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CASH ANALYSIS AND MANAGEMENT

Cash is the life blood of every business because without it, a business would not run

Cash gives more liquidity than securities- thus the reason business people don't take all their cash and invest it in interest-bearing securities

Thus determining how much cash has been generated in every bottom line year in critical

Is should be noted that there are transaction items that hit the balance sheet which don't hit the P &L and vice versa

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These items are captured by the cash flow statement accordingly

A cash flow layout is identified as follows:

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IAS 7

STANDARD LAYOUT OF THE CASH FLOW STATEMENT Net cash flow from operating activities ▼ PLUS OR MINUS Investing Activities ▼ Financing ▼ EQUALSINCREASE OR DECREASE IN CASH OVER THE PERIOD

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NET CASH FLOW FROM OPRATING ACTIVITIES

DIRECT METHODCash from sales* xxxxLess Cash paid for purchases * (xxxx)Less cash paid for admin expenses (xxx)Less cash paid for distribution expenses (xxx)LESS TAXATION (xxx)Net cash flow from operating activities xxxx*CASH FROM SALES= Sales +opening debtors –closing debtors*CASH PURCHASES= Purchases+ open creditors- closing

creditors

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INDIRECT METHOD-NOTE ONE

Operating profit xxxxADD: Depreciation xxxADD: loss on sale of fixed assets xxxLESS: Profit on sale of fixed assets (xxx)INCREASES IN STOCKS (XXX)DECREASE IN STOCKS XXXINCREASE IN DEBTORS (XXX)DECREASE IN DEBTORS XXXINCREASE IN CREDITORS XXXDECREASE IN CREDITORS (XXX)LESS TAXATION (XXX)

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=NET cash flow from operating activities XXXX

NOTE TWO OF CASH FLOW Usually changes in cash- BANK balance and

ODMAY TAKE AN ILLUSTRATION

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Cashflow statement when used with other corporate reports will help bankers and other users of F/I assess:

Coy’s ability to generate future net cashflowWhether a coy is able to meet its financial

obligations e.g. payment of dividends, interest etcThe effect on the coy’s financial position of

investments undertaken during the accounting period

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The reasons for differences between profits and cashflows arising from normal operating activity

The value of a business since the statement provides a useful information for business valuation models based on estimates of likely future cashflows

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SOURCES Of CASH

INTERNAL SOURCESBusiness operations-basically NOTE 1Reducing investment in business assets- reduce stocks

for exampleRetained earningsLoans from directorsEXTERNAL SOURCES- DEPENDS ONThe nature of the businessThe size of the businessDirectors involved

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Economic factors etcTHE SOURCES INCLUDELoans- short-term, medium-term, long-termShares –various typesDebentures- basically loan agreementGovernment- grantsBondsFriends and family members

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IAS 7-CAH FLOW STATEMENT

The objective of IAS 7 is to require the presentation of information about the historical changes in cash and cash equivalents of an enterprise by means of a statement of cash flows, which classifies cash flows during the period according to operating, investing, and financing activities

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RELEVANT CASH FLOWS

operating activities are the main revenue-producing activities of the enterprise that are not investing or financing activities, so operating cash flows include cash received from customers and cash paid to suppliers and employees –WILL SEE MORE IN WC management

investing activities are the acquisition and disposal of long-term assets and other investments that are not considered to be cash equivalents

Management of liquid resources- short-term investments –usually within a year –e.g. stocks assets

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Financing- these include:SHARES NAMELYGoing public- advantagesOwners can diversify-growthIncreases liquidityFacilitates raising new corporate cashEstablishes a value for the firmSets up merger negotiationsIncreases potential markets

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Going public-disadvantagesCost of reportingDisclosuresSelf-dealings-???Inactive market/low price- fight for a market shareControl- voting rightsLOANS AND DEBENTURESThese are interest bearing funds and could beShort-term

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Medium-termLong-termNOTEThe way these are arranged is important. Managers don't want to finance for example long-

term investments with short-term loans. This is a recipe for corporate failure

In fact it is important to WATCH for any short-term loans . Can the firm pay these as they fall due in the short-term

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Long-term loans are preferred

UNBALANCED FINANCIAL DEVELOPMENTSIts top management’s job to maintain an

appropriate balance between:Long-termMedium-termShort-term finance

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And, within the first category an acceptable relationship must exist between:

Share capital andLoan capitalIt should be noted that once expansion occurs,

additional long-term finance is needed to cover the cost of fixed assets and working capital requirements; while a reduction in the scale of a company’s operations may permit the repayment of certain sources of finance

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These issues require proper planning- as management often fail to achieve a balanced financial structure either because it does not plan, ahead or because unexpected events occur.

There are two main aspects of unbalanced financial development namely:

Over-tradingOver-capitalization

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OVER-TRADING

This is a situation which will occur when the volume of business activity is excessive in relation to the finance provided by the shareholders

A situation like this will lead to the company to start going for external finance in the form of loan capital, bank overdrafts, and trade credit

In essence management has attempted to undertake too much too quickly meaning the company is left with insufficient resources to meet its currently maturing liabilities

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The company would therefore find it difficult to pay wages due to employees, debts due to suppliers, tax payable to the government, etc

The signs of over-trading should be looked for in the balance sheet and they include:

A decline in the ratios of debtors /creditors and current assets/current liabilities

A low figure of working capital A high ratio of fixed assets to working capital A severe shortage of cash Bankers are particularly interested in this scenario (over-trading)

because it is common cause of business failure

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OVER-CAPILIZATION

Occurs when management is unable to make full use of the capital available.

In this case, it may be prudent for management to return capital to the members either by purchasing or redeeming some of its shares or by canceling shares not unrepresented by assets.

SOLUTIONS?Return part of the capital by:Purchasing shares/redemption of sharesRepayment of loan capital

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CASH OPERATING CYCLE

Defined as the gap that exists between the time it takes for payments for goods or raw materials received into stock AND the collection cash from customers following their sale

During this period, the goods acquired together with the value added in the case of manufacturers must be financed by the coy

NOTE the shorter the length of time between the initial outlay and the ultimate collection of cash the smaller is the value of W/C

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WORKING CAPITAL to be financedCALCULATIONCalculate the time which the product spends in

each stage of its progression from acquisition to sale and actual cash receipt

LESS the period of credit received from suppliersElements in the calculation include:Stocks-held for a time then used or sold. These

would include:

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Raw materials- held in stock and then transferred to production

Work in progress- actual processing of raw materials

Finished goods-transferred from factory to ware house

Debtors – the average age of debts should be found from the values of debtors and sales

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Creditors- these finance the production and selling cycle from the time raw materials/goods are received into stock until they are paid for. The period is found from the values of creditors and purchases

Liquidity check may be used alongside W/C management

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Liquidity (quick) ratio = current assets-inven Current LiabilitiesPurpose is to examine solvency. Concentrates

attention more directly on a coy’s prospect of paying its debts as they fall due by excluding current assets which will not be converted into cash within the next couple of months.

Called the acid test of solvency

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EXAMPLE OF COMPUTATION

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Raw material stock= raw materials stocks raw materials consumed+production period= Work in progres COG manufactured+finished goods stocks= finished goods COG Sold+credit to customers = debtors SalesLESS Credit from suppliers=Creditors Purchases of raw=CASH OPERATING CYCLE IN DAYS

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Good to take an example at this stage on COC

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WORKING CAPITAL MANAGEMENT

Need to observe the relationship between the cash operating cycle and working capital by looking at our example and identifying whether or not WORKING CAPITAL HAS INCREASED

This done by analysing movement in:StocksDebtorsCreditorsFor the two years 2009 and 2008

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WORKING CAPITAL MANAGEMENT

Defined as the excess of current assets over current liabilities

Shed more light on the short-term solvency of the coy i.e. its ability to pay debts as they fall due

The gist of the matter is to determine the rate at which current assets are converted into cash and how quickly current liabilities are paid

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This is certainly unique to every industry e.g. a retailer who sells goods for cash may operate with a much lower ratio than a manufacturer who sells goods on credit. This is because for the manufacturer, goods sold are ‘tied up’ as debts before cash becomes available.

On the same vain, the period for which stocks are held varies from industry to industry e.g. a small metal manufacturer may convert raw materials into finished goods much faster than a construction company

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It should be noted the recommended Working Capital ratio is 2:1.

The working capital ratio = Current assets Current LiabilitiesAnd the result is given as a ratioThe above arguments guide on what should be an

acceptable ratio (and not just a conclusion of an ideal 2:1)

Again this is closely linked to the cash operating cycle

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EFFICIENCY RATIOS

THE INVENTORY CONVERSION PERIOD= Inventory * 365 (IN DAYS SalesTells us how long it takes to convert raw materials raw

materials into finished goodsRECEIVABLE COLLECTION PERIOD= Receivables *365 (In days) SalesTells us how long it takes to convert receivables after a

sale into Cash.

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CREDIT POLICY

Credit period- what is the length of time buyers are given to pay for their purchases?

Discounts given- usually given for early settlement of accounts. If payment not done within the discount period, then FULL amounts are paid

Credit standards- means the required financial strength of acceptable credit customers. Lower credit standards boost sales BUT also increase the possibility of bad debts

Collection policy- usually gauged by its efficiency in-terms of collecting slow-paying accounts

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PAYABLE S DEFERRAL PERIOD= Payables*365 ( IN DAYS) PurchasesOR= Payables *365 Cost of goods soldThis basically the average length of time between

the purchase of materials and labor and subsequent cash payment for these

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TAXATION EFFECTS

IAS 12 particularly deals with the management of income tax

DEFINES THE FOLLOWINGTemporary difference: A difference between the

carrying amount of an asset or liability and its tax base.

Taxable temporary difference: A temporary difference that will result in taxable amounts in the future when the carrying amount of the asset is recovered or the liability is settled

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Deductible temporary difference: A temporary difference that will result in amounts that are tax deductible in the future when the carrying amount of the asset is recovered or the liability is settled

CURRENT TAX-Current tax for the current and prior periods should be recognised as a liability to the extent that it has not yet been settled, and as an asset to the extent that the amounts already paid exceed the amount due.

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Current tax assets and liabilities should be measured at the amount expected to be paid to (recovered from) taxation authorities, using the rates/laws that have been enacted or substantively enacted by the balance sheet date

TREATMENT/EFFECTAccrued items go the balance sheetCASH ITEMS go to the CASH FLOW statementCASH ITEMS are itemized in Cash budget/cash

forecast

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VALUE ADDED TAX

Tax charged at every stage ‘VALUE’ is added to a product

Organizations subjected to VAT receive cash net of VAT deductions and therefore this effect must be taken into account

There is a further cash effect when the VAT collected called the output tax less any tax paid on purchases (input VAT) is charged

If the input tax exceeds the output tax, reimbursement of the difference is made to the company

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VAT transactions should be carefully analyzed for cash budget purposes

EXAMPLEMaarifa Limited had a credit balance payable in

January 2010 on its VAT account of KSH 16,000 on December 2009. During the first three months of 2010 the organization made cash purchases net of VAT of KSH 250,000 and cash sales including VAT of KSH 425,500. Assume rate of VAT of 15%

REQUIRED

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1. Prepare the company’s VAT account for the first three months of 2010, showing the balance due at 31 March 2010

2. Prepare a schedule showing the appropriate numbers relating to purchases and sales

a) In the cash accountb) In the trading accountSOLUTION

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VALUE ADDED TAX ACCOUNTJan 2010 -VAT paid 16,000 Jan 1 2010 B/F 16000VAT on purchases * 37,500 VAT Sales * 55,500March 31 2010 C/D 18,000 0 71,500 71,500*Purchases ksh 250,000*15%= Ksh 37,500*Sales 115% = 425,500 ? 100% = 425,500*100/115= 370,000Thus: VAT = 425,500-370,000= Ksh 55,500

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CASH ACCOUNTDR Sales cash Ksh 425,500CR Purchases cash Ksh 287,500TRADING ACCOUNTDR Purchases (net of VAT)= Ksh 250,000CR Sales (net of VAT) Ksh 370,000NOTEWhen sales made on credit the company’s liability

to pay VAT arises once the invoice is issued.

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This may mean that VAT is actually paid out to the government before the cash is received from customers

On the other hand VAT on credit purchases may be set off against output VAT as soon as liability is entered into the books and before payments to the creditors are made. ( it is not necessary to wait until the debt is settled)

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PROJECTS WITH UNEQUAL LIVES

when choosing between mutually exclusive projects, we must first determine if they can be repeated, and if so, we must take this into account when we estimate the projects’ profitability.

If a company is choosing between two mutually exclusive alternatives with significantly different lives, an adjustment may be necessary

ILLUSTRATIONWe may illustrate this by assuming a company that

wishes to invest in TWO mutually exclusive projects

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Lets call these projects A and B as followsPROJECT A is a SIX year period project CASH FLOWS ARE AS FOLLOWS:YR0 KSH -40,000YR1 KSH 8,000YR2 KSH 14,000YR3 KSH 13,000YR4 KSH 12,000YR5 KSH 11,000YR6 KSH 10,000

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PROJECT B is a THREE year projectCASH FLOWS ARE AS FOLLOWSYR0 KSH-20,000YR1 KSH 7,000YR2 KSH 13,000YR3 KSH 12,000The COST of capital of the company is 12%IF we were to do the NPV of the two projects, we

can conclude as follows:

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NPV PROJECTS A AND B

YR CF DF PVYR0 KSH -40,000 1 -40,000YR1 KSH 8,000 0.8929 7,143.20YR2 KSH 14,000 0.7972 11,160.80YR3 KSH 13,000 0.7118 9,253.40YR4 KSH 12,000 0.6355 7,626.00YR5 KSH 11,000 0.5674 6,241.40YR6 KSH 10,00 0.5066 5,066.00 NPV (A) 6,490.80

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B

YR CF DF PV(KSH)YR0 KSH-20,000 1 -20,000YR1 KSH 7,000 0.8929 6,250.30YR2 KSH 13,000 0.7972 10,363.60YR3 KSH 12,000 0.7118 8,541.60NPV (B) 5,155.50Thus from this analysis the company will choose

project A since it has the higher NPVIRR of A =17.5% AND of B = 25.2%

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BUT

Although the analysis suggests that Project A should be selected, this analysis is incomplete, and the decision to choose Project A is actually incorrect.

If we choose Project B, we will have an opportunity to make a similar investment in three years, and if cost and revenue conditions remain at the SAME, this second investment will also be profitable.

However, if we choose Project A, we will not have this second investment opportunity.

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THE COMMON LIFE APPROACH

Therefore, to make a proper comparison of Projects A and B, we could apply the replacement chain (common life) approach

This involves finding the NPV of Project B over a six-year period, and then comparing this extended NPV with the NPV of Project C over the same six years.

The NPV for Project A as calculated is already over the six-year common life.

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For Project B, however, we must add in a second project to extend the overall life of the combined projects to six years.

Here we assume (1) that Project B’s costs and annual cash inflows will

not change if the project is repeated in three years and

(2) that the COY’s cost of capital will remain at 12%THUS YRS 4-5 &6 = CFs Ksh 7,000, 13,000 and 12,000

respectively

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NPV OF B ON COMMON LIFE

YR0 KSH-20,000 1 -20,000YR1 KSH 7,000 0.8929 6,250.30YR2 KSH 13,000 0.7972 10,363.60YR3 KSH -8,000* 0.7118 -5,694.40YR4 KSH 7,000 0.6355 4,448.50YR5 KSH 13,000 0.5674 7,376.20YR6 KSH 12,000 0.5066 6,079.20NPV(B-COMMON LIFE APPROACH) 8,823.40* (12,000-20,000). B is selected.

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EXPANSION AND STRATEGIC OPTIONS

Strategic management is the formal and structured process by which an organization establishes a position of strategic leadership.

Strategic leadership is about the achievement of sustained comparative advantage over the competition

Thus strategy is knowing the business you propose to carry out

Kenneth Andrew (1971) defined strategy as the pattern of major objectives; purposes or goals and essential policies or plans for achieving those goals, stated in such a way as to define what business the company is in or is to be in and the kind of company it is or is to be

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Kenichi Ohmae (1983) defined strategy as the way in which a corporation endeavours to differentiate itself positively from its competitors, using its relative strengths to better satisfy customer needs.

I define strategy as being different!. Your talents are unique, and they indeed can be implemented in a unique way.

SO, how does a business move from here? Capital budgeting-identify projects SOURCES of capital-capital structure decisions Cash flow management- CASH is CRITICAL Strategy management- stay ahead

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CAPITAL STRUCTURE OF A FIRM

Defined as the proportionate re-alignment of a company's different funding sources, including debt, equity and other hybrid instruments such as convertible bonds. Capital structure can fairly easily be measured by the ratio of long-term debt to total capital.

At the beginning of trade, a coy should have a balanced capital structure

This means assets should be financed/funded by the appropriate types of finance

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NOTE: Balance sheet shows assets and how they are financed- IAS 1 guides on full disclosure

Long-term sources of finance e.g. equity capital and debentures should cover all investment in fixed assets

But with sufficient excess to make a significant contribution towards funding current assets

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This so in order that we can achieve the ideal WORKING CAPITAL RATIO of 2:1 i.e. half the value of current assets should be financed by long-term capital and the remainder by short term sources e.g. creditors

Even within the long-term sources of funds, a satisfactory relationship should be created between various types available- whether it is shares or loans

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The optimum structure depends on such factors as the nature of the trade undertaken, the likely stability of profits (product lines, markets etc)

Lets assume this ideal structure is established as at the beginning of trade

On day one of trade, the financial structure established at the outset begins to be affected by the results of trading as well as passage of time namely:

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The initial investment increased by the amounts of profits earned and retained in the business and is reduced by losses

Passage of time means long-term loans being paid gets closer to the end of their term and may be classified as current liabilities

The rate at which debtors pay and creditors are paid affect the balance between current assets and current liabilities

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Credit purchases of additional stock needed to expand a successful coy and credit sales also affect the balance between current assets and current liabilities

In the long-run, success may encourage the acquisition of extra production capacity which must be funded by appropriate type of finance to maintain the structure

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Flows of resources take place with trading, and these have an impact on the enterprise

The impact may be beneficial or detrimental i.e. may lead to success or failure

Managers are paid to manage this structure and desirable balance of financing business activities

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PRACTICAL ASPECTS

The value of a firm is the present value of its expected future cash flows (FCFs) discounted at its Weighted Average Cost of Capital(WACC)

WACC depend on such factors as :The percentage of debt and equity (Wd and We)The cost of debt (rd)The cost of stock(rs)The corporate tax rate(T)THIS MEANSWACC= Wd(1-T)rd+ We*rs

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The implication of this is that the only way any DECESION can change a firm’s value is by affecting its:

Free cash flowsThe cost of capitalWHY?Because:V(Value of the firm)= ∑ FCFt (1+WACC)t

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Debt increases the cost of stock rs- this is because the fixed claim of debt-holders makes the residual claim of stockholders become less certain, hence increasing the cost of stock

Debt reduces the taxes a company will pay- this because companies deduct interest expenses when calculating taxable income. Notice the sharing of the company’s ‘spoils’ is between the debt-holders, investors and the government. This reduction in taxes reduces the after-tax cost of DEBT

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The risk of bankruptcy increases the cost of debt rd- this is because with higher bankruptcy risk, debt-holders will insist on a higher expected return- and this effectively increases pre-tax cost of debt

The risk of bankruptcy REDUCES Free Cash Flow- this is because :

as risk of bankruptcy increases, some customers will certainly opt to buy from another more stable company –which reduces sales. This scenario effectively DECREASES Net Operating Profit after Tax (NOPAT)-thereby reducing FCF

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Bankruptcy threat also negatively affects the productivity of workers and managers and this again reduces NOPAT and FCF

Bankruptcy threat also makes suppliers tighten their credit levels –which reduces payables causing net operating working capital to increase and therefore reducing FCF. These events effectively reduces the value of the firm

Bankruptcy threat AFFECTS agency costs- this is because:

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When business is performing well, managers may waste cash flow on unnecessary expenditures e.g. expensive cars. This is purely an agency cost (CALLED THE AGENCY PROBLEM). Threat of bankruptcy and possible take-over bids reduces this wasteful spending and this INCREASES FCF

The other effect is that in times of threats, managers may reject risky but would be profitable projects because to the manager- the company is his only investment BUT shareholders may be well diversified and therefore willing to take on risk projects which promise higher returns (CALLED THE UNDERINVESTMENT PROBLEM)

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BUSINESS AND FINACIAL RISKBusiness risk is the risk a firm’s common shareholders

would encounter if the firm had no debt. Note that the greater the use of debt, the greater the concentration of risk on the stockholders, and the higher the cost of common equity.

Business risk arises from uncertainty in projections of an entity’s cash flows- which simply means uncertainty about the entity’s operating profit as well as its capital (investment)requirements

The return on INVESTED capital (ROIC) puts these two aspects together to measure business risk

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ROIC= NOPAT = EBIT(1-T) Capital Capital= Net Income to common stockholders + After tax interest payments

CapitalNOTE :CAPITAL= FIRM’S DEBT + EQUITYAnd it means the required amount of

operating capital accordingly

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Business risk depends on the following factors: Demand variability- the more stable the demand is, the

lower the firm’s business risk Sales price variability- the more reliable output prices are,

the lower the firm’s business risk Input cost variability- the more stable the input costs the

lower the business risk Ability to change output prices when output costs changes-

the greater the ability to adjust and match output prices with input costs the lower the business risk

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Ability to develop new products in a cost effective and timely fashion- the faster the possibilities to develop new products as older ones become obsolete the lower the business risk

Foreign risk exposure- if a firm engages in the production of overseas products, it is subject to exchange rate fluctuations. The faster the fluctuations the higher the business risk

Political and economic stability- the less the stability, the higher the business risk

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The extent to which costs are fixed- the harder it is for the firm to vary its costs (they are fixed) the higher the business risk.

NOTE: This scenario is known as OPERATING LEVERAGE

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FINANCIAL RISK

This is the additional risk that the common stockholders have to content with because of a decision to FINANCE USING DEBT

Note that normally, stockholders would be exposed to a risk inherent in the firm’s operations- this is basically the business risk being the uncertainty inherent in the projections of future ROIC (ROCE)

Where an entity uses debt (financial leverage), this increases risk to the common stockholders

Financial experts call this risk CONCENTRATION-

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CALLED SO because the debt-holders who receive a fixed interest payments BEAR NONE of the business risk

In CONCLUSION- financing with debt increases the common stock-holders expected rate of return on an investment project

Debt also increases the common stockholder’s risk in an investment project accordingly

But typically, FINANCIAL LEVERAGE increases expected ROE (Return On Equity) but also INCREASES RISK

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It is important to appreciate how a trade-off between the two should be managed since they affect the VALUE of the firm.

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OPERATING LEVERAGE

This term is used in business to mean-that- other things constant, a relatively small change in sales results in a large change in EBIT (Earnings Before Interest and Tax)

The higher a firm’s fixed costs, the higher is its operating leverage

Note that other things constant, the higher the firm’s operating leverage, the higher is its business risk- simply because the said firm can not vary its costs as DEMAND changes.

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Operating leverage aspect can be use well illustrated by break-even analysis

REVENUE +VE EBIT

-VE EBIT

SALES

BREAK-EVEN EBIT=0

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High operating leverage Low operating leverage

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MODIGLIANI AND MILLER-NO TAXES

Assumptions of the theory of these two gentlemen There are no brokerage costs There are no taxes There are bankruptcy costs Investors can borrow at the same rate as corporations All investors have the same information as

management about the firm’s investment opportunities

EBIT is not affected by the use of debt

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The argument of this theory is that if all these assumptions hold: then a firm’s VALUE is not affected by its CAPITAL STRUCTURE

THUSVL= VU=SL+DWHEREVL= The value of a levered firm VU= The value of an identical but unlevered firmSL= The value of the levered firm’s stock D= The value the levered firm’s Debt

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Thus if MM CAPITAL STRUCTURE THEORY assumptions are correct- then it would not matter how a firm finances its operations and therefore CAPITAL STRUCTURE DECISIONS would be irrelevant.

The moral of this theory therefore is the fact that- it tells us when capital decisions would be irrelevant and thus helps financial experts deal with what is required for capital structure decisions to remain relevant and hence determining a firm’s VALUE

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MM THE EFFECT OF CORPORATE TAXES

This followed a relaxation of the assumption-no taxes and means corporations will factor in taxation

Interest payments are expenses deductible (DIVIDEND IS NOT)and therefore interest payment reduces the amount of taxes paid by a corporation

This subsequently means that if corporations pay less taxes to the government, then more of its cash flow is made available to its investors (i.e. the tax deductibility of the interest payments shield a firm’s pre-tax income)

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THUSMM tax shield formulaVL= VU + PV OF TAX SHIELDAccording to MM, the PV of the tax shield =

Corporation tax T*the amount of debt DTHUSVL= VU+TDWHEREVL=Value of the levered firmVU=Value of the unlevered firm

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MILLER: CORPORATE & PERSONAL TAXES

This theory of Miller, without Modigliani, brings in the aspects of personal taxes

He separated income as follows: Income from bonds- which is basically interest and

which is taxed at rates (Td) Income from stocks which is basically dividends as well

as capital gains- and that CAPITAL gains are taxed at a LOWER effective rate (Ts) than returns on debt (dividend tax is withheld in Kenya)

(IF stock is held until the owner dies no taxes paid)

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He argued that due to these tax implications: Investors are willing to accept comparatively low BEFORE

tax returns on stocks relative to the BEFORE tax returns on bonds (WHY?)

Remember risk- and how it affects required rate of returnThe point is:The more favourable tax treatment of income from stock

lowers the required rate of return on stocks and therefore favouring equity financing

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The deductibility of interest on the other hand favors the use of debt financing

According to Miller, the net impact of both corporate and personal taxes can be measured by the equation:

VL=VU + 1- (1-Tc)(1-Ts) *D (1-Td)

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WHERE

Tc= Corporate Tax rateTs= personal tax on income from stocksTd= tax rate on income from debt accordinglyNOTEMiller’s argument is that the marginal tax rates on

stock and debt balance out such that the entire bracket portion of the equation equals ZERO

ThusVL=VU

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However, experts still believe that there is a tax advantage to debt

EXAMPLEIf we assume a Tc 40%, Td=30% and Ts=12%Then the advantage of debt financing isVL= VU+ 1 – (1-0.4)(1-0.12) *D (1-0.30) VL = VU+0.25D

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THE TRADE-OFF THEORY

MM theory assumes no bankruptcy costsThe truth is that bankruptcy can be quite costly

because this exercise leads to extremely high legal and other accounting expenses

Customers , suppliers and employees are also lostEntities may also be forced to realise assets for less

than they would be worth in normal business operations

It should noted that most fixed assets are illiquid as they are made to meet the specific company’s needs

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When there is huge debt in the capital structure bankruptcy gets more complicated- particularly if debt is utilised to purchase fixed assets which would otherwise not sell in bankruptcy

It is these developments that led to the development of the so called TRADE-OFF THEROY LEVERAGE

Entities simply trade-off the benefits of DEBT FINANCING (favourable corporate tax treatment) AGAINST the higher interest rates and bankruptcy costs

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Thus according to this theory, VL= VU + Value of any side effects which

include:The tax shiedThe expected costs due to bankruptcy and

financial distress

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THE SIGNALING THEORYMM assumed symmetric information i.e. investors have

the same information about a firm’s prospects as its managers

But the truth is that managers have better information about the firm than the firm’s investors

This is what is known as Asymmetric information and it does in fact affect the optimal capital structure

SUMMARY A firm with positive prospects would AVOID selling

stock/shares and GO FOR DEBT FINANCE to avoid EPS dilution

SAN LIO 94

Thus debt offering is taken as a positive SIGNAL On the other hand- a firm with negative prospects

would go for stock/shares sell- which would mean bringing in new investors to share the losses

Thus the announcement of stock offering is taken as a SIGNAL that the firm’s prospects as seen by its management are not good

WHATS UP WITH STOCK?We are looking at future prospects of a firm

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A firm with better prospects would not sell shares- because it wants to avoid EPS dilution- hence it will go for debt financing- and make the ‘kill’ for its existing shareholders

A firm with poor future prospects on the other hand will sell stocks-and avoid debt- since it may not even repay the debt in the future- and thus invites others to share in the losses

IN SUMMARY

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Since issuing stock sends the wrong signals, and thereby depressing the stock price even when the company’s prospects are bright,

A firm should maintain a BORROWIN CAPACITY that can be used when good investment opportunities come along

This simply means in normal circumstances, firms should use MORE EQUITY and LESS DEBT

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ASYMMETRIC SITUATION

This drives an entity to raise capital in a PECKING ORDER thus:

Raise capital internally by reinvesting its net income as well as selling its short-term marketable securities

Issue debt- is a good signalIssue preferred stock- is a good signalOnly as a last resort will the managers issue

common stock

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SUMMARY

Estimating the optimal capital structure of a firm should involve the following STEPS namely:

Estimate the interest rate the entity will payEstimate the cost of equityEstimate the weighted average cost of capitalEstimate the free cash flows and their present

value, which basically is the value of the firmDeduct the value of the debt to find the

shareholders wealth- which is MAXIMIZED

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GENERALLY-FIRMS CONSIDER:

Sales stability- stable sales will allow for taking more debt

Asset structure- assets that are suitable as security for debt encourage firms to heavily go for debt

Operational leverage- firms with less operating leverage can employ financial leverage since it will have less business risk

Growth- encourages reliance on external capital sourcesProfitability- the higher the return on investment, the

less the debt

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Taxes- the higher the firm’s taxes, the greater the advantage for debt finance

Control- debt may be a better option where control is a factor

Management attitudes- this is about management judgement on capital structure. Conservative managers use less debt

Lender and rating agency attitudes- these will influence capital structure accordingly

Market conditions- stock & bond market conditions, when they cant sell, debt becomes the choice

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The firm’s internal conditions- a firm with better future prospects would rather go for debt finance until the higher expected earnings are realised- BECAUSE THESE MAKE THE STOCK PRICE BETTER

Financial flexibility- the more the profitable investment opportunities, the more it is likely to have a flexible capital structure

WHILE MAKING CAPITAL DECISIONS.