Tesla Inc. Financial Decision Making Report
The stock price of Tesla has been in downtrend recently and this paper tries to uncover some of the financial decision by the Tesla Inc. that may have contributed to the performance of the stock in the stock market. Although, sometime the performance of a stock may be influenced by the non-financial decision such as market sentiments the long-term performance is related to financial decision making by the management.
TESLA was founded in 2003. A group of engineers found this company has a strategy in mind that people must not compromise to drive electric vehicles (Tesla, Inc., 2018). Tesla builds not only the electric vehicles but also clean energy generation and storage products. The main aim of the company is to make the world a better place to live in by making it pollution free. They don’t want people to rely on fossils anymore. All the vehicles of TESLA are made in its factory in Fremont, California. The majority of all the components of the vehicles are also made there. To create an entirely sustainable ecosystem for the world it also manufactures a unique set of energy solutions such as power wall, power pack, and solar roof. Tesla is trying every day to build more and more affordable and accessible products to more and more people. They want the future to be powerful, pure, and secure. Being a manufacturing company, Tesla operations entails huge capital investment in modern technology production and assembly plants. Additionally, the company requires huge capital to invest in research and development in order to develop new products that are environmentally friendly and keep up with fierce competition from other companies. Tesla is also a relatively young company in the growth stage and hence requires more capital to finance its growth compared to the established company.
Evaluation of capital structure
From the year ended 2017 financial statement, it is evident that Tesla Company has used excessive debt to finance its operations. For example, the total liabilities for the company total $23,022,980,000 compared to total assets of $28,655,372,000 (Tesla, Inc., 2017). The total debt to asset ratio is $23,022,980,000/$28,655,372,000 = 80.3% indicating that over 80% of Tesla Company assets are financed by debt while shareholder equity funds about 19.7% (Tesla, Inc., 2017). The company total stockholder’s equity is 4,237,242,000 hence it has a debt to equity ratio is $23,022,980,000/ 4,237,242,000= 5.43. This means that debt capital or liabilities are more than 5.43 times the total shareholder equity. The finance theory on capital structure claims that debt capital is a cheaper source of capital when used moderately because it has a predetermined rate and cost of debt is a tax allowable expense. While on other hand equity cost of capital is residual, cannot be determined in advance and is payments of dividends is not a tax allowable expense. All the profit after tax is treated as earnings to the equity stockholders usually denoted by the earning per share (EPS), hence when a company is making profit the use of more debt capital and less of equity capital is reasonable as it increase EPS or the wealth of the owners of the company (Courtois, Lai, & Drake, 2016). The main objective of a company is to maximize the wealth of it shareholder’s hence the decision of using more debt financing than equity may appear to supplement the achievement of the goal of the firm (Walker, 1996). However, the optimal capital structure theory states that excessive use debt is counterproductive as it increases the financial risk of the firm increasing both the required return on equity and debt capital and consequently raising the weighted average cost of capital (WACC) of the firm (Ross, Westerfield, & Jordan, 2016). The use of more debt increases the financial risk because the cost of debt is a legal obligation and failure to pay this cost may this debt may prompt legal action leading to winding up company. Additionally, when a company uses more debt it credit risk increases while the riskiness of it stock increases because equity owners have a residual claim to the assets of the firm hence when the company’s credit risk increases significantly equity owners are in higher risk of losing their investment in the company.
Proposal for Financing
After analyzing the consolidated statement of financial position of Tesla Inc. the company indebtedness seems to be a bit higher and consider the financial performance over the last few years the company ought to reduce its indebtedness. I would suggest the company to consider the use of equity financing instead of considering debt finance as this may affect its credit ratings and it may also default if the profitability of its business does not improve drastically. Reducing the debt capital used will improve the credit risk and reduce the financial leverage leading to lower finance costs. I would propose a plan, which may not increase the wealth of shareholder in the short-term but, would increase the long-term wealth of shareholders by issuing more equity capital through a rights issue so as to give the shareholder a chance to maintain their control or ownership positions. However, if the issue fails to generate enough capital the company should issue equity capital through the private placement or secondary market. The company can also negotiate debt restricting to ensure favorable terms of debt. The company also ought to generate internal capital through retained earning which currently is negative due to accumulated losses. The management needs to improve the profitability of Tesla Company operations by reducing operating costs because the company revenues seem to increase but it operating expenses are too high. If the company started generating profits this would provide a cheap source of capital as there is not underwriting expenses to be incurred and other floatation costs.
Capital structure Proposal
Due to the risk associated with high levels of debt, I would suggest a debt structure of about 60% debt and 40% equity capital. The current debt level may not be optimal for the minimization of company WACC. I would propose the Tesla management to reduce the total liabilities from the current level of 80.3% to about 60% of the total capital and increase the equity capital from the 19.7% to about 40 %. This can be done in two ways, for example, the company can reduce the level of debt capital or increase the equity capital. However, for the debt level to be reduced the equity capital must be used to repay the debt either by issuing new equity or by using retained earnings. The company can also increase the equity capital only through the accumulation of profit and issuance of new equity without repaying the outstanding debt. My proposal is to issue new equity capital because the company is in the early growth stage and needs a huge capital to fund it the high growth of revenues. The gearing ratio at 60% will not cause any concern about insolvency risk of the company, especially if the company turnaround its operations to a profit-making business.
Dividend policy proposal
Tesla Company is in need of huge capital to fund its growth, invest in new technology solutions, research, innovate and develop new products. In this regard, the company needs an internal source of capital as well as external sources. I would suggest a no dividend policy and all retained earnings should be used in profitable investments to increase the long-term wealth of the Tesla company shareholders and provide product and service that meet the expectations and needs of other stakeholders. The company is currently not generating profits or positive cash flow from its operations and hence it is unreasonable to use cash flow from investing and finance activities to pay dividends. The cash used to pay dividends can be used in other urgent needs and profitable investments. For example, the company can repay some of it interest-bearing debt or invest in new profitable projects. I would suggest the company to maintain a no dividends policy until a time when it is able to generate enough cash flow from its operating activities to meet its capital needs and when there no profitable investment project that can be financed using that cash. Cash dividends are appealing to the investors as they provide a source of income to the investors however the benefits of cash dividends to the investors do not outweigh the benefits of using that cash in other projects.
Critical evaluation of the role of Finance in Management
Finance management is one of the most important roles in the management of a firm as it involves both strategic decisions such as sourcing of funds, allocation of the funds to the most efficient activities of the firm and rewarding the provider of the funds. At operational level finance has a role in recording daily transactions, supervising cash receipts and payments, safeguarding cash balance, reporting, custody, and safeguarding of assets and other important documents of the firm. These routine functions of finance management involve many procedures, systems, a lot of paperwork and are usually done by junior staff in finance management. The management role of finance is concerned with the following strategic decisions;
Strategic planning and budgeting
Strategic planning involves making the long-term strategic plan, which maximizes the value of the firm (McNamara, 2010). Strategic planning entails setting priorities of the company, allocating resources to achieve these priorities, focusing energy and aligning the goals of various department and employees in the achievement of these priorities. A strategic plan is a document that states the priorities of the firm or its long-term objective and communicates this to various stakeholders such as employees and shareholder of the company. The strategic plan enables a firm to achieve a competitive edge over its competitors by improving its internal efficiency, taking opportunities, and responding to threats. The strategic planning process involves a company analyzing its internal strengths and weaknesses and also evaluating the external environment to identify any opportunities available or any threat that may threaten the achievement of the organization goal. After identifying the available opportunities and threats, the company then set its priorities, subject to it capabilities such as strength and weakness. The company will then break the long-term strategic plan into medium-term and short-term operational plans with specific tasks to be achieved by various department and milestones when such a task will be achieved (Bass, 2012). The strategic planning allocates resources to the various department responsible for achieving specific tasks, coordinates their operations, and aligns their goal towards the achievement of the larger strategic objective. To ensure that progress is being made in achieving the strategic strategy according to the initial plan, evaluation, and measurement of various goals and milestones and compare to the strategic plan. Where there is any deviation from the plan actions are taken to ensure that the achievement of the strategic goal is not derailed.
Budgeting is a planning process that setting the standards or desired goals to be achieved in a specified time and allocating resources to achieve those goals (White, 2015). There two types of budgeting such as capital budgeting and operational or recurrent budgeting. Capital budging involves planning on the mix of longer-term investment assets that maximize the value of the firm. Capital budgeting refers to the firm’s decision to use current resources to the purchase of fixed assets or investments with the hope of positive future cash flows from these projects. Capital budgeting involves making investment appraisal to decide on which project to invest in, subject to the available funds and the firm’s goal of maximizing the wealth of shareholder. The recurrent budgets also referred to as cash budgets are plans on the expected use of available funds to generate cash. They indicate the planned expenditure and the expected revenues from the operations of the firm. The company forecasts it expected revenues and the cost of generating these revenues from the historical experience and future growth prospects. Budgeting helps a firm to allocate resources to most profitable activities and encourages employees to work toward a specific achievable goal. Budgeting also reduces wastage of resources by minimizing cost, creates a sense of competition among employees and departments as they strive to achieve their budgets. The budgeting process involves an evaluation of performance hence acts as a control tool. Results are measured and compared to the set standards and any variances are investigated and necessary actions are taken to correct them.
Capital management refers to the decision on the sources of funds to finance investment projects, allocation of these funds and division of the earning generated by the investments. The finance management has a role in deciding the proportion of equity and debt. The mix of debt and equity capital affects the firm’s cost of capital (WACC) as well as the financial risk. The capital structure of the firm plays an important decision in determining the value of the firm. The optimal capital structure is one that minimizes the cost of financing for the firm. Debt capital has a lower risk profile to an investor perspective compared to the equity because it has a superior claim to the assets of the firm and it cost is a legal obligation, unlike the equity capital. Due to the risk-return trade-offs, investors require lower returns from their investment in debt than in their investment in the equity capital. This makes the debt capital to be less costly compared to the equity capital (AccountingExplained, 2018). However, on a company’s perspective debt capital is riskier than equity capital because debt and interest payments are legal obligations unlike equity capital, which is not. Additional debt is temporary capital while equity capital is a permanent source of capital as there is no timeline to repay equity capital. After making financing decision and sourcing the funds, the company then decides how to allocate the funds. This may involve investment in long-term assets or capital budgeting and investment in working capital or short-term assets ( EduPristine, 2018 ). Working capital management entails decision regarding the balance between current assets and current liabilities (Maneval, n.d.). Working capital management involves making liquidity decisions in that it decides what amount of capital to allocate to current assets, which are used to repay the current liabilities as they fall due (Hawley, 2018 ). The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are invested in current assets. Surplus working capital is costly to firm as it earns little or no profit, while lack of current assets will affect operations of a firm as currents assets are required to meet current financial needs of the firm. Another role in capital management is making the decision regarding the distribution of earning while the debt providers earning is guaranteed through payment of interest the management must decide on whether to distribute earnings to the shareholders or not.
Cash is the most liquid and important asset to any organization and hence sound management plan for cash must be put in place to avoid the risk of misappropriation and pilferage. Cash management involves planning on the cash level to maintain, collecting cash, cash payments and deciding on types of short-term investments to invest surplus cash and short-term cash arrangements with banks in case of cash shortage (Investopedia, n.d.). This ensures that profit is maximized without affecting the operations of the company. The cash plans are usually in form of cash budgets.
Profit planning and cost controls
Profit planning and cost control entails making a prediction about the expected sales revenues and cost to be incurred in generating these revenues (Millians, 1947). The plans are represented in Pro-forma financial statements, which are based on the expected sales growth and then assumptions, are made about the cost of sales, operating costs, working capital requirements, and increase in fixed assets. The process of profit planning involves the following steps; setting the profit goals, forecasting the sales volume, expenses estimation and establishing the expected profit (Nitisha, n.d.). The profit planning and cost controls motivate the firm employees to achieve the set goal and acts as a tool for evaluating performance as the actual results are compared to the planned results. the company then looks at the causes of variances and decides on how to correct such deviations.
Risk management in strategic decision making
The risk is uncertainty associated with any undertaking that it can fail to produce the desired results. Risk management in strategic decision-making is the process by which an organization management defines the level of risk it is willing or plans to take, measures the actual level of risk it is taking, and adjusts the actual level of risk to equal the planned risk level (CFA Institute, 2015). Risk management involves taking actions to reduce the probability of loss or failure occurring or the impact of the loss to the firm. Risk management does not guarantee that great losses or failures will not occur, and it does not eliminate the likelihood of total failure (CFA Institute, 2015). To guarantee no loss or failure would normally necessitate that the quantity of risk taken be so small that the business would be effectively constrained from pursuing its principal goals (CFA Institute, 2015). Risk taking is essential in all forms of commercial activity and in life generally as the there is no possibility of zero risks and probability of loss is never totally eliminated (CFA Institute, 2015). The risk management in strategic decision making makes target various actions in a firm which includes.
Operating activities-The risk involved in operating activities is the possibility that a firm may fail to achieve it operations goals. Operating activities are main activities, which an organization undertakes to achieve the goal of the firm. The risk associated with operating activities includes any occurrence that may result in the business failing to achieve its goals. For example machine breakdown, employee strike, product failure, change in economic, fluctuation in exchange rates, political and legal environment. To manage these risks the firm may use several measures such as the use of the forward contracts, futures contracts or other derivatives to manage foreign exchange risk.
Financing activities-, the risk associated with financing are those events that may prevent the firm from achieving a financing goal for example repayment of debt, failure to get enough funds to finance a project or meeting the expectation of capital providers. The firm can manage such risk by reducing credit default risk, use of interest swaps and other derivatives to manage change in interest rates. For example, the Tesla Inc. has indicated that it has such hedging activities place.
Investing activities - Investing activities involve investment in fixed and long-term assets of the firm. The company can manage the risk associated with it long-term assets by using measures as insurance policies.
The report investigates the financial performance and management of the Tesla company, proposes the financing plan appropriate, capital structure and dividend policy. The paper also critically evaluates the role of financial management in any company. The strategic planning and budgeting, capital management, cash management, profit planning, and cost control roles of finance management are discussed. Additionally, the paper discusses the role of risk management in strategic decision-making.
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