Advantages of Limited Company - Essay Example

? Barcolenatta Ltd. Table of Contents Advantages of Limited Company 3 Types of Source of Finance 3 Recommendation for Additional Financing 7 Effects of Additional Financing 8 Weighted Average Cost of Capital 9 Payback Period 10 Net Present Value 11 Unit Cost 12 Cash Flow Trends 13 Cash Flow Statement 14 Liquidity 15 Reference List 16 Barcolenatta Ltd. 1a Advantages of Limited Company By forming a limited company, shareholders are at low level of risk of losing their money as compared to sole proprietorship and partnership. Under limited liability setup shareholders become liable for the invested amount that they have placed in the business and their personal holdings / assets are not subjected to liquidation in case of bankruptcy. On the other hand, sole proprietorship and partnerships have unlimited liability for shareholders. Although, it is easier to set up sole proprietorship or partnership as compared to the limited company, but limited companies have better access to external markets for funding and business opportunities. This implies that there is a separation of the business and individuals holding interests in the company. This type also has the advantage of being able to raise large amounts of funds from external sources. Also, the business is managed by a group of professional directors who have the experience and knowledge to operate different affairs of the business (Bendrey, Hussey, & West, 2004). In addition, only those profits, which are taken out from the limited company’s accounts are taxed as compared. Whereas, the entire profit of sole proprietorship is taxed. 1b Types of Source of Finance Types of Finance Definition Advantages Disadvantages Short Term Finance Trade Credit Credit obtained by business for inventory and receivables management. It is less costly. It is easier to arrange. It does not require security. It is difficult to arrange large amounts. It is only trade related. Factoring Sale of receivables for cash in advance. It allows transfer of risk associated with credit sales. It frees up cash of businesses tied up in receivables. It is highly costly. It is not available to all kinds of industries. It involves complicated legal terms. Bank Overdrafts Short term borrowing from banks. It is not fixed for a specific period of time. It is suitable for businesses requiring finance occasionally. It is less costly for large companies. It is difficult to manage in periods of high interest rate volatility. It requires personal guarantees from owners or directors of the company. Medium Term Finance Loans Medium term borrowing from banks. It is for specific period of time and less fluctuation in interest payments. It allows businesses to ascertain the cost of finance in advance. It allows businesses to negotiate terms of repayment according to their projections. It is faster to arrange such loans. It is costlier as compared to overdrafts. It can affect creditworthiness of the business if fails to meet loan obligations. Lease Obtaining the right of use of asset without purchasing them. Allows a business or individual to preserve liquid assets. Fixed repayments are required and the lender can not cancel the agreement on its own. It is difficult to arrange. It is difficult to record and report leases. It may not be possible to acquire all types of assets on lease. Long Term Finance Debt Finance Long term borrowing from banks or other finance providing companies. It allows access to larger pool of funds. It allows to upgrade equipment and machinery on regular basis. It requires security. It involves high interest charge due to its long-term nature. It is difficult to obtain loan for assets other than property in some countries. The accessibility to this type of finance depends upon assessment of creditworthiness of companies. It is finance against future profits of the business and can therefore restrict utilization of internal funds for business growth. Debentures and Loan Stock By issuing debt instrument in the secondary market. It is difficult for small companies to issue debentures. It requires expertise and separate team for managing them. They are more secured as compared to subscribing to the company’s shares therefore they may attract greater investment. The price may fluctuate according to the market conditions. Poor rating of the company can affect the price of debentures issued by the company. Equity Finance (Limited Companies) By issuing ordinary shares in the capital market. It allows access to a large pool of investors. It allows access to large funds. It allows sharing of risks and liabilities with investors. It allows low debt to equity ratio improving accessibility to future finance. It is very costly to arrange. It implies sharing of ownership and decision-making. It may result in distribution of profits in amounts larger than the required amount against a loan. Source: (Berry, Jarvis, & Jarvis, 2005) 1c Recommendation for Additional Financing Based on the financial statements of Barcolenatta Ltd., it is recommended for the company to raise additional funds through short-term borrowing. Additional equity finance is not possible for the company, as it does not have sufficient retained earnings to finance the additional funding requirement. The company can apply for short term borrowing from banks to finance its additional requirement depending upon the expected returns from the new investment and its ability to pay of off its short-term borrowing. The company will be able to acquire this additional financing more quickly and can benefit from low interest charge for the loan. The company can expect to generate higher revenues and profit before interest and tax to meet its repayment and interest obligations. This will not affect the company’s solvency position, which is measured by banks using the debt to equity ratio of the company. Moreover, long-term borrowing may be difficult for the company, as its current solvency position determined by the debt to equity ratio is weak. The ratio value is greater than 1 and the debt issuers (i.e. banks) may consider this against the creditworthiness of the company. This could also result in high interest charge for the company placed by the issuer of the debt finance. Moreover, by issuing new shares the company will have to face dilution of the ownership of the existing owners. 1d Effects of Additional Financing If the company decides to acquire the additional funding with half being equity and half debt then we can expected both liabilities and equity position of the company to be altered. This is based on the accounting equation, which implies that the company’s assets side is equal to its total liabilities and equity. The company does not have sufficient equity therefore it has to raise equity from new share issue. Moreover, by acquiring additional debt the company’s long term borrowing will increased, which will affect the solvency position of the company. The extract of the company’s balance sheet presented below shows how this additional finance will affect the company’s financial position. This is prepared on the financial position of Barcolenatta Ltd. In 2012 and additional GBP 1,000,000 is equally added to both long-term borrowings and equity of the company. 2012 Additional Funding Long Term Borrowings 550 1,050 Share Capital 1400 1,900 Long Term Borrowings + Share Capital 1,950 2,950 The table above indicates that the addition in the company’s assets will be offset by increase in both long-term liabilities and share capital of the company. 2a Weighted Average Cost of Capital Weighted Average Cost of Capital (WACC) is the cost of raising capital for new investment projects. In other words, WACC is “the marginal cost of a composite dollar of dent and equity” (Hirschey, 2009). Depending upon the capital structure of the company, it can estimate the cost of raising funds for its new projects. The optimal capital structure is therefore which minimizes the weighted average cost of capital. In simple terms it is calculated as the average after tax cost of all types of source of finance that a company has access to in order to finance its funding requirements. These sources include debt, preferred stock, and equity. Based on this explanation, the following formula can be used to estimate the WACC of a company. WACC = [% of Debt][After Tax Cost of Debt] + [% of Preferred Stock][Cost of Preferred Stock] + [% of Common Equity][Cost of Common Equity] (Brigham & Ehrhardt, 2011) Different methods can be deployed to estimate cost of each source of finance to be used for calculating WACC (Hirschey, 2009). As per the provided information for Barcolenatta Ltd, its WACC can be calculated as follows: WACC Re 8% Rd 8% T (Projected 2013) 88% K/(K+D) 0.5 D/(K+D) 0.5 WACC K/(K+D) x Re + D/(K+D) x Rd x (1-T) WACC 4.46% Where Re = Cost of Equity Rd = Cost of Debt K+D = V = Value of Firm From the above table, the company’s WACC is estimated at 4.46%, which can be used for discounting cash flows from the new capital investment that the company is planning to undertake. 2b Payback Period 1 Years Cash Flow = 350+400=750 Balance Amount = 1,000 – 750 = 250 Balance Period = 250/600 = 0.42 Payback Period = 2.42 Years The payback period determined here suggests that the company will be able to recover the initial investment in less than 3 years. For a company to make such recovery in this short period of time is a good sign that it should consider investing in the new project. However, this method of estimating payback period is quite simple and does not take into account the time value of future cash flows. For this purpose, discounted cash flows can be used for determining the discounted payback period as follows: 2 Years Discounted Cash Flow = 332.50 + 366.55 = 701.60 Balance Amount = 1,000 – 701.60 = 298.40 Balance Period = 298.40 / 526.33 = 0.57 Discounted Payback Period = 2.57 Years There is a slight increase in the payback period of the new project based on the discounted payback period method. Net Present Value Net Present Value (NPV) is calculated using WACC of 5.54% for discounting next five years’ cash flows. The calculations are illustrated in the following table; Year 0 1 2 3 4 5 Inflows   950 1,000 1,200 1,400 1,500 Outflow 1,000 600 600 600 600 600 Net Cash Flow (1,000) 350 400 600 800 900               WACC 4.46%           Discount Factor 1.0000 0.9573 0.9164 0.8772 0.8397 0.8039 PV of Cash Flow (1,000.00) 335.05 366.55 526.33 671.80 723.48 Net Present Value 1,623.21           From the above table, it can be indicated that the NPV of the new investment is positive. This is supporting payback period estimation in the previous section as the company is expecting positive net cash flows from the new investment over the next five years. Based on this estimation, it is recommended that Barcolenatta Ltd. must go ahead with the investment in order to yield positive results for its business. The use of NPV is most common in order to determine the feasibility of the new investment decisions that business have. However, it has been argued that this traditional method of capital investment appraisal considers businesses to hold their assets passively. This method does not take into account the possibilities of changes in the whole business scenario or some factors, which can affect the outcome of the new investment. For this purpose, it is suggested that value of real options are added to the NPV derived for the new project (Schwartz & Trigeorgis, 2004). 2c Unit Cost Unit cost is the cost of producing, storing and selling one unit of a product manufactured by a company. There are different methods that can be used for costing of one unit depending on the type of processes involved in the manufacturing and also based on the type of business. These methods include (1) job costing which allows costing according to the job performed for the completion of the product. This type is further categorized into (a) contract costing (b) cost plus contract and (c) batch costing. (2) Process costing which is suitable for continuous production. This type is further categorized into (a) operation costing (b) operating costing (c) output costing (d) multiple costing. There are different techniques, which can be used for costing under these methods including (a) historical costing (b) absorption costing (c) marginal costing (d) uniform costing and (e) standard costing (Schwartz & Trigeorgis, 2004). Barcolenatta Ltd should consider various factors and processes, which are involved for its new outlet. For this absorption costing is preferred which takes into account variable costs and overheads and also distributes fixed cost and overheads to a single unit of product distributed. 3a Cash Flow Trends The projections made for cash flow over a period of 6 months indicate that Month 3 and Month 6 will have greater variations in sales and net receipts/expenses. This suggests volatility in sales every three months. Expenses as shown in the graph below do not reflect as much variations as compared to the company’s sales and therefore, it can be inferred that the variation in net receipts/expenses is due to that in the company’s sales. 3b Cash Flow Statement Different groups may be interested in the company’s cash flow statements and use the information provided in the cash flow statements to evaluate a business from different perspectives. These groups include (1) potential investors who are interested in the financial soundness of the company (2) potential lenders / creditors who are interested in evaluating the business’ ability to payback from its cash (3) potential employees and other personnel who are interested in estimating whether the company will be able to cover their payroll and other expenses. A company, which is generating profits, can still have liquidity problems assessed by its ability to finance its day-to-day business requirements. There are several reasons for this condition including the company is making high volume of sales on credit and its cash is tied up in receivables which is not allowing the company to pay its suppliers. Revenues are recorded in the company’s income statement when they are earned not when cash is received for them. Therefore, profit reported does not mean that the company has received cash for its funding requirements. In order to meet its finance needs the company makes short term borrowing, which further weakens its liquidity position (Berry, Jarvis, & Jarvis, 2005). 3c Liquidity The company’s liquidity position is quite weak. It has improved since 2011 as indicated by two important ratios used for this purpose including the current ratio and quick ratio. The following table shows calculations performed for each ratio. 2013 Budgeted 2012 2011 Current Ratio 82/183 0.45 56/88 0.64 43/91 0.47 Quick Ratio (82-17)/183 0.36 (56-15)/88 0.47 (43-10)/91 0.36 The improvement in the ratio values is mainly due increase in the company’s receivables over the year which are also expected to increase as per the projected balance sheet. But this could be of concern as well as the company makes more credit sales and its cash can get tied up if cash is not received for these sales. The obvious reason for both ratios to have low values i.e. less than 1 is that the company’s current liabilities are greater than its current assets. Particularly, the company has high value of trade payables, which is the credit allowed by its suppliers. The quick ratio, which does not take into account the company’s inventory value, reasserts that the company has liquidity issues and it must take certain steps to reduce its current liabilities. Profitability The profitability position of the company also remains weak in 2011 and 2012. On the basis of two useful ratios including net profit margin and return on equity, it can be stated that the company has not able to generate reasonable profit from its operations and it is delivery very low return on shareholders investment in the business.   2013 Budgeted 2012 2011 Net Profit Margin 11/2,750 0.40% 13/2,000 0.65% 10/1,500 0.67% Return on Equity 11/1,446 0.76% 13/1,443 0.90% 10/421 2.38% There is a slight decline in the net profit margin in 2012 and it is further expected to decrease as per budgeted 2013 figures, which are based on the new investment plan that the company is considering, the profitability position is indicated to become worse. This is mainly due to high administrative, selling and other expenses that the company expects to incur in the projected year. Similarly, ROE also indicates declining performance of the company despite of the cash injected in 2012 through issue of new shares. Reference List Schwartz, ?. S., & Trigeorgis, L. (2004). Real Options and Investment Under Uncertainty: Classical Readings and Recent Contributions. Massacheusts: The MIT Press. Bendrey, M., Hussey, R., & West, C. (2004). Essentials of Financial Accounting in Business. Mason: Cengage Learning EMEA. Berry, A., Jarvis, P., & Jarvis, R. (2005). Accounting in a Business Context. Mason: Cengage Learning EMEA. . Brigham, E. F., & Ehrhardt, M. C. (2011). Financial Management: Theory and Practice. Mason: Cengage Learning. Hirschey, M. (2009). Managerial Economics . Mason: Cengage Learning. Read More