Module Preparation Seminar (Part II) for Module B on Corporate Financing. Speaker Mr. Walter Lau

Transcription

1 Module Preparation Seminar (Part II) for Module B on Corporate Financing Speaker Mr. Walter Lau 25 October 2013

2 EXECUTIVE TRAINING COMPANY (INTERNATIONAL) LTD

3 About the Lecturer Mr Walter Lau ETC Lecturer QP MB & ACCA F7 BBA, FCCA, MSC Finance Extensive full time teaching experience in academic and professional programmes in the top universities Specialized in Corporate Financial and Financial Reporting Big Four and listed company experience Professional exam marker Experienced notes writer HKICPA speaker

4 Module B Corporate Financing Module Preparation Seminar on Major or Difficult Syllabus Topics (Part II) Working capital management Dividend policy Capital structure Business failure and insolvency

5 Module B Corporate Financing Working capital management Reference: LP Chapter 8

6 MB Working capital management Content 1. Working Capital Management 2. Objectives of Working Capital Management 3. Cash Operating Cycle 4. Working Capital Requirement 5. Working Capital Liquidity Ratios 6. Inventory Management (Refer to LP: JIT Procurement) 7. Receivables Management 8. Payables Management 9. Cash Forecasting 10. Cash and Treasury Management 11. Working Capital Funding Strategy (Refer to LP)

7 MB Working capital management 1. Working Capital Management Net Working Capital (NWC) = Current Assets - Current Liabilities The size of NWC has a direct effect on the liquidity of a business. Working capital management manages the relationship between current assets and current liabilities so cash flows and returns are acceptable. Effective working capital management ensures the firm s ability to operate and that it has sufficient cash available to meet its short and long-term requirements (servicing debt and covering operational expenses) 2. Objectives of Working Capital Management Liquidity (minimize the risk of insolvency) Profitability (maximize the return on assets) Consideration on the level of working capital depends on firms attitude (Conservative / Aggressive / Moderate approaches) and industry norms, production process, management-specific issues.

8 MB Working capital management 3. Cash Operating Cycle Cash operating cycle is the period of time that elapses between the point when cash starts to be spent on the production of a product and the collection of cash from a purchaser.

9 MB Working capital management 3. Cash Operating Cycle Example: A company buys raw materials from suppliers on 75 days' credit. The raw materials remain in inventory for 30 days and it takes the company 60 days to produce its goods. The goods are sold within 10 days of completion of production and customers take on average 45 days to make payment. Activity Financing is required for 145 days in total but 75 of these days are financed by the period of time taken to pay suppliers. Time (Days) Average time that raw materials remain in inventory 30 Period of credit taken from suppliers (75) Time taken to produce the goods 60 Time goods remain in finished inventory 10 Time taken by customers to pay for the goods 45 Cash operating cycle 70

10 MB Working capital management 3. Cash Operating Cycle Ways to manage the length of cash operating cycle Inventory minimise the holding of raw materials and finished goods ensure production processes are efficient Just-in-time procurement (Please refer to LP) Receivables Early settlement discounts (the benefit of interest cost of overdraft should exceed the cost of discount allowed) Factoring Invoice discounting Payables Trade credit from suppliers (without a loss on goodwill/ discount) Careful consideration before taking early settlement discounts

11 MB Working capital management 4. Working Capital Requirement Example: The following data relate to Corn, a manufacturing company. Sales revenue for the year $1,500,000 Costs as percentages of sales % Direct materials 30 Direct labour 25 Variable overheads 10 Fixed overheads 15 Selling and distribution 5

12 MB Working capital management 4. Working Capital Requirement Example: On average a) Debtors take 2.5 months before payment b) Raw materials are in inventory for three months c) Work-in-progress represents two months worth of half-produced goods d) Finished goods represent one month's production e) Credit is taken as follows (i) Direct materials: 2 months (ii) Direct labour: 1 week (iii) Variable overheads: 1 month (iv) Fixed overheads: 1 month (v) Selling and distribution: 0.5 months Work-in-progress and finished goods are valued at material, labour and variable expense cost.

13 MB Working capital management 4. Working Capital Requirement Example: Compute the average working capital requirement of Corn assuming the labour force is paid for 50 working weeks a year. Working capital is defined for the purpose of this exercise as inventories (raw materials, work in progress and finished goods) plus receivables minus current liabilities.

14 MB Working capital management 4. Working Capital Requirement Example: Answer (a) The annual costs incurred will be as follows: $ Direct materials 30% $1,500, ,000 Direct labour 25% $1,500, ,000 Variable overheads 10% $1,500, ,000 Fixed overheads 15% $1,500, ,000 Selling and distribution 5% $1,500,000 75,000

15 MB Working capital management 4. Working Capital Requirement Example: Answer (b) The average value of current assets will be as follows: $ $ Raw materials 3/12 $450, ,500 Work-in-progress Materials (50% complete) 1/12 $450,000 37,500 Labour (50% complete) 1/12 $375,000 31,250 Variable overheads (50% complete) 1/12 $150,000 12,500 81,250 Finished goods Materials 1/12 $450,000 37,500 Labour 1/12 $375,000 31,250 Variable overheads 1/12 $150,000 12,500 81,250 Receivables 2.5/12 $1,500, , ,500

16 MB Working capital management 4. Working Capital Requirement Example: Answer (c) Average value of current liabilities will be as follows: $ Materials 2/12 $450,000 75,000 Labour 1/50 $375,000 7,500 Variable overheads 1/12 $150,000 12,500 Fixed overheads 1/12 $225,000 18,750 Selling and distribution 0.5/12 $75,000 3, ,875 Answer (d) Working capital required is ($(587, ,875)) = 470,625

17 MB Working capital management 5. Working Capital Liquidity Ratios Liquidity Current Ratio = Current assets / Current liabilities Quick Ratio = (Current Assets Inventories) / Current Liabilities Periods (days) AR Settlement Period = (Trade Receivable / Credit Sales Revenue) x 365 Finished Goods(FG) Holding Period = (Avg. FG Inv./ Cost of Sales) x 365 Raw Materials(RW) Holding Period = (Avg. RW Inv./ Annual Purchase) x 365 Production/ WIP Period = (Avg. WIP/ Cost of Sales) x 365 AP Payment Period = (Avg. Trade Payable / Cost of Sales) x 365 Efficiency Sales/ Net Working Capital = Sales Revenue/(Current Assets - Current Liabilities)

18 MB Working capital management 5. Working Capital Liquidity Ratios Symptoms of Overtrading a) Rapid increase in sales revenues b) Fast and dramatic increase in the volume of current assets (and possibly non-current assets) c) Rate of increase in inventories and accounts receivable is greater than the rate of increase in sales revenues d) Only a small increase in shareholders' equity with most of the increase in assets financed by short-term credit, mainly trade accounts payable (payment period likely to lengthen) and bank overdraft (often reaching or exceeding the agreed facility) e) Some ratios alter dramatically, for example the proportion of total assets financed by shareholders' equity falls and the proportion financed by credit rises and the current and acid test ratios fall f) The business might be illiquid (i.e. current liabilities are greater than current assets).

19 MB Working capital management 6. Inventory Management Motives for holding inventory a) Transaction motive (i.e. purchase in bulk to obtain trade discount) b) Precautionary motive (i.e. inventory is held in case the business receives a sudden customer order or a risk regarding future deliveries of inventory arises) c) Speculative motive (i.e. inventory has been bought to hedge against future price rises) Costs relating to inventory Purchase/production cost of inventory: Production Cost (PC) x Demand (D) Holding/carrying/storage cost: Holding Cost (HC) x Order Quantity (Q) / 2 Ordering/procuring cost: Order Cost (OC) x Demand (D) / Order Quantity (Q) Shortage/stock-out costs (SC) Total Cost = (PC x D) + (HC x Q/2) + (OC x D/Q)

20 MB Working capital management 6. Inventory Management Economic Order Quantity (EOQ) Optimal ordering quantity for an item of inventory that will minimise costs. Total Cost = (PC x D) + (HC x Q/2) + (OC x D/Q) Partial differentiate the total cost curve with respect to Q and set to 0 then solve for Q, i.e. Assumptions: Ordering cost is constant. Rate of demand is known, and spread evenly throughout the year. Lead time is fixed. Purchase price of the item is constant i.e. no discount is available Replenishment is made instantaneously, the whole batch is delivered at once. Only one product is involved.

21 MB Working capital management 6. Inventory Management Economic Order Quantity (EOQ) with Discount Where a bulk discount is available and the required order quantity is greater than the EOQ, the EOQ will be determined through the following steps: Step 1 Calculate EOQ, ignoring discount. Step 2 If this is below the level for discount, calculate the total annual I nventory cost (i.e. OC + HC). Step 3 Recalculate total annual inventory costs using the order size required to just obtain the discount. Step 4 Compare the cost of Step 2 and Step 3 to the saving from the discount and select the minimum cost alternative. Step 5 Repeat for all discount levels until the maximum saving in cost is achieved and the ordering quantity will be the ultimate EOQ.

22 MB Working capital management 6. Inventory Management Economic Order Quantity (EOQ) with Discount Example: Demand = 30,000; Unit Cost = $120; Order Cost = $2,500; Holding Cost = 20% of Unit Cost = $120 x 0.2 = $24 The supplier offers to give 2% discount for ordering at least 2,500 units. Should the firm take the offer? Without Offer Order Quantity EOQ = 2,500 5,000 Number of order per year (D/Q) 12 6 With Offer Inventory cycle (52 weeks/ no. of order) 4.33 weeks 8.67 weeks Total Cost = HC+OC (ignore product cost) $60,000 $73,800

23 MB Working capital management 6. Inventory Management Re-Order Level Uncertainties in demand and lead times taken to fulfil orders mean that inventory will be ordered once it reaches a re-order level (ROL). Inventory levels might fluctuate with this system. The x points show the ROL at which a new order is placed, with the number of units ordered each time being the EOQ.

24 MB Working capital management 6. Inventory Management Re-Order Level Use of a re-order level builds in a measure of safety inventory and minimises the risk of the organisation running out of inventory. The average annual cost of such a safety inventory is: Quantity of safety inventory (units) holding cost per unit per annum Inventory Level: Maximum inventory level = ROL + ROQ (min. usage min. lead time) Minimum inventory level = ROL (avg. usage avg. lead time). Average inventory = Minimum inventory level + ROL/2 Annual stock-out cost = Cost of one stock-out Expected number of stock-outs per order Number of orders per year

25 MB Working capital management 6. Inventory Management Example: Re-Order Level Maximum consumption = 2000 Units per Week Normal Consumption = 1500 Units Minimum Consumption = 1000 Units Delivery Time = 8 to 10 weeks Re-order Level = 20,000 Units Minimum Level = 20,000 - (1,500 X 9) = 20,000 13,500 = 6,500 units

26 MB Working capital management 7. Receivables Management A balance between profit improvement from sales obtained by allowing credit and the cost of the credit allowed to customers. The cost of offering credit is the interest charged on an overdraft to fund the period of credit, or the interest lost on the cash not received and deposited in the bank. Decisions involved in receivables management: 1. Assessment of creditworthiness (new customer check/ rating agency) 2. Managing accounts receivable (aging/ utilisation report) 3. Extending additional credit (Example 1) 4. Collection of receivables (collection procedure) 5. Offering early settlement discounts (Example 2) 6. Monitoring bad debts risk 7. Receivables Financing: Factoring / Invoice Discounting (Example 3) 8. Further consideration on foreign trade (LC/ Trade Insurance)

27 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit The management of a company are considering a change of credit policy that will increase the average collection period from 1 to 2 months. The relaxation in credit is expected to produce an increase in sales in each year amounting to 25% of the current sales volume. The company's products sell at a contribution ratio of 15% and current sales are $240m. The required rate of return on investments is 20%. Assuming that the 25% increase in sales would result in additional inventories of $10m and additional accounts payable of $2m, advise the company on whether or not to extend the credit period offered to customers if: a) all customers take the longer credit of two months. b) existing customers do not change their payment habits and only the new customers take the extended credit.

28 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit Answer (a): The additional investment required, if all accounts receivable take two months' credit is as follows: $m Average accounts receivable after the sales increase (2/12 $300m) 50 Less current average accounts receivable (1/12 $240m) (20) Increase in accounts receivable 30 Increase in inventories 10 Less increase in accounts payable (2) Net increase in working capital investment 38

29 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit Answer (a) (Cont d): Increase in sales revenue is $60m and at a contribution ratio of 15%, this is an increase in contribution of $9m. The change in credit policy is justifiable if the rate of return on the additional investment in working capital exceeds 20%. The return on extra investment if all accounts receivable take two months' credit is: $9m/ $38m = 23.7% > 20%, Good to go!!

30 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit Answer (b): The additional investment required, if only new customers take two months' credit is as follows: $m Average accounts receivable after the sales increase (2/12 $60m) 10 Increase in accounts receivable 10 Increase in inventories 10 Less increase in accounts payable (2) Net increase in working capital investment 18 The return on extra investment if only new customers take two months' credit is: $9m/ $18m = 50.0% > 20% Good to go!!

31 MB Working capital management 7. Receivables Management Example 2: Offering Settlement Discounts A company has annual credit sales of $30m with two months being the usual credit period given to customers. Not all customers, however, adhere to the policies as evidenced by the actual receivables ageing record as follows: Actual credit term % of customers 2 months 60 3 months 40 Average collection period is therefore = (2 0.6) + (3 0.4) = 2.4 months

32 MB Working capital management 7. Receivables Management Example 2: Offering Settlement Discounts The company's management decide to offer a 15% discount for payments made within 14 working days (assuming one year = 350 working days) of the invoice being raised and to reduce the maximum time allowed for payment to one month. It is estimated that 80% of customers will take the discount and the remainder will use the existing credit terms. If such a scheme is offered to customers, sales will increase by 20% (at a contribution margin of 30%) and bad debts will be reduced from 10% to 6% of credit sales. The company requires a 25% per annum return on investment. Is implementation of the early settlement discount scheme worthwhile in financial terms?

33 MB Working capital management 7. Receivables Management Example 2: Offering Settlement Discounts Answer: Without discount $m With discount $m Benefits Contribution earned 9 $30m x 1.2 x 30% 10.8 Costs Discount given - $30m x 1.2 x 0.8 x 15% (4.32) Bad debts ($30m x 10%) (3) $30m x 1.2 x 6% (2.16) Cost of working capital invested ($30m x 2.4/12 x 25%) (1.5) $30m x 1.2 x 0.8 x 14/350 x 25% $30m x 1.2 x 0.2 x 3/12 x 25% The company should not adopt the early settlement discount scheme, as it results in a net decrease in benefits of $0.92 million. (0.29) (0.45) Net benefits

34 MB Working capital management 7. Receivables Management Example 3: Factoring A company makes annual credit sales of $200m. Credit terms are one month, but its debt administration has been poor and the average collection period has been two months with 2% of sales resulting in bad debts which are written off. A non-recourse factor would take on the task of debt administration and credit checking, at an annual fee of 6% of sales receipts. The company would save $8m a year in administration costs. The factor would also provide an advance of 75% of invoiced debts at once at an interest rate of 3% above the current base rate which is at 10% and the remaining 25% is payable in normal credit term. The company normally obtains an overdraft facility to finance its debtors at a rate of 2% over base rate. Assuming constant monthly turnover, should the factor's services be accepted?

35 MB Working capital management 7. Receivables Management Example 3: Factoring Answer: Benefits $m Costs $m Savings in cost of finance ($200m x 2/12 x 0.12) Bad debts avoided ($200m x 0.02) Savings Administration costs Factoring charges ($200m x 0.06) Cost of finance from the factor ($200m x 0.75 x 1/12 x 0.13) Cost of finance from the bank ($200m x 0.25 x 1/12 x 0.12) The factoring services should be accepted as there is a net benefit of $1.87 million.

36 MB Working capital management 8. Payables Management To seek satisfactory credit terms from suppliers, getting credit extended during periods of cash shortage, and maintaining good relations with suppliers.. Costs of making maximum use of trade credit include the loss of suppliers' goodwill, and loss of any available cash discounts for the early payment of debts. The cost of taking advantage cash discounts can be calculated by comparing the saving from the discount with the opportunity cost of investing the cash.

37 MB Working capital management 8. Payables Management Example: Early Payment Discount A company has annual credit purchases of HK$20m from its major supplier. The credit terms are payment must be made in 60 days of the invoice without discount but a cash discount of 4% will be given if payment is made within 10 days of the invoice. The company's required return on investment is at 15% per annum. Is the cash discount of 4% worth undertaking from a financial viewpoint? It is cheaper to accept the discount.

38 MB Working capital management 8. Payables Management Example: Early Payment Discount Answer: Taking discount $m Early payment ($20m x 0.96) 19.2 Refusing discount Payment made 20 Return earned ($20m x 0.15 x 50/365) (0.41) It is cheaper to accept the discount.

39 MB Working capital management 9. Cash Forecasting Cash flow forecasts show the expected receipts and payments during a forecast period and are a vital management control tool, especially during times of recession. Motives for companies to hold cash a) Transaction Motive b) Precautionary Motive c) Speculative Motive Cash Flow Problems Continual losses being incurred Inflation Non-current assets/ working capital increase in time of growth Seasonal or cyclical sales A single non-recurring item of expenditure

40 MB Working capital management 10. Cash and Treasury Management Baumol model (Optimal Cash Holding Level) The Baumol model uses an equation of the same form as the EOQ formula and, similarly to the EOQ, costs are minimised when: Drawback of Baumol model: a) It is difficult to predict amounts required over future periods with much certainty in reality. b) There is no buffer inventory of cash allowed for and there may be costs associated with running out of cash. c) There may be other normal costs of holding cash which increase with the average amount held.

41 MB Working capital management 10. Cash and Treasury Management Example: Baumol model A company requires $480,000 of cash over each period of one year for the foreseeable future and is considering two alternatives: Option (1) Option (2) Taking up a bank loan of $480,000 at once for a one-year period at an interest rate of 12% per annum on the initial balance Sale of existing securities which will incur a transaction fee of $1,000 based on the Baumol model (the return from the securities investment is currently at 15% per annum) Any fund/cash not in use will be placed in a call deposit at 9% per annum. Which of the two options is financially better to undertake?

42 MB Working capital management 10. Cash and Treasury Management Example: Baumol model Answer: Option (1) Option (2) Annual cash required $0.48m $0.48m Cash to be raised/cycle $0.48m Number of cycles/year 1

43 MB Working capital management 10. Cash and Treasury Management Example: Baumol model Answer: Total costs per annum under each option ($): Option 1 $m Option 2 $m Interest payable ($0.48m x 0.12) Lost return on investment ($0.48m/2) x 0.09 (57,600) (21,600) Ordering cost ($1,000 x 4) Holding cost ($0.48m/2) x 0.15 Return on investment ($126,491/2) x 0.09 Option (2) should be chosen, as its total cost is marginally lower than option (1). 4,000 36,000 (5,700) Total cost 36,000 34,300

44 MB Working capital management 10. Cash and Treasury Management Miller-Orr Model Miller-Orr model manages to achieve a fair degree of realism. Since the cash balance is likely to meander upwards or downwards. Miller-Orr model does no attempt to manage cash balances but imposes limits to this meandering. a) The cash balance held should always be close to a normal level / return point (RP). b) If the cash balance increases and reaches an upper limit (UL), firms should buy/invest sufficient securities to utilise the excess cash and bring cash balance back to the RP. c) If the cash balances decreases and reaches a lower limit (LL), firms should sell/dispose of sufficient securities to bring the balance back to the RP.

45 MB Working capital management 10. Cash and Treasury Management Miller-Orr Model Upper Limit = Lower limit + 1 Spread Lower Limit is to be set by management Example: Lower limit = $8,000; Variance = 4,000,000 (Standard Deviation = 2,000) Transaction cost = $50; Interest Rate = 0.025% per day Spread = $25,303 Upper Limit = Lower limit + Spread = $8,000 + $25,303 = $33,303 Return Point = Lower limit + 1/3 Spread = $16,433

46 MB Working capital management

47 MB Working capital management

48 MB Working capital management

49 Module B Corporate Financing Dividend policy Reference: LP Chapter 10

50 MB Dividend Policy Content 1. Dividends 2. Relationship between financial strategy and dividend policy 3. Theories of dividend policy 4. Practical factors influencing dividend policy 5. Other forms of dividend 6. A framework for analysing dividend policy

51 MB Dividend policy 1. Dividends Shareholders Wealth = Dividends + Capital Gain (- Loss) Dividends are an allocation of company profits to the shareholders. Dividend policy determines the proportion of profits (if any) paid to the shareholders and the amount retained for internal financing of new long-term projects.

52 MB Dividend policy 2. Relationship between financial strategy and dividend policy Different views on dividend policy a) Investors view dividend policy as a positive indicator of a company's profit expectations. b) Companies reinvest their profits via capital expenditure while others may wish to build cash reserves in times of economic hardship. c) Investors may rely on income from dividends thus companies try to ensure consistent dividends as part of managing investor relations. Corporate policy related to dividend 1. Target dividend payout ratio (short term / long term) 2. Consistent dividends in dollar term 3. Reluctant to make changes to current dividend policy

53 MB Dividend policy 3. Theories of dividend policy Residual Theory If a company can identify projects with positive NPVs, it should invest in them, and only when these investment opportunities are exhausted should dividends be paid. Traditional View The dividends a company pays may be treated as a signal to investors. A company needs to take account of different clienteles of shareholders and their preference for dividends or capital growth in deciding what dividends to pay.

54 MB Dividend policy 3. Theories of dividend policy Irrelevancy Theory Modigliani and Miller (MM) proposed that in a tax-free world, shareholders are indifferent between dividends and capital gains. The value of a company is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets and investments. Reasons: a) It is information provided by the dividends with respect to future earnings which causes shareholders to bid up (or down) the share price, not the dividend itself. b) Shareholders have sacrificed future dividends in order to receive a dividend now. c) One clientele would be entirely as good as another in terms of the valuation it would imply for the firm

55 MB Dividend policy 3. Theories of dividend policy Irrelevancy Theory Criticisms against MM s view : a) Differing rates of taxation on dividends and capital gains can create a preference b) Companies prefer dividend retention in a period of capital rationing c) Under imperfect markets and liquidity concern, shareholders might need high dividends for funds to invest in other opportunities. d) With transaction costs on the sale of shares, investors prefer to receive dividends rather than to sell their shares to get the cash they want. e) Information available to shareholders is imperfect, and they are not aware of the future investment plans and expected profits of their company. f) Shareholders may prefer a current dividend to future capital gains (or deferred dividends) because the future is more uncertain ( Bird in the hand )

56 MB Dividend policy 4. Practical factors influencing dividend policy a) Feasibility to raise extra external finance b) Liquidity position c) Due date of outstanding debt obligation d) Dividend restraints imposed by loan agreements e) Required gearing level f) Signalling effect of dividends g) Inflation h) Law on distributable profits i) Profitability j) Economic instability and turbulence: conservative dividend policy to improve balance sheet flexibility and provide a source of internal finance

57 MB Dividend policy 5. Other forms of dividends Scrip dividends: dividend paid by the issue of additional company shares, rather than in cash. Stock split: the larger number of shares with lower market value might improve the marketability of the shares. Shares repurchases: purchase by a company of its own shares can take place for various reasons and must be in accordance with any requirements of legislation

58 MB Dividend policy 5. Other forms of dividends Example of dividend alternatives The board of directors of Alligo Company is discussing the level and nature of the company's next dividend payment. Alligo's current share price is $40 cum div. Three options are under consideration: 1) A cash dividend of $1.50 per share 2) A 5% scrip dividend 3) The company repurchases 10% of the ordinary share capital at the current market price and pays a cash dividend as in (1) above Calculate the expected effect of each suggestion on a shareholder in Alligo owning 1,000 shares (and whose current wealth cum div is therefore 1,000 shares at $40 = $40,000) explaining how accurate estimates are likely to be. Ignore taxation.

59 MB Dividend policy 5. Other forms of dividends Example of dividend alternatives Summary excerpts from the accounts of Alligo are as follows: Income statement $m Revenue 1,500 Operation profit 50 Net interest earned Taxation 31 Available to shareholders 159

60 MB Dividend policy 5. Other forms of dividends Example of dividend alternatives Summary excerpts from the accounts of Alligo are as follows: Statement of Financial Position Non-current assets (net) 600 Current assets Inventories 200 Receivables 200 Cash and cash equivalents Less: current liabilities (300) 1,100 Shareholders equity 200 Share capital (40 million shares) 900 Retained earnings 1,100 $m

61 MB Dividend policy 5. Other forms of dividends Example of dividend alternatives Answer (1): After a cash dividend is paid the expected wealth is $ 1,000 shares at $ ,500 Cash dividend 1,000 at $1.50 1,500 40,000

62 MB Dividend policy 5. Other forms of dividends Example of dividend alternatives Answer (2): A 5% scrip dividend would mean the issue of two million new shares. The total market value of the company of 40 million shares at $40 or $1,600 million would be unchanged, but would now be split between 42 million shares leading to a new expected share price of: $1,600m / 42m shares = $38.10 The shareholder would receive 50 new shares, giving 1,050 in total. The expected wealth of the shareholder would be unchanged at 1,050 $38.10 = $40,000.

63 MB Dividend policy 5. Other forms of dividends Example of dividend alternatives Answer (3): The company repurchases 10% of the ordinary share capital at the current market price and pays a cash dividend as in (1) above Repurchase of 10% of the ordinary share capital would cost $1,600m 10% = $160 million, presumably from the cash at bank. This would reduce the company s value by $160 million, but the share price would be expected to remain unchanged. $1,440m / 36m shares = $40

64 MB Dividend policy 6. A framework for analysing dividend policy The Aswath Damadaran framework asks 2 questions to analyse dividend policy: 1) How much cash is available to be paid out as dividends and how much of that cash is actually paid out to shareholders? 2) How good are the investment projects available to the company?

65 MB Dividend policy

66 Module B Corporate Financing Capital structure Reference: LP Chapter 14

67 MB Capital structure Content 1. Gearing 2. Effect on shareholders wealth 3. Capital structure decision 4. The FRICT framework 5. Summary

68 MB Capital structure 1. Gearing Gearing is the amount of debt finance a company uses relative to its equity finance. Debt finance tends to be relatively low risk for the debt holder as it is interest-bearing and can be secured. The cost of debt to the company is therefore relatively low. The greater the level of debt, the more financial risk (of reduced dividends after the payment of debt interest) to the shareholder of the company, so the higher is their required return. Financial gearing measures the relationship between shareholders' funds and prior charge capital. Operational gearing measures the relationship between contribution and profit before interest and tax.

69 MB Capital structure 1. Gearing Ratios Ability to raise debt when: a) The company is in a healthy competitive position. b) Cash flows and earnings are stable. c) Profit margins are reasonable. d) Operational gearing is low e) Bulk of the company's assets are tangible. f) Liquidity and cash flow position is strong. g) Debt-equity ratio is low. h) Share prices are low.

70 MB Capital structure 2. Effect on shareholder wealth a) If the returns on capital in excess of the interest payable on debt, financial gearing will raise the EPS. b) Gearing will, however, increase the variability of returns for shareholders and increase the chance of corporate failure. EPS as an evaluation of a finance plan One measure of gearing uses earnings per share The indifference points between any two methods of financing can be determined by solving for operating profit

71 MB Capital structure 2. Effect on shareholder wealth Example 1: EPS and financing option A company has 10,000 million shares in issue and wants to raise $5,000m to fund an investment by either: a) issuing and selling 2,500m shares at $2 each or b) issuing $5,000m 10% loan stock at par The income tax rate is 40%. In order to calculate the indifference point between issuing equity shares and issuing debt, we use the above equation. OP = 2,500

72 MB Capital structure 2. Effect on shareholder wealth Example 1: EPS and financing option Proof: At a level of operating profit above $2,500 million, it will be better to issue debt, as every $ extra of earnings will be distributed between fewer shareholders. At a level of operating profit below $2,500 million, it will be better to issue equity, as the loss of each $ will be by more shareholders. Issues equity Issues debt $m $m Operating profit 2,500 2,500 Interest (500) Profit before tax 2,500 2,000 Tax (1,000) (800) Earnings after tax 1,500 1,200 Number of shares 12,500 10,000 Earning per share $0.12 $0.12

73 MB Capital structure 2. Effect on shareholder wealth Effect on other ratios when EPS falls due to debt If EPS falls because of an increased burden from increased gearing, an increased P/E ratio will indicate that the market views positively the projects that the increased gearing will fund. a) To maintain levels of dividend cover by a reductions in dividend. b) To maintain dividend levels, in which case dividend cover will fall, indicating an increased risk that the company will not be able to maintain the same dividend payments in future years, should earnings fall. If the additional debt finance is to be used to generate good returns in the longterm, the dividend yield might fall significantly in the short-term, but increase in the market price reflecting market expectations of enhanced long-term returns.

74 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing A summarised statement of financial position of Rufus is as follows: $m Assets less current liabilities 150 Debt capital (70) 80 Share capital (10 million shares) 20 Reserves 60 80

75 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing The company's profits in the year just ended are as follows: $m Profit from operations 21 Interest 6 Profit before tax 15 Taxation at 16.5% 4.5 Profit after tax (earnings) 10.5 Dividends 6.5 Retained profits 4

76 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing The company is now considering an investment of $25 million. This will add $5 million each year to profits before interest and tax. a) There are two ways of financing this investment. One would be to borrow $25 million at a cost of 8% per annum in interest. The other would be to raise the money by means of a 1-for-4 rights issue. b) Whichever financing method is used, the company will increase dividends per share next year from 65c to 70c. c) The company does not intend to allow its gearing level, measured as debt finance as a proportion of equity capital plus debt finance, to exceed 55% as at the end of any financial year. In addition, the company will not accept any dilution in earnings per share.

77 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing Assume that the rate of taxation will remain at 16.5% and that debt interest costs will be $6 million plus the interest cost of any new debt capital. a) Produce a profit forecast for next year, assuming that the new project is undertaken and is financed (i) by debt capital or (ii) by a rights issue. b) Calculate the earnings per share next year, with each financing method. c) Calculate the effect on gearing as at the end of next year, with each financing method. d) Explain whether either or both methods of funding would be acceptable.

78 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing Answer: If the project is financed by $25 million of debt at 8%, interest charges will rise by $2 million. If the project is financed by a 1-for-4 rights issue, there will be 12.5 million shares in issue.

79 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing Answer: Finance with debt Finance with rights issue $m $m Profit before interest and tax (+ 5.0) Interest Taxation (16.5%) Profit after tax Dividends (70c per share) Retained profits Earnings (profits after tax) $12.6m $14m Number of shares 10m 12.5m Earnings per share $1.26 $1.12

80 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing Answer: Assets less current liabilities (150 + new capital 25 + retained profits) Finance with debt Finance with rights issue $m $m Debt capital (95) (70) Share capital Reserves Debt capital Debt capital plus equity finance ( ) ( ) Gearing 53% 39%

81 MB Capital structure 2. Effect on shareholder wealth Example 2: Gearing Answer: Either financing method would be acceptable, since the requirements for no dilution in EPS would be met with both rights issue and borrowing, and the requirement for the gearing level to remain below 55% is (just) met even if the company were to borrow the money.

82 MB Capital structure 3. Capital Structure Decisions The Traditional View The cost declines initially and then rises as gearing increases. The optimal capital structure will be the point at which WACC is lowest. The Modigliani-Miller (MM) Model a) In the absence of tax, a company's capital structure would have no impact upon its WACC. b) The tax relief on interest payments (the tax shield) lowers the cost of debt and hence the weighted average cost of capital. As a result MM claimed that as debt finance is increased the WACC would continue to fall, up to gearing of 100%. The lower a company's WACC, the higher the NPV of its future cash flows and the higher its market value.

83 MB Capital structure 3. Capital Structure Decisions Market Imperfection In practice, the existence of bankruptcy risk, agency costs and tax exhaustion prevent the levels of debt (100%) as advocated by MM. Pecking Order Theory Companies will prefer retained earnings to any other source of finance, and then will choose debt, and last of all equity. The order of preference will be: retained earnings straight debt convertible debt preference shares equity shares

84 MB Capital structure 4. The FRICT framework The FRICT framework, (Flexibility, Risk, Income, Control and Timing) is a useful tool for analysing capital structure issues that arise when a firm raises long-term finance and is faced with several alternatives. Flexibility How many financing options does the firm have? Risk How much additional financial risk can the firm afford? Income Can obligations be met as they fall due? Control If debt finance were raised, would the covenants imposed be too restrictive? Timing Will one alternative that is available today be less accessible in the future?

85 MB Capital structure 5. Summary Other capital structure considerations include: understanding the advantages and disadvantages of share issues as a source of funds long run viability of the company managerial conservatism lending and rating agency attitudes borrowing capacity/availability maintenance of control of the company by management, rather than by lenders asset structure of the company growth rate of the company profitability of the company taxation costs.

86 MB Capital structure

87 Module B Corporate Financing Business failure and insolvency Reference: LP Chapter 20

88 MB Business failure and insolvency Content 1. Introduction 2. Cause of excessive debt or solvency problems 3. Common problem areas within finance and treasury 4. Action to resolve common problem areas 5. Business failures 6. Methods of predicting corporate failure 7. Insolvency

89 MB Business failure and insolvency 1. Introduction There are many common reasons for business failure including bad management, weak capital structure and poor financial management. a) Companies that are making losses may be at risk of insolvency. b) Profitable companies may also fail: they may be at risk of failure due to insufficient liquidity.

90 MB Business failure and insolvency 2. Causes of excessive debt/ solvency problem Major causes associated with corporate failures over the last 20 years High gearing policy Capital losses from a fall in asset prices Complex ownership structure Overtrading Overpaying for an acquisition Purchase or pursuit of a white elephant and/or construction of a Taj Mahal Under-performance of a business unit Working capital implosion A recessionary economy

91 MB Business failure and insolvency 3. Common problem areas within finance and treasury a) Inadequate or excessive liquidity b) Inadequate capital and excessive gearing c) Inability to access funding (i) Internal events (insufficient cash flows or unprofitable) (ii) External events (regulatory restrictions or market liquidity) d) Interest rate increase or adverse currency movements e) Business market or product/service failure f) Cash management g) Breach of lending documentation h) Shareholder, banker and capital market dissatisfaction i) Excessive risk (business or financial) j) Lack of internal controls within the treasury function

92 MB Business failure and insolvency 4. Action to resolve common problem areas Understanding financial risks and their impact The key financial risks will be: Interest rate risk Falling rates of return on the company's asset base Foreign exchange risk Unexpected funding requirements Changing sentiments in debt and equity markets Taxation and accounting changes Decision on level of gearing Preferring simplicity to complexity Involvement of central control

93 MB Business failure and insolvency 5. Business failures Reasons for business failure Inadequate management Weak capital structure Lack of financial management Structural economic/market changes High cost structure Failure of big projects and acquisitions

94 MB Business failure and insolvency 6. Methods of predicting corporate failure Financial ratios to predict failure Performance ratios (gross margin, operating margin, ROCE Efficiency ratios (labour turnover ratios and labour efficiency ratios) Risk related ratios (gearing ratios, debt service coverage ratios) Liquidity ratios (current ratio and cash exhaustion ratio) Working capital ratios (debtor days, creditor days and stock days)

95 MB Business failure and insolvency 6. Methods of predicting corporate failure Beaver's univariate approach Operating cash flow is a better measure of a business's profits than earnings Companies with a Beaver failure ratio of less than 0.3 fail within 5 years. The univariate approach was considered too rigid due to its dependency on a single ratio. Instead, a combination of ratios was considered more useful in predicting failure

96 MB Business failure and insolvency 6. Methods of predicting corporate failure Altman's multivariate approach (the Z-Score model) 5 key indicators are used to derive Altman's Z-Score model.

97 MB Business failure and insolvency 7. Insolvency Bankruptcy is a legally declared inability or impairment of ability of an organisation to pay its creditors. Creditors may file a bankruptcy petition against a debtor (involuntary bankruptcy or winding-up) in an effort to recoup a portion of what they are owed or initiate a restructuring. Bankruptcy initiated by the insolvent organisation is known as voluntary bankruptcy or windingup. In a winding-up of a limited company, all the assets of the company would be realised (sold off and converted to cash) through a legal process in order to repay its debts. Winding-up would bring the company to an end.

98 MB Business failure and insolvency

99 MB Business failure and insolvency 7. Insolvency Petition for winding-up a written demand issued by the creditor requiring the company to pay the debt must be left by hand. 21 days must be given to the company to pay the debt. If the company fails to pay the debt within 21 days, the creditor can present the petition to the Court. Grounds for a winding-up order a) Special resolution of the members (subscribers or shareholders), b) The company does not commence its business within a year from its date of incorporation, or suspends its business for a whole year; c) The company has no subscriber or no shareholder; d) The company is unable to pay its debts; e) An trigger event occurs of which the company's memorandum or articles of association provides that the company is to be dissolved; or f) The Court is of an opinion that it is just and equitable to do so.

100 MB Business failure and insolvency 7. Insolvency Conclusion of winding-up The liquidator can apply to the Court for the release of the duties once the following have been accomplished: All the assets of the company have been realised (i.e. all assets have been sold and converted to cash); Investigations related to the winding-up proceedings are completed; and A final dividend (if any) has been paid to the creditors to settle the debts.

101 MB Business failure and insolvency 7. Insolvency Voluntary winding-up A general meeting of its shareholders may be hold to bring itself to an end by winding-up procedures. a) A special resolution for voluntary winding-up is passed by the shareholders b) The company calls a meeting of creditors. c) A liquidator is appointed, by the shareholders or by the meeting of creditors. d) Further, an inspection committee may be appointed to supervise the exercise of power by the liquidator. e) The directors have to make a full statement of the position of the company's affairs, together with a list of creditors and the estimated amount of their claims. f) The liquidator deals with the affairs of the company, the liquidation of assets and payments to creditors until the liquidation process is complete. g) When the affairs of the company have been fully wound up, the liquidator will produce an account of the winding-up, and call a final meeting of the company and of the company's creditors. The liquidator obtains his release. h) The company is dissolved.

102 MB Business failure and insolvency 7. Insolvency Financial reconstruction schemes Title to the distressed company's assets is transferred to a third party (called an assignee or trustee) who liquidates the assets through a sale or public auction and then distributes the proceeds to the creditors on a pro rata basis, according to the seniority of the claims. The company's creditors work directly with management to establish a plan for returning the company to a sound financial basis. These plans usually involve some restructuring of the company's debt, with creditors agreeing either to reduce or reschedule debt payments in order to ensure the company's continuing operation.

103 MB Business failure and insolvency 7. Insolvency Financial reconstruction schemes Order of priority: Secured money lenders (e.g. debentureholders) Preference shareholders Unsecured creditors Ordinary shareholders Response to a reconstruction schemes 1. Secured lenders will respond positively if they are convinced that they cannot recover their entire dues on liquidation. 2. Preference shareholders generally suffer a lower amount of loss as compared to the ordinary shareholders in the case of liquidation. 3. Unsecured creditors will vote in favour of reconstruction if they hope to recover maximum claims in this manner. 4. Ordinary shareholders are more likely to favour a scheme that will help them to retain their stake in the company

104 MB Business failure and insolvency

105 Exam Questions Review Sept 2009 Qu 4

106 MB Exam Questions Review [Sept 2009 Qu 4] Question In the wake of the global financial crisis in 2008, many businesses felt the full impact of the credit crunch. Financing, which used to be easily accessible, has now been unavailable even to the largest companies. In order to survive, many companies have tried their very best to cut their operating expenses to the bone and unlock cash from their businesses. According to a survey, more than 60% of the companies in the Asia Pacific region have reviewed their working capital to find ways to reduce inefficiency and improve cashflow.

107 MB Exam Questions Review [Sept 2009 Qu 4] Question DG-Star is a sneaker manufacturer in Dongguan, China. John Lee, the CFO of the company, is looking for ways to enhance the cash position of the company. After reviewing the balance sheet in detail, John is of the view that too many funds have been tied up in accounts receivable. Under its current credit policy, DG-Star makes all sales on 90-day credit and offers no cash discount. On average, the company sells one million pairs of sneakers per month at the price of $120 for each pair at a cost of $95.

108 MB Exam Questions Review [Sept 2009 Qu 4] Question John has discussed with the Sales Manager and come up with two proposals: Proposal 1: To reduce the credit period to 15 days. However, due to this more stringent credit policy, the Sales Manager expects that some of the customers will be lost and sales will drop by 17%.

109 MB Exam Questions Review [Sept 2009 Qu 4] Question Proposal 2: To offer 7% discount to customers who settle the account within one month. The Sales Manager estimates that 80% of the customers will take advantage of this incentive, and the rest will continue to settle their accounts at the end of the 90-day credit period. As a result of the discount, sales are expected to increase by 11%. The company requires a return on investment of 20%. Assume 360 days in a year and round up to 3 decimal points in discount factors.

110 MB Exam Questions Review [Sept 2009 Qu 4] Question a) Use the NPV analysis to decide whether the existing policy, Proposal 1 or Proposal 2 is more advantageous to DG-Star? Show your calculations. (14 marks) b) Apart from shortening the payment collection period, what are the other possible areas that a company can consider for improving the working capital? (6 marks) (20 marks approximately 36 minutes)

111 MB Exam Questions Review [Sept 2009 Qu 4] Answer (a) Existing Policy: 90-day Unit $ After cash Discount discount Factor Probability NPV Sales 1,000, ,240,000 Costs 1,000, (95,000,000) Profit 19,240,000 Proposal 1: 15-day Sales 830, ,803,200 Costs 830, (78,850,000) Profit 19,953,200 Proposal 2: 30-day 7% discount Sales 1,110, ,515,187 1,110, ,361,280 Costs 1,110, (105,450,000) Profit 17,426,467