce the cost of capital considerably as the rate of interest would be only 6%. Moreover the interest cost on debt is tax deductible which would further reduce the cost of capital. Hence this method would be suitable when we appraise only on the basis of the cost factor. But this is not the sole criterion on which one should base the decision as suggested by David Broderick One also has to take into consideration the risk factor involved due to excess gearing. Excess gearing increases the risk of bankruptcy as discussed earlier. Therefore, the use of only debt as a source of finance is not appropriate. One should use a mix of debt and equity so as to reduce the cost and the risk. Hence, weighted average cost of capital seems most suitable to appraise the project. 1) Brigham, Eugene E. Houston Joel F. Fundamentals of Financial Management (Fifth Edition); USA, Thomas Learning Inc. 2007 2) Pratt, Shannon P.; Grabowski, Roger J.; 2008 Cost of Capital Applications and Examples, John Wiley & Sons Inc. New Jersey 3) Groppelli, A. A., Nikbakth, Ehsan, Finance (Fourth Edition), New York, Barron's Education Series, Inc. 2000. 4) Higgins, Robert C., Analysis for financial management, (6th Edition), Virginia Irwin/McGraw-Hill, 2001 Read More