Accounting and Finance for Managers - Report Example

Accounting and finance for Managers Table of Contents Introduction 3 Capital Structure Theories 3 Ford Motor Company: Overview 5 The Evaluation of Ford’s Capital Structure 5 Conclusion 12 Reference 13 Introduction Finance is often referred as the ‘life blood’ of business. Financial aspects of business include its income, expenditure, funding and capital structure. Small and private sector businesses are known to have simpler structures than their public counterparts. The public companies collect the required capital from various sources. Generally, two types of capital are available i.e. owned capital and loaned capital. For public sector companies, capital structure includes various types of capital like equity, debt, preference, long term and short term loans etc. Capital structure decisions are significant as they determine the company’s profitability and financial flexibility. Therefore, while forming capital structure plans, the financial decision maker must consider the nature of business, external & internal conditions, economic conditions and the future plan of a company. This paper will attempt to analyse the capital structure policies of a public company (listed on stock exchange) along with the merits and demerits of capital structure. The primary focus of this paper will be to evaluate the capital structure policies of the company in context of relevant capital structure theories. The initial sections will have a brief discussion on various capital structure theories. This will be followed by a brief overview of the selected public company so as to understand its nature of business and the prevailing capital structure policy of the company. The overall findings of the project will be discussed in the concluding section. Capital Structure Theories Designing the capital structure of a public company is very much crucial as it helps to reduce financial risk. Besides, the financial managers have to keep redesigning the company’s capital structure for maintaining proper leverage. Gerestonbeg has defined capital structure of a company as “the composition or make-up of its capitalization” that includes “all long-term capital resources i.e. loans, reserves, shares and bonds” (Patra, 2006, p.237). Many scholars have developed various capital structure theories for trading off between the owned capital and loaned capital. Some of popular theories of capital structure are trade off theory, pecking order theory, agency cost theory and Modigliani & Miller theory. Out of these theories, Modigliani & Miller theory is the most important and widely accepted capital structure theory. In order to trade off between costs and benefit of debts, the financial managers must choose the optimum level of capital structure. The cost of capital structure may include high financial charges, high tax and low profitability; whereas, the benefits of optimum capital structure include tax shield, lower leverage, high profitability and high liquidity (Parrino & Kidwell, 2009). Modigliani and Miller developed a theorem on capital structure for modern corporate finance. They formed two propositions for capital under two conditions i.e. corporate without tax and corporate with tax. In case of corporate without taxes they stated that “there are no benefits, in terms of value creation, to increasing leverage” and in case of taxes they told that “such benefits, by way of interest tax shield, do accrue when leverage is introduced and/or increased” (Cohen, n.d.). The second proposition helps a firm to restructure the optimum combination of debt and equity to achieve higher profitability. Ford Motor Company: Overview In order to evaluate a public company, Ford Motor Company has been chosen for this paper. It is a popular American based multinational automobile company. The company was listed in New York Stock Exchange on 07 Mar 1956 and its ticker symbol is “F” in this exchange (NYSE, 2010). Ford is one of the leading manufacturer and designer in the global automotive industry. It has expanded its business in nearly six continents. Currently the company is operating worldwide with “159,000 employees and about 70 plants” and its famous brands includes “Ford, Lincoln and Mercury” (Ford-a, 2010). The Ford Motor Company was founded by Henry Ford during 1903 with the help of twelve investors. It has captured significant market shares in most of the global automobile industry. It has its manufacturing units in many countries and together they have formed a mission which states ‘One Ford’. Global Ford concentrates in developing one team, one plan and one goal. The company strives to provide profitable growth to its stakeholders and society. The ‘one plan’ of Ford focuses on new product development, finance and teamwork (Ford-b, 2010). The company have also realized its corporate social responsibility and it has taken necessary steps for the safety of people and society. With the help of research & development, it is now trying to produce more eco-friendly and safety cars. To reduce the negative effects of global warming, its operating processes takes into account important issues like water, energy and human right (Ford-c, 2009/10). The Evaluation of Ford’s Capital Structure The management of the company has efficiently managed the financial risks. One of the primary responsibilities of financial management is to avoid financial risk by implementing effective financial policies. Ford Motor Company is always investing in new projects to ensure product development. In order to improve its balance sheet, the management is trying to increases the profitability and decreases the leverage of the company. In 2010, it restructured its balance sheet by adjusting its equity and debt capital to ensure profitability and sustainability. The annual report of the company has disclosed vital information regarding the capital structure of Ford Motor Company. The company uses debt-equity ratios for making important financial decisions which also helps to evaluate its financial positions. The company takes into account two types of leverages i.e. financial leverage and managed leverage. Financial leverage is calculated using the simple formula that is ‘Debt/Equity’ and to calculate the managed leverages it uses the traditional method. The method for calculating managed risk has been below. Equation 1 (Source: Ford: Annual Report, 2009, p.49) The annual report also discloses the calculation of financial and managed leverages using the total equity and debt. Table 1 and 2 depicts the calculation of Ford’s financial and managed leverages. Table 1: Ford’s Calculation of Financial leverage (in billion expect the ratio) (Source: Ford: Annual Report, 2009, p.49) Table 2: Ford’s Calculation of Managed leverage (in billion expect the ratio) (Source: Ford: Annual Report, 2009, p.49) The above tables are important as it calculates and compares the last leverage with the one preceding it. The company was able to reduce the leverage risk in comparison to the previous performances. In 2009, the financial leverage of the company was reduced to 8.8 from 12 in 2008 and 10.4 in 2007. The managed leverage was also significantly reduced to 7.3 in 2009 from 9.9 in 2008 and 9.8 in 2007. In 2008, the leverages of the company increased because of the global financial crisis. However, the recession also made the management more cautious to financial risks. According to the management, managing leverage is very important as many investors take into account the leverage of the company before making investment decisions. Table 3 and 4 portrays the balance sheet of assets and liabilities respectively for the Ford Motor Company. Data, precisely the balance sheet positions of three years are compared with each other. Table 3 (Source: Forbs, 2010) Table 4 (Source: Forbs, 2010) The balance sheet of the company reveals important information about the financial position of the company. It has increased its total equity in 2009 as compared to 2008. Information inferred from the balance sheet reveals that Ford is now aiming to reduce its leverages in the coming years by reducing the amount of debt capital. The current policies and plans make it evident that necessary changes in its balance sheet have been done. Some of the important decisions have been given. On April 2010, the company was able to reduce its debt by $3 billion as it paid up the drawn amounts. After the completion of the equity distribution program of 2008, it has raised $565 million and it has also raised $1.6 billion by issuing Ford common stock. In 2009, it registered another equity distribution program of $1 billion. It has been able to secure guaranteed £360 million-pound loan from the European investment bank for its 5 years development plan. By entering the agreement, it has also secured up to $5.9 billion loan, the interest rates of which will be similar to the U.S treasury rate of 10-years. It has issued Senior Convertible Notes for $2.875 billion at 4.25% (Ford-d, 2009/10). Conclusion The capital structure of any public sector company is an important aspect that affects the financial position of that company. The term ‘capital structure’ is used in public companies since the capital structure of these companies include equity and debt. The primary objective of companies is to trade off between its equity capital and debt capital. The capital structure theories are important while managing the leverage for the company. Modigliani & Miller theory of capital structure is the one most commonly used for reducing the leverage in capital structure. The Ford Motor Company is a multinational public company operating in America. The financial management of the company mainly focuses on its leverage as it is a very important indicator in the decision making process. According to management, low leverage will attract more investors. Since the last few years, the company has been taking important measures to improve its balance sheet and financial position. From the above discussion on the future plan of the company it seems that the company will strive to reduce its leverage by reducing the amount of debt. Reference Cohen, R.D. No date. An Implication of the Modigliani-Miller Capital Structuring Theorems on the Relation between Equity and Debt. [Pdf]. Available at: http://rdcohen.50megs.com/MM.pdf. [Accessed on 22 August, 2010]. Forbes. 2010. FORD MOTOR COMPANY. [Online] Available at: http://finapps.forbes.com/finapps/jsp/finance/compinfo/FinancialIndustrial.jsp?tkr=F. [Accessed on 22 August, 2010]. Ford. 2009. Annual Report. [Pdf]. Available at: http://www.ford.com/doc/2009_annual_report.pdf. [Accessed on 22 August, 2010]. Ford-a. 2010. About Ford: Ford Global. [Online] Available at: http://www.ford.com/about-ford/company-information/ford-international-websites. [Accessed on 22 August, 2010]. Ford-b. 2010. One Ford. [Pdf]. Available at: http://www.ford.com/doc/one_ford.pdf. [Accessed on 22 August, 2010]. Ford-c. 2009/10. Blueprint for Sustainability: The Future at Work. [Pdf]. Available at: http://www.ford.com/doc/sr09-blueprint-summary.pdf. [Accessed on 22 August, 2010]. Ford-d. 2009/10. Financing our Plan and Improving our Balance sheet. [Online] Available at: http://www.ford.com/microsites/sustainability-report-2009-10/economy-recovery-financing. [Accessed on 22 August, 2010]. NYSE. 2010. Ford Motor Company. [Online] Available at: http://www.nyse.com/about/listed/f.html. [Accessed on 22 August, 2010]. Parrino, R. and Kidwell, D.S. 2009. Fundamentals of Corporate Finance. John Wiley and Sons. Patra, K. 2006. Accounting and Finance for Managers. Sarup & Sons. Read More