Financial Decision Making - Essay Example

Financial Decision Making The manager of Caledonian Limited should know that ‘surplus’ means that the total receipts were more than the total payments, hence the company made some profits. On the other hand, ‘deficits’ to the company means that the total payments or expenses are more than the total amount that the company is making (total receipts), hence the company will be making losses since it uses more than it receives or makes. The manager should therefore reduce its expenses by reducing the payments or cutting down on the amount they pay out in the case of ‘deficits’ so that at least their expenses can be met by their receipts. The company can also increase or improve on its sales so that however much the payments are, the receipts will still be more in order to for the company to meet its current liabilities. In case of surplus, the company can plough back the surplus into investment and in order to increase future sales hence better future receipts. Task 2 a) i) Selling price per unit (with a markup of 10% ) Variable cost per unit = £20 Fixed cost per unit = £10 Total cost per unit = £30 C + M = S and M = 10% of S. C + 0.1S = S C = S-0.1S C= 0.9S C= 30 Hence, 30 = 0.9S S= 30/0.9 S= £33.33 Hence selling price per unit with a markup of 10% = £33.33 ii) Selling price per unit = £33.33 Hence 500 units will sell at: S of 500 units = 500 x 33.33 = £16,665 Cost per unit = £30 Hence 500 units will cost: C of 500 units = 500 x 30 = £15,000 Profit = total selling price – total cost = 16,665 – 15,000 = £1,665 b) i) Without the fixed cost, the total production cost will only consider the variable cost which is £20. Therefore, after production of 500 units, any additional production will use 20 as the production cost (C). To calculate the new selling price per unit; S = 30% of 20 = 6 Hence the selling price = £6 Therefore, per unit selling price when production is done after 500 units are produced, hence without the fixed cost, is £6 ii) When additional 200 units are produced; Per unit cost = £20 hence total cost will be 9 x 500 = £4500 Per unit selling price = £6 hence total selling price for 200 additional units will be; 6x 200 = £1,200 Profit = total selling price – total cost = £4500 – 1,200 = £3,300 Hence, the profit for additional 200 units will be £3,300 Task 3 Project Alpha (initial cost = 120,000) Year Cash Flow (£) 10% PV Factors Present Value (£) 1 60,000 0.909 54,540 2 60,0000 0.826 49,560 3 30,000 0.751 22,530 4 15,000 0.683 10,245 5 15,000 0.621 9,315 Total 146,190 Investment (120,000) Net Present Value 26,190 Project Beta (Initial cost £150,000) Year Cash Flow (£) 10% PV Factor Net Present Value (£) 1 30,000 0.909 27,000 2 45,000 0.826 37,170 3 75,000 0.751 56,325 4 75,000 0.683 55,225 5 50,000 0.621 31,050 Total 206,770 Initial Investment (150,000) Net Present Value 56,770 Payback Period Alpha project with initial cost of £120,000 Net Cash Flow Time for Cash Flow to Payback Investment Investment £120,000 Year 1 54,540 65,460 Year 2 104,100 15,900 Year 3 126,630 -6,630 Year 4 136,875 -16,875 Year 5 146,190 -26,190 Payback period will be between the second and the third year. Year 1: 104,100 Year 2: 126,630 Payback period: 120,000 126,630 – 104,100 = 22,530 120,000 – 104,100 = 15,900 If 22,530 = 1 year, 15,900 = ? (15,900 x 1)/22,530 0.7 of a year = 8 months, 4 weeks. Hence, the payback period for this project will be 2 years, 8 months and 4 weeks. Payback period for project Beta with initial cost of 150,000 Near Cash Flow Time for Cash Flow to Payback Investment Investment 150,000 Year 1 27,000 123,000 Year 2 64,170 85,830 Year 3 120,495 29,505 Year 4 175,720 -25,720 Year 5 206,770 -56,770 The payback period for 150,000 will be between year 3 and year 4. Year 3: 120,495 Year 4: 175,720 Investment: 150,000 150,000 -120,495 = 29,505 175,720 – 120,495 = 55,225 If 55,225 = 1 year 29,505 = ? = (29,505 x 1)55,225 = 0.5 0.5 0f a year = 0.5 x 12 = 6 months Hence, 150,000 will be paid back in the project beta after 3 years and 6 months. Report to the CEO of Ace Corporation Net Present Value is the difference between the present value of the cash inflows and the present value of the net outflows. Project cash flows are discounted using an appropriate rate which is the minimum rate of return required by the investor. In the case of these two projects; Alpha and Beta projects, the discounting rate is 10% which is used to calculate the discounting factors with the formula 1/(1 + r)n where r is the discounting rate and n is the number of years. The appropriate cash flows are the after tax cash flows, therefore the net cash flows should be estimated on the after tax basis. However, in these projects, there was no tax involved and no project had a residual value after the completion period of 5 years. Computation of cash flows requires a special treatment of non-cash expenses such as depreciation though in these projects, there is no depreciation considered. However, in case of depreciation, it has an indirect effect on the cash flow since it is a tax deduction expense. The general criteria for Net Present Value is that the project with a negative net present value should be undertaken since it increases the wealth of the shareholders and a project with a negative net present value should not be undertaken since it reduces the wealth of the shareholders. In a case where the manager is faced with several projects and would like to choose one to implement, then the net present values of all the projects will be calculated and compared. The project with the highest net present value should be preferred to the others with low net present value. Considering these two projects: the project Alpha and project Beta, both the projects will last for 5 years and will have a discounting rate of 10% each. The cost of project Alpha is £120,000 and the cost of project Beta is £150,000. When the net present values of these two projects are calculated, it is evident that project Alpha will have a net present value of £26,190 while project Beta will have a net present value of £56,770 by the end of the fifth year. Both the net present values are positive, so according to the net present value criteria, both projects can be undertaken since they increase the wealth of the shareholders. However, if only one project was to be selected for implementation, then the project with the highest net present value should be selected. In this case, project Beta has a higher net present value of £56,770 than project Alpha with a net present value of £26,190. It therefore follows that project Beta should be preferred and selected for implementation since it will have more benefits in terms of net present value than project Alpha. Payback period on the other hand, refers to the number of years or periods taken by a project to generate cash inflows sufficient enough to recover its initial cost. If the project under consideration is expected to generate equal annual net cash inflows, its payback period will be calculated as follows: Payback Period = (cost of the investment / Annual cash input) in years. The general criteria for Payback period method is that, the project with a payback period shorter than the other projects should be accepted by the management. This means that, the project with the shortest payback period will be ranked first among the alternatives. Considering the two projects we have here; project Alpha and project Beta, project Alpha has a payback period of 2 years and 8 months, while project Beta has a payback period of 3 years, 6 months. This shows clearly, according to the general criterion, that project Alpha will be ranked first between the two. This is because it takes the shortest period to payback the initial investment cost; just 2 years and 8 months, unlike project Beta which takes 3 years and 6 months. The decision on which project to implement then becomes a tricky act to the manager. This is because, according to the net present value, project Beta should be implemented unlike according to payback period where it is project Alpha that should be accepted. However, it is very evident that the manager will be required to use more investment cost to execute project Beta than the amount he will require to execute project Alpha. And being that project Alpha also pays back this investment cost faster in just 2 years 8 months, the manager will then have a reason to choose project Alpha instead of project Beta. Project Beta gives better net present value but it takes longer to repay the initial investment cost and also the initial investment cost is high, hence it does not become the more favorable to invest in. it is also advisable to take the project with the shortest payback period to minimize the risks associated with the returns in the future. Again, the choice of the project with the shortest payback period improves the liquidity position of the company. Task 4 a) The purpose of the financial statements is basically to provide information required about financial position, performance, and changes in the financial position of a business. This information is normally regarded as useful to a wide range of users in making decisions about the particular enterprise. There are two major financial statements that are used by nearly all businesses and that have a universal format. These are income statements and balance sheets. Purpose of an Income statement in an Enterprise Income statements provide the basis for measuring performance of an entity throughout the course of an accounting period. Normally, performance is assessed from the income statement on the basis of the following; Change in sales revenue over a particular period and in comparison to the growth of the industry. Change in gross profit margin, operating profit margin and net profit margin over the period. Increase or decrease in the net profit, operating profit and gross profit over the period. Comparison of the enterprise’s profitability with other organizations operating in similar industries or sectors. There are also certain financial evaluations of an enterprise that are done on the basis of income statement when it is analyzed in conjunction with the information contained in other types of financial statements such as: Change in earnings per share over the period Analysis of working capital when compared to similar income statement elements such as ratios of receivables as reported in the balance sheet to the credit sales as reported in the financial statements. This is also called debt turnover ratio Analysis of ratios such as interest cove and dividend cover ratios. In a small enterprise, the format normally differs from the how it looks in a well established business. In small enterprises, we only have the sales, cost of sales, gross profit and net profits. On the other hand, we have a well detailed income statement in a well established enterprise with varied sources of income and total income for the period, and well detailed items of expenses in the expense side. There is also the gross profit, overheads and the net profit. The other main financial statement is a balance sheet. Balance sheet is also known as a statement of the financial position of a business. The creditors and some interested invested can possibly use the balance sheet to show the financial position of the enterprise so that they can decide to either invest in the business or give credit to the business. The balance sheet actually lists both what the company owns and what it owes. It contains the company’s assets (what it owns), and its liabilities (the debt it has). When the company’s liabilities are subtracted from the assets, what is left is the shareholders’ equity which is the share of the shareholders in the business (Laurie, 2014). Therefore the purpose of a balance sheet is to allow creditors to evaluate the business and assess whether it is liable for a loan and for the investors to evaluate whether the company is worth investing in. the difference in the format of a balance sheet of a small business and a well established business is in the size of accounts and the diversity of operating system (Marquis, 2014). b) Information needs of users of financial statement: i) Managers; they require financial statement information in order to manage the affairs of the business by assessing and evaluating the financial position of the company and making certain financial decisions out of the financial position. ii) Shareholders: they use the financial statements to assess the risk and return associated with their investment which allow them to take investment decisions based on their analysis. iii) Investors: they use the information from the financial statements to asses the viability of investing in the company. The investors may foresee future dividends associated with investing in the company and the risk that might be associated with it. For instance, if the financial statements are full of fluctuating profits, this indicates a higher risk of investing in the business. Therefore, the statements are used to make investing decisions in by investors. iv) Financial institutions: these institutions such as banks normally use financial information from the financial statements to gauge whether to offer loans to a business or not. Any decision to lend must always be supported by sufficient asset base or liquidity. v) Suppliers; these use financial information from the financial statements to ascertain the credit worthiness of a business in order to supply goods in credit. vi) Customers; they use the financial information from the statements to assess whether a supplier has the required resources for a steady supply of goods to the business in the future. vii) General public: this uses the information to assess the effects of the business to the environment, economy and to the local community. viii) Government: they use the financial statements to ascertain the amount of taxes that the business should pay to the local government authority. c) Ratios i) Gross Profit Margin = (gross profit / sales) x 100 For MKTG; = 4,100/ 30,570 0.13 x 100 = 13% This means that 87% of sales revenue was taken up by the cost of sales while 13% was the gross profit. This is not good enough as the cost of sales has taken up a bigger percentage of sales. For FSA: = 7,170/16,280 = 0.44 x 100 = 44% This also shows that 56% of the total sales were taken up by the cost of sales, leaving only 44% to the gross profit. ii) Net Profit Margin = (net profit/sales) / 100% For MKTG; = 440/30,570 = 0.014 x 100 = 1.4% This indicates that 98.6% of the sales were taken up by the cost of sales, operating and financial expenses while only 1.4% remained as net profit. For FSA; = 690/16,280 = 0.042 x 100 = 4.2% This shows that 95.8% of the sales went to the cost of sales, operating and financial expenses while only 4.2% were left as the net profit. iii) Current Ratio = Current Assets/Current Liabilities For MKTG; = 2510/1950 = 1.29 This shows that current assets are 1.29 times the current liabilities as this ratio measures the number of times the current liabilities can be paid by the current assets. For FSA; = 5070/2950 = 1.72 This shows that the current Assets are 1.72 times the current liabilities. iv) Quick Ratio = (Current Assets – Stock) / Current Liabilities For MKTG; = (2510 – 2420) / 1950 = 0.046 This ratio indicates the firm’s ability to pay its current liabilities from the more liquids of the firm. In this case however, it is very hard for the firm to pay its current liabilities since the quick ratio is less than 1. For FSA; = (5070 -2370) / 2950 = 0.95 This is almost 1 hence the firm’s current liabilities can easily be paid by the current assets without the stock. v) Gearing Debt to equity ratio = total debt / Total equity For MKTG; = 3950/2000 = 1.98 This ratio shows the amount of fixed charge capital in the capital structure of the firm for every unit of the owner’s equity hence this shows that there is 1.98 units in every 2 units of the owners equity. For FSA; = 6950/4500 = 1.544 This shows that there are 1.544 units of capital charge in every 2 units of owner’s equity. Task 5 a) i) The sources of finance available for this business include: Personal savings Depending on the agreement of the partnership, equal partners will contribute an equal percentage of capital into the partnership while other unequal partners will contribute according to the agreement in the partnership. Small Business Loans A partnership can also approach a bank of a financial institution to apply for a loan (Kristie, 2014). Sometime each partner may approach a bank where they have an account. Where this happens, each partner will be responsible for the repayment of the loan which they borrowed. ii) In the case of personal savings, which each person contributed to the business, each partner will be entitled to ownership of the business up to the extent of their contributions. For the loans, each partner will have to be responsible for the repayment of the amount of loan which they borrowed from the specific banks. In this case also, these loans determine the percentage by which the profits of the business are shared amongst the partners. iii) The cost of personal savings may be determined by the agreement of the partners. But generally, personal contributions from personal savings normally do not have any cost. Instead, the percentage of contribution by each partner is normally used to share the profits of the business among the partners. However, the loans borrowed from bank are normally given at a certain interest charge. Therefore when repaying the loan, we normally pay even the interest. iv) Loans normally increase liability hence reducing the liquidity level of the business. However, personal contributions are normally considered as capital, hence they reduce the shareholders equity. v) Financial planning always helps businesses to have a logical plan of usage of funds hence avoiding engaging funds into inappropriate functions. It helps a business to avoid deficits and situations whereby the expenses are more than the cash available to take care of the deficits. Bibliography Kristie, L. (2014). Sources of Funds for Partnership. The Chron Journal for Small Businesses , 1 3. Laurie, R. (2014). The Purpose of a Balance Sheet and Income Statement. The Chron Journal For Small Businesses , 1-3. Marquis, C. (2014). Differences Between Single-Owner Balance Sheet and a Corporation Balance Sheet. The Chron Journal for Small Businesses , 1-2. Read More