Strategic Corporate Finance
Part A: Financial Analysis
Financial analysis is performed to assess the financial health of the firm. It reveals the trends in finance and the determination of whether the firm has met its financial expectations. The analysis of Power Assets Company indicates a decline in profitability between 2017 and 2019. With declining profit, the ability of the firm to reward shareholders with dividends also declined (Pike, Neal, & Akbar 2018). The company needs to devise appropriate strategies to boost the level of profits to remain relevant to shareholders, among other financiers. Further to that, as the profit decline, the firms also become less appealing to credit providers. They may not readily have access to debt financing. Ratio analysis below depicts the financial performance of Power assets over the past three years.
Table 1: Financial Ratio for Power Assets
Sourced from Power Assets (2020)
Ratio Analysis
Analysis of financial ratios is a method used to evaluate the financial position and health of the company. The financial ratio categories include ratios, liquidity, efficiency, and solvency ratios. The availability of data determines the type of financial ratio for analysis. Primarily, these ratios are used to compare financial statement items to give insights into financial liquidity, profitability, solvency, and operational efficiency. It allows the manager to compare financial performance over time and with other companies in the same industry. However, it is vital to complement with other metrics to obtain a more comprehensive picture of the financial health of the company.
Profitability Ratio
Profitability ratio conveys the ability of the firm to generate profit from its business operations. These ratios include return on assets, profit margin, return on capital employed, and return on equity. For the case of Power Assets, it was vital to assess its ability to meet the needs and expectations of shareholders as providers of equity. The most relevant ratio is the return on equity to evaluate the firm ability to maximize the wealth of equity providers. However, this can only be possible if the firm can generate profits to guarantee sufficient earnings on equity in the form of dividends. There was a sharp decline in return on equity ratio. It reduced from 0.1 to 0.09 between 2017 and 2019 due to reducing profit over the same period. Accordingly, Power Assets is not poised to meet the needs and expectations of equity providers.
As a consequence, the company is becoming less attractive to current and potential investors. Generally, investors seek high returns on their capital and Power Assets is unlikely to offer the same due to profit decline. Therefore, a decline in return to equity is likely to have adverse effects on Power Assets and left unaddressed going into the future.
Power assets can reverse the trend by enhancing profits through aggressive marketing and innovation products and services. It can also adopt advanced technology to improve operational efficiency to reduce the cost of operations (Pidun 2019). In particular, lean operations strategy can be adopted to aid Power Assets to cut down operational costs. The financial report indicates that the company is generating a high income from the investment. Therefore, Power Assets can attain profit growth from enhanced investments in other companies and joint ventures. The movement in return on assets is summarized in figure 1. It is evident from figure 1 that return on equity declined considerably between 2017 and 2019 from 0.1 to 0.08, and 009, respectively.
Figure 1: Trend in Return on Equity
Liquidity Ratio
Liquidity ratios are measures of the firm’s ability to meet its short term obligations as they fall due using quick assets such as cash and near-cash assets. The common ones include working capital ratio, quick ratio, and current ratio. The current ratio for Power Assets declined for the 2017-2019 from 3.74 to 1.34 and eventually 1.16. If the decline is not addressed, Power may not be able to meet its short term financial obligations. The steady decline in the ratio is attributed to the increasing level of current liabilities compared to current assets over the same period. The graphical presentation is summarized in the figure below.
Figure 2: Trend in current ratio
Efficiency/Activity Ratio
Efficiency ratios evaluate management efficiency to optimize its asset and liabilities to generate maximum sales and profits. They include receivable turnover ratio, days’ sales inventory, and inventory turnover. Receivable turnover ratio is an indicator of efficiency in collecting payments from debt sales. Power recorded a sharp increase in the turnover ratio over 2017-2019 from 8.5 to 51.3. Therefore, either Power Assets is efficiently extending credit to less risky client or effective collection of accounts receivables. The improved collection of payment from debt sales is key to boosting the current ratio and meet short term obligations (Sutō, & Takehara 2018). The ratio is thus a good indicator of operational efficiency which is good for the company faced with declining liquidity. However, the management must also be weary of the effects of a low receivable turnover ratio because being overcautious in extending credit can adversely affect sales revenue and hence profitability.
Figure 3: Receivable turnover ratio
Solvency Ratio
Solvency, also known as leverage ratio and are used to compare firm’s level of debt against its assets, earnings, and equity. They are used to evaluate the ability of the firm to service and service its long term debt together with accrued interest. The main types include debt assets ratio, debt to equity ratio, and interest coverage ratios. Power’s debt ratio declined slightly in 2017 to 2018 from 0.11 to 0.09 to remain stable in 2019 at 0.09. The ratio indicates a slightly higher asset value over the liabilities. The firm is in good solvency and can access easily credit from lenders using the assets as security. Therefore, the risk of insolvency or financial distress is significantly low. It is also possible to gain short term borrowing to address the short term liquidity problem. Given a decline in profitability and current ratio, the company is better placed in maintaining a low debt ratio as opposed to huge borrowings. Figure summarizes the firm’s debt ratio.
Figure 4: Trends in Debt Ratio
As shown the figure, debt ratio is considerably low implying that most financing of the asset is through owners’ equity rather than debt financing. Therefore, Power assets risk exposure to insolvency is significantly low. Ideally, debt financing expose a corporate entity to solvency risk while equity finance reduces the risk of insolvency. Therefore, despite profit decline, Power Assets is on the side with respect to debt obligations.
Part II: Capital Structure
The concept of capital structure is an important indicator of financing strategy of any firm. Theories of capital structure explore the use of equity and debt in financing business activities and valuation of a company. An optimal capital structure has a mix of equity and debt which maximizes firm’s value and minimizes the cost of capital. Relevance capital structure theory states that firm’s level of performance is influenced by the capital structure. For instance, companies fully financed through equity do not make interest payments. Contrasting this are firms financed through debt which are required to pay the cost of debt. However, debt financing firms enjoys tax advantage because interest expenses are deductible to taxable income.
Power assets case financing is largely through equity at 9 percent hence the company is highly exposed to financial distress risks (Pike, Neale, & Akbar 2018). Power is subject to high interest payments on accrued on long term debt. The company cannot enjoys benefits of high equity financing such including ability to invest in long term projects because the firm is under no obligation to pay for the cost of capital. Besides, high equity financing accords the firm a chance to access funding faster from lenders and exploit unused debt financing opportunity. Therefore, in the event that Power needs extra funds, it cannot easily access debt financing faster from banks but would opt for the issuance of equity which is time consuming. Besides, the cost of debt financing could be lower compared to issuance of equity in the market. In conclusion, as the situation stands, Power Assets is worse off operating with current capital structure without further alteration. Power Assets has 9 percent equity financing has exposed the firm to the risk of financial distress.
Conclusion
Financial ratio analysis of Power Assets indicates a sharp decline in return on equity ratio over three years to 2019 due to reducing profit. Accordingly, Power Assets may not meet the needs and expectations of equity providers if the problem is not addressed. The ratio further suggests a declining liquidity ratio hence the need to improve liquidity of the company by boosting profits. However, improved collection of payment from debt sales is key to boosting the current ratio and meet short term obligations the liquidity problem. The firm is in a worse solvency position and cannot easily access credit from lenders using the assets as security. Finally, Power Assets is worse off operating with current capital structure but further alteration is needed to boost equity because it is highly exposed to the risk of financial distress.
Part B: Effect of the news on stock price
The chart below represents the changes in stock price of CK Assets ahead of and after the announcement of the planned purchase of Greene King.
Source: Li Ka-Shing’s CK Asset 2020
The graphical representation above shows that there was a decline in the stock price from August 2019 onwards. The purchase of Greene King led to a decrease in CK Asset’s share price instead of a raise, which resulted in a reduction of the company’s value. The purchase of Greene King by CK Asset resulted in the alteration of the latter’s financial status. Spending US$ 3.27 on the acquisition negatively affected the organization’s capability to service its debt and run its functions. Through acquisitions, companies expect to increase their sales hence more revenue, which results in profitability. According to Campbell, Sirmon, and Schijven (2016), the reduction in the stock price is an indication of low investor confidence in the acquisition. The decrease in the stock price shows that the process of company valuation was poorly done. In its projections, CK Asset did not assign the correct value to Greene King.
Carrying out a valuation for an acquisition is complicated because it is determined by the collaboration that is obtained from the union of the two firms and the expanded demands of management on the more prominent organization, unlike the smaller company ahead of the purchase (Ben-David, Drake & Roulstone 2015). Additionally, the reasons for the acquisition may also affect the results of the purchase. For example, some managers may be motivated by the desire to manage larger companies as opposed to the economic effects of such acquisitions. Lack of a monetary motive from the onset may result in a reduction in the price of the stocks. A reduction in stock price may be attributed to the signaling theory (Bergh et al. 2014). According to this theory, shareholders may be in the know about the dismal state of the purchased company and or the likelihood that it will perform poorly in the future. Shareholders’ may have lost trust and confidence in the company’s potential to register improved performance in the future due to such negative perceptions, which resulted in more shares being offered for sale. An increase in the number of shares of a firm offered for sale in the exchange causes a reduction in the share price. Similarly, when there is a decline in the demand for stocks of a particular organization in the exchange, the stock value also declines. It is, therefore, prudent to consider these scenarios to manage stock prices effectively.
When a firm purchases a company whose value is low, but at an overvalued price, its share price is likely to decrease. The decision by CK Asset to purchase Greene King at an overvalued price of US$ 3.27 billion led to a reduction in its stock prices. Firms buy either undervalued or overvalued companies due to poor acquisition valuations (Ben-David, Drake & Roulstone 2015). In this case, Greene King was overstated, which resulted in the reduction of CK Asset share prices. A reduction in the company’s value may lead to a drop in the stock prices when information about such a reduction in the value reaches the investors.
Efficient market hypothesis
According to the efficient market hypothesis, the stock prices of a market mirror all the information regarding the company, and shares are sold and bought at their fair value on the markets. Therefore, it is impossible for an investor to buy understated stocks or sell stocks at an overstated price (Gabriela 2015). Based on CK Asset’s stock price movement, this perception is not applicable. As noted earlier on, CK Asset’s stocks rapidly declined after the acquisition of Green King. This decline in share price implies that CK Asset did not purchase the company at the correct cost. The supposition here is that the information on the acquisition of a firm with several branches and with the capacity to generate profits mirrored the stock prices. Instead, investors were less interested in the firm’s stocks. A decline in the demand for a stock in the exchange causes a decrease in its price. In this case, the efficient market theory cannot explain as to why the purchase of Greene King that was expected to increase revenues and profits resulted in a decrease in the stock prices of CK Asset. Purchasing underpriced stocks is usually profitable for investors. Nevertheless, the existence of underpriced shares is ruled out by the efficient market hypothesis, which advocates the notion that stocks are generally purchased at the fair prices in the market.
The connection that exists between the current market information and the stock prices is a critical factor used to measure market efficiency. The efficient market hypothesis is founded on the supposition that share prices are hinged on all the relevant information regarding that share, which in turn results in the share prices being always being fair (Gabriela 2015). This assumption, therefore, refutes the rationale that stocks in the market may be either very low or very high. However, this does not apply to CK Asset’s case, where the acquisition of Greene King was expected to improve its performance. Instead, it resulted in a decline in the demand for its shares, which caused a reduction in the stock prices in the exchange. According to the efficient market hypothesis, traders pay the right price when purchasing stocks in the market. However, this is contentious, as observed in CK Asset’s case, where the purchase of another company resulted in a decrease in its stock price instead of having a raise in the share prices.
A study by (Gabriela 2015) noted that the efficient market hypothesis (EMH) has some shortcomings. For example, it is now evident that stock prices vary based on the day of the week. The presupposition is based on the notion that share prices in the market are never fixed. Still, they keep on oscillating during the week, even when there is no new information available in the market about the shares. The large oscillation of the share prices contradicts the efficient market theory.
Similarly, the stock market faces the risk of being unresponsive to new market information and data. The effective market hypothesis is not in agreement with the momentum effect, which is founded on the supposition that the decision to purchase shares is anchored on conscious perceptions. However, the demand for a specific stock may be as a result of the emotional connection with the share, which may increase the share prices even in the absence of information on the noticeable changes in the value of the stock. A decline in response to recent information results in a reduction in the capability to identify the right stock prices.
The decision by CK Asset to acquire Greene King was wrong. The firm might have purchased the other company at an overvalued price more than its projection, which shows another weakness of the EMH. Occasionally, markets experience mispricing of shares, which mislead investors who end up paying for overstated or underpriced stocks. The supposition, as provided by the EMH, that the correct level of price is exhibited in the exchange is hence not correct. Firms and individual investors intending to purchase shares in the market always look for undervalued stocks (Gabriela 2015). Purchasing undervalued shares give higher returns if the price of such shares raises, a phenomenon that is not supported by the efficient market theory. Therefore, there is a need to reassess the correctness of the EMH and its applicability in firms. This theory is vital in the identification of the changes in the stock prices but does not explain those changes.
Decisions by financial managers
Specific decisions about stock prices and acquisitions are sometimes made by financial managers. For example, the discussion above demonstrates that the prices of shares do not always mirror a company’s complete information. Therefore, a detailed assessment of all the data about the company is needed. The results of the above analyses may also influence the financial managers’ decisions. Before the execution of the acquisitions, financial managers must analyze a company’s value so that they only pay for the correct value of the company (Lebedev et al. 2015). In this case, financial managers at CK Asset may have failed to evaluate and determine the real value of Greene King and ended up purchasing an overvalued company.
Conclusion
Firms with surplus cash invest this money in securities such as stocks to enhance the value of the company by selling the acquired shares at a higher price. However, firms record losses when the share price declines. Overpricing of shares occasionally happens in the market, contrary to the efficient market hypothesis. When making decisions regarding acquisitions, financial managers should not presuppose that the market is efficient. The purchase of Greene King by AK Asset was undertaken without adequate information about the firm, which resulted in a reduction in the stock price of AK Asset. Therefore, financial managers must obtain all the relevant data about a firm, which enables them to determine the correct stock prices.
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