All management decisions which affect the firm’s cash flow are considered to be capital budgeting decisions. In undertaking investment projects such as acquisitions or new projects, management teams need to conduct cash flow analysis. In finance, cash flow refers to the total amount of net cash that a given investment or project generates during a given period. Through cash flow analysis, the management team can determine whether it is profitable to undertake the project. This arises from the fact that cash flow analysis ensures that a project evaluation is in line with the shareholder’s wealth maximization objective. A firm’s cash flow over a given period can be used to determine the firm’s value (Driffield 3).
The report is aimed at evaluating the issues that face a manager in the process of evaluating a new project. This is done through consideration of cash flow evaluation and estimation methods. The report also analyzes the impact of capital structure on the firm’s valuation and the criteria that a manager can use in determining optimal capital structure. In addition, credit ratings as considered in assessing bankruptcy costs in capital structure decisions are evaluated.
The report is organized into several sections; the first section involves an analysis of the issues to be considered in determining acquisition or a new project. The impact of capital structure on a firm’s valuation together with the method of determining optimal capital structure is also evaluated. In addition, the relationship between bankruptcy cost and credit rating about capital structure decisions are also evaluated.
Issues in determining acquisition or a new project
Decisions related to acquisition or implementing new projects are aimed at improving the firm’s value. In undertaking such decisions, the manager is faced with several issues. One of the issues entails the determination of the expected cash flow for the desired acquisition or project. This is the most challenging task that the manager has to undertake. This arises from the fact that the manager has to consider all the aspects related to the projects which have the capacity of affecting the project’s cash flow. In addition, the manager is faced with the challenge of determining cash flows that extend for a long duration of time.
The manager has to undertake a post-implementation review. This entails evaluating the anticipated cash flows and actual results. To calculate a project’s cash flow, the manager has to identify the most appropriate source of project forecasts. For example, in the case of a new project, the manager has to involve the firm’s engineering team which designed the project intended to be implemented. On the other hand, operating costs will be determined by the firms’ cost accountants. If the project does not entail the development of a new product, the manager has to decide on the most appropriate method of determining the cash flow. Such a task is challenging since the manager has to make a forecast of the expected sales and prices. In addition, the manager has to determine all the associated cash flows and possible deviations. This will entail consideration of diverse factors which include market trends and the nature of the economy. To undertake this, the manager has to decide on the most appropriate decision criteria to use. This may entail the calculation of the project’s Net Present Value (NPV) or the Internal Rate of Return (IRR). The decision to whether undertake or reject the project depends on the NPV obtained.
In evaluating the project’s cash flows, the manager has to consider several elements. These include calculation of the net initial outlay which entails expected cash flow at inception. Incremental revenue should be calculated for all the subsequent years to determine annual cash flow. In addition, terminal cash flow includes the expected cash flow upon the project coming to an end.
Impact of capital structure on a firm’s valuation
A firm’s capital structure entails the nature of capital that has been used to finance its operation. The two main sources of finance available to a firm include equity and debt finance. Determination of capital structure is vital for a firm’s financial wellbeing. Implementation of poor financial decisions about a firm’s capital structure may result in the firm undergoing financial constraints, bankruptcy which may culminate into liquidation. A firm’s capital structure affects various elements which affect the value of the company. Cost of capital is one of the major determinants of the firm’s capital structure and hence the value of the company. However, these two elements are indirectly related. Other elements which determine the value of a firm include dividend, earning per share, payout ratio, net profit, and the firm’s liquidity.
Studies conducted by Miller and Modigliani assert that there is no relationship between a firm’s financial leverage and its value. However, in a world characterized by various tax deductibles and interest payments, a positive relationship exists between capital structure and the firm’s value (Hatfield, Cheng & Davidson 1). In case a firm is characterized by high leverage, the management team should consider the most effective way to integrate mixture within its capital structure. The resultant effect is that the firm will be able to reduce its capital’s weighted cost. Such a strategy would result in an increment in the firm’s net economic return hence its value. A high leveraged firm tends to have a low value. However, high leverage results in minimal agency problems. This arises from the fact that external stakeholders limit management’s opportunistic behavior between the two parties. Despite the capacity of high leverage in a firm reducing agency problems, it hurts the firm’s financial flexibility. This arises from the fact that the firm tends to have a debt ratio that may result in bankruptcy.
A firm’s ownership structure affects its value. Initially, managerial share ownership results in an increment in the firm’s value. A certain degree of managerial share-ownership can culminate into a reduction in the firm’s value. This arises from the existence of incentives amongst the managers to expropriate the shareholder’s wealth. This means that managers will be committed to ensuring that all the firm’s operations are aimed at maximizing shareholders’ wealth. In addition, a firm characterized by a low- debt experiences a significant abnormal return which means that its value is increased (Driffield 6).
Method of determining optimal capital structure
There is no definite optimal capital that is generally accepted across a given industry. Optimal capital structure entails a capital structure that results in the maximization of the firm’s stock price. This means that the firm’s debt ratio has to be lower than that which results in maximization of the firm’s earnings per share (Brigham & Houston 450). There are several factors which managers should consider in determining a firm’s optimal capital structure. Optimal capital structure refers to a mix of finances which the management considers being the best for the firm. In determining capital structure, managers should weigh between risks and return (Wet 2). Optimal capital structure establishes an equilibrium between risk and return. There are several steps that a manager can incorporate in determining the firm’s optimal capital structure. These are outlined below.
- Estimation of the rate of interest to be paid by the firm
- Determination of cost of equity
- Determination of Weighted Average Cost of Capital (WACC)
- Determining the FCF (Free Cash Flow) and their corresponding present value.
- Deduction of debt to establish the shareholder’s wealth. The value obtained represents the amount to be maximized
A firm’s optimal capital structure should be made by determining a capital structure that results in the maximization of the company’s stock price. A capital structure that results in maximization of the firm’s share price leads to the firm’s Weighted Average Cost of Capital (WACC) diminishing (Brigham & Houston 450). However; it is possible to forecast how changes in the firm’s capital structure will affect its WACC compared to its effect on the share price. As a result, managers utilize the relationship between WACC and capital structure to make decisions regarding the desired optimal capital structure.
Bankruptcy costs in capital structure decisions
In the operation of a firm, the chances of the firm undergoing bankruptcy cannot be overruled. Occurrence of bankruptcy results in adverse effects on the firm’s accounting and legal expenses. In addition, such a firm is not able to retain its customers and suppliers. The occurrence of bankruptcy also affects the firm’s capital structure. This arises from the fact that it increases the probability of the firm incurring more debt. There are various costs associated with bankruptcy. For instance, bankruptcy increases agency costs. For example, the shareholders may make decisions for their interest and disregard debt holders. In such a case, creditors should take several actions to protect their interests. Some of these include increasing the rate of adjustable-rate debt or taking the firm to court to enforce fulfillment of their rights. Credit rating is the most effective way through which a firm’s default risk can be determined. To attain this qualitative and quantitative factors are considered in making such assessments. Qualitative factors considered include the various operational risks facing the firm originating from both internal and external environments. On the other hand, quantitative factors considered entailing evaluation of the firm’s capital structure.
In the process of evaluating a new project or acquisition, managers are faced with several issues. The manager has to determine all the streams of expected cash flow in the entire life of the project. This presents a challenge to the manager since he has to consider all various external issues such as the prevailing economic conditions. The most appropriate methods of cash flow evaluation and estimation also have to be determined. In addition, the determination of optimal capital structure and its impact on the firm’s value is paramount. This enables the manager to determine the mixture of the firm’s capital structure. Considering the probability of bankruptcy, the manager needs to ensure that the firm has a high credit rating. This will prevent the firm’s capital structure and its operation from being affected.
To attain efficiency in their operation, managers should consider the following issues.
- Minimal leveraging should be used in financing the firm’s long-term projects since it has the effect of reducing the firm’s value.
- Determination of optimal capital structure should be undertaken by considering the firm’s WACC.
Brigham, Eugene and Houston, Joel. Fundamentals of financial management. New York: Cengage Learning, 2007.
Driffield, Nigel. How Does Ownership Structure Affect Capital Structure and Firm Performance? Recent Evidence from East Asia. Mumbai, India: Crisil Centre for Economic Research, 2006.
Hatfield, Gay, Cheng, Louis and Davidson, Wallace. The determination of optimal capital structure: the effect of firm and industry debt ratios on market value. Journal of Financial and Strategic Decisions. 7 (3) 1994: 1-14.
Wet ,JHvH de. Determining the optimal capital structure: a practical contemporary approach. Meditari Accountancy Research 14 (2) 2006: 1-16.