Financial Management

FINANCIAL MANAGEMENT

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Financial Management Table of Contents Introduction 1. Critically discuss the importance of capital gearing and its effect upon WACC, company value and shareholder wealth.

2. Critically compare and contrast two investment appraisal techniques indicating their merits and limitations in aiding the sound financial management of a company. Conclusion Reference List

Financial Management Introduction The significance of capital gearing is crucial for all successful organizations. It has a direct impact on divisible profits of an organization and thus, a proper capital gearing is essential for the smooth financial operations. In the event of low geared organization, the fixed cost of capital in the form of fixed dividend on interest and preference share, and also interest on debentures is low, and possibly equity shareholders may receive higher divisible profits. Whereas in a highly geared organization the fixed cost of capital is usually higher thus would be lesser divisible profits for the equity shareholders. The most crucial factor that should be always considered by the organization while drafting the financial plan of an organization is capital gearing. In other words, gearing is a

limit of many types of financial securities to total capitalization. This term, when employed to the capital of an organization, means the ratio of equity of share to the total capital, which is the capital gearing or capital gear ratio. Arnold states capital gearing is the relation of equity shares (ordinary shares) to preference share capital and loan capital involved illustrate as the capital gearing. The capital gearing is highly valuable for the uniform operations of an organization It influences the profitability of an organization. In a low geared organization, the fixed cost of capital is low, and the equity shareholders get a high profit in a way of dividend, and the fixed cost of capital is high in case of high gearing and profits to the shared by the equity shareholders will go down (Arnold 2002). Capital gearing plays a crucial role in a business and acts as gears of an automobile. In an automobile, gears maintain the required speed. At the beginning, an automobile picks up with a low gear, but as soon as it gains momentum, the gears changes subsequently. In a same way, an organization starts its business with a low gear, i.e., higher share of equity capital, and as the business gains momentum, it subsequently releases fixed cost securities such as

Financial Management debentures and/or preference shares. Hence the capital gearing process concerns with the raising of capitalization. 1. Critically discuss the importance of capital gearing and its effect upon WACC, company value and shareholder wealth. The reasons for capital gearing What differentiates fixed return capital from equity capital is cost. Since fixed cost capital providers do not face as much risk as the equity shareholders as such, they acknowledge relatively low returns. In certain cases where an organization is well functioning, and the procurement of finance is strictly on a quality asset the risk is indeed minimum. In such circumstances, an organization may not need to provide much above the

interest rate currently in existence on government securities. In cases of preference shares the risk is much higher, but still it is possible to be significantly lower than the ordinary shares. This means that fixed return capital is comparatively cheaper, and this is its main attraction. The next reasoning for the cheapness of most variants of fixed capital return is the interest payments that are tax deductible, whereas the profit of shareholders is fully taxable. It means that the net cost to an organization, and thus, to shareholders, it is the amount of interest less the rate of tax. Hence, a loan having an interest rate of 10% annually would cost 6.7%, which is 10% less tax at 33% (Davies 2000). Capital Gearing and its Effect From the shareholders perspective, capital gearing seems to be too strong and true. However, it is not essentially as sturdy as it looks. The problems that associate with capital gearing are risk. Certain obligations to give interests payments likely exposes increased risk for shareholders. In case of capital gearing, the impact of changes in the level of operating profit is usually multiplied. When the level of profit is low, the affects on shareholders returns are

Financial Management severe with the need for making interest payments, and in case of higher levels of profits, shareholders receive substantial benefits. Moreover, when an organization is making an appreciable rate of return on its assets, which is higher than the cost of return on the fixed finance, gearing is advantageous to shareholders. Whereas, in case the return is below the cost of the fixed return finance then shareholders suffers.

Obviously, no organization will increase fixed return on finance at a cost that is higher on the evaluated future rate of return on the organizations assets. Hence the anticipation will be that the net impact of capital gearing will be advantageous to ordinary shareholders. Moreover, ordinary shareholders are not certain about the exact level of profit in the future, and whether the impact of capital gearing will be profitable or detrimental. With this increased uncertainty, the ordinary shareholders will place less value on their shares. When there is a higher level of capital gearing, the higher is the risk to an ordinary shareholder (Rappaport 1998). The relationship between capital gearing and the cost of capital The purpose of capital gearing that prevailed until 1960 was the clear benefits to the shareholders. This is because WCC will tend to decline as the level of the capital gearing increases up to appropriate levels of capital gearing. It will leave a beneficial impact on the shareholders because the lower is the WACC, the more is worth of an organization. Since an increase, in the value of an organization raise the value of shareholders thus gearing up to a reasonable level will be profitable. It shows that, with an increase in level of capital gearing, WACC declines. This is due to an increasing proportion of the cheaper fixed return on finance. With the increase in gearing level, the shareholders observe greater risk and as a result, require high returns for compensation.

Financial Management

These high levels of return required by ordinary shareholders are not enough, at low levels of gearing, to compensate the benefits of the much more cheaply fixed return capital. However, at high levels the shareholders will likely to see their returns more risky and will expect higher returns. In the same way, as levels of gearing increase, the lenders of fixed return finance start looking an increase in the risk of their returns. The high amount of interest and dividend on preference share, that the organization commits to pay at higher levels of capital gearing, put in jeopardy an organizations capability to meet all of these liabilities. Thus, an organization will only have the ability in raising more fixed return capital by providing increasingly high interest rates and preference dividend. At a certain point, the elevated requirements of group of providers of finance can drive up WACC. Thus, WACC will most likely decline initially as the level of gearing increases. At certain gearing level, it will attain a minimum value after which it will rise again. Therefore, there is an optimum gearing level at which WACC is at a minimal, and the value of an organization is at a maximum (Solomon 1963). Modigliani and Miller view showing capital gearing and the cost of capital Relationship Modigliani and Miller, two US economists, and winner of Nobel prizes, published a paper in 1958 which challenged the traditional view. They argue, by supporting rigorous analysis, that it is irrational to contend that the value of an organization relates to how that the organization procure finance. The value of the organization depends upon the future cash flows which are likely to be generated by that organizations activities and will not change with the financing method. MM acknowledged that fixed return finance is certainly cheaper than equity finance because of less risk but at the same time they argued that adding fixed return finance into an

Financial Management organizations capital structure would not lower WACC, since the ordinary shareholder demands will accurately counteract the impact of the cheap fixed return finance. Hence the cost of capital will be independent of the gearing level. The analysis of MM relies upon various assumptions; most of them are not practical in real life. It is fairly reasonable to contend that the lacking of reality in case of most of the hypothesis does not seriously weaken the conclusions of MM. However, one of the assumptions of no taxes, truly flaws the logic of MM because loan interest is deductible in the tax. This implies that there is powerful effect on the organizations net cash flows, and hence the value of the organization as an outcome of this deductibility in tax (Miller 1961). In 1963, MM, removed their no-taxes hypothesis and derived at the conclusion that

the higher the capital gearing level, the lower is the WACC and higher will be the value of an organization and every ordinary share. MM another assumption, whose absence of reality could seriously demand their conclusion into questioning, relate to the efficacious cost to the ordinary shareholders of an organization going into liquidation. If an organization possesses capital gearing, the probability to satisfy its contractual, financial obligations increases. The higher is the gearing level the higher is the likelihood of financial failure. The difficulty with financial torment is that it costs finance. It is because costs of disposing the organizations assets and legal expenses would be incurred. Further, there is also the cost of assets that have its own value to an organization, and the organization may not get this value if it has to be sold in fragments. Hence, the value of the organization equals the value of the equivalent ungeared organization plus the value of tax advantage minus the value of the cost of financial torment (Pettit 1977). 2. Critically compare and contrast two investment appraisal techniques indicating their merits and limitations in aiding the sound financial management of a company. Financial aspects of investment appraisal

Financial Management Investment appraisal is for examining a potential capital investment by an organization and evaluates its potential value to the organization. There are more than one

methods of Investment Appraisal, and each method permits the potential return on investment to be analyzed in a different way. Methods of Investment Appraisal There are 3 methods of investment appraisal. They are: 1. Payback 2. Accounting rate of return 3. Net Present Value Accounting rate of return The calculation of ARR is principally in the same method as return on investment as:

Whether profit is to be levied before or after interest charges and an investment is the initial disbursement or is the average over the lifespan of the business is unclear. This deficiency in clarity looks strange. The most prominent point of this ARR is that it possesses the same principles as the published financial statements. Measurement of managers and organizations is usually by the return on investment or return on capital applied, ratio achieved from published P&L account and balance sheet (Rozeff 1986). The two ratios are similar, merely reflecting both sides of the balance sheet; capital utilized shows the financing of an organization, investments show the usage of that finance. Therefore, it is logical that calculation must be done in a manner which makes it distinguishable with these ratios. Since the balance sheet incorporates written down assets values, ARR to be calculated as follows:

Financial Management Profit Average (written down) investment This agrees with common sense because if charging of profit is after depreciation, then one can expect that depreciation influence the value of the investment. Pursuing the same principle that the numerator and denominator should be equivalent will allow other obstacles to be solved. While estimating managements performance the ratio is: Profit before interest and tax Average (total) capital employed In case we are evaluating return to shareholders the ratio is: Profit after interest and tax Shareholders funds We must equate return with the investment or funds which create that return. The following are the benefits of ARR: it is easier to calculate, it accounts the total lifespan of the business, The disadvantages of ARR are; it does not consider capital allowances or tax, it does not account the accurate timing of the cash flows, it uses profits instead of cash flows. Payback

Payback is another classic investment appraisal technique that determines how long it will need before the initial investment is paid back. Unlike ARR, this commits to definition of profit and investment, and concentrates on the cash flows which an investment will produce. In this regard, payback is better than ARR because the finance accounting theory of decision making relies on whether the shareholders wealth will increase in case of certain decision. The conventions and definitions of financial accounting should not be permitted to muddy the waters of such essentially ordinary problems. The well known disadvantages of

Financial Management the payment technique depend on the fact that future cash flows, do not demonstrate

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increased wealth in themselves. It is because a flow of money in the future is not as worthy as the same flow of money at present (cash available currently can be invested and hence is more worthy than the same cash flow at a later stage) (Stewart 2001). Some of the disadvantages of payback are: 1. All cash flows during the payback period receive equal consideration; 2. Cash flows that are outside the payback period are usually ignored; 3. It is difficult to ascertain duration of the payback period. Although payback is less used due to disadvantages, but it is widely popular, and its simplicity explains its recognition; 4. Calculations are straight and most likely error free; 5. The fact that data in itself is not trustworthy, refined analysis may not be justifiable. Payback is also beneficial if an organization needs liquid funds in the near future a business that payback before this date is desirable to one which requires financing for a longer period. The next advantage is the risk avoidance of payback. It is rarely wise to implement payback on its own for investment appraisal, and it should combine with at least one another technique, preferentially based on DCF procedures, to make sure that all returns include into account. Discounted payback The biggest disadvantage of payback is its deficiency to consider the time value of funding, but it can be overpower by discounting the cash flows to its current values and then applying these discounted values for calculation of the payback period. Discounting techniques Net Present Value

Financial Management The theoretically appropriate method is to calculate the NPV of an investment by discounting future cash flows to its present value and netting them together. The current value of a future cash flow can be thus calculated by multiplying it by the factor.

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Where r stands for discount rate and n, show number of years or the number of periods in the future when the cash flow will occur. Discounting is the opposite from compounding, remembering a principal X will rise to an amount, V, after n years if investment is at a rate of interest r, then we get: V = X (1 And X= It can be said that X rises to V in n years or, equally, that the future cash flow V is worthy X in present value terms. By discounting future cash flows the issue of the time value of money is removed and, if the net present value is positive, the project can be approved (Levine 1981). Conclusion The capital gearing is extremely significant from the financial managers perspective. He must understand, for what finance securities for an organization should be raised and also in what proportion. It is extremely necessary for a successful organization as it affects all creditors, shareholders; debenture holders and the organization. A low geared organization pays more dividends to shareholders, and even a high geared organization can also pay high dividend in inflationary conditions, if essential capital gearing is sustainable. r)n

Financial Management Reference List

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Arnold, G.C 2002, Corporate Financial Management, London: Financial TimesPrentice Hall. Davies, M., Arnold, G.C., Cornelius, I. and Walmsley, S 2000, Managing for Shareholder Value, London: Informa Publishing Group. An introductory overviewof VBM. Levine, P. and Aaronovitch, S 1981, The financial characteristics of firms and theories of merger activity, Journal of Industrial Economics , 30, pp. 14972. Miller, M.H. and Modigliani, F 1961, Dividend policy, growth and the valuation of shares, Journal of Business, 34, October, pp. 35-89. Pettit, R.R 1977, Taxes, transaction costs and clientele effects of dividends, Journal of Financial Economics , December. Discusses the clientele effect. Rappaport, A 1998, Creating Shareholder Value, New York: Free Press. Rozeff, M 1986, How companies set their dividend payout ratios, Reprinted in J.M.Stern and D.H. Chew (eds), The Revolution in Corporate Finance . Oxford: BasilBlackwell. Stewart, G.B 2001, Market Myths. In The New Corporate Finance. 3rd edn. Edited byDonald H. Chew, McGraw-Hill/Irwin. New York. An easy to read discussion of the differences between accounting measurement and economic value metrics. Stern, J.M., Stewart, G.B. and Chew, D.H 2001, The EVA Financial Management System in The New Corporate Finance by D.H. Chew (ed.) New York: McGraw-Hill/Irwin. Solomon, E 1963, The Theory of Financial Management, New York: Columbia University Press. WACC presented for the first time.