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Transcript of Financial Management
Financial Management
UGB231
Individual Assignment
Guided by: Mr. Bernard Joseph
Prepared by:
Name: Kaminie d/o Dalasubmanim
Intake: September 2010 – August 2012
NRIC No: 890719-07-5028
Student No: 109090030/1
Programme: UOS – BABM (2+0)
1
Executive Summary
This coursework is mainly discussed about Glee plc companies and how the
company is underperforming in terms of profit and new projects which are not going as
well as the Board of Directors hoped. Glee plc is one of the universal electric public
company engages in the manufacture and distribution of electrical home appliances
primarily.
The company is now facing some problems of not having a proper balanced
capital structure. To rise above this dangers there are some variable sources of finance
available for Glee plc to solve it. Furthermore there is a not only source of finance but
there are also cost of capital, optimum capital structure and finally investment appraisal.
Therefore, Glee plc has to go through three main areas about the issues which are
sources of finance where sourcing money can be done for a variety of reasons to solve the
problems. Traditional areas of need may be for capital asset acquirement such as new
machinery or the construction of a new building. Secondly, optimum capital structure is
about how Glee plc should have good debt capacity to borrow quickly on favorable in
terms to pursue an attractive opportunity. Moreover, investment appraisal is one of the
key areas of long-term decision-making that firms must undertake of investment that
need to commit funds by purchasing land, buildings, machinery and so on, in expectation
of being able to earn an income greater than the funds committed. In order to handle
these decisions, Glee plc have to make an assessment of the size of the outflows and
inflows of funds, the duration of the investment, the degree of risk attached and the cost
of obtaining funds.
The theories, models and techniques of the main areas above by which the
company could improve the performance will make a good choice for the company. So
Glee plc can have a proper balanced capital structure to achieve a low cost of capital.
2
Table of Content Pages
Executive Summary 1
1.0 Introduction 3
2.0 Overview of the Sources of Finance and the Cost of Capital 3
2.1 Equity and Debt Financing 3
2.1.1 Equity Financing 3
2.1.2 Debt Financing 4
2.2 Cost of Capital 4
3.0 Optimum Capital Structure 5
3.1 Traditional View 5
3.2 Modigliani & Miller’s View 7
3.2.1 Modigliani & Miller’s (1958) 7
3.2.2 Modigliani & Miller’s (1963) 8
4.0 Investment Appraisal Techniques 10
4.1 Payback Method 10
4.2 Accounting Rate of Return (ARR) 10
4.3 Net Present Value (NPV) 11
4.4 Internal Rate of Return (IRR) 11
5.0 Conclusion 12
6.0 Appendix 13
7.0 References 22
3
To: Board of Director
From: Senior Management Accountant
Date: 7th January 2011
Subject: Improving Performance of Glee plc in Financial Management
1.0 Introduction
Glee plc (GPLC) is one of the universal electric public company engages in the
manufacture and distribution of electrical home appliances primarily. GPLC company’s
products include a range of refrigerators, freezers, such as chest freezer, beverage cooler,
and wine cellar, and washing machines, both 2-tubs semiautomatic and automatic single
tub. GPLC is not performing as good as in terms of profit and new projects as the Board
of Directors hoped. Due to these troubles the projects of GPLC are not going well as they
don’t have the proper structure approach to evaluate. To improve the problems that
GPLC facing, there are three main areas to go through which are sources of finance,
optimum capital structure and investment appraisal.
2.0 Overview of the Sources of Finance and the Cost of Capital
There is two parts that have been covered in the next part which is about the sources of
finance and the cost of capitals which are consist of the cost of debt, the cost of equity
and the weighted average cost of capital. Besides that, preference share is another option
that can be included.
2.1 Equity and Debt Financing
2.1.1 Equity Financing
Sources of finance means for many businesses, the issue is about where to get funds for
investment in order to understand the various sources of finance
(http://tutor2u.net/business/finance/finance_sources_equity_introduction.asp,viewed on
6th December) There are three main methods where GPLC should raising equity in the
4
company such as retained profits, right issues and new issues of shares to the public.
GPLC should come up with certain amount cash with them as this will help them to stay
away for the burden of debts. Besides, GPLC should consider the type of investors that
might offer valuable business assistant at the moment an in future as both of this two as
considered as advantages of equity finance. Moreover, the disadvantages are investors
expect more than they invest thus, GPLC should always consider the type of investors
they are going to deal with.
2.1.2 Debt Financing
Debt is borrowing money from an outside source with the promise to return the principal.
(http://entrepreneurs.about.com/od/financing/a/debtfinancing.htm, viewed on 6th
December 2010). Debt securities that take many forms, for example, term loan, bonds,
convertible securities debt with warrants and leasing besides taking out a bank loan. The
advantage is the interests that GPLC can repay is tax deductable which will be a good
option that is debt financing in this way. One of the disadvantages is if the loan payments
are not pay back it is impossible GPLC to make borrowing in the future even it is a
smaller amount.
2.2 Cost of Capital
The cost of capital is a key factor in choosing the mixture of debt and equity used to
finance. GPLC should use a mixture of debt and equity to reduce their cost. GPLC debt is
a mixture of loans, bonds (kd) and other securities (ATkd). Besides that, the cost of
equity (ke) is defined as the rate of return that an investor expects to earn for bearing
risks in investing in the shares of a company. (http://www.ventureline.com/accounting-
glossary/C/cost-of-equity-definition/, viewed on 6th December 2010). Furthermore, the
weighted average cost of capital (WACC) is used in finance to measure a firm's cost
of capital that has been used in GPLC as a discount rate for financed projects. Thus
the capital structure of a firm comprises three main components such as preferred
equity, common equity and debt.
5
3.0 Optimum Capital Structure
Optimum capital structure means the combination of a company's long-term debt,
specific short-term debt, common equity, and preferred equity. GPLC should keep the
cost low to undertake and may rise for establishing its business to keep it in control when
the operations are growing.
(http://www.premiumbusinesstraining.com/working_capital.php, viewed on 28th
December 2010)
An optimal capital structure refers to the particular combination which minimizes the cost
of capital, and maximizing the stock price. It's an important financial decision undertaken
by the managers of GPLC to have balanced capital structure. On the other hand, the
capital structure is said to be optimum structure when GPLC has selected such a
combination of equity and debt so that the wealth of GPLC is maximum. The objective is
therefore to find the capital structure that gives the lowest overall cost of capital and,
consequently, the highest company value. There are two types of view of debate on
capital structure which is Traditional view and Modigliani & Miller’s view. There are
two options under Modigliani & Miller’s (M&M) view which is without tax at the year of
1958 and with tax at the year of 1963.
3.1 Traditional View
Traditional view of capital structure means when a company starts to borrow, the
advantages be more important than the disadvantages. The cheap cost of debt is
combined with its tax advantage, will cause the WACC to fall as borrowing increases.
However, as gearing increases, the effect of financial leverage causes shareholders to
increase their required return where the GPLC cost of equity rises. At high gearing the
cost of debt also rises because the chance of the GPLC failure to pay on the debt is higher
where bankruptcy risk might happen. So at higher gearing, the WACC will increase. To
6
determine the optimum capital structure will be where the WACC is the lowest in the
graph.
Gearing level of GPLC represents how much debt is being used by in comparison to
equity. Both, equity and debt have their own benefits and costs. But, it does not really
matter whether company goes for debt or equity financing. This critique will analyze
whether there is a link between the debt levels and cost of capital of any company. M&M
theory suggests that cost of capital is unaffected by the gearing level of the GPLC under
certain assumptions. But, these assumptions do not hold true in practical world. The main
problem with the traditional view is that there is no underlying theory to show by how
much the cost of equity should increase because of financial leverage or the cost of debt
should increase because of default risk. (http://www.linkedin.com/answers/finance-
accounting/corporate-debt/FIN_CDT/563069-55715560, viewed on 28th December 2010)
The result is that GPLC should be able to identify a minimum WACC and an optimal
gearing, as shown on the graph below.
Graph 1: Traditional View
7
However, the extreme levels of gearing will incur higher cost of debt because of the
higher risk exposed by the debt providers. As debt increase, the cost of equity capital
increase at a higher level compared to the level increase in the cost of debt. When the cost
of capital is minimized, the market value of the firm’s debt and equity will be maximized.
The cost of debt starts off low because of the tax protect and its low risk. The cost of
equity rises gradually as the GPLC gears up. Overall, the WACC falls in the early stages
as the company gears up, because of the introduction of cheap, efficient debt. However as
bankruptcy worry bites, driving up the cost of debt and equity sharply, the WACC will
also start to rise.
3.2 Modigliani & Miller’s View
These professors have a different view than the Traditional View. Their studies can be
divided into 2 views which is Modigliani & Miller’s (M&M) at the year 1958 without
tax and Modigliani & Miller’s at the year 1963 which is after five years with tax.
3.2.1 Modigliani & Miller’s (1958)
According to M&M (1958), when there are no taxes and capital markets function well, it
makes no difference whether the firm borrows or individual shareholders borrow.
Therefore, the market value of a company does not depend on its capital structure.
Implications of M&M theory are that gearing is irrelevant and the firm’s value will be
determined by its project cash flows. The cost of capital does not change as gearing level
of GPLC should increase. As a firm increases its leverage, the cost of equity will increase
just enough to off-set any gains to the power.
This theory assumes that there are no taxes but in reality taxes do exist and also, in
practice, interest on debt is tax deductible where as cash flows on equity are not. This
theorem also assumes that there is no agency cost which is managers maximizes
shareholder’s wealth. Another assumption is that markets are perfect, in other words,
corporate insiders and outsiders have the same information.
8
(http://www.listedall.com/2009/05/modigliani-miller-approach-to-capital.html, viewed
on 30th December 2010) Below is the example of Modigliani and Miller (1958) graph
looks:
Graph 2: Modigliani & Miller’s (1958)
3.2.2 Modigliani & Miller’s (1963)
Weighted average cost of capital (WACC) is depending on cost of equity and cost of debt
and also market value ratios of equity and debt to firm value. M&M (1963) recognized
the effect of taxes by using assumption of none corporate tax and in this way corporations
were permitted to deduct interest in the form of expense.
M&M (1963) recognized that net of tax approach encouraged the firms to utilize 100
percent debt in capital structure but M&M (1963) discouraged 100 percent debt policy.
Some other sources were also there to generate the funds at lower costs like retained
earnings. In some conditions, retained earnings may be cheaper even tax status of
9
shareholders under the personal income tax also considered.
(http://articlesforte.com/finance/basic-finance/miller-and-modigliani-theory-3776.html,
viewed on 30th December 2010) Example of Modigliani and Miller (1963) graph:
Graph 3: Modigliani & Miller’s (1963)
In conclusion, it appears that link between costs of capital and gearing levels of GPLC is
not irrelevant. But, it is difficult to understand the exact relationship between cost of
capital and gearing. Link between cost of capital and gearing level is not direct and
relative. Glee plc should look into all the associated factors like tax implications, agency
costs, default risk, bankruptcy costs, cost of servicing the debt, business risk before
deciding its capital structure.
10
4.0 Investment Appraisal Techniques
Investment appraisal is extremely important because the capacity of production of the
economy depends on the capital available to produce. Investment appraisal is an
evaluation of the attractiveness of an investment proposal, which using four methods
such as payback method, accounting rate of return (ARR), net present value (NPV) and
internal rate of return (IRR).
4.1 Payback Method
The payback method is to evaluate an investment project. Besides that, according to
appendix 1.0 GPLC should choose Machine B since Machine B has a shorter payback
period than Machine A, it appears that Machine B is more desirable than machine A and
because the machine has a fastest return compare to Machine A.
There are a number of serious drawbacks to the payback method where it ignores the
timing of cash flows within the payback period and also the time value of money which
means that it does not take account of the fact that RM1 today is worth more than RM1 in
one year's time as an investor who has RM1 today can either consume it immediately or
alternatively by investing it. The payback method does have advantages, especially as an
initial screening device which means capital is occupied.
(http://www.accountingformanagement.com/
pay_back_method_of_capital_budgeting_decisions.htm, viewed on 30th December 2010)
4.2 Accounting Rate of Return (ARR)
The accounting rate of return (ARR) is a way of comparing the profits that expect to
make from an investment which is normally calculated as the average annual profit. The
higher the ARR, the more attractive the investment as GPLC can compare to their own
target rate of return. For an example, according to the example in the appendix 2.0,
GPLC can choose both equipment items because the both equipment X and Y is above
11
the company’s required return. However, equipment X is better. The ARR is widely
used to provide a rough guide to how attractive an investment as it is easy to understand.
Besides, ARR are based on profits rather than cash flow.
(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf, viewed on 30th
December 2010)
4.3 Net Present Value (NPV)
Net present value (NPV) compares the value of cash today to the value of that same cash
in the future. The net present value (NPV) of cash inflows exceeds the NPV of cash
outflows by RM 74,720, which means that the project will earn a discounted cash flow
(DCF) yield in excess of 15%. So, GPLC should therefore be undertaken according to the
case in the appendix 3.0. On the other hand, the advantages of net present value are
essential for financial appraisal of long-term projects which measures the excess or
shortfall of cash flows as NPV model is assumed. The disadvantage is adjustment for risk
by adding a premium to the discount rate thus making cost higher.
(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf, viewed on 30th
December 2010)
4.4 Internal Rate of Return (IRR)
The internal rate of return (IRR) which relative measure (%) in contrast to the total
measure resulting from NPV calculations. GPLC can be estimated the IRR as 19.8%
according to the example in appendix 4.0. The NPV should then be recalculated using
this interest rate that results equal to or very near or zero. The main advantage is that the
information it provides is more easily understood by managers, especially non-financial
managers. IRR also calculates an alternative cost of capital including an appropriate risk
premium and is not being used to rate mutually exclusive projects.
(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf, viewed on 30th
December 2010)
12
5.0 Conclusion
As a conclusion, there are several areas that GPLC has go through to improve the
company of having a balanced capital structure to achieve a low cost of capital. The
important key areas are sources of finance, optimum capital structure and investment
appraisal to make as recommendation to improve GPLC to a good level.
Sources of finance is available from variety of sources but each source has its own
cost and benefits. It is important to choose an appropriate and cheap source of finance for
the smooth operation of GPLC. The thrust of this report has been to develop the
formation in order to solve financial capital structure. The main key areas in the sources
of finance are debt financing and equity financing.
The optimal capital structure is a critical decision for any organization. This
decision is important not only because of the need to maximize returns, but also because
of the impact such a decision has on an organization’s ability to deal with its competitive
environment. The tax deductibility of interest provides the opportunity to add to company
value by employing the correct amount of debt relative to equity. Consequently, the use
of debt is logical if interest is tax deductible and GPLC need to expect to realize the
benefit of that deduction. The higher the corporate tax rate GPLC must go on, the greater
the value of issuing debt.
The purpose of investment appraisal is to assess the forecast of a proposed
investment project. It is a method for calculating the expected return based on cash flow
forecasts of many, often inter-related, project variables. Risk emanates from the
uncertainty around GPLC projected variables. The evaluation of project risk therefore
depends, on the one hand, on the ability to identify and understand the nature of
uncertainty surrounding the key project variables.
The dividend policy such as the payment of dividend affects the market price of
share. If there is a debate in this issue, this theory is commonly accepted. WACC enters
the picture only to assess the impact of a new project on firm value, once it has been
accepted, and when a fixed debt ratio policy is in place.
13
6.0 Appendix
Appendix 1
Example: Payback Period
Dell is deciding between two machines, Machine A and Machine B in order to add
capacity to its existing plant. The company estimates the cash flows for each machine to
be as follows:
Year Machine A (RM) Machine B(RM)
0 (5,000) (2,000)
1 500 500
2 1,000 1,500
3 1,000 1,500
4 1,500 1,500
5 2,500 1,500
Answer:
First it would be helpful to determine cumulative cash flow for the machine project A.
This is done in the following table:
Year Cash Flow (RM) Cumulative Cash Flow
(RM)
0 (5,000) (5,000)
1 500 (4,500)
2 1,000 (3,500)
3 1,000 (2,500)
4 1,500 (1,000)
14
5 2,500 1,500
Payback period for Machine A = 4 years +
= 4 years 5 months
Answer:
First it would be helpful to determine cumulative cash flow for the machine project B.
This is done in the following table:
Year Cash Flow (RM) Cumulative Cash Flow
(RM)
0 (2,000) (2,000)
1 500 (1,500)
2 1,500 0
3 1,500 1,500
4 1,500 3,000
5 1,500 4,500
Payback period for Machine B = 1 year +
= 1 years 12 months
Machine B should be accepted because the machine has a fastest return compare
to Machine A.
15
Appendix 2
Example: Accounting Rate of Return (ARR)
A company wants to buy a new item of equipment. Two models of equipment are
available, one with a little high power and better consistency than the other. The expected
costs and profits of each item are as below. The average annual profit should be
calculated after depreciation. It required deciding which equipment should be selected if
the company’s target accounting rate of return (ARR) is 25%.
Equipment item X (RM) Equipment item Y (RM)
Capital cost 90,000 160,000
Estimated Useful Life 5 years 5 years
Profit before depreciation
Year 1 50,000 50,000
Year 2 50,000 50,000
Year 3 30,000 60,000
Year 4 20,000 60,000
Year 5 10,000 60,000
Estimated disposal value Nil Nil
Answer: First it would be helpful to determine the four steps which are depreciation,
average annual profit, average investment and finally calculate accounting rate of return
(ARR) for Equipment item X.
Step 1: Calculate Depreciation
Depreciation =
=
16
= RM 18,000 per annum
Step 2: Calculate Average Annual Profit
Year Cash Flow (RM) Profit (RM)
1 50,000 32,000
2 50,000 32,000
3 30,000 12,000
4 20,000 2,000
5 10,000 (8,000)
Total 70,000
Average Annual Profit =
= RM 14,000 per annum
Step 3: Calculate Average Investment
Average Investment =
=
RM 45,000
Step 4: Calculate Accounting Rate of Return (ARR)
Accounting Rate of Return (ARR) =
=
= 31 %
17
Answer: First it would be helpful to determine the four steps which are depreciation,
average annual profit, average investment and finally calculate accounting rate of return
(ARR) for Equipment item Y.
Step 1: Calculate Depreciation
Depreciation =
=
= RM 32,000 per annum
Step 2: Calculate Average Annual Profit
Year Cash Flow (RM) Profit (RM)
1 50,000 18,000
2 50,000 18,000
3 60,000 28,000
4 60,000 28,000
5 60,000 28,000
Total 120,000
Average Annual Profit =
= RM 24,000 per annum
18
Step 3: Calculate Average Investment
Average Investment =
=
RM 80,000
Step 4: Calculate Accounting Rate of Return (ARR)
Accounting Rate of Return (ARR) =
=
= 30 %
The company can choose both equipment items because the both equipment X
and Y is above the company’s required return. However, equipment X is better.
19
Appendix 3
Example: Net Present Value (NPV)
ABC Plc has a cost of capital of 15% and is considering a capital investment project,
where the estimated cash flows are as follows:
Year Cash Flow (RM)
0 (now) (110,000)
1 70,000
2 90,000
3 50,000
4 40,000
Calculate the NPV of the project and assess whether it should be undertaken.
Answer: Initial it would be helpful to determine discounted cash flow. This is done in the
following table:
Year Cash Flow
(RM)
Discounted Factor
(15%)
Discounted Cash
Flow (RM)
0 (110,000) 1.000 (110,000)
1 70,000 0.870 60,900
2 90,000 0.756 68,040
3 50,000 0.658 32,900
4 40,000 0.572 22,880
Total 74,720
The net present value (NPV) of cash inflows exceeds the NPV of cash outflows by RM
74,720, which means that the project will earn a discounted cash flow (DCF) yield in
excess of 15%. So, it should therefore be undertaken.
20
Appendix 4
Example: Internal Rate of Return (IRR)
Bee plc is trying to decide whether to buy a machine for RM 90,000 which will save
costs of RM30,000 per annum for five years and which will have a resale value of RM10,
000 at the end of year 5. If it is the company's policy to undertake projects only if they
are expected to yield a DCF return of 10% or more, ascertain using the IRR method
whether this project should be undertaken.
Answer:
Year Cash Flow
(RM)
Discount
Factor
(10%)
Discounted
Cash Flow
Discount
Factor
(20%)
Discounted
Cash Flow
0 (90,000) 1.00 (90,000) 1.00 (90,000)
1 30,000 0.91 27,300 0.83 24,900
2 30,000 0.83 24,900 0.69 20,700
3 30,000 0.75 22,500 0.58 17,400
4 30,000 0.68 20,400 0.48 14,400
5 40,000 0.62 24,800 0.40 12,000
Total 29,900 (600)
IRR = A +
= 10 % +
= 19.8 %
Appendix 5
21
Example: Weighted Average Cost (WACC)
1) Debt = 0% , Equity = 100%
WACC: (0% 8%) + (0.2 20%)
= 0 + 4
= 4%
2) Debt = 40% , Equity = 60%
WACC: (0.4% 8%) + (0.6 15%)
= 3.2 + 9
= 12.2%
3) Debt = 50% , Equity = 50%
WACC: (0.5% 8%) + (0.5 30%)
= 4 + 15
=19%
7.0 References
22
(tutor2u, Equity Finance, viewed on 6th December 2010)
(http://tutor2u.net/business/finance/finance_sources_equity_introduction.asp)
(Daniel Richards, Debt Financing, viewed on 6th December 2010)
(http://entrepreneurs.about.com/od/financing/a/debtfinancing.htm)
(Ventureline, Cost of Equity Definition, viewed on 6th December 2010)
(http://www.ventureline.com/accounting-glossary/C/cost-of-
equity-definition/)
(Premium Business Training, Working Capital, viewed on 28th December 2010)
(http://www.premiumbusinesstraining.com/working_capital.php)
(Daniel D., Linked in, Finance Accounting, viewed on 28th December 2010)
(http://www.linkedin.com/answers/finance-accounting/corporate-
debt/FIN_CDT/563069-55715560)
(Listedall, Articles-Modigliani Miller, viewed on 30th December 2010)(http://www.listedall.com/2009/05/modigliani-miller-approach-to-capital.html)
(Bobbyshan, December 25, 2010, Miller and Modigliani Theory, viewed on 30th
December 2010)
(http://articlesforte.com/finance/basic-finance/miller-and-modigliani-theory-
3776.html)
(AccountingForManagement.com, Payback Method, viewed on 30th December 2010)(http://www.accountingformanagement.com/
pay_back_method_of_capital_budgeting_decisions.htm)
(Pamela Peterson-Drake, Florida Atlantic University, viewed on 30th December 2010)(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf)
23