Essentials of Corporate Financial Management - Coursework Example

? XXXX XXXX Accounting Consultancy 19/10/11 Accounting Consultancy Client In the first instance, the client is considering using net present value (NPV) as the basis for assessing the merits of the current project. The literature (Arnold, 2007, Brealey et al, 2006) on finance and accounting would seem to indicate that the NPV methodology is one of the most comprehensive and reliable tools to use in a project appraisal. The advantages of NVP are that firstly the tool recognises the time value of money by using a discount rate (12% in this case), often WACC is used as the discount rate (Tennentt, 2008). In addition, the tool can easily be modified to reflect updated information or changes in perceived risk, this is done by amending either the cash flows used or using an alternative discount rate. NPV however, is not without its problems. While the method is easily understood by those with an accounting background, a positive NPV leading to the acceptance of a project and a negative NPV a rejection. The actual calculations can be difficult to explain to a non-financial manager, the method can also be time consuming to set up in the first place. As such, the client may choose to use alternative methods including payback period or internal rate of return (IRR). Payback period is tool which gives a simple approximation of the length of time a project will take to pay back based upon an undiscounted cash flow. As such, the tool is easily explained to the non-financial manager but can be seen as oversimplified, not taking into account the time value of money (Arnold, 2007, Tennentt 2008). IRR on the other hand is similar to NPV in that the tool works with discounted cash flows however, instead of delivering a bottom line return on the project, the tool returns a return as a percentage in relation to the discount rate used. As such, this can be an appealing way of presenting financial information to managers who are used to dealing with percentages and other forms of sales data. Despite the use of these tools for the purposes of financial evaluation, it may be of greater importance for the client to consider qualitative data in relation to potential projects as well as the financial data. For instance, the client may consider the marketing benefits associated with the project which could be used to drive a clear message of the company’s commitments to the community and the wider social environment. In addition, the client also needs to be careful to consider the nature of the assumptions used in the building of any financial models. For instance, an assumption has been made that the cost of particle acquisition has been guaranteed by contract at ?3.50 per tonne for the next five years. However, the client should consider various scenarios such as the liquidation of the supplier and the then changed cost of acquiring the raw material in such an environment. As such, it may be stated that the validity of any financial modelling is only as good as the information from which the model is built. As such, while the clients NPV methodology is a good one in conducting a project appraisal, the client should also consider conducting a number of other forms of analysis alongside this, including payback period, IRR and qualitative analysis. A sample payback period, NPV and IRR have been provided in appendix one with the following results: NPV: ?3,847,144 – Accept Project IRR: 79.93% - Accept Project Payback period – Within 2 years Client 2 In the scenario presented, the client is left with two major options for the funding of any future expansions, namely long term debt funding through bonds and long term equity funding through the issue of new share capital. In addition, the client may consider a hybrid option issuing both long term debt and equity to fund future growth. In making any decision, one of the prime considerations of any financing exercise is to consider the cost of finance. In general terms, the cost of debt is seen in the literature as having a generally lower cost than that of equity (Bingham and Ehrhardt, 2005). This is primarily because debt funded finance has a definitive period while equity in essence is a form of finance which lasts in perpetuity. Despite this fact, there are a number of reasons for which equity may still be selected over debt as a source of funding. In the first case, increasing levels of debt over time make a company look more risky to investors which has the effect of pushing up the cost of future attempts to issue debt based funding. In addition, where a company has unstable cash flows in the future, there is option to suspend dividend payments where finance has been sought through equity. This is not an option in relation to debt based financing as a failure to pay interest payments on outstanding bonds may lead to serious financial consequences including the liquidation of the company (Arnold 2007, Bingham and Ehrhardt, 2005). In the case, the finance director has referred to “the pecking order theory,” this is simply the consideration that firms will choose to raise funding in the order of least resistance or using retained profits first, then debt and finally equity (Brealey et al, 2006) . In considering the costs associated with each method the client should consider the following. By choosing debt funding the company would incur an 11% interest charge annually for the next 10 years. Based upon a bond issue of ?12.5m this would be an annual charge of ?1.375m and a total charge of ?13.75m, in addition the company would also be liable for a one time 20% charge on redemption of 20%on the par value of the bond adding another ?2.5m to the cost. This would make the total cost of source of finance ?16.25m. If the company where to raise the same amount of finance by issuing new shares and achieving the market rate of ?3.50 per share this would require the issue of 3,571,429 additional shares. Based upon the current dividend of 0.175 per share this would lead to an additional annual cost of just ?625,000 in dividend payments. However, there are a number of considerations here, firstly once issued, new equity remains a liability in perpetuity, thus the annual charge in effect lasts for the life time of the company. Secondly, over the past three years the dividend has grown suggesting that this source of funding will steadily increase in costs as the company grows. As such, while equity funding may look like a cheap option for funding the company’s planned expansion, the reality is that over the long term the limited time frame associated with debt based funding may make the issue of bonds a much more attractive option. This can be seen in appendix two where the cost of equity funding appears to be only 5% in comparison to the cost of debt funding at 7.07% however, such simple analysis fails to take account of the long term obligation of equity funding. Client 3 When wishing to create a hedge, one option is to use exchange traded derivatives such as futures and options as opposed to making use of over the counter (OTC) derivatives arranged by a broker. In using exchange traded derivatives, the main options available are “futures” and “options” each of which function slightly differently but serve the same purpose, namely to hedge against a risk and create stability. Here it is assumed that derivatives are settled on a cash basis in the relevant exchange rather than taking physical delivery of a given commodity (Bingham and Ehrhardt, 2005). Futures – A futures contract is a derivative in which a user of a futures contract agrees to buy or sell an exchange traded commodity (including currencies) at a fixed price at some point in the future. As such, stability of the price of the commodity in question is guaranteed regardless of the fluctuations in price of the underlying commodity (Bingham and Ehrhardt, 2005). For instance is Nester PLC agrees to buy an amount of As$ futures at today’s price at a point in the future, should the market price rise in between the present day and the date of redemption, Nester PLC would have an increased cost in regards to its currency operations on the open market. However, the increased cost would be offset by the profit made on settlement of the futures contract to the same degree, hence the company has hedged its position and created a stable cost of business. On the other hand, should the currency fall in value, Nester PLC would have an diminished cost with regards to its currency operations in the open market, however thus would be offset by the loss made on the settlement of the futures contract on the redemption date. Again Nester PLC would have achieved a stable cost of currency options by hedging with a futures based derivative. Options – An options derivative is similar to that of a futures contract however, the key difference is that on the date of redemption the buyer of the option has “right” to exercise the option but not the “obligation” (Bingham and Ehrhardt, 2005). This means that where the position where it would be an advantage for the holder of an option to exercise the contract (if currency had appreciated in value) then the option holder would do so making a profit on the contract but losing out on the increased cost of the currency. However, where the position of the option holder would lead to a loss on settlement, the option holder simply walks away from the contract and these only loses the premium paid for the contract in the first place. This is a significant advantage of a futures contract as the possible loss incurred by an option holder is limited to that of the premium paid to buy the option in the first place. Thus one can see that standard exchange traded derivatives can be a valuable way of hedging one position in regards to the costs and risks associated with international currency transactions. The basic principal being that in an increase or decrease in the direct costs associated with a particular activity can be offset by the relevant profit or loss associated with the use of an exchange traded derivative. Client 4 This section will now consider two key issues, firstly the issue of the risks associated with diversification and secondly those associated with funding the proposed diversification through bonds. Diversification Risk In the first instance, diversification is usually seen as a way of reducing, rather than increasing business risk (Brealey et al, 2006, Johnson et al, 2008). Here the company is considering two separate forms of diversification namely, geographic and product based diversifications. Such diversifications are often seen as a way of hedging against a fall in demand in any single market, product or geographic area. However, not all forms of risk can be diversified away by a company and diversification in some cases introduces new levels of risk which were not previously relevant. In the case of product based diversification, the risk may mainly be seen as related to the businesses brand and image. On concern is that by offering a wide range of products and services, the company may lose its credibility as a specialist in its given field of expertise amongst customers (Brassington and Pettitt, 2006). The second risk is that in diversifying, the company many not in itself have sufficient knowledge of the market to operate successfully, this could be due to lack of knowledge about the needs of customers or poor knowledge of the operations of the market. Where a firm chooses to expand geographically, the main risks may be seen as relating to financial and legal risks. For instance, in expanding into Europe and the US the company will have to consider issues such as exchange rate fluctuations and interest rate risks. In addition, the legal systems in both areas may be significantly different to those the company is used to operating under in the UK. This may be especially true in the highly regulated food sector. Bond Risk Another risk to consider that of the risk associated with financing the planned expansion. If the company where to fund the expansion through the issue of bonds the main risk the company would have to take into account is that associated with the ability to pay back the interest charges associated with the bonds. In short, the company would be increasing its long term costs over a significant period of time in order to gain the necessary capital to fund the planned expansion (Brealey et al, 2006). In addition to the direct risk associated with the payment of interest charges, there is also the consideration that having a higher level of gearing following the issue of the bonds, the company may find it more difficult to obtain future financing at a reasonable rate in both the debt and equity markets. This may in itself be seen as a form of risk for the company brought about by the current plants to fund the expansion through the issue of bonds. As such, while it may seem that the company’s planned expansion program is one way to hedge against a fall in any given market, be it a product related market or a geographic market. The reality is that such an expansion program also introduces a number of additional risks to the business including both business and financially related risks. Bibliography Arnold, G. 2007. Essentials of corporate financial management. Harlow: FT Prentice Hall. Brassington and Pettitt. Principals of marketing. 4th ed. 2006. Harlow: FT Prentice Hall. Brealey, R, A, Myers, S, C, Franklin, A. 2006. Principals of corporate finance. 8th ed. London: McGraw-Hill Brigham, E, F, Ehrhardt, M, C. 2005. Financial management theory and practise. 11th ed. Australia: South-Western Publishing. Drury, C. 2004. Management and cost accounting. 6th ed. Australia: Thomson. Johnson, G, Scholes, K, Whittington, R. 2008. Exploring corporate strategy Text and cases. 8th Ed. Harlow: FT Prentice Hall. Tennent, J. 2008. The economist guide to financial management. London: Profile Books. Appendix One Client One   Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Annual Tonnage 0 80,000 88,000 96,800 106,480 117,128 Initial Outlay ?1,060,000 ?0 ?0 ?0 ?0 ?0 Salvage ?0 ?0 ?0 ?0 ?0 ?115,000 Sales Rev ?0 ?1,200,000 ?1,320,000 ?1,452,000 ?1,597,200 ?1,756,920 Disposal Revenue ?0 ?3,200,000 ?3,520,000 ?3,872,000 ?4,259,200 ?4,685,120 Maintenance ?0 -?43,000 -?43,000 -?43,000 -?43,000 -?43,000 Processing Cost ?0 -?2,960,000 -?3,256,000 -?3,581,600 -?3,939,760 -?4,333,736 Material Costs @ ?3.50 Ton ?0 -?280,000 -?308,000 -?338,800 -?372,680 -?409,948 Cash flow Before Tax -?1,060,000 ?1,117,000 ?1,233,000 ?1,360,600 ?1,500,960 ?1,770,356 Tax ?0 ?312,760 ?345,240 ?380,968 ?420,269 ?495,700 Cash flow After Tax -?1,060,000 ?804,240 ?887,760 ?979,632 ?1,080,691 ?1,274,656 NPV ?3,847,144 IRR 79.93% Payback Year 2 Appendix Two Client 2 Outstanding Stock 32,000 Par Value ?0.50 Market Value ?3.50     Ordinary Share Value ?16,000.00 Weight of Equity 56.14% Cost of Equity 5.00%     Total Debt 12,500 Weight of Debt 43.86% Pre-tax Cost 11% Tax 30% Post-Tax Cost 7.07%     WACC 5.91% Read More