financial management final
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presentation on financial management-basic concepts explained briefly n covering full aspectsTRANSCRIPT
FinanceMoney is an arm or a leg. You can either
use it or lose it._ Henry FordThe Sanskrit saying “arthahsachivah”
means finance reigns supreme.Ready money is Alladin’ lamp._Byron
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Meaning of financeFinance is the management of the monetary
affairs of a company. ____ Paul G HasingsFinancing is the process of organizing the
flow of funds so that a business firm can carry out its objectives in the most efficient manner and meet its obligations as they fall due. __Ronald
Finance is the common denominator for a vast range of corporate objectives, and the major part of any corporate plan must be expressed in financial terms. ____________ALKignshott
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Finance means to arrange payment for it. __George Christy and Peter Rodan
The act of providing the means of payment. __Encyclopaedia Britannica In nutshell finance is closely linked with the
flow of money, the availability of funds at a time, advance knowledge of, or information about financial commitments etc. The focus of finance is on the flow of funds which is justifiable, because the financial manager must take financial decisions based on mainly flow of funds.
Financial management Financial management is an applied branch of
general management that looks after the finance function of a business. Management in general deals with effective procurement and utilization of basic inputs like men, machines, methods, materials and markets, and money or finance is a common thread that passes through the wide-spectrum of all business activities; and management of finance is a key variable that determines the success or failure of any business activity.
Financial management is a dynamic subject and is responsible for operating a business efficiently and effectively. Traditionally the subject of financial management was considered only in narrow sense but the modern concept of financial management has very wide coverage. It has to bring compatibility between conflicting goals of liquidity and profitability.
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Financial management, however, should not be taken to be a profit-extracting device. No doubt finances have to be so planned as to contribute to profit-making activities within an organization, as finance cannot be generated without profits. But there is much more. Financial management implies a more comprehensive concept than the simple objective of profit making or efficiency.
Its broader mission is to maximize the value of the firm so that interests of different sections of society remain undisturbed and protected.
Financial management is an integrated and composite subject. It welds together substantial material that is found in accounting, economics, mathematics, systems analysis and behavioral sciences and uses other disciplines as its tool.
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“Financial management deals with how the corporation obtains the funds and how it uses them”.--- Hoagland
“The term financial management refers to the application of skills in the manipulation, use and control of funds”.--- Mock, Schultz and Shuckett
“Financial management is the custodian of corporate funds. It has to plan, organise and control the finances of the enterprise”. ---S A Sherlekar
It can be concluded by saying that financial management is not only concerned with procurement of funds but it also deals with three decision-making areas called investment decisions, financing decisions and dividend decisions.
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Financial management emerged as a distinct field of study at the turn of 20th century. Its evolution can be divided into three broad phases( though the demarcating lines between these phases are somewhat arbitrary)__the traditional phase, the transitional phase, and the modern phase.
Traditional Phase The traditional phase lasted for about four decades.
Following were its important features:1)The focus of financial management was mainly on certain
episodic events like formation, issuance of capital, major expansion, merger, reorganization and liquidation in the lifecycle of the firm.
2)The approach was mainly descriptive and institutional. 3)The approach placed great emphasis on long term
problems. 4)The outsider’s like investment bankers, lenders and other
outside interest point of view was dominant.5) Financial management was not considered to be a
managerial function. A typical work of the traditional phase is The Financial
Policy Of Corporations by Arthur S Dewing.
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Transitional Phase The Transitional Phase began around the
early 1940s and continued through the early 1950s. Though the nature of financial management during was similar to that of the traditional phase, greater was placed on the day-to-day problems faced by financial managers in the areas of funds analysis, planning and control. The focus shifted to Working Capital Management.
A representative work of this phase is Essays On Business Finance by Wilford J. Eitman et al.
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Modern Phase The Modern Phase began in mid 1950s and has
witnessed an accelerated pace of development with the infusion of ideas from economic theory and application of quantitative methods of analysis. The distinctive features of the modern phase are:
1) The central concern of financial management is considered to be a rational matching of funds to their uses so as to maximize the wealth of the shareholders.
2) The approach of financial management has become more analytical.
3) It covers security markets and studies security analysis and portfolio management.
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4) It covers fund management of government, profitable and non-profitable social oriented institutions like educational institutions, hospitals clubs and NGOs.
5) It provides coverage to international fund flow management, foreign exchange and risk management.
6) Finance has assumed the position of a managerial function and is no longer an outsider looking approach. It deals with three decision-making areas called investment decisions, financing decisions and dividend decisions.
7) Modern financial management covers various tools and techniques of evaluation, important being, funds flow analysis, cash flow analysis, capital budgeting, cost of capital, leverages, working capital management, eva, mva and capm etc.
Scope Of Financial Management
As already discussed the scope of financial management has increased manifold i.e. from simply raising of funds to investment decisions, financing decisions and dividend decisions.
The scope of financial management may broadly be classified into five A’s viz.
1)Anticipation of the financial needs of the organization;
2)Acquisition of the necessary capital and determining the sources of finance;
3)Allocation of funds which with the deployment of total funds between the different components of fixed and current assets;
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4) Appropriation which basically considers the division of total earnings between the dividend distribution and retention of profits in the business and
5)Assessment which deals with the control over financial activities.
Objectives of Financial Management
Basic ObjectivesOther Objectives
Basic Objectives: 1) Profit Maximisation 2) Wealth Maximisation
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Profit Maximization Profit maximisation implies that a firm either
produces maximum output for a given amount of input, or uses minimum input for producing a given output. Profit earning is the main aim of every business activity.
A business being an economic institution must earn profit to cover its costs and provide funds for growth. Profit is the measure of efficiency. Profits provide protection against risks. Accumulated profits help an organization to face market oscillations. Thus profit maximisation is considered to be the main objective of a business enterprise .Profit is considered as the most appropriate measure of a firm’s performance.
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Points in favour of Profit maximisation.
Profit is a barometer through which the performance of a business unit can be gauged.
Profit ensures maximum welfare of all the stakeholders.
Profit maximisation increases the confidence of management for modernization, expansion and diversification.
Profit maximisation attracts the investors to invest.
Profits indicate efficient utilization of funds. Profits ensure survival during adverse business
conditions.
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Points Against Profit Maximisation
It may encourage corrupt and unethical practices.It ignores time value of money.It does not take into account the element of risk.It attracts cut throat competition.Huge amount of profit may attract Government
intervention.Huge profits may invite problems from workers
who may demand increased wages and salaries.Customers may feel exploited.Profit maximisation may adversely affect the long
term liquidity position of the company.
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The term profit is vague and it cannot be defined precisely.
The effect of dividend policy on the market price of shares is not considered.
All said and done there is no denying the fact that no organization can ignore the aspect of profit. The point to be taken care of is that it is earned following ethical practices. The interests of all the stakeholders should be kept in mind. The point of view of the society at large should not be ignored.
Wealth Maximisation The goals of the management should be such all the
stakeholders are benefitted. A financial action that has a positive NPV creates wealth for shareholders and, therefore, is desirable. Between mutually exclusive projects the one with the highest NPV should be adopted. This is referred to as the principle of value additivity. The wealth will be maximized if NPV criteria is followed in making financial decisions.
The objective of wealth maximisation takes care of the questions of the timing and risk of the expected benefits. It is important to emphasize that benefits are measured in terms of cash flows. In investment and financing decisions, it is the flow of cash that is important, not the accounting profits.
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Elements Of Wealth MaximisationIncrease in profitsReduction in costsJudicious choice regarding sources of fundsMinimum riskLong term value
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Points in Favour of Wealth MaximisationAs the net present value of cash flows is
considered, the net effect of investments and benefits can be measured in quantitative terms.
It considers the concept of time value of money. The present values of cash inflows and outflows helps the management to achieve the overall objective of the company.
It takes care of the interests of all the stakeholders.
It guides the management in formulating a consistent dividend policy.
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It considers the impact of risk factor and while calculating the NPV at a particular discount rate, adjustment is made to cover the risk that is associated with investments.
It implies long run survival and growth of the firm.
It leads to maximizing stockholders’ utility or value maximisation of equity shareholders through increase in stock price per share.
Point Against Wealth MaximisationIt may not be socially desirable.There is some confusion as to whether the
objective is to maximize stockholders’ wealth or the wealth of the firm , the latter includes other financial claimholders also such as debenture holders and preference shareholders etc.
Because of divorce between ownership and management, the latter may be more interested in maximizing managerial utility than shareholders wealth.
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Risk Return Trade Off Financial decisions incur different degrees of risk.
Financial decisions of a firm are guided by the risk return trade-off. These decisions are interrelated and jointly affect the market value of its shares by influencing return and risk of the firm. The relationship between return and risk can be expressed as follows:
Return= Risk free rate+Risk premium Risk free rate is a rate obtainable from a default-free
Government security. Risk free rate is a compensation for time and risk premium for risk. Higher the risk of an action, higher will be the risk premium leading to higher required return on that action. A proper balance between return and risk should be maintained.
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To maximize the market value of a firm’s shares. Such balance is called risk-return trade-off, and every financial decision involves this trade off.
The financial manager , in a bid to maximize shareholders’ wealth, should strive to maximize returns in relation to the given risk; he or she should seek courses of actions that avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to ensure that they are safeguarded and properly utilized. The financial reporting system must be designed to provide timely and accurate picture of the firm’s activities.
All said and done, both the basic
objectives of financial management are important, though in the present day set up , wealth maximisation has emerged to be the premier.
There is no harm in maximizing the profits, if they are earned in a fair, just, transparent and judicious manner. Profits earned by resorting to unethical, corrupt and undesirable practices are not welcome. Profits earned in a fair manner will certainly lead to the achievement of ultimate object of financial management.
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Other ObjectivesEnsuring a fair return to shareholdersBuilding up reserves for growth and
expansionEnsuring maximum operational efficiency by
efficient and effective utilization of finances.Ensuring financial discipline in the
organizationMaintenance of liquid assets
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Capital Budgeting Capital budgeting is the process of making
investment decisions in capital expenditure. When huge funds are to be committed for a fairly long period of time, various alternative proposals may be available. Putting/Ranking such proposals in order of merit or priority is called capital budgeting. Utmost care has to be exercised at this stage because reversing such a decision is a very costly affair.
Capital budgeting refers to the planned and pre-decided allocation of funds available to the firm to long term assets so as to achieve the maximum from these resources.
‘Capital budgeting, then, consists in planning the deployment of available capital for the purpose of maximizing the long term profitability(return on investment) of the firm’.---- R M Lynch
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‘Capital budgeting involves a current investment in which the benefits are expected to be received beyond one year in future’.--- Van Horne
‘The capital budgeting decision, therefore, involves current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits’.
----G D Quirin ‘Capital budgeting refers to the total process of
generating, evaluating, selecting and following up on capital expenditure alternatives’.--- Lawrence J Gitman
‘Capital budgeting is a long term planning for making and financing proposed capital outlays’.---Horngreen
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Capital ExpenditureA capital expenditure may be defined as
an expenditure the benefit of which are expected to be received over period of time exceeding one year. For e.g.
Cost of acquisition of permanent asset as land and building, plant and machinery etc.
Cost of addition, expansion, improvement or alteration of permanent asset.
Cost of replacement of permanent asset.Research and development project costs
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Need and importance of Capital Budgeting Capital budgeting, or in other words, making decisions regarding heavy investment in fixed assets sunk for a long time, is of utmost importance. ‘A keen watchfulness and a positive awareness of capital expenditure needs,’ states J. Batty , is essential at all times The importance, near indispensability and necessity of having a systematic budgeting for capital expenditure is on account of the following factors:1.Huge investment of funds2.Long term commitment of funds3.Reversal causes huge losses4.Factor of obsolescence5.Loss of flexibility6.Essential for various decisions and forecasts 7.Impact on future cost structure8.National importance04/08/23 12:59 PM
Capital Budgeting ProcessIdentification of Investment ProposalsScreening the ProposalEvaluation of Various ProposalsFixing PrioritiesFinal Approval and Presentation of Capital
Expenditure BudgetImplementing ProposalPerformance Review
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Project formulation is one of the basic techniques through which planning can
change from an intuitive base to an institutional and rational base.
G. Myrdal
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Stages/Process of Project formulation
1) Project identification2) Technical analysis a) Input Analysis
b) Demand and Supply analysis
(i) Location (ii) Size and cost of land
(iii) Raw materials (iv) Utilities
(v) Manpower (vi) Transport facilities
(vii) Incentives and concessions
(viii) Environmental considerations
(ix) Climatic and natural hazard considerations
(x) Technological aspects
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3) Economic analysis (a) Capital cost (b) Working capital requirements (c) estimates of operating costs (d) estimates of operating revenues (e) Depreciation/Taxes & (f) Profits
4) Financial analysis a)Financial analysis based on commercial profitability
(b) Financial analysis based on cost-benefit profitability
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(i) Simple rate of return (ii) Pay back period
(iii) Net present value (iv) IRR
(v) Financial ratios (vi) Cash flow statement
(i) Break even analysis
(ii) Sensitivity analysis
(iii) Risk analysis
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(i) Technical (ii) Economic
(iii) Financial (iv) Commercial
(v) Organizational (vi) Managerial
(vii) Social (viii) Environmental
Project SelectionThose projects which have been found
feasible have to pass through another test. These have to be ranked from the point of view of two points:
1.Liquidity- which refers to time factor, employing the period of recovery of the investment.
2.Profitability- which hints at the rate of return on the investment into capital projects.
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Different main methods of ranking capital investment proposals:1. Urgency2. Pay-back method3. Average rate of return4. Discounted cash flow techniques These methods, along with their
variations will be discussed in the matter to follow.
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Methods of Capital budgetingTraditional MethodsPay-back period
MethodImprovement of
traditional approach to pay-back period Method
Rate of Return Method
Time-adjusted Methods
Net Present Value Method
Internal Rate of Return Method
Profitability Index Method
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Factors Influencing Capital Expenditure DecisionsUrgencyDegree of CertaintyLegal factorsIntangible FactorsAvailability of FundsFuture EarningsResearch and Development Projects
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Capital RationingCapital rationing means distribution of
capital in favour of more acceptable proposals. It refers to a situation where the firm is constrained for external, or self imposed, reasons to obtain necessary funds to invest in all investment projects with positive NPV. Under capital rationing, the management has not simply to determine the profitable investment opportunities, but it has also to decide to obtain that combination of the profitable projects which yield highest NPV within the available funds. There are two types of capital rationing:
1)External capital rationing2)Internal capital rationing
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In a study of Indian companies it has been revealed that most companies do not reject projects on account of capital shortage. They face the problem of shortage of funds due to the management’s desire to limit capital expenditures to internally generated funds or the reluctance to raise capital from outside. In most of companies the bases to choose projects under capital rationing are:
Profitability;Priorities set by management;Experience
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Some companies satisfy the criteria of profitability and strategic considerations for allocating limited funds.
Generally companies do not reject profitable projects under capital rationing; they postpone till funds become available in future.
Two independent projects may be mutually exclusive if a financial constraint is imposed. If limited funds are available to accept either project A or project B, this would be an example of financial exclusiveness or capital rationing.
SOURCES OF LONG-TERM FINANCE
Borrowing Debentures
SHARE CAPITALPUBLIC DEPOSIT
SAVING FROM NON RESIDENTS LEASE FINANCING
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Share Capital
Share Capital: Long term funds can be raised from share capital. According to Section 86 of Companies Act, 1956, a company can issue only two types of shares i.e. (a) Equity shares (b) Preference shares
Equity Shares Preference Shares
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SHARES
Equity SharesEquity shareholders are known as the real
owners of the business. They have a control over the working of the company.
Equity shares are paid dividend after the preference shares.
At the time of winding up equity capital is paid back after meeting all other obligations.
They do not have a right to get fixed percentage of dividends.
The dividend depends upon the amount of profits available. When there is no profit, they do not get any dividend.
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Merits of Equity Shares Company does not have the forced obligation
to pay dividend to equity shareholders. Equity shares are a permanent source of
funds which facilitates flexibility in usage of funds.
The obligation to repay the equity capital arises only at the time of liquidation of the company.
The shareholders can participate in the management of the company through voting rights.
Equity shares can be issued without creating any charge over the assets.
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Demerits of Equity Shares:Equity shares are always associated with the
expectations of the investors. It may not be possible to fulfill the expectations of the investors.
Equity shareholders have to bear all the losses at the time of winding up.
Interests of many persons are involved in the working of the company and hence sometimes it creates delay in decision-making.
When finance has to be raised for less risky projects, then this is not a good source of raising finance.
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If only equity shares are issued then the company can not avail the benefits of trading on equity.
Investors who have a desire to invest in safe or fixed returns have no attraction of such shares.
There may be danger of over-capitalization, as equity share capital cannot be paid back during the life time of the company.
Rise in the market value of shares may lead to unhealthy speculation.
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In case a company wants to increase its authorized share capital, so many legal formalities are to be complied with.
Such shares have no attraction for those investors who desire to have a regular income.
Such shareholders have to remain contended without any dividend or with nominal dividend in case of absence of profits or inadequate profits.
In spite of all the disadvantages, equity shares continue to be the first choice, particularly in initial years and in case of companies having intermittent earnings.
Preference shares
Preference shares are those shares which are entitled to a priority in the payment of dividends at a fixed rate and the return of the capital in the event of winding up of the company.
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Types of Preference shares Cumulative Preference Shares: Cumulative preference
shares are those shares on which the amount of dividend goes on accumulating. It means that on these shares, if dividend is not paid in one year, that dividend will be combined in the next year. For example in the year 2007, if company is unable to pay dividend of Rs.5,000, then in the year 2008, the company has to pay Rs. 5,000 of 2007 and Rs. 5,000 of the year 2008.
Non-cumulative Preference Shares: Such shares do not have the privilege of the accumulation of unpaid dividend. In other words, if profits during a particular year are not sufficient, no dividend will be paid for that year in the years to follow.
Participating Preference Shares: These shares get dual benefit on the capital, first a fixed rate of dividend and then a fraction of surplus profits left after paying dividend to equity shareholders. The surplus profits are distributed between the preference shares and equity shares.
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Non Participating Preference Shares: These shares do not carry the additional right of sharing the surplus.
Redeemable Preference Shares: Those preference shares which are to be repaid after the expiry of a certain period of time.
Irredeemable Preference shares: Those shares which can only be repaid only at the time of winding up.
Convertible Preference shares: Those shares which can be converted into equity shares or other category of preference shares after the expiry of a stipulated period of time.
Non-convertible Preference Shares: Those preference shares which cannot be converted.
Merits of Preference Shares: It provides preferential right to pay dividend
and the repayment of the capital. Preference shares provide long term capital. There is no liability to redeem the preference
shares except redeemable preference shares. It earns a fixed rate of dividend. Preference shares although carry no voting
right but the holders of such shares can vote on matters pertaining to them.
Redeemable preference shares have the added advantage of repayment of capital when there are surplus funds with the company.
These shares provide strongest appeal to the cautious investors who want to combine security of the returns with the higher rate of return.
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Demerits of Preference Shares: It is an expensive source of finance as
compared to debt because generally the investors expect a high return of dividend than the interest on debentures.
Cumulative preference shares become a permanent burden so far as the payment of dividend is concerned.
Preference shares have no charge on the assets so it looses the interest of the investors.
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Preference shareholders are deprived of voting rights.
Generally preference shareholders have no right to participate in the surplus.
Preference shareholders are put to loss if their holdings are redeemed during periods of depression.
The device of sinking fund may be introduced for the purpose of redemption which itself is full of many abuses.
Debentures: A debenture is a document issued by the
company as an acknowledgement of debt. It is a certificate issued by the company under its seal acknowledging a debt due to its holder.
On debentures a fixed rate of interest is paid at regular intervals. Usually these are secured by some asset of the company. A debenture holder is a creditor of the company.
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Types of Debentures:
Simple or Naked or Unsecured Debentures: These debentures are not given any security on debentures.
Secured or Mortgage Debentures: These debentures are given security on assets of the company.
Bearer Debentures: These debentures are easily transferable. Anybody who holds these debentures becomes the owner of such debentures.
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Registered Debentures: Registered debentures are those debentures which are registered with the company. These debentures can not be transferred by mere delivery but a proper procedure is to be followed for transfer. Both transferor and transferee are expected to sign the transfer deed.
Redeemable Debentures: These debentures are to be redeemed on the expiry of a certain period. The interest on debentures is paid periodically but the principle amount is returned after a fixed period.
Irredeemable / Perpetual debentures : Those debentures which can be repaid at the time of winding up.
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Convertible debentures: Those debentures which can be converted into shares or other category of debentures.
Non-Convertible debentures: Those debentures which cannot be converted.
Partly Convertible debentures: When a part is converted into shares and the remaining part is called non-convertible portion.
Zero interest debentures: It is usually a convertible debenture which yields no interest. The investor is compensated for the loss of interest through conversion into equity shares at a specified future date.
Merits Of DebenturesCertainty of finance for a fixed periodGreat market response in the days of
depressionAssist in mobilisation of savings of a class
of investors which is highly cautiousProvide long term fundsUsually lower rate of interest than the
rate of dividendLower effective cost
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No dilution of controlNo effect of price level changesFlexibility in capital structureProvide regular, fixed and stable source of
earningsSafer for the holders as they have some
chargeDefinite maturity period
Demerits Of debentures The fixed interest charges and repayment of principal
on maturity are legal obligations which have to be met.
Charge on assets restricts a company from using this source of finance.
Cost of raising finance is high because of high stamp duty.
Not useful for companies having irregular and inadequate earnings.
No controlling power with the investors as they have no voting rights
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Public DepositsThe third source of raising long term funds which
has been particularly popular in the textile industry of Ahmedabad and Bombay as well as in the tea gardens of Bengal and Assam is the public deposits. It consists of accepting deposits by a company from the members of public(including shareholders and directors) for periods ranging from six months to thirty six months.
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Advantages:
1) No legal formalities;2) Higher dividends;3) No charge on the property of the
company;4) Elasticity in capital structure; 5)Reserve fund for development;6)Reasonable effective post tax cost;7)Easiest source of finance;8)Profitable instrument of trading on equity04/08/23 12:59 PM
Disadvantages1)Fair-weather friend;2)Uncertain source of finance;3)Unsound source of finance;4)Inelastic source of finance;5)Costly source of finance;6)Short maturity period
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7)Government restrictions;8)Higher risky for the investor;9)Neither covered by insurance nor
guaranteed by Government;10)Not as liquid as bank deposits;11)May encourage non priority sectors.
Factors Affecting long term fund Requirements1)Nature of industry;2)Quantity of product;3)size of factory;4)Production plus marketing or merely
marketing;5)Method of handling of production;6)Provision for intangible assets.
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Lease Financing In addition to debt and equity financing, lease
financing has emerged as another important source for long-term financing.
A lease may be defined as a contract whereby the owner of an asset grants to another party the exclusive right to use the asset without actually receiving ownership title, for an agreed period of time in return for the periodic payment of pre-determined rentals(normally spread of the lease period). The former is called ‘lessor’ and the latter ‘lessee’. The lessee acquires most of the economic values associated with the asset without acquiring title.
Lease financing has become popular in past three decades or so, because of exorbitant escalation in the cost of capital equipment.
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Lease agreement must contain the following:1)The basic lease period and the condition for
non-cancellation of the lease agreement.2)The timing and amount of periodical rental
payment during the basic lease period.3)The option to renew the lease or to purchase
the asset at the end of the basic lease period.4)Particulars relating to payment of cost of
maintenance, repairs, taxes, insurance and other expenses.
5)Signing of the lease agreement.
Types of LeasingOperating Lease/Real Lease/ Service Lease
Financial Lease/Capital Lease
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Operating LeaseIt is a short-term lease on a period to period
basis. The lease period in such a contract is less than the usual life of the asset.
The lease is usually cancellable by the lessee.The lessee usually has the option of renewing
the lease after the expiry of lease period.The lessor is generally responsible for
maintenance, insurance and taxes. Lease rentals are higher as compared to
other leases.
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Operating lease is suitable in the following cases:
1)Assets which have rapid obsolescence;
2)Overcoming the temporary financial problems of the lessee by taking the equipment on operating lease as well as postponing to buy the same.
Financial Lease A financial lease is a non-cancellable
contractual commitment on the part of a lessee to make a series of payments to the lessor for the use of an asset. With a financial lease, the lease period generally corresponds to the economic life of the asset.
Most of the leases in India are financial leases that are commonly used for leasing land, buildings, office equipments, diesel generators, earth moving equipments, locomotives and hotel equipment etc.
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The present value of the total lease rentals payable during the period of the lease exceeds or is equal to the substantially the whole of the fair value of the leased asset.
As compared to the operational lease, a financial lease is for a long period of time.
It is usually non-cancellable by the lessee prior to its expiration date.
The lessee is generally responsible for maintenance, insurance and service of the asset.
Forms of Financial Lease Sale and Lease backDirect leasingLeveraged LeasingStraight Lease and Modified LeasePrimary and secondary Lease
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Sale and Lease BackUnder a sale and lease back arrangement,
a firm sells an asset to another party, and this party leases it back to the firm.
Usually the asset is sold at its market value. The firm receives sale price in cash and the economic use of the asset during the lease period. In turn, it contracts to make periodic lease payments and gives up the title of the asset. Residual value will now belong to the lessor and not to the firm.
Lessors engaged in this include insurance companies, finance companies and other institutional investors.
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Direct Leasing Under Direct leasing, a firm acquires the
use of an asset that it does not already own. A direct lease may be arranged either from
the manufacturer or through the leasing company. A wide variety of direct leasing arrangements meet various needs of firms.
For leasing arrangements involving all but manufacturers, the vendor sells the asset to the lessor, who in turn leases it to the lessee. In certain cases, the lessor may achieve economies of scale in the purchase of capital assets and may pass them on to the lessee at lower lease rentals.
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Leveraged lease A leveraged lease is an arrangement under which
the lessor borrows funds, for purchasing the asset, from a third party called lender, which is usually a bank or finance company. Generally 20% to 50% of cost is contributed by the lessor. The loan is usually secured by the mortgage of the asset and the lease rentals to be received from the lessee. From the standpoint of lessee there is no difference between this lease and any other lease.
In this type of lease, a wide range of equipments such as rail-road rolling stocks, coal mining, electricity, generating plants, pipelines, ships etc. are acquired.
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Straight Lease and Modified LeaseStraight lease requires the lessee firm to pay
lease rentals over expected life of the asset and does not provide for any modifications to the terms and conditions of the basic lease.
Modified Lease, on the other hand, provides several options to the lessee during the lease period. For example, the option of terminating lease may be provided by either purchasing the asset or returning the same.
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Primary and Secondary Lease (Front-ended and back-ended Lease)Under primary and secondary lease, the lease
rentals are charged in such a manner that the lessor recovers the cost of asset and acceptable profits during the initial period of the lease and then secondary lease is provided at nominal rentals. In other words, the rent charged in the primary period are much more than that of the secondary period.
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Advantages of lease to the LesseeAvoidance of Initial Cash OutlayMinimum DelayEasy source of financeShifting the risk of obsolesenceEnhanced LiquidityTax planning and AdvantageHigher return on capital employedConvenience and Flexibility
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DisadvantagesHigher CostRisk of being deprived of the use of assetLoss of ownership incentivesPenalty on termination of leaseLoss of salvage value of the assetNo alteration or change in asset
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Advantages of Leasing to the LessorHigher profitsTax BenefitsQuick ReturnsIncreased SalesBenefits of residual value
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Limitations of Leasing to the LessorHigh risk of ObsolescenceCompetitive Market Price-level ChangesManagement of cash flowsIncreased cost due to the loss of user benefitLong-term investment
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AS-19, as issued by ICAI, prescribes for lessees and lessors, the appropriate accounting policies and disclosures in relation to finance leases and operating leases. This standard came into effect in respect of all assets leased during accounting periods commencing on or after April 1,2001 and is mandatory in nature.
Capital StructureCapital structure refers to the composition or
make-up or mix of capital i.e. in what proportion equity share capital, preference share capital, long term loans and debentures have been issued.
Capitalization refers to the sum total of all kinds of long term securities i.e. equity share capital, preference share capital and long term loans and debentures.
Financial structure refers to all the financial resources, short as well as long term. In nutshell it is the sum total of the liability side of the balance sheet.
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According to Gerstenberg, ‘capital structure of a company refers to the make-up of its capitalization’.
There are no ready made rules so far as the proportion of different types of securities is concerned. However, Gerstenberg has given two general principles in this regard.
1)The greater the stability of earnings, the higher may be the ratio of bonds to stock in capital structure.
2)The capital structure should be balanced with a sufficient equity cushion to absorb the shocks of business cycle and to afford flexibility.
Theories of Capital StructureNet Income ApproachNet Operating Income ApproachTraditional ApproachModigliani and Miller Approach
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Net Income ApproachAccording to this approach, a firm can minimise
the weighted average cost of capital and increase the value of the firm as well as market price of equity share by using debt financing. The theory propounds that a company can increase its value and reduce the overall cost of capital by increasing the proportion of debt in its capital structure. The basic Assumptions are:
The cost of debt is less than the cost of equity.There are no taxes.The risk perception of investors is not changed by
the use of debt.
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Net Operating Income ApproachAccording to this approach, change in
capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. The main assumptions are:
The market capitalizes the value of the firm as a whole.
The business risk remains constant at every level of debt-equity mix.
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Traditional ApproachAccording to this theory, the value of the firm
can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheap source of finance. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of equity shareholders.
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Modigliani and Miller approachIn the absence of TaxesThe theory proves that the cost of capital is not
affected by the changes in the capital structure. The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increases.
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When the corporate taxes are assumed to existThe value of the firm will increase or the cost
of capital will decrease with the use of debt on account of deductibility of interest charges for tax purposes.
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Factors determining Capital StructureFinancial Leverage or
Trading on EquityGrowth and stability of
salesCost of CapitalNature and Size of FirmControlFlexibilityRequirement of
InvestorsCapital Market
Requirements
Asset StructurePurpose of FinancingPeriod of FinancePersonal
ConsiderationsCorporate Tax rateLegal Requirements
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Cost of capitalCost of capital refers to the minimum required
rate of return of a proposal that a company must earn to cover the cost of investment. Funds can be procured from different sources such as equity and preference shareholders, debt holders and depositors. All those who have invested in the company, would require a return on their investment.
To satisfy the expectations of the stakeholders, the projects of the firm must be able to attain a minimum cut-off rate. Capital raised from different sources is called components of capital. Each of these sources has a cost.
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Cost of capital is “ a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of stock.’’--------James C. Van Horne
“ Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditures.”
Cost of capital is “the rate of return the firm requires from investment in order to increase the value of the firm in the market place.”
Significance of Cost of CapitalAs an acceptance criteria in Capital
BudgetingAs a determinant of capital mix in capital
structure decisionsAs a basis for evaluating the financial
performanceAs a basis for taking other financial decisions
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Computation of Cost of CapitalCost of DebtKd=I/P
Where, Kdb= Before tax Cost of Debt
I= InterestP= Principal Amount
If debt is issued at Premium or Discount Kdb= I/NP (Where NP= Net Proceeds)
After-tax cost of debt
Kda=I/NP(1-t)
Where
Kda=After tax cost of debt
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Cost of Redeemable DebtBefore Tax cost of Debt
Where I=Annual Interest n=No. of years on which debt is to be redeemed
RV=Redeemable value of debtNP=Net proceeds of debentures
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Cost of Redeemable DebtAfter Tax cost of redeemable debt
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Where I=Annual Interest t=Tax rate
n=No. of years on which debt is to be redeemedRV=Redeemable value of debtNP=Net proceeds of debentures
Cost of Preference SharesKp= D/P
Kp= Cost of Preference capitals
D= Annual Preference Dividend
P= Preference Share CapitalRedeemable Preference Share
Kpr=D+MV-NPWhere Kpr= Cost of Redeemable Preference
ShareD= Annual Preference DividendMV= Maturity Value of Preference ShareNP= Net Proceeds of Preference Shares04/08/23 12:59 PM
Cost of Equity Shares Ke= D/NP or D/MP
Ke= Cost of Equity Capital
D= Expected dividend per share
NP= Net proceeds per share
MP=Market price per share
Dividend yield plus growth in dividend method
Ke=D/NP+G
Ke= Cost of Equity Capital
D= Expected dividend per share
NP= Net proceeds per share
G= Rate of growth in dividends
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Cost of Retained EarningsKr= (D/NP+G)x(1-t)x(1-b)
Where Kr = Cost of Retained EarningsD = Expected DividendNP= Net Proceeds of Equity IssueG = Rate of Growth
t = Tax rate b = Brokerage cost etc.
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Weighted Average Cost Of CapitalIt is the average cost of the costs of various sources of
financing. It is also called composite cost of capital, overall cost of capital or average cost of capital.
Once the specific cost of individual sources of finance is determined, we can compute weighted average cost of capital by putting weights to the specific cost of capital in proportion of the various sources of funds to the total.
Kw= ∑XW ∑W Where, Kw= weighted average cost of capital X = cost of specific source of finance W = weight, proportion of specific source
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LeveragesLeverage has been defined as the action of a
lever , and the mechanical advantage gained by it. It allows us to accomplish certain things i.e., Lifting of heavy objects etc.
In financial management, the term leverage is used to describe the firm’s ability to use fixed cost assets or funds to increase the return to its investors i.e. equity shareholders. The capital structure of a company is said to be leveraged or geared when there is the presence of debt in it.
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The concept of leverage assumes significance if one appreciates that different investors have different attitudes towards risk and return.
Some like to bear more risks in the hope of earning good returns while others prefer fixed and regular income even at a lower rate provided risk involved is less.
The former category makes investment in equity share capital while the latter in fixed income bearing securities.
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The company chooses a suitable leverage with another objective also. It has to ensure to its equity shareholders an adequate amount of dividend as they are the actual risk bearers. This amply compensates the real owners of the company for no dividend or little dividend allowed to them in the years of lean profits.
The right gearing/ leverage of capital is also important for a correct policy of dividend distribution and creation of reserves.
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To quote Brown and Howard ‘It(capital gearing or leverage) must be carefully planned since it affects company’s capacity to maintain an even distribution in the face of any difficult trading periods which may occur.
Furthermore its immediate effect may be to enable a company to pay higher ordinary dividends when there is only a narrow margin of profit but its long term effects on the efficiency of the company are far reaching.’
Types of leverages
There are basically two types of leverages
Financial LeverageOperating Leverage
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Financial Leverage It is also called trading on equity. A company
may raise funds either by way of equity or debt. When a concern uses borrowed funds as well as owned capital, it is said to be trading on equity.
The philosophy behind trading on equity is to evolve such a capital structure which involves minimum cost of capital and ensures maximum return to equity shareholders.
Return is a function of risk, debentures and preference shares being more secure attract less return than dividend on equity shares.
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“The degree to which debt is used in acquiring assets is known as trading on equity.”------Hastings
“the use of borrowed funds or preferred stock for financing is known as trading on equity.”---Guthman and Dougall
“When a person or a corporation uses borrowed capital as well as owned capital in the regular conduct of its business, he or it is said to be trading on equity.”
Illustration◦ A firm is considering two financial plans with a view to examining their impact on earnings per share (EPS). The total funds required for investment in assets are Rs. 5,00,000
◦ Debt(10%) 4,00,000 1,00,000
◦ Equity shares 4,00,000 1,00,000
◦ Total 5,00,000 5,00,000
◦ No. of equity shares 40,000 10,000 ◦ EBIT are assumed to be Rs. 50,000, Rs.75,000 and Rs. 1,25,000. The rate of tax is 50%. Comment
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Significance of financial leverage
1)Planning of capital structure: The capital structure is concerned with the raising of long-term funds both from shareholders and long-term creditors. A financial manager has to decide about the ratio between fixed cost funds and equity share capital. The effect of borrowings on cost of capital and financial risk have to be decided before selecting a final capital structure.
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2)Profit Planning: The earning per share is effected by the degree of financial leverage. If the profitability of the concern is regular and sufficient, then fixed cost funds will help in increasing the availability of profits for equity shareholders.
Limitations of financial leverage
1)Double-edged weapon: Trading on equity is a double-edged weapon. It can be successfully employed to increase the earnings of the company for equity share holders if debt can be raised at a rate which is less than the rate of dividend. On the other hand, if it does not earn as much as the cost of interest bearing securities, then it will work adversely and hence can not be employed.
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2) Benefits only to those companies which have stability of earnings: Trading on equity can be enjoyed only by those companies which have adequate, stable and regular earnings. This is so because interest on debentures is a recurring burden on the company and has to be paid whether there is profit or not.
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3) Increased risk and rate of interest: Another limitation of trading on equity is on account of the fact that every rupee of extra debt increases the risk and hence the rate of interest on subsequent borrowings also goes on increasing. It become difficult for the company to obtain further debts without offering extra securities and higher rate of interest, which may result in reduced earnings.
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4)Restriction from financial institutions: The financial institutions also impose restrictions on companies which resort to excessive trading on equity because of the risk factor and to maintain a balance in the capital structure of the company.
Operating Leverage Operating leverage takes place when a change in
revenue produces a greater change in EBIT. It indicates the impact of changes in sales on operating income.
A firm with a high operating leverage has a relatively on EBIT for small changes in sales. A small rise in sales may enhance profits considerably, while a small decline in sales may reduce and even wipe out the EBIT. NO firm likes to operate under conditions of a high operating leverage as it creates a high risk situation. It is always safe for a firm to operate sufficiently above the break even point to avoid dangerous fluctuations in sales and profits.
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A firm with relatively high fixed costs uses much of its marginal contribution to cover fixed costs. It is interesting to note that beyond the break-even point, the marginal contribution is converted into EBIT. The operating leverage is highest near the break even point.
Operating Leverage= Marginal Contribution/EBIT
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Combined LeverageFinancial leverage is the result of financial
decisions. Operating leverage affects the income which is the result of production. Combined leverage focuses attention on the entire income of the concern. The risk factor should be properly assessed by the management before using the composite leverage.
Degree of composite leverage = Percentage change in EPS/Percentage change in sales
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Meaning of Working CapitalWorking capital refers to that part of total capital
which is required for meeting routine and repetitive expenses of day-to-day business operations e.g. working capital will stand invested in raw-materials and stock, debtors, cash and bank balance. Expenses like wages, salaries, rents, rates etc. are met from these sources.
In simple words it is the amount required for day-to-day running of the business. It can be aptly compared with a river which remains there every time but the water in it is constantly changing. That is why it is also called ‘fluctuating’ ‘revolving’ ‘floating’ ‘circulating’ capital.
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“Working capital means current assets.” ---Mead, Mallot and Field “The sum of the current assets is the working capital
of the business.”-----------J.S.Mill “Circulating capital means current assets of a
company that are changed in the ordinary course of business from one form to another, as for example from cash to inventories, inventories to receivables and receivables to cash.”---------------------Gerestenberg
“Working capital is descriptive of that capital which is not fixed. But the more common use of working capital is to consider it as difference between book value of the current assets and current liabilities.”----Hoagland
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From these definitions it can be observed that according to some authorities working capital is equal to the sum total of current assets, while according to others it is the excess of current assets over the current liabilities. To avoid this confusion two different concepts have come into existence.
1)Gross working capital: Which is equal to the some total of current assets.
2)Net working capital: Which is equal to the excess of current assets over current liabilities.
The modern view is increasingly in favour of net working capital.
That is why when we talk of working capital, it refers to the excess of current assets over current liabilities.
Classification/Kinds of Working CapitalPermanent or Regular working Capital 1)Permanent working capital 2)Reserve working capitalTemporary or Variable Working capital 1)Seasonal working capital 2)Special working capital
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Advantages of adequate Working CapitalIndex of sound liquidity position;Facility of cash discount;Prompt payment to suppliers; Easy loans from banks;Attractive dividends;Creation of goodwill;Meeting special needs;Survival during adverse business
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Factors Determining Working Capital RequirementsNature of business;Size of the business;Proportion of raw material cost to total
cost;Nature of industry;Time lag in production;Rapidity of turnover;Need for stock-piling;
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Terms and conditions of purchase and sale;
Requirements of cash;Relation with the banks;Policy regarding dividends;Seasonal variations;Cyclical fluctuations;Price level changes;Other factors.
Dangers of Redundant Working CapitalRedundant working capital denotes a
situation of too much or excessive working capital. Its existence is not a welcome sign as it reflects poor management of funds.
Lack of steady returnDistortions in current ratioReckless purchasingLack of activityAffects relations with banksChances of excessive bad debts
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Financing of Long-term working CapitalSharesDebenturesPublic DepositsRetained earnings Loans from Financial Institutions
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Financing of short-term Working CapitalIndigenous BankersTrade CreditInstalment CreditAdvancesFactoring/Accounts receivable creditAccrued ExpensesDeferred IncomesCommercial PapersCommercial banks
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Retained earnings or ploughing back of profits Retained earnings is a technique of financial
management under which all the profits of a company are not distributed among the shareholders as dividend, but a part of it is retained/reinvested in the company. This process of retaining profits year after year is known as ploughing back of profits.
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Necessity of Retained Earnings For the replacement of assets which have
become/will be obsolete. For the expansion and growth of business. For contributing towards the fixed as well
as working capital needs of the company. For making the company self-dependent of
finance from outside sources. For redemption of loan and debentures.
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Advantages of Retained Earnings:From Companies Point of ViewA Cushion to absorb the shocks of business
oscillations.Economical method of financingHelps on following stable dividend policyFlexible financial structureMakes the company self-dependentEnables to redeem the long-term liabilities
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From Shareholders point of view Increase in the value of shares Safety of Investment No dilution of control Evasion of super tax
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Disadvantages of Retained Earnings: Over-capitalization Creation of Monopolies Misuse of retained earnings Manipulation in the value of shares Evasion of Taxes Dissatisfaction among Shareholders
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Management of EarningsProcurement of adequate amount of capital,
although a significant task before management, is not the be-all and end-all of the entire duties of management.
As a matter of fact, the dexterity of management lies more in management of earnings than in procurement of capital. After obtaining the necessary amount of capital, the next important function is to invest and utilize the raised capital in such a way that the investors may get an adequate return and the capital too may remain intact.
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Efficient utilization of capital and the management of earnings are delicate issues. Prior to the distribution of profits in the form of dividends, a part is retained for the rainy days, in the form of reserves. Creation of ill-planned reserves, unsound depreciation policy and absence of scientific internal financial control are symbols of defective management of earnings and may even lead to liquidation.
Scope of management of earningsManagement of earnings includes:Determination of ProfitsDetermination of SurplusesCreation of ReservesProvision of DepreciationDeclaration of DividendRetained Earnings
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Sources of ProfitsIncome from BusinessIncome from other sourcesIncome from Investments
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Kinds and Sources of SurplusesEarned SurplusesCapital SurplusesSurpluses from Unrealised appreciation of
assetsSurpluses from realised appreciation of
assetsSurpluses from MergersSurpluses from reduction of Share CapitalSurpluses from Secret Reserves
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ReservesThe term Reserve refers to the amount set
aside out of profits. The amount may be set aside to cover any liability, contingency, commitment or depreciation in the value of the assets.
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Classification of ReservesGeneral ReservesSpecial ReservesCapital ReservesRevenue ReservesAssets ReservesLiability ReservesFunded ReservesSinking Fund ReservesSecret ReservesProprietary Reserves
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Dividend PolicyDividend refers to that part of the profit
which is distributed by the company among its shareholders.
It is the reward of the shareholders for investment made by them in the shares of the company. Whole of the profit cannot be distributed as dividend as the company has to make provision for its rainy days.
Dexterity of the management lies in striking a balance between dividend paid and the amount retained for the purpose of self financing.
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The dividend policy should be designed in such a fashion that the shareholders are not deprived of their due and the interests of the company are not adversely affected so far as future growth prospects are concerned. That dividend policy is considered satisfactory which permits distribution of regular dividends at a gradually increasing rate.
If a company earns huge profits in a particular year, it is advisable to increase the rate of dividend marginally.
Types of Dividend PoliciesRegular Dividend PolicyStable Dividend policyIrregular Dividend policyNo dividend Policy
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Forms of DividendsCash DividendBond Dividend/Scrip DividendProperty DividendStock Dividend
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Considerations in dividend policy Legal restrictions Magnitude and trend of earnings Desire and type of shareholders Nature of industry Age of the company Future financial requirements Government’ economic policy Taxation policy Inflation Control objectives Requirements of institutional investors Stability of dividends Liquid resources
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Forms of Dividend Theories:The Irrelevance Concept of Dividend
or the Theory of Irrelevance 1)Residual Approach 2)Modigliani and Miller Approach(MM
Model)The Relevance Concept of Dividend or
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Bonus SharesWhen a company has huge accumulated
reserves, it may decide to distribute a part of these reserves among its equity shareholders.
No company will generally like to distribute these reserves in the form of cash, as it may adversely affect its working capital position. Therefore, in lieu of such reserves, shares are issued which are called bonus shares. This process of issuing bonus shares is also called capitalisation of reserves
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Sources of Bonus Shares Balance in Profit and Loss Account General Reserve Capital Reserve Share Premium account(received in cash) Balance in sinking fund for redemption of debentures, after
debentures have been redeemed Development rebate reserve, development allowance
reserve etc. allowed under Income Tax Act, 1961 after the expiry of a specified period i.e. 8years.
Capital redemption reserve account Other free revenue reserves Share premium and CRR can only be used to issue
fully paid bonus shares.
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Advantages of Bonus Shares From Company’s point of view Helps to get rid of market influences Helpful in showing correct earning capacity Liquidity position is not effected Enhanced creditworthiness Decreased rate of dividend has positive impact on
employees and consumers Realistic picture of capital structure in Balance Sheet
When a company pays bonus to its shareholders in the value of shares and not in cash, its liquid resources are maintained and working capital is not affected
It is cheaper method of raising additional capital for the expansion of the business.
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From shareholders’ point of viewThe bonus shares are permanent source of
income to the investors.The investors can easily sell these shares and
get immediate cash, if they desire so.Even if the rate of dividend falls, the total
amount of dividend may increase as the investor gets dividend on a large number of shares.
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Disadvantages of Bonus SharesThe reserves of the company after bonus
shares decline and leaves lesser security to the investors.
The fall in future rate of dividend results in the fall of the market price of shares.
The issue of bonus shares leads to a drastic fall in the future rate of dividend.
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Corporate RestructuringRestructuring is the corporate management term for the
act of partially dismantling and reorganizing a company for the purpose of making it more efficient and therefore, more profitable. It generally involves selling off portions of the company and making severe staff reductions.
Restructuring is often done as part of a bankruptcy or of a takeover by another firm, particularly a leveraged buyout by a private equity firm. It may also be done by a new CEO hired specifically to make the difficult and controversial decisions required to save or reposition the company.
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CharactersticsThe selling of portions of the company, such as a division
that is no longer profitable or which has distracted management from its core business, can greatly improve the company's balance sheet.
Staff reductions are often accomplished partly through the selling or closing of unprofitable portions of the company and partly by consolidating or outsourcing parts of the company that perform redundant functions (such as payroll, human resources, and training) left over from old acquisitions that were never fully integrated into the parent organization.
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Other characteristics of restructuring can include: Changes in corporate management (usually with golden
parachutes) Sale of underutilized assets, such as patents or brands Outsourcing of operations such as payroll and technical
support to a more efficient third party Moving of operations such as manufacturing to lower-cost
locations Reorganization of functions such as sales, marketing, and
distribution Renegotiation of labor contracts to reduce overhead Refinancing of corporate debt to reduce interest payments A major public relations campaign to reposition the company
with consumers
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ResultsA company that has been restructured effectively will
generally be leaner, more efficient, better organized, and better focused on its core business. If the restructured company was a leverage acquisition, the parent company will likely resell it at a profit when the restructuring has proven successful.
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Merger and acquisitons
Definition One plus one makes three: this equation is the special
alchemy of a merger or an acquisition . The key principle behind buying a company is to create
shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies - at least, that's the reasoning behind M&A. This rationale is particularly alluring to companies when times are tough.
Strong companies will act to buy other companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone.
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Distinction between Mergers and AcquisitionsAlthough they are often uttered in the same breath and
used as though they were synonymous, the terms merger and acquisition mean slightly different things.
When one company takes over another and clearly established itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer "swallows" the business and the buyer's stock continues to be traded.
In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated. This kind of action is more precisely referred to as a "merger of equals." Both companies' stocks are surrendered and new company stock is issued in its place
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ExampleFor example, both Daimler-Benz and Chrysler
ceased to exist when the two firms merged, and a new company, Daimler Chrysler, was created.
In practice, however, actual mergers of equals don't happen very often. Usually, one company will buy another and, as part of the deal's terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it's technically an acquisition.
Being bought out often carries negative connotations, therefore, by describing the deal as a merger, deal makers and top managers try to make the takeover more palatable.
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A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly - that is, when the target company does not want to be purchased - it is always regarded as an acquisition.
Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company's BOD , employees and shareholders.
By merging, the companies hope to benefit as follows : Staff reductions - As every employee knows, mergers
tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package.
Economies of scale Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders, companies have a greater ability to negotiate prices with their suppliers.
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Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.
Improved market reach and industry visibility - Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.
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That said, achieving synergy is easier said than done - it is not automatically realized once two companies merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes a merger does just the opposite. In many cases, one and one add up to less than two.
Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers. Where there is no value to be created, the CEO and investment bankers - who have much to gain from a successful M&A deal - will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the company by assigning it a discounted share price. We'll talk more about why M&A may fail in a later section of this tutorial.
Varieties of Mergers From the perspective of business structures, there is a whole
host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging:
Horizontal Merger- Two companies that are in direct competition and share the same product lines and markets.
Vertical Merger- A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker.
Market-extension merger - Two companies that sell the same products in different markets.
Product-extension merger - Two companies selling different but related products in the same market.
Conglomeration - Two companies that have no common business areas.
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There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors:
Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable.Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company.
Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.
Acquisitions As you can see, an acquisition may be only slightly different from
a merger. In fact, it may be different in name only. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another - there is no exchange of stock or consolidation as a new company. Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times, acquisitions are more hostile.
In an acquisition, as in some of the merger deals we discuss above, a company can buy another company with cash, stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business.
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Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable share.
Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved
Types of AcquisitionsAn acquisition can take the form of a purchase of the stock or other
equity interests of the target entity, or the acquisition of all or a substantial amount of its assets.
Share purchases - in a share purchase the buyer buys the shares of the target company from the shareholders of the target company. The buyer will take on the company with all its assets and liabilities.
Asset purchases - in an asset purchase the buyer buys the assets of the target company from the target company. In simplest form this leaves the target company as an empty shell, and the cash it receives from the acquisition is then paid back to its shareholders by dividend or through liquidation. However, one of the advantages of an asset purchase for the buyer is that it can "cherry-pick" the assets that it wants and leave the assets - and liabilities - that it does not. This leaves the target in a different position after the purchase, but liquidation is nevertheless usually the end result.
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Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the
companies. Various methods of financing an M&A deal exist:
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All shares deal A "merger" or "merger of equals" is often financed by an all stock
deal (a stock swap), known in the UK as an all share deal. Such deals are considered mergers rather than acquisitions because neither company pays money, and the shareholders of each company end up as the combined shareholders of the merged company. There are two methods of merging companies in this way:
one company takes ownership of the other, issuing new shares in itself to the shareholders of the company being acquired as payment, or
a third company is created which takes ownership of both companies (or their assets) in exchange for shares in itself issued to the shareholders of the two merging companies.
Where one company is notably larger than the other, people may nevertheless be wary of calling the deal a merger, as the shareholders of the larger company will still dominate the merged company.
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A company acquiring another will frequently pay for the other company by cash. Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder's shareholders alone.
Hybrids An acquisition can involve a cash and debt combination,
or a combination of cash and stock of the purchasing entity, or just stock. The Sears-Kmart acquisition is an example of a cash deal.
Sell Offs A sell off is a disinvestment technique wherein a
part of the organisation (such as a division or a product line) may be sold to a third party as a process of strategic planning. A firm may take such a decision to concentrate on its core business activities by selling non-core business. A sell off may be desirable:
1) To improve the liquidity position 2)To reduce business risk by selling high risk
activities 3)To concentrate on core business areas 4)To increase efficiency and profitability 5)To protect the firm from hostile takeovers etc.
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Notes: A sell-off may occur for many reasons. For
example, if a company issues a disappointing earnings report, it can spark a sell-off of that company's stock. Sell-offs also can occur more broadly. For example, when oil prices surge, this often sparks a sell-off in the broad market (say, the S&P 500) due to increased fear .
TAKEOVERTakeover means the acquisition of control of
shares in one company by another company or person or group of related companies or persons.
A Company is said to be taken over when acquiring company or the person is able to nominate the majority of members on the BOD of the company being acquired, on account of the voting power they command at the shareholders meeting.
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Methods of Takeover Friendly Takeover –Firstly a person or a
company intending to takeover another corporation can approach the existing controlling interest of that corporation ,for across the board negotiations and purchase.
This form of purchase of shares is generally referred to as consent takeovers or friendly takeovers.
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Hostile Takeovers –The second way is that of a person seeking control over a company, purchases the required number of shares from non- controlling shareholders in the open market.
This method normally involves purchasing of small holdings of small shareholders over a period of time at various places. As a strategy the purchaser keeps his identity a secret. This kind of takeovers are usually referred to as a hostile or violent takeovers .
Reasons/Benefits Of Mergers etc.Economies of scaleEconomies of scopeEconomies of vertical integrationComplementary resourcesTax shieldsUtilisation of surplus fundsManagerial effectivenessEliminating/Minimising inefficienciesIndustry consolidation
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• Some dubious reasons for mergers:1) Diversification2)Lower financing costs3)Increasing earnings per share
Factors affecting mergers
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Economic Value AddedEconomic Value Added (EVA) is often defined as the value of
an activity that is left over after subtracting from it the cost of executing that activity and the cost of having lost the opportunity of investing consumed resources in an alternative activity.
Peter Drucker has described Economic value added as “ A vital measure of total factor productivity, one that reflects all the dimension by which management can increase values.”
The underlying concept was first introduced by Eugen Schmalenbach, and the current theory was formulated by Joel M. Stern.
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EVA has been described as the unique measure, which acts as a basis of all financial management decisions.
Proponents of EVA say that it is a miracle that rejuvenates a company from top to bottom.
EVA is said to be the panacea that improves corporate governance, makes manager’s think, act and get paid like owners and re-engineers the financial management system to measure and reward value creating activities.
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In order to achieve the goal of wealth maximisation, a financial manger has the important function of creating economic value of the organization.
EVA is a financial tool, which provides to the organization, knowledge of how much value the company is adding above the total cost of capital. It is also a performance measurement that accounts for changes in share values.
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EVA makes managers act like share holders. It will provide the company after tax profits from operations minus the cost of all capital employed to produce those profits.
If the finance manager uses EVA it will help all corporate decisions. It brings about financial discipline in the company. It will harmonize decisions to maximize the wealth of the firm.
Calculating EVAIn the field of corporate finance, economic value added is
a way to determine the value created, above the required
return, for the shareholders of a company.EVA=Net operating profit after tax- Cost of
funds employed.If the business earns more than the cost
of funds employed, it denotes the creation of shareholders wealth and the business has added value and vice versa.
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Market Value AddedIn terms of market and book values
shareholders investment, market value added may be defined as the excess of market value over book value. It is also called shareholders value creation (SVC).
Does higher growth and accounting profitability lead to increased value to shareholders? Modern financial management posits that a firm must seek to maximize the shareholders value.
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Market value of the firm’s shares is a measurement of the shareholders wealth. It is the shareholders’ appraisal of the firm’s efficiency in employing their capital. The capital contributed by shareholders is reflected by the book value of the firm’s shares.
Market Value Added=Market value-Invested capital
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Invested capital or capital employed is the amount of equity capital and debt capital supplied by the firm’s shareholders and debt-holders to finance assets. The firm is said to have created value if MVA is positive; i.e. the firm’s MV is in excess of IC or CE.
There is conceptual problem with MVA. Considering the alternative opportunities of equivalent risk, the economic value of invested capital would be much higher today.
C A P MThe capital asset pricing model is a model
that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of an asset.
The required rate of return specified by CAPM helps in valuing an asset.
One can also compare the expected (estimated) rate of return on an asset with its required rate of return and determine whether the asset is fairly valued.
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The concepts of risk and return under CAPM
have intuitive appeal and they are quite simple to understand. Financial managers use these concepts in a number of financial decision-making processes such as valuation of securities, cost of capital measurement and investment risk analysis etc. In spite of all this CAPM suffers from some practical problems:
1) It is based on unrealistic assumptions.(see next slide)
2)It is difficult to test the validity of CAPM.3)Betas do not remain stable over time.
Assumptions of CAMP *Market efficiency-It implies that share price reflects
all available information.*Risk aversion and mean- variance optimization-
Investors are risk averse *Return and risk is evaluated in terms of variance and
standard deviation.*They prefer highest expectations for a given level of
risk.*Homogenous expectation –All investors have same
expectations about the expected returns and risks of the securities.
*Single time period- All investors’ decisions are based on a Single time period.
*Risk free rate - All investors can lend and borrow at a Risk free rate of interest.
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CAPM is based on a number of assumptions. Given these assumption, it provides a logical framework for measuring risk and linking risk and return.