Managing Financial Resouces and Decisions - Assignment Example

MANAGING FINANCIAL RESOURCES AND DECISIONS By The sources of finance involve funding business activities to achieve its financial obligations. As stated by BTEC Edexcel (2011), the main purpose of efficient financing policy is to raise an appropriate level of funds, at the time they are needed, at the lowest cost. The sources of finance are usually divided into internal and external finance. These sources are based on short, medium or long-term funds. In a broad perspective, they are categorized into equity or debt finance. Internal finance (Equity) is cash generated by a company itself. In this case, the company is not meeting any operating costs. External finance (Dept) is a cash generated from outside the company (external source), but the company is ready to meet operating cost of finance. In these categories therefore, there are pros and cons, so management of the company has to find the right solution of the sources of finance in order to generate a cash flow at the lowest price and to obtain wealth of the company ( Chakravarty, 2004). In the case of the Wm Morrison Supermarkets PLC, the most appropriate sources of finance is a combination of equity and dept finance. A critical analysis of the sources of finance shows that Equity sources of finance that are: shares issue, Sale of fixed assets, Retained profits as well as the dept sources of finance; debentures, bank loans, bank overdraft, leasing. Accordingly, there is need to consider and assess certain sources of finance implication to the company. For this reason, there is an eventual need to discuss advantages and disadvantages of each appropriate sources of finance for the Wm Morrison Supermarkets PLC. Types of shares: There are two types of shares, Ordinary Shares (Equities) and Preference Shares. Ordinary Shares (Equities) are the most common shares. An ordinary share confers the right to vote in strategic company decisions (approval of the financial statements, auditors report and election of the Boar). Investors who have ordinary shares usually earns from rising value of the shares and the dividends. Ordinary shareholders do not always receive dividend. Dividends are first paid to the preference shareholders and then the remaining portion of the profit is paid to the Ordinary shareholders. Despite the fact that Ordinary shareholders receive dividends last in good economic period, they can however get much higher dividends than Preference shareholders at some instances. In a case of companys bankruptcy, the ordinary shareholders are paid last. If a company is bankrupted, and its assets have been sold and the funds that is received first is settled with ​​employees. The taxes, repayments to banks, and bondholders are settled with the owners of preferred shares. The remainder is then distributed to the Ordinary shareholders. From company’s point of view however, the worst part of issue of additional equity shares dilutes the voting power and earnings of existing equity shareholders. Also, the cost of equity is generally more as compared to the cost of raising funds through other sources ( Chakravarty, 2004). Preference shares are external sources of finance. Preference shareholders generally have no voting rights in making strategic decisions in the company, but are entitled to receive an annual fixed payment - dividends. Preference shareholders receive dividends even if the company operating at a loss. Dividend amount is set by the companys articles of association. Dividend is usually expressed as a percentage of the nominal value of the preference share. Preference shareholders have no voting rights, so they do not affect the control of equity shareholders over the management and fixed rate of dividend may enable a company to declare higher rates of dividend for the equity shareholders in good times. The disadvantage of this source of finance is that the rate of dividend is higher than the rate of interest on debenture and dividend paid is not tax deductible, thus there is no tax saving as in the case of interest on a loan (Needham, Dransfield, and others 1999). Rights Issue A rights issue provides a way of raising new share capital by means of an offer to the existing shareholders, inviting them to subscribe cash for new shares in the proportion to their existing holdings at a relatively cheap price. Retained profit It is when the profits made are ploughed back into the business. Profits earned are not distributed to the owners but are reinvested in the business. Disadvantage of this source of finance is that company by using its profit reduce capital of the company. Also, this source is available just for a business that is running more than one year and sometimes business may not make enough profit to plough back. However, on other hand Retained Profit does not have to be repaid, and there is no interest to be paid (Needham, Dransfield, and others 1999). Sale of fixed assets. This is money comes in from selling off fixed assets, such as a piece of machinery that is no longer needed. This is a short – term sources of finance. Sometimes can be a slow method of raising finance, because need time for a sale process and this is a permanent source of finance. Loans – could be debentures, bank loans and mortgages, Merchant or Investment Banks, Government Grants. Thus it is money borrowed at an agreed rate of interest over a set period of time. It could be a medium or long-term source of finance, and it is dept finance that increase liability of the company. In mortgages and bank term loan case usually bank asking property or some other asset acts as security for the loan. The advantage is that set repayments are spread over a period of time that is good for budgeting, and loans are tax – deductible (Needham, Dransfield, and others 1999). Debenture is a written acknowledgment of a debt by a company, usually given under its seal and normally containing provisions as to payment of interest and the terms of repayment of principal. A debenture may be secured on some or all of the assets of the company or its subsidiaries. Some Debentures could be convertible, whereby the Debenture can be converted into shares of the corporation’s common stock. Generally, if Debentures are convertible they typically carry lower interest rates than Debentures without the convertibility feature (New Walls Street Journal, 2013). Bank overdraft – is a short term source of finance, and it allows a company to withdraw an amount in excess of its current account balance. Advantage is that the company can cover the period between money going out of and coming into a business Overdrafts are repayable on demand, but in case overdraft was used over a longer period of time it can be expensive. Leasing it is an agreement with a lessor that allows the business to use an asset without having to buy it outright. It is mean that company can use an asset without having to find the money to pay for it immediately. Leasing is two types: Operating and Finance lease. Operating leasing is rental agreements between the lessor and the lessee where lessor supplies the equipment to the lessee, and he is responsible for servicing and maintaining the leased equipment. Depended of the period of the lease, the end of agreement lessor can lease the equipment to someone else or to sell second hand. Advantage of it is that company does not have to buy equipment and to spend some amount of money, but can use it just for operating fees (Needham, Dransfield, and others 1999). Finance lease is agreements between the user of the leased asset and a provider of finance for a longer period usually until the agreement will cover most of the asset’s useful life. Lessor requires payments to total in excess of the cash price of the asset. Usually the equipment has comparatively little value of the end of the lease term, so agreement allows the lessee to continue leasing for an indefinite secondary period for a very low nominal rent or to purchase the assets. Lessee himself have to take all responsibility for the upkeep, maintenance and servicing of the equipment. Payments are spread over a period of time which is good for budgeting (Chakravarty, 2004). On the Wm Morrison Supermarkets PLC Balance Sheet we can see that company have liabilities that are mean that they use dept sources of finance in combined with equity capital. Sources of finance must be suitable for particular company, if it is Limited Liability Company, they cannot take an opportunity to issue shares in public, but if it is Public Limited Company like Wm Morrison Supermarkets PLC they have more opportunities to fund their investments. Also organizations that have equity capital look more reliable for investors. Thus, company’s managers for any business project implementation have to evaluate capacity of the company and opportunities which is available for particular company. Task 2 Financial planning is one of the most important enterprises challenges. Each entrepreneur firms have to evaluate the cost and impact of different sources of finance to his company. Therefore is necessary to consider costs and impact to the Wm Morrison Supermarkets PLC of equity and debt sources of finance. Shares issue. Cost of Ordinary shares is generally maximum as such shareholders expect much higher return on their investment as compare to others long term investors. Also the dividend payable on shares is an appropriation of profits and not a charge against profits. Hence it is paid out of profits after tax only. On the other hand, Preference shareholders have a priority of a fix amount of dividend payment and repayment of capital if a company is doing very well. These shares are cumulative. If dividend was not paid in a year of loss is carried over to the subsequent year till there is a sufficient profit to pay the dividends. Generally, Preference shares rate of dividend is more than the rate of interest on debentures or loans. Preference shares like equity dividend is not tax deductible payment ( Chakravarty, 2004). On other hand, cost of debentures is much lower than the cost of equity or preference capital since the interest is tax deductible. The British tax system affects the relative cost of different sources of finance, and has been instrumental in the growth of debt finance over preference shares. Interest charges are tax – deductible but dividends are not (Needham,et, al, 1999). Many companies use other equity source of finance like - retained profit or earrings and there is a mistake to think that this source of finance does not cost for the company. It is part of the capital structure of a company, which is could be used for common shareholders paid out as dividends, but earnings are ploughed back into the firm for growth and use it as part of their capital structure. The cost of Retained profit to the company is an opportunity cost. An opportunity cost determines the chose between two alternatives where the cost of choosing one alternative over another is an opportunity cost. In other words an opportunity cost is the benefits you lose by choosing one alternative over another one ( Peavler,2013). Bank lending is a medium or short term debt source of finance, but very common in these days. The cost of borrowing from the bank is interest. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate. Bank overdraft is very flexible form of short – term finance, because fund are there when the business needs them, and interest is only charged on the daily balance, but company should keep within a limit set by the bank (Needham, Dransfield, and others 1999). Leasing is good opportunity for those who do not have cash to pay for asset full amount, and they can use an asset with debt financing where the debt repayment is spread over a period of years. Consequently, debt financing is cheaper than equity financing as adept financing is tax – deductible and equity non-tax – deductible ( Grossman, Livingstone, 2009). From Wm Morrison Supermarkets PLC Financial statements we can see, and that company have debt and equity funding system. There are some techniques to find cost of capital and one of most popular is WACC (Weighted Average Cost of Capital). “The weighted average cost of capital (the discount rate) is calculated by weighting the cost of debt and equity in proportion to their contributions to the total capital of the firm.”(Arnold, 2007). The most important task for financial managers is financial planning which includes raising capital to fund the internal investments of the firm. Thus businesses have to identify, analyze, and approve investment opportunities and on the other hand financial managers have to choose the most efficient way to fund these internal investments. The most important task here is to find the most appropriate source of finance or combination of sources for the particular company where the main goal is to reduce or minimize cost of capital. Other important criteria which determine the suitability of the particular sources of finance is risk and return in relation of choice the right mix of debt and equity finance. There is certainly that any investor prefers less risk than greater risk of investment, but in turn, if their high risk of investment investor expects to earn a higher rate of return. So between risk and return there are strong relationship as much risky investment is as much investor expecting in return. Therefore, to make any financial decision need to evaluate a lot of factors, such like period of time for which you need a funding, the amount to be invested, evaluate the liabilities, evaluate the cost of the financial source and risk, the company’s current position and opportunities (Needham, Dransfield, and others 1999). Consequently, financial managers have to evaluate such internal and external environment where business operating. Very often external environment has large impact to the company’s financial planning such like taxation system in country, any political decisions made or inflation. Evaluation of internal environment is very important for any decision making. Before management decides how to fund their business expansion has to understand their business weaknesses and strengths, threats and opportunities. The table below revealed the impact of each source of finance to the financial statements. Sources of finance Income Statement Statement of Financial Position Statement of cash flow Shares Reduce profit Increase capital Increase cash Retained profit No cost Reduce capital Increase cash Sell of fix assets No cost Reduce asset Increase cash Bank lending Reduce profit Increase liability Increase cash Bank overdraft No effect Increase liability Increase cash Debentures Reduce profit Increase liability Increase cash Operating lease Reduce profit No affect Increase cash Finance lease Reduce profit Increase asset Increase cash Table 2.1 On the table 2.1 above, is shown how each source of finance affects financial statements. All of them are increasing cash on Cash Flow Statement. On other hand, almost all sources o finance has cost ant it reducing company’s profit which is revealed on Income Statement. Statement of Financial Position shows the company’s capital and asset and liabilities. Thus, almost all debt sources of finance increase the liability of the company. Actually, liabilities are a vital aspect of a companys operations because they are used to fund operations and pay company’s expansions. Task 3 The annual budget is a statement of expenditures and revenues that are likely to occur in a business concern during the fiscal. The budget has to be realistic in the sense that all items of reduction have to be justified to respective departments when cuts will be introduced. The budget should ensure optimum resource allocation that matches the organisation’s priorities. Unplanned expenditures (over or under spending) might affect the development plans of the business. Required reductions in expenditures have to be justified respectively. Variations of actual outputs from budgeted helps control level of financial activities and hence facilitate investors to make informed decisions by analysing budget variances. Unit cost is very important parameter when financial decision is evaluated on financial information. It describes all variable, fixed costs including manufacturing expenses. It is very important because depending on how a company establishes per unit cost of items, and the distribution and production costs would impact the structure of company’s income statements. Mathematically, the cost per unit of identical products are calculated using the following formula, Where, Total variable costs includes direct materials and wages; total fixed cost includes rent, and other operating expenses. Total units of production are total number of units produced in particular accounting period. The basic theories on pricing decisions suggest that the high-price strategy prevails in case of specialty products whereas the low-price strategy is used for preference and convenience products. NPV The NPV for a series of cash flows (outflow and inflow) is the summation of present value of each cash flow discounted at appropriate discounting rate which the investors expect to earn during the period of investment. The technique compares the present value of money on present day with the money expected to be received in future. The process is recommendable because it considers practical factors such as inflation and returns. Mathematically, Project Evaluation criteria: Case 1: When NPV>0 Recommendation: Such projects should be accepted Case 2: When NPV Read More