Link between Different Corporate Financial Decisions - Assignment Example

FINANCIAL MANAGEMENT Table of Contents Part A 3 Investment Decision 3 Financing Decision 4 Dividend Distribution Decision 5 Link between Different Corporate Financial Decisions 7 Part B 7 Part C 11 References 13 Bibliography 15 Part A Investment Decision Every business employs it’s assets to generate earnings. A part of these earnings are returned to the equity shareholders for their contribution to business while the remaining part may be re-invested into business or parked into other profitable investment opportunities. This activity of deciding ‘what is the optimum investment option’, is evaluated by financial managers and approved by the Board of Directors is known as Investment decision. The Board of Directors (headed by Chairman of Board) ultimately takes investment decisions after consulting with other shareholders. On the basis of time horizon, amount and type of asset that the business would like to hold, investment decision may be classified into short-term investment decisions and long-term investment decisions. Investment decisions are always in-line with business objectives and long-term strategies (including business expansion into newer geographies, diversification of product line, etc.). Investment generally involves buying, replacing, selling, holding and managing assets like land, plant & machinery, buildings, etc. While short-term investment decisions are generally focused on ‘working capital management’ that balances current assets and liabilities to carryout day-to-day normal business operations, the firm’s long-term investment decisions has direct impact on its capital structure and hence is also sometimes called capital budgeting (Kayhan and Titman, 2004, pp.1-5). Capital budgeting helps to answers the following questions, Should the business acquire other firms for expansion of resources or make fresh green-field investment? What type of plant, property, and equipment should the business hold? What line of business should the business focus? Is it logical to replace existing machineries that are increasing company’s recurring expenditures? Should more efficient distribution system replace current one? Form the above issues/questions the objective of investment decision is clear, which is optimally allocate monetary resources and other assets (Faulkender and Peterson, 2005, pp.45-47). But the obvious question that arises is that from where the company will manage financial resources to carry-out such activities. This is where the Financing decision comes into play which is explained in next section. Financing Decision The investment decision gives an idea regarding optimal investment alternative but almost every investment activity requires firm’s to pay for assets. For instance, the business may use its retained earnings or take a bank loan to make investment. The loan from bank will provide the firm with cash in exchange for financial assets which the business entity promises to repay along with interest. Other options include issuing fresh equity (or potion of paid-up capital), issue of debentures (with fixed or floating coupon rate of interest payable on outstanding principal), uses hybrid financing structure that combines some or all of above options. The main objective of financial management is concerned with investment decisions, financing decisions, and dividend decisions aimed at shareholders’ wealth maximisation. This will ensure maximisation of shareholders’ wealth and optimum utilisation of scarce resources. These decisions are not only dependent on capital project but other ‘economic’ factors significantly influence these decisions. For instance, if the management finds that financing from domestic market under current economic climate could elevate the cost of borrowing due to factors such as high inflation, high bank rates, higher expected returns by shareholders, etc., then it may opt for raising the funds from international markets (foreign investment). This could give the added firm advantages especially when home currency is relatively stronger to country from where funds are raised. The interest rates on deposits in many countries are close to zero that often increases the risk appetite of investors to investment in emerging economies in expectation of higher returns (Graham and Harvey, 2002, pp.10-15). Now, when investment and financing decisions are agreed upon by the shareholders, management and the board, the shareholders may expect handsome returns from their investment which will maximise their wealth (that is cash) which is also the ultimate objective of financial management. The next section explains how the management, the Board, and the shareholders decide portion of profits attributable to owners after considering current economic climate as important decision criteria. Dividend Distribution Decision The shareholders who invest in company’s paid-up equity capital are the ultimate risk takers and are entitled to entire residual profits generated by the business after all internal and external liabilities are obliged. Dividend decision refers to management policy of distributing business earnings to shareholders for their contribution of capital in business. This decision is very important because the proportion of retained earnings to dividend distribution reflects business outlook. The distribution of dividends is not mandatory and the management may defer dividends in case the company fails to generate sufficient profits or incurs losses. This is because in such case the owners will have to share losses and management or directors may decide not to declare dividend payouts. The dividend distributions are very important as it influences stock price and capital structure (Glickman, 1996, pp.16-17). In addition, dividends also have implications on tax liability of stockholders (as per Modigliani-Miller Approach, including taxes). The board generally takes dividend decisions based on following factors, 1. Current climate or conduciveness of economic factors for investment 2. Availability of free-cash flow 3. Information signalling (a theory developed by Miller and Rock in 1985) that states announcements on dividends convey important information to investors regarding future prospects of business. For example, distribution of dividends might be perceived by investors as lack of profitable investment options to the management and hence the firm is not planning any capital investment in near future (Bharath, Pasquariello, and Wu, 2009, pp.3215-3216). 4. Different investor has different preferences over dividend like an old retired individual might prefer investment in firms that regularly payout dividends whereas a young high income earning investor might avoid dividends to reduce high marginal tax liability on income and consider capital appreciation of stocks instead (Goldstein, Ju, and Leland, 2001, pp.483-486). This phenomenon is also known as the ‘clientele effect’ which is determined by individual preferences. Link between Different Corporate Financial Decisions After discussing the financing decision it is clear that primarily funds may be classified into internal (retained earnings) and external funds (new debt or equity). An appropriate mix of these sources of finance determines cost of borrowing, capital structure and payout ratio of the firm. The payout ratio is basically the dividend decision and is based on the principle that whenever profitable investment opportunity exists there will be less or no dividend declaration and vice-versa. These decisions increase the market value of the firm and maximises shareholders’ wealth. Part B The financial management which basically revolves around the three types of decision discussed earlier aims to maximise shareholders’ wealth. The 3 decisions namely investment decision, financing decision, dividends distribution decision might look different from their individual definition but if one looks at them with the perspective of directors or ultimate business objectives then they are all inter-connected to achieve the main goals of business. This can be best understood by considering a practical illustration. The aim of this section is critically analyse the above concepts/decisions and to what extent any randomly chosen UK limited company uses these decisions to optimise allocation of resources and shareholders’ wealth. The company chosen for this activity is Tesco Plc, which is the third largest retailer in the world in terms of revenues (after Walmart and Carrefour). It is a British MNC headquartered in Hertfordshire, England; and its shares are listed and publicly traded in London stock exchange. The annual reports, published accounts, along with other press releases of the company will help to practically relate and distinguish the three types of decisions used in financial management. The following key issues are required to be kept in mind while analysing the published accounts of Tesco plc and relating the three theoretical concepts discussed in Part A: What investments were made, and why? - The annual report of Tesco Plc reveals that both the management and shareholders were motivated to continue business expansion from the company’s compounded annual growth in sales of over 12.8 percent. The Chairman’s statement to shareholders states that continued profits reflects that re-investment decisions in UK are paying-off. Tesco plc recorded total revenues over £64.8 billion for the year ending 2013 booked operating and net profit over £3.07 billion and £124 million respectively. The company invested in fixed assets to expand services in Thailand to over 1,115 stores which is becoming a key market for the company. Further, the chairman’s statement clearly states that the immediate objective of firm is develop Tesco as international MNC retailer with very strong brand recognition and identity appreciated by clients across globe (Tesco, 2013, pp.1-9). Were there any significant disposals? - The corporate governance report of Tesco reveals states that it has obtained new funding worth £1.4 billion from disposal of owned properties. This is also helped the group to reduce its net debt liability from £6.6 billion in 2012 to £6.6 billion in current fiscal. Judging by the magnitude of disposal it can be said that this was significant disposal and indication of better investment option replacing old ones. Who comments on these investments/disposals in the report – Chairman/CEO/CFO and why? - The comments on all investment/disposal decision are given by the CEO of Tesco as the board committee has been found to support the CEO in developing primary investor relation with the shareholders. However, both the CEO and CFO regularly hold meeting with shareholders to update the board on outcome of every meeting and activities (Tesco, 2013, pp.24-40). Was finance obtained from internal or external sources (or both)? - The notes in annual report of Tesco reveals that no new bonds were issued during the financial year but the company raised £57 million by issuing ordinary shares of face value of 5p each (Tesco, 2013, p.133). At the annual general meeting (AGM) of 2012, shareholders authorised the company to raise funds by issuing paid-up equity capital at current market price to maximum ceiling up to 10 percent of issued share capital. Hence, the company mainly obtained financial resources from internal sources (Tesco, 2013, p.67). Was finance from short term or long term sources? - The company has been found to raise capital from long-term financial sources and no short-term funds were employed for financing long-term projects. What were the sources of any external finance? - The main sources of external finance used by Tesco during 2013 are, 1. Hire purchase or leasing – The company has experienced tremendous economic growth and strong market position from emerging economies such as Malaysia, South Korea and Thailand. The company opened about 300 express stores in Thailand contributed primarily from hire-purchase or lease of fixed assets and properties. 2. Loans – There were inter-firm transfer of cash between joint ventures and associates but no significant long-term debt was taken during the year. Is there any governance discussion of the risk relating to the investments/disposals and the impact on financing? - Tesco plc discusses in detail regarding any risk related to investments/disposals, their impact on financing and investors in their annual report which is prepared by maintaining all requirements of IFRS 12, IAS 32 and IAS 39 (Disclosures of ‘Financial Instruments’ and their measurements). Was there evidence of any finance being repaid to investors? - On September 2012, Tesco plc had repaid its long-term debt liability worth £1.5 billion which is mentioned in page-108 of the annual report of Tesco plc for 2013. How do this year’s dividends compare to previous years? - When the current year’s dividends were compared to the previous years it was found that the Board of Directors has maintained same dividend payout policy. The proposed final dividend that is approved by the Board also requires shareholders’ approval (generally made at AGM). (Source: Tesco, 2013) The proposed final dividend for current financial year stood at £815 million or 10.13p per share (Tesco, 2013, p.93). Part C The critical analysis of the business policies and financial management practices of Tesco plc particular to investment, financing and dividend decisions reveals that these decisions (illustrated in Part B) were not made in isolation and hence they are all inter-linked. For instance, the chairman’s statement clearly states that the immediate objective of firm is develop Tesco as international MNC retailer with very strong brand recognition and identity appreciated by clients across globe. This implies that the firm will continue investing in emerging economies for expanding business by efficient allocation of resources. Also, the financial statements of the company reveals that investment in fixed assets increased from 13,675 million in 2012 to 14,540 million in 2013 (up by 6.3 percent). A significant portion of this investment was dedicated into emerging economies where company experienced strong market and customer brand recognition. Such decision justifies the Chairman’s statement given the primary objective of Tesco’s Board is to create long-term value for shareholders of company (Tesco, 2013, p.2). The optimal financing decision for this investment was combination of internal accruals, lease or disposal of non-core assets, and issue of equity. The group already retired debt liability worth £1.5 billion during previous fiscal which shows that the group is not considering current economic conditions suitable for borrowing. The dividend payouts were remained unchanged by the Board and also approved by shareholders showing that there are profitable investment opportunities for expansion and the management in consensus with shareholders will prefers leveraging this opportunity to increase scale of operations internationally. This will also reduce current high marginal tax liability of shareholders which would be applicable if the company decided to declare higher dividends this year. These strategic financial decisions were taken after considering optimisation of shareholders’ wealth and minimisation of firm’s overall cost of capital (Tesco, 2013, pp.94-95). References Bharath, S. T., Pasquariello, P. and Wu, G., 2009. Does Asymmetric Information Drive Capital Structure Decisions. [Pdf]. The Review of Financial Studies, Vol. 22 n 8. Available at: http://webuser.bus.umich.edu/ppasquar/microcorp.pdf. [Accessed on February 03, 2014]. Faulkender, M. and Peterson, M. A., 2005. Does the Source of Capital Affect Capital Structure? [Pdf]. The Review of Financial Studies, v 19 n. Available at: http://apps.olin.wustl.edu/workingpapers/pdf/2005-02-003.pdf. [Accessed on February 03, 2014]. Glickman, M., 1996. Modigliani and Miller on capital Structure: A Post Keynesian Critique. [Pdf]. UEL Department of Economics Working Paper, No.8. Available at: ftp://ftp.repec.org/RePEc/wuk/elecwp/elecwp9608.pdf. [Accessed on February 03, 2014]. Goldstein, R., Ju, N. and Leland, H., 2001. An EBIT-Based Model of Dynamic Capital Structure. [Pdf]. Journal of Business, Vol. 74, no.4. Available at: http://www.haas.berkeley.edu/groups/finance/WP/Goldstein-Ju-Leland.pdf. [Accessed on February 03, 2014]. Graham, J. and Harvey, D., 2002. How do CFOs Make Capital Budgeting and Capital Structure Decisions?. [Pdf]. Journal of Applied Corporate Finance, Volume 15, No.1. Available at: https://faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf. [Accessed on February 03, 2014]. Kayhan, A. and Titman, S., 2004. Firms’ Histories and Their Capital Structures. [Pdf].Available at: http://leeds-faculty.colorado.edu/bhagat/CapitalStructure-FirmHistory.pdf. [Accessed on February 03, 2014]. Tesco, 2013. Tesco PLC Annual Report and Financial Statements 2013. [Pdf].Available at: http://files.the-group.net/library/tesco/annualreport2013/pdfs/tesco_annual_report_2013.pdf. [Accessed on February 03, 2014]. Bibliography Antoniou, A., et al, 2002. Determinants of Corporate Capital Structure: Evidence from European Countries. Working Papers, University of Durham. Simerly, R. L. and Li, M. No Date. Re-Thinking the Capital Structure Decision. [Web]. Available at: . [Accessed on February 03, 2014]. Read More