Present Value and Balance Sheet Position of a Company - Essay Example

Financial Management Question The aim of all companies is to maximize their shareholder value and share price is a useful representative of companyvalue (Walden-University) . The price of a product or service determines its value, so the market price of a share determines the value investors place on it considering its current and future prospects. The price of a share is determined by the market forces of demand and supply (EconomyWatch); here expectations have a huge role to play. Companies are particular about share price because a share is like a portion of the company’s ownership. So firms make effort to keep their share price high, otherwise some other firm might be able to acquire a huge number of their shares and be successful in a hostile takeover (Metafilter) . A hostile takeover will result in the current management being dissolved by the company taking over. Progressive companies are always looking for new projects and opportunities, and to pursue them capital is an essential ingredient. Companies want to raise the price of their stock for future issues of stock (Investopedia). So in future when companies raise capital through stocks, they receive large amounts of premium; moreover even when it borrows, firms charge less interest on credible debtors, so it also helps in raising funds cheaply. Companies are concerned about their market capitalization; it refers to the size or worth of a business enterprise and can be calculated by multiplying the current market price with the number of shares outstanding. If the worth of the company falls, investors will be less interested in it and the company will lose its status (Henneman). Employee stock option/ownership is again a strong motivation for raising share price value for management. Employee stock options are a form of non-cash benefit that gives an employee the right to buy the company’s share at a particular price at a future date (Balsam, Chen and Sankaraguruswamy). So management puts an effort to raise the share value above that value to take benefit of this option. Moreover the management raises the stock price to please their stockholders and to maximize their value. The reason is that the shareholders elect the board of directors which elects the CEO. So the CEO has to please the board which then wants to please shareholders to get re-elected. Share price represents a number of aspects of a company. These aspects include company management, business’s current and future earnings and net assets, goodwill in the market, future outlook, credibility etc. Company management The present value and balance sheet position of a company represents how well the management is running the firm. A strong management makes sure that it runs a company in a way that not just its current but its future is also secure and profitable. The management of an organization also makes sure that it keeps good relations with its suppliers, customers, government and other stakeholders. So the share price can be called an instrument to measure the performance or a way of getting feedback of its management and the effectiveness of its strategies. Future prospects There are a number of startup companies which had very high stock value, although they had not gained significant market share. The reason of it is the value that investors perceive the firm will get in future. The value of a firm is the discounted value of its future net cash flows this is called NPV (Coyne and Witter). So the NPV divided by the number of shares gives the value of a share. Financial indicators The price of a share is directly related with the company’s earnings and net assets. The higher the profits and net assets growth in the company, the more the value of a company increases and the more will the shareholders be ready to pay for its ownership. Indicator of goodwill There are a number of firms in the market which have more debt than their industry counterparts, yet they manage to get new loans at lower interest rates. This happens when a company has created good reputation in the market and has a large amount of goodwill as its intangible asset in the market. Company management also wants their share price to remain up to create goodwill in the market, that the position of the firm is stable. So we reach a conclusion that corporations are concerned about share prices due to concerns about hostile takeover, market capitalization, value of future issue of stocks, re-election of board of directors, employee stock ownership options and because share price is a measure of value of different aspects of a company such as future outlook, financial position, goodwill, company’s management performance etc. Question 2 All firms have to raise capital during their course of life; it can be short-term or long-term, from internal sources or external sources. The term of the source for raising funds depends upon the need for which funds are required, for instance if the need is short-term for example working capital then short-term sources like bank overdraft, trade credit etc. are used. But in case it is for longer-term, then bonds or share capital can be issued. A more important question is whether to raise it from outside sources or should the firm raise it internally. External sources of funds are bank loans, leasing; and internal sources of funds include using up retained earnings. Raising capital from either of the two has its own costs and benefits. Internal sources of funds The greatest benefit of raising capital internally is that you don’t have compulsion to pay interest to any one, nor do you have to accept covenants while taking a bank loan. They are less expensive and take less time and transaction costs to raise funds. But the disadvantages are that you are unable to get in close contact with another organization when you need more cash, secondly you credit history is not constructed on the basis of which you can get more funds (Kauffman-Foundation). External sources of funds External sources have the benefit of faster growth for the firm because the firm can keep its profits and develop new products, go into new markets etc. Larger businesses usually get loans on lower rates of interest, so they can benefit from lower costs through bargaining, plus their fixed cost of capital is spread on a larger output, so leveraging a larger firm provides huge growth potential. (London) For a corporation that raises capital through issuing more stocks, it will lose some future control, ownership of the firm and future profits as well. Debt-based external financing can create restrictions on a firm in the form of covenants. The cost of it are also generally higher because interest and more profit payments to firms are required, this will also influence the cash flows. (Chambers) There are a number of reasons for different countries having their own preferred sources of funds. This disparity primarily exists because of the dissimilarities in the cost of capital of sources of financing. Cost of capital is the cost or rate at which companies can raise funds (it can be debt or equity). Cost of capital can be found through CAPM model, through which the rate of return of an asset or project is determined. Its formula is written below: Where represents expected return on the asset. is the risk-free rate or the rate on long-term government bonds. is beta or sensitivity of that asset’s returns to the returns of the market. is the return on the market. Even for two firms competing in different countries and having the same cash flow, the difference in cost of capital will be reflected if we calculate the present value of the firms (Stulz). If the cost of capital is high, the cash flows will be discounted with a larger rate and the present value will be lesser than what is can be with a lower cost of capital. So in situations where cost of capital is higher, even projects that have positive future outlook can be rejected because of negative NPV. As we know that the risk-free rate in Japan is way lower than in America, so the cost of capital is lower in Japan. This is the basic underlying reason for Japanese firms raising more capital from external sources (1/2) than from internal sources; where as in America internally generated funds are 4/5 or 80% of all the capital raised. Firms also raise capital internally to avoid a prospective takeover by other firms. For instance we see that in America the corporations are more vulnerable to a takeover than the firms in Japan. This is another reason that American firms avoid issuing more shares. The concept of agency cost is mentioned in the article by (Stulz) in which he explains how due to lack of trust on management (principal agent problem) can increase the cost of raising the capital from external sources, as people believe that management will maximize its own interests. In Japan the agency cost is very low and raising capital from external sources does not have negative impact, if fact there is evidence that after the announcement of an equity issue, the value of the Japanese firm rose by 0.7% (Stulz). In order to reduce agency cost the management of corporations has to work hard to prove that they are committed to increasing shareholder value. There is also evidence that raising capital through convertible in Japan gives higher return than in America. This refers to the use that companies can make of their capital. Japanese firms tend to have a larger return on capital employed than American firms. According to a research (Booth, Aivazian and Demirguc-Kunt), the lower the debt ratio, the more profitable the firm. Or basically profitable firms have less demand for external capital. Availability of financial institutions and liquidity in the markets is another important factor which determines whether companies raise funds through internal or external sources. In developing countries where the secondary markets are not developed, the market does not have depth to sustain enough trade and the information asymmetries are very high, the investors are reluctant to invest their funds in stock and firms avoid floating shares. Transaction costs are also very important to discuss here. Internally generated funds have lower transaction costs that funds raised from external sources. So if firms use more of internal capital that external, their cost of capital will fall (Park and Pincus). Wehy has also proved that firms with greater internal equity tend to have larger earnings. So we reach a conclusion that risk-free rate, the probability of takeover, agency costs, availability of financial institutions and liquidity in the markets and transaction costs are the major determinants of the disparity between the sources of funds in different countries. Works Cited Balsam, Steven, Lucy Huajing Chen and Srinivasan Sankaraguruswamy. SSRN. jan 2003. 3 april 2011 . Booth, Laurence, et al. "Capital Structures in Developing Countries." http://siteresources.worldbank.org/DEC/Resources/84797-1114437274304/capitals.pdf. 1999. Chambers, Shawn. eHow.com. 16 may 2010. 3 april 2011 . Coyne, Kevin P. and Jonathan W. Witter. T H E M c K I N S E Y Q U A R T E R LY. 2002. 2011 . EconomyWatch. EconomyWatch. 2011. 3 april 2011 . Henneman, Paul. AllExperts. 2 oct 2006. 3 april 2011 . Investopedia. Investopedia. 2011. 3 april 2011 . Kauffman-Foundation. Entrepreneurship. 2011. 3 april 2011 . London, John. eHow. 29 september 2010. 3 april 2011 . Metafilter, Ask. Ask Metafilter. 4 june 2007. 3 april 2011 . Park, Chul W. and Morton Pincus. "Internal versus External Equity Funding Sources and Earnings Response Coefficients." Springerlink, REVIEW OF QUANTITATIVE FINANCE AND ACCOUNTING (n.d.): http://www.springerlink.com/content/gj421p747m075t02/. Stulz, René M. "Does the cost of capital differ across countries?" 1995. Walden-University. Walden University. 2011. 2011 . Read More