FINANCIAL MANAGEMENT

REPORT
Semester One 2017/2018

MADE BY:

SALMAN BUZAID – 201400057

MANSOOR ALMANSOOR – 201501397
MOHAMMED ALMANSOOR – 201501398
MOHAMMED ALMERAISI - 201301402
MARYAM HUSAIN - 201400493

JANUARY 5, 2018
BAHRAIN POLYTECHNIC
BU7404– Financial Management

Table of Contents

Question One............................................................................................................................. 2
Question Two ............................................................................................................................ 4
Question Three .......................................................................................................................... 5
Question Four ............................................................................................................................ 6
References ............................................................................................................................... 11
BU7404– Financial Management

Question One
When business owners would like to expand and grow their business, managers are kept in a
challenging situation to choose a new profitable investment. They should consider an
important skill of allocating capital which will help them avoid the unyielding investment.
Therefore, the Investment decisions can be decided by using three methods of investment
appraisals. They are the Net Present Value (NPV), the Internal Rate of Return (IRR), and the
Payback method.

(TVM)1 is a fundamental aspect needs to be known before investing a new investment. NPV is
one of the investment appraisal measurements utilized in capital budgeting to decide whether
investing in a project will be profitable and worthwhile to invest in or not. To illustrate further,
it is the differentiation of the cash inflows present value and the cash outflows present value2.
The most obvious benefit is that NPV considers the TVM. It converts the future amount that
the business will get in return for today’s dollar as the capital cost in each period is discounted
by the other capital cost period. Furthermore, managers will use the NPV because it gives an
actual number which helps in comparing the initial expenditures of the cash to the return of
the present value. Moreover, the managers will know whether the invested project will
generate a profit for the investors and the company in terms of the exact amount that will be
earned (The Motley Staff, 2015).

The IRR3 is an alternative method that managers could consider. As the IRR evaluates the
attractiveness of the investment, it has a rule that if the IRR exceeds the required rate of
return of the company, then the investment will be an appropriate one. But, if it drops lower
than the required rate of return it should be rejected (Internal Rate of Return (IRR), n.d.). One
of the IRR benefits is the consideration of TVM. It recognizes the TVM of cash flows as it
expects a high-interest rate from the investment and stated by the financial theory that the
payment will worth more if the company receives an early payment for the investment. So,
this concept is reflected by the IRR as it assigns and early payment of cash with a higher value

1
Time Value of Money is an economic principle which shows the value of the amount received in the
present, worth’s more in the future.
2
A positive NPV will demonstrate that the investment will be positive if the project earnings produced
by the investment goes above the anticipated cost. But, if the calculations show a negative result than
it will end up with a net loss. Therefore, NPV’s rule dictates that the positive NPV results are the only
investments that should be made (Gallo & Wessel, 2017).
3
IRR is the expectation of growth rate the investment will generate. It indicates the quality, efficiency
or yield of the project. To demonstrate, it is used to measure the profitability and percentage rate
earned for every single dollar invested for each period of the potential investment. It makes all NPV
cash flows of the investment (positive or negative) equals to zero.
BU7404– Financial Management

than cash payment which will arise in the future years. Moreover, the IRR is easily understood
in comparison to the NPV method as the investment decisions are often done by executives
who are not financed specialist but familiar with interest rates. The Association of Chartered
Certified Accountants (ACCA) states that the executives who are the non-financial specialists
will tend to be more relaxed and comfortable with percentages that the IRR gives to easily
compare and understand the available investments choices. Rather than ranking investments
by the NPV, managers can rank it by the overall rate of return (Garcia, 2017).

The last investment appraisal is the payback period4. The benefits of using the payback, is the
simplicity as it is universal and understood by everyone. Employees who have limited
knowledge in evaluating capital budgeting can easily calculate it by an electronic spreadsheet
or a calculator. Furthermore, it is risk focus. It measures the investment risk which occurs as
the analysis determination show how quick the return of the invested amount of money will
be. So, it will compare the payback period and the project risk (Woodruff, n.d.). New
established companies or the ones with limited cash and resources which needs to quickly
recover their money back will consider this. Projects with less payback period to recover their
original investment amount and eliminate risk. Finally, it considers liquidity problems as it
provides the best ranking among the investments which will quickly return the money. To
conclude, it is suggested to use the payback period in conjunction with other investment
appraisals as it ignores the TVM and investments which are subsequent (Parikh, 2011).

4
Payback period is a capital management concepts which is an evaluation technique used to determine
the required time of the project cash flows to generate revenue which will recover the revenue by the
company. The decision rule will be accepted or rejected based on the investment payback period. The
project should be accepted if it has shortest payback period which is less than the targeted one.
BU7404– Financial Management

Question Two
First of all, it’s important to understand the significance of capital structure. It refers to how a
corporation finances its operations by the use of different funding methods. Companies could
have a different combinations of capital structures, they could either be fully financed through
equity, or debt, or 50% equity and 50% debt, or a higher percentage of equity to debt and vice
versa (eFinanceMangement Team, 2017). According to the irrelevance proposition of M&M5,
the working capital of a company is irrelevant because the weighted average cost of capital
remains constant, and thus no optimal capital structure (Investopedia, n.d.). However, this
theory assumes that there is no bankruptcy cost and taxes applicable. Therefore, they
adjusted their theory and recognized the benefit of tax deductibles given when loans are
borrowed by a firm. This then suggests that the optimal capital structure is one that minimizes
the weighted average cost of capital (WACC), as it maximizes the company’s value
(Investopedia, n.d.). This could be achieved in the trade-off theory of leverage, which
recognizes tax benefit thus having a high gearing ratio could benefit the company from tax
deductibles, consequently as the proportion of debt to equity in a company increases, the
return on equity of a company increases, a high gearing ratio makes investing in the company
very risky, therefore shareholders demand higher returns as a reward for high risk. The trade-
off theory of M&M recognizes the importance of the capital structure of the company.
However, there is a technique that individual investors could use to artificially modify the
leverage of the firm, and that’s called homemade leverage. This happens when individuals
mimic the corporate leverage of the firm by borrowing loans at the same rate in which the
company borrows which adds leverage to the investor’s portfolio (Wilkinson, 2013). For
example, if an individual invested in an unlevered firm for BD50,000, he could then borrow
money at the same rate that the company would borrow at, say 4.5% interest. Consequently,
he borrows BD50,000 from a bank at 4.5% interest if he wanted to adjust his own portfolio to
be 50% leveraged. Therefore, an investor could invest in unlevered firms (which do not use
debt to finance their companies) and borrow on his own at the rate in which the company
would borrow to essentially make himself invest in a leveraged version of that exact company.
This makes the capital structure of a firm irrelevant because individuals could choose or adjust
the level of leverage to what they would like it to be by borrowing at the same rate of the
company. Accordingly, from an individual investor’s point of view, the capital structure of a
firm does not affect his decision on whether a company is worth investing in or not as he could

5
M&M refers to Modigliani and Miller.
BU7404– Financial Management

adjust his own portfolio. However, individual leverage is not the same as corporate leverage
and this is partially true when taxes are involved.

Question Three
Corporate tax can be defined as a percentage which the government stated for the firm’s
profit (Corporate Tax, n.d.). It is a legal obligation that the firm must follow to pay the
government. Thus, all the current expense is required for the operation of the business which
are fully tax deductible including their investment and real estate which the corporation can
deduct their employees’ salaries and health benefit. Corporate tax is calculated when the firm
earns their operating profit and then they subtract their expense within the cost of goods sold
and deprecation from their revenue.

Capital structure is composited of two categories which are debt and equity, which are the
most difficult areas of the financial decision (Capital Structure, n.d.). It provides how the firm
finances all the operations and growth by having several sources of funds. Debts arrive with
the bond issues and long-term notes payable. In contrast, equity specified as a common stock,
preferred stock or retained earnings. Additionally, short-term debt as a working capital is
considered as a part of the capital structure.

Debt can impact some of the firm operational expense and the net income (Boyte-White,
n.d.). A firm with a high proportion of debt in their capital structure would lead to an increase
in the interest payment every year which will reduce the firm’s profit. Therefore, using a debt
financing will increase revenue which exceeds the interest payment. Furthermore, interest
payment is a tax deductible which will reduce the firm overall tax rate. Consequently, if the
firm received less profit the tax will be in a lower rate.

According to M&M6 hypothesis which they stated two models regarding capital structure
which include irrelevance proposition and trade-off of leverage (Optimum Capital Structure,
2016). As the first assumptions does not consist of a tax it will result in a perfect capital market
which will leads the (WACC) remain as all the level of gearing. Furthermore, when the firm
gears up and the (WACC) will fall due to a cheaper debt and it is the offset with an increase in
the (WACC) because of the increase in the cost of equity due to the financial risk.

On the other hand, when M&M stated a corporate tax they noticed the debt will be much
cheaper due to the tax relief on the interest payment which leads to a fall in the cost of debt

6
M&M refers to Modigliani and Miller.
BU7404– Financial Management

(Optimum Capital Structure, 2016). Moreover, a cheaper debt will make the (WACC) fall due
to the tax relief which the financial risk will increase more. To finalize their hypothesis with
tax, will leads to a cheaper debt but the financial risk will increase. As a result, it is better for
companies to fund their operations through debt as they would benefit from tax deductibles
which would decrease their (WACC).

Question Four
Capital Structure is the method that a company uses to finance itself, and it is either by debt
or equity. Debt finance comes from long-term notes payable and the issuance of bonds. While
equity finance comes from common shareholder stock, preferred shareholder stock or
retained earnings (Investopedia, n.d.).

Out of the two ways to finance a company debt would be preferred as the company would
have a tax advantage, because of TAD7. Furthermore, the owners would not have to give away
ownership. In contrast, equity is expensive, however the company is not required to pay if the
company incurs losses, but the new owners would require some of the future earnings
(Investopedia, n.d.).

Companies that are highly geared means that it uses more debt than equity to support its
business operations (Bragg, 2013). That may be due to several reasons, the owners may not
like to issue shares. Moreover, debt would be a cheaper alternative. Highly geared businesses
like Toys R US which finances its capital mostly through debt, as 82.7% of its capital is
supported by debt. Such highly financial geared company would have high financial risk that
would in turn lead to high interest payments as Toys R Us had to pay $450 million a year just
to pay its loans (Hartung, Toys R Us - How Bad Assumptions Fed Bad Financial Planning
Creating Failure, 2017). High interest payments would prevent them from paying dividends to
shareholders and that would discourage investors. In addition to low credit ratings due to the
company not being regarded as a safe company to give debt to. All these issues piling up had
ultimately led to the closure of the business (Chinweike, 2009).

7
TAD refers to Tax Allowable Depreciation.
BU7404– Financial Management

Dividend policy is the set of guidelines an organization uses to decide the amount of its
income it will pay out to investors. There are three main dividend policies that could be used,
residual, stability or a mix of the two policies8 (Investopedia, n.d.).

There are several arguments about whether the dividend policy of a company is irrelevant or
not. Some may argue that dividend pay-outs are not important as investors have the capability
to create their own “homemade” dividends thus adjusting their portfolios to reflect that. As
investors that want a stable flow of income could invest on bonds as interest payments are
constant. Another argument is that taxation capital gain is lower than dividend pay-outs. As
well they suggest that on the long run it would be beneficial to take on more projects
repurchase some of its shares back and acquire subsidiaries. However, if the company pays
dividends it reflects the financial well-being of the company, and it also attracts investors that
are searching for a secured income (Investopedia, n.d.).

Sources of Finance

Equity financing it is the type of financing when the company issues new equity shares to the
public (Borad, 2017). The disadvantages of equity financing is that the company should share
its profits with its investors (Kunigis, n.d.). Moreover, it leads to loss of control as the investors
owns percentage of the company. Also, sharing the ownership of the company will lead to a
conflict if the management has different vision and different style of running the business.
Furthermore, investors will expect to receive dividends which it is tax deductible unlike the
debt (What Factors You Need To Consider When Choosing A Source Of Finance In Business,
2016).

Debt financing is capital that is arranged through external sources such as financial
institutions (Borad, 2017). The disadvantages of debt financing is that the borrower has the
right to sell the company assets in case of liquidation. In addition, the company will have to
pay back the debt through installments and interest. Therefore, the firm should pay the
installments even if its sales decreases. Moreover, the bank takes the company credit history

8
Residual dividend policy generally relies on equity generated by the company that would be used to
finance new projects. Thus, dividend payments of such policy would be the result of any surplus after
all the financial requirement of the new projects are met. Consequently, creating volatility in the
dividend payments of said companies. Moreover, some investors find the volatility of the payments
undesirable.
Dividend stability policy unlike the residual policy it ensures certainty in the dividend payments which
would in turn provide income for the investors. Such policies are adopted by companies that are aiming
to share their profits with shareholders rather than investing excess cash onto new projects.
BU7404– Financial Management

into consideration in order to secure themselves through providing a higher interest rate.
Consequently, if the business is struggling they will have to pay high interests.

External source of finance refers to the capital generated from outside the company (Borad,
2017). It is crucial decision made by top-level managers to decide the suitable source of
finance. A wrong source of finance will lead to an increase in the cost of funds which will have
its impact on the “feasibility of project under concern (Borad, 2017)”.

Toys R Us used the debt financing as source of finance (Hartung, 2017). Back in 2005 their
total debt has reached $6.2B which was 82.7% of total capital. Moreover, they had a 7.25%
interest on debt which ends by paying $450m per year. Furthermore, the business was making
a profit of 2%, however, the debt was twice company’s profits. Also, Toys R Us are struggling
as they do not have enough cash and assets to repay its $400m debt which is due in 2018.

Working Capital9 is a measure of the business short-term financial health and efficiency
(Working Capital, n.d.). However, the working capital ratio10 would indicate whether the
business has enough short-term assets in order to cover its short-term debt or not. The total
of less than one indicates a negative working capital. In contrast, a total of more than two
means that the business in not investing their excess assets. Consequently, it is recommended
to have a ratio between 1.2 and 2.0.

The business might find issues in paying the creditors in the short-term as if the current assets
are less than its current liabilities (Working Capital, n.d.). Therefore, the probability of
bankruptcy occurs. A decrease in the working capital in long period is an indicator to the
company, which has to be investigated. For instance, the business sales decreases which will
lead to a decrease in the account receivable. Moreover, working capital provides the idea of
business’s underlying operation efficiency to the investors. The company cannot pay its
obligations if the money is tied up in inventory or the customers owe to the business.
Therefore, the working capital reflects the efficiency of the company’. Slow collection might
indicate underlying problem in business’s operation if the working capital is compared
between two periods. Therefore, having a working capital ratio less than one indicate that the
company has a negative working capital and thus more prone to corporate failure.

On October 2017 it was reported that Toys R Us total current assets worth $3,842m and total
current liabilities worth $1,714m (Toys "R" Us, Inc., 2017). Therefore, its working capital

9
(Working Capital = Current Assets – Current Liabilities).
10
(Working Capital Ratio = (Current Assets/Current Liabilities).
BU7404– Financial Management

equals to 2,128 and working capital ratio equals to 2.24. However, these numbers does not
reflect that the company is doing well as their sales are decreasing yearly and total liabilities
exceeds their total assets.

Risk management11

Poor governance could lead to corporate failure, it is the depiction of what the board of
directors and official administration do to regulate the company’s planning and operations
and guarantee the adequacy of the methodology used (James Deloach & Jeff Thomson, 2014).
This happens when there is a disconnection between the tones of at the top of the hierarchy
with the tone at the middle of the hierarchy. Usually the board of directors provide the crucial
establishment for the straightforwardness, receptiveness and responsibility regarding
constant change which is so essential for the compelling danger of managing risk (Deloach,
2016). However, without the compliance of the middle managers whom communicate with
employees on a day-to-day basis. The foundation provided does not take into effect, and the
company seems unsynchronized. This could lead to corporate failure as risk management is
not being addressed proactively.

Reckless risk taking have led to a lot of business failures. This occurs when the board of
directors and official administration make decisions that are reckless and not a risky decision.
It often happens during periods of rapid growth, this is because when managers observe that
the company is preforming very well during that period, they take on more risk to increase
their returns. This proves to be fatal for the company’s survival because of reckless decisions.
This occurs when management has no limits in their decision making who may be ill-advised
and unaware of the tremendous risks that they are taking because of their limited
understanding and they lack any independent monitoring over their decision to assess the
risk-level associated with a specific decision (Deloach, 2016). This could be seen in Toys R Us
decision to raise $5.3billion debt by using their assets, which is considered a reckless risk-
taking as it increased their total debt to an astonishing 82.7% of total capital (Hartung, 2017).

Advice to manufacturing firms

Manufacturers have so much tied up in assets like work force, machinery, devices, products
and more. While these assets are in due course important, they provide increased risk levels

11
Risk management is the process of identifying, assessing and controlling threats to an organization's
capital and earnings. These threats, or risks, could stem from a wide variety of sources, including
financial uncertainty, legal liabilities, strategic management errors, accidents and natural disasters.
BU7404– Financial Management

to manufacturers. The smallest disturbance in operations extending from robbery and

property harm to workforce disturbance and cataclysmic events can be intensely affect a
manufacturer’s own main concern, as well as its capacity to convey products and ventures for
customers on time and on budget (Francis, 2016).

Due to the above, decision makers of manufacturing companies find it essential to have an
all-encompassing comprehension of the dangers that can possibly affect their operations, and
knowledge of how to adequately moderate those dangers to ensure their benefits and their
image, and to keep operations running effortlessly (Francis, 2016).

Risk assessment – it is important for a manufacturing firm to recognize their vulnerabilities

and risk, it needs to comprehend the nature and seriousness of the dangers confronting the
organization. It is also important to be proactive and not wait for the incident to occur and
then react, once vulnerabilities have been identified, companies should work on ways to
allocation their resources to better fortify their weak areas (Francis, 2016).

Personnel and partners – one of the best measures that a manufacturing company can
undertake to minimize risk is to be have a very concise applicant screening and carry out
background checks on potential new employees and be very diligent throughout the whole
process (Francis, 2016).

Facility security – Manufacturing companies should have strict surveillance by adopting

certain procedures that would minimize potential risk that could be faced due to robbery for
example. This could be done by controlling access to the premises of the facility, fencing and
guarding it throughout the night (Francis, 2016).
BU7404– Financial Management

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