CEE – HND Business Course Title: Finance Semester: 2010 Time: Managing April – July Morning

Assignment Title Cost of Finance & Financial Planning Tutor: Mr. Vijay Nair Student: Rashida Yvonne Campbell Hand in date: 16th May 2010 Assignment: No. 2

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Contents
Assignment Description Deciding the location Cost of Issuing Shares Cost of Bank Loan Cost of Retained Earnings Cost of Competitor investment Recommendation Quartz Corporation Altitude Training Centre Task B Financial Planning Capital Structure Dividend Decisions Investment Decisions Budgeting Working Capital Conclusion 10

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Task A:
Scenario

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ACB Training with an annual turnover £25million, is contemplating relocating to new premises. Two possible sites are available with slightly different features and aspects. The re-location will help them to be able to meet client’s needs more effectively. Location 1: Investment required for the move = £10million The location is in the heart of the city centre and an estimated increase of 25% is expected if this option is chosen. Location 2: Investment required for the move = £8million Very close to city centre and business will increase by 10% if this option is selected. ACB Training private limited company formed 10 years ago by 5 exlecturers. The 5 of them are the main shareholders but there is also a shareholder who was a local business person who approached 2 of the owners to run a training course for her company. They have the following options to generate finance: a) The management is thinking of generating the required finance by issuing 1million new shares of £10 each. b) One of the banks with which ACB has long financial relations has sent a quote for the loan at interest rate 7% per annum for a maximum of 10 years. c) The retained earnings account showed a balance of £25 million in the last year’s balance sheet. d) One of the competitor companies has offered to help ACB but the investors are expecting 80% share of the profit in the future venture. Evaluate the costs of the sources of finance. Also mention how the option selected will reflect on company’s financial statement.

Task B:
Write an essay on the importance of financial planning and how the needs of decisions makers can be met?

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Deciding the location
The first part of the scenario requires a decision to be made on either choosing location 1, or location 2. Choosing location 1 would require an investment of £10,000,000 with a benefit of 25% increase in sales per year. Calculation:10,000,000 x 25 = £2.5 million (2,500,000) 100 Choosing location 2 would require an investment of £8,000,000 with a benefit of 10% increase in sales per year. Calculation:8,000,000 x 10 = £800,000 million (£0.8 million) 100 Taking option 1 provides an opportunity cost of Calculation:2,500,000 – 800,000 = £1,700,000 million (£1.7 million) Therefore taking location 1 provides more profits at an opportunity cost of £1.7 million more. ACB should choose location 1. The second part of the task is to evaluate the different costs of the sources of finance given for option A, B, C and D.

A Issuing of new 1 million shares at £10 each would raise the total of £10 million pounds required for the relocation.
Calculation: 1,000,000 shares x £10 = £10 million

Cost benefits of issuing shares to raise finance are:
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The company will avoid using its retained profits Retained earnings can be used for other purposes such as: pay out its profits between the existing share holders, Invest into stocks etc. By holding its retained earnings the balance sheet will not be affect. Avoids taking bank loans and re-paying the interest. Dividends on shares only need to be paid if the company makes a profit

Cost disadvantage of issuing shares to raise finance are:
• • • • • • New shares means present shareholders ownership is reduced. There may not be any buyers (no demand) for the new shares, leaving the company with insufficient funds for the venture. When a company announces the issue of new shares it leads to speculations that the company has financial problems and that the firm may be entering into risky businesses. New shareholders expect the share value to increase so that they can sell the shares at a later date earn a profit. New shareholders expect to receive a return on the investment in the form of dividends. Issuing shares has costs involved such as administrative and legal costs.

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Time factors means that to raise finance in this way will not always be immediate it takes time to arrange and to receive buyers of the new shares.

B Bank loan £10 million at 7% interest rate per annum for 10 years
Calculation Costs for the bank loan source of finance would be: 10,000,000 x 7% = £700,000 per annum or (£0.7 million) 100 Over a period of 10 years £0.7million x 10 years = £7,000,000 Total interest rate payable over 10 years for the amount borrowed = £7 million So the bank loan of £10m investment receives 25% profit of £2.5m minus 7% interest Calculation: £2.5m profit – 0.7% interest = £1.8 million net profit Opportunity cost: £2.5m

£1.8m = £0.7 million (£700,000)

Therefore £2.5 million is the gross profit after interest payments of £0.7 million net profits are £1.8 million, to calculate in percentage terms: Percentage profit: £1.8m net profit x 100 = 72% profit earned £2.5 m gross profit

Cost benefits of the bank loan source of finance are:
Companies can take advantage of Tax Relief on the profits before deducting the interest. In this case: Calculation Tax Relief: Gross profit = £2.5 million Interest charge = £0.7 million Net profit =£1.8 million Tax without interest payments means the gross profit £2.5 million would be taxable. Due to interest payments now Tax Relief can be applied, only the net profit £1.8 million is taxable. As an example if we take the Tax rate at 10% the calculation are as follows: Gross profit £2.5m x 10% tax = £250,000 100
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On £2.5 million tax payable is £250,000 Net profit £1.8 x 10% tax = £180,000 100 On £1.8 million tax payable is £180,000 A difference of £250,000 - £180,000 = £70,000 Tax Relief Benefit

Another benefit of the bank loan means that the company will maintain its retained earnings and would not need to issue new shares to raise the finance. When retained earnings are untouched it indicates on the cash flow statement that the company has no cash flow problems. Cash flow is important for the firm to run smoothly, to purchase raw materials, payment of wages and meeting other operating costs.

Cost disadvantages of bank loan as a source of finance

Commercial loans usually carry high interest rates. Opportunity cost means that instead of paying £0.7 million in interest payments a year the business could do something else with this money such as marketing & promotion which could generate further profits for the company for example £1million. Taking the loan and paying interest means that the opportunity to earn this possible £1million is lost. Another disadvantage is security, if the loan is secured on assets of the business, then the company has limitations as to what it can do with that asset, such as selling it would not be possible if it is held as a security.

C Use retained earnings a balance of £25million last year’s balance sheet
If the company decides to withdraw £10million from retained earnings of £25million calculations are as follows: £25million retained earnings - £10million for relocation = £15million Retained earnings balance = £15 million The term retained earnings refers to the organisations cumulative net income minus the cumulative amount of dividends declared. To show large amounts or retained earnings on the balance sheet is important for the calculation of stockholders equity. If retained earnings of £10m are used for the relocation assuming it will receive a benefit of 25%, therefore: £10m x 25% profit = £2.5m gross profit with no interest payments (but other costs must be deducted such as tax, working capital etc) Therefore the balance of retained earnings needs to be considered again as part of the 25% profit will be added to the total sum of the retained earnings from the last balance. However it would take a long time before
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the company benefited from the 25% profit earned to reach its original balance of £25m. Retained earnings are essential from the perspective of shareholders because the balance of retained earnings are debited and credited to the current liabilities of dividends payable, the declaration of cash dividends reduces Retained Earnings, an example of how it decreases is as follows:

ACB Training Company Statement of Retained Earnings 2009
Retained Earnings 2009 25,000,000 Net Income 1,000, 000 Total 26,000,000 Less Dividends 500,000 Retained Earnings 2010 25,500,000 Should the company decide to withdraw £10m from retained earnings as a source of finance for the relocation project the statement would show as follows: (an example only)

ACB Training Company Statement of Retained Earnings 2010
Retained Earnings 2009 25,000,000 Relocation project 2010 10,000,000 15,000,000 Net Income 1,000,000 Total 16,000,000 Less Dividends 500,000 Retained Earnings 2010 15,500,000 Therefore when investors compare last years statement it appears more promising and attractive to creditors than this year’s statement. It shows retained earnings as spent elsewhere rather than in the form of higher dividends payment.

Cost benefits of using Retained Earnings as a source of
finance • The money is available no waiting time. • No need to pay interest rates on loans. • Goods for short-term usage.
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Businesses have to pay tax on their earnings so reducing the amount of earnings by investing elsewhere the amount taxable is reduced

Cost disadvantages of using Retained Earnings as a source
of finance • A business needs its earnings to pay for such things as wages, rent, materials, utilities etc. Otherwise workers will leave and production will be reduced. Only through the selling of goods will a company generate profit. Retained earnings are needs for working capital for the survival of the company. • Dividends need to be paid for the cost of the share capital. If this is not met shareholders lose loyalty in the company. • Opportunity cost must be considered. If £10m of retained earnings is used for relocation then this reduces the amount of capital for other projects. If the other projects can generate a profit of 37% then the cost of using the £10m for relocation is the 37% profit foregone. The total amount shown as retained earnings may not be the total amount that is available in cash. It may be in the form of assets or liquidity, or tied up in other investments.

D Competitor Company will raise the finance for 80% of the profits.
The calculations for this source of finance are as follows: £10m at 25% = £2.5m profit If the competitor takes 80% of the profits the calculations are as follow: £2.5m profit x 80% to competitor = £2 million will go to the competitor 100 The remaining profit left for ACB Training would be £500,000 (£0.5m) Therefore the opportunity cost = £2 million foregone The competitor’s percentage profit for its investment would be: 2,000,000 x 100 = 20% profit 10,000,000 The percentage profit for ACB Training = 5%

Cost benefits of using competitor as a source of finance
• • • • • The competitor is no longer a competitor for example Sony-Ericson. Both companies can join their resources together to improve and add value to their products or services. The experience of two companies is better than one. The risk of the £10 million has been shifted to the competitor When companies join in ventures they become larger and can take on more and new projects
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Cost disadvantages of using competitor as a source of
finance • Loss of majority of the profits. • Ownership is reduced. • Decision making is divided reducing the power and authority of the original owners. • May need to make redundancies as the number of employees increase when two companies join. • If the venture does not succeed the competitor can pull out of the contract and will have obtained internal confidential information.

Recommendation
Management must identify the "optimal mix" of financing the capital structure where the cost of capital is minimized so that the firm's value can be maximized. It is important to show that on the one hand a company pays out dividends and on the other hand they re-invest its profits wisely in order to make new profits, but chooses the right combination of financial mix and considers the cost involved. It would therefore be recommendable for ACB-Training to consider using a mixture of both retained earnings and the bank loan. Withdraw £5 million from retained earnings and £5 million from the bank at an interest rate of 7%. This would result in the company benefiting from reduced interest payments and the length of time for the loan. The percentage profit the firm would make is greater. The reduction of £5 million from retained earnings of £25 million would be a more reasonable amount left on the balance sheet of £20 million and £5 million shown as investment activities is more likely to be accepted by shareholders and other creditors. This method also means that the opportunity cost enhances the financial choices rather than hinder them. Benefits for this decision are calculated below (as an example) Bank Loan £5 million Retained Earnings £5 million £5 million bank loan at 7% interest rate: 5,000,000 x 7% = £350,000 interest per annum 100 If ACB-Training relies on the bank for £5 million the total amount of interest payable for the period of 10 years: £350,000 per annum x 10 years = £3.5 million Rate of Return on £10 million: Therefore gross profit: Interest payable: £10m x 25% = £2.5 million £2,500,000 million £350,000
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Net profit:

£2,150,000

Percentage profit £5m Retained Earnings £2,150,000 x 100 = 43% £5,000,000 The banks percentage profit is: £350,000 interest x 100 = 7% £5,000,000

If ACB-Training relies on the bank for the full £10m the total amount of interest payable for the period of 10 years: 10,000,000 x 7% = £700,000 per annum or (£0.7 million) 100 Over a period of 10 years £0.7million x 10 years = £7,000,000 Total interest rate payable over 10 years for the amount borrowed = £7 million for the £10m borrowed compared to £3.5 million for the £5m borrowed

A major benefit of raising £5 million from the bank and £5 million from retained earnings is the advantage of the leverage (gearing) effect. From the calculations above we can see the benefits of the leverage effect: £10 million retained earnings gives a percentage profit of 25% as calculated below: £2.5m profit x 100 £10m retained earnings = 25%

£5 million retained earnings gives a percentage net profit of 43% as calculated below: £2,150,000 net profit x 100 = 43% £5m retained earnings The solution chosen according to the above findings is therefore to withdraw £5m from retained earnings and £5m as a bank loan at 7%. This also spreads the risk, but allowing ACB-Training to maintain a good level of retained earnings without reducing their ownership control and power in decision making should they have chosen any of the above options. Businesses are always requiring extra finance for a variety of reasons, usually for expansion and growth. The impact of a financing option on the financial statements of the business will affect different users of this information. Due to legal requirements financial movements of the company must be reported in the balance sheets. Two companies have been chosen to illustrate their methods for raising finance: Quartz a large
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global organisation and Altitude Training Centre a small firm owned by 4 people.

http://www.principlesofaccounting.com/chapter%201.htm

Analysing the above information regarding Quartz Corporation we can see that the company has previously raised finance through share issues as now they are showing payment of dividends to shareholders and this has been deducted from the retained earnings in the “Statement of Retained Earnings.” It can be identified in the “statement of cash flows” Quartz has withdrawn from its earnings to fund in Investing activities to purchase land at $250,000. If the investing activities was not deducted the cash for December would be £352,000. Let’s assume that the $250,000 can generate a profit of 35% the profit would be: $250,000 x 35% = $87,000 100 Most financial managers would calculate to see if the percentage benefits are worth raising funds from internal sources of the company. If the percentage on the return on investment will provide a good return then using retained earnings is a better choice. The reasons for raising this source of finance avoids time delays, interest payments and the profits generated will be put back into the company and not shared through alternative investors. If a company has a good amount of retained earnings as for the case of Quartz it is advisable to raise its finance using its own retained earnings. Another company operating in Dubai Academic city is run and owned by 4 people, their business is expanding and they need to move from their
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small office to a larger office within the same complex. The four owners initially invested their own private savings to start up the business. However for the new premises they choose to raise finance through a long term loan and retained earnings. The company expects to receive additional increases of 40% generated from the new office premises. The interest rate payable is 10% over 5 years. The financial statements are as follows:

Retained Earnings as at 31 December 20XX AED (Dirhams) 200,000 100,000 300,000 90,000 210,000

Statement of cash flows 31 December 20XX AED (Dirhams) AED
Retained earnings 31 Dec 210,000 Investing new Offices 100,000 Financed by: Cash 60,000 Loan 40,000 100,000

Retained earnings Net income

Less share capital Retained earnings 31 Dec
http://www.altitudetrain.com/

This second example shows that the company has used two sources of finance to move to the new office premises. The company has withdrawn 60,000 AED cash from retained earnings and 40,000 AED as a bank loan. The total amount required is 100,000 AED with expected increase in profits of 40%. The calculations are as follows: 40,000 AED bank loan at 10% interest: AED Rate of return 100,000 AED at 40%: AED 100 Therefore Gross profit: Interest payable Net profit: 40,000 AED -4,000 AED 36,000 AED 36,000 AED x 100 = 60% 40,000 x 10% interest = 4,000 100 100,000 x 40% = 40,000

Percentage profit retained earnings:
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Taking advantage of the loan

60,000 AED

If Altitude Training Centre used all 100,000 AED from retained earning their percentage profit would be: 40,000 x 100 = 40% 100,000 Again this example shows the leverage effect that companies can benefit from. Also the other benefit of not using the total amount required from retained earnings is should the company need further investors at a later stage in the future the balance sheet will show that the company has plenty of cash. Cash offers protection against tough times, and it also gives companies more options for future growth. Growing cash reserves often signal strong company performance. The balance sheet, tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets" or "shareholders equity". The balance sheet tells investors a lot about a company's fundamentals: how much debt the company has, how much it needs to collect from customers (and how fast it does so), how much cash and equivalents it possesses and what kinds of funds the company has generated over time.

Task B:
Write an essay on the importance of financial planning and how the needs of decisions makers can be met?
Financial planning is the task of determining how a business will afford to achieve its strategic goals and objectives. Usually, a company creates a Financial Plan immediately after the vision and objectives have been set. The Financial Plan describes each of the activities, resources, equipment and materials that are needed to achieve these objectives, as well as the timeframes involved. Financial plan can be a budget, a plan for spending and saving future income. This plan allocates future income to various types of expenses, such as rent or utilities, and also reserves some income for short-term and long-term savings. A financial plan can also be an investment plan, which allocates savings to various assets or projects expected to produce future income, such as a new business or product line or shares in an existing business. In business, a financial plan can refer to the three primary financial statements (balance sheet, income statement, and cash flow statement) created within a business plan. Financial Page 13

forecast or financial plan can also refer to an annual projection of income and expenses for a company, division or department. A financial plan can also be an estimation of cash needs and a decision on how to raise the cash, such as through borrowing or issuing additional shares in a company. While a financial plan refers to estimating future income, expenses and assets, a financing plan or finance plan usually refers to the means by which cash will be acquired to cover future expenses, for instance through earning, borrowing or using saved cash (retained earnings).

The steps to financial planning are: • Deciding on the Capital structure and sources of long-term funds. • Dividend decisions; how much profit is to be retained or paid out. • Investment decisions; how much funds should be invested in each asset. • Management of budgeting • Working capital; purchasing of goods for trade, wages etc. Financial planning is conducted by the financial manager and finance department of an organisation. It involves the above four kinds of decisions. Capital structure refers to the way an organisation has arranged its funding between ordinary shares, preference shares, and debentures. Its importance is that shares pay dividends which may be waived in bad trading years, whereas debentures pay interest which cannot be avoided. Usually companies receive their long-term funds for investment from these two main sources. How much capital a company requires is how much it should rise through these two sources. Capital structure decision is regarding how much percentage of capital is raised through equity or debt. It shows the overall investment and financing strategy of the firm. Capital structure can be of various kinds, an example a capital structure strategy is “Horizontal Capital Structure” this strategy is where the firm aims to have zero debt in the structure mix. Expansion of the firm will raise finance through retained earnings and equity. Capital structure reflects the firm’s strategy; it shows the risk profile of the company, it acts as a tax management tool, helps to minimize risk and maximize profits. Capital structure can be used to build up firms assets.

How Capital Structure affects the needs of the different decision makers. • Corporate strategy top managers and directors to make certain that the capital structure will assist in meeting the overall vision of the company, its long term aims in size and profitability. • Stock-market decision makers need the information of a company’s capital structure to decide whether to buy or sell. • Shareholders require the capital structure of a firm; to determine whether or not to invest.
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• •

Government also need the capital structure information for taxation purposes. Other creditors such as banks require capital structure information when deciding if it will finance a loan for the company.

Dividend decisions: is a decision made by the directors of a company. It relates to how much of the profits should be retained, re-invested or paid out to shareholders. Decisions are made about the amount and timing of any cash payments made to the company's stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay. There are three main factors that may influence a firm's dividend decision: Free-cash flow; Dividend clienteles and Information signalling. Free cash flow dividends is when the firm simply pays out, as dividends, any cash that is surplus after it re-invests in positive projects. Dividend clienteles: If clienteles exist for particular patterns of dividend payments, a firm may be able to maximise its stock price and minimise its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies. Information signalling: Managers have more information than investors about the firm, and such information may enlighten their dividend decision making. Managers that have access to information that indicates very good future prospects for the firm are more likely to increase dividends. How Dividend decisions affect different decision makers • Investors can use this knowledge about managers' behaviour to inform their decision to buy or sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. • Stock market speculators and investors • Competitors to scan on the company’s success or failure • Internal and external shareholders Investment Decisions: The investment manager has to make decisions on how the capital and profits collected by a firm are spent. Decisions such as re-investment, purchasing of more stock to secure future sales, or held back in savings, increase assets, split the investments into the various strategic business units to fund more projects such as research and development. The investment manager must perform ongoing monitoring of investments. The manager has to consider the rate of return, risk, safety, liquidity and the time period. How investment decisions affect different decision makers The key role belongs to the Investment manager of the company his choices will affect a variety of different people and departments: • Employees in the stock department
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• • •

• •

Research and development employees would require the investment decisions of the company to confirm if they are going to receive funding for there research Human resources need investment funding for the head count for the number of employees each division and is allowed Sales managers acquire the knowledge of investment decisions, should the investment manager decide not to fund in new or more products the sales team would no longer be able to make bonuses from these products. Travelling would also be reduced Creditors and banker also use the information of the investment decisions a company has made. So bankers can determine level and length of any loans. Business development units like marketing rely on investments from within its own organisation to fund future marketing ventures Project managers also rely on investment funding and need to know the decisions of the investment manager regarding current and future projects.

Budgeting: Budgeting is part of the financial planning process; it explains in monetary terms the plan for the income, expenditure and capital investment (buying fixed assets). Budgeting helps to determine if a firm's long term
investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It ensures that no department or individual spends more than the company expects. Steps to budgeting:

Make judgements on the likely sales revenue for the coming year Set a cost ceiling that allows for an acceptable level of profit The budget for the whole company is then broken down into division, department or by the cost centre. • The budget maybe broken down further for each manager and gives them some spending power • Budgets are then monitored Budgeting helps to ensure the objectives of the organisation. It helps to compel planning and decision making. It communicates ideas and plans to the company. It co-ordinates activities. It gives a framework for responsibility. It establishes a system of monitoring and control. How budgeting decisions affect different decision makers: • Budgeting will affect all departments and divisions of the organisation • Suppliers are also affect by budgeting the company’s choice of expenditure will impact the amount of profit a supplier is able to make • Directors need to agree on the master budget for the whole • Regional managers will rely on the budget decisions of the directors so they can allocate a budget to each branch manager • Branch managers rely on the previous decisions of budgets so they can divide the budget between section managers • Finally the shop floor workers help to meet the budget targets
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• • •

Working Capital It is the day to day finance for running a business the formula is: Current assets minus current liabilities = working capital It is used for running costs, wages, raw materials and it also funds the credit offered to customers (debtors) when making a sale. It is not the funds invested in fixed costs. If a firm has too little working capital available it may struggle to finance increased production without straining its liquidity position. If a firm has too much capital, in the short-term it may not be able to afford the new machinery that could boost efficiency. Managers need to: • Identify costs involved in making products, this is the first step to decide the selling price • Work out how many products they need to sell to make a profit • Find out how much capital they need and the best way to obtain the capital • Keep a tight control over the way in which the firm’s money is spent How working capital affects different decision makers All the organisational employees, departments, divisions, sections, all the way down to the shop floor will base their decisions according to the way the working capital has been planned. The main decision makers that it will affect are • Suppliers, because too little working capital means not enough capital to pay bills on time • Banks, because the business will find it difficult to get loans if it has insufficient working capital • Stock department needs enough working capital to order more stocks • Employees will all be affected if there is not enough working capital to pay wages. There are a range of people who are interested in the financial data and planning that a company produces such as shareholders, creditors, competitors, governments/regulators, auditors, employees, suppliers, customers, partners etc. They all base their decisions according to the organisations financial planning. The main function of the financial plan is to ensure objectives of the firm are being met. This is ultimately in the form of profits. Although financial planning is complex it requires sophisticated using tools, techniques, computer programs, decision making tools. The end result is basically to guarantee that money and capital raised for the business is invested wisely in order to receive a return in the form of profits.

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