- Evaluation of the Company’s Objectives
The corporate objectives of Aztec Catering, a company providing catering services to businesses, schools, colleges, hospitals and retirement houses in the United Kingdom are the following:
These corporate objectives of the company require substantial work to refine, extract and direct the company towards profitability, sustainability and growth. The first step in refining the corporate objectives of the company is to be familiar with what a corporate objective is. Faucett (2012), defines corporate objectives as ”statements of intent that provide the basic direction for the activities of an organization in pursuit of its mission.” This means that a corporate objective is a broad, catch-all statement of what the company intends to do or achieve but incorporates very specific, measurable, achievable, realistic time-based, exciting and recorded plans. This type of formulation of corporate objectives is espoused by RAPIDBI (2007) an online resource that specializes in “Business & Organizational Development Tools, Training & Services - Human Resources, OD & Leadership”. In their website, they propose that corporate objectives be SMARTER (specific, measurable, achievable, realistic time-based, exciting and recorded) to be more effective. Rightfully so, a corporate objective must specify what it is exactly that a corporation is intending to do. It must provide a measurable in that there is a quantifiable goal in mind. The corporate objective must be achievable meaning that it can be specific and measurable but also implementable and within the bounds of the capabilities of the organization. The corporate objective must also be realistic such that it can be achieved within certain acceptable parameters. Corporate objectives must also be time-based, which means that it should be implementable over a foreseeable time frame and not insensitively phased. The corporate objective must be exciting for the organization to take motivation from it and recorded, such that is relevant and can be reviewed after a certain period.
Using the SMARTER formulation for corporate objectives, we evaluate those of Aztec’s as shown below. The corporate objectives of Aztec fail in at least five out of the seven aspects of good corporate objectives.
- Financial Plan
The financial projections for Aztec are shown below. The assumptions used herein are based on the case information, namely:
- The sales growth is from 2012 to 2015 has been projected to increase. However, after 2015 sales growth is zero
- Profit growth is also zero from 2016 onwards. From 2012 to 2015, profit is 24% of sales
- Profit before tax is 0.83% of operating profit (assumed)
- Taxes will remain to be 30%
- Dividends and retained profit are split 50 – 50 of the after tax profit
- Sales to capital employed is 1 to 10
- Debt to Capital Employed is 40 – 60
- Interest rate is at 10% for borrowings
The projections below are static in nature, meaning they do not consider any change in the competitive environment that Aztec operates in. Therefore the projections must be used with caution. At the face level, Aztec will not experience any difficulties with their operations in the next five and ten years. However there is concern with their financial position at the end of 2015 when the projections are more guesses that actual intelligent data. The following are the critical items that I believe Aztec should take focus on:
- Growth
Aztec is not projecting growth through sales after 2015. Growth is the principal driver for profitability and sustainability. Weaver (2010) states how important growth is in his article Growth: The Importance of Growing Your Business. In his article he says that everyone talks about growing their business and why it is important. He says that businessmen are never satisfied with their business being just as it is because of two underlying factors. The first is that business is never in a steady, static state. This is a lesson that the directors of Aztec should take into account well, the fact that business is fluid and dynamic. Business leaders should respond accordingly to the sea of change because if not, the business will shrink and shrink very fast. Focusing on growth therefore motivates everyone to stay focused, deliver the requirements of the company to succeed and utilize its resources to implement its corporate growth.
Secondly, growth is directly linked with the long-term value of the company. A business is valuable if it has long term prospects for growth. For example, if a company wants to purchase Aztec, it will do so by valuing what cash it could generate in the future. If Aztec cannot improve its cash flow standings then it becomes less attractive and therefore less valuable as an enterprise. Therefore, growing a company is one of the main directives of management and the fact that the executives of Aztec are ok with stagnation after 2015 indicate that they may not understand the importance of growth to Aztec. At this point, it is important to go back at the corporate objectives of the company and ask “Where do we derive growth? What strategies should we implement and when? What is the desired outcome of those strategies and how can we build on them to improve our performance?”
- Capital Budgeting
Capital budgeting decisions are based on two underlying principles. The first is the abundance of logical, implementable, realistic, potentially beneficial projects for Aztec. The second is that Aztec has limited resources and can only fund select projects. Capital budgeting makes it easier for managers to decide which projects to purpose to effect growth for the company.
In the case of Aztec, the financial projections indicate that the company will be utilizing its funds to invest in capital assets if it retains its current assets to 100. This means that for the company to grow, it would be building new facilities, buying new equipment, using more trucks and expanding its product portfolio to gain more customers and sales. While this is the estimate, the sales growth does not reflect this decision thereby necessitating the review of the sales projections.
Net present value is the investment evaluation approach that utilizes the time value of money as the central driver for the valuation. This comes from the wisdom that a dollar today is worth more than a dollar tomorrow, next year or ten years from now. To conduct the NPV analysis, the cash flows generated by the business operations are discounted using a certain hurdle rate. This hurdle rate is the interest rate that the company could get from other investments and so becomes the benchmark for which the particular project is measured upon. Once the cashflows are “discounted” they are compared with the initial investment and if the sum of all those cashflows is positive, then the project is worthwhile taking and considerable as the company’s next initiative. If it does not provide a positive sum then the proposed project can be rejected because it will not add value to the company.
When comparing multiple projects, the total cost approach may be utilized. In this approach, all the costs and cash flows that are relevant to a particular business decision (and its alternative) are listed down, then adjusted based on time-value and then summed for the present value. This makes all the decisions clear to the business owner but this technique is rather involved and cumbersome for quick decision making. Tools such as decision tree analysis were developed for evaluating projects using the Total Cost Approach.
Another technique is the Incremental Cost Approach wherein only the incremental differences are taken into account, but every other logical step is followed as prescribed in the Total Cost Approach. This is particularly useful for evaluating a series of options because it is less cumbersome and errors are avoidable.
The most common evaluation technique is the payback method. This technique is easy to use and understand and answers the question, “when will I get my money back from this investment?” Many businessmen rely on the payback method as a back-of-envelope type of analysis but it is more than just that. The pay-back method takes into account all the assumptions made for the operations of the business to quickly count the number of period before the investment is covered in full by the project’s cash flow. All cash flows after that are pure profits, in this sense. This is a great technique but it fails to put into perspective the time value of money and therefore cannot be used as the sole basis for capital budgeting decisions.
In the case of Aztec, it is important that the company determine the capital budgeting approach to take. If it does invest in capital assets, it must review its growth projections to justify its investments. Any investment without growth effects is neither good for the company or its managers.
- Financing of Growth
The third concern is how Aztec looks at financing. For example, the projections below indicated that the company is considering expansion through the purchase of long-term assets. It will be retaining a smaller portion of its assets in very liquid form (current assets) but will be pumping its purchase of long-term capital goods through short-term financing which will strain its operations and cash flow. This means that there is a mismatch between how Aztec funds its long-term plays with its short-term financing. Mike Andrews (2012) of eHow explains that it is critical that there is matching of fund source and fund use. Smarta (2012) has similar instructions on matching long-term obligations with long-term sources to ensure that the operations are not hampered by too large or abrupt payments.
There are several ways the company can finance its operations for growth and development. The profits of Aztec are not enough to cover growth prospects. For instance, in the calculations above, the company makes a fraction of the non-current assets projected per year. The non-current assets, which are growing continuously yearly, represent investments in capital assets such as machineries and other hardware. The profits from operations simply cannot cover that. Clearly the company requires additional financing. This could be sourced through shareholders or through debt and the understanding of how both works is important to Aztec to determine which financing avenue to take.
- Debt finance, some rules of thumb are:
- Short-term financing such as quick loans and overdrafts are suitable only for short-term financing requirements
- Long-term financing such as bank loans, which are very expensive must be utilized for long-term projects
- Repayments must be budgeted well because of its impact on net cash flow, retained earnings, taxes and dividends
Using debt has several advantages, the most important of which is the fact that interest paid on debt is tax-deductible. It has several disadvantages however, such as:
- The rising interest rates make debt financing expensive
- Debt financing is difficult to secure for most types of businesses due to their inherent risks
- Some banks require personal guarantees
- Equity finance, which are investor’s contribution to the company may come from
- Current investors that want to expand their shareholdings in the company. Usually this happens when the company is poised for growth.
- Venture capital firms are outsiders wanting in on the company through unsecured finance but carry with them additional requirements for management expertise, credibility and networking.
- Angel investors are those that are like venture capitalists but require softer terms
- Private equity firms are those that are in control of other people’s money and will invest these in viable projects
Equity finance has several advantages but what is important is the understanding of the following difficulties of using equity funding:
- Equity investments are difficult and a matching of equity investor is required per project
- Equity investments mean giving up control of the company
- Equity investments are time consuming to secure
At the end of the day, the company must determine how much to spend and how to get money for spending. This would be dependent on how much resources the company can acquire to secure financing and what types of activities will be implemented to pay back what it would owe. Every business is different and Aztec should realize how to manage its investments and capital resources well to succeed.
- Cost of Capital and Shareholder Value Analysis
The cost of the capital used by Aztec can be summarized using the Weighted Average Cost of Capital (WACC) approach. This approach utilizes the known information about debt and equity and combines them in an intuitive formula for use. The WACC is the hurdle rate for Aztec when it identifies projects it wishes to implement because it takes into account the value of the resource it is using for making the investment.
The first step in figuring the WACC is finding the cost of debt which is easy to do since debt will be declared by whoever will be lending money to the firm. The cost of debt can therefore be based on what the banks as as interest for payment of the loans. The cost of equity is trickier but doable using the Capital Asset Pricing Model (CAPM) which is given off by the formula:
Cost of equity = risk-free rate + beta * (market rate of return - risk-free rate)
The formula for the WACC is therefore:
Once the WACC is calculated and the Shareholder’s Value is assessed. The Shareholder Value Analysis (SVA) assumes that the company is doing everything to maximize shareholder wealth. SVA is like NPV analysis except that it looks at investments from the shareholder’s perspective in that it looks into the contributions of the business unit to the whole project as a way to gauge long-term financial involvement in the business. The intrinsic basis for SVA is that shareholder value can only be true if the shareholder cost is less than the shareholder’s equity returns.
The current calculations indicate that the Shareholder Value does increase nominally. Its dividends are retained at 50% which increases in nominal value yearly but does not increase in real value. Therefore according to the SVA, the capital budgeting projects of the company could be rejected because it fails to improve shareholder value.
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