The Importance of Working Capital Management, the Use of Discounted Pay Back - Term Paper Example

?QUESTION a). Net Present Value is the discounted net value of a project within specified period of time. Net present value is present cash inflowsless present cash out flows. Positive net present value promises increase in value, which indicates greater return than those of rate of return and should be accepted. Zero net present value indicates that the return is equal to rate of return; therefore the project may be acceptable. However, when the net present value is negative, it indicates that return of the project is less than the required rate of return. Annual Cash flow 2012 2013 2014 2015 2016 2017 Sales ?0 ? 8,000,000 ?8,800,000 ?9,600,000 ?7,200,000 ?6,000,000 Variable costs ?0 ? 5,500,000 ?6,050,000 ?6,600,000 ?4,950,000 ?4,400,000 Contribution ?0 ?2,500,000 ?2,750,000 ?3,000,000 ?2,250,000 ?1,600,000 Additional Fixed costs ?0 ?1,150,000 ?1,150,000 ?1,150,000 ?1,150,000 ?1,150,000 Annual net cash flow ?0 ?1,350,000 ?1,600,000 ?1,850,000 ?1,100,000 ?450,000 The total working capital to be reclaimed at the end of the period =?1,350,000 (?900,000 + ?450,000) The salvage value = ?425,000 (10% ? ?425,000,000). Total variable per unit (Materials and Labour) = ?55 (?30+?25). Year t Cash inflows Cash outflows Net cash flow (1+r)^-t Net present value Initial Investment (Plant and machinery + working capital 2012 0 0 -?5,150,000 -?5,150,000 1 -?5,150,000 Annual net cash flow and Working capital 2013 1 ?1,350,000 -?450,000 ?900,000 0.892857143 ?803,571 Annual net cash flow 2014 2 1,600,000 ?0 ?1,600,000 0.797193878 ?1,275,510 Annual net cash flow 2015 3 1,850,000 ?0 ?1,850,000 0.711780248 ?1,316,793 Annual net cash flow 2016 4 1,100,000 ? 0 ?1,100,000 0.635518078 ?699,070 Working capital + salvage value + Annual net inflow 2017 5 ?2,225,000 ?0 ?2,225,000 0.567426856 ?1,262,525 Net Present value ?207,470 Payback refers to a period when the business is supposed to recoup its initial investment from the cash it generates. Payback period = investment required? Net annual cash flow. Salvage value of the machinery is cash inflow to the company after five years. Year ended 31/12 2012 2013 2014 2015 2016 2017 Sales ?- ?8,000,000 ?8,800,000 ?9,600,000 ?7,200,000 ?6,000,000 Less Variable cost ?- ?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 Less Fixed expenses ?- ?1,150,000 ?1,150,000 ?1,150,000 ?1,150,000 ?1,150,000 Net annual inflow ?- ?1,350,000 ?1,600,000 ?1,850,000 ?1,100,000 ?450,000 Average annual Investment required = Cost of new plant and machinery + Additional working capital - less salvage value = ?4,250,000 + ?1,350,000 - ?425,000 = ?5,175,000 Payback period = Investment required/average net annual cash flow =?5,175,000 ??1,270,000 = 4.07 years Where average net cash flow = (?1,350,000 +?1,600,000 +?1,850,000 +?1,100,000 +?450,000)/5 = ?1,270,000 According to Moles, Parrino and Kidwell (2011 p. 386.), Internal Rate of Return is a discount rate that causes the net present value to be zero and is the minimum rate of return that a project under must yield to be acceptable. Trial and error method is used IRR because it involves salvage values and unequal net annual cash inflows. IRR is computed using two rates, one that gives positive and the other that gives negative net present value. If IRR is less than the required, investment is rejected and vice versa. Discount rate of 13.5% Discount rate of 13.0% year Cash inflows cash outflows Net cash flow (1+r)^-t Net present value (1+r)^-t Net present value Initial Investment (Plant and machinery + working capital 0 0 -5150000 -5150000 1 -5150000 1 -5150000 Annual net cash flow and Working capital 1 1350000 -450000 900000 0.881057269 792951.5419 0.884955752 796460.177 Annual net cash flow 2 1600000 0 1600000 0.776261911 1242019.057 0.783146683 1253034.693 Annual net cash flow 3 1850000 0 1850000 0.683931199 1265272.718 0.693050162 1282142.8 Annual net cash flow 4 1100000 0 1100000 0.602582554 662840.8095 0.613318728 674650.6004 Working capital + salvage value + Annual net inflow 5 2225000 0 2225000 0.530909739 1181274.17 0.542759936 1207640.858 Net Present value -5641.70345 63929.12865 1.096791091 =0.135483955 Equivalent to 13.5483955% Where r2= smallest rate of interest r1=Highest rate of interest N1= NPV at the smallest rate N2=NPV at the highest rate b) A rationale treatment of initial research, depreciation and working capital, Salvage value is recognized as cash inflow because it is generate hard cash to the business once the asset is sold. Increase in working capital is treated as part of initial investment. An additional operating expense is also treated as cash outflows. Working capital may be released and this is treated as cash inflow at that time. During the calculation of net present value, depreciation is not deducted because it is not cash outflow and that discounted cash flow provide for return of investment automatically. It is assumed that all cash flows are realized at the end of the period and that income generated by the investment are immediately reinvested. QUESTION 2 a) Evaluating the financing options as discussed by the Board on gearing and capital structure of the company. Current borrowing is an overdraft of ?150,000 Issue of shares The problem and challenge of raising additional capital via issue of shares is that owner of the company do not have full control of company’s operations. Instead, they are accountable to stockholders who can block plans to protect their investments if they discover that such plans may be detrimental to their investments. The second disadvantage of raising capital through issue of shares is that, additional shares dilutes holding of existing shareholders, and may lead to dissatisfaction from minority shareholders. The more the company raise additional income from issue of shares, the capital structure changes because most investment are made using shareholders funds, thus reducing gearing ratio. Borrowing refers to debt financing, which involves sourcing money on loan from outside the company at a cost. Borrowing is in a form of overdrafts, loans, debentures, bills of exchanges, hire purchase and credit cards among others. The cost of debt financing involves interest and other transaction costs such as insurance. Advantages associated with debt financing include; first, borrowing money from financial institutions allows the owners of the borrowing business entity to maintain control because there is very little external interference if any. This is because unlike shareholders, lending institutions does not exact much influence on how the business entity is run. Secondly, with debt financing cost of financing including interest payments are allowed for tax deductions. In addition, if the company is financially sound, it is possible to borrow as much as possible within a short period as compared to initial public offers that usually take months to conclude. However, there are disadvantages associated with borrowing. The business must repay the loan and interest even if the business is not performing well. If bankruptcy occurs, the lenders are paid first before company’s shareholders. Secondly, debt financing erodes company’s credit rating and the more money it is borrowed the risk to the lender increases, which may push interest rates higher. Third, all lending institutions need collateral to secure the amount they lend. According to Moles et al (2011 p. 631), debt financing reduces WACC of the firm. Debt increases the value of the firm when the interests payments are tax deductibles but dividends payment do not. Debt financing increases company’s gearing ratio because most company investment is funded using short- term and long term borrowed funds. Increase gearing make the company risky. b) 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 Risk-adjusted discount rate refers to inclusion of risk premium. It is risk free rate plus risk premium (Risk-adjusted discount rate= Risk free rate + risk premium). Adjusted risk rate allows for inclusion of risk into operations. It is a composite discount rate. If future returns become more uncertain, then the risk premium becomes greater. Higher premium rate reflects riskier projects and lower rates reflect less risky projects. Net present value of a given project decreases with increase in adjusted discount rate. For example, risk free rate is 13%, additional rate of 3% is added to compensate for potential risk and the adjusted discount (composite) rate will be 16%. Since the interest rate is 12% and is assumed as risk free rate and risk premium is 3%, adjusted discount rate is 12%+ 3%= 15%. The new net present value will be -?206,010 down from ?207,470. Discounted payback period (DPB) is the number of years it takes for cumulative discounted cash flows from a project to equal the original investment. It partly addresses the weakness of the payback period. It accounts for time value of money and risk within the discounted payback period but ignores cash flows after the discounted payback period. Discounted payback period is longer than the payback period because it considers time value of money. Discounted payback period is 5.49 years as compared to initial payback period of 4.07 years. Payback period = Investment required/average net annual cash flow =?5, 216,512 ??950,415 = 5.49 years QUESTION 3 The importance of Working Capital Management Working capital refers to the total amount of money and assets that are easily converted to cash. Working capital to finance day to day operation of the company including raw materials, stock, salaries and wages. Strictly speaking, working capital is equal to current assets minus current liabilities (Current assets-current Liabilities). Current assets are composed of stock, debtors, receivables, and cash at bank and at hand. It also includes marketable securities (treasury bills, commercial paper, certificates of deposits and repurchase agreements) made with idle cash. Importance of working capital management Excess working capital indicates operating efficiencies. Money tied in inventory or owed to company by customers cannot be used to pay off financial obligations of the company. Slow collection of debts, is bad and indicate underlying problems in the operations of the company (James Sagner 2010). A competent finance manager can easily adjust company’s working capital by obtaining short term loan or managing debtors, inventory and outstanding company’s income properly. Collection efforts include sending notices, taking legal action, telephoning, and monitoring status among others. Working capital deficiency is bad for the business. This is because it can be made bankrupt, it can fail to pay emergency short term liabilities or it can be forced to take short term loan at higher interest rates. Insufficient working capital cause the company to forego cash discounts offered by traders, deterioration of credit rating, possible financial insolvency or increase cost of borrowing. b) Appraising the need for Treasury Management in global and international business entities. Treasury management refers to management of company’s liquidity with an intention of minimizing operational, reputational and financial risks as well as maximizes its liquidity. In big companies, treasury management covers currency, financial derivatives and bond trading. Treasury management is under chief financial officers, finance directors or finance controller among other key finance staff. Treasury also manages foreign currency to mitigate against currency loss from international transactions. QUESTION 5 Business entities are valued for mergers and acquisitions, restructuring and repurchases of shares. Valuations serve as roadmaps or compasses for different type of investors who would like to establish real value of the assets of the company. Business valuation needs not to be very high or very low to avoid overpayment that may lead to lost opportunities or underpayment that may lead to losses (Lee and Hood 2011). The value of North York Wolds plc is computed using asset based valuation. Under asset-based valuation, the value of the company is equal to total assets minus current liabilities. Under asset valuation method, the prospective buyer is concerned with assets of the business and business is split up and assets are sold separately and the business has no goodwill. The value of North York Wolds plc The company’s total shares =Total value of shares? price per share = ?90,000,000 ? ?50 = 1,800,000 Value of share =Net Assets ? shares outstanding =?171,000,000 ?1,800,000 = ?95 per share The value of Dales Plc The company’s total shares =Total value of shares? price per share = ?162,000,000 ? ?50 = 3,240,000 Value of shares =Net Assets ? shares outstanding =?288,000,000 ?3,240,000 = ?88.89 per share Other alternative valuation methods are Price Earnings (P/E) Ratio method which uses earnings, where earnings are multiplied by the P/E ration method to obtain value of the company. The value obtain is divided by the number of shares of the company to obtain price per share. The alternative company valuation methods include; Market-based approach, discounted cash flow, free cash flow valuation, price earning multiple and return on investment capital methods are alternative methods of valuing a company. Market value valuation method is used by quoted companies only and the value of the company is dictated by market factors. This approach also considers value of similar businesses and uses economic principle of competition as it compares the value of similar entities. It is a value obtained by multiplying quoted price of the company by the total number of issued shares. Free cash flow valuation is common method of valuing both public and private companies. b. The importance of non-financial factors in contributing to the success of a merger Objectives, goals and project scope must be clear and complete. The parties to a merger need to develop clear, complete and concise objectives. The objectives are important to ensure that parties involved remain focus to merger activities. Merger objectives and goals act as a point of reference during evaluation of merger progress and cam also be used to measure the level of satisfaction of the parties involved. The client must consult widely and accept terms. Consultation is very important to ensure that almost all factors if not all are taken into consideration. Consultations are important because key corporate offices need to be involved to ensure that what the parties hope to achieve from merger or acquisitions are discussed adequately. Managers must be committed and competent. Commitment ensures that each party plays its role accordingly. At the same time, the managers concerned needs to have relevant expertise to ensure that the company to be acquired is priced appropriately. The manager should also be in a position to draw to the company external expertise such as investment banking professionals. Competent and committed company officers ensures that due diligence is undertaken; where visual representation of company’s corporate structure under consideration is created. In addition, the parent or subsidiary business of the company under consideration need to be taken into account because the entities related to the business may affect rules and nature of the merger. Tight secrecy is important. A corporate lawyer is asked to draft confidentiality agreements to protect key information that parties of a merger will share and exchange during negotiation and due diligence. It is also important to realize that each company has risks. Therefore, it is critical to establish, develop and execute a risk management plan to cushion the company concerned against operational, financial, political, social and economic risks of merger company. References Clayman, 2012. Corporate Finance: A Practical Approach. 2nd ed. West Sussex: John Wiley & Sons. Lee, R.T. & Hood, P.L., 2011. A Reviewer's Handbook to Business Valuation: Practical Guidance to the Use and Abuse of a Business Appraisal. 6th ed. West Sussex : John Wiley & Sons, Moles, P., Parrino, R. & Kidwell, S.D., 2011. Fundamentals of Corporate Finance. West Sussex: John Wiley & Sons. Sagner, J., 2010. Essentials of Working Capital Management. West Sussex: John Wiley & Sons. Read More