Commercial Issues Facing a Finance Manager in an SME When Borrowing from a Bank - Assignment Example

Financial Management - MBA Question No. 1 What are the commercial issues facing a finance manager in an SME when borrowing from a bank? Answer No. 1 Small and Medium-sized Enterprises or SMEs “A stipulation of the European Regional Development Fund Grant is that potential beneficiaries are, amongst other things a Small to Medium Sized Enterprise. SME’s are companies that employ less than 250 people, have a turn over of less than €50 million (or a balance sheet total of less than €43 million), and not more than 25% owned by a non-SME”. LPDU – Glossary [Online] www.comp.lancs.ac.uk/engineering/lpdu/Glossary.htm (Accessed December 23, 2005) “EU Member States traditionally had their own definition of what constitutes an SME, for example the traditional definition in Germany had a limit of 500 employees, while (for example) in Belgium it could have been 100. But nowadays the EU has started to standardize the concept. Its current definition categorizes companies with fewer than 50 employees as "small", and those with fewer than 250 as "medium”. In most economies, smaller enterprises predominate. In the EU, SMEs comprise approximately 99% of all firms and employ between them about 65 million people. SMEs, in contrast to big business, have a reputation for innovation. For this reason, and because of their difficulties in attracting capital, national and regional fostering of SMEs commonly occurs”. Small and Medium-sized Enterprise - Wikipedia, the free encyclopedia [Online] http://en.wikipedia.org/wiki/Small_and_Medium-sized_Enterprise (Accessed December 23, 2005) “Debt appears to be the most important source of external SME financing. Today, The sheer magnitude of debt as a source of SME financing suggests that it is critical that we understand how financial intermediaries and trade creditors make credit decisions, and that we understand which firms get financing and which firms do not. In addition, it is important to understand that there are many powerful commercial factors and issues that determine the relative importance of the lending technologies. These factors likely include: the status of a country’s commercial laws and their enforcement, the development of a country’s information infrastructure, the efficiency of a country’s bankruptcy system, the vibrancy of a country’s community banks, the market structure of the banking system, the presence and importance of non-bank lenders, and the level of development of country’s capital markets. One of the most significant commercial issues is data availability. Part of the solution, of course, could be investment in better data sets. Remember! The creative use of existing data sets can be equally fruitful”. Not Available [Online] http://www.kelley.iu.edu/finance/workingpapers/SME.Lending.IU.Working%20Paper.Udell.3.4.04.pdf (Accessed December 23, 2005) Question No. 2 Critically evaluate the degree to which the practical difficulties facing companies when calculating their WACC can be overcome? Answer No. 2 The Cost of Capital To properly evaluate potential investments, firms must know how much their capital costs. Without a measure, of the cost of capital, for example, a firm invests in a new project with an expected return of 10 percent, even though the capital used for the investment costs 15 percent. If a firm’s capital costs 15 percent, then the firm must seek investments that return at least that much. It is vital, then, that managers know how much their firm's capital costs before commuting to investments. Suppliers and users of capital use cost estimates before making short- or long-term financial decisions. Investors determine their required | rate of return, k, to value either a bond or stock before they invest. That required rate of return, k, for each type of security issued is the cost of capital source. Overall, the cost of capital is the compensation investors demand of firms that use their funds, adjusted for taxes and transaction costs in certain cases. The Weighted Average Cost of Capital (WACC) To estimate a firm's overall cost of capital, the firm must first estimate the cost for each component source of capital. The component sources include the after-tax cost of debt, AT kd: the cost of preferred stock, kp ; and the cost of common stock equity.ks, and the cost of new common stock equity, kn. Book Value “A book value is a value on the balance sheet (total assets or total liabilities and equity). Market Value Market value is calculated by using market values of equity (stock price * number of shares) + market value of debt. WACC Calculations In WACC calculations it is recommended and preferable to use market-value weights to avoid calculating problems. Always remember that book values and market values can be similar or different to each other, so don’t confuse. It is even more preferable to use target weights. If the company has a target debt-equity ratio in mind, it should be taken into account when computing the WACC. The Best Practice – A Survey According to a survey, 59% of corporations and 30% of financial managers or advisors use market weight to avoid or overcome the calculation problems”. Chapter 13, ROIC and WACC [Online] http://216.239.59.104/search?q=cache:x2nnemf_v3MJ:flash.lakeheadu.ca/~pgreg/assignments/3019chapter13_w05n.pdf+WACC+calculations+issues&hl=en (Accessed December 23, 2005) Question No. 3 What problems face a company when using the internal rate of return in long-term project evaluation? Answer No. 3 The Internal Rate of Return (IRR} Method The internal rate of return (IRR) is the estimated rate of return for a p project, given the project's incremental cash flows. Just like the NPV method, the IRR method considers all cash flows for a project and adjusts for the time value of money. However, the IRR results are expressed as a percentage, not a dollar or pound figure. When capital budgeting decisions are made using the IRR method, the IRR of the proposed project is compared to the rate of return management requires for the project. The required rate of return is often referred to as the hurdle rate. If the project’s IRR is greater than or equal to the hurdle rate (jumps over the hurdle), the project is accepted. Problems with the IRR Method – Long-Term Projects The IRR method has several problems, however. First, since the IRR is a percentage number, it does not show how much the firm will change if the project is selected. If a project is quite small, for instance, it may have a high IRR, but a small effect on the value of the firm. (Consider a project that requites a $10 investment and returns S100 a year later. The project’s IRR is 900 percent, but the effect on the value of firm if the project is adopted is negligible. If the primary goal for the firm is to maximize its value, then knowing the rate of return of a project is not the primary concern. What is most important is the amount by which the firm's value will change if the project is adopted, which is measured by NPV. To drive this point home, ask yourself whether you would rather earn 100 percent rate of return $5 ($5) or a 50 percent rate of return on $l,000 ($500). As you can see, it is not the rate of return that is important, but the dollar value. Why? Dol­lars, not percentages, comprise a firm's cash flows. NPV tells financial analysts how much value will he created. IRR does not. The second problem with the IRR method is that, in rare cases, a project may have more than one IRR, or no IRR. The IRR can be a useful tool in evaluating capital budgeting projects. As with any tool, however, knowing its limitations will enhance decision making. Conflicting Rankings between the NPV and IRR Methods As long as proposed capital budgeting projects are independent, both the NPV and IRR methods will produce the same accept/reject indication. That is, a project that has a positive NPV will also have an IRR that is greater than the discount rates. As a result, project will be acceptable based on both the NPV and IRR values. However, when mutually exclusive projects are considered and ranked, a conflict occasionally arises. For instance one project may have a higher NPV than another project, but a lower IRR. Question No. 4 To what extent are auditors independent? Answer No. 4 Independent Auditor A person (specialist) who audits a company’s financial statements and other related stuff, but is not associated or employed with the company. Auditing Auditing means an examination of the account books and the relative documentary evidence in order to ascertain the accuracy of the figures appearing therein. Briefly put, auditing means to find out that figures are facts. It is essential in an audit that there shall be a report of some kind, whether long or short. The auditors report may some times be very long or at times it may merely consist of the words “examined and found correct”   The audit of the accounts of a joint stock company is made compulsory by law, but it is not so in other cases. Whether or not an audit is legally required, the following are the advantages of having the accounts audited by an independent auditor: An independent verification of the financial position and earnings of a business concern or an institution is made by a professional accountant. Errors and frauds are brought to the light and their future prevention is secured by the reason of the moral effect of the audit. Audit accounts are considered more reliable for purpose of taxation (such as income tax, sales tax, wealth tax or expenditure tax), claims for fire loss, proposed sale of the business. The audit tends to keep the accounting work efficient and up to date, and the management is enabled to take any desired information from the accounts at any time without difficulty. Although it is not the duty of the professional accountant to give advice to its clients with regards to the management of the business, yet an auditor may be consulted as an expert in the matter of making improvement in the financial policy of an accounting system. In the case of a private firm an independent audit ensures that the rights of the partners inter se are correctly observed and given effect to. It also facilitates the settlement between the firm and a retiring partner Question No. 5 Briefly discuss the reasons why the return on capital employed method of invest appraisal remains a popular technique in evaluating long term projects despite its widely recognized drawbacks and weak theoretical base.   Answer No. 5 The return on capital indicates the productivity of capital employed. The denominator is normally calculated as the average of the capital employed at the beginning and the end of year. Problems of seasonality, new capital introduced or other factors may necessitate taking the average of periods within the year. The return on capital employed is known as the primary ratio in a ratio pyramid. Return on capital employed, alternatively termed return on investment (ROI), is a commonly used relative measure of divisional performance appraisal. It has the appeal of simplicity in that a single percentage figure, prepared from readily available and understand financial information, is used both as a measure of divisional performance and as a basis of comparison with other divisions and their opportunities available to the firm. However, ROCE has numerous limitations and needs to be used with caution.   Profit and investment can be defined in a variety of ways, which are discussed below, but such variations are relatively unimportant compared with the potential problems, which may arise from the fact that any form of ROCE is a ratio measure.   Any ratio measure improperly used is unsuitable for ranking investments so that improper use of ROCE can use cause local management to make sub optimal decisions. ROCE measures the average return on divisional investment and local management can only improve their ROCE by investing in projects, which earn above the existing ROCE or by ceasing existing projects, which earn below their average ROCE.   This is a safety policy, which means that local management may act in a manner detrimental to the interests of the firm as a whole. Problems ROCE is not an ideal internal performance measure. It has some problems listed below PERCENTAGE RETURN VERSUS THE SIZE OF THE INVESTMENT: it is better to have 15 percentages on $100000 or to have a 12 percentage on $200000. Shareholders would probably prefer the higher return on smaller investments leaving freedom to invest the remaining elsewhere. SHORT-TERM VERSUS LONG-TERM RETURNS: a successful business is always reducing the profit it could earn this year in order to create a situation, which will generate a greater profit in the future. But what are the rules for this? What is the current ROI? What is required in the long term? The ROCE doesn’t solve this problem. DIFFERENT BUSINESS AND INDUSTRIES HAVE DIFFERENT ROCE: ROCE of an advertising company will normally appear to be much greater than that of a steel company. Question No. 6 What should financial managers take account of the time value of money when evaluating long- term projects? Answer No. 6 The Time Value of Money The time value of money means that money you hold in your hand today is worth more than money you expect to receive in the future. Similarly, money you must pay out today is a greater burden than the same amount paid in the future. The interest rates are positive in part because people prefer to consume now rather than later. Positive interest rates indicate, then, that money has time value. When one person lets another borrow money, the first person requires compensation in exchange for reducing current consumption. The person who borrows the money is willing to pay to increase current consumption. The cost paid by the borrower to the lender for reducing consumption, known as opportunity cost, is the real rate of interest. The real rate of interest reflects compensation for the pure time value of money. The real rate of interest does not include interest charged for expected inflation of the risk factors. There are many factors including the pure time value of money, inflation, fault risk, liquidity risk, and maturity risk that determine market interest rates. The required rate of return on an investment reflects the pure time value money, an adjustment for expected inflation, and any risk premiums present. The Time Value of Money Problems Financial managers face various types of problem when evaluating long-term projects. They often face time value of money problems even when they know both the value and the future value of art investment. In long-term projects financial managers may need to find out what return an investment made - that is, what the interest rate is on the investment. Still other times financial managers must find either the number of payment periods, or the amount of an annuity payment. Finding the Interest Rate Financial managers frequently have to solve for the interest rate (k) when firm make a long term investment. The method for solving k depends on whether the investment on a single amount or an annuity. Finding k of a Single Amount Investment Financial managers may need to determine how much periodic return an investment generated over time. Finding k for a PVA Problem Financial managers may need to find the interest rate for a PVA problem when they know the starting amount (PVA), n, and the annuity payment (PMT), but they do not know the interest rate (k). Question No. 7 Explain the main reasons for not using the weighted average cost of capital as the discount rate in net present value calculations? Answer No. 7 “The average cost of companies finance (equity, debentures, bank loan) weighted according to their proportion each element bears to the pool of capital. Weighting is usually based on market valuations, current yields and cost after tax. The weighted average cost of capital is often used: 1 as the measure to be used as the hurdle rate for investment decisions; and 2 as the measure to be minimized in order to find the optimal capital structure for the company.” Cima official terminology. The weighted average cost of capital (WACC) assumes that when a company raises finance, the cash raised is added into a pool of funds. When a potential investment project is identified, the project is assumed to be financed from the pool, rather than from any specific fund raising operation.   If the mix of equity debt and preference shares within the pool of funds is assumed to remain constant over time, the discount rate to apply in appraising the project would be the cost of pool of the funds that is the weighted cost of capital.   The WACC can be found by calculating the cost of each long-term source of finance used. In theory the market value of the securities should be used in the gearing calculations as these give a more accurate measure of the company’s value, although book values are frequently used in practice. Assumptions In The Use Of WACC WACC can be used as a cut-ff or discounting rate for calculating the NPVs of projected cash flows for new investments, but the following criteria should be met: Capital structure is reasonably constant; New investment does not carry a significant risk profile from that of the existing entity; New investment is marginal to the entity; All cash flows are level perpetuities. John Fieldings Recommendations First WACC is not used; given that most business cover more than one business activity, each of which may support different levels of gearing, the use of WACC is totally inappropriate and may lead to non optimal decision making within the firm.   Secondly if we are not using WACC, it is not our company’s beta, which is of concern, but the betas of companies operating in the same business as the division or projects being analyzed. In general WACC can only be used where: The company has one main line of business; Projects cash flows are of approximately the same systematical risk as the companies existing line of business; Gearing is expected to remain constant. Question No. 8 What are the implications of high gearing companies?   Answer No. 8 High gearing relates to financial gearing which is the relationship between a company’s borrowing, which includes both prior charge capital and long term debt, and its share holders (ordinary share capital and reserves). Gearing calculations can be made in a number of ways, and may be based on capital values or on earning/interest relationship. Overdraft and interest paid thereon may also be included:                         Profit before interest and tax / Profit before tax Shows the effect of interest on the operating profit Profit before interest and tax / Interest expense Shows the number of times that profit will cover interest expense. Total long-term debt / Shareholders funds plus long-term debt Shows the proportion of long term financing which is being supplied by debt.                         Total long-term debt / Total assets A measure of capacity to redeem debt obligation by the sale of assets. A company with a high proportion of profit charge capital to share holders funds in high geared, and are low geared if the reverse situation applies.   The relationship between fixed interest capital source (debenture and preference shares) and equity source is known as the gearing f the firm (leverage in American terminology) and is usually expressed as a percentage. Various gearing ratio formula exist. the fixed interest capital and the equity capital may be expressed either in terms f book values or market values.    The higher the proportion of fixed interest capital source to equity the higher the gearing of the company. There is general acceptance that higher the gearing the more vulnerable the firm because in times of falling sales or recession.  Effects of Change in Gearing The general effect of increase in gearing ratio is to increase the risk of both equity and fixed interest investors but particularly those of the equity shareholders, because of the fixed interest entitlement whether not profits are made or are high or low. Thus a gearing ratio increases; holders of both equity and fixed interest capital are likely to require higher returns to compensate for their increased vulnerability of their interest or dividends.   What gearing ratio to aim for, that is, the optimal financial structure of the company, is a matter of some debate? No hard and fast rules can be laid down as to what is the optimum gearing ratio with many successful firms, often in the same industry, operating on quite different ratios. Nevertheless, firms with high gearing ratios are inherently less stable in fluctuating conditions than those with lower ratios.   Question No. 9 Briefly discuss the reasons why the pay back method of invest appraisal remains a popular technique in evaluating long term projects despite its widely recognized drawbacks and weak theoretical base. Answer No. 9 “The time required for the cash inflows from a capital investment projects to equal the cash outflows.” Cima official terminology. Description: Payback is a simple investment appraisal technique, which involves determining how long, will be needed before the initial investment is paid back. Unlike accounting rate of return, which is bound by accounting definition of ‘profit’ and ’investment’, payback concentrates on the specific cash flows, which an investment will generate. In this respect, payback is superior to accounting rate of return because the management accounting theory of decision-making is based on whether the wealth of the decision maker will be increased if a particular decision is made. The definition and conventions of financial accounting should not be allowed to muddy the waters of this essentially simple problem.   The well-documented drawbacks of payback technique are based on the facts that future cash flow in them does not indicate increased wealth. This is because a money flow in the future is not worth as the same money flow now. (Cash available now can be invested and so is worth more than the same cash flow at a latter date.)   The disadvantages of payback are: All cash flows within the payback period are given equal weight; Cash flow outside the payback period are ignored; It is not easy to determine how long the payback should be. Although one might think that payback to be little used because of these disadvantages, in practice it is used extensively! Its simplicity probably explains its popularity: Decision makers understand information presented to them; Calculations are straight forward and likely to be error free; Since data is itself unreliable (estimates of future cash flows) sophisticated analysis may not be justified. Payback can also be recommended if the business requires liquid funds at some date in the future-a project which ‘pays back’ before this data would be preferable to one which needs to be funded for a long period. A further advantage is the ‘risk aversion’ of payback. It’s seldom wise to use payback on its own for investment appraisal and it should be combined with at least one other technique, preferably based on discounted cash flow procedures, to ensure that all project returns are taken into account.   Question No. 10 In finance theory, risk relates specifically to the variability of returns. As far as interest rate risk is concerned, companies face two potential dangers: an interest rate increase if the company borrows money or a fall in interest rates if the company has surplus funds on deposit. Apart from the use of swaps, briefly outline and evaluate three ways in which companies can hedge against adverse movements in interest rates. Answer No. 10 Management Risk Every company face various types of risk when starts operating in a country. These operations provide special challenges and opportunities, but also spe­cial risks to management. Interest rate and exchange rate risk can be hedged. Investors and foreigh companies often find diversification benefits when foreign investments are added to an all-domestic portfolio. Risk of foreign securities held by the U.K. or U.S citizens, caused by fluctuating exchange rates, can be managed by purchasing foreign claim on foreign securities denominated in the U.S. dollars or U.K pounds. Hedging The risk that a multinational corporation faces due to fluctuating exchange rates is one that can be managed. Forward contracts, futures contracts, and currency swaps are all available to help a company hedge currency risk. A hedge is a financial agreement used to offset or guard against risk. A company may choose to hedge against adverse changes in interest rates, commodity prices, or currency exchange rates. Foreign Contracts Foreign contracts are contracts where one party agrees to buy, and the other party agrees to sell, a certain amount of an asset (a currency for example) at a spec­ified price (exchange rate) at a specified future time. Futures Contracts Futures contracts are similar ex­cept they are standardized contracts and can be traded on organized exchanges. Swaps Swaps are directly negotiated contracts, like forward contracts in which each party agree to swap payments at specified points in the time according to a predetermined formula. For instance, one party could pay U.S. dollars and the other Japanese yen, each according to amounts called for in the swap contract. By agreeing to a forward, futures, or swap contract, a company can protect against a loss that will occur if the feared change in interest rates, exchange rates, or commodity prices occurs. The firm using these hedging instruments insulates itself from the risk. Bibliography Chapter 13, ROIC and WACC [Online] http://216.239.59.104/search?q=cache:x2nnemf_v3MJ:flash.lakeheadu.ca/~pgreg/assignments/3019chapter13_w05n.pdf+WACC+calculations+issues&hl=en (Accessed December 23, 2005) LPDU – Glossary [Online] www.comp.lancs.ac.uk/engineering/lpdu/Glossary.htm (Accessed December 23, 2005) Small and Medium-sized Enterprise - Wikipedia, the free encyclopedia [Online] http://en.wikipedia.org/wiki/Small_and_Medium-sized_Enterprise (Accessed December 23, 2005) Not Available [Online] http://www.kelley.iu.edu/finance/workingpapers/SME.Lending.IU.Working%20Paper.Udell.3.4.04.pdf (Accessed December 23, 2005) Van Horne and Wachowicz. Fundamentals of Financial Management, 10th Edition. Prentice Hall. Gallagher, and D. Andrew. Financial Management – Principles and Practice, International Edition. Prentice Hall. Read More