Topic 2 Sources of Finance 20/25 mark essays

ChocsAway Limited is a small private company that makes and sells high-quality chocolates.

The company has an issued share capital of 200,000 £1 ordinary shares, all of which are owned by
the three directors.

The company wishes to expand production of chocolates and would also like to purchase new
factory premises. The directors seek your advice on two issues:

1. How to fund the increase in net current assets that will be necessary as production is
increased, creating short term cash flow problems.
2. How to finance the purchase of new premises

Issue 1

The finance director has prepared budgeted financial statements for the next sixth months, based
upon an increase in production of 20%. The statements show that increases in inventory, trade
receivables and trade payables would lead to an overdrawn bank balance of £25,000, instead of the
present £4,000 of money in the bank at the end of the sixth month period.

The finance director advises that a bank overdraft facility should be arranged for 12 months- interest
would be charged at a rate of 8% per annum. The alternative would be a bank short-term loan for
twelve months at an interest rate of 6%.

Issue 2

Currently ChocsAway Limted rents its factory premises at a cost of £2000 per month. New factory
premises to purchase have been identified at a cost of £700,000. The finance director suggests that
50% of the cost could be financed through a commercial mortgage for 10 years at a rate of 4% per
annum. The new factory premises are large enough to allow for future expansion of the company
and, if the company buys them, it will give up the rented premises.

You are to evaluate potential sources of finance to:

a) Solve the funding of the increased net current assets (working capital).;
b) Finance the purchase of new premises.

Planning

The command word in this question is:

This means that you must look at both sides of an argument/the “for and against” before coming to
a reasoned conclusion.

NOTE: For this question, you actually have to make 2 conclusions- one advising which source of
finance would be best to solve the short term cash flow problems and one advising which source of
finance is best to purchase the new premises.
Firstly, which TWO sources of finance do you need to evaluate to solve the SHORT TERM cash flow
problems:

1)

2)

Secondly, as well as the MORTGAGE that has been suggested to purchase the new premises, which
other LONG TERM source of finance are you going to evaluate?

1) Mortgage

2)

Structure

Paragraph 1- Evaluate the bank overdraft

In this paragraph you need to look at the positives and negatives of a bank overdraft.

Remember to put emphasis on which points you think are more significant than others.

Make sure you do a calculation to work out the interest that would be paid if the overdraft was used
for the whole year (but also remember that the business will only pay interest on the amount that
they are in the bank overdraft rather than on the whole amount)

Remember to explain WHY your points are good or bad- consider the business and their situation
(context)

Paragraph 2- Evaluate the short term bank loan

In this paragraph you need to look at the positives and negatives of a bank loan.

Remember to put emphasis on which points you think are more significant than others.

Make sure you do a calculation to work out the interest that would be paid on the loan per year.

Remember to explain WHY your points are good or bad- consider the business and their situation
(context)

Paragraph 3- Make a decision about which one is best for their circumstances

In this paragraph you need to make a decision about which one is best and why.

Remember:

To question the data- consider that your decision is based on budgeted figures- are these going to be
accurate?

It also depends whether the whole amount of the overdraft will be needed to decide which is the
cheaper option.

Your decision is dependent on the business being able to get a loan or an overdraft- is this likely
considering their situation?

Would you advise that the business looks at other ways of improving their cash flow instead of or as
well as a loan or an overdraft- consider why they need the overdraft or the loan in the first place.
Paragraph 4- Evaluate the commercial mortgage

In this paragraph you need to look at the positives and negatives of a commercial mortgage.
Remember to put emphasis on which points you think are more significant than others.

Do a calculation to work out how much they would save in rent.

How much would they actually borrow and how much would this cost in interest per year?

Do a calculation to work out how much they would save overall.

Paragraph 5- Evaluate the ‘other’ form of long term finance

As the mortgage will only provide half of the money they need, you now need to evaluate the
positives and negatives of the other form of finance you suggest.

Remember to put emphasis on which points you think are more significant than others.

Will they be able to raise this extra finance given their situation?

Paragraph 6- Make a decision about which one is best for their circumstances

In this paragraph you need to make a decision about which one is best and why.

Remember:

To question the data- consider that your decision is based on budgeted figures- are these going to be
accurate?

Your decision is dependent on the business being able to get a mortgage or sell shares- is this likely
considering their situation?

Is there an alternative to spending £700,000 on buying a premises?

It there anything else that your advice depends on?