Introduction
From time to time, various companies have experienced thriving demands for their products in the market, while at the same time failed to register impressive results in terms of profit. Similarly, numerous businesses have as well failed to achieve the anticipated impression on new projects, despite registering good sales of their products. Glee plc is not an exception and after carrying out a review of the company, I realized that though the board of directors understands the different sources of funding for the company, they do not appear to value the importance of having a balanced capital structure, in their effort towards attaining capital at low cost. In addition, Glee plc does not seem to have a structured way of evaluating investment opportunities. This report will therefore attempt to identify and evaluate the main sources of capital accessible to an organization. In addition, the report will bring out the poignancy of understanding the major determinant of an organization’s capital structure. Finally, the report will explain and reflect the key issues worth considering in the effective administration of an organization’s finance.
Sources of Capital
According to Gerstenberg (1959, P.624), companies often source for money from different avenues due to the myriad needs of money in organizations. Gerstenberg (1959, P.624) further observes that among the most common reasons why organizations seek more capital are capital asset purchase, procurement of a new machinery or even construction of a company’s new premises or plant. The development of a new line of products may equally be very costly for a company to ‑ shoulder the whole cost alone; consequently, organizations will often seek money to roll out new product lines or to diversify into other kinds of business.
A company might raise finance from some of the following sources:
Loan stock
This refers to a long-term debt capital raised by a company with fixed rate and interest which usually payable twice per year. Those who provide loan stock to an organization often are the long-term loaners to the company. The loan stock is valued and payable depending on the interest rate attached to it. Therefore, companies have to understand the terms especially in relation to interest rate to know the cost of the loan. This is critical because one could easily take loan stock without factoring in related terms only to find one taking all revenues into loan payment.
For instance, when an organization gets loan stock at the interest rate of 20%, it means that the money has to be paid back with a 20% yield at the end of the year. Thing are a little simpler when the interest payable is simple interest. Often loans are issued and compound interest used. In this case, if the compounding is per month, it means an organization pays more than would be paid if simple interest were the case. Consequently, if one does not understand the related terms, an organization could easily end up with bad debt.
Retained earning
Retained earnings refer to a certain amount of profit that is ploughed back into the company, as a substitute of being paid to the shareholders in terms of dividends. Many companies prefer to use retained earnings rather than pay high dividends and then solicit new equity. This idea is propelled by the fact that retained earning are funds, ‑ which do not incur the company any extra cost, and thus projects can be embarked on devoid of involving shareholders or any outsider.
Bank lending
This source involves a corporation borrowing from a banking institution. Bank lending comes either in form of short or medium term loans. Short-term loans take the form of bank overdraft, which often has interest being paid at varying rates. On the other hand, medium term loans may take a period of three to ten years. In this case, the urgency occasioned by the circumstances facing an organization, coupled with other requirements such as the interest rate charged on the loan disbursed, will to a great extent determine the type of loan a company may go for.
Government Assistance
As part of its policy, the government usually provides companies with finance in form of cash grants and through other means. In as much as individual companies benefit from this approach, the main reason behind making available such finances to companies is usually to stimulating economic growth.
Organization’s Capital Structure
Every time financial managers are faced with the question of capital structure, it is either the question of optimum or balanced capital structure (Sharma & Kumar, 1998, p.404). This question usually demands making decisions pertaining to the proposition of long period finance that is gained either through borrowings or through investment from owners.
According to Sharma & Kumar (1998, p.404), the most favorable or balanced capital structure refers to a perfect combination of borrowed and owned capital that may ‑
achieve the marginal objective. In this case, a balanced capital structure will maximize market worth for every share or minimize the asking price of capital. The market value will be maximized or the rate of capital will be reduced when the actual cost of every source of finances is the same. It is a challenging task of the financial supervisor to establish the mixture of the diverse sources of long-term finance.
Consequence of Unplanned Capital Structure
Though companies that fail to plan their capital structure may flourish in the short run, they will eventually suffer great hardships in raising substantial amount of capital to finance their future investment projects. It is therefore of paramount importance for all financial managers to make rational decisions concerning capital structures.
Key Determinants of an Organization’s Capital Structure
The question of how best firms can make their capital structure decision still disturbs many financial managers the world over (Sharma & Kumar, 1998, p.436). In point of view of many financial managers, as discussed by Sharma & Kumar (1998, p.436), believe that many capital structure resolution are subjective thus purely dependent on owner’s perceptions towards debt as restrained by outside environmental circumstances.
Several theories have been proposed to explain capital structure decisions making paradigms. One such theory is the swapping theory, which to a great degree relies on the conventional features such as tax benefits and possible bankruptcy cost of debt. The evidence shows that financial flexibility and the earnings per share intensity are the most imperative determinants of the capital structure decisions. However, according to Bancel (2002, p.1) research shows that financial flexibility and the earnings ‑ per share strength are the most significant determinants of the capital structure decisions
Basic Issues in Effective Financial Management
There are some basic skills required for effective financial management. According to McKinney (2004, p.1), the common expertise required in effective financial management starts in the decisive areas of money administration and bookkeeping. These practices are expected to be performed in line with certain financial directives or principles that help towards guaranteeing integrity. Some of the principles or skills necessary for effective financial management include the following:-
Financial controls and risk management
Financial control and risk management are critical skills. For instance, it is imperative that a culture that ensures financial dealings are constantly recorded in a suitable fashion is cultivated. These control measures are very helpful for they help risk of financial loss. Recording of financial transactions, for example, helps reduce the risk or possibility of theft from members of staff. Other caution to avoid risks should be adopted in embracement of internal control system and mostly in area such as the disbursement of funds and payroll. Similarly, internal control should be used to reduce financial deception in addition to evasion of common but expensive bookkeeping mistakes.
Financial planning
Financial planning involves taking decisions in advance that make a difference. In order to manage organizational finances well, a financial manager has to prioritize ‑ and make well-tailored budgets. The budget identifies clearly the source of funds and intended use thus there is no risk of misuse or misappropriation.
Managing operating budgets
A budget usually reflects what a company expects to spend and what it anticipates to gain or earn in a specified period. A budget will help financial managers to effectively manage the company’s resources owing to the fact that it helps in projecting how much money a company need for a major initiative such as buying a facility, or hiring a new employee. A budget will also help track the finance manager whether he is on plan or not.
Managing cash flow
Cash flow is basically one of the most important financial statements that any financial manager may rely on in ensuring an effective management of organization finance. A cash flow usually reflects the amount of money a company receives, less the total amount the company has spent. Managing cash flow is critical because it ensures that there is enough cash within the organization that is used in dealing with recurrent expenditure and other emergency related expenditure.
Credit and collection
Most firms get into debt and offer credit to trustworthy customers. For an organization to stay afloat and flourish, a financial manager should be in a position to monitor matters of credit and collection. In most cases, companies loose financial resources usually due to bad debt or uncollected debt. To avoid such situations, the finance manager should come up with elaborate measures concerning how company debts are collected in order to avoid instances of bad debt.
Dealing with Challenges Associated with Capital Structure
In order to avoid problems associated with an unbalanced capital structure and in order to reduce the cost of capital, some models and concepts can be helpful.
One way of dealing with the problems associated with capital structure is capital budgeting. Capital budgeting involves taking decisions on how to assign capital and related accountability measures. Among the analytical techniques developed for evaluating capital expenditure, include the discounted cash flow method and present value method.
Discounted Cash Flow Method
This is an assessment method used to guesstimate the attractiveness of a venturing opportunity. This method uses prospective free cash flow protrusion and discounts them to arrive at a present value, which is used to appraise the prospective for investment. If the resulting value is higher than the present asking price of the investment, the chance may be a good one.
Advantages of Using the Discounted Cash Flow Method
This method looks into the whole economic life of capital employed and related returns on the capital
The method is valuable in long term capital decision because the method explicitly and routinely weighs the time value of money
The method produces a measure, which is specifically similar amongst projects, in spite of of the nature, time and shape of their acceptance and outlay.
Limitation of the Discounted Cash Flow Method
Since the method involves a deal of calculations, many people perceive it as intricate and complex.
The method does not match up to accounting conception for recording costs and income.
It is actually very hard for one to estimate with precision the economic life of an investment.
Present value method
This method is also widely referred to as ‘time adjusted rate of return’ or ‘internal rate of return’. This method is based on the assumption that the future value of say a dollar, cannot be taken to equal the current value of a dollar. The predicament of difference in time can be determined by translating the prospect amounts to their present values to make them equivalent. Therefore, when budgeting for future based on current capital financial managers try to seek that internal rate of return that ensures the time related difference in the value of money is taken into account. In present investments, the financial manager has to seek to ensure that the value of inputs and the value of outputs somehow are the equal. The present value of future cash inflows can be premeditated with assistance of the following method:
PV=S/ (1+I) n
Where: PV = present value of future cash inflow
I=internal rate of returns
S= future value of a sum of money
N=number of year
Numerical Computation Of Net Present Value Method
Under this technique, an essential rate of return is assumed and a similarity is made among the present value of cash inflows at diverse times and the original venture, in order to establish the potential effectiveness. This technique is based on the fundamental standard. If the present value of cash inflows discounted at a particular rate of return equals or go beyond the quantity of speculation, the suggestion ought to be acknowledged.
Present value charts are normally used whenever one wishes to compute the present value in order to make the computation quick. The present value tables also help financial managers to understand the present value of the cash inflows at essential earning portion equivalent to diverse periods. One can however use a formula to make out the present value attainable after a specified period at a known rate of concession.
PV=S/ (1+I) n
Where: PV=present value
R=rate of discount
Illustration
An investment proposal requires an initial outlay of $ 40,000 with an expected cash inflow of $ 1000 per year for five years. Should the proposal be accepted if the rate of discount is a) 15% or b) 6%.
By use of the present value chart, one can promptly land at the present value of the money inflow.
Year
(1)
Cash inflow
(2)
Present value of return@ ‑
15% (3)
‑
Total present value@ ‑
15%(2)*(3)
‑
Present value of return@6%
‑
(5)
‑
Total present value @ 6%
‑
(2)*(5)
‑
1
2
3
4
5
1000
1000
1000
1000
1000
.870
.756
.658
.572
.497
870
756
658
572
497
3353
.943
.890
.840
.792
.747
943
890
840
792
747
4212
(Fig 1.0)
From the above-tabulated computation, one can come up with the following conclusion. Given the present value of $3353 at an interest rate of 15 %, is below $ 4000, which is the sum of the initial investment, the suggestion cannot be established. If one decides to ignore the other non-quantitative deliberations. However, the present value of $ 4212 at a concession rate of 6 % exceeds the original investment of $ 4,000, from that fact the proposal can readily be acceptable.
The following are some of the reasons why this method is preferred to other methods of investment assessment.
The formula takes into consideration the whole economic life of the venture investment and returns.
The method is valuable in long-term capital decision.
By recognizing the time factor, the method provides for ambiguity and perils
This method proves to be the best incase of appraising projects where the cash flow are irregular.
References
Bancel, F., 2002. The Determinant of Capital Structure Choice: A Survey of European Firms. University of Manitoba publishers: Canada
Gerstenberg, C, W., 1959. Financial Organization and Management of Business. Prentice-Hall Publishers: California
McKinney, J, B., 2004. Effective Financial Management in Public and Nonprofit Agencies. Greenwood Publishing Group: Pittsburgh
Sharma, R., Kumar, A., 1998. Managerial Economics. Atlantic Publisher: New York