Financial Management

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You work as a financial analyst at a large automobile corporation that occasionally makes acquisitions of smaller companies that specialize in the production and assembly of small component parts. In order to achieve vertical integration of its newest sports sedan model, the company is evaluating a few manufacturing companies that have experienced strong financial performance in the past few years. These companies would make excellent acquisitions due to the nature and quality of the product and the anticipated ease of transition. You have been tasked to evaluate these companies from a financial perspective and choose one. To do this, you need to brush up on a few concepts by addressing the following topics:
1. Describe what a crediting rate/score is. Should this be a factor in evaluating companies?
2. The firm will need to raise funds immediately for the acquisition, and debt will be used. Should the firm borrow on a long-term or short-term basis? Why?
3. Explain the effect, if any, inflation rates will have on the purchase? How significant is this factor?
4. Define the relationship between yield curves and the term structure of interest rates.
5. Explain what would happen to interest rates if a new process was developed that allowed automobiles to run off oil that was formulated based on lemonade? The technology used to convert this liquid to gas would be pricey but well worth it. What impact would this technology have on interest rates?
6. Discuss what ratios should be used to assess the financial health of the potential acquisition?

Sample Solution

Congratulations on being tasked with evaluating potential acquisitions for your company’s sports sedan model! Let’s delve into the key financial concepts you need to consider:

  1. Credit Rating/Score
  • Definition: A credit rating/score is an assessment of a company’s creditworthiness, indicating its ability to repay debt obligations. Higher ratings signify lower risk of default.
  • Evaluation Factor: Credit rating/score is a useful factor in your evaluation. It provides a quick snapshot of the target company’s financial health and potential borrowing costs. However, it shouldn’t be the sole deciding factor. You should also analyze the company’s financial statements and future prospects.
  1. Long-Term vs. Short-Term Debt
  • Acquisition Funding: Since this is a permanent acquisition, long-term debt is the preferred choice. Short-term debt (usually maturing within a year) isn’t suitable for financing a long-term asset like a manufacturing company.
  • Benefits of Long-Term Debt:
    • Spreads out repayment, allowing for smoother cash flow management.
    • Potentially lower interest rates compared to short-term debt.
  1. Inflation and Acquisition Costs
  • Effect of Inflation: Inflation generally increases the cost of goods and services over time. This can be a significant factor in an acquisition.
  • Impact on Acquisition: Consider how inflation might affect the future value of the acquisition. The target company’s production costs might rise, potentially impacting profit margins. You might need to factor in inflation projections when determining the acquisition price.
  1. Yield Curve and Term Structure
  • Relationship: The yield curve depicts the relationship between interest rates and the maturity of debt instruments (short-term vs. long-term). A normal yield curve shows higher rates for longer maturities.
  • Importance: The yield curve can influence your debt financing decision. If long-term interest rates are currently low, it might be more favorable to borrow long-term for the acquisition.
  1. Lemonade-Powered Cars and Interest Rates
  • Impact on Rates: This hypothetical technology would likely have a complex impact on interest rates. Here’s why:
    • Reduced Oil Dependence: Decreased demand for oil could lead to lower interest rates for oil companies and potentially lower overall inflation, potentially pushing interest rates down.
    • Increased Investment: The new technology might require significant investment, potentially influencing interest rates depending on the Federal Reserve’s monetary policy.
    • Market Uncertainty: The initial market disruption caused by this technology could create uncertainty, potentially leading to short-term fluctuations in interest rates.

Overall, the impact on interest rates is difficult to predict with certainty.

  1. Financial Ratios for Acquisition Evaluation

Several financial ratios can help assess the target company’s financial health:

  • Profitability Ratios: These ratios measure a company’s ability to generate profits, such as net profit margin and return on equity (ROE).
  • Liquidity Ratios: These ratios assess a company’s ability to meet short-term obligations, such as the current ratio and quick ratio.
  • Solvency Ratios: These ratios measure a company’s long-term debt repayment ability, such as the debt-to-equity ratio.
  • Efficiency Ratios: These ratios assess how effectively a company manages its assets and resources, such as inventory turnover and receivable turnover.

By analyzing these ratios alongside other factors like credit rating and market position, you can create a comprehensive picture of the potential acquisition target’s financial health and how it aligns with your company’s goals.

 

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