Managing Financial Resource and Decisions: Brightview PLC - Case Study Example

Section One: Sources of Finance “The primary function of inventory is to serve the The inventory may be finished goods, MRO items, or service parts that are carried in a distribution system.” (Toomey, 2000) Almost each and every manufacturing company carries stock and inventory in various forms such as raw materials, Work in progress and finished goods. This sort of inventory would form a huge part of the overall assets of a business. Brightview plc is involved in the production of tunnelling equipment and accessories for mining industry. Brightview plc can use numerous ways to manage the its stock more efficiently and effectively such as: Brightview plc can buy raw materials in bulk quantity to avail discounts, as bulk purchase carries a discount and availing such discounts would lower the cost for Brightview plc when it comes to purchasing of stock. This would lead to better control over costs hence leading to better profitability for Brightview plc. The other way for Brightview plc is to take better decision over holding buffer stocks in order to eliminate the risk of running out of stock during the normal production run. “Buffer stock is maintained to cover uncertainty between operations. If the number of operations within the supply chain can be reduced and/or the transition, from one operation to the next made smoother, the buffer stock can be reduced.” (Toomey, 2000) Economic Order Quantity (EOQ) model can also be used to manage stock efficiently and effectively. The EOQ model can be used to decide the optimum order size for stocks. This helps in minimising the ordering and the holding costs. Besides these techniques there are many other techniques that can be used to effectively manage stocks. One of these techniques is the adoption of Just in Time (JIT) procurement system. JIT can help in the reduction of stock holding costs, manufacturing lead times, better labour productivity and reduced scrap and rework leading to reduction in warranty costs. “The prime goal of JIT is the achievement of zero inventory, not just within the confines of a single organization, but ultimately throughout the entire supply chain” (Hutchins, 1988) The financial viability of getting appropriate source of funding or setting up a business depends upon the financial resources available to the owner of that particular firm/company. It is usually difficult to ascertain a suitable source of financing and this in result affects the profitability and liquidity objectives of a company. (Fleming) The four main options available to any owner are: Share Issue Strengths Access to a wider pool of finance if a share issue is made to the public, hence reducing the risk of falling short on the required level of capital. The funding is committed to the business; the investors show greater interest in the company ad they become the owners of the company after their investment in it. If Brightview plc is listed on the Stock Exchange, it would be able to generate capital more easily. Listing on a stock exchange enhances the company’s image. Weaknesses Share issue is considered more expensive as many costs have to be incurred prior to the issue of shares to the general public. Costs such as underwriting and other marketing costs would be incurred before a share issue. Greater share issue would dilute the Earning per Share of the company, hence leading the existing investors in the company to protest against any future issue, such as bonus or right issue. Retained Earnings are the retained cash earnings of a company that have been kept along for any capital expenditure. Brightview plc can use its retained earnings to fund its expansion if it has enough. Strength It is a low cost source of finance for a company It is usually at the owner’s discretion to use it without any consent from other but as Brightview plc is a public limited company, a proper consent of all the share holder would be required to use the retained earnings in the expansion Weaknesses It may not be enough to support a huge expansion or restructuring. It may be difficult to use such fund for any capital expenditure or an expansion during a period when the shareholders would be demanding a higher dividend. Loan Stock/Debentures Strength Debentures or loan stocks are a cheaper form of finance. Debentures seem more attractive to investors because they will be secured on the assets of the company. Debenture holders are ranked above all the shareholders in case of bankruptcy. Weaknesses A Fixed commitment is to met regularly i.e. interest If such mode is availed for a longer period of time, higher interest would have to be paid. Warrants Strengths Warrants do not involve the payment of interest or dividends Warrants make a loan stock issue more attractive hence creating a possibility of issuing unsecured loan stock where appropriate security is lacking. Weaknesses Issuing warrants would dilute the Basic Earnings per Share in the future when the shares would be originally issued. Warrants, if exercised by an investor may reduce the owner’s holding in the company. Section Two Finance as a Resource a) “Weighted Average Cost of Capital (WACC) is the after-tax weighted average required return on all types of securities issued by a firm, in which percentage of each type of financing in a firm’s overall financial structure”. (Smart et al,) The weighted average cost of capital is the average cost of the company’s finance, weighted according to the relative size of each element compared with total capital. Brightview plc’s existing weighted average cost of capital is: Discounted Value for the Market Value of Debt after 2 yrs at 5% discount factor = 12,000,000 * 0.907 = 10,884,000 WACC = 6% * 30,000,000/ 40,884,000 + 5% * 10,884,000/ 40,884,000 WACC = 0.044 + 0.013 WACC = 0.057 or 5.7% approximately. b) Market Value of Brightview’s debentures after the fall in interest rates. Market Value of debt discounted for three years at 4% discount rate = 12,000,000 * 0.889 = 10,668,000 This decrease in the market value of the debentures is because the rate offered to the lenders has decreased due to the fall in the interest rates. Now at 4%, if the debenture would be sold in the market, it would fetch lesser interest as compared to a 5% interest; hence this affects its market value which would decrease as a consequence. c) CASH FLOW FORECAST January (£’000) February (£000) March (£’000) April (£’000) May (£’000) June (£’000) July (£’000) Sales 1,250 1,650 1,860 1,980 2,250 2,450 PAYMENTS Wages and salaries 850 850 850 1,460 1,460 1,460 Supplies 450 750 970 1,070 1,240 1,890 Rent and Rates 80 80 80 80 80 80 Advertising 50 50 50 50 50 50 Miscellaneous 10 10 10 15 15 15 TOTAL 1,440 1,740 1,960 2,675 2,845 3,495 Receipt minus payments (190) (90) (100) (695) (595) (1045) Balance Brought Forward 750 560 470 370 (325) (920) (1965) Balance Carried Forward 560 470 370 (325) (920) (1965) Recalculation of Cash Flow January (£’000) February (£000) March (£’000) April (£’000) May (£’000) June (£’000) July (£’000) Sales 1,250 1,650 1,860 1,980 2,250 2,450 PAYMENTS Wages and salaries 850 850 850 1,460 1,460 1,460 Supplies 450 540 648 778 934 1,121 Rent and Rates 80 80 80 100 80 80 Advertising 50 50 50 50 50 50 Miscellaneous 10 10 10 30 15 15 TOTAL 1,440 1,530 1,638 2,418 2,539 2,726 Receipt minus payments (190) 120 222 (438) (289) (276) Balance Brought Forward 750 560 680 902 464 175 (101) Balance Carried Forward 560 680 902 464 175 (101) The main trends in the re calculated cash flow is the increasing nature of supplies and wages and salaries, because of it large amounts, Brightview plc’s cash flow shows an outflow in the month of April, May and June. The sales figure for Brightview plc has remained the same for the last three months and there is no improvement in it, this is an alarming situation for Brightview plc as the payments are gradually becoming heavier than the receipts and if such a momentum continues, then the company may face severe liquidity issues. Section Three Financial Decisions a) Payback Year Cash Inflow (£’000) Cash Outflow (£’000) Cumulative Cash flow (£’000) 0 10,000 (10,000) 1 8,250 2,700 5,550 2 13,410 5,710 7,700 3 14,980 6,280 8,700 4 18,590 7,890 10,700 5 17,850 8,230 9,620 Total 32,270 Payback = 5,550 (1 Yr) + (4,450/7,700 * 12) (6.9 months) The Payback period for the above investment is 1 year and 7 months approximately. Accounting Rate of Return =Profit (Cumulative Cash inflow minus Depreciation)/ Initial Increase Investment Depreciation = 10,000,000/5 = 2,000,000 ARR = 32,270 – 2000/ 10,000 = 3.027% (LANGDON, K, 2002).  Net Present Value (£’000) Yr 0 1 2 3 4 5 Cash inflow 8,250 13,410 14,980 18,590 17,850 Cash outflow (10,000) (2,700) (5,710) (6,280) (7,890) (8,230) Depreciation (2,000) (2,000) (2,000) (2,000) (2,000) Net Cash Flow (10,000) 3,550 5,700 6,700 8,700 7,620 Discount Factor @ 5% 1 0.962 0.907 0.864 0.823 0.784 Discounted Cash flow (10,000) 3,415 5,170 5,789 7,160 5,974 NPV = (10,000) + 3,415 + 5,170 + 5,789 + 7,160 + 5,974 NPV = +17,508 b) Pay Back Method Strengths It is simple to calculate and is easily understandable It uses cash flow rather than accounting profit and cash flows give a better picture of the organization’s ability to generate funds. It is really helpful in capital rationing situations to identify those projects which generate additional cash for investment quickly. Weaknesses Ignores the timing of cash flows within the payback period It ignores the time value of money of the investment over the years It is difficult to distinguish between within the same payback period. (Merino et al,) Accounting Rate of Return Strengths The calculation is quick and simple Looks at the entire project life Weaknesses It is based upon accounting profit and not the cash flows, leading it to be more debatable. It does not take into account, the size of the investment. The time period of the investment is ignored Net Present Value Strengths The time value of money is considered as appropriate discounting factors are used. It uses all relevant cash flows relating to the investment, ignoring any other irrelevant costs such as sunk costs, etc. The timing of the cash flows is also considered. Weaknesses It uses future cash flow for discounting, these cash flows can be subjective as they are all estimates and estimates cannot be accurate. The cost of capital used as discounting factor is difficult to estimate and it may change over the life of the entire project. All positive NPV cannot be accepted in a limited capital situation. (Aplin et al, 1995) c) There are many factors that Brightview plc should consider when setting prices. The cash flow forecast depends upon the process set and the assumptions about the levels of demand of such mining goods. There are many factors that can either affect the level of demand or the general price level. When setting up the prices, Inflation is one of the major concerns which should be given a thought, a grater inflation rate can lead to increase in the price level; this may also affect the level of demand for the products of Brightview plc. Besides inflation, other factors that need consideration are the level of employment, the technological advancement, government policy towards mining products, etc. After considering all these factors an appropriate price can be set up by Brightview plc for its products. (Piana, 2001) Section 4 Financial Performance a) Brightview plc Profit and loss for the half year ended 2010 £’000 Sales 18,000 Less: Cost of Manufacturing Supplies (6,390) Gross Profit 11,610 Less: Expenses Wages & Salaries 6,930 Rent & Rates 480 Advertising 300 Miscellaneous 75 Depreciation 2,000 Net Profit 3,825 Balance Sheet as 30th June 2010 £’000 ASSETS Fixed Assets 10,000 Depreciation (2,000) 8,000 Current Assets Stock 2,000 Cash 4,000 Receivables 6,000 Total Assets 20,000 EQUITY AND LIABILITIES Ordinary Share Capital 8,000 Preference Share Capital 500 Retained Earnings 5,000 TOTAL EQUITY 13,500 LIABILITIES Current Liabilities Payables 2,500 Long Term Liabilities 4,000 TOTAL EQUITY AND LIABILITIES 20,000 Note The financial statement above has been prepared using fictitious figures. The main distinction between Brightview’s financial statement and other organization’s financial statements is the fact that Brightview plc is a manufacturing company and for that a proper manufacturing account is to be kept by the company to accurately calculate the cost incurred during the course of production. b) It is a legal requirement for many companies to produce a balance sheet and a profit and loss statement. Besides these two financial statements, there are other financial statements as well such as Cash Flow Statement, Statement of Changes in Equity, etc. The purpose of balance sheet and profit and loss are as follows: Profit and Loss Statement This statement shows the profit or loss made by any company in the normal course of business. It further elaborates the associated costs and revenues in a particular business. This sort of statement helps in comparing the performance of a company with other similar companies. This comparison helps in understanding any setbacks within a company. Besides this, a profit and loss statement helps investors to have a look at different organization profit making ability. Balance Sheet Balance sheet is a summary of all the assets, liabilities and the equity of a business. It gives a presentation of a company’s position at any particular point in time. The purpose of maintaining such a statement is to identify working capital issues such as liquidity or going concern position of a company. A balance sheet can help in identifying a company’s ability to meet its long or short term financial obligations. c) Ratio Analysis Ratio analysis is done by comparing meaningful information of companies between similar businesses. Ratios can be grouped into different categories such as: Profitability Ratios Liquidity Ratios Gearing ratios; etc Profitability ratios help in determining the profit making ability of a company. There are different ways of assessing profitability ratios such as: Return On Capital Employed = Profit Before Interest and Tax/ Capital employed This profitability ratios looks upon the return being provided by a company with respect to the capital invested in it. Investors would have their differing requirements in respect of the return on capital they have invested in an organization. Liquidity ratios determine a company ability to pay off its obligation as they fall due for e.g. Current Ratio This ratio looks upon the ability of a company to pay off its current obligation with appropriate current assets. A ratio in excess of 1 is supposed to be a good sign but this may differ in accordance with the industries concerned. d) The NPV is positive and the payback period is less than 2 years, hence this shows a great result and the project seems viable but besides that, the cash flow forecast is suggesting a loss for Brightview plc. According to the NPV calculation, it seems that the profit for Brightview plc would increase rapidly as there are positive cash inflows in the years to come and if the project is accepted, it would also increase the Net Assets of Brightview plc in its Balance Sheet. References CASLER, G. L., ANDERSON, B. L., & APLIN, R. D. (1984). Capital investment analysis: using discounted cash flows. Columbus, Ohio, Grid Pub. FLEMING, L. (2000). Excel preliminary business studies. Glebe, N.S.W., Pascal Press HUTCHINS, D. C. (1988). Just in time. Aldershot, Hants, England, Gower Technical Press ISOM, T. A., & AMEMBAL, S. P. (1980). How to interpret financial statements. [New York, N.Y.], AMACOM LANGDON, K. (2002). Investment appraisal. ExpressExec, 05.04. Oxford, England, Capstone Pub. http://www.netlibrary.com/urlapi.asp?action=summary&v=1&bookid=71295. LANG, H. J., & MERINO, D. N. (1993). The selection process for capital projects. New York, Wiley MEGGINSON, W. L., WHITE, S., SMART, S. 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