Thomas McGills Financial Decision from 1990 to 2007 - Essay Example

Thomas McGill’s financial decision from 1990 to 2007 1990: From the information presented it is clear that in precisely the year 1990 Star Bay required external funds amounting to $20 million in which half of this amount was raised by issuing of common stock and the remaining half was raised through long term bonds. It is seen that during the year 1986 to 1989 expenditure of R & D by Star Bay was extremely high. During this period the increase in earnings was not at par with the increase in sales. It is noted that albeit Star Bay was a new company compared to others who they were in competition with in the market they already had a debt percentage of around 30% which was close in proximity to the industry’s average of 38% resulting to a mix of bond and stock issuance being the best available option. The risks involved with the stocks is much higher than that of bonds hence resulting to the cost of bond issue being lower than that of selling common stock. It should also be noted that the issuance of stocks was very risky because the Star Bay was a not a very well established firm since it had a price to earnings ratio of 10 in comparison to the industry’s standard which was at 18 hence limiting the probability of investors buying the stocks of the company. Due to the fact that it was a new company it was hard for star Bay to raise funds by debt because a loan is issued on the sole basis of credit worthiness of the borrower. The Star Bay could have issued more bonds compared to the 50:50 bonds and stocks because in its financing, we see that the debt percentage was lower in regards to that of the industry so it could without a doubt have leveraged more in long term the bonds issue. 1992: It should be noted that all the figures in $ for the year 1992 Cash Budget for the year 1992 Quarter 1 ‘92 Quarter 2 ‘92 Quarter 3 ‘92 Quarter 4 ‘92 Beginning Cash Balance Nil -12100 -10100 -8600 Cash Inflows Total Sales 29000 44000 51000 54000 Cash Outflows Total Purchases 37500 37500 45000 22500 Expenditure 3600 4500 4500 5200 Total Cash Outflow 41100 42000 49500 27700 Ending Cash Balance -12100 -10100 -8600 17700 Minimum Desired cash level 5000 5000 5000 5000 A total of 25$ million was required so that the products of motor housing could be accessed but the only obstacle was that it could be done only through cash or also by issuing Star Bay company’s of equal value. A recommendation by Thomas McGill was made that they do it by giving cash. Stock issuance or the long term debt means could have been used to finance this cash. Debt borrowing would have definitely impacted the credit worthiness of Star Bay Company in a negative way. An agreement could not be fully reached on the issue of borrowing because of the fact that the debt ratio in financing of Star Bay had increased to 35% in the year clocking 1990. Raising some amount through equity issuance, some amount through loan at 5% interest while some amount via short term borrowing at 4.25% interest would have been a better option instead of using a 15 year long term loan. 1995: Plans of reduction of the Star Bay Company’s debt were initiated by McGill in that retiring of $25million of 5% long term debt. It was a bad idea to defer the retirement of the debt since the debt of star bay company was very high and it was increasing further. In 1992 it borrowed $25million through long term borrowing and since then it had been 3years. Reduction of its debt should have been done as soon as possible. Wall Street analysts though believe that the rates will go up due to the inflationary pressures but that was just a mere speculation. Retirement of some percentage of the debt would have been a better idea than the decision to retire the debt. 1999: The company needed $15 million to finance its continuous growth. Even with the steady growth of the company money was still needed to finance its growth and a number of options were available: Common stock at the price of $33, long term convertible at 6.5% and could be converted to $40/ share, like short term debt at the rate 7.5% and long term, non convertible at 7.5% Issuing long term convertible bond was completely justified because the debt ratio of the company was lower than that of the industry’ average (37%). Also the cost associated with the bond issue is lower than the cost of stock issue. Decision to finance using convertibles was fully justified because the stocks of Star Bay were doing well in the market. They had been split thrice and were trading at the price of $35. The investors will be attracted to this deal because they will have the option to convert their bonds into the stock, if the stock is doing well. Thus it can be said that McGill’s decision to use this idea was without a doubt completely justified in regards with the performance of the company. 2002: Inflationary pressures resulted there being high chances that the interest rates would raise high throughout 2002; hence McGill’s suggestion was that refunding of the short term loans with the long term loans. Existing level of short term loan was 6%, so the board issued the non convertible bonds at an interest rate of 7.25%. This was correct considering a significant increase in the interest rates that would negatively impact the short term borrowing cost. Totally depends on the organization and the prevailing economic conditions. The long term financing is better if the company doesn’t have immediate sources of cash inflows or the company is planning to have liquidity in its hand in terms of large working capital. Benefits and disadvantages are associated with both the means of financing i.e. somewhere long term financing is better and somewhere the short term financing. 2004: Initial capital outlay: $12.5 million. Returns: Year 1: $ 8.0 million, Year 2-9: $ 2.5 million, Year 10- $ 3.0 million. Cost of capital 10% Net present value of the investment: NPV= -12.5 + 8/ (1.1) + 2.5/ (1.1) ^ 2 + 2.5/ (1.1) ^ 3 + 2.5/ (1.1) ^ 4 + 2.5/ (1.1) ^ 5 + 2.5/ (1.1) ^ 6 + 2.5/ (1.1) ^ 7 + 2.5/ (1.1) ^ 8 + 2.5/ (1.1) ^ 9 + 3/ (1.1) ^ 10 = -12.5 + 20.64 NPV = $8.14 million Due to the present value of the investment being positive this means that it is profitable in relation to the cash inflows and cash outflows that are associated with the project. Delivery of profits on a long term is guaranteed but it requires an initial investment of $12.5 million. This can be done either by borrowing from the bank or by issuing bonds. Present value of an investment cannot be solely be used as the final indicator to whether accept or reject the opportunity. Considering the cost of capital as 10% and with the present bank interest rates of 9% and bond interest rate of 8%, the project seems to be profitable and appears to be one in which investment should be made. A number of other factors are also needed to be considered before finalizing anything. For example the internal policies of the company, the organization may be using its cash to expand or to acquire some assets which might are necessary at that particular time or are of importance in future. Thus, in that case the company might not have the funds required for initial outlay and may require funding through external sources. 2007: Decision of Thomas McGill of postponing the investment plan proved to be a right one as the better investment opportunities together with the favorable economic conditions have come up in 2007 and this is evident by the following arguments in that, economic conditions of the nation have improved over the years. They can now take the advantage of the favorable contracts for the needed capital equipment. The requirement of the fund is $20 million, this could be raised either by long term debt option with fixed interest rate of 10% or by issuing long term bonds with interest rate of 8.75%. Since the cost associated with the debt option is more, therefore it is rejected and the issuance of bond is decided by the management to raise capital. 11. View on McGill’s decisions McGill has seen all the ups and downs in the business. He has evaluated all the financial decisions of the company and gives his suggestions to the upper management. He has been associated with the organization, since its starting and has been a key person in making some of the most viable decisions for the Star Bay Company. Some of his decisions have proved not to be very good for the company but still most of the decisions taken by him were correct considering the financial strength of the company and then prevailing economic conditions of the nation. 111. If I were George Teel Analyzing external financing decisions it is found that Thomas has proved to be correct most of the times since due to his association with the organization and hence has gained experience of over 20years. I would evaluate the performance and effectiveness of Thomas McGill over the various departments, budgeting, MIS reporting and policies of the Star Bay Company. All these results will give the idea of the internal management and operations of the company. Some of his decisions proved not to be very good for the company, but still forecasting the risk and return for the company is quite a difficult job. it was found that the company has a very well organized financial control and the budgeting procedures. The credit for this can be given to Thomas McGill. I would make a strong recommendation that Star Bay Company should really appreciate the efforts of Thomas McGill and should not let him go away. Since he knows the company from starting, thus his decision making ability would be somewhat better. On many situations he has correctly analyzed the economic conditions that would prevail and also helped the Star Bay Company to choose the best financing source among the various which were available at different point of time. Read More