financial strategy

Benefits of retained earnings as a source of finance

No interest payment

No dilution of ownership

Generally quick to access

No external approval required

Disadvantages of retaining as a source of finance

May disappointment shareholders expecting dividends

Cash may already be required for operations

opportunity cost of using retained earnings should be considered

Advantages of using bank borrowing as a source of finance

Ownership not diluted

Interest may be tax deductible

Repayments can be matched to the life of the asset

Disadvantages of bank borrowers as a source of finance

Interest and repayment must be made

Increases gearing and financial risk

Security may be required

Lender may impose covenant

Advantages of bond or debt issuances as a source of finance

Can raise substantial amounts

Fix debt provides certainty

Ownership is not diluted

Disadvantages of bond or debt issuance as a source of finance

Issuance costs may be high

Regular interest payments are required

The company may need a strong credit rating

Increases financial risk

Benefits of rights issue as a source of raising finance

Raise permanent Capital

Does not require mandatory repayment

Existing shareholders can maintain their ownership percentage

Disadvantages of rights issue as a source of raising finance

Can dilute ownership if shareholders do not participate

May signal that the company is experiencing financial difficulty

Can be expensive and time-consuming

Shareholders may be unwilling to invest further

New share issue advantages as a source of finance

No compulsory interest payment

Reduces reliance on debt

May improve borrowing capacity

Disadvantages of new share issue as a source of raising finance

Ownership and control may be diluted

Dividends are not tax deductible

Shareholders may expect a higher return

Insurance costs can be significant

Consequences of high gearing

Increased interest costs

Reduced financial flexibility

Greater risk of reaching loan covenant

Difficult difficulty obtaining further finance

A low credit rating

Increased risk of financial distress

Pressure from Lender’s

Greater sensitivity to interest rate movements

What is the weighted average cost of Capital?

Combines the cost of debt and equity based on their proportions in the companies Capital structure.

What can weighted average cost of Capital be used for?

A discount rate in investment appraisal

A benchmark for assessing expected return returns

An indicator of the organisations financing cost

A measure against which value creation can be assessed

What factors affect the cost of Capital?

Business risk

Financial gearing

Interest rates

Investor confidence

Market conditions

Credit rating

Country risk

Currency risk

The risk of the individual project

Methods for investment appraisal

Net present value

Internal rate of return

Payback period

Accounting rate of return

Non-financial considerations for investment appraisal

Strategic fit

Operational capacity

Implementation risk

Employee capability

Environmental effects

Reputational implications

Regulatory risk

Stakeholder reaction

Alternative uses of funds

What is net present value?

NPV discount future cash flows to their present value

Decision rule - positive and PV the project is expected to create shareholder value. negative NPV - the project is expected to destroy shareholder value.

Advantages and limitations of NPV

Advantages - Consider the time value of money, Uses cash flow rather than accounting profits, Considers the whole project, Directly linked to shareholder value

Limitations - Depends heavily on assumptions, Forecast cash flows may be unreliable, The discount rate may be difficult to determine, Strategic benefits may be difficult to quantify

Advantages and disadvantages of internal rate return

Advantage- Express expressed as a percentage, Easy to compare with a required return

Limitations - May produce misleading results for unusual cash flows, Can conflict with NPV, Does not show the absolute amount of value created

Sensitivity analysis

Change as one valuable at a time to assess how sensitive the result is for example sales volume selling price raw material cost costs exchange rates interest rates implementation cost costs project delays

Scenario analysis

Considers the combined effect of several assumptions common scenarios include best case expected case worst case

Stress testing

Assesses by the organisation could survive an extreme plausible event

What is asset based evaluation benefits and limitations?

Values the company based on his net assets

Useful where the company owns significant tangible assets the business is being liquidated asset values are more reliable than earnings

Limitations may ignore internally generated brands and intellectual

May not reflect future earnings potential

Book values may not equal market values

What is earning based evaluation advantages, and limitations?

Applies an earnings multiple to maintainable earnings

Useful

where the company is profitable comparable listed companies exist

Future earnings are reasonably stable

Limitations

Selecting an appropriate multiple of subjective

Accounting policies made distort earnings

Useful or non-recurring items must be adjusted

Discounted cash flow evaluation

Discount expected future cash flow

Advantages

Forward looking

Based on cash

Can reflect the specific characteristics of the business

Limitations

Highly sensitive to assumptions

Terminal value may represent a large proportion of the evaluation

Difficult where future performance is uncertain

Synergy considerations

They can include

Cost savings

Removal of duplicated functions

Increased purchasing power

Access to new customers

Cross selling

Improved use of assets

Tax benefit benefits

However

Overestimated

Delayed

Expensive to achieve

Dependent on employee retention

Offset by integration problems

Arguments for paying dividends

Provide shareholders with a return

May increase investor confidence

May attract income focused investors

Signals confidence in future cash flows

Arguments for not paying dividends

Provide provides finance for investment

Avoids raising external finance

Protects liquidity

Reduces gearing

Provides a buffer during uncertainty

Methods of managing foreign exchange risk

Forward contract

Currency option

Money market hedge

Natural hedge

Forward contract

Fixes an exchange rate for a future transaction

Advantages

Provide provides certainty

Disadvantages

The company cannot benefit from favourable exchange rate movement

Currency options

Provides the right but not the obligation to exchange currency at an agreed rate

Advantages

Protect protects against adverse movements while allowing benefit from favourable movements

Disadvantages

A premium must be paid

Money market hedge

Uses borrowing an investment to lock in the Home currency value of a future foreign currency cash flow

Natural hedge

Matches foreign currency receipts with payments in the same currency

Advantages

May avoid derivative cost

Disadvantages

May not provide a perfect match

What is interest rate risk and how can we hedge it?

A company with a variable rate borrowing faces the risk of the interest payments will rise

Possible hedging methods include;

Fixed rate borrowing

Interest rate swaps

Forward rate agreement

Interest rate options