The Project of Installing New Equipment - Assignment Example

FINANCIAL DECISION MAKING Task a) Sources of funds There are two main financing sources for the project of installing new equipment. One is raisingfunds through issuance of securities, and the other is debt financing, i.e., issuance of preference capital, debentures, or raising loans through financial institutions like banks. Equity holders are the owners of the company. They get dividend on their investments in equities only when dividend is declared. Equity holders’ claim to dividend and to the refund of investment on liquidation comes after company meeting all other liabilities including payment to preference capital. Equity gives the real strength to company. The credit worthiness of the company is based on its equity investments. But the cost of issuance of equity capital is much higher than raising funds on basis of borrowings. Raising funds on basis of borrowings is also called debt funding. The main sources of debt funding are issuance of preference shares, issuance of debentures (also called bonds), short and long term loans from banks or other financial institutions. Funding through borrowings has the advantage of repayment of fixed interest or dividend and principal amount; Thereafter the entire income and assets belong to equity holders. Preference capital normally does not have voting powers. The disadvantage is that high cost is associated with the issuance of preference capital. Borrowings from other sources like issuance of bonds, loans from bank etc. costs less than both issuance of equity shares and preference shares. The company has to meet the repayment schedule of interest and principal amount at all costs. Otherwise, the company has to face bankruptcy. Though borrowings do not have control over the working of the company, but some time debt agreements put restrictions on certain activities. b) Trading Profit and Loss Account and Balance Sheet No fixed form has been prescribed for these financial statements. But generally speaking, these financial statements should have the qualities like comparability with earlier year of the statements of the organizations as well as with the statements of other organizations. Accrual basis of accountancy be used in preparation of these statements. These statements should be based on the accounting concept of going concern. Also these statements should present a true and fair picture of the organizations earnings and position as to assets and liabilities on a particular date of balance sheet. The users of these statements are investors, whether present or future, account payables and account receivable, providers of debt funding, and many others. Users also include students, government departments like statistical departments. Though the purpose of balance sheets and trading profit and loss accounts of all types of organizations is the same, but those are presented in differently for different organizational structure. Capital account of proprietorship includes proprietor investments, income and withdrawals as well. In case of companies retained earnings and reserves are shown separately than paid up capital of different types. There are no treasury stocks in proprietorships and partnerships. Assets some time are not categorized c) Ratio Analysis Profitability: Gross margin ratio of Alpha, Beta, and Gamma are calculated as 50%, 58%, and 45% respectively. Gross profit is the difference between net sales and cost of goods sold. Gross margin ratio shows the margin left after meting manufacturing and/ or trading cost, and measures the efficiency of production an/ or trading as well as pricing. From this point of Beta has efficiently managed its trading and pricing of goods as its gross margin is better than others. Net margin ratio shows the earnings left for shareholders as a percentage of net sales. The net margin ratios of Alpha, Beta, and Gamma are 14%, 30%, and 9% respectively. Again the best ratio is of Beta. This ratio measures the overall efficiency of production, selling, pricing, and administration. Jointly considered the gross profit and net profit ratios provide a valuable cost and profit structure of the entities, and as Beta’s both ratios are superior than others, and therefore it can be observed that profitability wise beta has out performed the other companies. Liquidity: Current ratio measures liquidity and is defined as Current Assets/ Current Liabilities. As per this formula the current ratio of Alpha, Beta, and Gamma ratio are 1.51, 2.14, and 1.53 respectively. Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year. The higher the current ratio, the greater is the short term solvency of the firm. From this point of view the current ratio of Beta is greater than others. Therefore beta is most solvent company in short run. Efficiency Return on Capital employed (ROCE) and Return on equity are efficiency indicators of efficiency of any firm. The formula to calculate ROCE is Profit before Interest and Tax/ Average Total Assets. Based on this formula the ROCE of Alpha, Beta, and Gamma are 0.23, 0.33, and 0.17 respectively. ROCE reflects the earning power of a business organization, and thus its efficiency. Assets of previous year are not given. Therefore total assets at the end of 2007 are considered as average assets of the firm. Here again Beta has best earning capacity and therefore is efficient than the other two companies. d) Use of financial information: The financial information of any firm is useful for makings decisions in many ways. Some of the uses of the financial information are enumerated as under: 1 Public company raises funds from the market and for the financial information about the company are required to be submitted to stock exchanges and other controlling authorities. Investors study the financial statement and other financial information about the company before investing into equities or debt instruments of the company. 2. The financial information is required to assess the efficiency of the working of the company as compared to earlier years of the company as well as inter- company comparisons in the same industry. 3. Information from financial statements are analyzed for calculating current and deferred tax liabilities 4. Various government agencies make use of financial information of firms for statistical records that serves various purposes for achieving ruling government’s objectives. 5. Financial information of firms are required to take capital budgeting and other regular operational activities decisions. Task 2 a) a) Payback Period. Payback period of a project is found by counting the number of years it takes before the cumulative forecasted cash flows equal to initial investment. In case of Adrian Lockwood initial investment of two projects are $80000 and $ 100000. Each project’s projected net cash flow is stated as under: $ $ Initial cost 80000 100000 Net Cash Flows in Year 1 40000 20000 Year 2 40000 30000 Year 3 20000 50000 Year 4 10000 50000 Year 5 10000 40000 The project with initial investment of $80000 would be recovered from 2years of net cash flow. On the other hand project with initial investment of $100000 would take 3 years to recover the investment. The earliest is the best under payback period method. Accordingly as per this method project with $80000 initial investment is preferable. b) Net Present value This method is also called discounted cash flow method, as we have to calculate present value of future cash inflows of 5 years in each project and then after adjusting the total of present values of inflows with outflow we will arrive at net present value of each project. The NPV of two projects will be compared and the one with higher NPV will be selected. The calculations are as under: The above calculations show that total NPV of project with $100000 investment is more than the project with investment of $80000. Accordingly the project with $100000 is preferable under this method. Comparing the two methods, the result of NPV method is preferable to result of Pay Back period method because the Pay Back Period does not consider the value of future inflows, which is an important ingredient in capital investment decision making. b) Advantages and disadvantages Pay back Period Payback period method is easy and the firm does not have to make tedious calculations for finding present value. Beside this advantage of simplicity, Pay Back Period methodology suffers from following two serious limitations: 1. The pay back rule ignores all cash flows after the cut off date. 2. The back rule gives equal weight to all cash flows before or after the cut off date. Net Present value NPV rule recognizes that a dollar toady is worth more than a dollar tomorrow because dollar today can be invested to start earning interest immediately. Any investment rule which does not recognize time value of money is not scientific. Another advantage of NPV is that this method depends solely on the forecasted cash flows of the project and the opportunity cost of capital NPV is based on present values and thus it is scientific to make additions of those present values in order to arrive at a decision. Task 3 f) Limitations of BEP Breakeven point is a very simple and useful tool for decision making, but it certain limitation hereunder: 1. At one particular a time Break point suits in the analysis of one product only 2. Break event point does not work when it is difficult to distinguish between fixed overheads and its variable cost 3. Break even does not consider cash flows of the project in decision making. Read More