Category: Corporate Finance

Advantages and disadvantages of debt financing

A new business venture requires finance throughout its operation. A firm usually raises money for working capital requirements and also for making capital expenditures. It usually achieves this by selling debentures, bonds, bills, or promissory notes. Sometimes they seek financial assistance from outside companies or other organizations for raising additional capital. They could also decide to approach the public through IPO’s (Initial Public Offerings). Financing decisions need to be made by the company according to the characteristics of their financial needs and repayment capabilities.

The organization should choose the right financing strategy according to their company’s rules, policies, and regulatory norms. They can either go for debt financing or they can seek equity finance. Or they could seek a judicious blend between the two.

First of all, it is necessary to discuss what debt and equity financing are, and how they could impinge upon the company’s financial structure and professed objectives.

Debt financing

Fundamentally, debt financing means borrowing money from outside sources under the condition that it will be repaid at a fixed period of time in the future usually for a definite rate of interest. The term debt means money that is owed to somebody else. There are many advantages as far as debt financing is considered. The biggest advantage is that the lending person will not get any ownership of the loanee business so that maximum control can be retained over the business by present owners. The commitment to the lending party would be in terms of having to repay the debt on schedule in time with fixed interest.

Another advantage of debt financing is that it is tax-deductible.

Debt financing has got many disadvantages also. The main disadvantage is that the business could not use its entire cash to run the business and also from the interesting point of view which might be higher in most of the cases. The firm may even sometimes lose future flexibility due to enforcement of equity ownership and resultant dilution of share ownership.

Debt financing

Debt financing can be broadly divided into two broad categories according to the type of debt that is being searched for. It includes long-term or short-term financing. The long term finance is generally acquired for purchasing assets for our business such as equipment, building, land, and machinery.

In long-term financing, the repayments extend to a period exceeding one year. Short-term financing can be for a period of less than one year and is acquired for day-to-day operations of the business, such as the purchase of raw materials, paying wages, etc. Equity financing is also a financing technique that does not involve any outside debt. It is usually done by selling stock to individual stakeholders or institutional investors. In this case, the business is receiving funds from the investor since the business is sharing ownership with the investor. (Creative Capital Associates: Financing vs. Equity vs. debt).

In order to balance our decision between debt and equity financing, the debt-equity ratio need to be worked out. The amount of debt should be compared with the amount of equity. This ratio is very important from the point of view of lenders, in the sense that it gives a real idea about the money available for repayment in case of default.

The use of debt financing generally increases the shareholder’s rate of return. Usually, the debt holder gets top priority for receiving the returns in the form of repayment of principal and interests. If any default is been made on the repayment to the debtors, the firm may be made bankrupt by debt holders through legal processes.

Use of debt financing affect rate of required return

The equity shareholders hold an advantageous position in that they will be paid higher dividend rates since they can demand a higher risk premium. As the company issues more debt, the shareholders can demand a higher rate of returns in the form of a dividend. The shareholder’s demand could be met only if the company goes for undertaking riskier, albeit more profitable projects.

The Miller-Modigliani Theorem

The Miller-Modigliani Theorem clearly explains the concept that if a firm is not having any tax obligations, default risk, or agency risks, the capital structures themselves become irrelevant, which means the firm is independent of its debt ratio. The cost of debt is the market interest rate that the firm has to pay on its borrowing. This will mainly depend on three components like the general interest rates, the default premium, and the firm’s tax rate. (Finding the right financing needs: Miller –Modigliani Theorem: The capital structure design P. 23).

Optimal Capital structure

Optimal capital structure means that the firm should have an optimal mix between debt and equity financing, which means there should be a trade-off between the debt and equity. The simplest way to measure the firm’s financing mix is just to look at the amount or the proportion of the debt that the firm is using in the total finance. This could be finding out by using the Debt to capital ratio.

• Debt-capital ratio = Debt / Debt+ Equity

The company has to choose the mix based on its policies. If the company is facing a higher marginal tax rate, then the company should have more debt financing in its capital structure. For example, real estate corporations have higher debt ratios.

A firm that is not going for debt financing means that it generates higher income and cash flows each year. If adequate cash flows are not made, it will lead to incompetent management which may affect its overall performance.

Besides equity capital could be used for expansion programs, diversification, and business acquisitions, including setting up of overseas offices and branches.

The management should take into consideration that the investments, either in debt or equity, should earn at least enough to cover the fixed interest expenses. Considering another case, if the firm is on the road to bankruptcy, it should go for less debt financing, according to the given level of debt. If the firm is facing some agency problems, the firm should use less debt financing. This is because debt financing is a binding and mandatory payment that has to be extinguished irrespective of the presence of adequate cash inflows, cash profits, or not. In the event debt payment is not serviced, the creditors could seek a court order to wind up the company, sell its assets and recover their dues from it.

Case Studies

Tesco: Tesco is the UK’s leading supermarket chain. It has made strong financial progress in the international market over the years. It has delivered high growth in turnover, profits, and returns over the years. Its sales were up by 23% to £9.2 billion and profits up by 17.4% to £465 billion. (Tesco: Annual review and summary financial statement 2006). The directors have also proposed a final dividend of 6.10% to the shareholders, which brings a full-year dividend per share to 8.63%.

The future line of dividends will depend upon earnings per share (EPS). (Tesco: Annual review and summary financial statement 2006). Since the sales and profits are really high for Tesco, it is not essential to go for debt financing, even with present equity financing, the business could be run. However, with the approval of their Board of Directors, they could consider expansions and acquisitions with debt capital.

Intercontinental Hotel Group (IHG): It operates in the global hotel market that is presently in the process of restructuring and reducing the number of hotels owned. Annual group turnover during FY 2006 is £ 201M. (InterContinental Hotels Group: Annual Review and Summary Financial Statements 2006.)

The share holders’ returns are also increased to£ 2.7B; a further £31 M remains to be returned through their ongoing share buyback programs. The Group has announced an £850M return of funds comprising of £100M share buyback and £ 700M special dividend with a proposed share consolidation. (Source: financial performance and financial mix of intercontinental hotel group)

Since the Group is restructuring its capital base, they can better go for debt financing. They have also got enough funds to run the existing business from the sales proceeds. So the company can better adopt a judicious blend of debt and equity financing for future needs.

Sony Electronics: Sony Electronics (US) is a major player in the global contract manufacturing industry with operations in a wide variety of products and services in the field of entertainment electronics, and also Electronic items and PCs. Sony Electronics (US) is a major player in the global contract manufacturing industry with operations in a wide variety of fields, including HDTV, Electronic items, and PCs. Even though Sony experiences tremendous growth over the past 60 years, its organizational structure had become fragmented with limited integration and needs to be revitalized. Massive cost reduction schemes are on the anvil to make Sony even more competitive in global markets (New Management’s Mid-Term Corporate Strategy :

Cited Works

(Creative Capital Associates: Financing vs. Equity vs. debt). Web.

Access Commercial Mortgages. Web.

Finding the right financing needs: Miller –Modigliani Theorem: The capital structure design( P. 23). Web.

Tesco: Annual review and summary financial statement 2006. Web.

(InterContinental Hotels Group: Annual Review and Summary Financial Statements. 2006. Web.

(New Management’s Mid-Term Corporate Strategy. Web.

The Chief Financial Officer of any organization has many different responsibilities, such as internal financial control, financial reporting, assessment of the capital budgeting process, financing the organization, and other different responsibilities. Organizations are operating to raise the value of the share and it should not only consider the internal structure, its product, and competitor, but also the interaction and performance of the organization, and if any person in the organization has the combination of this thing then it might be possible that those get promoted to higher post in the organization.

The role of the CFO is evolving and that is why organizations are promoting their CFO to the position of CEO, but not all CFOs have the qualities to become a CEO. Nowadays CFOs are expected to interact with the higher authorities and board of directors and he has to take part in different activities such as strategic planning. Many CFOs cannot become successful, the reason is that many CFOs come from a pure accounting background and are not generally expected to make such a speedy rise up the corporate ladder.

Individuals who can gain a breadth of experience across several functions may stand a better chance of rising to CEO and will be more indispensable to the kind of ECO who seeks advice from their staff. CEO not only thinks about increasing the value of there company’s share but the look for different ways to generate more revenues, for example; Calloway the CEO of PepsiCo, after buying KFC he not only extended the menu of the restaurant but also make it available at lunch and dinner time.

He also focuses on the company on snack foods and restaurants and getting rid of several non-cores, low-profit businesses, such as North American Van Lines and Wilson Leach of Donaldson, Lufkin & Jenrette. Former CFOs who have been successful in making the transition to CEO have certain characteristics in common. they are strong, goal-oriented leaders who have a clear vision of the future, an external, marketplace-driven focus, and the willingness to take chances.

“CEOs are not made with cookie-cutters; it takes years of experience and a developed set of appropriate experiences to build to that position,” says Dick Gustafson, managing partner for health care practice at the Chicago-based executive search firm Heidrick & Struggles. An often effective first step for CFOs who wish to pursue careers as CEOs is to find ways to sharpen leadership skills in their organizations because, says Gustafson, “people are more willing to take a risk with someone they know than with someone they do not know. And they usually are more forgiving of the sins of commission than the sins of omission.”

If any person wants to become CEO in his or her future then he has to be immensely good in finance and operations because if a person is only good in finance then he can pursue his career in finance and nowadays in very few organizations financial manager’s job is only to do technical work and decisions making job is done by operations managers. In the future, if the CFO is not good in decision making, interpersonal communication, and goal oriented then there is very little chance for CFO to become CEO because CEOs are not good at decision making but also they efficiently perform finance-related jobs.

Reference

Janine Brewis (1999). How a CFO can graduate to CEO. Corporate Finance,(175), 13. Web.

Picker, Ida (1989). Do CFOs Really Make Good CEOs. Institutional Investor, 23(9), 47. Web.

Karen Sandrick, (1995). From CFO to CEO: what does it take to make the leap? HFM Resource Guide: Personal Finance. Web.

Introduction

American Express Inc. was incorporated in the year 1965 as a New York Corporation. Its primary objective was to serve as an international money payment, interacting and travel services Company throughout the world with branches in principal global cities. The main lines of its business have been in the following areas:

• Global credit and debit card networking source.
• Green, Gold, Platinum Charge card and credit card for different varieties of consumers and global business travelers and fliers.

According to the Brand Survey conducted by Interbrand, American Express enjoys the 14^th Spot in the List of Top 100 Global Brands in 2006 period only goes after citation (The 100 Top Global brands 2006, 2000-2007 ).

The elements of analysis based on the Annual reports of Amex would be:

1. Analysis of revenues net of interest, expenses
2. Analysis of returns on average equities
3. Dilution of earnings per share, from continuing operations
4. Current ratios
5. Fixed assets turnover ratios
6. Debts to total assets ratios.
7. returns to shareholders on total assets ratios
8. Five years profitability analysis
9. Five years profits earnings ratios.

Present scenario

American Express has been going through a difficult phase in recent years, mainly due to strong competition in the cards and travel trade markets. In order to consolidate its position, American Express has taken recourse to enter into affiliations with around 40 other credit card companies in order to offset their competitors and retain vital market share. Besides, credit card markets are high risks since the occurrences of default and non-payments by cardholders are very high, and there are quite frequent occurrences of bad debts and non-realization of bills in credit card segments. The main reasons could be that credit cards do not carry collateral securities and the company could only proceed legally against the defaulter for non-payment of accumulated debts.

Besides, the global credit card has been shorn of exclusivity, and clients are often not fully screened before being offered credit card facilities, with the net result that risks of default and non-payments run high and many customers may vanish or become bankrupt after using substantial credit limits, incurring heavy losses for the company.

Lure of competition

While the credit card company needs to ensure that credit cards are utilized by genuine customers, there are also the risks that potential customers could be lured away by competitors, offering more attractive deals and facilities to customers. Therefore, it becomes necessary for credit card companies to woo customers who may not always be high potential customers but to increase customer base and generate business for the Company. Its ambitious credit card network can be seen from the fact that “American Express has issued more than 86 million cards worldwide” (American Express company, 2008).

From the graphs below, it is discernible that the growth of the Company is present, despite tough competition in these areas, and American Express needs to make its global presence more strongly felt, especially in the developing Third World Countries, like India, China, Brazil, and several Far East countries. (Consolidated financial highlights. 2007).

The first chart deals with revenues net of interest, expenses for the years 2003 thru 2007. There has been an average rate of growth in this area to the tune of around 10% pa. The second chart deals with ROE. The average rate of growth in ROE is around 17%pa. The third chart portrays diluted earnings per share, where the average rate of growth during the period under review is around 18% pa.

Current ratios

The current ratios of Amex need to be improved since now it stands at an average of less than 2 over the five-year period whereas the industry standards is around 4.There is a need to improve realizations from credit cards business and this is reflected in its current ratios. Therefore it needs to pursue credit cards and other receivables aggressively if it were to improve its present current ratio and remain competitive in this business. In the years to come, it is believed that, with increasing competitiveness from other major players like Standard Chartered, Thomas Cook, and Visa card, it not only needs to consolidate its market position but also build a robust business.

Table 1: Five-year Computation of current ratio.

Ratio of fixed assets to turnover ratio

It is observed that the ratio of fixed assets to turnover ratio in the case of Amex, or the proportion of the fixed assets that contribute to turnover during the years under review is very low in the case of Amex. While the industry standards are hovering around 3 times, in this case, as computed from the Annual reports for the periods under review, it is just around 0.428. However, it is needed to know that Amex is in the service sector, and therefore the deployment of fixed assets may not be as significant as a manufacturing industry.

Five-year Computation of Asset management ratio:

Table 2: Fixed Asset Turnover (millions).

DTA ratio

Coming to the DTA ratio, that is the deployment of debts to total assets, it is seen that during the financial years 2003 and 2004, according to their Annual Financial Statements, Amex has shown above-average DTA ratios. However, from 2005 onwards, it has begun to post below-average ratios, and against an industry average of 40%, it has registered 49%. Therefore, Amex needs to either substantially reduce debts in future years or increase its fixed assets base with new assets acquisition in order to improve asset value.

Table 3: Total debts to total assets (millions).

Table 4: Five-year Profitability analysis of American Express Co. (millions).

Ratio of net income available for distribution to shareholders

According to the figures provided in its annual reports for the 5-year period under review, the ratio of net income available for distribution to shareholders seen as a proportion of total assets is average 2.44 over this period against the industry standard of 9%. Therefore, it has become imperative for the company to address the factors of falling income and escalating costs in order to set right these anomalies. Amex needs to improve performance in profitability areas and also implement strategies for lowering costs in future years.

Table 5: Price per Share/Earnings per Share.

The Market Value of AmEx Company has been fluctuating considerably over the years since 2003 and in the year 2007, it stands at $52.02 cite. Thus, it is seen that from the point of view of investments, it may not be a safe bet to invest in AmEx shares in the near future, until it registers a higher market value and is able to consolidate its market position in the trade. It is expected that the stock prices will dip in the future too.

A potential investor would look in terms of earnings and long-term value for his shareholdings, which are both at low levels at present. Therefore, investors need to adopt a wait-and-watch attitude before placing monies in AmEx Co. The element of risks in shareholdings being evident, it would be some time before investors’ confidence and market activities could boost the market value to higher value in the future. Until such time, it is seen that investor confidence would be low at least in the short-term period.

It can be judged that the financial performance of American Express Co. over the five-year period has not been up to stockholders’ expectations. It is necessary that such comparisons be made so that a wealth of information about the actual performance of service companies is made. “An analysis of its statements can highlight a company’s strengths and shortcomings, and this information can be used by management to improve performance and by others to predict future results ” (Brigham & Ehrhardt, P 74).

Price/Sale and Price/Earnings Ratios

Coming to the aspects of the performance of American Express Co. to that of the industry and also the markets, it could be said that its Price/Sale Ratio at 1.63 is higher than industry standards, but falls below the market standard of 1.69. Similarly, its Price-earnings and Price/Cash flow ratio at 12.98 and 6.04 are much lower than markets standards of 16.25 and 10.38 respectively. (American Express Company. 2008).

Conclusions

American Express enjoys the prerogative of being the largest credit card company in the world. In order to retain this position, it has invested in advanced technologies to serve customers with optimum efficiency and effectiveness. For this, they have entered into strategic alliances and internet applications.

“Web-enabled applications allowed the company to handle 78% of their customer transactions – from payments to disputes – via the Internet, with over 5.5 million U.S. cardmembers… resulting in unit cost reductions of up to 60% for certain transactions, reduced rates of credit problems of credit card fraud (by up to 96% at certain merchants and overall by over 25% in 2001) and of customer disputes (by up to 50%).” (Case Study in “on-demand” computing, 2007).

It is expected that in the time to come the company would be able to add brand value and reinforce its customer base by serving a large segment of the global community desirous of using its products and services.

References

The 100 Top Global brands 2006. (2000-2007). McGraw-Hill company. Business Week. Web.

American Express company. (2008). Hoovers. Web.

Consolidated financial highlights. (2007). American Express Company. Web.

Consolidated financial highlights: Financial Review. (2007). American Express Company. P 29. Web.

American Express Company. (2008). Hoover: Web.

Consolidated financial highlights: Uncommon Service: ANNUAL REPORT 2007: American Express Company. Shareholders’ Returns: P. 16. Web.

Brigham, Eugene F., & Ehrhardt, Michael C. Financial Management Theory and Practice (10th Edition), Analysis of Financial Statements, P. 74.

Case Study in “on-demand” computing: American Express Company: American Express Company’s internet initiative. (2007). Outsourcing Law. Web.

Thesis statement: The practice of corporate finance has evolved such that there are several methods that various players in the industry have identified as appropriate to be used as project evaluation methods and these are the NPV, CAPM and the discount rate method.

Introduction

The authors in this paper carried out a study that aimed at analysing the current practice of corporate finance in the areas of cost of capital, capital budgeting and capital structure. The study was conducted with a great reference to Lintner’s path breaking analysis on dividend policy. The hope of the two authors is that the findings of the study will help other researchers and academicians to improve their knowledge on issues related to corporate finance and how they affect firm performance. The authors therefore chose to concentrate on three main issues in corporate finance and the summary of these issues is presented below (Graham and Harvey, 2).

Cost of capital

An evaluation of the use of cost of capital by firms noted that CAPM is by far the most popular method of estimating the cost of capital. It is also noted that CAPM is mostly preferred by larger firms than smaller firms. The results from the survey showed that firms that have already established themselves are likely to use a company-wide discount rate to evaluate their projects while firms with foreign exposure use it to evaluate overseas projects. The survey also noted that public corporations are most likely to use a risk matched-discount rate than private corporations. They also noted that the use of CAPM by small firms is inversely proportional to managerial ownership (Graham and Harvey, 7).

Capital budgeting

The survey conducted by the authors is different from those of others because it does not concentrate on large firms only, but also small sized firms and that the IRR is the only primary method of evaluation. The new survey not only focuses on the controlled characteristics of the firm but also enquires if the firms uses evaluation techniques (e.g. pay-back period, profitability index, accounting rate of return), use of earnings multiples and use of other types of analysis. Results from the respondents showed that the use of net present value as an evaluation technique is more preferred by large firms than by small firms.

It is also important to note that the results of the survey showed that firms that pay dividends are more likely to use the NPV and the IRR methods of capital budgeting than those firms that do not pay dividends. The authors also indicate that their results did not find any relationship between the use of the payback period method of capital budgeting and the leverage of the company, the credit ratings of the company as well as the dividend policy of the company (Graham and Harvey, 5).

Capital structure

The survey shows that the desire for financial flexibility is not determined by the factors behind pecking-order theory which suggest that firms use external financing only when internal funds are insufficient. Insufficiency of internal funds leads to the decision of issuing debt and this mostly happens to small firms compared to large firms. Equity-issuance decisions are also affected by the stock price performance especially where information asymmetry is involved. The results of the survey also show that credit ratings are important to debt decisions and that industry debt ratios are an important input for bond ratings.

However, it is important to note that the decision to issue equity is not influenced greatly by the equity policies of other firms in a given industry. The results also show that most firms choose their debt maturity by matching it with asset life hence differentiating between short-term and long-term debt. Such matching of the debt maturity and asset life helps in the management of risk associated with the capital structure of a company (Graham and Harvey, 10).

Methodology

The survey focused on three main areas: cost of capital, capital budgeting and capital structure. The survey questionnaires contained 15 questions where some of them had subparts and covered the three areas that were the main focus of the survey. The survey questionnaires were sent out to respondents of the study. A total of 392 questionnaires were returned and subjected to data analysis (Graham and Harvey, 3).

Conclusion

Based on the survey the authors conclude that NPV and CAPM are widely used currently as compared to the previous decades. The authors also conclude that small firms are less likely to use NPV or CAPM whereas in capital structure financial flexibility and credit rating are most important debt policy factors. When determining capital structure, financial executives are less likely to follow the academically proscribed factors and theories hence the need for additional thought and research. NPV and CAPM are widely understood because they make a more precise prediction and have been accepted as a mainstream for longer as compared to capital structures theories.

Works Cited

Graham, John, and Harvey Campbell. “The theory and practice of corporate finance: Evidence from the field” Journal of Financial Economics, 61(2001): 000-000. Print.

Since modern firms are often constrained financially, it is vital for them to seek external funds so as to expand innovative industries, thus making innovation as a very key and important part of future corporate success. Welch (2011) using micro data, illustrate that access to finance matters for entry of uprising and small firms helps expansion of new firms following successful initial investment. Welch stresses that modern firms most often faced tighter financial constraints. Grenadier and Malenko (2011) from their study found that for a larger percentage of United Kingdom firms, the financial difficulties they faced were essential for young firms and states that these firms “are more prone to facing asymmetric information problems”. When a measure of negative correlation between market power and bank distress was taken, it showed that banks that have higher shares of cross-border assets have a larger market power at home.

Grenadier & Malenko (2011) notes “there has been an increase in financial market sophistication leading to a constant change and increase in competition therefore Innovation and the development of new products is a core factor that is important in the development of the finance industry.” In regards to the Islamic finance industry, they are faced by critical issues which involve new product development and Sharia compliance. A major challenge faced by the Islamic finance industry is refusal by the United Kingdom to apply Sharia law in disputes since they follow the New York law while Islamic finance industry complies with the Islamic law when carrying out business transactions. Another challenge facing the Islamic finance industry is the lack of scholars with financial experience and also a scarcity in skilled professionals in the Islamic finance sector. Also policies that find supply effects in corporate finance have been suggested by topical developments in asset pricing in combination with opportunistic executives. In most recent times due to a change in investor preferences and limited intermediation, capital supply independently varies from corporate fundamentals.

Another issue in corporate finance is capital budgeting given that the practical manifestation of value maximization is to recognize and invest in positive NPV undertakings. A difference occurs where the hurdle rate used by the firm manager in deciding whether to accept or decline a project and the cost of capital which is measured by the expected return demanded by shareholders. Usually the hurdle rate is higher and this proves that firms fix their capital budgeting hurdle rate higher than the expected return demanded by shareholders. In corporations nowadays, firm managers are delegated decisions by the owners. Scores of empirical corporate finance centers on the sources of demand in capital, not supply. This has changed most recently.

There are numerous challenges facing corporate finance. Firstly, there are not many actual arbitrage limitations that would let third party groups to compel rational behavior against non-value optimizing corporations. Secondly, managers use toxic drugs and spread out boards as mechanisms to segregate themselves from aggressive external influences. Grenadier & Malenko (2011) notes “the value consequence of poor corporate policies is usually less than takeover premium needed to unseat management even when not in place.” This illustrates that the Darwinian selection is weak. Another constraint facing the corporate finance is that; the data frequency in corporate finance is often moderately low though there is a huge capacity of firms in the cross section with the most common being annual data. “Also the financial statement data from the final fiscal year of firms is hardly available when they disappear mid year (on average after 10 years. This results to survivorship biases” (Grenadier & Malenko 2011).

Currently corporate finance has faced several challenges and has been affected by modern issues worldwide.This is due to economic changes inclusive of inflation which has had a huge effect on corporate finance globally.

References

Grenadier, S. & Malenko, A. (2011). Real Options Signaling Games with Applications to Corporate Finance. Review of Financial Studies, Rock Center for Corporate Governance at Stanford University Working Paper No. 57 1-57.

Welch, I. (2011). A Critique of Recent Quantitative and Deep-Structure Modeling in Capital Structure Research and Beyond. AFA 2011 Denver Meetings Paper, 1-45.

Introduction

Sorouh Real Estate PJSC styles itself as one of the largest real estate developers in the Middle East. The firm was founded in 2005 and since that time it has grown into one of the most leading companies operating in the property sector. Sorouh has already carried out several projects that have earned them a good reputation in the United Arab Emirates, for example, we can mention the Towers on Reem Island or Golf Gardens in Abu Dhabi (Sorouh, unpaged).

So, we may say that this enterprise holds a strong position in the UAE market. However, it has recently faced several challenges due to its imprudent policies and dramatic changes in the global economy and housing market. One of these challenges is the decline in lease and sales profits. This paper aims to propose recommendations that can alleviate the problems which Sorouh currently experience. It is based mostly on primary sources, namely annual income statements and sustainability reports.

Overall, the management of this organization should develop more flexible pricing policies for those customers who may want to rent their buildings and purchase them in the future. This may give them a competitive advantage over other firms operating in this area. To prove the validity of this strategy, we should first discuss the factors which have led to the decline in their profits.

Financial situation in the company

First, the World Economic Crisis and especially the notorious credit crunch has produced profound effects on the performance of many real estate developers. Their income rates have significantly dropped because the products are no longer as valuable as they used to be. Moreover, these organizations are struggling to work out their pricing policies. The thing is that before the housing bubble, the cost of real estate reached its peak and leading companies expected to gain considerable income from them. But in 2007 and 2008 it drastically decreased and real estate developers can no longer yield the profits which they initially expected.

Additionally, many of them have several long-term projects which could be started before 2007 and these projects have involved considerable investments. Currently, the return on these investments is relatively low. Some real estate developers are on the brink of bankruptcy. Naturally, Sourouh has passed through this crisis and the financial situation is stable and yet this company has not escaped the aftereffects of the housing bubble.

According to their annual reports, one may single out several rather disturbing tendencies. The basic earnings per share decreased twice, from 0,19 per cent to 0.09 (Sorouh, 2007, p 4). There is additional evidence that eloquently proves that this firm is passing through a very difficult period. Over these two years, the cost of revenue has grown by almost thirty per cent.

In 2008, this number constituted $503,227 while in 2009 this number has risen to $955,511 (Sorouh, 2009. p 2). Overall, this data indicates that the companys operating expenses are becoming more costly. In part, these numbers show that Sorouh fails to meet rather ambitious standards which they set for themselves. Most importantly, this ineffectiveness is not only due to the global economy. These low results may stem from some of their internal policies.

At this stage, we need to carry out a ratio analysis to identify the peculiarities of the companys development over this period. One of the most important criteria is the relationship between total assets and total liabilities. This is one of the first questions which draw the attention of potential investors. It has to be admitted that the statistics are not very encouraging because Sohour increases its debt obligations.

• Current Ratio Assets/Liabilities = 16.558.382/10.638.658= 1,556 (Sorouh, 2009, p 6)

In sharp contrast, in 2006 this ratio was much higher. In fact, in 2006 this ratio was 1, 777. To some extent, this is a sign which shows that the liquidity of this firm has diminished. Potential investors who may be looking at these numerical data may find that Sorouh now encounters certain financial difficulties. Apart from that, experts usually focus on such parameters as the ratio between current assets and daily operation costs

• Current Ratio Assets/Costs = 16.558.382/75.392 = 219,530. (Sorouh, 2009, p 6)

Again, we have to emphasize the idea that in 2006 and 2007, daily expenses of the company were much lower. These figures demonstrate that over the past years the performance of this firm has deteriorated. But we cannot attribute these changes only to the world financial crisis. The thing is that they began to manifest themselves before the crisis. Hence, they may have even different origins. One of the key issues is that the company mostly rents their building but nowadays more and more customers are willing to purchase houses rather than rent them. Sorouh has not developed appropriate lending schemes for the customers.

Performance (Profitability) Ratios Calculations.

Liquidity Ratios Calculations.

Investment Ratios Calculations.

On the one hand, it is quite possible to understand the logic of Sorouh management because renting a building seems more profitable to them. But this is not what their clients are looking for. They need ownership but the housing, developed by this organization is rather expensive. Therefore, Sorouh must give them feasible credit options for the long term.

To propose recommendations to the management it is first necessary to assess the major strengths of this enterprise. First, as it has been noted before, they have established their reputation. They no longer must spend money on the advertisement of their services. Furthermore, over this period they have acquired vast experience in this field. Even though this company was founded only o in 2005, it has already participated in various projects ranging from the construction of single houses to urban planning.

Sorouh has also established partnerships with domestic and foreign real estate developers and at this stage, they are trying to render their services to several foreign clients (Sorouh, 2009, unpaged). The firm has also been given a substantial number of awards like Best New Business, Best Commercial Project of the Year, Best Strategic Real Estate Portal and so forth (Sorouh, 2009, unpaged). So, their record speaks for itself. To some degree, this reputation lays the foundations for success, but the company must take full advantage of this opportunity.

Relative Performance for five years

As regards their major weaknesses, we should first mention inappropriate marketing policies. Again, there are more interested in renting the buildings which they construct but now more and more customers want to buy housing. We also need to say that their target audience is rather limited. Sorouh attempts to suit the needs of such private organizations, like luxury hotels and oil companies. However, there also may be smaller enterprises willing to rent or buy their buildings and Sorouh should carry out the projects which are affordable to such clients. Overall, one can say that their buildings are not easily accessible.

It seems that Sorouh should place more emphasis on civil construction. We should also take into consideration that the construction market in UAE is becoming more competitive and Sorouh management also needs to improve their customer service. Thus, one can conclude that recent difficulties were caused by external and internal factors, particularly instability of the construction market and marketing strategies.

Comparison with related firms in the UAE

At this stage, it is of crucial importance for us to draw parallels between Sourouh and other real estate developers, operating in the United Arab Emirates, for example, Aldar Properties PJSC. The vast majority of their developments are located in Abu Dhabi. Aldar specializes in the construction of hotels. Overall, we can say that, unlike Sourouh, they give preference to selling rather than renting their building. To compare their performance, we need to pay attention to such parameters as return on assets (RoA) and return on equity (RoE).

As far as Sorouh is concerned, we may say that these numbers are not as encouraging. For instance, their return on assets has decreased in comparison with the previous year. At this stage, their ROA equals 5, 8 %. ¹ Furthermore, their return on equity reduced from 35% to 15, 9 per cent. (ADCB, 2009, p 1) This data eloquently demonstrates that Aldar is much more efficient. This can be accounted for by the fact that their developments (hotels) enjoy more demand. Additionally, Aldar provides more opportunities for clients to purchase their buildings.

This graphic demonstrates that Sorouh profits may be larger than those of Aldar. However, their performance is gradually declining.

Recommendations

Judging from this discussion, one can propose the following recommendations. 1) At first, the management must implement a more flexible pricing strategy for those clients who want to buy their buildings. This can eventually increase their sales rates. 2) Secondly, they should carefully analyze the situation in the housing market because the prices of real estate are unstable. It seems that Surah should avoid grand-scale projects because they entail higher risks. There are several rationales for this policy: 1) it may be quite difficult to find clients for such buildings. Moreover, due to market fluctuations, they may eventually devaluate and bring virtually no dividends. Finally, the company should try to diversify their products

Conclusion

Currently, Sorouh Real Estate PJSC can win the palm of supremacy in the Middle East. It has the experience and resources to do it. However, this can be done only by adopting flexible pricing policies on their buildings. Naturally, the difficulties faced by this enterprise are only temporary, but their effects may be disastrous unless the management changes its policies.

Reference List

ADCB (2009). Sorouh Real Estate. PJSC. Web.

Oxford Business Group (2009). The Report Abu Dhabi 09. Oxford Business Group.

Ross S. Westerfield R, W. & Jordan B.D (2008). Corporate Finance Fundamentals Eighth. McGraw-Hill Education.

Sorouh Real Estate PJSC (2007). Review Report and Interim Financial Information for the period ended in 2007. Web.

Sorouh Real Estate PJSC (2009). Web.

Sorouh Real Estate PJSC (2009). ADX Financial Report. Web.

TAIB Research (2009). Aldar Properties. Web.

Interest rates are an essential tool used by the state and central banks to regulate economic growth. When the economy grows faster than required, the government intervenes and raises interest rates to discourage businesses from borrowing to expand and individuals from borrowing to buy, thereby slowing the economy. When economic growth stops or does not occur quickly enough, the government usually lowers interest rates to stimulate economic growth. As a result, changes in interest rates also affect financial markets. The purpose of this essay is to identify the relationship between the level of interest rate and the price of bonds and to study the factors taken into account when assessing the company’s ability to make payments on outstanding debt.

The interest rate is inversely related to the bond price. This implies that when interest rates rise, bond prices fall, and the other way around. This happens when the bonds have a fixed interest rate — the coupon interest rate. Therefore, when interest rates rise, bond yields — the interest that an investor gets from buying a bond must also increase so as not to lose demand compared to higher interest rates. The interest rate affects people to save in order for their incomes to grow (Mushtaq & Siddiqui, 2016). Since the coupon’s interest rate is fixed, the bond’s yield can only be raised by reducing the bond’s price.

In general, the amount of reduction in the price of bonds depends on their validity period. In practice, the duration is used to determine the sensitivity of a bond to changes in the interest rate. The longer the term of the bond, the more it is affected by changes in interest rates (Gallant, 2021). This relationship must be true since investors have certain risks associated with securities. The current situation with low-interest rates has attracted many new customers to the bond market, which has positively impacted the country’s economy.

In order to assess the company’s ability to make payments on outstanding debt, it is necessary to consider such factors as the debt ratio, the debt to equity ratio, and the debt to tangible net capital ratio. If the company’s debt is substantial, then the company may default. Therefore, the company’s debt ratio is an essential factor in accounting. The debt ratio shows what percentage of the company’s assets were financed from debt funds.

To assess the capital structure of an enterprise, it is necessary to correlate debt to equity. In the long run, the debt-to-equity ratio has an impact on the firm’s earnings (Nukala & Rao, 2021). As a result, it will be needed to get a ratio in which liabilities are a means of financing the company compared to equity. If a company is bought by an investor who seeks to sell the company’s assets in the event of a default, it is necessary to assess the debt to tangible equity.

In conclusion, it is imperative to understand that the market is far-sighted; therefore, everything that is known about the market at the moment is reflected in prices. Therefore, if it is known that interest rates are likely to rise and if the financial media increasingly mentions this, then you can be sure that experienced corporate investors who lead the trades and, therefore, dictate prices also know this information. All is needed to look at the current market situation to see if the market expects an increase in interest rates and how it will react.

References

Gallant, C. (2021). Interest rate risk between long-term and short-term bonds.Investopedia. Web.

Mushtaq, S. & Siddiqui, D.A. (2016). Effect of interest rate on economic performance: evidence from Islamic and non-Islamic economies. Financial Innovation, 2(9), 1-14. Web.

Nukala, V.B. & Rao, P.S.S. (2021). Role of debt-to-equity ratio in project investment valuation, assessing risk and return in capital markets. Future Business Journal, 7(13), 1-23. Web.