Accounting and Managerial Finance Issues - Essay Example

QUESTION Should Mr. Tar recommend submitting the bid to the navy at the proposed price of $30 per yard? The discount rate for this project is 12 percent. BRIEF FACTS OF THE SCENARIO: The Sheetbend & Halyard Inc. is going to bid for a contract relating to supply of duffel canvas to U.S. Navy. Mr. tar was required to review the bid in order to decide whether it should be submitted or not. Sales staff prepared the draft bid and the forecasts of the income that will be generated from the contract along with the supporting documents of the bid, provided that the bid is accepted by U.S. Navy. The bid is to supply duffel canvas amounting 100,000 yards to U.S. navy every year at a fixed price of $30 per yard for 5 years. Mr. Tar, the CFO of the company, gathered the information required for the bid and following facts and assumptions were reached: 1. The duffel canvas production will require an additional investment of $1.5 million in order to purchase new machinery costing $1 million and refurbishing of idle plant that will cost $500,000. 2. The investment related to machinery can be depreciated for tax purposes on the 5-year MACRS schedule while that of related to refurbishing of plant can be depreciated on 10-year MACRS schedule. The residual value of machine at the end of 5 years is expected to be zero. 3. The following income statement has been fore casted by the sales staff of the Sheetbend & Halyard Inc. which appeared to be correct to Mr. Tar except that the book depreciation was used, not the tax depreciation. In the meantime, Sheetbend & Halyard Inc. received a firm offer from Maine real estate developer to purchase Pleasantboro land and plant for $1.5 million in cash. The plant is fully depreciated while land’s cost is $10,000. EVALUATIONS OF MR. TAR: On the basis of the information available, the CFO Mr. Tar was asked to advise whether the company should bid for the proposal of U.S. Navy. If the proposal is bid and accepted, the company shall receive cash flows for continuous succeeding 5 years. The cash flows are confirmed under the circumstances. However, if such bid is not made, the company may sell the Pleasantboro land and plant immediately. The company will also not need to make additional investment of $1.5 million for the purchase of machinery and refurbishing of plant. To evaluate which of the two choices is better, the net worth between these two should be compared. The projected Income statement prepared by the sales department is correct in the opinion of Mr. Tar. However, the tax depreciated should be accounted for in the Income statement in place of book depreciation. Using the MACRS depreciation schedule on the 10-years and 5-years for plant and machinery respectively, the following depreciation schedule for future years was made: MACRS Table Year 3-year 5-year 7-year 10-year 1 0.333 0.200 0.143 0.100 2 0.445 0.320 0.245 0.180 3 0.148 0.192 0.175 0.144 4 0.074 0.115 0.125 0.115 5 0.115 0.089 0.092 6 0.058 0.089 0.074 7 0.089 0.066 8 0.045 0.066 9 0.065 10 0.065 11 0.033 DEPRECIATIOON SCHEDULE Year Cost of Macinery $ 5-year Depreciation $ Cost of Refurbishing of Plant $ 10-Year Depreciation $ Total $ 1 1,000,000 0.200 200,000 500,000 0.100 50,000 250,000 2   0.320 320,000   0.180 90,000 410,000 3   0.192 192,000   0.144 72,000 264,000 4   0.115 115,000   0.115 57,500 172,500 5   0.115 115,000   0.092 46,000 161,000 6   0.058 58,000   0.074 37,000 95,000 7         0.066 33,000 33,000 8         0.066 33,000 33,000 9         0.065 32,500 32,500 10         0.065 32,500 32,500 11         0.033 16,500 16,500 1.000 1,000,000 1.000 500,000 On the basis of the depreciation calculated as per MACRS schedule and the data prepared by the sales department staff, the following forecasted Income statement for the navy duffel canvas project was prepared by Mr. Tar: SHEETBEND & HALYARD INC. FORECASTED INCOME STATEMENT FOR THE NAVY DUFFEL PROJECT Years 1 2 3 4 5 Yards sold 100,000 100,000 100,000 100,000 100,000 Price per yard 30 30 30 30 30 Revenue 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Cost of goods sold: Fixed costs (300,000) (312,000) (324,480) (337,459) (350,958) Opening - 180,000 187,200 194,688 202,476 Purchases 1,980,000 1,879,200 1,954,368 2,032,543 2,113,844 Closing 180,000 187,200 194,688 202,476 210,575 Variable costs (1,800,000) (1,872,000) (1,946,880) (2,024,755) (2,105,745) Total (2,100,000) (2,184,000) (2,271,360) (2,362,214) (2,456,703) Operating cash flow 900,000 816,000 728,640 637,786 543,297 Depreciation (From MACRS Depreciation Schedule) 250,000 410,000 264,000 172,500 161,000 Income 650,000 406,000 464,640 465,286 382,297 Tax @ 35% 227,500 142,100 162,624 162,850 133,804 Net Income 422,500 263,900 302,016 302,436 248,493 In the forecasted income statement prepared by sales staff, two deficiencies were mainly pointed out by Mr. Tar which are provided for in the forecasted Income statement prepared by him. Firstly, Mr. Tar has provided the depreciation in the Income Statement for tax purposes on the basis of 10-years MACRS schedule for the plant and 5-years MACRS schedule for the machinery. Thus, the income before tax has been changed. Consequently, the tax expense for the relevant years and Net Income after tax has also been changed. Secondly, Mr. Tar has provided the accounting for working capital in the Income statement which is maintained at 10% of the gross sales. The net operating income amounts to $ 3,625,723 whereas the initial investments on the project amount to $1.5 million. Apparently, it appears that the net cash inflows generated from the project are $2,125,723. The project appears to be quite profitable. However, these cash flows are to be generated in future periods. To evaluate the actual value of the cash flows today, Mr. Tar computed the discounted cash flows generated from the project had it been accepted by U.S. navy. The Net Present Value of the cash inflows generated from the project in the 5 years are computed as follows: Years 1 2 3 4 5 Total Operating cash flows 900,000 816,000 728,640 637,786 543,297 3,625,723 Discount rate 1.120 1.254 1.405 1.574 1.762 Discounted Cash InFlows 803,571 650,510 518,632 405,324 308,281 2,686,319 Thus, the cash inflows amounting $3,625,723 has a present value of $2,686,319 today. Moreover, the Pleasantboro land, having good and valuable location, may be sold alongwith idle plant in the future at $600,000. This amount if discounted on 5 years will have an amount of $340,456. Thus, the present value of total cash inflows of the project is $3,026,775. The cash outflows related to the project are those related to the costs of purchase of new machinery for the project and the refurbishing of the existing plant. These outflows will be made in the period the costs are incurred. However, they will be accounted for against the future cash inflows in the form of depreciation expense in future periods. The amounts will not be discounted as the outflow will be occurred at the inception of the project. the costs shall be accounted for as follows: Years 1 2 3 4 5 Total Discounted Cash InFlows 803,571 650,510 518,632 405,324 308,281 2,686,319 Discounted Cash Inflow from sale of land 340,456 340,456 Net Present Value of cash Inflows 3,026,775 Depreciation 250,000 410,000 264,000 172,500 161,000 1,257,500 Additional depreciation for last year 95,000 95,000 Additional depreciation for last years 6-11 147,500 147,500 Cash Outflows 1,500,000 Net Present Value of Tax Payments 203,125 113,281 115,753 103,494 75,924 611,577 Net Cash Outflows (2,111,577) Net Cash flows to the company 915,198 The company also received a firm offer from Maine real estate developer for the purchase of Sheetbend’s Pleasantboro land and plant for $1.5 million cash. The net cash inflows from this sale transaction are of $1.5 million. No discounted value adjustment is required for this transaction. The tax on this transaction @35% will amount to $525,000. Thus, the net cash inflow from this sale transaction will amount to $975,000 Thus, the company may receive surplus cash amounting $59,802 if the company opt to sale the Pleasantboro land and plant for $1.5 million cash. Hence, the company should opt for the offer from Maine real estate developer. QUESTION 2: FINANCING A BUSINESS: When a business is incorporated, the money is invested into the business by the founders in order to make it capable of starting its operations in order to generate future profits. Large businesses usually need quite large funding to start their operations which is usually not possible to be provided by an individual or a group of individuals. In such a case, the funding is partly provided by the owners of the business (termed as shareholders in limited companies) and partly through borrowing. The amount invested in the business as a loan taken from third parties is termed as debt. Thus, there are two main components of business finance; Debt and Equity. Financial Policy: The policy which describes the criteria of a company’s choices in relation to debt and equity mix, currency of denomination, methods and modes of financing of investment projects and the decisions in respect of hedging of financial instruments with a primary goal of maximizing the business value for the stockholders. These policies may be either short-term financing policies or long-term financing policies Short-Term Financing Policies: Short term financing policies are the policies which describe the financial objectives that are to be achieved in short-term, that is, within a year. Short term financing policy generally relates to the financing required for continuing operations of the company. The short term financial policy may be reflected in two ways: 1. Investment of firm in its current assets: this investment is normally measured relative to the company’s total sales. A flexible short-term financial policy maintains current assets to sales ratio which is relatively high. On the other hand, a restrictive short-term financial policy maintains a low current assets to sales ratio. 2. Current Assets financing: the current assets financing is measured as a ratio of short term debt and long-term debt that is used for the financing of current assets. A flexible short-term policy means lesser portion of short-term debt as compared to long-term debt, whereas the restrictive short-term policy means higher portion of short-term debt as compared to long-term debts. Long-Term Financing Policies: The financial policy adopted to describe the long-term financing objectives of the company. These policies reflect the financing related to the long-term projects and assets. Long-term financing is generally done through equity financing, issuing corporate bonds and capital notes. RAISING CAPITAL FOR INVESTMENT: When a business develops, it usually needs additional resources in the form of capital. These resources may be achieved by any of the two ways; either by increasing the equity by issuing shares, debentures or other equity items to existing or new shareholders (not including right issue) or by taking a long-term debt or loan from any financial institution. However, the decision of considering whether the financing should be made of debt or of equity is not so easy. Various factors are considered before reaching upon a final conclusion. However, the main question that should be asked before raising capital is that what price is being paid for financing the business. To determine the cost of raising capital, the company should know all the expenses it will have to make and raise the capital accordingly. The company should consider the infrastructure in determining the cost of raising capital. The infrastructure of a company includes the equipment, the insurance paid, the taxes and the salaries of the employees. Another factor is the financial flexibility of the company that determines the ability of the firm to raise capital in bad times. The companies may easily raise capital in good times. However, a company is considered to be financially flexible when it can raise capital in its bad times. Thus, the financial flexibility also determines the strategy to be adopted to raise capital depending on the circumstances under which such debt is being taken. The management style also determines the policy to be adopted to raise capital. The management with conservative inclination will not prefer to use debts to increase the profits of the company. On the other hand, aggressive management will opt all options to grow quickly. It may raise finance by using debt in order to show rising Earning per share of the company. The market conditions also affect significantly the policy of raising capital. These conditions determine whether the company should borrow or issue equity instruments for the purpose of raising capital. On the basis of the above factors, the company should evaluate whether it should finance its business from debt or from equity. The financing strategy should be adopted carefully as it has long-term impacts on the company’s operations. Usually, a company opts for a mix strategy. However, the proportion of debt component and equity component in a mix strategy shall also be evaluated considering the above factors. Debt Financing: Whatever policy the company chooses for raising the capital, it is necessary for it to keep a balance between debt and equity. The company should neither rely too much on taking loans from financial institutions nor should it issue equity instruments quite frequently for raising capital. The companies have some reservations regarding borrowings from third parties in order to raise capital. Such borrowings surrender a portion of cash profits. However, it is a good option if the company can reasonably expect that it may generate sufficient cash from these borrowings which will enable it to pay back the loan along with interest. The basic benefit regarding debt financing is the retention of ownership of the company. The loans, for a good credit business having sufficient equity to cover the loans and not already bearing heavy loans, are easy to obtain. The loans may be granted for a period of less than one year (short-term loans) or more than one year (long-term loans). The funding is usually secured by the business assets which may be used by the bank for receiving the loan back if the company defaults on its payment. In case of Uniliver Plc, the company has raised funding through borrowings which include both short term and long term borrowings. As at December 31, 2013, the short-term borrowings amount to £3,191.26 million while the long-term borrowings amount to £6,132.14 million. Another company Associated British Foods Plc has also raised funding through borrowings. The short-term borrowings amounts to £394 millions and the long-term borrowings amount to £772 millions as at September 14, 2013. Despite their huge businesses, these companies have not depended solely on equity financing, rather they have raised finance through debt also which shows the importance of debt financing. Equity Financing: Equity financing is another way of obtaining finance from outside third parties. No debt payment is required in this type of financing. The investors only share the profits of the business. And if the company fails to capitalize profits, nothing is payable to the equity holders. However, once equity financing is obtained, the ownership of the company is divided further dividing the overall future profits of the company. If the capital is raised by issuing too much equity, it will reduce the earning per share and the share of profits of the owner in the company. But equity financing is also supposed to increase the profits of the business more steadily and rapidly as it is not only money which is brought in by the investor. The contacts, the expertise of management and the business partners, all come in together with the cash thereby increasing the scope and area of operations of the business. The effectiveness and efficiency of the business is also enhanced. Thus, the overall profits are increased and the owner is benefited despite decrease in the share of owner in the total ownership of the company. The Unilever plc has total equity amounting £12,405.8 million as at December 31, 2013 while the Associated British Foods Plc has equity of £6,497 million as at September 14, 2013. If the debt and equity is measured with each other, it may be clearly seen that the company never relies on debt financing heavily. The reason is the same of having burden of repayment of loan. In both cases, the equity is quite large than the debt obtained by the company. Thus, the company is always advised to rely more on equity financing and less on the debt financing. DEBT-EQUITY BALANCE: Both of the debt and equity financing is necessary. Thus, most of the businesses maintain a balance between debt and equity financing throughout the life-cycle of the business. Such balanced proportion is called ‘leverage ratio’. This ratio in substance determines not only the financing mode the company intends to use in future but also company’s ability to meet its obligations. The leverage can be calculated by using many ratios but the most important and most commonly used is debt to equity ratio. The companies with less debt-equity ratio are less risky than those who have higher debt-equity ratio. The leverage ratio (debt-equity ratio) can be calculated by the following formula: Leverage Ratio = (Short-term debt + Long-term debt) Shareholder’s Equity The leverage ratio for Unilever Plc. for the year ended December 31, 2013 comes out to be: Leverage Ratio = (3191.26 + 6132.14) = 0.776 12011.39 The leverage ratio for Associated British Foods, Plc. for the year ended September 14, 2013 comes out to be: Leverage Ratio = (394 + 772) = 0.776 6133 The analysis of the above averages show that the leverage ratio of Associated British Foods, Plc. is higher than that of Unilever, Plc. Thus, it indicates that ABF Plc. has better ability to meet its obligations than that of Unilever Inc. Moreover Unilever Plc. depends more on debt as compared to ABF Plc. However, in substance, both companies have good leverage ratio showing their capability of meeting their all debts as both have leverage ratio of less than 1. However, the ratio should be maintained at such level which minimizes the cost of financing and also keeps company protected from restrictions on the operations of the business. The owner or founder of the company intends to maximize the profits and keep full control over the company. However, in some cases, it becomes necessary for the company to obtain equity financing as the investors bring in not only cash but also some additional benefits which could not be obtained otherwise. These benefits include personal contacts, management expertise, business partners and channels of marketing. Similarly, the financial strategy of obtaining debt financing can also be valuable for the company. The debt providers usually become the business advisor of the company before it achieves the required level of profitability. When such level is achieved, the bank gives debt to the company as a source of finance. The raising of funds in a business is an ongoing process which continues throughout the business life cycle. Thus, a single source of funding or capital to meet the financial needs of the company will not be appropriate. Rather, it is an ongoing process which continues throughout the life cycle of the business. As the business is developed, the expansion of the staff, the marketing and the manufacturing efforts will be required. Thus, continuous funding are required throughout the development and progress of the company. Thus, the risk of the company and the investor is limited by this approach. REFERENCES 1. MACRS Table. Modified Accelerated Cost Recovery System: the MACRS Depreciation Method, [Online], Available: http://campus.murraystate.edu/academic/faculty/lguin/fin330/MACRS.htm [16 April 2014]. 2. 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