Working Capital Management in Business - Term Paper Example

? Financial Management Investment Appraisal Time 0 2 3 4 5 Sales ? 8,000,000 ?8,800,000?9,600,000 ?7,200,000 ?6,000,000 Variable costs ( ? 5,500,000) (?6,050,000) (?6,600,000) (?4,950,000) (?4,400,000) Contribution ?2,500,000 ?2,750,000 ?3,000,000 ?2,250,000 ?1,600,000 Relevant Fixed costs (?1,150,000) (?1,150,000) (?1,150,000) (?1,150,000) (?1,150,000) Capital Expenditure (?4,250,000) Scrap Value ?425,000 Working Capital (?900,000) (?450,000) ?1,350,000 Cash Flow (?5,150,000) ?900,000 ?1,600,000 ?1,850,000 ?1,100,000 ?2,225,000 Discount Factor @ 12% Cost of Capital 1.00 0.893 0.797 0.712 0.636 0.567 Present Value (?5,150,000) ?803,700 ?1,275,200 ?1,317,200 ?699,600 ?1,261,575 NPV ?207,275 NPV:-?5,150,000 + ?803,700 + ?1,275,200 + ?1,317,200 + ?699,600 + ?1,261,575 = ?207,275 The Net Present Value of a company is the value of a future number in terms of today. It basically helps in finding out a project’s is profitability. It requires finding out the present value of each future cash flow discounted at a specific value, which is the cost of capital of the project given in the form of a percentage. It uses the concept of discounted cash flows. Time Cash Flow (?5,150,000) ?900,000 ?1,600,000 ?1,850,000 ?1,100,000 ?2,225,000 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Cash Flow (?5,150,000) ?900,000 ?1,600,000 ?1,850,000 ?1,100,000 ?2,225,000 Discount Factor @ 14% Cost of Capital 1.00 0.877 0.769 0.675 0.592 0.519 Present Value (?5,150,000) ?789,300 ?1,230,400 ?1,248,750 ?651,200 ?1,154,775 NPV (?75,575) NPV = -?5,150,000 + ?789,300 + ?1,230,400 + ?1,248,750 + ?651,200 + ?1,154,775 NPV = (?75,575) Payback Payback = 4,250,000 – 900,000 (Yr 1) – 1,600,000 (Yr 2) = 1750000 ? 1,850,000 (Yr 3) * 12 Payback = 2 Years and 11 months This is a technique used to measure the feasibility of projects in terms of the number of years that it takes to pay back an initial investment. It is measured in number of years till full recovery and the following formula can be used to measure it. Payback = No. of years prior to full recovery + Unrecovered cost at beginning of year/Cash flow during full recovery year. Payback basically represents the period of time during which the initial investment gets recovered. IRR: To calculate IRR, a negative NPV would be calculated. Hence a discount factor of 14% is selected. IRR = LDR + [PV1/PV1-PV2]* (HDR-LDR) LDR = Lower Discount Rate HDR = Higher Discount Rate Pv1 = Present Value at Lower Rate of Return Pv2= Present Value at Higher Rate of Return IRR = 12% + [207,275/ 207,275 – (-75,575) * (14% - 12%)] IRR = 13.46% IRR is the value where the NPV is equal to zero. It is the optimal value where a project is most beneficial. IRR can gauge the profitability of a proposed investment by taking into consideration the concept of discounted cash flows. IRR is not very easy to be calculated as any other accounting measure such as NPV and if done then it does not give accurate answers. It is done on a trial and error. b) Provide a rationale for your treatment of initial research, depreciation and working capital, supporting your answer with links to theory briefly indicate other considerations which might also affect the decision Initial research would not be included within the Net Present Value (NPV) calculation. This is because the initial research cost had already been incurred before starting the project hence the cost was deemed to be a sunk cost. Sunk costs are not to be included within the NPV calculation because these costs have already been incurred and that do not affect the decision of either commencing or aborting any business plan. Depreciation costs do not get included within the calculation of NPV. This is because depreciation is a non-cash item and the NPV purely constitutes cash related items with respect to the time value of money. Although depreciation expense is only included within the NPV calculation in order to ascertain the Tax savings. The tax savings on allowances allowed by the tax authorities are only included within the NPV calculations (ACCA, 2009; Arnold, 2008). Working capital requirements are basically the funds that are required in order to fund a particular project over a given period of time. These requirements are generally short-term requirements i.e. funds required to run day-to-day operations. The basic assumption with working capital requirement is that it is shown as a positive figure at the end of the project assuming that all the working capital expense would be recovered at the end of the project’s life (ACCA, 2009). Scrap Value is always assumed to be recovered at the end of the project’s life i.e. when the asset is disposed off. Q2. a) Evaluate both of the financing options discussed by the Board, to issue shares or to borrow to finance potential investment projects. Your answer should include comments on the impact of both options on the gearing and capital structure of the company. The two options that the company has for raising capital are equity and debt. Both these options have their own advantages and disadvantages that affect the capital structure and gearing of the company. If the company wishes to raise funds by equity financing, the main advantages of it are that it does not have to be repaid like debt. The company does not owe payments of any sort to anyone except the dividends that may be demanded by the shareholders which in return may be reinvested in the company. Another advantage of equity financing is that it does not make the balance sheet seem to be in a bad position because it does not affect on the gearing of the company. A highly geared company is considered to be risky in terms of investment. However the main disadvantage of equity financing is that those who invest money into the company become part owners of the company and demand rights from the company. If someone buys more than a certain amount of shares in a company he has increased decision making rights and can intervene into the company. This leads to a problem known as the agency problem which is the difference of interest between the equity holders and the managers who have separate interests. This negatively affects the working of the company and can create many problems (ACCA, 2009). On the other hand, debt too has its own advantages and disadvantages. The main benefit of debt is that it can be taken for a short term and the effects can be removed when it is paid off. It does not permanently give anyone the rights to intervene in the business. The main disadvantage of using debts as a source of finance however is that it disturbs the cash flows of a business and it also has a negative impact on the gearing of the company, if it is highly indebted, its share price may fall to a great extent and people may not want to invest in the business either. It will also disturb the company’s working capital and the company will need to be able to pay off liabilities and make sure its asset turnover ratio is greater than 1. It depends on whether the company has enough funds and can afford to pay off a loan in time, to pay its principal amount along with interest payments each year. The company would know better whether it can afford to have intervention from shareholders and whether it would affect the operations of the company. Generally it is advised that if a company wants to get saved from paying huge taxes, it should take a loan as it does not account for in the company’s wealth. If a company has a high equity it will have to pay higher taxes (Arnold, 2008). b) In response to questions from various members of the Board, advise on the use of Discounted Pay Back, and Risk Adjusted Discount Rates as part of risk management, Provide calculations to support your answer assuming that Reclaim & Re-use PLC increases its discount factor by 3% when assessing risky projects. Discounted Payback is a method through which a company ascertains the time period during which the company would be able to recover its initial investment from the new cash flows that arise as a result of the operations. The payback period hence is criticized for ignoring the time value of money i.e. the total worth of money after a particular period of time (Arnold, 2008). Besides this, the other issue with the Payback period is that it only focuses on the recovery of the initial investment thus ignoring the benefits and cash inflows after the payback period and not measuring profitability. Risk adjusted discount rates, though are purely subjective because of their calculations and the amount of judgment required in its calculation. But the main advantage of this method is that it considers the time value of money by incorporating that within the discount factor calculated. The more the time, the lesser the value of the money recovered. The discount rates calculated, also consider the risk element, higher the risk, higher would the cost of capital i.e. the amount required by the investor (ACCA, 2009). Risk adjusted discounts rate is a very accurate and realistic measure. It involves the addition of a risk premium to the risk free rate of return on an investment that is risky. It helps calculate the rate of return on an investment that is risky. Risk adjusted discount rate = Risk Free Rate + Risk Premium (Brigham & Ehrhardt, 2010; Arnold, 2008). With an increase in the discount factor by 3%, the discount factor would be 15%. Hence the NPV for a 15% discount factor would be as follows: Time Cash Flow Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Cash Flow (?5,150,000) ?900,000 ?1,600,000 ?1,850,000 ?1,100,000 ?2,225,000 Discount Factor @ 15% 1 0.870 0.756 0.658 0.572 0.497 Discounted Cash Flow (?5,150,000) ?783,000 ?1,209,600 ?1,217,300 ?629,200 ?1,105,825 NPV (?205,075) NPV = -?5,150,000 + ?783,000 + ?1,209,600 + ?1,217,300 + ?629,200 + ?1,105,825 NPV = (?205,075) QUESTION 3 a) Evaluate the importance of Working Capital Management to all business especially in the present economic climate, supporting your answer with examples. Working capital refers to the liquidity of a business which is the ease with which a company can pay off its liabilities and the time it takes to convert assets into cash. Working capital is calculated as current assets – current liabilities and is an important phenomenon in a company’s day to day operations. A positive working capital helps to make sure that a company does not have problems of cash flows. If a company has a working capital or current ratio of 1:1, it means that the company is in stable position where it can pay off one dollar of its debt for each dollar that it possesses. Working capital management is therefore compulsory for a business in order to make sure its operations run smoothly and effectively. Working capital constitutes of inventory or stock, cash drawer and debtors. It also includes any kind of accounts receivable that the company is to receive within a span of one year. The liabilities include whatever the company owes to people. This includes creditors and any interest payments that are to be paid within a year. The working capital represents assets and liabilities which are due within a year. In today’s economic climate where work in for instance technology industries is very rapid and in this tough competition where there is neck to neck competition, the basis of war is the quick and timely response of companies towards changes in the environment. b) Appraise the need for Treasury Management in global and international business entities. Treasury Management is a very significant concept in the world of Finance as it involves the management of cash, bonds, reserves, investments as well as funds of a business. Treasury Management has become an increasingly important phenomenon in recent years because firms like to keep reserves of not only cash but they like to retain their liquidity in the forms of bonds etc. as well. They need to make sure they have management as well as contingency reserves in order to maintain its operational activities. Treasury management is a mitigation of risk to avoid shortage of cash. It involves liquidity management, financial risk management and banking management (Madura, 2010) and (Brigham, 2010). Q4, “Occasionally financial and other assets go through periods of boom and bust. There are explosive upward movements generating unsustainable prices, which may persist for many years, followed by a crash. These bubbles seem at odds with the theory of efficient markets because prices are not supposed to deviate markedly from fundamental value.” REQUIRED Evaluate recent developments in the financial markets The above diagram shows a cycle of the financial markets. When there is optimism and stability in a country it leads to growth in financial markets. When it reaches its peak the financial market is at its maximum point in terms of market wellness. However this boom situation is temporary and has to reach a point in equilibrium. Hence ultimately the market starts to decline due to reasons such as inflation or high risks and the issues of supply and demand. Where demand increases, price also increases and when price increases demand falls hence supply rises, reaching a state of equilibrium again. This state then leads to a decline and a market trough is seen where the financial market is in a bust. The current state of the financial market is a recovery from financial crisis which occurred just a few years back. The recent issues in financial markets are those of credit quality, risk of investment and liquidity risk as people are not investing as much as they do in a boom (Brigham & Ehrhardt, 2008; Davidson, 2002; Arnold, 2008). Bibliography ASSOCIATION OF CHARTERED CERTIFIED ACCOUNTANTS (GREAT BRITAIN). (2009). Financial management. Wokingham, Berkshire, Kaplan Pub. ARNOLD, G. (2008), Corporate Financial Management, 4th Edition, Harlow, Pearson Education Limited. p585. BRIGHAM, E. And EHRHARDT, M. 2010. Financial Management Theory and Practice. United States of America: Cengage Learning BRIGHAM, E. And EHRHARDT, M. 2008. Corporate Finance. A focused Approach. United States of America: Cengage Learning DAVIDSON, P. 2002. Financial Markets, Money, and the Real World.;Montpellier. Edward Elgar Publishing limited. HASHEMIA, R. 2010. Financial Markets for the Rest of Us: An Easy Guide to Money, Bonds, Futures. United States. Writer’s club press. MADURA, J. 2010. Financial Markets and Institutions United States: Cengage Learning. Read More