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Corporate
Finance FIN 622
VU
Lesson
32
CREDIT
POLICY AND INTRODUCTION OF MERGERS &
ACQUISITIONS
In this hand
out we will discuss the
following topics:
Effects of
discounts Not effecting
volume
Extension
of credit
Factoring
Management
of creditors
Mergers
& Acquisitions
Purpose
of combinations
Synergies
Effect of
discounts Not effecting
volumes
As we
have become aware of the fact
that significant funds are invested in
debtors, and therefore, it
becomes
very critical issue in working capital
management. Several factors
must be addressed when a
policy
for
credit control is under discussion. These
issues may include controlling
collection cost, extra need
of
funds when credit
is extended in terms of increase in
debtors' investment and increase in
stocks. The cost
of
additional loans / funds when credit is
extended and saving that
can be achieved by offering
discounts of
customers
are also outstanding issues surrounding
debtors' management.
A firm
will always try to generate
cash from debtors as quickly
as possible but most of the
sales activity is
conduct on credit
basis. One of the main reason
companies have to allow credit to
its customer due to
competitiveness
or norms of trade or industry. However, a
firm will try to recover the
amount from debtors
quickly
by surrendering some of its
profit in terms of discount to clients.
This is an inducement to the
customers
to reduce their cost of
sales by having cheaper inputs by paying
earlier than agreed
period.
The
motive behind offering discount to
customers may have different
secondary meaning to the
firm.
However,
the main objective is to improve the cash
flow. Other may include
increasing the sales as the
discounts
directly affect the cost of sales of
customer and customer may
place enhanced order,
thus
increasing
the turnover.
However,
a fir may offer discounts
just to improve the cash
flow with no increase in volume. In this
case,
we
need to evaluate that by
offering discount to customer can we
decrease the investment in debtors?
A
decrease
in debtors will eventually release the
investment which can be used
elsewhere in business for
more
productivity.
The
financial viability would be calculated
by deducting the cost of discount from the
return on investment
on the amount of
funds released. For example, by
offering 2% discount can reduce
Rs. 200,000/- worth
of
investment in
debtors and this can be
invested @ 10% in other business
areas, then the net benefit
would
be:
Return on
investment (Rs200,000)@10% =
20,000
Less:
cost of discount 2%
=
10,000
(Assuming
on sales of Rs. 1/2
million)
Net
Benefit
=
10,000
Expansion
of credit:
In this
case we consider that if
increase credit period is allowed to
customers then what areas
needs to be
assessed.
This may result in increase
sales, profitability from
extra sales, and length of
collection period and
required
rate of return on additional investment
in debtors as a result of increased
credit period.
It is
important to note that when
the credit period is increased then a
firm needs more investment
in
debtors
and these additional funds do
carry some cost with
them.
Further,
these sorts of policies have
different levels of bad
debts risk, greater the credit period
higher the
probability
of default by the customers. Therefore,
expansion of credit involves two
types of risks
additional
cost of funds and bad
debts.
The
financial viability would be computed by
determining the total benefit of extra
sales reduced by the
cost
of
additional funds and bad
debts.
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Corporate
Finance FIN 622
VU
Factoring:
Factoring
refers to an arrangement where debt
collections and some related
functions are performed by
someone
else than the firm itself.
The person or entity who
performs such functions charges a
fee that may
be a
specific percentage of total
debtors. Factor normally advances a
proportion of the amount to be
collected
and the rest when he
actually recovers the amount from
firm's debtors after deducting
his
commission
or fee agreed in advance.
The other factor functions
may be like:
Main
function of a factor is to collect the
accounts receivables on behalf of seller
but may also involve
in
invoicing
and sales accounting.
Exact term of
factoring will depend on mutual
agreement.
Factor
also takes over the risk of
loss in case of bad
debt.
Factor
also insures client against
such losses. This type of factoring is
known as non-recourse.
In
case of action against defaulters,
factor initiate action.
Factor
makes advance payments to
seller in return for
commission of certain %age of
total debt. This is
often
referred as factor financing.
Factoring
carries some advantages and
disadvantages as well, which are as
under:
Factoring
has positive effect on cash
cycle. Substantial portion of
total debtors is received
quickly and can
be
used to pay off creditors
and avail discount from them for
early settlement of their
invoices.
Optimum
stock level can be maintained because the
business will have ample
liquidity to pay for stocks
it
requires.
Financing (factor)
is directly linked to level of sales /
accounts receivables.
Reduction in
collection expense and staff
payroll costs because most
the functions of sales
administration
are
taken over by the factor so
there's no need of some of the
sales staff.
The
manager of the business have
more time to concentrate on other
areas rather than thinking
and
confronting
issues like slow payment
from debtors.
Disadvantages:
Expensive:
Normally factor charge hefty
commission or fee for rendering
such services.
It may
have adverse effect on customers'
loyalty. (Factor attitude
may be harsh with customers)
and may
tarnish
company's image. Further, it
can result in loss of
customers and it turn this
will result in loss of
sales.
For
computing financial feasibility the
benefit would be reduction in debtors'
administration cost, payroll
cost
and bad debts and
will be reduced by the expense
like factor fee /
commission. However, there
may be
some
other issues that need to be
considered in reaching at net benefit of
factoring.
Management
of creditors:
There is
comparatively less room in management of
creditors than debtors.
However, this side of
working
capital
is not less important
because it is a spontaneous source of
financing and also provides the
basic
inputs to the
business.
There
are three aspects of creditors'
management. First, the company would
like to obtain credit as big as
it
can.
The firm must have
amicable relationship with vendors.
The credit period obtained from
vendors will
effect the
operating cycle significantly.
During
the period of uneven or lower
cash flow the firm will
try to get extension in credit. In
order to
adjust
the operating cycle, a firm normally
defers the payments to creditors rather
than to take loans to
finance
the deficit.
Like a
firm offers discounts to its
customers for early recovery
of invoices, creditors do offer discount
for
early
payment from its customers.
Therefore, this is very important point in creditors'
management because
it directly
affects the cost of sale of the
company. Any discount offered by the
creditors for early
payment
of
their invoices, the firm
must evaluate whether or not to avail the
discount. This evaluation is on the same
pattern as we
had for debtors. The
fundamental idea will be to determine the
cost and benefit and
then to
compute
the net benefit / cost. There are
two types of decisions to be
made by the company. First, is to
reduce
the cost by taping the discount offered
by creditors by paying earlier than
allowed time. This is as
good
as increasing profit. The
other side of this issue
would be to burden the cash flow
and company may
have
to seek loans. Second, would
be keep the operating cycle in positive
and there will not be
any burden
on the
cash flow however, the firm
will loose the discount.
These
decisions are predominantly
are based on level of discount,
cash flow pattern, operating cycle
and the
portion
of total creditors offering discount.
These will vary firm to firm
and business to
business.
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Corporate
Finance FIN 622
VU
MERGERS
& ACQUISITIONS
Growth
is very essential for a company
because a company can add
value by expanding it business and
can
attract
the first rate human
resources. The growth can be
internal and
external.
During
our previous studies we have
covered internal growth and
evaluation process. Companies
acquire
assets
for its expansion or make
investment in business. External growth
involves taking over or acquiring
a
separate
entity or already established
business. However, there are
significant differences in internal
and
external
growth method.
This
rationale is particularly alluring to companies when
times are tough. Strong
companies will act to
buy
other
companies to create a more competitive,
cost-efficient company. The companies
will come together
hoping
to gain a greater market
share or to achieve greater efficiency.
Because of these potential
benefits,
target
companies will often agree
to be purchased when they know they
cannot survive alone.
One
plus one makes three: this
equation is the special alchemy of a
merger or an acquisition. The
key
principle
behind buying a company is to
create shareholder value
over and above that of the
sum of the two
companies.
Two companies together are
more valuable than two
separate companies - at least,
that's the
reasoning
behind M&A.
The
important reason for merger
and acquisition is the increase in the
sales. Operating economies
can be
achieved
by increasing sales and
utilizing fixed cost
effectively.
Synergy
and sources of synergy:
One
plus one makes three: this
equation is the special alchemy of a
merger or an acquisition. The
key
principle
behind buying a company is to
create shareholder value
over and above that of the
sum of the two
companies.
Two companies together are
more valuable than two
separate companies - at least,
that's the
reasoning
behind M&A.
Synergy
is the magic force that allows
for enhanced cost
efficiencies of the new business.
Synergy takes the
form
of revenue enhancement and
cost savings. By merging, the
companies hope to benefit from
the
following:
· Staff
reductions - As every employee
knows, mergers tend to mean
job losses. Consider all
the
money
saved from reducing the number of staff
members from accounting, marketing
and other
departments.
Job cuts will also include
the former CEO, who
typically leaves with a
compensation
package.
· Economies
of scale - Yes, size
matters. Whether it's purchasing
stationery or a new corporate IT
system,
a bigger company placing the
orders can save more on
costs. Mergers also
translate into
improved
purchasing power to buy equipment or
office supplies - when placing
larger orders,
companies
have a greater ability to
negotiate prices with their
suppliers.
· Acquiring
new technology - To stay competitive,
companies need to stay on
top of technological
developments
and their business
applications. By buying a smaller
company with unique
technologies,
a large company can maintain or develop a
competitive edge.
· Improved
market reach and industry
visibility - Companies buy
companies to reach new
markets
and
grow revenues and earnings. A
merge may expand two
companies' marketing and
distribution,
giving
them new sales opportunities. A
merger can also improve a
company's standing in the
investment
community: bigger firms often have an
easier time raising capital
than smaller ones.
That
said, achieving synergy is
easier said than done - it is
not automatically realized once
two companies
merge.
Sure, there ought to be
economies of scale when two
businesses are combined, but
sometimes a
merger
does just the opposite. In many
cases, one and one
add up to less than
two.
Sadly,
synergy opportunities may
exist only in the minds of the corporate
leaders and the deal
makers.
Where
there is no value to be created, the
CEO and investment bankers -
who have much to gain
from a
successful
M&A deal - will try to
create an image of enhanced
value. The market, however, eventually
sees
through
this and penalizes the company by
assigning it a discounted share
price. We'll talk more about
why
M&A
may fail in the next
tutorial.
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