Financial Policy: Evaluating an Acquisition or a New Project

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Acquisition refers to the act of contracting or taking possession of something. Firms that have an acquisition contract agree on the terms and conditions that will guide the contract. It, therefore, seems that the acquiring company starts a new project which requires specific considerations. The issues that a manager is likely to face are:

Capital budgeting: This is the process of decision-making by a financial manager on whether it is worth investing in a particular capital asset or project. This is usually a very common scenario in the case whereby a company is acquiring a new firm. During this process, the financial manager is required to determine which projects can offer a good investment opportunity for the firm, desirable assets to acquire, and what amount of money should be spent on such assets (Redman & Margaret, 71). Capital budgeting is made up of the following factors:

Initial Investment-Outlay: This is made up of the cash needed to establish a new firm less any net proceeds obtained on disposal of the firm. Any additional capital as a result of acquiring this new firm is also included in this outlay. According to Redman & Margart (72), “the initial investment outlay includes only those changes that occurred during the starting of the new project”. Any working capital which may be needed or may not be required in the future is considered to be cash-outflow or in-flow during this time.

Net Cash-benefits: This is the operating cost deducted from operating revenues as a result of incremental change.

Terminal cash-flow: This is net cash which is derived from asset sales, tax from asset termination, and net-working-capital released (Redman & Margart, 78).

Net present value: The financial manager should use discounted cash flow to determine the potential value of the project. According to Redman & Margart (78)” the timing and size of the incremental cash flows of the project should be estimated during this step”. The discount rates are likely to affect the net present value and therefore it becomes a critical decision for the financial manager. This discount rate is the possible least acceptable return expected on a project. It should consider the risks that are associated with the project and which are determined by cash flow velocity (Redman & Margart, 80).

Funding sources: To plan for capital budgeting, the financial manager is supposed to determine where to seek funds. The three ways for corporations to get funds are common stocks, preferred stock, and corporate bonds (Redman & Margart, 70).

The decision to select one of these is determined by the associated financial risks.

Gomper and Kovner (21) defined capital structure as “how a corporation finances its assets by the use debt, hybrid and equity combination”. Capital structure is likely to affect a firm valuation in that; there is a positive correlation between the leverage and firm value which is a result of the existing debt tax-shield effect (Gomper and Kovner, 20). In addition, for a scenario whereby the market conditions are perfect, the value of a firm is dependent on its operating profit and not its capital structure. It is evident that for the case of corporate taxes, the interest payment is equivalent to the tax that can be deducted. For this case, firms aim to have an optimal capital structure depending on the financial distress disadvantages and tax advantage. Therefore firms tend to work according to the objective and are therefore able to determine their prospects by structure change. The overall result is that the value of the firm increases when an increase in debt occurs (Gomper and Kovner, 22).

Another impact associated with the capital structure is that bankruptcy costs are likely to happen indirectly. The failure to represent some stakeholders at the bankruptcy-bargaining table can lead to such stakeholders as customers suffering some material costs that result from bankruptcy. This impact can be demonstrated using the standard trade-off model. By applying this model at the optimal capital structure, the marginal bankrupt costs that are associated with the debt of a firm are made equal to the marginal tax profit. The negative effects associated with bankruptcy cause costs on the debt, therefore, preventing firms to have the desire to get more debt (Gomper and Kovner, 31-3).

Methods or criteria a manager can use to determine a firm’s optimal capital structure

Capital gearing: When using this method, the measure of the long-term liability (LTL) ratio is required. This refers to the amount that falls after more than one year to the funds by the stakeholders. This method suggests showing how easy a firm can be able to pay its debts by selling its assets; this is so because the funds of the shareholders can measure net assets (Brealey and Myers, 15).

Capital gearing = LTL

Interest cover and income gearing: This method considers how the lack of ability to pay interest is triggered by the debt crisis. According to Brealey and Myers (17), “the objective of a firm is the reliability and the size of the income of a company depending on the firm’s commitment to making the interest”. For a firm to acquire its interest obligations, cash flow is determined by the ratio of the profit before interest and tax to the charges of the interest which is also referred to as the interest cover (Brealey and Myers, 28).

Combining of operating and financial-leverage: Financial and operating leverages are used by companies at various levels. Computation of the level of the combined- leverage can be used to determine the combined use. According to Keown (386) “this degree is referred to as the percent change in earnings per the share divided by the percentage change in sales”. This computation offers the financial manager the position to determine the impact on total leverage as a result of the addition of financial leverage to operating leverage.

Weighted average cost-capital: According to Rosenbaum & Pear (69), “this method can be used by financial managers to determine the cost capital of a firm”. A firm total capital is equal to the equity value added to its debt costs. In this case, equity represents the total market value and not the equity of the stakeholders included in the balance sheet. Therefore the individual financing sources should be calculated to get the weighted capital cost.

Target capital-structure: The method aims at specifying a particular capital structure. The firm is required to make a definition of what it refers to as optimal long-term gearing ratio and this is followed by the firm adhering to this particular ratio when financing operations in the future. For instance, if the optimal ratio is likely to result in 50% debt and 50% equity, any of the future functions should have finance of this proportion (Brealey and Myers, 31).

Qualitative and quantitative factors considered in assessing bankruptcy costs

Bankruptcy probability is an important factor for consideration when making capital structure decisions. This is because bankruptcy is the major factor that contributes to the restriction of amount total borrowed capital. Bankruptcy probability is therefore assessed at multiple time frames in the future based on the debt capital proportion and other components of the financial position of a firm. This is followed by calculating how such probabilities influence the value of the firm (Rosenbaum & Pear, 65). There are several factors that influence the value and existence of the optimal debt and the equity of a firm; they can be divided into broad categories:

Characteristics of a firm’s debt: These are determined by the proponent of the short-term debt, maturity horizon of the short-term component, and the cost of services. These are all useful factors when making a capital structure assessment because they will determine if the debt status is favorable for a firm.

Characteristics of a firm’s ability to pay the debt: These are important factors because they are used to represent the dependency of optimal and dependency ratio. There is therefore the need to use real data in making this assessment to determine the ability of a firm to pay its debts.

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BusinessEssay. "Financial Policy: Evaluating an Acquisition or a New Project." November 1, 2022.