Viability Report on JV
There lies a distinguishing characteristic of Multinational Corporation (MNC) in contrast with a collection of independent national firms dealing at arm’s length is, its ability to move money to its affiliates through internal transfer mechanism. In multinational financial system there is transfer of goods, services, technology and capital.
In the interest of facilitating stronger sustainable profitability and growth, decisions on resource allocation in organizations require a systematic, analytical and though approach as well as sound judgement. Project and investment appraisals and capital budgeting which involves assessing the financial feasibility of a report should use Discounted Cash Flow(DCF) analysis as a supporting technique to; a)Compare cost and benefit in different time period and b) calculate the Net Present Value(NPV). DCF is an improvement of Pay Back Period (PBP). The object of this method is also to show the most profitable investment. Only the difference between the method and PBP & Average Rate of Return (ARR) is that it not only shows the period of recovery of original cost of the assets invested but at the same time reveals the total earnings during the entire life of assets in term of present value. At present this method is considered as the best one in evaluating the capital expenditure decisions whether fixed or working capital. (Kroeger, 1984)
The acceptance or rejection of any project whether long term or short term- joint venture, under present value method depends upon the comparison between the present values of future cash inflows and present value of future cash out flows. (Lundholm and O'keefe, 2001, pp. 311--335)
If the companies present value of future cash inflows are greater than or equal to the present value of future cash out flows that is if the NPV is greater than or equal to zero than the proposal of investment either on fixed capital or working capital in the project would be considered else it would be rejected. The cost of capital is 12%, hence discount factor at 12% cost of capital is considered for finding out the present value of the cash flows. Since depreciation does not entail any cash outlay, it is deducted in finding out operational cost. The present value of 1euro at the end of year 1 to year 4 are, .8929, .7972, .7118, .6335 respectively. The sum total of present values of future cash outflows is 1.341 million euro since 60% of the investment to be made in the beginning at the year that is year 0, no discounting factor is applied to it. The net present value i.e., the difference of present value of cash inflows and cash outflows is -.5237. Hence the proposal of joint venture is not worth to be accepted. (Ross, 1995, pp. 96--102)
Operational and strategic challenges in re-domiciling the parent company to Monaco and carry on with the expansion project in to Asia.
IFM is a multinational financial services company based in France and has been operating for more than a half a century. The company at present turns over 60 million Euros per annum and generates a profit of 1.8 million Euros per annum. (Corpataux and Crevoisier et al., 2009, pp. 313--334)
In this financial background and given the strategic position of the company in the financial services business scenario, the company enjoys a strong and confident position France based. For the purpose of expansion and growth it would like to shift the headquarters to Monaco. These strategic decisions will require the firm to invest 5 million Euros. The company was originally established in Monaco and now wants to re-enter to base a headquarters with expectation of accelerating growth and ultimately increase by 5% in the next five years. The global market place is getting rapidly competitive. The ability to operate profitably in different global markets and flexibly shifting marketing operations between countries ia a matter of challenge for a global firm. About, half a century ago global operations meant a company doing businesses in a number of countries and market places. The top management of the companies consisted of senior employees from the parent countries, and the middle and lower levels consisted of people of the country of operation. But the scenario is quite different now. Technology and communication advancement has changed the way the companies operate and the customers think. Previously the companies, consumers, and their employees operated and made decisions on a local or regional basis. Today and in the future fewer boundaries will remain to constrain business, culture, and demand. Strategic challenge is how to develop the company through a central strategy. It is necessary the strategic management team not only put people into an international project, but also to cultivate new ideas from people from across the world. It helps the global management team to successfully navigate the global company in the face of global challenges. The operational and strategic challenges that are associated with materialization of the decisions, namely re-domiciling the parent company in to Monaco, and getting along with the expansion project are as follows;
1. The financial and taxation statutes in Monaco are different from that in France. This may disturb the arithmetical calculation associated with the finance and accounts of the company.
2. Entry into a new financial market poses few challenges from the competitor to the new entrant.
3. Placing the key officials into the new headquarters also could be issues of concern for the management.
4. Finding the right local partner in Asia
5. Exit from France might encourage a strong competitor to enter in the French Financial Services market and bite into the market share so far enjoyed by IFM Plc.
6. Managing cultural issues in foreign countries.
7. Political diversities in different countries.
8. Economic diversity in regard to national wealth.
9. Regional diversity as regard to distribution of wealthy and population.
10. Cultural and linguistic diversity.
11. Diversity in regards to country size and population.
Sources of finance to support the proposed expansion.
The company is planning of an expansion project across Asia especially in China and India. The objective is to increase by 5% in 5 years. This will require 250 million Euros.
The biggest advantage of using such funds is that the organization does not have to repay these during its lifetime (Though redeemable preference shares have to be redeemed at the end of the maturity period) however, the organization cannot go on issuing such shares as that would dilute the control in the organization and also weakens the capital base. The cost of equity is the dividend paid on such shares and is denoted by Ke. Retained earnings are the past years profit. The organization can use such funds to meet various requirements. Though these funds do not have a specific cost but the opportunity cost can be considered to be the interest forgone had the money been invested somewhere else. According to some scholars the cost of retained earnings can be considered to be same as cost of equity. Debt funds are the cheapest source o finance as the interest paid on such funds is tax deductible. For example if the rate of tax is 40% and the organization has paid $100 as interest the cost of debt would be 100(1-40%)= $60. Which means the organization was able to save $40 in the $100 paid as interest. However the organization cannot resort to debt funding all the time as it impact the capital structure and also the rate of interest keeps on increasing with an increase in the amount of debt. Debts are outsiders capital put in the business for which the company pays a predetermined rate of interest. Debt capital consists of Term Loan, Debenture and Short Term Loan. The key difference between Equity and Debts as:
1. Debts investors are entitled to a contractual set of cash flow (Interest and capital) whereas equity investors are entitled to a non contractual cash flow as dividend on profit from the residual income remaining after satisfying the paying off Debt investors.
2. Interest paid on debts is a tax deductable expenditure whereas dividend payments are not so.
3. Debt has a limited time period, but equity has an infinite life.
4. Equity holders have a prerogative of controlling the affairs of the company whereas Debt investors play a passive role but can impose some restrictions so that their interest is protected.
Advantages of equity capital:
(i) It has no compulsion to pay dividend. If the company has financial crunch, it can skip paying dividend without facing any legal consequences.
(ii) Equity capital has an infinite life so there is no obligation of the form to redeem it.
(iii) Equity capital provides a cushion to the lender. This increases the creditworthiness of the company.
Disadvantages of equity capital:
(iv) Issuing equity shares to outsiders would dilute the control of existing shares.
(v) The cost of capital of equity capital is very high actually highest. The equity holders’ expected return is higher than other investors.
(vi) Payment of equity dividend is not tax deductible.
(vii) The cost of issuing equity shares is high as compared to the cost of issuing other securities. Underwriting commission, brokerage, and other issue related expenses are high.
Retained earnings
Retained earnings are the undistributed profit, withheld in the business for expansion purposes in the future. This is an internal source of finance. If depreciation is used for replacing worn out fixed assets, then retained earnings are the only source of financing expansion and growth. Since share holders sacrifice their claim to retained earnings, it is also called internal equity. The companies retain 30% to 80% of profit after tax for financing growth. (Lintner, 1956, pp. 97--113)
Advantages of retained earnings:
(i) It is easily available; the company does not have to look outside for finance.
(ii) Retained earning effectively induces infusion of equity in to the business. Cost of issue and loss due to under pricing can be avoided. (Langemeier and Finley, 1968)
(iii) There is no dilution of control due to its utilisation.
(iv) Equity issues are generally viewed with scepticism in the stock market but there is no such negative connotation associated with retained earnings.
Disadvantages of retained earnings:
(i) The amount raised may not be sufficient.
(ii) The quantum of retained earning susceptible to variation due to the fact that companies follow a stable dividend policy, and as a result variability of profit after tax sustainably transmitted to retained earnings.
(iii) The opportunity cost is very high because it is that portion of profit which is forgone by the shareholders.
(iv) Many firms do not fully appreciate the opportunity cost of retained earnings. With a comfortable feeling they invest the retained earnings in sub-marginal projects that have a negative NPV. Obviously this hurts the interest of the shareholders.
Different sources of debt capital:
Preference Capital:
Preference share is a hybrid of equity capital and debt capital. It is equity capital in the sense, preference dividend is payable only out of profit after tax, the preference dividend is not an obligatory payment. Its payment depends upon the directors, and preference dividend is not tax deductible. It is akin to debt in the sense, rate of preference dividend is usually fixed, claim of preference share holders are prior to the right to equity holders, as regard to payment of dividend. Like lenders preference share holders do not have voting right. Nevertheless preference share is a kind of loan from outsiders. (Laurent and Ra, 2000)
Advantages of preference shares:
(i) There is no obligation to preference dividend; the company neither faces bankruptcy nor legal action if no dividend is paid.
(ii) There is no redemption liability if the preference shares are perpetual even for redeemable preference shares, it can be done by sinking fund method, and can be delayed without5 much penalty.
(iii) Preference share capital is generally regarded as part of net worth. Hence it increases credit-worthiness of the company.
(iv) Preference shares do not dilute control.
Disadvantages of preference share capital:
(i) This is a costly source of finance since dividend payment is not tax deductible like debt.
(ii) Though there is no obligation to pay preference dividend but skipping of payment can significantly hurt the image of the company.
(iii) Compared to equity share holders the preference share holders have a pirior claim to the earning of the company.
(iv) If preference dividend is not paid for three years then the share holders of preference shares have to be granted voting right.
Term Loan:
Term loans are loans provided by the banks for a pre agreed period time and for a pre-agreed rate of interest. The interest is paid on the same on monthly or half yearly basis. So long as outside financing is concerned the sources are either term loan or issue of debentures. Term loan refers to finance from bank payable in less than 10 years. They are used to finance fixed assets and to acquire working capital margin. Term loan is different from short term loan which is financed by banks and use to finance short term working capital needs. They are liquidated in less than 1 year. Following are the features of term loan;
(a) Currency: Financial institutions give foreign currency loan for investment in fixed assets and payment foreign know-how fee. (Scholnick, 1999, pp. 5--26)
(b) Security: Term loan typically represent secured borrowing. The asset puechased acts as security for the loan. Other assets of the firm may serve as collateral security.
(c) All loans provided by financial institutions, along with interest, liquidated damages, commitment charges, expenses are secured by way of ;
(a) First equitable mortgage of all immoveable properties of the borrower both present and the future.
(b) Hypothecation of all moveable properties of the borrower both present and future.
Advantages of debt financing:
(i) Interest on debt is tax deductible expenditure.
(ii) Debt financing does not result in dilution of control.
(iii) Debt-holders do not partake to the value created by the company as payment to them is limited to payment of interest.
(iv) Issue cost of debt is significantly lower than issue cost of equity or preference shares.
(v) Debt interest in nominal in nature as a result the debt provides protection from high un-anticipated inflation.
Disadvantages of debt financing:
(i) Debt financing creates obligation to pay principal and interest. Failure to meet this obligation may lead to financial embarrassment and even bankruptcy.
(ii) Debt financing raises financial leverage and thus, according to CAPM, it raises cost of equity.
(iii) Debt contracts put constraint on the firm’s borrowing, that limits the firms financial and operating flexibility, which in-turn affects the firms’ optimising behaviour.
(iv) If the inflation rate falls below expectation, cost of debt would become more than expected.
Debentures:
For a publicly traded company debenture is a viable alternative to term loan. Like promissory note it is an instrument of raising loan. Debenture holders are creditors of the company. The obligation to pay debenture holders is similar to that of a borrower who commits to pay the debt with interest within a specific period. (Ladley and Wilford, 1980)
Advantages and disadvantages of debentures:
The advantages and disadvantages of term loans as discussed above apply to debentures as well. One significant difference may however be noted. Before issue of debentures the firm enjoys great amount of flexibility in designing the issue, but after the debentures are issued the firm looses the freedom to re-negotiate the terms. In case of term loan the scenario is just reverse. The reason is clear. In case debenture the firm deals with numerous investors, but in case of term loan it has to deal with only a few institutional investors. (Atkinson, 2005)
Comparison summary:
References
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Corpataux, J., Crevoisier, O. and Theurillat, T. 2009. The expansion of the finance industry and its impact on the economy: a territorial approach based on Swiss pension funds. Economic Geography, 85 (3), pp. 313--334.
Hartley, P. R. 1998. Inside money as a source of investment finance. Journal of Money, Credit and Banking, pp. 193--217.
Kroeger, H. E. 1984. Using discounted cash flow effectively. Homewood, Ill.: Dow Jones-Irwin.
Laan, E. V. D. and Teunter, R. H. 2000. Average costs versus net present value. Magdeburg: Otto von Guericke Univ., FEMM.
Ladley, B. and Wilford, J. 1980. Money & finance. New York, N.Y.: Neal-Schuman Publishers.
Langemeier, L. N. and Finley, R. M. 1968. Effect of capital rationing and time on optimal farm organizations. Columbia, Mo.: University of Missouri, College of Agriculture, Agricultural Experiment Station.
Laurent, S. and Ra. 2000. Capital Structure Decision: The Use of Preference Shares and Convertible Debt in the UK. EFMA.
Lintner, J. 1956. Distribution of incomes of corporations among dividends, retained earnings, and taxes. American economic review, 46 (2), pp. 97--113.
Lundholm, R. and O'keefe, T. 2001. Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model*. Contemporary Accounting Research, 18 (2), pp. 311--335.
Ross, S. A. 1995. Uses, abuses, and alternatives to the net-present-value rule. Financial Management, pp. 96--102.
Scholnick, B. 1999. Interest rate asymmetries in long-term loan and deposit markets. Journal of Financial Services Research, 16 (1), pp. 5--26.
