UK Tax System - Assignment Example

UK Tax System Over-trading Over-trading happens when there is an imbalance between the orders which a company takes to fulfill and the capacity of it which it can bear. Following are some of the dangers that can arise due to over-trading: Borrow money in order to satisfy the flow of over-trading: To tackle this hurdle, the company should design a plan to delay payments, collect receivables as efficiently as possible and also keep a certain balance and limit to be financed through bank overdraft (Bytestart Ltd. 2011). Profit margins are small: Higher expenditure and lower selling prices will lead to a lesser bottom-line and so lower dividend payments. This problem can be overcome by working efficiently and effectively to generate high sales and stand up competitively by not lowering the prices of goods. Late payments from customers will seriously influence the cash flow: In this case credit terms should be discussed before hand with customers and be kept strict so as to make inflows earliest. Key supplier (s) will gradually be dissatisfied: If payment problems to suppliers arise due to the expansion or new orders being taken, suppliers will be alarmed and dissatisfied with the company. To cure this problem, the company should beforehand discuss the situation with the suppliers and the credit terms should be precisely conveyed so as to prevent future problems. (a) There are a number of short-term finances available to the company to finance its proposed expansion; two of them are discussed as follows: Bank Loan, and Bank Overdraft Bank Loan: In the case of this company, bank loan pertains to the short-term period usually equal to or less than a year. The bank according to the credit rating lends the company a certain amount of loan needed and on an interest rate negotiated. Strengths: Amount will be received on one-time basis and the payment will be done in monthly, quarterly or semi annually installments Cost of borrowing is lower than other means such as Bank Overdraft Interest rates are low Reliability and security is always there in terms of getting the money from the bank on time and for a certain period of time contracted upon with the bank Weaknesses: The loan will be secured against the company’s assets The riskier the business is, the higher the interest rate the bank will charge to cover up its risk Arrangement fees as well as repayment fees will have to be paid In case of early repayment of loan, an extra charge will have to be paid Bank Overdraft: It is a kind of loan arrangement under which a bank extends credit allotted to a company up to a maximum amount called the overdraft limit against which a customer or company who has current or checking account with the bank can write checks or make withdrawals (Business Dictionary 2011). Strengths: Appropriate for short-term financing Not secured against any asset of the company so the process of obtaining the loan Is expedited Only charged for the amount overdrawn from the bank account and also pertaining only to the period of time the overdraft facility had been used by the company Weaknesses: The bank overdraft amount has to be paid on demand of the bank. This puts the company under a great risk in the case when the bank decides to request the money back at an inconvenient time for the business High interest rate is charged (b) Capital Gearing Ratio This ratio tells us that how much risky the company is in terms of financial risk and it is used by companies as well as its shareholders to analyze the company’s capital structure and leverage (Accounting for Management 2011). Its formula of calculation is as follows: Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds If the company has a high gearing or high leverage, it will be more prone and vulnerable to downward fluctuations in the business cycle because the company will have to continue to service its debt (payment of interest and principal) regardless of how poor sales and operations are. On the other hand, a low gearing ratio that is a higher faction of equity induces a cushion and is depicted as a measure of financial strength. Section Two: Finance as a Resource (a) Weighted Average Cost of Capital (WACC) The Weighted Average Cost of Capital or WACC is the cost of capital (depicted in percentage) for any investment that the shareholders perceive to receive if they would utilize or invest their money elsewhere; also called the opportunity cost (Mc-Graw Hill 2007). The formula for computing WACC is as follows: WACC = wd * kd * (1-t) + we * ke Where, Wd = the weight age or proportion of debt financing in the total value of the company’s capital structure. This is computed as follows: Wd = D / V, where D = Market Value of Debt, E = Market Value of Equity and V = Total Market Value of the company Kd = the cost of debt t = the corporate tax We = the weight age or proportion of equity financing in the total value of the company’s capital structure. This is calculated as follows: Wd = E / V Ke = the cost of equity Calculation of the existing WACC of the company WACC = wd * kd * (1-t) + we * ke V = D + E = £1,000,000 + (2,000,000 * £2) = £1,000,000 + £4,000,000 = £5,000,000 Wd = £1,000,000 / £5,000,000 = 20% We = £4,000,000 / £5,000,000 = 80% t = 0% kd = 4% ke = 6% WACC = {[0.20 * 4% * (1 – 0%)] + (0.80 * 6%)} WACC = 0.80% + 4.8% WACC = 5.6% The Weighted Average Cost of Capital (WACC) of the company turns out to be 5.6% so the company must earn a Return on Invested Capital (ROIC) of more than 5.6%. (b) UK Tax System Note: I think this part of the section two has an error in it; it should be about adopting a relatively low instead of a high gearing ratio. The UK tax system might encourage the company to adopt a relatively lower gearing ratio so as to increase its investments and experience growth. This will be attained in the manner that the lower the gearing ratio the lesser interest the company has to pay on its Loan Capital, however this will escalate the amount of corporation tax to be paid as the Profit Before Tax will be higher this time. This means that the Net Income will be higher so will the Dividend Payout be resulting in higher Retained Earnings for the company. This will create a conducive environment for the company to reinvest its Retained Earnings and mark its growth. (c) When talking about making financial decisions, the concept and implication of Opportunity Cost is considered imperative. The Opportunity Cost pertains to the value of an alternative decision that has been foregone so as to go for a particular course of action. In the case of the company, its opportunity cost will be the value of other alternative projects or orders that it would have gone for and which it has sacrificed. Profiting from other projects that have been foregone is the opportunity cost for the company. (d) (i) Appendix A – Cash Flow Forecast for January – June 2011 Jan (£000) Feb (£000) Mar (£000) April (£000) May (£000) June (£000) Sales 750 1150 1380 1460 1890 2139 PAYMENTS Wages and salaries 430 430 430 640 640 640 Supplies 160 460 540 540 540 880 Rent and rates 170 170 170 340 340 340 Advertising 50 50 50 50 50 50 Miscellaneous 100 100 100 150 150 150 TOTAL 910 1,210 1,290 1,720 1,720 2,060 Receipts minus payments (160) (60) 90 (260) 170 79 Balance brought forward 750 590 530 620 360 530 Balance carried forward 590 530 620 360 530 609 The balance carried forward for the month of June, 2011 will be £609,000. Implications of the Cash Flow Forecast: The ending balances are forecasted to reduce due to negative net receipts figures projected in the months of January, February and April, 2011 which is the month with the highest forecasted negative net receipts figure of £260,000. Wages and Salaries and Rent and Rates are projected to escalate from April, 2011 whereas the supplies show a rising trend and depict the highest figure (£880,000) in the last month concerned, June, 2011. (ii) The above cash flow forecast will be beneficial for the following groups of stakeholders of the company: Shareholders: Shareholders are always concerned of the company’s cash flow or liquidity position as this pertains to their right of receiving cash dividends. Banks: Bank is the key stakeholder keeping an eye on the company’s cash flow position. Banks analyze whether the company is in a fine position to repay their loans. Suppliers: Suppliers depend on the company’s ability to pay on time and in the case of taking a trade credit, early negotiations and arrangements should be done so as to prevent unforeseen cash shortages leading to supply cuts and ultimately in losing orders to competitors. Section Three: Financial Decisions Appendix B – Expected Cash Flows Year Cash Inflow (£000) Cash Outflow (£000) Net Cash Flows (£000) Cumulative Net Cash Flows (£000) 1 635 449 186 186 2 998 766 232 418 3 1,195 952 243 661 4 1,858 1,407 451 1,112 5 1,959 1,517 442 1,554 Anticipated Initial Capital Cost in Year 0 = £1,000,000 (a) Payback Period: Payback period is the amount of time required to cover up the initial or original investment for a project. The formula for its computation is as follows: Payback Period = Year before recovery of original investment + Uncovered cost at the beginning of the year / Net Cash Flow during the year Year before recovery = 3rd Uncovered cost at the beginning of the 4th year = £1,000,000 - £661,000 = £339,000 = £339,000 / £1,112,000 = 0.305 of the 4th year So the Payback Period is 3 years + 0.305 of the 4th year = 3 + 0.305 = 3.305 years or 3 years 3.66 months Accounting Rate of Return: The Accounting Rate of Return (ARR) takes into account the accounting income of the company and not the cash flows generated. The formula for computing ARR (in percentage form) of an investment is as follows: ARR = Average Profit / Average Investment Total Net Cash Flows = £1,554,000 Total Depreciation using Straight-Line Depreciation Depreciation Charge = (Cost – Salvage Value) / The economic life of the machinery (in years) Depreciation = (£1,000,000 – £0) / 5 = £200,000 Total Depreciation = £200,000 * 5 = £1,000,000 Total Profit = Total Net Cash Flow – Total Depreciation = £1,554,000 - £1,000,000 = £554,000 Average Profit = £554,000 / 5 = £110,800 Average Investment = (£1,000,000 + 0) / 5 years = £200,000 The Accounting Rate of Return on the proposed project = £110,800 / £200,000 = 55.4% (b) Payback Period Strengths: It takes into account the net cash flows of the company and not the accounting income or profit. The payback period is quite easy to use and interpret (Pietersz 2011). Weaknesses: The Payback Period does not consider the time value of money and the future cash flows which will arise after the payback period are ignored which does not give a complete picture of the project viability. Accounting Rate of Return (ARR) Strengths: The Accounting Rate of Return (ARR) takes into account average accounting profits and average investment on a project and gives the result in the form of a percentage. This enables the company to compare easily between projects. Weaknesses: The time value of money is not considered and cash flows are not used so the real analysis of the project is not possible. NPV (Net Present Value) vs IRR (Internal Rate of Return) NPV: NPV uses the discounting process to take out the present value of the future cash flows and subtract them with the initial outlay to come out to the final figure of NPV which depicts the viability of the project. Though the NPV is considered the most reliable technique in evaluating projects, it suffers the flaw of difficulty in comparability. As the NPV is an absolute figure and not a percentage, it alone is difficult to be used for comparison among projects. (Silber n.d.). IRR: The IRR calculates the rate of return at which the project will yield a zero NPV that is when the initial costs will be covered up and the project will break even. There are two main flaws in the IRR method, the Reinvestment assumption and the problem of Multiple IRRs. The IRR has an implied assumption that all cash flows will be reinvested throughout the life of the project using the IRR. This is not a rational assumption as the IRR of a viable project will always be greater than the WACC so reinvesting throughout the life of the project using a high rate of return is not realistic; it can occur for a couple of years but not for the complete tenor. Multiple IRRs arise when there is more than one investment on different times in the project; this will give two or more IRRs and comparing projects will be very cumbersome. The combination of both the above investment appraisal techniques will be a wise decision as used by most financial and investment managers in firms. (c) Pricing Techniques The setting of prices for customers is a strategic method used by companies. This varies from product to product and customer to customer. Some of the main factors that affect the pricing decisions are as follows: The product: The Product Life Cycle (PLC) gives a clear look of the product place in the market and about its pricing. For example, if the product is new and technologically advanced, it will likely be priced very expensive and the Porsche segment of customers will buy it first with the others waiting for the price to fall. Price Leadership Competition in the industry Brand Image Market Skimming Pricing Market Penetration Pricing Differential Pricing Price Sensitivity Quality Understanding customers, distinguishing from competitors and a price that ensures a profitable yield for the company are the factors taken into account while setting prices. The customer’s perception is that he or she is paying for the product and in turn getting value for it; this aspect must be considered by companies. The pricing strategy used for luxurious products or niche production is different from mass production and this goes side by side with the positioning of the product. (d) Unit Cost of Production in year 5 Unit cost of production in year 5 = (Cash Outflows in Year 5 + Annual Depreciation Charge) / No. of units Unit cost of production in year 5 = (£1,517,000 + £200,000) / 800 = £1,717,000 / 800 = £2,146.25 The cost of production per unit in year 5 will turn out to be £2,146.25. Section Four (a) Financial Statements – Balance Sheet and Profit and Loss Account Financial statements are the proofs of the financial performance of a company. They are legal documents developed to keep financial data of a company. Balance Sheet: This important statement summarizes a company’s assets, liabilities and shareholders’ equity at a particular point of time (a snapshot) normally at the end of a financial year (Accounting Coach 2011). Investors carefully analyze these three factions of the balance sheet so as to check what the company owns (assets), owes (liabilities) and what has been invested in the company (shareholders’ equity). The following equation is the basic phenomena observed in the Balance Sheet: Assets = Liabilities + Shareholders’ Equity (SHE). Profit and Loss Account or Income Statement: It shows whether a company has earned a profit or loss over a certain period of time (usually a year) that is the bottom-line. This is based on the company’s revenues and the costs involved in generating that revenue or sales. The basic formula for computing the bottom-line is as follows: Revenues – Costs = Profits or Bottom-Line (b) Format of Financial Statements and the Form of Organization The format of financial statements depends on the form of the organization. Keeping financial statements and publishing them are not mandatory for a sole trader or an unincorporated organization but if he or she decides to keep them, a format is not essential as it is just for the facility of the owner (RDI 2011). In the case of private and public limited companies, a particular format has been regulated by authorities under which the statements have to be developed. Publishing is mandatory for both types of companies. The annual report is the compiled form of all the financial information of a company and it is audited and checked by an external authorized auditing body to assure the accuracy of the documents and report in case of discrepancy. (c) Ratio Analysis: Profitability ratios include mainly the Net Profit Ratio, Gross Profit, Return on Assets (ROA) and Return on Equity (ROE) ratio. These ratios will assist in analyzing the company’s performance through trends and comparison. For example, if a company’s Net Profit Ratio is 7% while the industry averages waiver around 13%, this depicts that the company is not efficient in generating enough sales or in controlling costs that result in a lower bottom-line. In the case of ROE, the firm’s potential in earning profits on its investors’ wealth is analyzed and investors consider this ratio quite imperative (iSource biz 2011). (d) Book of Prime Entry: It is a chronological record of the transactions of a business according to the types of accounts such as sales, cash or debtors. Entries in a double-entry book keeping system are generated with the help of these books of account (Williamson 2003). Double-entry book keeping system: It is developed to record the same transaction as a debit to one account and as a credit to another. All asset, purchases and expense accounts have a natural debit balance whereas all liability, capital and sales accounts have natural credit balances and any increase or decrease goes in these respective directions (Knol Google 2011). Ledger: A ledger is a synchronization of account records used within a company. All the monetary transactions of debit and credit entries are recorded in this accounting book. Trial Balance: After the ledger has been made, all the balances from it are compiled and transferred into debit and credit columns in a Trial Balance which is a book-keeping worksheet designed periodically, usually at the end of every reporting period. References Accounting for Management, 2011, Capital Gearing Ratio: Definition and Explanation, viewed 28th October, 2011 Accounting Coach, 2011, Balance Sheet, viewed 28th October, 2011 < http://www.accountingcoach.com/online-accounting-course/05Xpg04.html> Bytestart Ltd., 2011, What are the dangers of overtrading? Viewed 28th October, 2011 Business Dictionary, 2011, Overdraft, viewed 28th October, 2011 Duncan Williamson, 2003, Books of Prime Entry, viewed 28th October, 2011 Greame Pietersz, 2011, Payback period, viewed 28th October, 2011 iSource biz, 2011, Financial Ratio Analysis, viewed 28th October, 2011 Knol Google, 2011, What is the double-entry bookkeeping system? Viewed 28th October, 2011 Mc-Graw Hill Higher Education, 2007, Opportunity Costs and the Time Value of Money, viewed 28th October, 2011 RDI, 2011, Different Legal forms, Module: Managing Financial Resources and Decisions, Unit: Sources of Finance, RDI Ltd., learning without boundaries. Toolkit Media Group, 2011, Trial Balance Worksheet, viewed 28th October, 2011 W. L. Silber, n.d., NPV Versus IRR, viewed 28th October, 2011 Read More