Finance Issues of the Company - Assignment Example

Corporate Finance Part 1. (a) Identify and discuss the types of cost and problems to business when holding: (i) too much inventory (ii) too little inventory Having too much inventories could cause to company to incur storage costs for the need to have a wider space to place the inventory. As a result of having wider space, there could be increased overhead to maintain the goods like cost of electricity, security cost of additional guards who will watch the inventories and other preservative supplies in certain cases. There could also be increase insurance cost since ownership of goods has it own risks when there owners want to protect himself from fire and other calamity insurance. On the other hand, holding too little has its problems and costs like the cost of lost profits that would have been made because of lost sales, the problem of loss of costumer loyalty and patronage, the cost of making more orders from time to time because of limited inventory on hand. 1(b) Discuss the arguments for and against the implementation of a just in time inventory management in this case. Just in time (JIT) practice reduces an inventory level which means lower investments in inventories. It also greatly improves the lead time reliability due to shorter delivery- lead time. There is reduced lead times and set-up time increases scheduling flexibility. Many companies had reported improved quality levels in using JIT. It is also believed that extensive valued analysis reduces cost of purchased materials. There will be lower investments in factory space for inventories and product. There will be also less obsolescence risk in inventories and less paper work and a reduction in scrap and rework. On the other hand, the arguments against JIT include the following: JIT presupposes a disciplined act and as such it demands a long term commitment from management to do it. It management is changing or if there is no stability, it possibly the company may lose what would have earned under the ordinary way of maintaining inventories. There is also great possibility that there would be large initial cost that would possibly not compensated by short term returns. JIT presupposed anticipated demand and supply of its products and if management commits mistake along the way, the effect could be disastrous. JIT also making a stable agreement with supplier for the timely delivery of inputs for production and this may also create problems with supplies of terms large of money to implement the plan for JIT. Related with the large cost is also a risk that will have to be considered by the companies in wanting to implement JIT1. 1. (c) Calculate the appropriate order size for the exhausts pipes that will minimize the total inventory management costs for exhaust pipes. The appropriate order size for the exhaust pipes that will minimize the total inventory cost is 110 units as computed below: The formula above uses D, which refers to annual demand for the product, O which stands for ordering cost per unit and C, or the carrying cost per unit. In so computing minimum inventory cost there was a need to determine the balance level of order that will reconcile the opposing behaviour of ordering cost and carrying cost.2 Part 2 -- To: The managing Director From: Finance Manager Re: Report on advantages and disadvantages of using debt, rather than equity to finance company operations. In a meeting that we had, it was your belief that there is a need to prioritize paying off all the company’s bank loams and overdrafts as soon as possible, because ‘paying interest on bank borrowing is expensive. You also believed that payment of interest just reduces profits’ and thus ‘it is better to use shareholder capital, which costs nothing’. You did request me to send a report when I had taken a view contrary to yours and so such is the purpose of this report. This report will also explain “what bank borrowings, and shareholders equity, and shareholders equity, are really costing the company.” In addition this paper is taking the position that will explain the advantages and disadvantages of using debt, rather than equity to finance company operations. By so doing, this paper assumes that there is a such as thing as optimal capital structure where there is a balance of having enough capitalization both in terms of equity and debts. To start with it is not true that there is no cost to using equity financing alone. It may be assumed that stockholders have their opportunity cost for their investment before they have put their money into out own company. Our company will be a failure to stockholders if management will not do anything to deliver their expectations in terms of dividends and increased value of the stock. In that given financial objective of the company to attain wealth maximization for stockholder, management necessarily incurs risks in the investment decision that the company will have make. Any wrong decision therefore about economic decision of the company’s management could drive present stockholders to sell their stockholders since the moment that they do not see their money is not earning, there are motivated to choose another investment option. But since this paper also argues for the advantages and disadvantages of debt financing let, me point out first the advantages. Some of the advantages include the capacity of present stockholders to retain maximum control of the business. This means that there are times that our company would have need capital to finance our expansions, in which case there would be need to for more funds. It could be asserted that resorting alone to equity financing could result to dilution in the stock ownership of current stockholders. Who would want to lose control when there are other options. Resorting to debt financing is a way to preserve that management control since creditors will have the same rights as stockholders in the election of directors who will manage the company. Another advantage of debt financing is the tax deductibility of interest expense. This means that having higher deduction for tax purposes would greatly reduce the income taxes for the company. Compared with the equity financing, dividends given to stockholders are not tax deductible. Therefore the tax savings that would be generated from interest expense could be used by the company to fund other requirements of the business. There are however disadvantages of debt financing that I must also discuss. First, it an admitted experience of companies that having too much debt could cause problems that moment that management rely on it and the company cannot generate revenues to pay back such obligations. The laws are crafted for the protection of creditors in such case where these creditors may have the power to cause bankruptcy of the company and if this happens even the money of presently stockholders could also be lost. In addition, too much debt indicates high risk for investors and prospective investors may shun investing with the company3. Part 3 3. (a) Calculate the incremental cash flows arising from a decision to decision to launch the project. (10 marks). The incremental cash flows are shown in Figure 1 below: Year 0 Year 1 Year 2 Year 3 Year 4 £000 £000 £000 £000 £000 Sales 180 200 160 120 Cost of Sales -115 -140 -110 -85 Variable overheads -27 -30 -24 -18 Market Survey -30 saving loss from old machine -70 salvage value of old machine 10 working capital   20       Net cash Inflow: -100 58 30 26 27 NPV at 10% £15.50 Figure 1 (b) Calculate the net present value, and approximate internal rate of return of the product. (7 marks) The net present value £15,500 and the approximated internal rate of return was of the product was computed at 18% as shown below: (c) State, with reasons, whether or not the product should be launched. (3 marks) The product should be launched since the incremental cash flows generated produced a positive NPV, using the cost of capital as discounting rate. Using the 10% cost of capital as discount rate means bringing reinvesting the rate as the cost of capital , thus making the use of NPV more reliable than IRR4, which assumes the 18% IRR as the reinvestment rate. At an IRR 18%, it also means that the company may generally earn incremental rate by about 8% based from 10% cost of capital. (d) Outline the strengths and weakness of the internal rate of return method as a basis for investment appraisal. (5 marks) The strengths and weakness of the internal rate of return method as basis of investment appraisal are as follows: First, IRR considers time value of money as that of NPV method. By so considering, the method is interested in cash flows rather the than the book value income that may be used in measuring the desirability of investments using other methods. It is also easy to use since investments are normally expressed in terms of rates of return. Finance people may find it easier to make comparable investments by simply using the IRR of projects. There are however instance where the use of IRR is not permissible when the cash flows per period do not it application. Hence there are cases that one cannot get the IRR of the project since in the circumstance may not allow it. In such a case, NPV can come to the rescue and still a possible appraisal of the investment options by discounting the cash flows using the cost of capital as discount rate. Another limitation of the IRR compared with the use of NPV is the fact the NPV is a better measure of the projects which are mutually exclusive. What the IRR says may be the correct one; hence NPV is still more superior. Another limitation is the reinvestment of cash at IRR rate when the more realistic method is the use of cost of capital under NPV method. Part 4- 4. a. Discuss the reasons why capital rationing may exists? (8 marks) Capital rationing exists because of the deficiency of enough capital to invest and that management must make the investment choices in order to maximize the wealth of the stock holders. This could be applicable to small companies which have not established their names and credit standing with capital sources. In other words, the size of the firms’ capital budget may be constrained. Thus in such situation, capital is scarce5 and it should be used in the most efficient way possible. There are procedures that will be followed for allocating capital so as to maximize the firm’s aggregate NPV subject to the constraint and that the capital rationing ceiling is not exceeded.6 4. b Determine the best way for Eros plc to invest the available funds and calculate the resultant NPV assuming that none of the projects are divisible. (17 marks) To determine the best way for Eros plc to invest the available funds, the company should use the respective NPVs of the three projects and decide which is the best possible option taken individually or a combination of two or three of the options as would be possible. It must be made clear that there are three projects and they are: Project 1 is to invest at work station assessments in the amount of £300,000 and which would generate cash flows due from saving to be made from labour cost, Project 2 is an £450,000 investment of in individual workstation for staff that would reduce administrative costs of £140,800 annually for the next five years, while Project 3 is an £400,000 investment for new ticket machines which will generate an £120,000 annual cash savings, which are expected to increase at 3.5% per year due to inflation during the five year period. It must be noted that that the following are the only four possible options: Option 1, which is to do Project 2 alone at £450,000; Option 2, which is to do Project 1 at 300,000 and Project 3 at £400, 000 combined, option 3 which is to do Project 3 alone and option 4, which is to do Project 1 alone. To choose only Project I would not possibly give the maximum effect since the 800,000 available investments must be assumed to be fully or substantially utilized in order to produce what is maximum return or profit. Thus there was need to generate another option, which is to doing both Project I and Project3. To choose only Project 2 excludes a possible combination with the other projects because the £800,000 would be exceeded. To choose Project 3 is not also logical under the reason used in Project I only. Based on the generated NPVs of the three possible options, it came out that combining Project 1 and Project 3 would generate less return for the company since Project I has a negative NPV. Option 2 is not possible also because of negative. Hence the only remaining option is doing Project 3 alone which has shown positive NPV. Since, there would an unused amount of £400,000 it must be assumed to earn at 12% cost of capital. The following are the results of analysis in making the comparisons: Comparative results of analysis Project I Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 £000 £000 £000 £000 £000 £000 Savings in labour costs (300.00) 85.00 90.00 95.00 100.00 95.00 less tax (25%)     (21.25) (22.50) (23.75) (25.00) (300.00) 85.00 68.75 72.50 76.25 70.00 NPV of Project 1 at 12% ($29.52) Project 2 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 cash flows (450.00) 140.80 140.80 140.80 140.80 140.80 less tax (25%) (35.20) (35.20) (35.20) (35.20) (450.00) 140.80 105.60 105.60 105.60 105.60 NPV of Project 2 at 12% ($37.91) Project 3 cash flows -400 120.00 124.32 128.80 133.43 138.24 less tax (25%)     30.00 31.08 32.20 33.36 (400.00) 120.00 154.32 159.88 165.63 171.59 NPV of Project 3 at 12% $146.59 Works Cited: Brigham and Houston, Introduction to Financial Management, Thomson-South Western, UK, 2002 Foreign Policy, The World According to Larry, July 2002 Frazier, S., JIT Manufacturing “Just in Time”, {www document} URL http://www.bsu.edu/web/scfrazier2/jit/mainpage.htm, Accessed June 18, 2008. Inventory management.com, Economic Order Quantity, {www document} URL http://www.azinventorymanagement.com/economic-order-quantity.htm, Accessed June 18, 2008. Paulo, S. Operating Income, Residual Income and EVA: Which Metric Is More Value Relevant-A Comment; Journal of Managerial Issues, Vol. 14, 2002 Peterson, P. Will America Grow Up before It Grows Old? The Atlantic Monthly, Vol. 277, May 1996 Strange, R., Japanese Manufacturing Investment in Europe: Its Impact on the UK Economy; Routledge, 1993 Swamidass, P. Innovations in Competitive Manufacturing; AMACOM, 2002 Wade and Apap Big-Bank Budgets ; ABA Banking Journal, Vol. 92, 2000 Womanowned.com, Debt financing v Equity Financing, {www document} URL http://www.womanowned.com/Growing/Funding/Financing.aspx, Accessed June 18, 2008. Read More