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SAN LIO 1
CASH ANALYSIS AND MANAGEMENT
Cash is the life blood of every business because without it, a business would not run
Cash gives more liquidity than securities- thus the reason business people don't take all their cash and invest it in interest-bearing securities
Thus determining how much cash has been generated in every bottom line year in critical
Is should be noted that there are transaction items that hit the balance sheet which don't hit the P &L and vice versa
SAN LIO 2
These items are captured by the cash flow statement accordingly
A cash flow layout is identified as follows:
SAN LIO 3
IAS 7
STANDARD LAYOUT OF THE CASH FLOW STATEMENT Net cash flow from operating activities ▼ PLUS OR MINUS Investing Activities ▼ Financing ▼ EQUALSINCREASE OR DECREASE IN CASH OVER THE PERIOD
SAN LIO 4
NET CASH FLOW FROM OPRATING ACTIVITIES
DIRECT METHODCash from sales* xxxxLess Cash paid for purchases * (xxxx)Less cash paid for admin expenses (xxx)Less cash paid for distribution expenses (xxx)LESS TAXATION (xxx)Net cash flow from operating activities xxxx*CASH FROM SALES= Sales +opening debtors –closing debtors*CASH PURCHASES= Purchases+ open creditors- closing
creditors
SAN LIO 5
INDIRECT METHOD-NOTE ONE
Operating profit xxxxADD: Depreciation xxxADD: loss on sale of fixed assets xxxLESS: Profit on sale of fixed assets (xxx)INCREASES IN STOCKS (XXX)DECREASE IN STOCKS XXXINCREASE IN DEBTORS (XXX)DECREASE IN DEBTORS XXXINCREASE IN CREDITORS XXXDECREASE IN CREDITORS (XXX)LESS TAXATION (XXX)
SAN LIO 6
=NET cash flow from operating activities XXXX
NOTE TWO OF CASH FLOW Usually changes in cash- BANK balance and
ODMAY TAKE AN ILLUSTRATION
SAN LIO 7
Cashflow statement when used with other corporate reports will help bankers and other users of F/I assess:
Coy’s ability to generate future net cashflowWhether a coy is able to meet its financial
obligations e.g. payment of dividends, interest etcThe effect on the coy’s financial position of
investments undertaken during the accounting period
SAN LIO 8
The reasons for differences between profits and cashflows arising from normal operating activity
The value of a business since the statement provides a useful information for business valuation models based on estimates of likely future cashflows
SAN LIO 9
SOURCES Of CASH
INTERNAL SOURCESBusiness operations-basically NOTE 1Reducing investment in business assets- reduce stocks
for exampleRetained earningsLoans from directorsEXTERNAL SOURCES- DEPENDS ONThe nature of the businessThe size of the businessDirectors involved
SAN LIO 10
Economic factors etcTHE SOURCES INCLUDELoans- short-term, medium-term, long-termShares –various typesDebentures- basically loan agreementGovernment- grantsBondsFriends and family members
SAN LIO 11
IAS 7-CAH FLOW STATEMENT
The objective of IAS 7 is to require the presentation of information about the historical changes in cash and cash equivalents of an enterprise by means of a statement of cash flows, which classifies cash flows during the period according to operating, investing, and financing activities
SAN LIO 12
RELEVANT CASH FLOWS
operating activities are the main revenue-producing activities of the enterprise that are not investing or financing activities, so operating cash flows include cash received from customers and cash paid to suppliers and employees –WILL SEE MORE IN WC management
investing activities are the acquisition and disposal of long-term assets and other investments that are not considered to be cash equivalents
Management of liquid resources- short-term investments –usually within a year –e.g. stocks assets
SAN LIO 13
Financing- these include:SHARES NAMELYGoing public- advantagesOwners can diversify-growthIncreases liquidityFacilitates raising new corporate cashEstablishes a value for the firmSets up merger negotiationsIncreases potential markets
SAN LIO 14
Going public-disadvantagesCost of reportingDisclosuresSelf-dealings-???Inactive market/low price- fight for a market shareControl- voting rightsLOANS AND DEBENTURESThese are interest bearing funds and could beShort-term
SAN LIO 15
Medium-termLong-termNOTEThe way these are arranged is important. Managers don't want to finance for example long-
term investments with short-term loans. This is a recipe for corporate failure
In fact it is important to WATCH for any short-term loans . Can the firm pay these as they fall due in the short-term
SAN LIO 16
Long-term loans are preferred
UNBALANCED FINANCIAL DEVELOPMENTSIts top management’s job to maintain an
appropriate balance between:Long-termMedium-termShort-term finance
SAN LIO 17
And, within the first category an acceptable relationship must exist between:
Share capital andLoan capitalIt should be noted that once expansion occurs,
additional long-term finance is needed to cover the cost of fixed assets and working capital requirements; while a reduction in the scale of a company’s operations may permit the repayment of certain sources of finance
SAN LIO 18
These issues require proper planning- as management often fail to achieve a balanced financial structure either because it does not plan, ahead or because unexpected events occur.
There are two main aspects of unbalanced financial development namely:
Over-tradingOver-capitalization
SAN LIO 19
OVER-TRADING
This is a situation which will occur when the volume of business activity is excessive in relation to the finance provided by the shareholders
A situation like this will lead to the company to start going for external finance in the form of loan capital, bank overdrafts, and trade credit
In essence management has attempted to undertake too much too quickly meaning the company is left with insufficient resources to meet its currently maturing liabilities
SAN LIO 20
The company would therefore find it difficult to pay wages due to employees, debts due to suppliers, tax payable to the government, etc
The signs of over-trading should be looked for in the balance sheet and they include:
A decline in the ratios of debtors /creditors and current assets/current liabilities
A low figure of working capital A high ratio of fixed assets to working capital A severe shortage of cash Bankers are particularly interested in this scenario (over-trading)
because it is common cause of business failure
SAN LIO 21
OVER-CAPILIZATION
Occurs when management is unable to make full use of the capital available.
In this case, it may be prudent for management to return capital to the members either by purchasing or redeeming some of its shares or by canceling shares not unrepresented by assets.
SOLUTIONS?Return part of the capital by:Purchasing shares/redemption of sharesRepayment of loan capital
SAN LIO 22
CASH OPERATING CYCLE
Defined as the gap that exists between the time it takes for payments for goods or raw materials received into stock AND the collection cash from customers following their sale
During this period, the goods acquired together with the value added in the case of manufacturers must be financed by the coy
NOTE the shorter the length of time between the initial outlay and the ultimate collection of cash the smaller is the value of W/C
SAN LIO 23
WORKING CAPITAL to be financedCALCULATIONCalculate the time which the product spends in
each stage of its progression from acquisition to sale and actual cash receipt
LESS the period of credit received from suppliersElements in the calculation include:Stocks-held for a time then used or sold. These
would include:
SAN LIO 24
Raw materials- held in stock and then transferred to production
Work in progress- actual processing of raw materials
Finished goods-transferred from factory to ware house
Debtors – the average age of debts should be found from the values of debtors and sales
SAN LIO 25
Creditors- these finance the production and selling cycle from the time raw materials/goods are received into stock until they are paid for. The period is found from the values of creditors and purchases
Liquidity check may be used alongside W/C management
SAN LIO 26
Liquidity (quick) ratio = current assets-inven Current LiabilitiesPurpose is to examine solvency. Concentrates
attention more directly on a coy’s prospect of paying its debts as they fall due by excluding current assets which will not be converted into cash within the next couple of months.
Called the acid test of solvency
27
EXAMPLE OF COMPUTATION
SAN LIO
Raw material stock= raw materials stocks raw materials consumed+production period= Work in progres COG manufactured+finished goods stocks= finished goods COG Sold+credit to customers = debtors SalesLESS Credit from suppliers=Creditors Purchases of raw=CASH OPERATING CYCLE IN DAYS
SAN LIO 28
Good to take an example at this stage on COC
SAN LIO 29
WORKING CAPITAL MANAGEMENT
Need to observe the relationship between the cash operating cycle and working capital by looking at our example and identifying whether or not WORKING CAPITAL HAS INCREASED
This done by analysing movement in:StocksDebtorsCreditorsFor the two years 2009 and 2008
SAN LIO 30
WORKING CAPITAL MANAGEMENT
Defined as the excess of current assets over current liabilities
Shed more light on the short-term solvency of the coy i.e. its ability to pay debts as they fall due
The gist of the matter is to determine the rate at which current assets are converted into cash and how quickly current liabilities are paid
SAN LIO 31
This is certainly unique to every industry e.g. a retailer who sells goods for cash may operate with a much lower ratio than a manufacturer who sells goods on credit. This is because for the manufacturer, goods sold are ‘tied up’ as debts before cash becomes available.
On the same vain, the period for which stocks are held varies from industry to industry e.g. a small metal manufacturer may convert raw materials into finished goods much faster than a construction company
SAN LIO 32
It should be noted the recommended Working Capital ratio is 2:1.
The working capital ratio = Current assets Current LiabilitiesAnd the result is given as a ratioThe above arguments guide on what should be an
acceptable ratio (and not just a conclusion of an ideal 2:1)
Again this is closely linked to the cash operating cycle
SAN LIO 33
EFFICIENCY RATIOS
THE INVENTORY CONVERSION PERIOD= Inventory * 365 (IN DAYS SalesTells us how long it takes to convert raw materials raw
materials into finished goodsRECEIVABLE COLLECTION PERIOD= Receivables *365 (In days) SalesTells us how long it takes to convert receivables after a
sale into Cash.
SAN LIO 34
CREDIT POLICY
Credit period- what is the length of time buyers are given to pay for their purchases?
Discounts given- usually given for early settlement of accounts. If payment not done within the discount period, then FULL amounts are paid
Credit standards- means the required financial strength of acceptable credit customers. Lower credit standards boost sales BUT also increase the possibility of bad debts
Collection policy- usually gauged by its efficiency in-terms of collecting slow-paying accounts
SAN LIO 35
PAYABLE S DEFERRAL PERIOD= Payables*365 ( IN DAYS) PurchasesOR= Payables *365 Cost of goods soldThis basically the average length of time between
the purchase of materials and labor and subsequent cash payment for these
SAN LIO 36
TAXATION EFFECTS
IAS 12 particularly deals with the management of income tax
DEFINES THE FOLLOWINGTemporary difference: A difference between the
carrying amount of an asset or liability and its tax base.
Taxable temporary difference: A temporary difference that will result in taxable amounts in the future when the carrying amount of the asset is recovered or the liability is settled
SAN LIO 37
Deductible temporary difference: A temporary difference that will result in amounts that are tax deductible in the future when the carrying amount of the asset is recovered or the liability is settled
CURRENT TAX-Current tax for the current and prior periods should be recognised as a liability to the extent that it has not yet been settled, and as an asset to the extent that the amounts already paid exceed the amount due.
SAN LIO 38
Current tax assets and liabilities should be measured at the amount expected to be paid to (recovered from) taxation authorities, using the rates/laws that have been enacted or substantively enacted by the balance sheet date
TREATMENT/EFFECTAccrued items go the balance sheetCASH ITEMS go to the CASH FLOW statementCASH ITEMS are itemized in Cash budget/cash
forecast
SAN LIO 39
VALUE ADDED TAX
Tax charged at every stage ‘VALUE’ is added to a product
Organizations subjected to VAT receive cash net of VAT deductions and therefore this effect must be taken into account
There is a further cash effect when the VAT collected called the output tax less any tax paid on purchases (input VAT) is charged
If the input tax exceeds the output tax, reimbursement of the difference is made to the company
SAN LIO 40
VAT transactions should be carefully analyzed for cash budget purposes
EXAMPLEMaarifa Limited had a credit balance payable in
January 2010 on its VAT account of KSH 16,000 on December 2009. During the first three months of 2010 the organization made cash purchases net of VAT of KSH 250,000 and cash sales including VAT of KSH 425,500. Assume rate of VAT of 15%
REQUIRED
SAN LIO 41
1. Prepare the company’s VAT account for the first three months of 2010, showing the balance due at 31 March 2010
2. Prepare a schedule showing the appropriate numbers relating to purchases and sales
a) In the cash accountb) In the trading accountSOLUTION
SAN LIO 42
VALUE ADDED TAX ACCOUNTJan 2010 -VAT paid 16,000 Jan 1 2010 B/F 16000VAT on purchases * 37,500 VAT Sales * 55,500March 31 2010 C/D 18,000 0 71,500 71,500*Purchases ksh 250,000*15%= Ksh 37,500*Sales 115% = 425,500 ? 100% = 425,500*100/115= 370,000Thus: VAT = 425,500-370,000= Ksh 55,500
SAN LIO 43
CASH ACCOUNTDR Sales cash Ksh 425,500CR Purchases cash Ksh 287,500TRADING ACCOUNTDR Purchases (net of VAT)= Ksh 250,000CR Sales (net of VAT) Ksh 370,000NOTEWhen sales made on credit the company’s liability
to pay VAT arises once the invoice is issued.
SAN LIO 44
This may mean that VAT is actually paid out to the government before the cash is received from customers
On the other hand VAT on credit purchases may be set off against output VAT as soon as liability is entered into the books and before payments to the creditors are made. ( it is not necessary to wait until the debt is settled)
SAN LIO 45
PROJECTS WITH UNEQUAL LIVES
when choosing between mutually exclusive projects, we must first determine if they can be repeated, and if so, we must take this into account when we estimate the projects’ profitability.
If a company is choosing between two mutually exclusive alternatives with significantly different lives, an adjustment may be necessary
ILLUSTRATIONWe may illustrate this by assuming a company that
wishes to invest in TWO mutually exclusive projects
SAN LIO 46
Lets call these projects A and B as followsPROJECT A is a SIX year period project CASH FLOWS ARE AS FOLLOWS:YR0 KSH -40,000YR1 KSH 8,000YR2 KSH 14,000YR3 KSH 13,000YR4 KSH 12,000YR5 KSH 11,000YR6 KSH 10,000
SAN LIO 47
PROJECT B is a THREE year projectCASH FLOWS ARE AS FOLLOWSYR0 KSH-20,000YR1 KSH 7,000YR2 KSH 13,000YR3 KSH 12,000The COST of capital of the company is 12%IF we were to do the NPV of the two projects, we
can conclude as follows:
SAN LIO 48
NPV PROJECTS A AND B
YR CF DF PVYR0 KSH -40,000 1 -40,000YR1 KSH 8,000 0.8929 7,143.20YR2 KSH 14,000 0.7972 11,160.80YR3 KSH 13,000 0.7118 9,253.40YR4 KSH 12,000 0.6355 7,626.00YR5 KSH 11,000 0.5674 6,241.40YR6 KSH 10,00 0.5066 5,066.00 NPV (A) 6,490.80
SAN LIO 49
B
YR CF DF PV(KSH)YR0 KSH-20,000 1 -20,000YR1 KSH 7,000 0.8929 6,250.30YR2 KSH 13,000 0.7972 10,363.60YR3 KSH 12,000 0.7118 8,541.60NPV (B) 5,155.50Thus from this analysis the company will choose
project A since it has the higher NPVIRR of A =17.5% AND of B = 25.2%
SAN LIO 50
BUT
Although the analysis suggests that Project A should be selected, this analysis is incomplete, and the decision to choose Project A is actually incorrect.
If we choose Project B, we will have an opportunity to make a similar investment in three years, and if cost and revenue conditions remain at the SAME, this second investment will also be profitable.
However, if we choose Project A, we will not have this second investment opportunity.
SAN LIO 51
THE COMMON LIFE APPROACH
Therefore, to make a proper comparison of Projects A and B, we could apply the replacement chain (common life) approach
This involves finding the NPV of Project B over a six-year period, and then comparing this extended NPV with the NPV of Project C over the same six years.
The NPV for Project A as calculated is already over the six-year common life.
SAN LIO 52
For Project B, however, we must add in a second project to extend the overall life of the combined projects to six years.
Here we assume (1) that Project B’s costs and annual cash inflows will
not change if the project is repeated in three years and
(2) that the COY’s cost of capital will remain at 12%THUS YRS 4-5 &6 = CFs Ksh 7,000, 13,000 and 12,000
respectively
SAN LIO 53
NPV OF B ON COMMON LIFE
YR0 KSH-20,000 1 -20,000YR1 KSH 7,000 0.8929 6,250.30YR2 KSH 13,000 0.7972 10,363.60YR3 KSH -8,000* 0.7118 -5,694.40YR4 KSH 7,000 0.6355 4,448.50YR5 KSH 13,000 0.5674 7,376.20YR6 KSH 12,000 0.5066 6,079.20NPV(B-COMMON LIFE APPROACH) 8,823.40* (12,000-20,000). B is selected.
SAN LIO 54
EXPANSION AND STRATEGIC OPTIONS
Strategic management is the formal and structured process by which an organization establishes a position of strategic leadership.
Strategic leadership is about the achievement of sustained comparative advantage over the competition
Thus strategy is knowing the business you propose to carry out
Kenneth Andrew (1971) defined strategy as the pattern of major objectives; purposes or goals and essential policies or plans for achieving those goals, stated in such a way as to define what business the company is in or is to be in and the kind of company it is or is to be
SAN LIO 55
Kenichi Ohmae (1983) defined strategy as the way in which a corporation endeavours to differentiate itself positively from its competitors, using its relative strengths to better satisfy customer needs.
I define strategy as being different!. Your talents are unique, and they indeed can be implemented in a unique way.
SO, how does a business move from here? Capital budgeting-identify projects SOURCES of capital-capital structure decisions Cash flow management- CASH is CRITICAL Strategy management- stay ahead
SAN LIO 56
CAPITAL STRUCTURE OF A FIRM
Defined as the proportionate re-alignment of a company's different funding sources, including debt, equity and other hybrid instruments such as convertible bonds. Capital structure can fairly easily be measured by the ratio of long-term debt to total capital.
At the beginning of trade, a coy should have a balanced capital structure
This means assets should be financed/funded by the appropriate types of finance
SAN LIO 57
NOTE: Balance sheet shows assets and how they are financed- IAS 1 guides on full disclosure
Long-term sources of finance e.g. equity capital and debentures should cover all investment in fixed assets
But with sufficient excess to make a significant contribution towards funding current assets
SAN LIO 58
This so in order that we can achieve the ideal WORKING CAPITAL RATIO of 2:1 i.e. half the value of current assets should be financed by long-term capital and the remainder by short term sources e.g. creditors
Even within the long-term sources of funds, a satisfactory relationship should be created between various types available- whether it is shares or loans
SAN LIO 59
The optimum structure depends on such factors as the nature of the trade undertaken, the likely stability of profits (product lines, markets etc)
Lets assume this ideal structure is established as at the beginning of trade
On day one of trade, the financial structure established at the outset begins to be affected by the results of trading as well as passage of time namely:
SAN LIO 60
The initial investment increased by the amounts of profits earned and retained in the business and is reduced by losses
Passage of time means long-term loans being paid gets closer to the end of their term and may be classified as current liabilities
The rate at which debtors pay and creditors are paid affect the balance between current assets and current liabilities
SAN LIO 61
Credit purchases of additional stock needed to expand a successful coy and credit sales also affect the balance between current assets and current liabilities
In the long-run, success may encourage the acquisition of extra production capacity which must be funded by appropriate type of finance to maintain the structure
SAN LIO 62
Flows of resources take place with trading, and these have an impact on the enterprise
The impact may be beneficial or detrimental i.e. may lead to success or failure
Managers are paid to manage this structure and desirable balance of financing business activities
SAN LIO 63
PRACTICAL ASPECTS
The value of a firm is the present value of its expected future cash flows (FCFs) discounted at its Weighted Average Cost of Capital(WACC)
WACC depend on such factors as :The percentage of debt and equity (Wd and We)The cost of debt (rd)The cost of stock(rs)The corporate tax rate(T)THIS MEANSWACC= Wd(1-T)rd+ We*rs
SAN LIO 64
The implication of this is that the only way any DECESION can change a firm’s value is by affecting its:
Free cash flowsThe cost of capitalWHY?Because:V(Value of the firm)= ∑ FCFt (1+WACC)t
SAN LIO 65
Debt increases the cost of stock rs- this is because the fixed claim of debt-holders makes the residual claim of stockholders become less certain, hence increasing the cost of stock
Debt reduces the taxes a company will pay- this because companies deduct interest expenses when calculating taxable income. Notice the sharing of the company’s ‘spoils’ is between the debt-holders, investors and the government. This reduction in taxes reduces the after-tax cost of DEBT
SAN LIO 66
The risk of bankruptcy increases the cost of debt rd- this is because with higher bankruptcy risk, debt-holders will insist on a higher expected return- and this effectively increases pre-tax cost of debt
The risk of bankruptcy REDUCES Free Cash Flow- this is because :
as risk of bankruptcy increases, some customers will certainly opt to buy from another more stable company –which reduces sales. This scenario effectively DECREASES Net Operating Profit after Tax (NOPAT)-thereby reducing FCF
SAN LIO 67
Bankruptcy threat also negatively affects the productivity of workers and managers and this again reduces NOPAT and FCF
Bankruptcy threat also makes suppliers tighten their credit levels –which reduces payables causing net operating working capital to increase and therefore reducing FCF. These events effectively reduces the value of the firm
Bankruptcy threat AFFECTS agency costs- this is because:
SAN LIO 68
When business is performing well, managers may waste cash flow on unnecessary expenditures e.g. expensive cars. This is purely an agency cost (CALLED THE AGENCY PROBLEM). Threat of bankruptcy and possible take-over bids reduces this wasteful spending and this INCREASES FCF
The other effect is that in times of threats, managers may reject risky but would be profitable projects because to the manager- the company is his only investment BUT shareholders may be well diversified and therefore willing to take on risk projects which promise higher returns (CALLED THE UNDERINVESTMENT PROBLEM)
SAN LIO 69
BUSINESS AND FINACIAL RISKBusiness risk is the risk a firm’s common shareholders
would encounter if the firm had no debt. Note that the greater the use of debt, the greater the concentration of risk on the stockholders, and the higher the cost of common equity.
Business risk arises from uncertainty in projections of an entity’s cash flows- which simply means uncertainty about the entity’s operating profit as well as its capital (investment)requirements
The return on INVESTED capital (ROIC) puts these two aspects together to measure business risk
SAN LIO 70
ROIC= NOPAT = EBIT(1-T) Capital Capital= Net Income to common stockholders + After tax interest payments
CapitalNOTE :CAPITAL= FIRM’S DEBT + EQUITYAnd it means the required amount of
operating capital accordingly
SAN LIO 71
Business risk depends on the following factors: Demand variability- the more stable the demand is, the
lower the firm’s business risk Sales price variability- the more reliable output prices are,
the lower the firm’s business risk Input cost variability- the more stable the input costs the
lower the business risk Ability to change output prices when output costs changes-
the greater the ability to adjust and match output prices with input costs the lower the business risk
SAN LIO 72
Ability to develop new products in a cost effective and timely fashion- the faster the possibilities to develop new products as older ones become obsolete the lower the business risk
Foreign risk exposure- if a firm engages in the production of overseas products, it is subject to exchange rate fluctuations. The faster the fluctuations the higher the business risk
Political and economic stability- the less the stability, the higher the business risk
SAN LIO 73
The extent to which costs are fixed- the harder it is for the firm to vary its costs (they are fixed) the higher the business risk.
NOTE: This scenario is known as OPERATING LEVERAGE
SAN LIO 74
FINANCIAL RISK
This is the additional risk that the common stockholders have to content with because of a decision to FINANCE USING DEBT
Note that normally, stockholders would be exposed to a risk inherent in the firm’s operations- this is basically the business risk being the uncertainty inherent in the projections of future ROIC (ROCE)
Where an entity uses debt (financial leverage), this increases risk to the common stockholders
Financial experts call this risk CONCENTRATION-
SAN LIO 75
CALLED SO because the debt-holders who receive a fixed interest payments BEAR NONE of the business risk
In CONCLUSION- financing with debt increases the common stock-holders expected rate of return on an investment project
Debt also increases the common stockholder’s risk in an investment project accordingly
But typically, FINANCIAL LEVERAGE increases expected ROE (Return On Equity) but also INCREASES RISK
SAN LIO 76
It is important to appreciate how a trade-off between the two should be managed since they affect the VALUE of the firm.
SAN LIO 77
OPERATING LEVERAGE
This term is used in business to mean-that- other things constant, a relatively small change in sales results in a large change in EBIT (Earnings Before Interest and Tax)
The higher a firm’s fixed costs, the higher is its operating leverage
Note that other things constant, the higher the firm’s operating leverage, the higher is its business risk- simply because the said firm can not vary its costs as DEMAND changes.
SAN LIO 78
Operating leverage aspect can be use well illustrated by break-even analysis
REVENUE +VE EBIT
-VE EBIT
SALES
BREAK-EVEN EBIT=0
SAN LIO 79
High operating leverage Low operating leverage
SAN LIO 80
MODIGLIANI AND MILLER-NO TAXES
Assumptions of the theory of these two gentlemen There are no brokerage costs There are no taxes There are bankruptcy costs Investors can borrow at the same rate as corporations All investors have the same information as
management about the firm’s investment opportunities
EBIT is not affected by the use of debt
SAN LIO 81
The argument of this theory is that if all these assumptions hold: then a firm’s VALUE is not affected by its CAPITAL STRUCTURE
THUSVL= VU=SL+DWHEREVL= The value of a levered firm VU= The value of an identical but unlevered firmSL= The value of the levered firm’s stock D= The value the levered firm’s Debt
SAN LIO 82
Thus if MM CAPITAL STRUCTURE THEORY assumptions are correct- then it would not matter how a firm finances its operations and therefore CAPITAL STRUCTURE DECISIONS would be irrelevant.
The moral of this theory therefore is the fact that- it tells us when capital decisions would be irrelevant and thus helps financial experts deal with what is required for capital structure decisions to remain relevant and hence determining a firm’s VALUE
SAN LIO 83
MM THE EFFECT OF CORPORATE TAXES
This followed a relaxation of the assumption-no taxes and means corporations will factor in taxation
Interest payments are expenses deductible (DIVIDEND IS NOT)and therefore interest payment reduces the amount of taxes paid by a corporation
This subsequently means that if corporations pay less taxes to the government, then more of its cash flow is made available to its investors (i.e. the tax deductibility of the interest payments shield a firm’s pre-tax income)
SAN LIO 84
THUSMM tax shield formulaVL= VU + PV OF TAX SHIELDAccording to MM, the PV of the tax shield =
Corporation tax T*the amount of debt DTHUSVL= VU+TDWHEREVL=Value of the levered firmVU=Value of the unlevered firm
SAN LIO 85
MILLER: CORPORATE & PERSONAL TAXES
This theory of Miller, without Modigliani, brings in the aspects of personal taxes
He separated income as follows: Income from bonds- which is basically interest and
which is taxed at rates (Td) Income from stocks which is basically dividends as well
as capital gains- and that CAPITAL gains are taxed at a LOWER effective rate (Ts) than returns on debt (dividend tax is withheld in Kenya)
(IF stock is held until the owner dies no taxes paid)
SAN LIO 86
He argued that due to these tax implications: Investors are willing to accept comparatively low BEFORE
tax returns on stocks relative to the BEFORE tax returns on bonds (WHY?)
Remember risk- and how it affects required rate of returnThe point is:The more favourable tax treatment of income from stock
lowers the required rate of return on stocks and therefore favouring equity financing
SAN LIO 87
The deductibility of interest on the other hand favors the use of debt financing
According to Miller, the net impact of both corporate and personal taxes can be measured by the equation:
VL=VU + 1- (1-Tc)(1-Ts) *D (1-Td)
SAN LIO 88
WHERE
Tc= Corporate Tax rateTs= personal tax on income from stocksTd= tax rate on income from debt accordinglyNOTEMiller’s argument is that the marginal tax rates on
stock and debt balance out such that the entire bracket portion of the equation equals ZERO
ThusVL=VU
SAN LIO 89
However, experts still believe that there is a tax advantage to debt
EXAMPLEIf we assume a Tc 40%, Td=30% and Ts=12%Then the advantage of debt financing isVL= VU+ 1 – (1-0.4)(1-0.12) *D (1-0.30) VL = VU+0.25D
SAN LIO 90
THE TRADE-OFF THEORY
MM theory assumes no bankruptcy costsThe truth is that bankruptcy can be quite costly
because this exercise leads to extremely high legal and other accounting expenses
Customers , suppliers and employees are also lostEntities may also be forced to realise assets for less
than they would be worth in normal business operations
It should noted that most fixed assets are illiquid as they are made to meet the specific company’s needs
SAN LIO 91
When there is huge debt in the capital structure bankruptcy gets more complicated- particularly if debt is utilised to purchase fixed assets which would otherwise not sell in bankruptcy
It is these developments that led to the development of the so called TRADE-OFF THEROY LEVERAGE
Entities simply trade-off the benefits of DEBT FINANCING (favourable corporate tax treatment) AGAINST the higher interest rates and bankruptcy costs
SAN LIO 92
Thus according to this theory, VL= VU + Value of any side effects which
include:The tax shiedThe expected costs due to bankruptcy and
financial distress
SAN LIO 93
THE SIGNALING THEORYMM assumed symmetric information i.e. investors have
the same information about a firm’s prospects as its managers
But the truth is that managers have better information about the firm than the firm’s investors
This is what is known as Asymmetric information and it does in fact affect the optimal capital structure
SUMMARY A firm with positive prospects would AVOID selling
stock/shares and GO FOR DEBT FINANCE to avoid EPS dilution
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Thus debt offering is taken as a positive SIGNAL On the other hand- a firm with negative prospects
would go for stock/shares sell- which would mean bringing in new investors to share the losses
Thus the announcement of stock offering is taken as a SIGNAL that the firm’s prospects as seen by its management are not good
WHATS UP WITH STOCK?We are looking at future prospects of a firm
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A firm with better prospects would not sell shares- because it wants to avoid EPS dilution- hence it will go for debt financing- and make the ‘kill’ for its existing shareholders
A firm with poor future prospects on the other hand will sell stocks-and avoid debt- since it may not even repay the debt in the future- and thus invites others to share in the losses
IN SUMMARY
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Since issuing stock sends the wrong signals, and thereby depressing the stock price even when the company’s prospects are bright,
A firm should maintain a BORROWIN CAPACITY that can be used when good investment opportunities come along
This simply means in normal circumstances, firms should use MORE EQUITY and LESS DEBT
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ASYMMETRIC SITUATION
This drives an entity to raise capital in a PECKING ORDER thus:
Raise capital internally by reinvesting its net income as well as selling its short-term marketable securities
Issue debt- is a good signalIssue preferred stock- is a good signalOnly as a last resort will the managers issue
common stock
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SUMMARY
Estimating the optimal capital structure of a firm should involve the following STEPS namely:
Estimate the interest rate the entity will payEstimate the cost of equityEstimate the weighted average cost of capitalEstimate the free cash flows and their present
value, which basically is the value of the firmDeduct the value of the debt to find the
shareholders wealth- which is MAXIMIZED
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GENERALLY-FIRMS CONSIDER:
Sales stability- stable sales will allow for taking more debt
Asset structure- assets that are suitable as security for debt encourage firms to heavily go for debt
Operational leverage- firms with less operating leverage can employ financial leverage since it will have less business risk
Growth- encourages reliance on external capital sourcesProfitability- the higher the return on investment, the
less the debt
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Taxes- the higher the firm’s taxes, the greater the advantage for debt finance
Control- debt may be a better option where control is a factor
Management attitudes- this is about management judgement on capital structure. Conservative managers use less debt
Lender and rating agency attitudes- these will influence capital structure accordingly
Market conditions- stock & bond market conditions, when they cant sell, debt becomes the choice
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The firm’s internal conditions- a firm with better future prospects would rather go for debt finance until the higher expected earnings are realised- BECAUSE THESE MAKE THE STOCK PRICE BETTER
Financial flexibility- the more the profitable investment opportunities, the more it is likely to have a flexible capital structure
WHILE MAKING CAPITAL DECISIONS.