Adequate Finance Decisions - Assignment Example

Fundamentals of Finance Swindon Plc Swindon Plc is a company, which is mainly dealing with the oil related products. Therefore, for taking the appropriate finance decision it is necessary to undertake several calculations, for taking the adequate finance decisions. A) Calculate the specific cost of each form of financing One of the most important considerations for an entrepreneur or an organization, while implementing a new project or undertaking expansion, diversification, modernization is ascertaining the cost of project and the means of finance. Financial sources as well as financial needs are short term, medium term, and long term. In this particular topic, it is necessary to evaluate the fundamentals of finance of Swindon Plc. At present, Swindon Plc is using the drill and plat form purchased earlier, which costs '10M i.e. '10000000. As far as the decision taken by the Swindon Plc is taken in to consideration, it is applying MACRS (Modified Accelerated Cost Recovery System) depreciation is taken in to fact. "Four factors are necessary to determine cost recovery deductions under the MACRS procedure. These are (1) class life, (2) depreciable basis after credit reduction, (3) acquisition year assumption, and (4) recovery method." (The Modified Accelerated Cost Recovery System (MACRS) - Basic Rules. 2001). It is necessary to taken in to consider that the property or asset class lives should be less than the actual life of the asset, so that the salvage value of such assets should be zero. Cost segregation and accelerated depreciation is essential for the effective implementation of investment decision. Like wise, it is necessary to increase the cash flows of an organization. While calculating the MACRS depreciation, salvage value is not as much effective in any other system for depreciation. If a particular property is utilizing for a period of five years or more then the depreciation rate should be calculated in accordance with this manner- First year-20%; Second year-32%; Third year-19.20%; Fourth and fifth year-11.52%; Last year or sixth year- 5.76%. So, by using this method, during the last or sixth year, the value of the specific asset so depreciated will be zero. (Salzmann 2007). In any organization, its structure is taking in to fact; there is a finance department, which is playing a prominent role, because finance is the life blood of any business activity. The basic and most fundamental financial activities are preparation of Balance sheet, Income statement, analysis of shareholders equity and cash flow, tools for profit analysis, preparation of capital and cash budget. Rate of Depreciation of Swindon Plc under MACRS Method. YEAR MACRS % Applicable 1 20% 2 32% 3 19.20% 4 11.52% 5 11.52% 6(Final Year) 5.76% In this particular case, the total purchase price of Drill and platform is '10000000; and this platform can be sold for '3.5M. i.e. '3500000 within a period of five years. Then, thereafter, Swindon plc bought a new platform costs '14M i.e. '14000000 with an addition of '1M i.e. '1000000 as installation charges. The latest platform should also have an estimated life of five years. But Swindon decided to undertake the sales of the latest platform after five years, at a cost of '4M i.e. '4000000. The Overall Summary of Drill and Platform of Swindon Plc. Particulars A) Cost of existing platform. Total selling price after 5years. Amount (in ') '10000000 '3500000 B) Cost of new drill and platform. Add: Installation charges. Total cost of Drill&Platform. Total selling price of new platform and drill. '14000000 '1000000 C) '15000000 '4000000. Cash flow analysis is an important tool with the finance manager for ascertaining the changes in balance of cash in hand and cash at bank. Cash flow statement analyses the reasons for changes in balance of cash in hand or at bank between two accounting period. Moreover, it shows the inflows and outflows of cash, practically, sources and applications of cash. Cash generating efficiency is a fact used while preparing the cash flow statement. It is the ability of a company to generate cash from its continuing business operations. This statement is divided on the basis of three distinctive heads, such as Operating activities, Investing activities, and Financing activities. One of the fundamental concepts in the preparation of cash flow statement analysis is the calculation of working capital changes, for deriving the total or net cash from Operating activities. Working capital changes should be computed by considering the rule of- Add the figure of Decrease in Current Assets. Add the figure of Increase in Current Liabilities. Less the figure of Increase in Current Assets. Less the figure of Decrease in Current Liabilities. Here, it is necessary to taken in to consideration the impact of the necessary working capital changes, such as accounts receivable will increase to '1.5M,i.e. '1500000; accounts payable will also increase to '1M,i.e. '1000000; and inventory will increase to '2M,i.e. '2000000. Therefore, as per the rules for finding the changes in working capital, increase in current assets like accounts receivable and inventory should be deducted, but increase in current liability like accounts payable should be added. Likely, Yearly cash inflows of Swindon plc during the five relevant years are- 1- '3,500,000, 2 -'4,000,000, 3 -'6,000,000, 4- '8,000,000, 5- '12,000,000 respectively. In addition to this, the Swindon plc is undertaking its financial operations and implications in an effective manner with appropriate sources of funds. B) Calculate the single Break Point associated with the firm's financial situation. This point results from exhaustion of retained earnings. Break-Even Analysis predicts the sales volume at a given price to recover the total cost. It is one of the most important tools in evaluating the economic feasibility of a new enterprise. Break-even sales can be calculated by applying the following formulae: Break-Even Sales''''''''' = Fixed Costs 1- Variable Costs Break even point means the point at which the total cost and income equals, it is the point at which there is no loss or gain. "The break-even point is the point at which income matches expenditures. Typically, initial expenditures are high. It takes time for the income to reach the same level. The break-even point can apply to a product, an investment, or the entire company's operations." (Reh 2007). Exhaustion of retained earnings is also crucial in the fundamental finance implications. Retained earnings is playing a wider role in the financial management. "The percentage of net earnings not paid out'as dividends, but retained by the company to be reinvested in its core business or to pay debt. It is recorded under shareholders' equity on the balance sheet. Calculated by adding net income to (or subtracting any net losses from) beginning retained earnings and subtracting any dividends paid to shareholders: (Retained Earnings. 2007). To attain the profitability and the return back of the required investment, it is essential to increase the relevant rate of investment. Retained earnings are the amount profit held by an entity and utilized for meeting the requirements, and it is not payable as dividend. In order to compute the Break points on the Marginal Cost of Capital (MCC), "Break Point= Maximum amount of the lower cost source of capital/Percentage financing provided by the source." (Shim & Siegel, P. 285). D) Calculation of Weighted Average Cost of Capital At the time of taking adequate investment decision, the Weighted Average Cost of Capital (WACC) is essential. Cost of capital is an important concept lying behind the effective running of a business entity. The measurement of cost of capital of each source of finance helps to evaluate the overall cost of capital of the entity as a whole. The composite of overall cost of capital of a firm is the weighted average cost of several sources of funds. Weights are taken as the proportion of each source of funds in the entire capital structure. While making the financial aspect of investment decision, the analysis of overall weighted cost is significant. For this, each and every investment procedure is financed from a collection of funds which may represent the various sources from which the required funds have been raised. Therefore, the investment decision shall be done with reference to the overall cost of capital. The Weighted Average Cost of Capital (WACC) is calculated by utilizing the following step by step procedures; 1. Calculating the cost of specific sources of funds, it may be either cost of debt, or cost of equity etc. 2. Multiplying the cost of each source by its proportion in capital structure. 3. Adding the weighted component costs to get the firm's WACC. So, this WACC of an organization should be expressed as- K0= K1 W1 + K2 W2+''''''..; Where, K1, K2 are component costs and W1, W2 are weights. For the purpose of computing WACC of Swindon Plc, a combination of debenture, preference shares, equity shares as well as the retained earnings are taken as the relevant sources of finance. As far as the Debenture is taken in to consideration, debenture of '1,000 par value, at an interest rate of 6.5%, in addition to this flotation cost of 2%per value, and an average discount of '20 per bond. Likely, preferred stock is issued at a par value of '100/share with 6%interest rate and flotation cost of '4 per share, and it is selling with a premium amounted to '102. The common or equity shares is dealing with '35/share with a dividend of 5% and cash dividend expected to be '3.25/ share also with a flotation cost of '2/share. Similarly, the expected retained earnings of the company is '100,000. Rather than this, the tax rate of Swindon plc is 40%. Cost Of Debt= Kd= I/NP*(1_T) Where, Kd- Cost of debt after tax. I - Annual interest rate. NP- Net proceeds of debentures. T - Tax rate. In this case if Debentures are issued at par value- Kd= '65/'1,000*(1-40%) = 3.9% If flotation cost is paid as 2% of par value. Kd= '65/'980*(1-40%) = 3.979% Cost of Preference shares- Kp= PD+ (RV_NP)/N/(RV+NP/2) PD= Annual preference dividend. RV= Redemption value of preference shares NP= Net proceeds an issue of preference share N= Life of preference shares. Assume that the number of preference shares issued is 500 shares. NP='50000 (500*'100/share) PD= 6% of the par value, i.e. 6%of '50000= '3000. RV= Redeemed at a premium of '102/share, i.e. '51000 is the redeemed value, and premium amount is '1000. N= Number of years, assumed to be nil or the preference shares are being redeemed within one year. Due to the absence of number of years available for redemption, it is assumed as irredeemable preference shares, so the cost of irredeemable preference shares= PD/PO. Here, PD= Annual Preference dividend; and PO= Net proceeds in issue of preference shares. Kp= PD/PO= '3000/ '50000=6% Cost of Equity- The calculation of cost of ordinary or common share is a complex procedure. In order to assign a certain cost of equity share capital should not provide a mere calculation. Ke= d1/P0 Where, Ke= Cost of equity. D1= Annual Dividend. P0= Market value of equity (ex dividend) OR Ke= D/NP Where, D= Dividend NP= Net proceeds. Assume total number of equity shares is 1000 shares, '35/share, '35000 is the equity capital or NP. While Dividend is '1750, i.e. 5% of '35000, and the cash dividend is '3.25/ share, i.e. 1000 shares @'3.25/ share is amounted to '3250. Ke= '1750+'3250/'35000= 14.285% Cost of Reserves/Retained earnings Here, the Swindon Plc is expected the retained earnings as '100,000. The profits retained by the company and used in the expansion of business also entail cost. The expectation of the investors from the new ordinary shares should be the opportunity cost of reserves. If earnings were paid out as dividends and simultaneously an offer for right shares was made shareholders would have subscribed to the right shares on the expectation of a certain return. Estimated Statement Showing Weighted Average Cost of Capital. PARTICULARS AMOUNT (') PROPORTION AFTER TAX COST WEIGHTED COST Equity capital Retained earnings Debt. TOTAL 5,00,000 2,00,000 3,00,000 0.50 0.20 0.30 0.18 0.18 0.065 0.09 0.036 0.0195 0.1455 WACC=14.5% Notes to Accounts: 1. The component costs before tax are: Equity capital 18%, Debt 10%. 2. WACC:- After tax cost of debt= Kd(1-T)=10%(1_0.35)=6.5% E) What happens when WACC is computed using Book Value Weights instead of Market Value Weights' Why' Explain. The weights to be used can be either book value weights or market value weights. Book value weights are easier to calculate and can be applied consistently. Market value weights are supposed to be superior to book value weights as component costs are opportunity costs and market values reflect economic values. However these weights fluctuate frequently and fluctuations are wide in nature. Both the concept[t of book value and market value is differ, because book value of the firm or book value weights remains constant, but the market value weights are goes on fluctuating. While computing WACC, mainly two kinds of weights are being used, such as book value weights and market value weights. The cost of capital is a significant factor in designing the capital structure of an undertaking. It is an important factor, which is essential for taking appropriate financial decisions. Capital structure refers to the mix of sources from where the long term funds required in a business may raised; the mix of such sources include equity capital, preference capital, internal sources, debentures, etc. There are mainly three major considerations while planning the capital structure, such as Risk, Cost of Capital, and Control. "Market value weights are determined by dividing the market value of each source by the sum of the market values of all sources. The use of market value weights for computing a firm's weighted average cost of capital is theoretically more appealing than the use of book value weights because the market values of the securities closely approximate the actual dollars to be received from their sale." (Shim & Siegel, P.283). Marginal cost of Capital (MCC) is the cost of raising an additional capital for improving the maximum sources of funds, for the efficient and effective running of the business. MCC is derived, when a company using the average cost of capital by using the marginal weights. Marginal weights mean the proportion of funds the firm intends to employ. The concept of book value weights and market value weights does not arise in the case of marginal cost of capital computation. But it is better to adopt market value weights than the book value weights, because the book value weights remains stable, it should not taken in to consideration the changing market value of debt and equity, as well as other sources of finance. Bibliography REH, F. John (2007). Break Even Point. Definition. [online]. About.com.Management. Last accessed 21 November 2007 at: http://management.about.com/cs/adminaccounting/g/breakeven.htm Retained Earnings. (2007). [online]. Invesopedia. Last accessed 21 November 2007 at: http://www.investopedia.com/terms/r/retainedearnings.asp SALZMAN, Mary (2007). Accounting Site. MACRS depreciation example. Modified Asset Cost Recovery System Method. [online]. Bella Online. Last accessed 21 November 2007 at: http://www.bellaonline.com/articles/art48923.asp SHIM, Jae K & SIEGEL, Joel G. Schaum's Outline of Financial Management. Level of financing and the Marginal Cost of Capital. (MCC) P.285. [online]. Google Book Search. Last accessed 21 November 2007 at: http://books.google.com/books'id=_lnmxnhoAUEC&pg=PA283&lpg=PA283&dq=book+value+weights+and+market+value+weights&source=web&ots=3O8dO6MMXa&sig=jAQzYWRtbtHTX1R0paJ7KR5tOBY#PPA285,M1 SHIM, Jae K & SIEGEL, Joel G. Schaum's Outline of Financial Management. Measuring the overall cost of capital. Historical Weights. Market Value Weights. P.283. [online]. Google Book Search. Last accessed 21 November 2007 at: http://books.google.com/books'id=_lnmxnhoAUEC&pg=PA283&lpg=PA283&dq=book+value+weights+and+market+value+weights&source=web&ots=3O8dO6MMXa&sig=jAQzYWRtbtHTX1R0paJ7KR5tOBY#PPA285,M1 The Modified Accelerated Cost Recovery System (MACRS) - Basic Rules. (2001). Four factors necessary to compute MACRS. Module10- Section 2. [online]. Last accessed 21 November 2007 at: http://taxpoint.swcollege.com/taxpoint_2001/student/m10/m10-2.html Read More