Ingredients of Equity Contributions - Assignment Example

Financial Decision Making TASK a) Sources of Finance for installing new equipment For equipment financing long term finances are required. Equity and debt are the two broad sources of long term finance. The key difference between equity and debt are as under: A contractual set of cash outflow is required to serve the debt financing, where equity providers have a claim on residual cash flows of the firm Interest paid on debt is an expense to calculate profitability of the firm. Dividends paid to equities are not considered expense but a share of profitability of the firm as per units of equities held. Debts have fixed maturity, whereas equity has infinite life. Equity investors enjoy the prerogative to control the affairs of the company, whereas debt investors play a passive role. The advantages, disadvantages and other ingredients of Equity contributions are as under: Right to income: The equity investors have a residual claim to the income of the company, that is to say income after meeting all interests and dividends on debt capital including preference contributions belong to equity holders. Retained earnings after distributing dividend also belong to equity holders. There is no compulsion to pay dividends. Dividends may not be declared say on account of insufficiency of funds. Equity provides a cushion to lenders as it enhances creditworthiness of the company. Sale of fresh equities dilutes the control of existing equity holders. The cost of issuing equity is generally higher than cost of issuing other types of securities. Underwriting commissions, brokerage costs, and other issue expenses are high for equity issues. The advantages, disadvantages of debt funds and their other ingredients are as under: Preference capital is generally regarded as part of net worth. There is no legal compulsion to pay dividends unless those are cumulative preference capital. Normally preference capital do not have any voting rights, hence no dilution of control. Assets are not pledged on issuance of preference capital. However preference capital has higher cost of issuance. Another limitation is that preference capital has a prior claim on assets and earnings of the company than equity holders. Interest on borrowings is an expense for calculating income of the company. Debt funding does not dilute the control of equity holders. Issue costs of debts are significantly lower than those on equities and preference capital. The burden of servicing debts is generally fixed in nominal terms. Failure to meet fixed interest and principal repayment obligations can cause a great deal of financial embarrassment and even lead to bankruptcy. Some time debt contracts impose restrictions that limit the company’s financial and operational flexibilities. Under inflations, the real cost of debts is greater than expected. b) Structure Users and Purposes of Trading Profit and loss Account and Balance Sheet Structure As per IAS 1, the objective of financial statements is to ensure comparability with entity’s previous year transactions and with the financial statements of other entities. Accordingly the structure of Trading & Profit and Loss account and the Balance sheet should bring this attribute of possibility of comparison as per the requirement of standards. Secondly the structure of these statements should present fairly the financial performance of the entity during the accounting period, and its financial position as on the date of balance sheet. The statements are required to be prepared on mercantile basis of accountancy, i.e, accrual basis and on the assumption of entity as a going concern. The material items in the financial statement should be presented separately, whereas dissimilar items may be aggregated if those are not material to the business. The common form of presentation is vertical presentation. However, the entities may also use T form provided above stated requirement are complied with. Users The users of financial statements normally are the investors and other fund providers, creditors and supplier, customers, government agencies like taxation and statistical departments, various research workers and many others. Every user has its own objectivity. Trading and profit and loss accounts is normally used to evaluate the operational and other performances, whereby the information of earnings of the company is analyzed from different angles and objectivities of the users. Balance Sheet users normally assess assets valuation in order ensure the safety of their dealings with the company. Balance should also reflect liquidity and capital structure of the company Purposes The main purpose of these two statements is to fairly present the performance of the company over a financial period, and status of the company as at balance sheet date. International accounting standards now require the companies to use fair values of assets and liabilities in presentation of such statements, so that users get practical information about the company. The purposes and users of Trading and Profit and loss account and Balance Sheet normally remain the same whether the entity is sole trader, partnership, or a limited company. However presentations differ as the company has to follow even the provisions of companies act with regard to capital employed and many other matters. Some accounting adjustments are dealt differently for different organizational structure. For example withdrawals by proprietors and partners are shown as reduction of capital invested, whereas in case of company those are dividend distributions out of retained earnings and like that. c) Evaluation of profitability, liquidity, and efficiency through financial ratios Profitability: The ratios used for evaluation are calculated as under: Beta has the best gross profit margins as compared to Alpha and Gamma. This shows that Beta has shown efficiency in managing the trading expenses or cost of goods sold, even though its sales are lower than Gamma. There might be lower cost of purchases, included in cost of goods sold , due to bulk purchases or any because availability of trade discount. Even net margins of beta are greater than other two companies. The company is efficient in managing its overhead expenditure. Despite good gross margins at 50% Alpha has not been able to control its overheads, and the same is the case with gamma. Liquidity: Current ratio is used to evaluate liquidity of the companies and that is calculated as under: Even liquidity wise Beta is the best of the three. In fact any industry the current ratio of 2:1 is considered the best. The beta has a much better ratio of 2.14: 1. The other two companies, Alpha and Gamma have poor current ratio 0f 1.51:1 and 1.53 respectively. That means these two companies may be finding difficult to meet their current obligations as those become due. Efficiency: The efficiency of the companies has been judged on basis of Inventory turnover and Assets turnover ratios calculated as under. It is assumed that figures of inventories and assets provided in the balance sheets are of average inventories and assets Inventory turnover of Gamma is 10times as compared to Alpha and Beta’s 6.59 times and 8.85 times respectively. This shows that Gamma is using its stocks effectively and efficiently to convert into sales faster than other companies. Assets turnover ratio of again Gamma is better than others. Gamma is using its assets possibly with no capacity to spare. That is why its sales is higher than other two companies. d) Importance of Financial Information The use of financial information is not only important but is necessary for the survival of the companies in this competitive business atmosphere, more specifically described as under: Financial information is necessary for budgeting the income and expenditure for the coming period. For raising equities and debt funds, the information contained in financial statements is studies and analyzed by the providers of those funds. Financial information is important for calculated various types of taxation liabilities of the companies. Auditors perform their auditing and investigating assignments on the basis of financial information contained in books of accounts and provided by the directors and other officials of the company. Creditors and debtors fix terms and conditions of business on basis of financial information contained in the financial statements of the companies. TASK 2 (a) Project evaluation a) Pay Back Period Method Project Name (assumed) A B Initial Cost of projects $ 80000 $ 100000 Cash Flow Year $ $ 1 40000 20000 2 40000 30000 3 20000 50000 4 10000 50000 5 10000 40000 Under pay back period method, the decision about project is taken on the basis of time taken by the project to recover the initial investment. According to this method, project A will recover its initial cost of $80000 by the end of second year, whereas the project B will recover its initial investment of $100000 by the end of third. As project A will recover its investment faster than project B, project is preferred as compared to project B. b) Net present Value Method For the sake of convenience the projects have been named as A and B Project A Project A Project B Project B Year Discount Factor Cash Inflow/ outflow(-) N P V (2 *3) Cash Inflow/ outflow(-) N P V (2 *5 (1) (2) (3) (4) (5) (6) 0 -80000 -80000 -100000 -100000 1 0.893 40000 35720 20000 17860 2 0.797 40000 31880 30000 23910 3 0.712 20000 14240 50000 35600 4 0.636 10000 6360 50000 31800 5 0.567 10000 5670 40000 22680 Total 13870 31850 Net Present value (NPV) of project A over the period is $13870 and that of project B is $31850. The basic formula is to accept that project which has got positive, but of the two projects, project B has NPV more than NPV of project A. Therefore project B is acceptable as compared to project A. As it will be seen from comparison of advantages and disadvantages of the two methods, NPV method is preferable method. Accordingly it is advised that Adrian Lockwood should undertake the project B. b) Advantages and disadvantages of each of the methods Payback Method Advantages: It is simple both in concept and application. It favors projects which generate substantial cash flows in the initial years and discriminate projects which bring cash flow in later years. Since it emphasizes earlier cash inflows, it may be sensible criterion when the firm is pressed with problems of liquidity. Disadvantages: It fails to consider the time value of money. This violates the most basic principle of financial analysis which stipulates that cash flows occurring at different points of time can be added or subtracted after suitable compounding/ discounting. It ignores the cash flows beyond the payback period. A project may be profitable but it may bring cash inflows during later years. Payback method will ignore such projects. It does not consider profitability of the project, but measures only the capital recovery. Net Present Value method Advantages As present value are measured in current monetary values, the value of a firm can be expressed as the sum of present value of projects in place as well as net present value of prospective projects. When a firm terminates an existing project which has a negative NPV based on its expected future cash flows, the value of the firm increases by that amount. Likewise when a firm undertakes a new project that has a negative NPV, the value of the decreases by that amount. The NPV rule assumes that the intermediate cash flows of a project are reinvested at a rate of return equal to cost of capita. The NPV of a project can also be calculated using different time- varying discount rates. Disadvantages The NPV is expressed in absolute terms rather than relative terms and hence does not factor in the scale of investment. The NPV rule does not consider the life of the project. Hence, when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favour of longer project. TASK 3 a) Table showing cost, sales revenue and profit or loss b) Graph of break even point c) Fixed Cost 12000 12000 Break- Even Point = ------------------------- = ---------- = --------- Contribution per unit 35-(8+12) 15 = 800 Units of Sales d) Graph at 200 and 1200 units Graph at 200 units of sales shows a loss of $ 9000 Graph at 1200 units of sales shows a profit of $6000 Respective calculations are as under: Amount in $ Units Sold 200 1200 Sales Revenue @ $35 per unit 7000 42000 Variable cost @ 20 per unit 4000 24000 Contribution (Sales- Variable Cost) 3000 18000 Fixed Overheads 12000 12000 Profit/Loss (-) (Contribution- Fixed overheads) - 9000 6000 e) Margin of Safety at 1000 units sales a month Total sales at 1000 units = 1000 * $35 = $ 35000 Sales at BEP = 800* $35 = $ 28000 Total Sales- Sales at BEP Margin of Safety as a percentage = -------------------------------- * 100 Total Sales 35000 - 28000 = ------------------ *100 or 20% 35000 f) Limitation of Break even analysis in short term decision making In short period it is difficult to analyze cost under ‘fixed’ and ‘variable’ elements since the nature of cost is not certain by that time. In absence of distinction of costs between fixed and variable in short period, the decision based on Break Even analysis regarding price fixation, manufacturing of product and others may prove faulty. Under short period even variable costs are estimated and therefore application of Break Even analysis may result in under or over recovery of overheads. Read More