Financial Management and Value of Money †Sample Assignment

Question: This course explores the financial management of the corporation. The course covers financial statements and cash flow analysis, financial impacts of decision-making, capital budgeting, strategic and operational planning. On the other hand, it explores the theoretical and practical issues of capital structure design, considers firm financing alternatives, including equity, long-term debt, hybrid securities, leasing, securitization, project finance, and examines the process through which securities are issued. The course also explores share repurchase, dividend policy, and risk management. Learning Outcomes (CLOs) Review the financing alternatives, time value of money, and categorize the valuation of financial assets (stocks and bonds). Assemble the component cost of capital for various types of capital structure. Evaluate past and future performance and measure proposed investments. The requirements Of the project are the following: Requirement no.1: Propose critical analysis for two academic articles on: Article number one . Extracting the article on Capital structure and cost of capital. Extract (weight of debt. (Liabilities)/ Weight of equity (owners equity)..Percentage. Article number two Past and future financial performance. (Evaluate the financial performance of the company using financial ratios such as Profitability ratios, Coverage ratios, Turnover ratios, Financial ratios, Leverage ratios..etc.). For example, you can write about cash mangers, stability.. etc). Please You will consider the following: the critical analysis will be as (debating not summary), you will go through 3 essential paragraphs, first paragraph will include (for example the author for my article who said (you will mention his findings). Second paragraph will include other authors views about the same topic. Third paragraph will include my opinion in the same topic like (I can see that based on.). Requirement No.2: Apply the outcomes from the previousarticles to the selected company as if you are the finance manager for such company. You will select a company from the link above, you will see how the selected company financially seen by auditors then you can extract financial statements which will measure capital structure (debt long term (non-current liability)), owners equity. Considering (ANNUALAUDITED 2014 or 2015). NOTE: show calculation in separate worksheets (Excel) when entering statement of income and financial position with related equations. (Excel template attached) you will fill in the worksheets in the attached excel template. Answer: Introduction The following report presents the critical analysis on the capital structure and cost of capital with reference to the article in one part. In the second part of the requirement, critical analysis for the past and future financial performance of a selected company. The financial performance evaluation will be based on the profitability ratios, coverage ratios, turnover ratios, financial ratios, leverage ratios and similar other ratios. The critical analysis in financial terms is important to evaluate for making better business decisions with respect to further investment, maximization of profits and revenues. Capital structure and cost of capital is derived from the two financial elements of the organization i.e. debt and equity (DeAngelo and Stulz 2015). Analysis of capital structure is essential to determine the companys financial sources to operate its overall business as well as to determine its sustainable growth by using several sources of funds. On the other hand, cost of capital is analyzed to determine the opportunity cost to make particular investment for the growth of business (Graham, Leary and Roberts 2015). However, in the second article, analysis on the financial performance on past and future trends of a company listed on Dubai Stock markets using several financial ratios. Further, in case of requirement two outcomes of analysis conducted in the first requirement will be used to evaluate the financial statements of a listed company for the purpose of further investment. The financial statement to be considered will be audited annual report for the year 2015 and measurement of capital structure and cost of capital considering debt and equity will be presented. The analysis on the financial statement of the company would assist in determining the past and future performance to make decisions on proposed investment for sustainable growth of the organization. Article 1: Critical Analysis on Capital structure and cost of capital Extraction of article on Capital Structure According to the article on A review on the Capital Structure Theories by Popescu Luigi and Visinescu Sorin, survey on the theories of capital structure has been considered from the start up point and further investment. For relevance of the theory, assumption of perfect capital market has been considered with respect to the debt and equity costs in optimal capital structure after the accounting of transaction costs like taxes and commissions. The article involves the study of Modigliani Miller theorem, the trade off theory and market timing theory. It states that there was no accepted theory of capital structure and therefore, the theory was conducted on the assumption of specific set of expected cash flows in a firm. On the other hand, trade off theory was used by incorporating income tax, which formed a benefit for reducing cost of debt. Additionally, the article presents a theory on optimal capital structure either by using companys own funds or by using external finance (Luigi a nd Sorin 2009). However, contention of other authors in this concept is different with regard to the capital structure and related transactions cost. It has been stated by the authors that transaction costs does not affect the carrying cost of capital for the purpose of investment and operating business activities. Costs on corporate income tax, interest charges, commission to agents and other transaction charges affect the amount of profit but not the capital structure of the organization (Faccio and Xu 2015). Apart from that, authors also mentioned that the expected cash flows of the company depend on the cost of capital and investment pattern of the organizations. Some of the articles also contradicted the assumptions of Modigliani Miller on perfect capital market with respect to the transactions costs. It is has been conducted that there are several transactions and business activities charges that are incorporated for business operations and affect the capital structure of the organization (Els as and Florysiak 2015). Considering the theory of A review on the Capital Structure Theories and reviews of other authors, it can be opined that the capital structure is a process to make decisions on the division and usage of organizations cash flow. The divisions can be based on the two components i.e. fixed component and residual component. Fixed component is structured to meet the liabilities towards debt capital while the residual component is structured to meet the capital amount for equity shareholders. Capital structure is a proportion of several long-term financial sources that are required to operate business activities (Schepens 2016). It is essential to have proportionate capital mix with respect to long-term debt and equity capital to manage financial leverage of the organization. Additionally, capital structure analysis is critical and is essential to make decisions with respect to finance the assets of the organizations and meet the short-term obligations of the business. It is important for the organization finance managers to conduct optimum mix of debt and equity to control the cost of capital as well as to maintain the expected return of the organizations. Extraction of article on Cost of Capital In the article of The Cost of Capital, Corporation Finance and the Theory of Investment by Franco Modigliani and Merton H. Miller, cost of capital has been identified as the funds used to acquire the assets of organizations having uncertain yields. The article presented the cost of capital to be obtained by using debt capital like debentures or other long- term debts and equity issues on the basis of pro-rata share. It is essential to manage cost of capital employed to maintain the sustainable growth of the business, evaluation and decisions on capital budget and investment proposal based on the micro and macro- economic level. The articles also covered the valuation of shares and valuation of cost of capital on the assumptions that the physical assets are owned by the organizations. It has been observed in the article that the market value of the organization is not dependent on the capital structure but on capitalization of its expected return. Moreover, the average cost of capital has been considered as the ratio of expected return (Xi) and market value of the securities (Yi) which is stated as Xi/ Yi for any of the organization (Modigliani and Miller 1958). Apparently, in view of articles by other authors, cost of capital is stated as the opportunity cost of entire capital employed in the business organizations. Cost of capital is a measurement of the proportionate cost of different modes of capital invested with respect to debt and equity. Cost of debt is determined as the equivalent or actual interest rate of using debt capital that is adjusted with the corporate tax rate (Core, Hail and Verdi 2015). On the other hand, cost of equity capital is determined by using the opportunity cost of investment by using market interest rate, risk free rate and the market investment risk. The illustration on cost of capital provided is cost of debt after tax is 8.1% whereas the cost of equity is 16.5% and the weight of debt used by the company is 15.9% while that of equity is 84.1%. Therefore, the average cost of capital= 8.1%* 15.9% + 16.5%* 84.1% = 15.1%. Hence, as per the articles of other authors, cost of capital has been derived from the debt and equity component instead of market values and securities (Li 2015). Considering the contents of articles provided by the authors, I conclude that the cost of capital should be measured by using the cost of long- term debts and equity capital invested by the organizations. Determination of cost of capital using the expected return and market values of securities does not reflect optimum results on using the companys finance to operate the business activities. It is an opportunity cost for using specific investment to manage risk and expected returns by employing the companys financial sources of funds. The cost of capital determination is different from company to company based on the profitability, credit worthiness and market value of the organizations shares and securities. Article 2: Financial Performance Financial performance is a measurement of optimum utilization of companys assets for the operation of its business in order to generate maximum revenue and profitability. It is used to analyze the financial position of the business organization and is measured by using the financial ratios (Flammer 2015). In the present assignment, financial performance of the company Abu Dhabi Aviation Group is presented by using several financial ratios. It has been observed from the companys financial reports for the year 2015 that the companys total asset is around AED 4,670 million and total equity is around AED 2,615 million. On the other hand, the companys profit during the year was AED 277 million and the earning per share was 0.60 AED (Abudhabiaviation.com 2016). Financial ratios or ratio analysis is a technique to determine the companys strength and weakness with respect to overall performance by considering two variables of financial information (Saeidi et al. 2015). There are various categories of financial ratios that are used to compare the relative performance level of the company and its competitors which are discussed as following: Profitability ratio analysis is a process to measure the financial performance during the year on considering the companys profitability. It is used to evaluate the organizations capacity to generate maximum earnings to benefit the company as well as its stakeholders (Bal 2016). The important components of the profitability ratios are gross profit margin, operating margin, return on assets, return on equity, return on sales and return on investment. Profitability Ratios 2015 2014 AED $ AED $ Gross profit margin Gross profit 553,283 416,140 Net Sales 2,181,612 1,611,413 Gross profit ratio 0.25 0.26 Operating margin Operating Income 277,347 244,686 Net sales 2,181,612 1,611,413 Operating margin ratio 0.13 0.15 Return on Assets Net Income 277,347 244,686 Average Total Assets 4,670,458 4,304,946 Return on assets 0.06 0.06 Return on equity Net Income 277,347 244,686 Shareholder's equity 2,408,445 2,199,105 Return on equity 0.12 0.11 Table 1: Profitability ratios of Abu Dhabi Aviation (Source: Created by author) It can be analyzed from the above calculation that the gross profit margin ratio of the organization is 0.25 in the year 2015 while 0.26 in the year 2014. It is a ratio used to measure the profitability of the company on selling the inventories. Higher gross profit margin means the organization is selling the inventories at higher percentage of profit. Accordingly, in the case of Abu Dhabi Aviation, gross margin ratio was higher in the year 2014 while it declined in 2015 (Abudhabiaviation.com 2016). Operating margin, on the other hand is an indicator for the companys investor to measure the efficiency of business operations. It is analyzed to determine the companys stability with respect to the profitability and turnover. In case of Abu Dhabi Aviation, operating margin in the year 2014 was 0.15 while in the year 2015 it declined to 0.13 (Abudhabiaviation.com 2016). A higher operating margin is favorable for the company because it shows that the ability to make more money for covering the operating expenses and maximizing profitability. Hence, Abu Dhabi Aviation seemed to have sound operating margin though it declined in the year 2015. Apart from operating and gross profit margin, profitability ratio of return on assets and return on equity shows the companys ability to finance the assets and shareholders or investors. Return on assets reflects the ability of company to earn maximum return on the assets invested since the assets are generally funded by equity or debt (Hogan 2015). From the above table, return on assets of Abu Dhabi Aviation shows the results at 0.06 in both the years 2015 and 2014. Hence, it can be said that the companys efficiency to earn return on invested capital is decent and intact. Similarly, return on equity reflects the efficiency of company in generating and maximizing profits from the investors fund. Therefore, higher the equity return ratio better is the organizations ability to earn income for the shareholders and maintain the business growth (Norvaiien, Stankevi ien and Kruinskas 2015). The results of Abu Dhabi Aviation show increment in the return on equity in the year 2015 at 0.12 whereas the return in the year 2014 was 0.11 and it can be concluded that the companys efficiency to earn income for investors is good. Coverage ratio is measured to identify the companys efficiency to make the payment of financial obligations and if the coverage ratio is higher, it can be said that the company is efficient to pay off its liabilities and debts. Interest coverage ratio is determined to measure the ability to pay off the interest amount to debenture holders within the due dates. It is used to measure the companys profitability and risk elements to evaluate the business values and operational efficiency (De Jonghe and ztekin 2015). Other coverage ratios that are used to determine the companys efficiency are asset coverage ratio, debt service coverage ratio and cash coverage ratio. Coverage Ratios 2015 2014 AED $ AED $ Interest coverage ratio EBIT 277,347 244,686 Interest expense 25,740 26,519 Interest coverage ratio 10.77 9.23 Debt service coverage ratio Net operating income 251,607 218,167 Debt service 807,418 673,949 Debt service coverage ratio 0.31 0.32 Asset coverage ratio Total assets- short term liabilities 4,183,717 3,923,662 Total Debt outstanding 807,418 673,949 Asset coverage ratio 5.18 5.82 Cash coverage ratio EBIT + non cash expenses (Depreciation) 490,079 434,072 Interest Expenses 25,740 26,519 Cash coverage ratio 19.04 16.37 Table 2: Coverage ratios of Abu Dhabi Aviation (Source: Created by author) It can be analyzed from the above computation that company, Abu Dhabi Aviations ability to meet the financial obligation is decent and sound. However, the cash coverage ratio and asset coverage ratio of the enterprise declined in the financial year 2015 compared to that of the financial year 2014. Therefore, the company seemed to have sound cash management and efficient in maintain the stability to perform the business operations effectively and efficiently. Abu Dhabi Aviation companys profitability ratios and cash coverage ratios reflected its capacity to maximize the profits, management of cash funds as well as maintaining the business stability. Requirement 2 To present the requirement for the purpose of companys financial performance and evaluating the capital structure, Abu Dhabi Aviation Company has been selected. The selected organization is an airline-based company listed at Abu Dhabi deals in oil fields and economic facilities and is one of the largest helicopter operators. It employs more than 900 people with current profit $2,773 million in the year 2015 and capital amount to $4,447 million. The company also generated maximum revenue in the year 2015, which increased at an approximate rat of 26% (Abudhabiaviation.com 2016). Following is the extract of companys financial report showing the audited income statement and financial position during the year 2015 and 2014. Income Statement 2015 2014 AED $ '000 AED $ ,000 Revenue 2,181,612 1,611,413 Operating cost (1,628,329) (1,195,273) Gross profit 553,283 416,140 Administrative expenditures -271,497 -222,386 Profit in change of value of investment 9,772 48,725 Investment income 6,409 6,758 Rent -2,172 -2,211 Finance income 2,522 2,563 Finance expenses -25,740 -21,394 Impairment loss -66261 -55514 Other incomes 624,314 488,145 Profit for the year 277,347 244,686 Balance Sheet Equity Share capital 444,787 444,787 Share premium 112,320 112,320 Reserves 1,521,531 1,434,163 Retained earnings 329,807 207,835 Non controlling interest 206,802 213,597 Total Equity 2,615,247 2,412,702 Liabilities Non- current liabilities 1,568,470 1,510,960 Current liabilities 486,741 381,284 Total Equity and liabilities 4,670,458 4,304,946 Assets Non- current Assets 3,103,593 3,151,263 Current Assets 1,566,865 1,153,683 Total Assets 4,670,458 4,304,946 Table 3: Financial statement of Abu Dhabi Aviation (Source: Created by author) The independent auditors have conducted observation and auditing of the financial statements of the company for the year 2015 with the presentation of comparative year 2014. Auditing has been conducted in accordance with the International Auditing Standards by placing the reasonable assurance and opinion on the income statements and balance sheet to examine the fairness and correctness. The auditor provides and expresses opinion on the valuation of assets and liabilities by checking the viability with respect to the accounting frameworks. It is also essential to examine the correctness of recording and recognizing the account payables and receivables with that of actual payments and dues (Joutsenvirta and Vaara 2015). In addition, the financial position of the company includes long-term debt in its capital structure during the financial years 2015 and 2014. 2015 2014 AED $ '000 AED $ ,000 Capital Structure Share capital 444,787 444,787 Share premium 112,320 112,320 Reserves 1,521,531 1,434,163 Retained earnings 329,807 207,835 Long- Term Debts 807,418 673,949 Financial Lease Liabilities 117,332 118,292 Table 4: Capital Structure of Abu Dhabi Aviation (Source: Created by author) It can be observed from the above statement of capital structure that there was increase in the companys earnings during the financial year 2015 than that in the year 2014. Along with that, the long-term debts also increased in the year 2015 approximately by 16%, which also increased the interest expenses in the year 2015. On the contrary, the liability of the company with respect to the long- term financial lease was declined in the year 2015 compared to the liability in 2014 at an average rate of 1.00% (Abudhabiaviation.com 2016). However, as per the computation of different profitability ratios and coverage ratios of the company, Abu Dhabi Aviation return on equity improved from 0.11 in the accounting year 2014 to 0.12 in the financial year 2015. Apart from the equity return, the earnings per share of the company also increased in the year 2015 at 0.60 while it was 0.48 in the financial year 2014 (Abudhabiaviation.com 2016). This increment in the companys return displays the efficiency of the companys generating maximum returns for the benefit of shareholders and employees. For the analysis of the companys financial performance in maximizing the profit and for future investment to generate maximum return, it is important to examine the financial assets and its sources of funds. According to the financial statements of the company, total non- current assets reflected the balance of $3,103 million in the year 2015 and $3,151 million in 2014. On the other hand, current asset balance shows $1,566 million in 2015 and $ 1,153 million in the year 2014 (Abudhabiaviation.com 2016). As the computation on ratio analysis for return on assets shows 0.06 for both the years 2015 and 2014, it can be said that the company is efficient to pay off its obligations. Additionally, cash flow statement of the company disclosed the cash funds earned from the operating activities is $431 million in the financial year 2015 whereas $445 million in the financial year 2014. The result reflects the decrease in cash return before the payment of interest and payment for employees benefit. 2015 2014 AED $ '000 AED $ ,000 Cash income from operating activities 431,670 445,442 Payment of Interest (25,740) (26,519) Payment of employees end of service benefits (6,287) (13,864) Net cash income for operating activities 399,643 405,059 Table 4: Cash generation of Abu Dhabi Aviation (Source: Created by author) Above statement, shows the net income of company from the operating activities declined at 1.33% during the accounting year 2015 compared to the year 2014. The difference is due to payment of interest, which decreased from $26 million in the year 2014 to $25 million in the financial year 2015. On the contrary, payment to the employee benefit decreased from $13 million in the year 2014 to $6 million in 2015 at an approximate rate 53%. But, at the same time companys gross cash income declined in the year 2015 at 3.10% (Abudhabiaviation.com 2016). Cash income from the investment activities in the statement of financial information disclosed the balance $334 million in the year 2015 and $713 million in the financial year 2014. On observing the cash- flow statement for income from investment activities it can be said that the investment value in the year 2015 had declined compared to that in the year 2014. During the year 2015, Abu Dhabi Aviation made investment in the shares of NCI valuing at $14 million. Moreover, the investment in joint venture that was made in 2014 at $40 million has been demolished in the year 2015 (Abudhabiaviation.com 2016). It can be observed from these transactions that the company needs to plan for further investment to increase its business operation and returns. For this purpose, the management is required to review the financial position of the company with respect to the fixed assets, current assets and liabilities. Further, companys capital structure should also be reviewed to analyze the companys position to operate its business activities efficiently and effectively. Observing the accounting information on Abu Dhabi Aviations capital, value of the organization reflected as the sum of share capital and long term debts. 2015 2014 AED $ '000 AED $ ,000 Share capital 444,787 444,787 Long- Term Debts 807,418 673,949 Value of the firm 1,252,205 1,118,736 Table 5: Value of Abu Dhabi Aviation (Source: Created by author) The above statement on computation of value of business discloses the value in the year 2014 at $1,118 million, which increased to $1,252 in the financial year 2015. It reflects the maximization in the market value of the company at an approximate rate of 12%, which represents the maximization in the value of shareholders wealth and companys returns. Another ratio that is used to measure the companys financial ability and strength is debt to equity ratio that reflects the percentage of finance come from investors and creditors. It is calculated by comparing the companys total debt and total equity as reported in the statement of financial position of the organization. Debt to equity ratio 2015 2014 AED $ '000 AED $ ,000 Long- Term Debts (a) 807,418 673,949 Financial Lease Liabilities (b) 117,332 118,292 Total Debt (a+ b) 924,750 792,241 Share capital 444,787 444,787 Debt to equity ratio 2.08 1.78 Table 6: Debt Equity ratio Abu Dhabi Aviation (Source: Created by author) Since the debt equity ratio of the company in both the years is more than one, it indicates that Abu Dhabi Aviation is employing debt financing more than the equity funds. A debt equity ratio if appears at lower than one then it can be said that the company id financial stable. On the other hand, it the debt equity ratio is higher than one, it is assumed that the company is experiencing risk towards its creditors for repayment and interest payment. Therefore, in case of Abu Dhabi Aviation, debt equity ratio was 1.78 in the year 2014, which increased to 2.08 in the financial year 2015. During the analysis of companys financial position, it is observed that the Abu Dhabi Aviation has encountered risk towards the long- term finance providers as well as towards the lease providers. Conclusion Therefore, analyzing the financial statements and several financial ratios of Abu Dhabi Aviation it can be concluded that the companys revenue increased from the year 2014 to 2015. However, the company also experienced decline in the investment and cash profits from the operating activities but it maintained the return on assets at 0.06 in both the financial year 2014 and 2015. At the same time higher debt equity ratio in the year, 2015 represents the elements of risk towards the creditors for the payment obligations. Although, net profit of the company increased in the year 2015 from 2014, yet the company experienced lower gross profit margin in the financial year 2015. In the view of above discussion, it can be recommended to the companys management that the operating expenses should be reviewed. It is important for Abu Dhabi Aviation to control the operating expenses so that the gross margin increases. At the same time, company should lower its debt financing and increase the equity capital to control the potential finance risk. It would assist the company to control the interest expenses and give the benefit to make further investment. Abu Dhabi Aviation is also recommended to manage its operating activities by maintaining the quality and controlling the relative costs. 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