StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

The Advantage of the Capital Restructure Program and the Companys Profitability - Research Paper Example

Cite this document
Summary
The paper describes the process of decreasing a company's shareholder equity through share cancellations and share repurchases is called capital restructuring. The reduction of capital is done by companies for numerous reasons like increasing their profitability and solvency…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER95.1% of users find it useful
The Advantage of the Capital Restructure Program and the Companys Profitability
Read Text Preview

Extract of sample "The Advantage of the Capital Restructure Program and the Companys Profitability"

 1) Following the disposal of a number of non-core operating assets, in 2002 Marks and Spencer (M&S) restructured its capital through the creation of a new holding company, whereby existing shareholders received a mixture of new ordinary shares and redeemable ‘B’ shares. For every ordinary M&S share currently held investors received one of these new ‘B’ shares. In addition, M&S reduced its share capital by issuing 17 new ordinary shares in exchange for every 21 ordinary shares currently held. These ‘B’ shares could be redeemed for cash plus interest at a series of dates in the future. According to the statement M&S has gone for a capital restructuring program by issuing a bonus share for every ordinary share for its existing shareholders. As a result of the capital restructuring program the company has reduced its share capital to a certain extent. The process of decreasing a company's shareholder equity through share cancellations and share repurchases is called capital restructuring (Coyle, 2000). The reduction of capital is done by companies for numerous reasons like increasing their profitability and solvency. M&S wanted to reduce the number of ordinary shares to 17 for each 21 and this has had some considerable impact on the capital structure of the firm. Irrespective of the issue of new redeemable shares for each ordinary share the company has effectively increased its debt capital ratio against the equity capital ratio. The net result of this is that the managers’ power to make critical decisions on leveraging has increased (Mcintosh, & McIntosh, 2001). In financial language capital structure is defined as the way in which a company finances its assets through some mixture of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. Is referred to as the firm's leverage. In reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, Capital market is the market for investment funds in the long-term where equity, bonds and other securities are traded. There are both a long term primary market for the primary equity issues and a secondary market for those existing shares (www.thefreedictionary.com). It is the market where long term financial assets are bought and sold. Thus it’s clear that capital markets don’t include short term money markets where money is lent and borrowed in the short run through the interaction of the institutional and non-institutional players such as banks, financial houses and individual money lenders. Functional efficiency of the capital market is determined by a number of factors including the government’s regulatory mechanisms (Whitehead, 1994). Shareholder value comes from the demand for and supply of company shares. If the management of the company were to decide in favor of more equity issues, then depending on the demand for the company shares the company value would rise or fall (Chisholm, 2002). With that the shareholder value also would rise or fall. Risk is inevitably associated with the value of the firm viz. managers or agents always prefer a higher level of debt because it increases the value of the firm or its assets. Indeed the risk also increases though from the viewpoint of the manager it’s irrelevant because equity issues would glut the market with company shares and bring down the value of the company (Chislett, 2009). As a result the existing shareholders cannot be happier. They would get a windfall if they sold their shares now. Similarly when more debt is issued the company becomes entitled to more tax benefits. That in turn increases the value of the firm and thereby the shareholder value. The simplified capital reduction of creditor protection is less solid, since there is no repayment to shareholders which means nothing is lost from the debt coverage potential. Instead, there are restrictions on the distribution of future profits and a dividend ban as long as the legal reserve amounts to less than the share capital. Thus correspondents the share holder’s power to control the firm has diminished. They have lost their voting power to take part in the decision making process. Due to the scenario company has reduced its equity capital to 3081.3 £m in 2002 from 4581.4 £m in 2001. Also, the value of the share capital decreased by 32.74% in the same year (http://annualreport.marksandspencer.com) One of the advantages of the capital restructuring is that reducing the weighted cost of capital increases the net economic returns, and adds to company a value. It places the company in a position that it can choose what it wants to do, rather than have circumstances force it to take a course of action. Because the use of too little debt results in a lower stock price, and too much debt also lowers the stock price, if there is a more risk company should manage its Debt/equity (D/E) ratio . It is not essential for the manager to have a knowledge of capital structure but also necessary to know how it works. He must also know programs, mergers and acquisitions, divestitures, leverage and buyouts, and strategies aimed at defeating takeover. It will be an alternative to traditional stock repurchase. Another advantage is that the managers of the company will enjoy a greater power in all the activities. And thus its balance sheet can reflect more accurately the capital employed in the business, where capital has been lost, and repay shareholders part of its paid-up capital in case the capital is not needed in the future. Because of the capital restructuring program the company has a less amount of liability to pay the dividends to their existing shareholders. It is clear that according to company’s profit and lost statement in the year 2002 ,the amount of dividend payable to its existing shareholders has come down to 238.9 £m from 258.3 £m as it reported in 2001. It has decreased by 7.51% than in 2001 (http://annualreport.marksandspencer.com) Another advantage of this capital restructure program is that it has increased company’s profitability in 2002 than the year of 2001. According to the company’s profit and lost statement in the year 2002, the company has reported a loss of Rs 263.8 £m. but it has come down to 85.9£m in 2002 by reporting a 67.43% huge amount. (http://annualreport.marksandspencer.com). This is a great advantage that the company has achieved because of the capital restructure program. Profitability is essential for the long term survival of every business.  Profit is the excess money generated in the production and sales of the products and services.  On the other hand the company’s earnings per share (EPS) has gone up due to the capital restructure program. This is another advantage that the company has achieved during the year. Because the profit should be divided among less number of shares the earning per share will be increased. It is clear that the earning per share of the company in 2002 is higher than the same in 2001. Adjusted earnings per share has increased From 11.2 it has gone up to 16.3 within a one year in the company reporting a 31.28%. And the ratio of EPS has gone up to 5.4% from 0.2% in the year of 2002. In general, a high EPS suggests that investors are expecting higher earnings growth in the future compared to companies with a lower EPS. (Hare, 2009).  . The disadvantages of the capital reduction program is that the existing shareholders will be demoralized because they will lose their voting power and the opportunity to take part to the decision making process. This is a one area that the management should be concerned. Due to the increase of earning per share of the company the dividend ratio has also increased to 9.5 % from 9.0% by reporting 5.5% growth in 2002 year. So the company’s share holders will be motivated by these financial terms. Dividend is the return that any investor is looking out of his investment made. (Schon, 2008). And thus the value of the company’s shares in the stock exchange will be increased due to dividend ratio. But due to the capital restructure program the taxation liability has gone up to 182.5 £m from 149.5 £m reported in 2001 company’s annual report. Indicating a 18.082% growth in the taxation rate. This is due to increase in profits. The more profits you earn more you have to pay taxes. It is profitable to pay interests for company’s debt than the dividends to the share holders. Because this will boost the EPS thus it motivates the existing share holders. Because of the capital reduction and the increase in EPS the company will boost its share prices in the share market. So this will be a good opportunity for the company to boost its share prices in the stock exchange. Another important aspect is that changing the capital structure does not change the total cash flows. Therefore the total value of the assets that give ownership of these cash flows should not be changed. if an investor would prefer a company to be more highly geared this can be simulated by buying shares and borrowing against them. Dividend policy is adopted by the management to distribute profits to those equity holders of the company and naturally such distribution is sanctioned after debt holders have been paid (Da Silva, Goergen, & Renneboog, 2004). As such the dividend policy becomes irrelevant when the company’s assets are mostly financed through debt, i.e. debt has to be settled irrespective of whether surplus profits would remain or not for distribution among equity holders. The capital structure of the firm is the basis on which it carries this policy. It’s obvious that the capital structure of the firm is decisive in levering or not levering the firm. However it must be noted here that in case there are no taxes or/and tax-related benefits to be gained through leverage, the whole set of assumptions and the subsequent theoretical postulate break down because the levered firm loses when there are not tax-related benefits to be gained by leveraging. It’s the tax-related benefits that enable the firm to make financial gains. 2) Locate Vodafone’s Annual Reports for years 2000 and 2001; access the following URL for Vodafone’s annual reports for these years: a) The agency problems that are likely to be faced by the company The capital market structure of Vodafone can be examined with reference to a number of theories. The Modigliani-Miller Theorem is the earliest of such theories to consider the relevance of capital structure to determine the value of a firm (Agrawal, & Mandelker, 1987). In recent times these theoretical constructs have been developed in line with an ever increasing tendency to consider the leverage issue of the company. Leveraging by managers to achieve exclusive personal goals is nothing new. In fact it’s the conflict of interests between the principals or owners (or shareholders) and the agents (or managers) that has thrust the issue of leverage to the fore. In other words the complex issues revolving around capital structure of the Vodafone are basically influenced by this conflict in which managers tend to have more information about the probable outcomes of future investments than shareholders. Thus this information asymmetry leads to a series of other problems (Brealey, &Myers, 2002). Disagreement between managers’ behavior on the one hand and the shareholders’ behavior on the other gives rise to a series of other related problems, e.g. information asymmetry, agency costs, taxation and bankruptcy costs. Information asymmetry refers to the manager’s ability to control the flow of information in his favor so that the principal or the owner would have less access to information. Agency costs are related to the principal-agent relationship. For example when a principal hires an agent he does so with the intention that the latter would act in conformance with certain rules to bring about what the former wishes (Jensen, & Meckling, 1976). However the motivating factor behind such performance is the monetary compensation such a good salary to the manager. Therefore such behavior on the part of the manager would not be in his best interest. His tendency to deviate from what is expected of him is common among all managers. In order to reduce such negative behavior the manager must be adequately compensated. However the principal does not know what the agent would do to ensure that his own interest prevails. Costs that are associated with this behavior are known as principal-agent costs or the principal-agent problem. Agency costs are divided into three sub-categories. These agency costs occur as a result of principal-agent problem. (a). Asset substitution effect As and when debt to equity ratio increases managers tend to substitute new assets through new investment thus relatively increasing debt in place of equity. Assuming that projects are riskier, there is still a fairer chance of success against failure thus obliging both debt-holders and share holders to condone such risky investment decisions on the part of managers (Fama, & French, 1998). Successful investment projects lead to cumulative share holder benefits while unsuccessful ones lead to cumulative debt-holder woes. However in the long run with new projects rising, the value of the firm is bound to decrease while a net transfer of wealth from debt-holders to share holders is more likely. (b). Underinvestment problem Managers would not hesitate to reject projects with positive Net Present Value (NPV) because they would not be bothered to increase the value of the firm any more than to allow the accrual of benefits associated with riskier debt to debt-holders themselves rather than to share holders. (c). Free cash flow problem Finally there is the problem of free cash flow. In the absence of free cash flow benefits accruing to investors, the manager has a tendency to reduce the value of the firm through prodigal behavior, such as granting bonuses and higher salaries. Therefore higher levels of leverage would act as a preventive factor of such behavior and ensure discipline. While these agency costs reduce the level of market perfection, there is no certainty that their ultimate impact would not be reduced in the light of intervening influences such as demand for and supply of debt /equity being regulated through efficient wealth redistribution methods. Next there is the problem of taxes. When corporate taxes are considered the firm is entitled to interest expense deduction which enables it to increase value of its assets. In other words investment related tax benefits would increase the value of the firm. According to Modigliani and Miller (1963) the tax exemption allows the firm to reduce the leverage-based premium in the cost associated with raising the equity capital. Subsequently Miller (1997) added personal taxes to the equation. According to him individual investors would want a greater benefit by way of pre-tax returns on their investments so that they might not be affected by higher personal tax obligations on their earnings. According to Miller when the equilibrium occurs, the individual tax liability will be so greater as to offset any benefits related to the corporate gain. This renders capital structure irrelevant. (d). Corporate governance Corporate governance refers to systemic control through policies, rules, customs, practices, procedures and so on of the business organization by either shareholders, i.e. owners or the management (Tirole, 2001). Minority shareholders tend to be treated differentially under each system. While the former tends to favour minority shareholders to a certain extent, the latter tends to ignore or sideline them at annual general meetings (AGMs). b) The impact that recent write-offs of assets and heavy indebtedness can have on the valuation of the company Asset valuation techniques have been over worked at Vodafone during the past few years. For instance the scrap value determination through cash flow method has been applied at Vodafone to determine the value of over-wrought assets (Myers, & Majluf, 1984). However the net result of this has been the fact that Vodafone has unnecessarily permitted market watches to downgrade its prime assets, thus leaving some of the best assets to be written off as unrecoverable. Similarly its level of debt accumulation has acquired a multiple negative dimension. In the first instance the company has accumulated £147, 782 million in debt in 2001. As a result the company’s capital structure has been partially skewed in favor of more debt and less equity (http://www.vodafone.com ). The first and foremost impact that assets write offs and heavy indebtedness can have on the valuation on the company is the share value might come down. Because unlike dividends creditors must be paid first. As a result the company would be incurring losses due to cumulative on expansion of debts and the inability to recover partial losses from some assets (Friedrich, 2007). For example assets that are directly related with bad debts write offs would have a big negative impact of the company to raise debt in commercial credit markets and above all such assets would affect the company’s long term cash flow objectives. Assets write offs at Vodafone have been one of the most difficult problems. According to their annual report the total assets of the Vodafone Company is £159,688 million and £148,927 million in 2001 and 2000 respectively, so subsequent decline in the assets can lead the company in decline in share prices and decline in there goodwill in the market (www.vodafone.com ). By comparing to the assets value of 2001 there is a decline in the assets by £10761 million. Resulting to increase in debts the creditors of the company have increased to £11235 million from £6374 million. This will badly increases the debtor turnover ratio and resulting to decrease in working capital of the company (Bohn, & Stein, 2009). Decrease in working capital of the company will result too many problems like liquidity problems and thus it arises the cash flow problems. Thus it will difficult to pay the cash for creditors on time. Heavy indebtedness will be resulting into high expenses on payment of interests and dividends can result to increase in operating expenses. Thus it drives to decrease in operating profit in the company. According to the annual report of Vodafone interest expenses have gone up to £1,260million from £523million in 2001. But in 2001 their current assets are increased rapidly due to the increase in investments. It will boost their debt in other hand company will face the difficulty of paying dividends and interests for investors, because unlike dividends the creditors must be paid first. It can be identified two debt management ratio as follows. i. Debt-to-Equity Ratio: The debt to equity ratio/financial leverage ratio reflects the extent to which the business relies on debt financing for their business activities. The higher the ratio, the greater amount of risk for the creditors and high debt to equity ratio indicates difficulty in paying interest and principal while obtaining more funding. Debt-to-Equity 2000 2001 Vodafone 0.08 0.18 Vodafone’s shareholder satisfaction has been diminishing while its ability to pay creditors has been increasing. As a result the company has successfully leveraged its debt-to-equity ratio. However shareholder value has been diminishing to such an extent to cause concern among majority shareholders. ii. Net Profit Margin: Net Profit Margin measures how well a company controls its costs. The higher the net profit margin is the better the company with refers to the control costs. In fact most of the investors have been used the net profit margin to compare companies in the same industry and well as between industries to determine what are the most profitable. Net Profit Margin 2000 2001 Vodafone 6.19% 65.07% In the year 2000 the company’s net margin showed 6.0% plus while in 2001 it was reversed to 65% minus. This is a huge difference and therefore the company’s profit performance and related variables received a negative jolt resulting in the loss of investor confidence. The company was compelled to adopt more stringent measures subsequently. Such measures included curtailing dividend payout and withholding interest payments on debt (Pettit, 2007). However even during the subsequent years minuses accumulated though the company did not go in to continuous loss incurring as some of its rivals did. This was attributed to better debt management and highly successful restructuring efforts. References 1. Agrawal, A & Mandelker, G 1987, ‘Managerial incentives and corporate investment and financing decisions’, The Journal of Finance, Vol. 42, pp.823-837. 2. Berger, P, Ofek, E & Yermack, D 1997, ‘Managerial entrenchment and capital structure decisions’, The Journal of Finance, vol. 52, pp.1411-1437. 3. Bevan, J 2007, The Rise and Fall of Marks and Spencer: and How it Rose Again, Profile Books, London. 4. Bohn, JR & Stein, RM 2009, Active Credit Portfolio Management in Practice, John Wiley & Sons, Inc, New Jersey. 5. Brealey, RA & Myers, SC 2002, Brealey & Myers on Corporate Finance: Financing and Risk Management, McGraw-Hill, New York. 6. Chisholm, A 2002, An Introduction to Capital Markets: Products, Strategies, Participants, John Wiley & Sons Ltd, West Sussex. 7. Chislett, H 2009, Marks in Time: 125 Years of Marks & Spencer, Weidenfeld & Nicolson, London. 8. Coyle, B 2000, Capital Structuring: Corporate Finance (Risk Management Series), Global Professional Publishing, Chicago. 9. Da Silva, LC, Goergen, M & Renneboog, L 2004, Dividend Policy and Corporate Governance, Oxford University Press, New York. 10. Fama, E & French, K 1998, ‘Taxes, financing decisions, and firm values’, Journal of Finance, vol. 53, pp.819-843. 11. Friedrich, B 2007, The Theory of Capital Structure: How theory meets practice in the German market, Book Surge Publishing, South Carolina. 12. Hare, J 2009, ‘Marks & Spencer: EU claims for cross-border loss relief. (European Union)’, Tax Executive, vol. 57, no. 4, pp. 340-344. 13. Jensen, MC & Meckling, WH 1976, ‘Theory of the firm: Managerial behavior, agency costs, and ownership structure’, Journal of Financial Economics, vol.3, no.4, pp.305-360. 14. Marks and Spencer annual report 2009, retrieved from, http://annualreport.marksandspencer.com/financial-statements/consolidated/default.aspx, on April 27, 2010. 15. Mcintosh, M & McIntosh, M 2001, Marks and Spencer: Global Companies in the Twentieth Century Volume VII, Routledge, London. 16. Miller, MH 1997, Merton Miller on derivatives, John Wiley & Sons, New Jersey. 17. Modigliani F & Miller, MH 1963, ‘Corporate income taxes and the cost of capital: a correction’, American Economic Review, vol. 53, pp. 433-443. 18. Myers, S, & Majluf, N 1984, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol.13, pp.187-222. 19. Pettit, J 2007, Strategic Corporate Finance: Applications in Valuation and Capital Structure, John Wiley & Sons, Inc, New Jersey. 20. Schon, W (ed.) 2008, Tax and Corporate Governance (MPI Studies on Intellectual Property, Competition and Tax Law), Springer, New York. 21. Tirole, J. 2001, Corporate Governance, Econometrica, Vol.69, No.1, pp. 1-35. 22. Vodafone Annual Report & Accounts 2000, retrieved from http://www.vodafone.com/etc/medialib/attachments/investor_relations/annual_reports/2000.Par.78371.File.tmp/vfatra_2000.pdf, on April 30, 2010. 23. Vodafone Annual Report & Accounts 2001, retrieved from http://www.vodafone.com/etc/medialib/attachments/investor_relations/annual_reports/2001.Par.47342.File.tmp/vfRA_2001.pdf, on April 30, 2010. 24. Whitehead, M 1994, ‘Marks & Spencer –: ‘Britain’s Leading Retailer: Quality and Value Worldwide’, Management Decision, vol. 32, no. 3. Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(The Advantage of the Capital Restructure Program and the Companys Research Paper, n.d.)
The Advantage of the Capital Restructure Program and the Companys Research Paper. Retrieved from https://studentshare.org/management/1737107-in-course-assignment-formal-report-financial-management
(The Advantage of the Capital Restructure Program and the Companys Research Paper)
The Advantage of the Capital Restructure Program and the Companys Research Paper. https://studentshare.org/management/1737107-in-course-assignment-formal-report-financial-management.
“The Advantage of the Capital Restructure Program and the Companys Research Paper”, n.d. https://studentshare.org/management/1737107-in-course-assignment-formal-report-financial-management.
  • Cited: 0 times

CHECK THESE SAMPLES OF The Advantage of the Capital Restructure Program and the Companys Profitability

Creating, Financing, and Marketing a Business

Another advantage of partnership is that the business has more access to capital.... Incremental analysis can also be performed by managers which will consider only those items of revenue, costs and volume directly related to the new product or service and how the overall profitability of the firm will be affected specifically by those product changes.... One of the advantages of a partnership is that since more than one person owns the business the organization has more human capital at its disposal than in a sole business....
4 Pages (1000 words) Essay

British Telecommunications as a Company in Transition

Over the next several years, BT will continue to confront price pressures in its broadband unit, declining residential phone service sales and a need to keep pace with the rapid technological development occurring in its various industries (BT Group 2006). … BT will be forced to make strategic capital investments if it hopes to successfully meet its competitive challenges and invest in potential growth markets.... This will require serious decisions by BT management about how to organise BT's capital structure....
11 Pages (2750 words) Assignment

ConocoPhillips Internal Business Analysis

As a publicly-traded company ConocoPhillips Corporation has lost access to direct foreign investment funds due to the fact that these forms of capital injection are prohibited in many countries to public companies.... The company has a competitive advantage in this market because they control all sides of the supply chain....
5 Pages (1250 words) Essay

Key Goals of the Takreer Company

For example, the company has taken advantage of the ever-changing technology to automate most of its oil production operations.... The company's mission is to enhance profitability and safety in mining and supplying of hydrocarbon fuels and feedstock.... This has been a threat to the stability of the company's profitability.... The global economic cycles affect the company's profitability as well.... For example, during the 2008 global financial crisis, the company registered a decline in profitability....
6 Pages (1500 words) Research Paper

Potential Funding Sources

The… It is difficult for a new start up company to arrange such a lump sum start up business operation capital.... There are two major funding options for the organization, such as lending capital from renowned commercial banks and borrowing funds from the angel investors.... The new kitchen appliances retail organization can propose different financial institutions and commercial banks in order to borrow the start up business capital....
8 Pages (2000 words) Essay

Key Aspects of Management Control and Audit

hellip; In a multivariate product scenario, where choices have to be exercised between choosing investments made to different product lines, marginal costing serves to enlighten management regarding the best production or marketing mix to be adopted for optimum profitability.... Therefore, by granting the status of variable costs to semi-variable costs, the overheads are hiked and thus profitability is reduced.... By assigning the nature of fixed costs to semi-variable costs, during times of lowered levels, there is a high overhead charge which significantly erodes profitability....
10 Pages (2500 words) Coursework

Short Term Debt Financing Used by Cable & Wireless

The reporter states that the balance sheet of Cable & Wireless reflects following obligations under the head 'Current Liabilities' that appear to be of being of the nature of short-term debt obligations of the company as on 31 March 2007… Short term financing arising from the normal operations of the firm is called 'Spontaneous financing'....
12 Pages (3000 words) Essay

The Concepts of Business and Corporate Level Strategy

Although, in recent years have been observed an increase orientation for organic food, the market is not entirely developed, so Hy-Vee has a competitive advantage, and it should also develop more on this field.... In order to provide the bigger picture in this matter, two companies would be considered: Hy-Vee and Fareway. The sections which will be presented overlook concepts… Hy-Vee is situated in the top 20 supermarket chains in the United States, and has a long history as a company (Hy-Vee)....
5 Pages (1250 words) Assignment
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us