The Primary Financial Management - Essay Example

Supervisor Diagnose and define problems relating to the use of accounting and financial processes within an organisational context. Present defensible solutions to organisational issues within a behavioural context. By: October, 2008 TABLE OF CONTENTS 0.0 Executive Summary 1.0 Introduction 1.1.1 Case Analysis-Main Issues in the Case 1.1.2 Competitors and Market Analysis 1.1.3 Wooden Post Ltd Competitive Advantage-SWOT Analysis 2.0 Analysis based on Agency theory and Contingency theory 2.1.1 Agency Theory 2.1.2 Contingency Theory 2.1.3 Reconciling Contingency and Agency Theories at Wooden Post Ltd 3.0 Investment Analyses 3.1.1 Investment appraisal of option one 3.1.2 Investment appraisal of Option 2 3.1.3 Investment Appraisal of Option 3 4.0 Various Options Available Compared to Each Other 4.1.1 Decision Point- Best Alternative 4.1.2 Conclusion and Recommendation 1.0 Introduction The primary financial management objective of a company is to create value through maximisation of shareholders wealth. It could have been a crucial decision for financial managers if altering the capital structure would increase company value. The capital structure refers to the extent to which debt and equity securities are used in the long-term financial structure of a company. (Ross et al, 2002). This paper is aimed at analysing the case study of Wooden Post Ltd a United Kingdom (UK) based. Following the firm’s initial impetus for growth that came from the marriage of the managing director (then a saw mill owner) and a wealthy forestry owner from the north of England, in the phase of the current market situation a number reforms are about to be implemented base on the best option. This paper is therefore going to analyse the case thoroughly by looking at the main issues discussed in the case study in section 2 below; evaluating the management control system of Wooden Post Ltd as described in the case study in section 3 below; analyzing the case using agency and contingency theories in section 4; comparing and contrasting agency and contingency theory perspectives as well as looking at how the interpretation of the case differ from each theoretical perspective in section . This will require using certain financial analysis tool such as the Net Present Value and the Payback. The last section takes a decision and provides conclusion and recommendations 1.1.1 Main Issues in the Case The Wooden Post Ltd case study raises some important themes. The case first of all highlighted the issue of cultural change. The main idea in the area included improving on its transportation system, reducing cost in other to boost the organization competitive position. Agency control is also highlighted in the case through the introduction of a new director’s incentive scheme and a fall in growth potentials. Other problems raised in the case involve issues of corporate restructuring, contracting and outsourcing, employee’s redundancy. Under the present situation, management is now faced with the options of either merger and acquisition, joint venture or closure of some facilities. A couple of research has been carried out with the view to answer the two fundamental question as follows; (1) Does capital structure matters- can the total market value of a firm be increase or decrease by altering the mix of equity and debt? And, (2) if capital structure is relevant, what factors determine the optimal mix of equity and debt that would maximise the firm’s market value and thus minimise it cost of capital. (Megginson, 1997). 1.1.2 Competitors and Market Analysis Porter (1985:4) contends that the Five Forces define the rules of competition in any industry and at the same time marks the bases for understanding a company’s success. Porter (1985) went further and argues that, competitive strategy must grow out of a sophisticated understanding of the rules of competition that determine an industry’s attractiveness. The researcher further claims that, “The ultimate aim of competitive strategy is to cope with and, ideally, to change those rules in the firm’s behaviour.” (1985: 4) and through their own strategy a firm can take hold of these five forces. From the Wooden Post Ltd case, one will not hesitate to link this to their present attempt at cost leadership strategy. Porters Five Forces Approach Application to the Wooden Post Ltd Case Relationship with suppliers The suppliers constitute independent farmers, local councils, and customers. Bargaining power of buyers High switching cost due to low supplier base and options available to buyers. Threats of new entrants Low threats of new entrants because of the human, time, material and financial resources necessary to set up the factory. However, and entry of a new entrant from other areas like the Scandinavian remain a big threat.. Threats of substitutes products or services The industry is characterized with many niche players. Rivalry amongst established firms Fierce competition with flat cost. No major player able to dominate the market. How ever with continuous innovation and design of new products, London counties presently have the biggest market share. Other key players includeWelshpool, Glens, Essex and others 1.1.3 Wooden Post Ltd Competitive Advantage-SWOT Analysis Strength Strong cost control system Lower Prices Sophisticated distribution facilities Weaknesses Slow down in growth opportunities Opportunities A pool of cheap credit facilities The growing pool of technology Likelihood of premium price Threats The lack and absence of unique product with total differentiation from those of competitors. The lack ownership of exclusive patents Eroding market share Competitive advantage can be referred to as a situation whereby a firm is able to provide a particular service in an industry better than its competitors will do thereby increasing its market share and profit potential (Mintzberg et al. 2003). 2.0 Analysis Based on Agency Theory and Contingency Theory 2.1.1 Agency Theory According to the theory of agency, proposed by Jensen and Meckling (1976) the relationship between shareholders and managers can be regarded from the perspective of the principal agent relationship in which the shareholders (principals) delegate work to the managers (agents). This relationship is governed by the employment contract. (Eisenhardt, 1989: p. 57) The contract stipulates that the manager (the agent) provides returns to the shareholders in the form in return for compensation such as salaries, stock options and other compensation schemes. Since ownership is separated from control in the modern form of corporation, the agency relationship poses two important problems. (Eisenhardt, 1989: p. 57) Firstly, the interests of the shareholder may be in conflict with those of the managers. While shareholders may expect managers to satisfy their interests, managers too may be interested in satisfying their selfish interests rather than what is best for the organization as a whole and the shareholders in particular. Secondly, the shareholder may find it difficult to observe the actions of the manager owing to the fact that both parties may have different attitudes towards risk. (Eisenhardt, 1989: p. 57) While the shareholder may be interested in seeing the manager invest in high risk high NPV projects, the manager may be risk-adverse and therefore discard such projects. Consequently, the principal agent relationship results into agency costs which are often incurred by the shareholders. Agency costs represent the shortfall in returns provided by managers to shareholders and the returns that could have been generated if the shareholders were managing the corporation themselves. (Jensen and Meckling, 1976). In the case of Wooden Post Ltd, agency costs existed between the original management of Wooden Post Ltd and the new directors. To better align the interest of the old management of Wooden Post Ltd with the interests of the new directors, Wooden Post Ltd had to carry out a number of re-structuring plans, including offering a welcome hello package of 10% shares ownership in addition of future bonuses based on performance. Wooden Post Ltd introduced a Management control system which further aligned managers’ interests to those of top management and thus those of shareholders. One obvious way of aligning this interest is through the use of target based compensation plans such as share option schemes. Recognizing that it was an A company, Wooden Post Ltd made it clear to all the managers that the additional 15% share bonuses were based on superior return on investment and growth in profit. Share option schemes imply that such managers would subsequently own shares in the company if they meet the performance targets set by the top management. 2.1.2 Contingency Theory “Contingency theory is guided by the general orientation hypothesis that organizations whose internal features best match the demands of their environments will achieve the best adaptation”. Consequently, organizations must adapt their structure to contingencies such as environment, organizational size and business strategy if the organization must perform well. (Drazin and Van de Ven, 1985; Gerdin and Greve, 2007: p. 2). This core idea of contingency theory was formulated by Galbriath (1973: p. 2) cited in Gerdin and Greve (2007: p. 2) as follows: 1. That there is no best way to organize; 2. Any way of organising is not equally effective. Consequently, effectiveness in organizational structures depends on the context or environment leading to the conclusion that no universally acceptable way of organizing is present. (Gerdin and Greve, 2007: p. 2). In some contexts certain organizational forms or structures will perform better than others although the others may perform better in another context. (Gerdin and Greve, 2007: p. 2). Organizations usually face a multiple number of uncertainties or contingencies from their environment and the question that has been posed by many researchers is whether organizational structures and processes should be matched to the environment, size or technology of the organization. (Drazin and Van de Ven, 1985: p. 520). It is difficult to match organizational structures to all contingencies given that multiple and conflicting contingencies may create internal inconsistencies in the structural patterns of organizations which indicate that a pattern analysis is required for the interactions of multiple contingencies and structural patterns on organizational performance. (Drazin and Van de Ven, 1985: p. 520). In the case of Wooden Post Ltd, the environment never really posed a lot of threats. The major external factors on Wooden Post Ltd were the fact that it had to cope with the new regulations of the EU on the restriction of state aid to industries as well as the commitment of the state to privatize state-owned enterprises. In addition, many competitors are growing stronger. It is obvious that a bulk of some employees were to lose their jobs if either of the strategic option is adopted. Following the action of the Labour Union, Wooden Post Ltd had to respond to this threat by turning down the plan. 2.1.3 Reconciling Contingency and Agency Theories at Wooden Post Ltd The main similarities between contingency theory and agency theory are the fact that they all result in costs to the organization. Contingency theory affects the cost structure of the organization in that it prompts the organization to devote resources to activities that enable it respond to external uncertainties or contingencies. For example, Wooden Post Ltd will have to respond to retaliation from the Labour Union in either of the three options by devoting resources to train personnel who will deliver the services that were about to be outsourced. It is clear that outsourcing is more cost effective to the organization and therefore Wooden Post Ltd must have to spend more by training personnel to provide the services internally. Agency costs arise as a result of the fact that the returns that shareholders receive are usually below the returns that could have been recognized if the shareholders were managing the firms themselves. In addition to these costs, Wooden Post Ltd shareholders will have to spend more money trying to align the interest of the managers with those of shareholders such as performance target compensation plans. For example Wooden Post Ltd had to provide managers with share option schemes on the condition that they grow profit and increase Return on Investment. However, using any of the approaches to study the problem at Wooden Post Ltd requires reconciling some differences. For example, while contingency theory is concerned with the relationship between the organization and its external environment whereas agency theory concerns itself with the relationship between the shareholders and the company. Consequently, contingency theory establishes the relationship between the organization and all its stakeholders such as customers, employees, government, regulatory bodies, and tax authorities. Contingency theory is also concerned with how macroeconomic conditions affect the organization as well as the responses given by the organization to these conditions. Agency theory is only concerned with the relationship between the organization and its shareholders. Interpretation of the case therefore differ from both theoretical perspectives in that while contingency theory concerns itself with solving the problem of employees and the Wooden Post Ltd, agency theory for the Wooden Post Ltd case is concerned with aligning the interests of managers with those of shareholders. 3.0 Investment Analyses According to Langfield-Smit (1998: p. 208; Otley, 1999) citing Anthony (1965) as “the process by which managers ensure that resources are obtained and used effectively and efficiently in the accomplishment of the organization’s objectives.” Management control systems encompass the largely accounting-based controls of planning, monitoring of activities, measuring performance and integrating mechanisms. (Langfield-Smit, 1998: p. 208). The above definition clearly differentiated the management control system from strategic and operational control. (Langfield-Smit, 1998: p. 208; Otley, 1999: p. 364). Management control systems also influence behaviour as they provide a means for gaining cooperation among collectives of individuals or organizational units who may share only partially. (Langfield-Smit, 1998: p. 208). In order to understand the role played by this information in managerial decision making, it is necessary to first of all obtain an understanding of how managers make use of the information provided to them. At Wooden Post Ltd for example, the finance director increasingly used finance information to judge and make decisions. “"the decision has to reflect future cashflows and if in order to secure future loans, there was a need to maintain the current return on investment”. Faced with the increasing complexities, conflicting and multiple objectives and capital constraint common to businesses, organisations have to make important choices taken into consideration the time value for money (Penman 2003). The management of Wooden Post Ltd is now faced with three important decisions. Using the payback period and the net present value of money the various options will be analyse. These metrics and the use of time value of money calculations can be very helpful in directly comparing the financial returns of the competing choices. Furthermore, these tools can also provide insights that are probably even more important, such as understanding what the sources of risk are in the projections and how you might anticipate and solve potential future problems (Brealey & Myers 2005, Damodaran 2002, Berlin & Lexa 2005) 3.1.1 Investment Appraisal Option one Discount factor 10% and 8% Year Cash outflow Cash Inflows Net Cash Flow Discount Factor Present Value PV2 0 60   -60 1 -60 (60) 1 -19 79 60  0.9090  54.54 55.554 2 -8 44 36   0.8264  29.75 36.3616 3 -3 46 43  0.7513  32.31 36.5148 4 -3 46 43  0.6830  29.369 33.81 5 -3 46 43  0.6209 26.69  31.3076 6 0 46 46  0.5645  25.967 28.9892 7 0 46 46  0.5132  23.6072 26.841 8 0 46 46  0.4665  21.459 24.8538 9 0 46 46  0.4241  19.508 23.0138 10 0 46 46  0.3855  17.733 21.3072      NPV      220.9332 248773.7 See appendix 1 excel file for working details According to Akalu (1999) capital investment appraisal techniques based on discounted cash flow have been in use since the 1970s. However, in spite of their popularity, the link between the value projects assured by these techniques and the value attained by the organization is not certain. The Net present Value uses the concept of opportunity cost to place a value on cash inflows arising from capital investment. “NPV is the difference between two categories of discounted cash flows (DCFs). It nets the present value of the investment from the present value of the benefit of the project (revenue)” (Akalu 1999:5). Brealey &Myers (2005) contends that, NPV is a technique where cash inflows expected in future years are discounted back to their present value. In other words, it measures the excess or shortfall of cash flows, in present value (PV) terms, once financing charges are met. Mathematically, the NPV can be presented as follows (Akalu 1999:5) When the investment (I) is made at the beginning of the period t = 0), the formula will be: that is where NPV is the net present value, NCFi is the net cash flow from the project at period i, k is the cost of capital, I0 is the amount of investment, and T is the life span of the project. Using this discounting method all projects with positive NPV are accepted and raked with the help of the profitability index (PI). Akalu (1999) praised the NPV because NPV considers all cash flows of the project and accounts for pattern and timing of the cash flows. In addition it measures the net worth of the firm as a result of the changes caused by the project. According to wikipedia NPV is an indicator of how much value an investment or project adds to the value of the firm. If It Means NPV > 0 the investment would add value to the firm Project accepted NPV < 0 the investment would subtract value from the firm Project Rejected NPV = 0 the investment would neither gain nor lose value for the firm Our decision should be indifferent maybe a public project However, it also has some drawbacks. Akalu (1999) argue that in mutually exclusive projects (differing in life and initial investment), the NPV may lead to different decision results. Moreover, it requires and assumes equal class of risk for both cash inflows and outflows of the project which is not often true in real life situation However NPV continues to be one of the most widely applied DCF techniques in business and industry. 3.1.2 Investment appraisal option 2 Years Cash Flow net 10% 8% PV1 PV2 0 (20) 1 1 (20) (20) 1 (20) 0.9090 0.9259 (18.18) (18.518) 2 (20) 0.8264 0.8573 (16.528) (17.146) 3 5 0.7513 0.7938 3.776 3.969 4 15 0.6830 0.7350 10.245 11.025 5 15 0.6209 0.6806 9.314 10.209 6 15 0.5645 0.6302 8.466 9.453 7 15 0.5132 0.5835 7.698 8.753 8 15 0.4665 0.5403 6.998 8.105 9 15 0.4241 0.5003 6.362 7.505 10 15 0.3845 0.4632 5.768 6.948 NPV 3.919 10.303 3.1.3 Investment Appraisal of Option 3 Cash out flow 14/3=4.6 Cash inflow 45/3 =15 Year Net Cash flow 10% 8% PV1 PV2 1 10.3 0.9090 0.9259 9.3627 9.5368 2 10.4 0.8264 0.8573 8.5946 8.9159 3 10.4 0.7513 0.7938 7.8135 8.2555 NPV 25.7708 26.7082 NPV is positive for Option 3 4.0 Choice and Decision From the investment analysis of the three option. Net present value for the three projects is positive. According to Akalu, the net present value of a project that is positive should be chosen for investment. However, because of capital constraint, our organization in question Wooden Post Ltd should select the first option with the highest NPV. This option offers investors positive cash flow at the earliest period. According to Brealey & Myers (2005) the time value of money rest on the premise that a dollar today is worth more than that same dollar to be received at time T. That is based on their argument; investors prefer to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all things being equal (Akalu 1999). 4.1.1 Conclusion and Recommendation The founder of this theory, Myer proclaimed that a firm would sometimes forgo its positive NPV project, if it means accepting the project would require the issue of new equity. According to him, with asymmetric information, the issue of new equity would be interpreted in the market as bad news because managers are motivated to make new equity issues only when shares are overvalues. The empirical evidence to this model transmits doubt when it comes to raising new equity for fund. The announcement of new equity issue in the capital market is interpreted to mean a sharp decline in stock price. This evidence shows why equity issues are comparatively rare among large established companies BIBLIOGRAPHY Akalu, M. M., (1999) Re-examining project appraisal and control: developing a focus on wealth creation. International Journal of Project Management. Vol.19, Issue7, Pp. 375-383 Berlin, W.J., & Lexa, J. F., (2005).Financial modelling in medicine: Cash flow, basic metrics, the time value of money, discount rates, and internal rate of return. Journal of American college of Radiology. Vol.2 Issue3, Pp. 225-231 Brealey, A.R., & and Myers, C. 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