5.3.1 Period Basis On the basis of period, the different sources of funds can be categorised into three parts. These are long-term sources, medium-term sources and short-term sources. The long-term sources fulfil the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-term borrowings and loans from financial institutions. Such financing is generally required for the acquisition of fixed assets such as equipment, plant, etc. Where the funds are required for a period of more than one year but less than five years, medium-term sources of finance are used. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions. Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans from commercial banks and commercial papers are some of the examples of the sources that provide funds for short duration. Short-term financing is most common for financing of current assets such as accounts receivable and inventories. Seasonal businesses that must build inventories in anticipation of selling requirements often need short term financing for the interim period between seasons. Wholesalers and manufacturers with a major portion of their assets tied up in inventories or receivables also require large amount of funds for a short period. 5.3.2 Ownership Basis On the basis of ownership, the sources can be classified into ‘owner’s funds’ and ‘borrowed funds’. Owner’s funds means funds that are provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company. Apart from capital, it also includes profits reinvested in the business. The owner’s capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business. Such capital forms the basis on which owners acquire their right of control of management. Issue of equity shares and retained earnings are the two important sources from where owner’s funds can be obtained. ‘Borrowed funds’ on the other hand, refer to the funds raised through loans or borrowings. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit. Such sources provide funds for a specified period, on certain terms and conditions and have to be repaid after the expiry of that period. A fixed rate of interest is paid by the borrowers on such funds. At times it puts a lot of burden on the business as payment of interest is to be made even when the earnings are low or when loss is incurred. Generally, borrowed funds are provided on the security of some fixed assets. 5.3.3 Source of Generation Basis Another basis of categorising the sources of funds can be whether the funds are generated from within the organisation or from external sources. Internal sources of funds are those that are generated from within the business. A business, for example, can generate funds 101 CU IDOL SELF LEARNING MATERIAL (SLM)
internally by accelerating collection of receivables, disposing of surplus inventories and ploughing back its profit. The internal sources of funds can fulfil only limited needs of the business. External sources of funds include those sources that lie outside an organisation, such as suppliers, lenders, and investors. When large amount of money is required to be raised, it is generally done through the use of external sources. External funds may be costly as compared to those raised through internal sources. In some cases, business is required to mortgage its assets as security while obtaining funds from external sources. Issue of debentures, borrowing from commercial banks and financial institutions and accepting public deposits are some of the examples of external sources of funds commonly used by business organisations. 5.4 SOURCES OF FINANCE A business can raise funds from various sources. Each of the source has unique characteristics, which must be properly understood so that the best available source of raising funds can be identified. There is not a single best source of funds for all organisations. Depending on the situation, purpose, cost and associated risk, a choice may be made about the source to be used. For example, if a business wants to raise funds for meeting fixed capital requirements, long term funds may be required which can be raised in the form of owned funds or borrowed funds. Similarly, if the purpose is to meet the day-to-day requirements of business, the short term sources may be tapped. A brief description of various sources, along with their advantages and limitations is given below. 5.4.1 Retained Earnings A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self- financing or ‘ploughing back of profits’. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation. Merits The merits of retained earnings as a source of finance are as follows: • Retained earnings is a permanent source of funds available to an organisation; • It does not involve any explicit cost in the form of interest, dividend or floatation cost; • As the funds are generated internally, there is a greater degree of operational freedom and flexibility; • It enhances the capacity of the business to absorb unexpected losses; • It may lead to increase in the market price of the equity shares of a company. LIMITATIONS Retained earnings as a source of funds has the following limitations: 102 CU IDOL SELF LEARNING MATERIAL (SLM)
• Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends; • It is an uncertain source of funds as the profits of business are fluctuating; • The opportunity cost associated with these funds is not recognised by many firms. This may lead to sub-optimal use of the funds. 5.4.2 Trade Credit Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by business organisations as a source of short- term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers. Merits The important merits of trade credit are as follows: • Trade credit is a convenient and continuous source of funds; • Trade credit may be readily available in case the credit worthiness of the customers is known to the seller; • Trade credit needs to promote the sales of an organisation; • If an organisation wants to increase its inventory level in order to meet expected rise in the sales volume in the near future, it may use trade credit to, finance the same; • It does not create any charge on the assets of the firm while providing funds. LIMITATIONS Trade credit as a source of funds has certain limitations, which are given as follows: • Availability of easy and flexible trade credit facilities may induce a firm to indulge in overtrading, which may add to the risks of the firm; • Only limited amount of funds can be generated through trade credit; • It is generally a costly source of funds as compared to most other sources of raising money 103 CU IDOL SELF LEARNING MATERIAL (SLM)
5.4.3 Factoring Factoring is a financial service under which the ‘factor’ renders various services which includes: • Discounting of bills (with or without recourse) and collection of the client’s debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two methods of factoring — recourse and non- recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non- recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad. • Providing information about credit worthiness of prospective client’s etc., Factors hold large amounts of information about the trading histories of the firms. This can be valuable to those who are using factoring services and can thereby avoid doing business with customers having poor payment record. Factors may also offer relevant consultancy services in the areas of finance, marketing, etc. The factor charges fees for the services rendered. Factoring appeared on the Indian financial scene only in the early nineties as a result of RBI initiatives. The organisations that provides such services include SBI Factors and Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd., State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank. In addition, many non- banking finance companies and other agencies provide factoring service. Merits The merits of factoring as a source of finance are as follows: • Obtaining funds through factoring is cheaper than financing through other means such as bank credit; • With cash flow accelerated by factoring, the client is able to meet his/her liabilities promptly as and when these arise; • Factoring as a source of funds is flexible and ensures a definite pattern of cash inflows from credit sales. It provides security for a debt that a firm might otherwise be unable to obtain; • It does not create any charge on the assets of the firm; • The client can concentrate on other functional areas of business as the responsibility of credit control is shouldered by the factor. Limitations 104 CU IDOL SELF LEARNING MATERIAL (SLM)
The limitations of factoring as a source of finance are as follows: • This source is expensive when the invoices are numerous and smaller in amount; • The advance finance provided by the factor firm is generally available at a higher interest cost than the usual rate of interest; • The factor is a third party to the customer who may not feel comfortable while dealing with it. 5.4.4 Lease Financing A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words it is a renting of an asset for some specified period. The owner of the assets is called the ‘lessor’ while the party that uses the assets is known as the ‘lessee’ . The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset. The terms and conditions regulating the lease arrangements are given in the lease contract. At the end of the lease period, the asset goes back to the lessor. Lease finance provides an important means of modernisation and diversification to the firm. Such type of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of the fast changing technological developments. While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same. Merits The important merits of lease financing are as follows: • It enables the lessee to acquire the asset with a lower investment; • Simple documentation makes it easier to finance assets; • Lease rentals paid by the lessee are deductible for computing taxable profits; • It provides finance without diluting the ownership or control of business; • The lease agreement does not affect the debt raising capacity of an enterprise; • The risk of obsolescence is borne by the lesser. This allows greater flexibility to the lessee to replace the asset. Limitations The limitations of lease financing are given as below: • A lease arrangement may impose certain restrictions on the use of assets. For example, it may not allow the lessee to make any alteration or modification in the asset; • The normal business operations may be affected in case the lease is not renewed; 105 CU IDOL SELF LEARNING MATERIAL (SLM)
• It may result in higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination of the lease agreement; and • The lessee never becomes the owner of the asset. It deprives him of the residual value of the asset. 5.4.5 Public Deposits The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation. While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period upto three years. The acceptance of public deposits is regulated by the Reserve Bank of India. Figure 5.2 106 CU IDOL SELF LEARNING MATERIAL (SLM)
Merits The merits of public deposits are: • The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement; • Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions; • Public deposits do not usually create any charge on the assets of the company. The assets can be used as security for raising loans from other sources; • As the depositors do not have voting rights, the control of the company is not diluted. Limitations The major limitation of public deposits are as follows: • New companies generally find it difficult to raise funds through public deposits; • It is an unreliable source of finance as the public may not respond when the company needs money; • Collection of public deposits may prove difficult, particularly when the size of deposits required is large. 5.4.6 Commercial Paper (Cp) Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. Its regulation comes under the purview of the Reserve Bank of India. The merits and limitations of a Commercial Paper are as follows: Merits • A commercial paper is sold on an unsecured basis and does not contain any restrictive conditions; • As it is a freely transferable instrument, it has high liquidity; • It provides more funds compared to other sources. Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans; • A commercial paper provides a continuous source of funds. This is because their maturity can be tailored to suit the requirements of the issuing firm. Further, maturing commercial paper can be repaid by selling new commercial paper; • Companies can park their excess funds in commercial paper thereby earning some good return on the same. 107 CU IDOL SELF LEARNING MATERIAL (SLM)
Limitations • Only financially sound and highly rated firms can raise money through commercial papers. New and moderately rated firms are not in a position to raise funds by this method; • The size of money that can be raised through commercial paper is limited to the excess liquidity available with the suppliers of funds at a particular time; • Commercial paper is an impersonal method of financing. As such if a firm is not in a position to redeem its paper due to financial difficulties, extending the maturity of a CP is not possible. 5.4.7 Issue of Shares The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has its nominal value. For example, a company can issue 1,00,000 shares of Rs. 10 each for a total value of Rs. 10,00,000. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital. (a) Equity Shares Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company. Merits The important merits of raising funds through issuing equity shares are given as below: • Equity shares are suitable for investors who are willing to assume risk for higher returns; • Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on the company in this respect; 108 CU IDOL SELF LEARNING MATERIAL (SLM)
• Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. As it stands last in the list of claims, it provides a cushion for creditors, in the event of winding up of a company; • Equity capital provides credit worthiness to the company and confidence to prospective loan providers; • Funds can be raised through equity issue without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings, if the need be; • Democratic control over management of the company is assured due to voting rights of equity shareholders. Limitations The major limitations of raising funds through issue of equity shares are as follows: • Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns; • The cost of equity shares is generally more as compared to the cost of raising funds through other sources; • Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders; • More formalities and procedural delays are involved while raising funds through issue of equity share. (b) Preference Shares The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways: • receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and • receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares. Merits The merits of preference shares are given as follows: 109 CU IDOL SELF LEARNING MATERIAL (SLM)
• Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment; • Preference shares are useful for those investors who want fixed rate of return with comparatively low risk; • It does not affect the control of equity shareholders over the management as preference shareholders don’t have voting rights; • Payment of fixed rate of dividend to preference shares may enable a company to declare higher rates of dividend for the equity shareholders in good times; • Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company; • Preference capital does not create any sort of charge against the assets of a company. Limitations The major limitations of preference shares as source of business finance are as follows: • Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns; • Preference capital dilutes the claims of equity shareholders over assets of the company; • The rate of dividend on preference shares is generally higher than the rate of interest on debentures; • As the dividend on these shares is to be paid only when the company earns profit, there is no assured return for the investors. Thus, these shares may not be very attractive to the investors; • The dividend paid is not deductible from profits as expense. Thus, there is no tax saving as in the case of interest on loans. 110 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 5.3 Debentures Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending. A company can issue different types of debentures (see Box C and D). Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest has also become popular in recent years. The difference between the face value of the debenture and its purchase price is the return to the investor. Merits The merits of raising funds through debentures are given as follows: • It is preferred by investors who want fixed income at lesser risk; • Debentures are fixed charge funds and do not participate in profits of the company; • The issue of debentures is suitable in the situation when the sales and earnings are relatively stable; • As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management; • (v) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible. 111 CU IDOL SELF LEARNING MATERIAL (SLM)
Limitations Debentures as source of funds has certain limitations. These are given as follows: • As fixed charge instruments, debentures put a permanent burden on the earnings of a company. There is a greater risk when earnings of the company fluctuate; • In case of redeemable debentures, the company has to make provisions for repayment on the specified date, even during periods of financial difficulty; • Each company has certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds reduces. 5.4.8 Commercial Banks Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in instalments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank. Merits The merits of raising funds from a commercial bank are as follows: • Banks provide timely assistance to business by providing funds as and when needed by it. • Secrecy of business can be maintained as the information supplied to the bank by the borrowers is kept confidential; • Formalities such as issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds; • Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed. Limitations The major limitations of commercial banks as a source of finance are as follows: • Funds are generally available for short periods and its extension or renewal is uncertain and difficult; 112 CU IDOL SELF LEARNING MATERIAL (SLM)
• Banks make detailed investigation of the company’s affairs, financial structure etc., and may also ask for security of assets and personal sureties. This makes the procedure of obtaining funds slightly difficult; • In some cases, difficult terms and conditions are imposed by banks. for the grant of loan. For example, restrictions may be imposed on the sale of mortgaged goods, thus making normal business working difficult Figure 5.4 5.4.9 Financial Institutions The government has established a number of financial institutions all over the country to provide finance to business organisations. These institutions are established by the central as well as state governments. They provide both owned capital and loan capital for long and medium term requirements and supplement the traditional financial agencies like commercial banks. As these institutions aim at promoting the industrial development of a country, these are also called ‘development banks’. In addition to providing financial assistance, these institutions also conduct market surveys and provide technical assistance and managerial services to people who run the enterprises. This source of financing is considered suitable when large funds for longer duration are required for expansion, reorganisation and modernisation of an enterprise. Merits The merits of raising funds through financial institutions are as follows: • Financial institutions provide long term finance, which are not provided by commercial banks; • Besides providing funds, many of these institutions provide financial, managerial and technical advice and consultancy to business firms; 113 CU IDOL SELF LEARNING MATERIAL (SLM)
• Obtaining loan from financial institutions increases the goodwill of the borrowing company in the capital market. Consequently, such a company can raise funds easily from other sources as well; • As repayment of loan can be made in easy instalments, it does not prove to be much of a burden on the business; • The funds are made available even during periods of depression, when other sources of finance are not available. Limitations The major limitations of raising funds from financial institutions are as given below: • Financial institutions follow rigid criteria for grant of loans. Too many formalities make the procedure time consuming and expensive; • Certain restrictions such as restriction on dividend payment are imposed on the powers of the borrowing company by the financial institutions; • Financial institutions may have their nominees on the Board of Directors of the borrowing company thereby restricting the powers of the company. Figure 5.5 5.4.10 International Financing In addition to the sources discussed above, there are various avenues for organisations to raise funds internationally. With the opening up of an economy and the operations of the business organisations becoming global, Indian companies have an access to funds in global capital market. Various international sources from where funds may be generated include: i. Commercial Banks: Commercial banks all over the world extend foreign currency loans for business purposes. They are an important source of financing 114 CU IDOL SELF LEARNING MATERIAL (SLM)
non-trade international operations. The types of loans and services provided by banks vary from country to country. For example, Standard Chartered emerged as a major source of foreign currency loans to the Indian industry. ii. International Agencies and Development Banks: A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium term loans and grants to promote the development of economically backward areas in the world. These bodies were set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects. The more notable among them include International Finance Corporation (IFC), EXIM Bank and Asian Development Bank. iii. International Capital Markets: Modern organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are: • Global Depository Receipts (GDR’s): The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. A holder of GDR can at any time convert it into the number of shares it represents. The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs (see Box F). • American Depository Receipts (ADRs): The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets, like regular stocks. It is similar to a GDR except that it can be issued only to American citizens and can be listed and traded on a stock exchange of USA. • Indian Depository Receipt (IDRs): An Indian Depository Receipt is a financial instrument denominated in Indian Rupees in the form of a Depository Receipt. It is created by an Indian Depository to enable a foreign company to raise funds from the Indian securities market. The IDR is a specific Indian version of the similar global depository receipts. The foreign company issuing IDR deposits shares to an Indian Depository (custodian of securities registered with the Securities and Exchange Board of India). In turn, the depository issues receipts to investors in India against 115 CU IDOL SELF LEARNING MATERIAL (SLM)
these shares. The benefits of the underlying shares (like bonus, dividends, etc.) accrue to the IDR holders in India. According to SEBI guidelines, IDRs are issued to Indian residents in the same way as domestic shares are issued. The issuer company makes a public offer in India, and residents can bid in exactly the same format and method as they bid for Indian shares. ‘Standard Chartered PLC’ was the first company that issued Indian Depository Receipt in Indian securities market in June 2010. • Foreign Currency Convertible Bonds (FCCBs): Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds. The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. FCCB’s are very similar to the convertible debentures issued in India. Figure 5.6 5.5 FACTORS AFFECTING THE CHOICE OF THE SOURCE OF FUNDS Financial needs of a business are of different types — long term, short term, fixed and fluctuating. Therefore, business firms resort to different types of sources for raising funds. 116 CU IDOL SELF LEARNING MATERIAL (SLM)
Short-term borrowings offer the benefit of reduced cost due to reduction of idle capital, but long – term borrowings are considered a necessity on many grounds. Similarly equity capital has a role to play in the scheme for raising funds in the corporate sector. As no source of funds is devoid of limitations, it is advisable to use a combination of sources, instead of relying only on a single source. A number of factors affect the choice of this combination, making it a very complex decision for the business. The factors that affect the choice of source of finance are briefly discussed below: i. Cost: There are two types of cost viz., the cost of procurement of funds and cost of utilising the funds. Both these costs should be taken into account while deciding about the source of funds that will be used by an organisation. ii. Financial strength and stability of operations: The financial strength of a business is also a key determinant. In the choice of source of funds business should be in a sound financial position so as to be able to repay the principal amount and interest on the borrowed amount. When the earnings of the organisation are not stable, fixed charged funds like preference shares and debentures should be carefully selected as these add to the financial burden of the organisation. iii. Form of organisation and legal status: The form of business organisation and status influences the choice of a source for raising money. A partnership firm, for example, cannot raise money by issue of equity shares as these can be issued only by a joint stock company. iv. Purpose and time period: Business should plan according to the time period for which the funds are required. A short-term need for example can be met through borrowing funds at low rate of interest through trade credit, commercial paper, etc. For long term finance, sources such as issue of shares and debentures are more appropriate. Similarly, the purpose for which funds are required need to be considered so that the source is matched with the use. For example, a long-term business expansion plan should not be financed by a bank overdraft which will be required to be repaid in the short term. v. Risk profile: Business should evaluate each of the source of finance in terms of the risk involved. For example, there is a least risk in equity as the share capital has to be repaid only at the time of winding up and dividends need not be paid if no profits are available. A loan on the other hand, has a repayment schedule for both the principal and the interest. The interest is required to be paid irrespective of the firm earning a profit or incurring a loss. vi. Control: A particular source of fund may affect the control and power of the owners on the management of a firm. Issue of equity shares may mean dilution of the control. For example, as equity share holders enjoy voting rights, financial institutions may take control of the assets or impose conditions as part of the loan 117 CU IDOL SELF LEARNING MATERIAL (SLM)
agreement. Thus, business firm should choose a source keeping in mind the extent to which they are willing to share their control over business. vii. Effect on credit worthiness: The dependence of business on certain sources may affect its credit worthiness in the market. For example, issue of secured debentures may affect the interest of unsecured creditors of the company and may adversely affect their willingness to extend further loans as credit to the company. viii. Flexibility and ease: Another aspect affecting the choice of a source of finance is the flexibility and ease of obtaining funds. Restrictive provisions, detailed investigation and documentation in case of borrowings from banks and financial institutions for example may be the reason that a business organisation may not prefer it, if other options are readily available. ix. Tax benefits: Various sources may also be weighed in terms of their tax benefits. For example, while the dividend on preference shares is not tax deductible, interest paid on debentures and loan is tax deductible and may, therefore, be preferred by organisations seeking tax advantage. 5.6 SUMMARY • Helps you understand the various sources of funds along with its relative merits and demerits for starting and running a business. • The financial needs of a business can be categorized as: (a) Fixed capital requirements: In order to start business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. The funds required for fixed assets remain invested in the business for a long period. (b)Working capital requirements: Funds needed for the business’ day-to-day operations is known as working capital of an enterprise, which is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes, and rent. • Sources of Funds: a) Period basis b) Ownership basis c) Sources generation basis • Period basis: a) Long Term - The long-term sources fulfil the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-term borrowings and loans from financial institutions. b) Short Term - Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans from commercial banks and commercial papers are some of the examples of the sources that provide funds for short duration. 118 CU IDOL SELF LEARNING MATERIAL (SLM)
c) Medium Term - Funds required for a period of more than one year but less than five years, medium-term sources of finance are used. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions. • Ownership basis a) Owner’s funds - Funds are provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company. b) Borrowed funds - Refer to the funds raised through loans or borrowings. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit. • Source of generation a) Internal sources b) External sources • Retained Earnings: A source of internal financing or self-financing or ‘ploughing back of profits. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation. • Trade credit: Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by business organisations as a source of short-term financing. • Factoring: a) Discounting of bills (with or without recourse) and collection of the client’s debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. b) Providing information about credit worthiness of prospective client’s etc., Factors hold large amounts of information about the trading histories of the firms. • Lease financing: A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words it is a renting of an asset for some specified period. • Public deposits: The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. • Commercial paper (CP): Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. 119 CU IDOL SELF LEARNING MATERIAL (SLM)
• Issue of shares: The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. There are two types of shares - equity shares and preference shares. The money raised by issue of equity shares and preference shares are called equity share capital and preference share capital respectively. (a) Equity Shares: Is an important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. (b) Preference Shares: The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways: Receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and Receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation. • Debentures: Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year. • Commercial banks: Commercial banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. • Financial institutions: These institutions provide both owned capital and loan capital for long- and medium-term requirements and supplement the traditional financial agencies like commercial banks. This source of financing is considered suitable when large funds for longer duration are required for expansion, reorganization and modernization of an enterprise. • International financing: Indian companies have access to funds in global capital market. Various international sources include: (i) Commercial Banks (ii) International Agencies and Development Banks (iii) International Capital Markets a. Global Depository Receipts (GDR’s) b. American Depository Receipts (ADRs) c. Indian Depository Receipt (IDRs) d. Foreign Currency Convertible Bonds (FCCBs) • Factors affecting the choice of the source of funds: 120 CU IDOL SELF LEARNING MATERIAL (SLM)
As no source of funds is devoid of limitations, it is advisable to use a combination of sources, instead of relying only on a single source. A number of factors affect the choice of this combination, making it a very complex decision for the business. The factors that affect the choice of source of finance are briefly discussed below: (i) Cost: (ii) Financial strength and stability of operations: (iii) Form of organisation and legal status (iv) Purpose and time period (v) Risk profile (vi) Control (vii) Effect on credit worthiness (viii) Flexibility and ease (ix) Tax benefits 5.7 KEYWORDS • Fixed capital • Working capital • Shares • Debentures • Commercial banks 5.8 LEARNING ACTIVITIES 1. A company needs to consider the amount of accumulated retained earnings held in the form of cash balances or short-term investments and how much of this will be needed to support existing operations. It may be the case that there is insufficient cash available to finance investment in new projects as a large proportion of retained earnings is tied up in existing projects in the form of stock, debtors and fixed assets. ________________________________________________________________________ ________________________________________________________________________ 5.9 UNIT END QUESTIONS A.Descriptive Questions Short Questions 1. State the return given to debenture holders for using their funds. 2. Give one feature of retained earnings that the other source of finance does not have. 121 CU IDOL SELF LEARNING MATERIAL (SLM)
3. Mention one similar function of Public deposits and ADR. Long Questions 1. Outline the reasons why convertible loan stock might be an attractive source of long- term finance for quoted companies. 2. Outline the advantages associated with a rights issue as a source of long-term finance compared to. a. Debt b. Private placing 3. Outline the advantages associated with each of the following sources of medium-term finance. a. Term loans b. Leasing c. Hire purchase B. Multiple Choice Questions 1. Debentures are an important instrument for raising long term debt capital. a. True b. False c. Partly True d. None of these 2. A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. a. True b. False c. Partly True d. None of these 3. Choose long terms from the following: a. Equity shares b. Debentures c. Preference shares d. All of these 4. Commercial banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. 122 CU IDOL SELF LEARNING MATERIAL (SLM)
a. True b. False 5.The deposits that are raised by organisations directly from the public are known as _____________ a. Private deposits b. Bank deposits c. Public deposits d. Debentures Answers 1-a, 2-a, 3-b, 4-a, 5-c 5.10 REFERENCES Text Books: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 123 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 6- PROJECT EVALUATION 124 Structure 6.0 Learning Objectives 6.1 Introduction 6.2 Project Evaluation 6.2.1 The Technical and Engineering Segment 6.2.2 The Management Segment 6.2.3 The Demand and Market Segment 6.2.4 The Financial Segment 6.2.5 The Economic Segment 6.3 Approaches to Evaluation 6.3.1 Participatory Evaluation 6.3.2 Empowerment Evaluation 6.4 Evaluation Methods 6.4.1 Quantitative Methods 6.4.2 Qualitative Methods 6.4.3 Mixed Methods 6.5 The Six Phases of Project Management 6.5.1 Initiation Phase 6.5.2 Definition Phase 6.5.3 Design Phase 6.5.4 Development Phase 6.5.5 Implementation Phase 6.5.6 Follow-Up Phase 6.6 Funding and Cost 6.7 The Evaluation Methodology 6.8 Evaluation Criteria 6.8.1 Net Present Value 6.8.2 Internal Rate of Return 6.8.3 Payback Period 6.8.4 Profitability Index and Benefit Cost Ration 6.9 Capital Structure Choices and Revisiting Project Evaluation 6.9.1 The Modigliani Miller World 6.9.2 Financial Distress Costs 6.9.3 Taxes 6.9.4 Nature of Assets 6.9.5 Nature of the Business and Competitive Position CU IDOL SELF LEARNING MATERIAL (SLM)
6.9.6 Risk Management 6.9.7 Ownership Control 6.9.8 The Perspective of the Top Management 6.10 Capital Structure and Project Evaluation 6.10.1 The WACC Method 6.10.2 The WACC, CAPM and the all-equity financed case 6.10.3 The APV Method 6.11 Project Life Cycle 6.12 Decision Making 6.13 Summary 6.14 Keywords 6.15 Learning Activity 6.16 Unit End Questions 6.17 References 6.0 LEARNING OBJECTIVES After studying this unit, students will be able to: • Describe what is Project Evaluation • What are the various approaches followed in project evaluation • Explain the various methods of project evaluation • Discuss the various phases of project evaluation • On what criteria the projects are evaluated • What are the various capital structure choices available • Explain project life cycle 6.1 INTRODUCTION Evaluation of a project involves a careful consideration of the totality of the project with a view to seeing how useful or valuable it is Evaluation enables us to attach proper financial value to a project and also allows us the liberty of comparing it with other projects. You will note that an analysis is not done in a vacuum. It is usually documented. A problem usually encountered in project evaluation is how to arrange the work to make it readable or understandable. A very simple format which we will adopt in the evaluation of projects is one that recognizes the various functional aspects or units of an organization. At the end of this unit, you should be able to explain the format for project evaluation. 125 CU IDOL SELF LEARNING MATERIAL (SLM)
6.2 PROJECT EVALUATION An Introductory Format Evaluation is important to assess the worth or merit of a project and to identify areas for improvement. It promotes appropriate decisions to take, including changes to the project’s objectives and methodology. An evaluation must be planned carefully. There is no one suite of techniques that fits all types of projects. The evaluation approach, design and methodologies should match the specific project. The focus and purpose of an evaluation differs depending on the needs of stakeholders that may include project developers, funding agencies, local government, community, teaching personnel and students. It is important to consult with stakeholders to select the most suitable approach. By identifying the highlights and lowlights of a project, evaluation leads to conclusions that may affect future decision making. Findings of evaluation reports, based on thorough analysis, are valuable input in planning processes. Evaluation supports learning and improvement through incorporation of recommendations into new projects, programs and strategies. 6.2.1 The Technical and Engineering Segment The technical and engineering segment of project evaluation tries to evaluate the total technical and engineering soundness of a project. It also tries to relate the project to the environment in which it is located. We will now proceed to draw up a checklist for the technical engineering segment of project evaluation. 126 CU IDOL SELF LEARNING MATERIAL (SLM)
6.2.2 The Management Segment After evaluating the technical and engineering segments of projects, the next segment we need to discuss is the management segment. The management segment focuses attention on the management aspects of a project. Projects only become successful if they are well managed. We do not need to over-stress the importance of management. Again, we need to evaluate the legal form of the organization that is evaluated and see if it can carry the project in question. 6.2.3 The Demand and Market Segment The next segment we shall consider is the demand and market segment. This segment focuses attention on the demand for goods and services and relates it to the market. An evaluation of the demand for goods and services is very important because demand 127 CU IDOL SELF LEARNING MATERIAL (SLM)
translates to revenues. Also, we need to evaluate supply situations in the market. These two topics will be treated in detail later. We will now examine a checklist for the demand and market segment. 6.2.4 The Financial Segment The financial segment of project evaluation focuses attention on the financial aspects of projects. In discussing financial issues, we are considering all financial aspects of a project such as start-up costs, financial plans, renames and costs and income statements. 6.2.5 The Economic Segment The last segment we will consider is the economic segment. The economic segment considers projects from the macroeconomic point of view. Economic analysis tries to measure the benefits and costs of projects in terms of their value to society as a whole. Next the various stages of project evaluation will be discussed in detail. The program evaluation process goes through four phases — planning, implementation, completion, and dissemination and reporting — that complement the phases of program development and implementation. Each phase has unique issues, methods, and procedures. In this section, each of the four phases is discussed Planning 128 CU IDOL SELF LEARNING MATERIAL (SLM)
The relevant questions during evaluation planning and implementation involve determining the feasibility of the evaluation, identifying stakeholders, and specifying short- and long-term goals. For example, does the program have the clarity of objectives or transparency in its methods required for evaluation? What criteria were used to determine the need for the program? Questions asked during evaluation planning also should consider the program’s conceptual framework or underpinnings. For example, does a proposed community-engaged research program draw on “best practices” of other programs, including the characteristics of successful researcher community partnerships? Is the program gathering information to ensure that it works in the current community context? Defining and identifying stakeholders is a significant component of the planning stage. Stakeholders are people or organizations that have an interest in or could be affected by the program evaluation. They can be people who are involved in program operations, people who are served or affected by the program, or the primary users of the evaluation. The inclusion of stakeholders in an evaluation not only helps build support for the evaluation but also increases its credibility, provides a participatory approach, and supplies the multiple perspectives of participants and partners Stakeholders might include community residents, businesses, community based organizations, schools, policy makers, legislators, politicians, educators, researchers, media, and the public , For example, in the evaluation of a program to increase access to healthy food choices in and near schools, stakeholders could include store merchants, school boards, zoning commissions, parents, and students. Stakeholders constitute an important resource for identifying the questions a program evaluation should consider, selecting the methodology to be used, identifying data sources, interpreting findings, and implementing recommendations. Once stakeholders are identified, a strategy must be created to engage them in all stages of the evaluation. Ideally, this engagement takes place from the beginning of the project or program or, at least, the beginning of the evaluation. The stakeholders should know that they are an important part of the evaluation and will be consulted on an ongoing basis throughout its development and implementation. The relationship between the stakeholders and the evaluators should involve two-way communication, and stakeholders should be comfortable initiating ideas and suggestions. One strategy to engage stakeholders in community programs and evaluations is to establish a community advisory board to oversee programs and evaluation activities in the community. This structure can be established as a resource to draw upon for multiple projects and activities that involve community engagement. An important consideration when engaging stakeholders in an evaluation, beginning with its planning, is the need to understand and embrace cultural 129 CU IDOL SELF LEARNING MATERIAL (SLM)
diversity. Recognizing diversity can improve the evaluation and ensure that important constructs and concepts are measured. Implementation — Formative and Process Evaluation Evaluation during a program’s implementation may examine whether the program is successfully recruiting and retaining its intended participants, using training materials that meet standards for accuracy and clarity, maintaining its projected timelines, coordinating efficiently with other ongoing programs and activities, and meeting applicable legal standards Evaluation during program implementation could be used to inform mid-course corrections to program implementation (formative evaluation) or to shed light on implementation processes (process evaluation)For community-engaged initiatives, formative and process evaluation can include evaluation of the process by which partnerships are created and maintained and ultimately succeed in functioning. Completion — Summative, Outcome, and Impact Evaluation Following completion of the program, evaluation may examine its immediate outcomes or long-term impact or summarize its overall performance, including, for example, its efficiency and sustainability A program’s outcome can be defined as “the state of the target population or the social conditions that a program is expected to have changed,”. For example, control of blood glucose was an appropriate program outcome when the efficacy of empowerment- based education of diabetes patients was evaluated. In contrast, the number of people who received the empowerment education or any program service would not be considered a program outcome unless participation in and of itself represented a change in behaviour or attitude (e.g., participating in a program to treat substance abuse) Similarly, the number of elderly housebound people receiving meals would not be considered a program outcome, but the nutritional benefits of the meals actually consumed for the health of the elderly, as well as improvements in their perceived quality of life, would be appropriate program outcomes .Program evaluation also can determine the extent to which a change in an outcome can be attributed to the program If a partnership is being evaluated, the contributions of that partnership to program outcomes may also be part of the evaluation. Once the positive outcome of a program is confirmed, subsequent program evaluation may examine the long-term impact the program hopes to have. For example, the outcome of a program designed to increase the skills and retention of health care workers in a medically underserved area would not be represented by the number of providers who participated in the training program, but it could be represented by the proportion of health care workers who stay for one year. Reduction in maternal mortality might constitute the long-term impact that such a program would hope to effect. Dissemination and Reporting 130 CU IDOL SELF LEARNING MATERIAL (SLM)
To ensure that the dissemination and reporting of results to all appropriate audiences is accomplished in a comprehensive and systematic manner, one needs to develop a dissemination plan during the planning stage of the evaluation This plan should include guidelines on who will present results, which audiences will receive the results, and who will be included as a co-author on manuscripts and presentations Dissemination of the results of the evaluation requires adequate resources, such as people, time, and money Finding time to write papers and make presentations may be difficult for community members who have other commitments .In addition, academics may not be rewarded for non-scientific presentations and may thus be hesitant to spend time on such activities Additional resources may be needed for the translation of materials to ensure that they are culturally appropriate Although the content and format of reporting may vary depending on the audience, the emphasis should be on full disclosure and a balanced assessment so that results can be used to strengthen the program Dissemination of results may also be used for building capacity among stakeholders. 6.3 APPROACHES TO EVALUATION Two approaches are particularly useful when framing an evaluation of community engagement programs; both engage stakeholders in one, the emphasis is on the importance of participation; in the other, it is on empowerment. 1. The first approach, participatory evaluation, actively engages the community in all stages of the evaluation process. 2. The second approach, empowerment evaluation, helps to equip program personnel with the necessary skills to conduct their own evaluation and ensure that the program runs effectively 3. This section describes the purposes and characteristics of the two approaches. 6.3.1 Participatory Evaluation Participatory evaluation can help improve program performance by 1. involving key stakeholders in evaluation design and decision making, 2. acknowledging and addressing asymmetrical levels of power and voice among stakeholders, 3. using multiple and varied methods, 4. having an action component so that evaluation findings are useful to the program’s end users, and 5. explicitly aiming to build the evaluation capacity of stakeholders (Burke, 1998). Characteristics of participatory evaluation include the following: 131 CU IDOL SELF LEARNING MATERIAL (SLM)
• The focus is on participant ownership; the evaluation is oriented to the needs of the program stakeholders rather than the funding agency. • Participants meet to communicate and negotiate to reach a consensus on evaluation results, solve problems, and make plans to improve the program. • Input is sought and recognized from all participants. • The emphasis is on identifying lessons learned to help improve program implementation and determine whether targets were met. • The evaluation design is flexible and determined (to the extent possible) during the group processes. • The evaluation is based on empirical data to determine what happened and why. • Stakeholders may conduct the evaluation with an outside expert serving as a facilitator. 6.3.2 Empowerment Evaluation Empowerment evaluation is an approach to help ensure program success by providing stakeholders with tools and skills to evaluate their program and ensuring that the evaluation is part of the planning and management of the program (Fetterman, 2008).The major goal of empowerment evaluation is to transfer evaluation activities from an external evaluator to the stakeholders. Empowerment evaluation has four steps: 1. taking stock of the program and determining where it stands, including its strengths and weaknesses; 2. establishing goals for the future with an explicit emphasis on program improvement; 3. developing strategies to help participants determine their own strengths that they can use to accomplish program goals and activities; and 4. helping program participants decide on and gather the evidence needed to document progress toward achieving their goals. Characteristics of empowerment evaluation include the following: • Values improvement in people, programs, and organizations to help them achieve results. • Community ownership of the design and conduct of the evaluation and implementation of the findings • Inclusion of appropriate participants from all levels of the program, funders, and community • Democratic participation and clear and open evaluation plans and methods. 132 CU IDOL SELF LEARNING MATERIAL (SLM)
• Commitment to social justice and a fair allocation of resources, opportunities, obligations, and bargaining power • Use of community knowledge to understand the local context and to interpret results • Use of evidence-based strategies with adaptations to the local environment and culture • Building the capacity of program staff and participants to improve their ability to conduct their own evaluations. • Organizational learning, ensuring that programs are responsive to changes and challenges • Accountability to funders’ expectations. Potential Disadvantages of Participatory and Empowerment Evaluation The potential disadvantages of participatory and empowerment evaluation include • the possibility that the evaluation will be viewed as less objective because of stakeholder involvement, • difficulties in addressing highly technical aspects, • the need for time and resources when involving an array of stakeholders, and • domination and misuse by some stakeholders to further their own interests. However, the benefits of fully engaging stakeholders throughout the evaluation outweigh these concerns. Table 6.1 133 CU IDOL SELF LEARNING MATERIAL (SLM)
6.4 EVALUATION METHODS An evaluation can use quantitative or qualitative data, and often includes both. Both methods provide important information for evaluation, and both can improve community engagement. These methods are rarely used alone; combined, they generally provide the best overview of the project. This section describes both quantitative and qualitative methods, and the above table shows examples of quantitative and qualitative questions according to stage of evaluation. 6.4.1 Quantitative Methods Quantitative data provide information that can be counted to answer such questions as “How many?”, “Who was involved?”, “What were the outcomes?”, and “How much did it cost?” Quantitative data can be collected by surveys or questionnaires, pre-tests and post- tests, observation, or review of existing documents and databases or by gathering clinical data. Surveys may be self- or interviewer-administered and conducted face-to-face or by telephone, by mail, or online. Analysis of quantitative data involves statistical analysis, from basic descriptive statistics to complex analyses. Quantitative data measure the depth and breadth of an implementation (e.g., the number of people who participated, the number of people who completed the program)Quantitative data collected before and after an intervention can show its outcomes and impact. The strengths of quantitative data for evaluation purposes include their generalizability (if the sample represents the population), the ease of analysis, and their consistency and precision (if collected reliably). The limitations of using quantitative data for evaluation can include poor response rates from surveys, difficulty obtaining documents, and difficulties in valid measurement in addition, quantitative data do not provide an understanding of the program’s context and may not be robust enough to explain complex issues or interactions 6.4.2 Qualitative Methods Qualitative data answer such questions as “What is the value added?”, “Who was responsible?”, and “When did something happen?’’ Qualitative data are collected through direct or participant observation, interviews, focus groups, and case studies and from written documents. Analyses of qualitative data include examining, comparing and contrasting, and interpreting patterns. Analysis will likely include the identification of themes, coding, clustering similar data, and reducing data to meaningful and important points, such as in grounded theory-building or other approaches to qualitative analysis . Observations may help explain behaviours as well as social context and meanings because the evaluator sees what is actually happening Observations can include watching a participant or program, videotaping an intervention, or even recording people who have 134 CU IDOL SELF LEARNING MATERIAL (SLM)
been asked to “think aloud” while they work .Interviews may be conducted with individuals alone or with groups of people and are especially useful for exploring complex issues. Interviews may be structured and conducted under controlled conditions, or they may be conducted with a loose set of questions asked in an open-ended manner. It may be helpful to tape-record interviews, with appropriate permissions, to facilitate the analysis of themes or content. Some interviews have a specific focus, such as a critical incident that an individual recalls and describes in detail. Another type of interview focuses on a person’s perceptions and motivations Focus groups are run by a facilitator who leads a discussion among a group of people who have been chosen because they have specific characteristics (e.g., were clients of the program being evaluated). Focus group participants discuss their ideas and insights in response to open-ended questions from the facilitator. The strength of this method is that group discussion can provide ideas and stimulate memories with topics cascading as discussion occurs . The strengths of qualitative data include providing contextual data to explain complex issues and complementing quantitative data by explaining the “why” and “how” behind the “what?” The limitations of qualitative data for evaluation may include lack of generalizability, the time-consuming and costly nature of data collection, and the difficulty and complexity of data analysis and interpretation. 6.4.3 Mixed Methods The evaluation of community engagement may need both qualitative and quantitative methods because of the diversity of issues addressed (e.g., population, type of project, and goals). The choice of methods should fit the need for the evaluation, its timeline, and available resources. 6.5 THE SIX PHASES OF PROJECT MANAGEMENT This chapter provides a sketch of the traditional method of project management. The model that is discussed here forms the basis for all methods of project management. Later chapters go into more depth regarding a model that is particularly appropriate for IT- related projects. Dividing a project into phases makes it possible to lead it in the best possible direction. Through this organisation into phases, the total work load of a project is divided into smaller components, thus making it easier to monitor. The following paragraphs describe a phasing model that has been useful in practice. It includes six phases: 1. Initiation phase 2. Definition phase 3. Design phase 4. Development phase 135 CU IDOL SELF LEARNING MATERIAL (SLM)
5. Implementation phase 6. Follow-up phase Fig 6.1 6.5.1 Initiation Phase The initiation phase is the beginning of the project. In this phase, the idea for the project is explored and elaborated. The goal of this phase is to examine the feasibility of the project. In addition, decisions are made concerning who is to carry out the project, which party (or parties) will be involved and whether the project has an adequate base of support among those who are involved. In this phase, the current or prospective project leader writes a proposal, which contains a description of the above-mentioned matters. Examples of this type of project proposal include business plans and grant applications. The prospective sponsors of the project evaluate the proposal and, upon approval, provide the necessary financing. The project officially begins at the time of approval. Questions to be answered in the initiation phase include the following: • Why this project? • Is it feasible? • Who are possible partners in this project? • What should the results be? • What are the boundaries of this project (what is outside the scope of the project)? The ability to say ‘no’ is an 136 CU IDOL SELF LEARNING MATERIAL (SLM)
important quality in a project leader. Projects tend to expand once people have become excited about them. The underlying thought is, ’While we’re at it, we might as well …’ Projects to which people keep adding objectives and projects that keep expanding are nearly certain to go off schedule, and they are unlikely to achieve their original goals. In the initiation phase, the project partners enter a (temporary) relationship with each other. To prevent the development of false expectations concerning the results of the project, it makes sense to explicitly agree on the type of project that is being started: • a research and development project; • a project that will deliver a prototype or ‘proof of concept’; • a project that will deliver a working product. The choice for a particular type of project largely determines its results. For example, a research and development project delivers a report that examines the technological feasibility of an application. A project in which a prototype is developed delivers all of the functionalities of an application, but they need not be suitable for use in a particular context (e.g. by hundreds of users). A project that delivers a working product must also consider matters of maintenance, instructions and the operational management of the application. Many misunderstandings and conflicts arise because the parties that are involved in a project are not clear on these matters. Customers may expect a working product, while the members of the project team think they are developing a prototype. A sponsor may think that the project will produce a working piece of software, while the members of the project team must first examine whether the idea itself is technically feasible. 6.5.2 Definition Phase After the project plan (which was developed in the initiation phase) has been approved, the project enters the second phase: the definition phase. In this phase, the requirements that are associated with a project result are specified as clearly as possible. This involves identifying the expectations that all of the involved parties have with regard to the project result. How many files are to be archived? Should the metadata conform to the Data Documentation Initiative format, or will the Dublin Core (DC) format suffice? May files be deposited in their original format, or will only those that conform to the ‘Preferred Standards’ be accepted? Must the depositor of a dataset ensure that it has been processed adequately in the archive, or is this the responsibility of the archivist? Which guarantees will be made on the results of the project? The list of questions goes on and on. It is important to identify the requirements as early in the process as possible. It distinguishes several categories of project requirements that can serve as a memory aid: • Preconditions • Functional requirements • Operational requirements • Design limitations Preconditions form the context within which the project must be conducted. Examples include legislation, working-condition regulations and approval requirements. These requirements cannot be influenced from within the project. Functional requirements are 137 CU IDOL SELF LEARNING MATERIAL (SLM)
requirements that have to do with the quality of the project result (e.g. how energy- efficient must an automobile be or how many rooms must a new building have?). Operational requirements involve the use of the project result. For example, after a software project has been realised, the number of malfunctions that occur must be reduced by ninety per cent. Finally, design limitations are requirements that involve the actual realisation of the project. For example, the project cannot involve the use of toxic materials or international partners for whom it is unclear whether they use child labour. During the definition phase of a project that involved developing a web application for a consortium of large organisations, no agreements were made concerning the browser that would be supported by the application. The consortium assumed that it would be Microsoft Explorer, because it was the browser that ‘everyone’ used. The programmers created the application in Firefox, because they worked with the browser themselves and because it had a number of functions that were particularly useful during the development. Because most of the websites that are made for Firefox also look good in Explorer, the difference was initially not noticeable. Near the end of the project, however, the customer began to complain that the website ‘didn’t look good’. The programmers, who had been opening the site in Firefox, did not understand the complaint. When the problem of the two browsers became clear, the programmers reacted defensively, ‘Can’t they just install Firefox? After all, it is free’. The organisations, however, were bound to the bureaucratic-minded system administrators who, for some possibly justified reason, refused to install Firefox in addition to Explorer. Even if they had wanted to install it, it would have involved a lengthy process, and there would have been extra costs for the time that the system administrators would have to spend on the task. It was ultimately decided that the application would have to be made suitable for Explorer. That involved considerable extra work, whereby the project ran even more behind schedule than it already had, and it was necessary to negotiate the extra costs. It was later discovered that the various organisations were working with different versions of Microsoft Explorer. It is very important that all parties that are involved in the project are able to collaborate during the definition phase, particularly the end users who will be using the project result. The fact that end users are often not the ones that order the project perhaps explains why they are often ignored. The client, who pays for the project, is indeed invited to collaborate on the requirements during the definition phase. Nonetheless, the project result benefits when its future users are also invited. As a point of departure, it is helpful to make a habit of organising meetings with all concerned parties during the definition phase of a project. During the development of an educational video game, the users (young people) were involved in the project only at a later stage. When the game was nearly completed, a group of young people was asked to test the game. Their initial assessments appeared mild and 138 CU IDOL SELF LEARNING MATERIAL (SLM)
friendly. When pressed, however, they admitted that they had actually found the game ‘extremely boring’ and that they would ‘certainly not play it themselves’. Had these young people been involved in the project earlier, the game would probably have been a success. As it stands, the game remains nearly unused on an Internet website. The result of the definition phase is a list of requirements from the various parties who are involved in the project. Every requirement obviously has a reverse side. The more elaborate the project becomes, the more time and money it will cost. In addition, some requirements may conflict with others. New copy machines are supposed to have less environmental impact; they must also meet requirements for fire safety. The fire-safety regulations require the use of flame-retardant materials, which are less environmentally friendly. As this illustration shows, some requirements must be negotiated. Ultimately, a list of definitive requirements is developed and presented for the approval of the project’s decision-makers. Once the list has been approved, the design phase can begin. At the close of the definition phase, most of the agreements between the customer and the project team have been established. The list of requirements specifies the guidelines that the project must adhere to. The project team is evaluated according to this list. After the definition phase, therefore, the customer can add no new requirements. A part of a new exhibit in a museum was comprised of a computer installation, the creation of which had been project-based. Because there had been no definition phase in the project, no clear agreements between the museum and those responsible for building the installation had been made. When the computer for the installation broke down halfway through the exhibit, the museum assumed that it would be covered by the project’s guarantee. The project team had a different opinion. Negotiations between the directors were necessary in order to arrive at an appropriate solution. 6.5.3 Design Phase The list of requirements that is developed in the definition phase can be used to make design choices. In the design phase, one or more designs are developed, with which the project result can apparently be achieved. Depending on the subject of the project, the products of the design phase can include dioramas, sketches, flow charts, site trees, HTML screen designs, prototypes, photo impressions and UML schemas. The project supervisors use these designs to choose the definitive design that will be produced in the project. This is followed by the development phase. As in the definition phase, once the design has been chosen, it cannot be changed in a later stage of the project. 139 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 6.2 Example: Global design for the DANS Architecture Archive In a young, very informal company, the design department was run by an artist. The term ‘design department’ was not accurate in this case; it was more a group of designers who were working together. In addition, everyone was much too busy, including the head of the department. One project involved producing a number of designs, which were quite important to the success of the project. A young designer on the project team created the designs. Although the head of the design department had ultimate responsibility for the designs, he never attended the meetings of the project team when the designs were to be discussed. The project leader always invited him, and sent him e-mails containing his young colleague’s sketches, but the e-mails remained unanswered. The project leader and the young designer erroneously assumed that the department head had approved the designs. The implementation phase began. When the project was nearly finished, the result was presented to the department head, who became furious and demanded that it be completely redone. The budget, however, was almost exhausted. 6.5.4 Development Phase During the development phase, everything that will be needed to implement the project is arranged. Potential suppliers or subcontractors are brought in, a schedule is made, materials and tools are ordered, instructions are given to the personnel and so forth. The development phase is complete when implementation is ready to start. All matters must be clear for the parties that will carry out the implementation. In some projects, particularly smaller ones, a formal development phase is probably not necessary. The important point 140 CU IDOL SELF LEARNING MATERIAL (SLM)
is that it must be clear what must be done in the implementation phase, by whom and when. 6.5.5 Implementation Phase The project takes shape during the implementation phase. This phase involves the construction of the actual project result. Programmers are occupied with encoding, designers are involved in developing graphic material, contractors are building, the actual reorganisation takes place. It is during this phase that the project becomes visible to outsiders, to whom it may appear that the project has just begun. The implementation phase is the ‘doing’ phase, and it is important to maintain the momentum. In one project, it had escaped the project team’s attention that one of the most important team members was expecting to become a father at any moment and would thereafter be completely unavailable for about a month. When the time came, an external specialist was brought in to take over his work, in order to keep the team from grinding to a halt. Although the team was able to proceed, the external expertise put a considerable dent in the budget. At the end of the implementation phase, the result is evaluated according to the list of requirements that was created in the definition phase. It is also evaluated according to the designs. For example, tests may be conducted to determine whether the web application does indeed support Explorer 5 and Firefox 1.0 and higher. It may be determined whether the trim on the building has been made according to the agreement, or whether the materials that were used were indeed those that had been specified in the definition phase. This phase is complete when all of the requirements have been met and when the result corresponds to the design. Those who are involved in a project should keep in mind that it is hardly ever possible to achieve a project result that precisely meets all of the requirements that were originally specified in the definition phase. Unexpected events or advancing insight sometimes require a project team to deviate from the original list of requirements or other design documents during the implementation of the project. This is a potential source of conflict, particularly if an external customer has ordered the project result. In such cases, the customer can appeal to the agreements that were made during the definition phase. As a rule, the requirements cannot be changed after the end of the definition phase. This also applies to designs: the design may not be changed after the design phase has been completed. Should this nonetheless be necessary (which does sometimes occur), the project leader should ensure that the changes are discussed with those involved (particularly the decision-makers or customers) as soon as possible. It is also important that the changes that have been chosen are well documented, in order to prevent later misunderstandings. More information about the documentation of the project follows later . 141 CU IDOL SELF LEARNING MATERIAL (SLM)
6.5.6 Follow-Up Phase Although it is extremely important, the follow-up phase is often neglected. During this phase, everything is arranged that is necessary to bring the project to a successful completion. Examples of activities in the follow-up phase include writing handbooks, providing instruction and training for users, setting up a help desk, maintaining the result, evaluating the project itself, writing the project report, holding a party to celebrate the result that has been achieved, transferring to the directors and dismantling the project team. The central question in the follow-up phase concerns when and where the project ends. Project leaders often joke among themselves that the first ninety per cent of a project proceeds quickly and that the final ten per cent can take years. The boundaries of the project should be considered in the beginning of a project, so that the project can be closed in the follow-up phase, once it has reached these boundaries. It is sometimes unclear for those concerned whether the project result is to be a prototype or a working product. This is particularly common in innovative projects in which the outcome is not certain. Customers may expect to receive a product, while the project team assumes that it is building a prototype. Such situations are particularly likely to manifest themselves in the follow-up phase. Consider the case of a software project to test a very new concept. There was some anxiety concerning whether any results would be produced at all. The project eventually produced good results. The team delivered a piece of software that worked well, at least within the testing context. The customer, who did not know much about IT, thought that he had received a working product. After all, it had worked on his office computer. The software did indeed work, but when it was installed on the computers of fifty employees, the prototype began to have problems, and it was sometimes instable. Although the programmers would have been able to repair the software, they had no time, as they were already involved in the next project. Furthermore, they had no interest in patching up something that they considered a trial piece. Several months later, when Microsoft released its Service Pack 2 for Windows, the software completely stopped functioning. The customer was angry that the ‘product’ once again did not work. Because the customer was important, the project leader tried to persuade the programmers to make a few repairs. The programmers were resistant, however, as repairing the bugs would cause too much disruption in their new project. Furthermore, they perceived the software as a prototype. Making it suitable for large-scale use would require changing the entire architectural structure. They wondered if the stream of complaints from the customer would ever stop. The motto, ‘Think before you act’ is at the heart of the six-phase model. Each phase has its own work package. Each work package has its own aspects that should be the focus of concentration. It is therefore unnecessary to continue discussing what is to be made during the implementation phase. If all has gone well, this was already determined in the definition phase and the design phase. For a more detailed description of the six-phase model and the task packets for each phase. 142 CU IDOL SELF LEARNING MATERIAL (SLM)
6.6 FUNDING AND COST The identification and selection of good investment projects is a key element in developing a sustainable successful future. The decision to move forward with good or bad projects, more than impacting the economic profile of the firm in the short term, will tend to have a lasting impact in the long term profitability. The analysis of a project has three quite different sequential dimensions. Firstly, we have a phase of gathering and assessing the data related to the project. In special, forecasted data (revenues, costs, etc.) need to be carefully analyzed as it will be cement of whatever criteria that will be used to evaluate the project. Just using the right methodology and tools to evaluate a given project will not help much to reach a good investment decision if the analysis is based in poor data. The robustness of the data employed is crucial in the evaluation process. Secondly we have the evaluation stage, in which we will assess the merits of the project to contribute for the value of the firm. Finally, we will have a third stage, of risk analysis, that will check the robustness of the evaluation results. 6.7 THE EVALUATION METHODOLOGY The analysis of the projects will be based on their cash flows. We will compare the cash invested and the cash generated by the project. Therefore there won´t be any accounting or similar features that may influence the decision. In the definition of the projects’ cash flows there are some principles that will be taken into account, especially: • The concept of incremental cash flows :To evaluate a project, we will consider the cash flows driven by the project; for instance, if the project will use available staff (that wouldn´t be dismissed in the absence of the project) this cost shouldn´t be included in the project; by contrast, if the project sales produce a reduction in the sales of another product this side effect should be accounted for. • The role of sunk costs: A sunk cost is an item generated by the project, independently of the decision of moving forward with it or not; a classical example are the costs associated with several studies conducted in the project analysis (market research, product conception, etc.) that will always be incurred by the firm whatever final decision regarding the project; in these cases, the associated (sunk) costs shouldn´t be included in the project evaluation. The finite life the project will run for a given period. The more common criteria to establish this time horizon is the economic life of the major component of the investment, but other criteria may be used according to the project’s characteristics (for instance, a concession period). • Asset disposals: Assuming that the project has a finite life, the sale of assets and realization of working capital balances will have to occur at the end of the project, 143 CU IDOL SELF LEARNING MATERIAL (SLM)
being its final cash flows. The value of the sale of assets should, though, be estimated. Usually, and adopting a conservative view, assets disposals will be carried out in the year after the last operating cash flow occurs (or operational activity is completed). • Nominal vs. real prices :Project data can be prepared assuming a zero inflation (real prices) or considering a given scenario for the evolution of prices (and their impact in the project outputs and inputs); the latter is more common, while the former is more used in projects developed in countries with high and especially unpredictable inflation. The real prices approach creates an additional difficulty in the valuation process regarding the calculation of the discount rate: this needs to be established taking into account the theoretical zero inflation scenario. Having computed the project’s stream of cash flows, we will evaluate the project on a two-step approach. Firstly, we will assume that there is an all-equity financed case. The goal is to evaluate the project on its own merits, eliminating any advantage that can come from the financing side. For instance, it will be useful to know if a project that will have access to a Government subsidy is still viable without that endorsement. The final decision will be taken, naturally, in the second step of the evaluation process, in which the financing dimension will be considered. 6.8 EVALUATION CRITERIA 6.8.1 Net present value (NPV) The NPV represents the present value of the stream of cash flows of the project: Being: CAPEX – Capital expenditure (or initial investment) at the year zero of the project r – The required rate of return for the project A positive NPV represents (today) the amount of value generated by the project over the initial investment and over the required rate of return (the discount rate for which NPV is equal to zero, as explained below). A negative NPV indicates, if the project is taken, a situation of value destruction, as it does not meet the return required by the resources that will be allocated to the project nor compensates for the initial investment. 6.8.2 Internal rate of return (IRR) The IRR is the average annual rate generated by the project and is the discount rate which makes NPV=0: 144 CU IDOL SELF LEARNING MATERIAL (SLM)
The IRR should be compared with the required rate of return used in the computation of the NPV. If the investor’s required rate of return is higher than the IRR, then the project will have negative NPV. If the investor’s required rate of return is lower than the IRR, the project will have a positive NPV and so it can be accepted (from a strictly financial perspective). Therefore, one can see the IRR as equal to the maximum rate of return that an investor may require for a given project. In the analysis of a single project, NPV and IRR lead to the same decision of accepting or rejecting a project (with a few odd exceptions, especially, if we have another negative cash flow during the life of the project that can create, from a mathematical point of view, multiple IRR). 6.8.3 Payback Period The payback period gives a different perspective of the project comparing with NPV and IRR. It tells us how much time it will take to recover the initial investment made in the project. It is, though, more a criteria of risk than a criterion of return measurement. Payback Period became popular in the 50´s within the multinational American firms that were starting, at that time, their international expansion into countries with unstable environments, in which the awareness of how fast the investment was recovered was more important than the absolute return. It cannot be viewed as a measure of value or return as it ignores all the cash flows after the initial investment is recovered. In any case and, again, just looking at a single project, it will lead to the same decision of NPV or IRR unless we have negative cash flows after the recovery of the investment. In fact, if the initial investment is not recovered throughout the life of the project, this means that NPV will be negative. On the other hand, if the initial investment is recovered, this means that after that moment, all cash flows are a plus regarding the initial investment, and so project’s NPV is positive. Interesting cases are the ones in which, at the end of the project, there is a negative cash flow such as in the case of the closure of a mine or of an electrical plant. 6.8.4 Profitability Index (Pi) And “Benefit-Cost Ratio” The PI represents the generation of cash, reported at the present, per unit of investment: The “Benefit-Cost ratio” will only be greater than one if the project has a positive NPV. The Profitability Index gives us how much NPV is generated by each unit of initial 145 CU IDOL SELF LEARNING MATERIAL (SLM)
investment. When analysing a single project the Profitability Index doesn´t provide additional relevant information over NPV, IRR and Payback. It can be useful in a situation of capital rationing, that is, when we have more than 1 project and more good projects than the capital available. In this case, the PI will be a good criterion in the establishment of a picking order. Alternative projects in this context, we are not, anymore, in the process of making a decision regarding the approval, or not, of a single project. Instead, we have more than one good project, and we need to choose one of them. Two main problems may arise: alternative projects with different initial investments and with different lives. If the difference is only in the amount of investment the solution is quite straightforward, we should pick the one with higher NPV. The rational lies in the fact that the difference between investment amounts will generate a zero NPV. In fact, if we had the chance to invest the difference in another project with positive NPV, then the alternative should be to invest in the smaller project plus this new project. If we are analysing projects with different lives, the solution is a little bit more complex. Let´s start with the more simple case: two projects having a similar risk profile, thus using the same discount rate. In these cases we can use the Equivalent Annual Cash Flow (EAC), or an average annual cash flow, weighted by the time value of money (given by the discount rate, r): This is to say that we have to find the annual constant cash flow which, multiplied by an annuity factor An;r gives us the NPV. Thus, if NPV = EAC x An;r then The annuity factor, for “n” periods and discount rate “r”, is equal to: So, the EAC represents the average annual cash flow during the life of the project (n). The project with a larger EAC will be chosen. Let’s consider now that the two projects have different discount rates. In these cases the solution will be to assume the infinite replication of the two projects. We then use each project’s EAC (computed using the specific discount rate of each project) and compute the present value of an annual EAC perpetuity: 146 CU IDOL SELF LEARNING MATERIAL (SLM)
Being Rp the discount rate of each project. We should note that the EAC is a simplification of this method (when both projects have the same discount rate), and therefore we can use the NPV with infinite replication to solve any case of alternative projects 6.9 CAPITAL STRUCTURE CHOICES AND REVISTING PROJECT EVALUATION The choice between equity and debt or, by other words, the definition of the capital structure, is a critical issue in the definition of the firm´s financial policy as it impacts in several relevant areas such as the risk profile of the company and, consequently the cost of funding, the gathering of resources to back up the firm´s future development and the timely response to opportunities, challenges and threats that a dynamic environment tend to regularly produce. The theory of corporate finance, in these last 40 years, has made some progress toward the definition of a guiding framework, although still far from fully overcoming and incorporating the frictions and imperfections that continue to characterize the financial world. In the following sections we try to provide some input that may help the decision maker to understand better some key elements that may affect the choice of the right capital structure. An initial straightforward and simplified concept: financial gearing (leverage) This simple concept, much more based in accounting values rather than in market values links the impact of the capital structure in the Return on equity (ROE = Net Income/Equity). The key message may be viewed in the following expression of ROE: Being: Gross ROA - EBIT/ASSETS rD– Average cost of debt D/E – Debt/Equity t – Corporate tax rate Looking at the formula we see that if GROSS ROA is higher than the cost of debt, more debt and less equity (increasing the D/E ratio) will increase the ROE of the firm, an effect usually called financial gearing (or leverage). This simplified concept assumes two things: 147 CU IDOL SELF LEARNING MATERIAL (SLM)
• The cost of debt will not change with the increase of debt; • Shareholders will be pleased with the nominal increase of ROE. These assumptions are both related with the perception of risk. But, if the company significantly increases its level of debt, changing though its risk profile, creditors will demand a higher interest rate and investors will require a higher return (that, eventually, will represent an increase larger than the growth of the ROE). Consequently, the financial gearing may be a useful concept for small changes in the firm´s capital structure, but it is not a general framework to model it. 6.9.1 The Modigliani–Miller (Mm) World The initial framework in 1958, Franco Modigliani and Merton Miller (later, both received the Nobel Prize), developed a theory regarding the optimal capital structure of the firm. They considered a perfect economy, without taxes, no transaction costs, information asymmetries, and investors’ homogenous expectations regarding the return/risk measurement and trade-off. In this perfect world they proved the irrelevancy of the capital structure. All possible D/E alternatives will end up with the same WACC and therefore not changing the value of the firm. The idea is quite straightforward. Let´s assume a firm that replaces equity by debt, replacing though, a costlier resource (equity) by a cheaper one (debt). In terms of the WACC this positive effect will be offset by two negative effects: creditors will require an increasing interest rate (if the firm already has debt) and investors will also require an increased return because for both, the risk profile of the firm has increased and shareholders are the last ones in the pecking order to receive anything in case of financial distress. Let´s present a simple illustration. Let´s assume a risk free rate of 4% and a market risk premium of 8%. The firm is all- equity financed its Beta is 0.8 and therefore the required rate by investors, using the CAPM is 10.4% (4 + 0.8 x 8). Let´s now assume that the firm decides to change its D/E to 1 (50% equity and 50% debt, the latter with a cost of 6%1 ). MM proved that the required rate of return by the investors (rL) is a linear function of the D/E with the following expression: Being rU the return required by investors of the unlevered firm and rD the cost of debt). In the new situation: We could achieve the same result using a different path. It makes sense that the assets’ beta (risk of the business) should not change with any modification of the capital structure and that the assets’ beta should correspond to a weighted average of the Betas of the resources employed in the firm (equity + debt). The cost of debt of 6% represents a debt 148 CU IDOL SELF LEARNING MATERIAL (SLM)
Beta of 0.25. In fact, using CAPM: 6 = 4 + BD x 8 implying that BD =0.25. Therefore if assets’ beta (or unlevered beta) is 0.8 and the business itself will not change its risk profile, the new levered Beta of the investors will be 1.35 (1.35 x 0.5 + 0.25 x 0.5 = 0.8). Using the CAPM, the new required return will be: RL = 4 + 1.35 x 8 = 14.8 The new capital structure will provide a WACC of: WACC = 14.8 x 0.5 + 6 x 0.5 = 10.4 Therefore, the WACC, from the initial all-equity financed scenario to the D/E=1 scenario didn´t change, and so the introduction of debt did not create any additional value for the firm (in a perfect world without taxes, transaction cost and with information asymmetries). He revisited MM world with corporate taxes in 1963, MM acknowledged the limitation of not having considered (corporate) taxes in their model. Introducing corporate taxes, which in practice reduce the effective cost of debt (as interest expense is tax deductible), the trade-off between equity and debt will favour the latter. In the previous illustration, considering a tax rate of 20%, the cost of debt will now be 4.8% (6 x (1-t)) and therefore the WACC will be only 9.8% (14.8 x 0.5 + 4.8 x 0.5), which is lower than in the all-equity financed initial case (10.4%). The conclusion is overwhelming: it would mean that the optimal capital structure is 100% debt. The consideration of taxes creates an addition to the value of the company equal to the present value of all tax savings due to debt. MM showed that Debt x tax rate corresponds to the size of this added value (the present value of a perpetual tax saving equal to debt x interest rate(r) x tax rate (t), using as discount rate the interest rate of debt, which means The reality of the corporate world If the MM model holds, we should see the wide majority of the firms highly levered. The reality is quite different with huge variations regarding the level of debt, across industries, size, profitability, indicating that there isn´t a clear pattern that may lead to the definition of an optimal single capital structure. There are several factors that may reinforce the use of equity or of debt, as described below. 6.9.2 Financial Distress Costs A highly levered firm will have also a higher probability of entering in financial distress and eventually in bankruptcy, if its business, for some reason, faces a downturn. This possibility will start to produce many indirect costs (many not very visible at first sight) such as qualified employees who will seek a more secure job, more difficult hiring, suppliers who will be more demanding and offering less attractive conditions, customers leaving with the fear of the discontinuity of the firm, among several other examples. These additional costs recommend the avoidance of a highly levered situation. 149 CU IDOL SELF LEARNING MATERIAL (SLM)
6.9.3 Taxes Corporate taxes are, naturally, an incentive to the use of debt. Increased taxes will favour the use of more debt. However, and more recently, there is a movement (as in France, Germany and Portugal) of the Governments to limit the tax advantage of debt (for instance, in Portugal, there is a limit of 70% of EBITDA of the amount of interest expense that can be considered as costs for tax purposes). These limitations are, in practice, a brake to use too much debt. 6.9.4 Nature of Assets Highly liquid (easy to trade) assets make easier (and less costly) the use of debt. For instance, firms with a relevant amount of intangible assets will find more difficult to raise debt (from a creditor perspective, illiquid assets will represent an additional risk in the case of bankruptcy, since they are not easily sold and thus exchanged for cash ). 6.9.5 Nature of The Business and Competitive Position In a more volatile business (prices, margins, returns) and/or in an industry with fierce competition, in which profits can easily be eroded, debt should be used in a more conservative perspective, as there is a higher chance of a firm entering in a financial distress situation (likelihood enhanced by an increased level of debt). In fact, increased financial leverage represents increased fixed costs, which must always be paid even when margins go down. Therefore, firms in highly competitive markets (and low margins) should keep their cost structure as much flexible (and variable) as possible, which is not compatible with high levels of debt. 6.9.6 Risk Management A firm that has an active risk management policy, that is, a company that is actively mitigating the impact of the variation of prices (commodities, currency rates, interest rates, etc.) in its cash flow and income, has an ability (other things equal) of raising more debt than a firm that faces the impact of price variation (favourable some times, unfavourable in others). Once again, and from a creditor perspective, a more stable stream of cash flows and profits will be rewarded with eased access to debt and in better conditions. 6.9.7 Ownership Control Especially in private companies (or in public companies with a majority shareholder), growth strategies, which demand more raise of funds, clash against the lack of equity capital to maintain the control of the firm. This situation leads to an increased use of debt or, even worst, to the sacrifice of attractive growth opportunities. This (cultural and social) inability to share ownership and the control of the firm is a well-established characteristic of the Southern European countries. 150 CU IDOL SELF LEARNING MATERIAL (SLM)
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