Corporate Finance - Wilkins - Assignment Example

Student Name: Tutor: Title: Corporate Finance Course: Institution: Executive summary Wilkins resigns from his work to start a journey of adventure of owning his own firm. From his savings, he is armed with $100,000 of buying a firm. However he has to raise an extra $200,000 in order to reach the minimum price. This report gives an account of Wilkins important decisions as he contemplates buying the firm when he meets Mitchell: a small firm owner. He has to look for ways of financing, managing, and deciding the future dividends policy of the firm. The answers to the four questions address some of the fundamental challenges that he has to face. Table of contents Executive summary 2 Question one 4 Question two 5 Question Three 9 Question Four 11 References 14 Question one Business valuation The discounted cash flow method has been used to determine the value of the firm. The various calculations have been done well. The business’ value depends on the future performance. History of the firm is important since it assist in the projecting the anticipated future performance of the firm. The performance of the business in its current time determines its performance in future. Mitchell idea of using discounted cash flows to determine the current worthiness of the business is very prudent. How the business will perform in future is important to its current valuation. A business can be bought at high price and start performing poorly later (Holton & Bates, 2009). In other circumstances other people sell their businesses when they start experiencing problems. Wilkins cannot dispute the method of valuation of the current business since is has discounted future value of cash flows to determine the value of the business currently. Some of the aspects that are considered in the determining the current value of a business include financial leverage, future performance, financial return expectation, cash flow, deal structure, and asset type as well as exit strategy (Meitner, 2006). The decision by Wilkins to pay $300,000 for the business is prudent regarding the method that has been used to discount the cash flows. However, the projections of the cash flows may be erroneous. The sales revenues have been projected to be increasing progressively. This is a business that is in financial turmoil and it may even take some years before making enough revenue to realize profits! There should unsteady growth in sales revenue as the business struggles to get back on its feet. Considering the current state of the business, it will require some proper re-organization before being able to post growth in the cash flows. Nevertheless, the projected cash flow values have increased from $10,000 to $100,000 in a period of about ten years. It would be unwise to decide on posting progressive figure of cash flows before understanding circumstance within which the business is operating. This projection of cash flows must be somehow erroneous. It would be wise for Wilkins to accept an amount that is lesser than $300,000 considering the assumption made by Mitchell in his valuation. It is not real to state that the variable costs will be constant between 1988 and 1993 as projected in the calculations. Question two Debt financing vs. Owner’s equity Wilkins has to contemplate between bringing in outside equity and using debt financing. Both options have their advantages and disadvantages from corporate finance perspective. Using equity from other partners will make Wilkins to lose control of running the business and making important decisions. It is important for Wilkins to evaluate the options available before settling for one. Surrendering two thirds share of capital to outside equity is letting the business succumb to external control. He has only $100,000 which made up a third of the required purchase price. He has to look for the remaining $200,000 so as successfully secure the business. However, a large percentage of external equity in the business has its own share of challenges that made Wilkins to be hesitant on the idea of outsourcing the remaining amount. Lack of control of the business would be one of the greatest disadvantages of this arrangement. Important decision would not be implemented without consulting the major stakeholders of the business. Large amount of outside equity will mean that the other partners will have more control of the business than Wilkins (Hawawini & Viallet, 2010, p.388). To effectively run the business and implement decisions that will turn around the business will require that Wilkins to be in charge of the business fully in order to enhance faster decision making. Allowing outside partners to have a larger share of the equity in business will expose the firm to instability. A partner can decide to pull out when he is needed the most. It would be unlikely that all partners will agree on the decisions made in the business. Delayed decision making and taking too long to reach consensus will hurt the effort of the firm to make use of every opportunity that comes in the market. For faster decision making and having enough legitimate control over the business, Wilkins has to be the main shareholder of the firm’s equity. Getting outside equity will also mean that the profits will have to be shared out and decisions concerning retained earnings will not be at Wilkins’ sole discretion. To limit outside equity to $100,000 allows Wilkins to have equal control over the business as the other partner. If he surrenders two thirds of the business to equity from outside, he will not be allowed to implement decisions without consulting other partners. This is a business that requires revitalization to get it back on track. Important decisions have to be done in the nick of time to take advantage of opportunities that may present themselves in the market. The decision to limit outside equity to $100,000 is very wise for Wilkins since he has to be in charge of the business in order to realize growth. Surrendering control to other partners will derail decision making. The partners who want to give equity capital would be directly involved in the running of the business and have to be consulted from time to time. Consequently, Wilkins will lose control over the business. Debt financing Debt financing is double-edged sword. When debt capital is used in moderation and wisely, it can prove to be an important instrument of a firm’s growth. On the other hand, when it is used in excess and imprudently, over-borrowing can lead to bankruptcy, financial ruin, and total disaster. For the case of a country, excess debt impairs the ability of the government to provide essential services to its citizens. Rising and high debt is a source of concern for any business. It is prudent for Wilkins to consider his options before resolving to accept large amount of debt financing. His concerns about debt financing are genuine following the implication of debt in a business. Where as debt financing can be used to seize an opportunity in the market, the same debt can lead to instability and eventual insolvency of the business (Murinde, 2006, p.361). Determining corporate leverage is one of the fundamental issues in corporate finance. The debt financing is risky when the loan is due and the firm has not yet started paying. Not being able to clear debts can lead to insolvency. When the creditors move in to claim what is theirs, the business can collapse within seconds and declared bankrupt. Regardless of the power of the debtor the debt has to be paid; this causes a strain on the business. The business can be liquidated easily if it gets into debt financing and fails to payback the amount loaned. Debt financing that is excess to the business also risk the stability of the business. However, debt financing allows the owner to have control over the business. Partners or investors are not allowed to meddle in the operation of the business in the event of debt financing. When debt financing is used, the interest that is repaid on the loan is tax-deductable. The good thing is that debt shields part of the business income from taxes and lowers tax liability charged in the financial year. Forfeiting the loan repayment in time can lead to financial ruin of the business (Buti & Franco, 2005, p.34). The commercial banks can move in and repossess the assets of the business. There are high stakes of liquidation of the business in case it fails to repay the money owed. The owner of the business is at stake of losing everything if he cannot pay back the loan plus the interest owed. The interest expense is an additional cost to the business and it leads to reduction of the profits of the business. If the assets are used as collateral in the acquisition of the loan, then the owner will lose everything in case he fails to repay the loan. The loan repayment can stress the financial strength of the business. The business will strain during low period when there is less money to repay the loan. The credit rating of the business can go down when it is unable to repay the loan and it will be hard for it to secure credit financing again from commercial institutions. Debt financing exposes the business to the risk of bankruptcy. The more debt financing is used in a business the higher the risk of being bankrupt. If Wilkins will go ahead and use debt financing for the remaining $200,000, the debt to equity ratio will be 3:1. This is dangerous for the business the owner’s equity is not enough to clear the debt in case of insolvency. This means that even the assets of the owner including personal assets will have to be sold to recover the loan. Whatever is pledged as collateral by the business will have to be sold. For any business to be safe debt financing should not exceed equity capital. The recommendation I would have given would not have differed from the stand taken by Wilkins on debt financing and outside equity. It is the stability and control of the business that is at stake in this case. I applaud Wilkins decision. Question Three Financing options If Wilkins is going to pay $300,000 for the Woofdale equity, he has to find a way of raising the remaining amount. It will be prudent to convince Mitchell to leave money in the firm, but unfortunately this has to be done if Wilkins has any hope of owning this firm. Wilkins can ask Mitchell to lease the plant and machinery to the company under capital leasing. In capital leasing the leasee has the intention of eventually buying the property being leased to him. Mitchell can be convinced to remain the owner of the plant under machinery and lease it to Wilkins under capital leasing. By so doing, Wilkins will run the business without worrying about interference from Mitchell. Mitchell will only have to wait for his monthly payments for the cost of the lease and nothing more. In this case, Wilkins will have full control over the business and still be able to have capital to run the business. Inviting Mitchell to be a partner will make Wilkins lose control of the business. Outside equity will also make Wilkins loss control over the business. The best way to have Mitchell contribution without making him a partner is to ask him to lease the property to Wilkins. From the options available to him, Wilkins can chose option (iv) where a fellow graduate student employed in a merchant bank can arrange for lease package for the plant and the equipment as well as the housing. Annual pay is $26,000 while the residual value is $140,000. 26000×5 = $130,000 The residual value is $ 140,000 Total paid = $(130,000 +140000) = $270,000 (However, this option will be $70,000 above the $200,000 required). This option would make the business strain under the expanse of repaying the debt. Leasing will not make Wilkins lose control over the business as the other three options. Outside equity in the first option will make Wilkins to lose control of the business since he will have other partners to consult. In the second option, Mitchell can leave his money in the business and hence have control over the business. This is a scenario that Wilkins does not what to imagine since he wants full control over his business. He wants to be the decision maker and the major sole owner of the business (Murinde, 2006, p.361). A commercial bill financing offered in option three is not a good idea since Wilkins wants to keep off debt financing, and it will also give less money as shown: Interest of the commercial bill is 11.5% The amount required is $200,000 The commercial bill will be accepted by the bank after deducting the amount of interest charged 11.5% of $200,000 = $23,000 The mount that the back will give will be $200,000 -$23,000 = $177,000 (this is after the bill is discounted in a bank; the amount given will be less than what is required). He wants inasmuch as possible to remain in control of the business. Debt financing exposes the business to risk and comes with some restrictions. The fourth option of leasing is the only viable option that Wilkins can consider owing to his terms of preference. Question Four Dividends policy In the event that Woofdale goes public, Wilkins has to decide on a dividend policy that will enable the firm to grow at the same time encourage more investors to pump into its investments. It is important for the right dividend policy to be decided on in order to encourage shareholders to continue investing in the company and even bring in more money. Dividend policies control how much of the earnings realized are to be distributed among the shareholders. This also determines the amount of money that should be retained in the business and what should be distributed to the shareholders. Dividend policy also decides the form in which dividend can be paid. Dividend plans vary from one company to another (Grullon, Michaely & Swaminathan, 2002, p.420-4). A company can decide to distribute large amounts of dividends to shareholder whereas another company can prefer investing back as much as possible the income realized into the business. Since the time of acquisition, Woofdale Audio was not doing very well. The company needs to invest any dime made in form of profits. When the company goes public in the next five years, it will have to invite members of the public to buys its shares. Through this means the company would be able to raise additional capital. When the members buy share from the company, they will definitely become shareholders. Shareholders have rights to dividends after every financial period. Shareholders are normally paid an amount of the realized earnings in what is called dividends. The board of directors declares the amount of dividends that has to be paid every financial year. An interim dividend is declared before the end of the financial period while final dividend is declared at the close of the period. The company has a choice to retain the earnings and not pay any dividends particularly for ordinary shareholders. For preference shareholders, they have to be paid despite the performance of the company. It is upon the company to decide whether to pay dividends to ordinary shareholders or not. The retained earnings are made up with what has not been paid to the shareholders. After the company goes public, it will be prudent for Wilkins to retain much of the earnings. For quite awhile the earnings should be retained and used to invest in further in financing activities. The retained earnings have to expand the operations of the business (Meitner, 2006). Woofdale Audio will need to allow retained earnings to boost its growth before commencing distribution of dividend to shareholders. The dividend payout ratio is obtained by dividing annual dividends per share by the diluted earnings per share. After Wilkins has decided to plough back the profit through retained earnings, he has to start paying out dividends in small amounts as a way of encouraging more investment from the shareholders. Absence of dividends payout for along time may highly demoralize the shareholders and discourage prospect investors. Moreover, other prospective shareholders will keep off from a business that they do not receive any incentives in the form of dividend. Holding a large amount of earnings in the business as retained earnings will be the best dividend policy for the early years. Secondly, the business can pay dividend through stocks and avoid money from flowing out of the business. After holding dividends in terms of retained earnings, the business will have to settle to paying dividends in form of stock (Buti & Franco, 2005, p.34). When the business has stabilized enough like after three years, it will be wise to start paying dividends in terms of cash. The company has to maintain low payout of dividends. This should be an amount that is sustainable for the business. High amounts of dividends payout may be incentives to investors but it can ruin priorities. All in all Wilkins should ensure that retained earnings are high in the first years of running this business. References Grullon, G., Michaely, R. & Swaminathan, B 2002, Are dividend changes a sing of firm maturity? Journal of Business, 75: 387-424. Buti, M. & Franco, M 2005, Fiscal Policy in Economic and Monetary Union: Theory, Evidence, and Institutions, Edward Elgar Publishing, London. P34. Hawawini, G. & Viallet, C 2010, Finance for Executives: Managing for Value Creation, Cengage Learning, New York. P. 388 Murinde, V 2006, Accounting, Banking and Corporate Financial Management in Emerging Economies, Emerald Group Publishing, Sidney. P.361 Holton, L. & Bates, J 2009, Business Valuation For Dummies, John Wiley & Sons, London. Meitner, M., 2006, The Market Approach to Comparable Company Valuation, Springer, New Mexico. Read More