Investment Appraisal Techniques for Cagoo Clothing Plc - Assignment Example

Management Accounting Table of Contents Task 3 Introduction 3 Investment Appraisal Techniques for Cagoo Clothing Plc 3 Conclusion 5 Task 3 6 a) Retained Earnings as a Source of Finance 6 Advantages of Retained Earnings as the Source of Finance 6 Disadvantages of Retained Earnings as the Source of Finance 7 b) Alternative Source of Finance other than Retained Earnings 7 Reference List 8 Appendix 1: Payback Period 9 Appendix 2: Net present Value 9 Task 1 Introduction The main aim of the report is to execute investment appraisal techniques for evaluating the project undertaken by Cagoo Clothing Plc to purchase a new shop in London by investing £7 million. The cash spent and received are assumed and justified based on the industry average and also after considering the financial data of large retailers such as Next plc. The source of finance for the new project is defined along with the cost of capital. Investment Appraisal Techniques for Cagoo Clothing Plc The investment appraisal techniques help in determining whether a particular project is profitable in the long run. The methods are net present value (NPV), payback period (PBP) and internal rate of return (IRR). These techniques are used for evaluating the new project that the owner of Cagoo Clothing Plc wants to undertake in London. The owners have the desire to purchase a new shop in London and want to invest £7 million. The cash inflow and outflow are assumed based on the industry performance. The cost of capital for the project is assumed to be 15%. The source of finance for the owner of Cagoo Clothing Plc is personal savings and bank. The break-up of the source of finance are given below. Source of finance Amount in £ million Personal savings 2 Bank 5 Total 7 The following assumptions are considered for the examining the project: The cash inflow and outflow for 12 years of Cagoo Clothing Plc are depicted below in the following table: The values of cash received are assumed based on the revenue data that are collected from the annual report of Next Plc, which is a renowned retail clothing company (Next Plc, 2015a; Next Plc, 2015b; Next Plc, 2015c). In the above table, the cash received column depicts the revenue that is expected to be generated by Cagoo Clothing Plc. However, the cash spent is the total amount invested for continuing the operation or the working capital that is required for everyday operation i.e. cost of sales, operational and administrative expenses etc. From the above mentioned data and assumptions NPV, IRR and PBP are calculated for evaluating the project that is expected to be undertaken by Cagoo Clothing Plc. The following results are obtained. 1) The PBP of the project of purchasing a new shop is 5.3 years i.e. Cagoo Clothing Plc will earn the investment of £7 million at the end of 5.3 years. Therefore it can be stated that the project is quite lucrative for the company is the PBP is considered (For calculation refer to Appendix 1). 2) The NPV of the project of purchasing a new shop is £ 9.5 million i.e. after 10 years the value of the project at cost of capital (10%) will be £ 9.5 million (For calculation refer to Appendix 2). Sensitivity analysis Discounting factor NPV Discounting factor IRR 10% £9.5 million 15% 14% 10.5% £9.0 million 18% 15% 12% £7.6 million Hence, the project is profitable with respect to NPV also. 3) The IRR of the project is 14% (Refer to excel sheet for the calculation of IRR). Conclusion The financial data considered for the investment appraisal are assumed and based on the performance of Next Plc, which is a renowned retail company. The appraisal of the data with the help of NPV, IRR and PBP revealed that the project of purchasing a new store in London by investing £7 million is profitable for the owner of Cagoo Clothing Plc. Task 3 a) Retained Earnings as a Source of Finance Companies require significant amount of capital for encountering growth and also for extending business (Shenoy, 2015; Bhat, 2010; Bierman and Smidt, 2003). These companies can acquire capital both aggressively and conservatively. The aggressively mode of financing is related to bank loans; however, one of the most significant conservative source of financing is retained earnings (Bhat, 2010; Bierman and Smidt, 2003). Retained earnings are the part of trading profits that are not distributed among the investors through dividends for the expansion of company. The amounts are invested in the equity shares, which takes the form of capital gains and dividends. It is generally defined as the internal source of finance that is available to a company. It is stated ass the sacrifice that is made by the shareholders. Like other source of finance, retained earnings have advantages and disadvantages (Shenoy, 2015; Bhat, 2010; Bierman and Smidt, 2003). Advantages of Retained Earnings as the Source of Finance There are many advantages of retained earnings as the source of internal financing. Firstly, the retained earnings add no cost to company. Secondly, it avoids flotation or issue related costs unlike other source of external and internal financing (Tirole, 2010; Chandra, 2008). Thirdly, the use of the retained earnings helps in avoiding possibility to change or dilute the control on existing shareholders, which actually results from the issue of new shares. Fourthly, if the companies use retained earnings as the source of financing it does not have to comply with legal formalities. It requires a resolution that should be passed in annual general meeting of company. Fifthly, it is the cheaper source of financing as it does not involve acquisition cost and it helps in strengthening the financial position of the business (Bhat, 2010; Bierman and Smidt, 2003). The most important advantage of retained earnings is that even if the company fails to earn profit but the shareholders get their dividend (Tirole, 2010; Chandra, 2008). Disadvantages of Retained Earnings as the Source of Finance The disadvantages of retained earnings as source of finance are discussed henceforth. The purpose of retained earnings is not stated and this it may end in irrational spending. Retained earnings are defined as the conservative source of financing, which may lead to accumulation of earnings and thus ends in over-capitalisation. It does not allow the shareholders to enjoy the benefits of actual earnings of the companies. Therefore, it develops sense of dissatisfaction among the shareholders. The cost of retained earnings is higher than any other source of finance; it is the dividends that are foregone by the shareholders, which also considers the opportunity cost (Tirole, 2010; Chandra, 2008). b) Alternative Source of Finance other than Retained Earnings The alternative source of finance for Growright is equity and debt financing. Both have equal disadvantages and advantages just like retained earnings. Through equity source of financing, the company aims at accumulating its finance conservatively but excessive debt financing leads to aggressive source of the financing. The main disadvantage of equity financing is that the company has to give up part of ownership to shareholders. Conversely, in case of debt financing the ownership status remains with company (Bhat, 2010; Bierman and Smidt, 2003). The most important disadvantage of debt financing is that the loan has to be paid back by the company even if it is not performing on the other hand the shareholders do not receive increased returns if the company does not earn enough profit. In case of equity financing, the risk of losing in the business opportunity is shared with the shareholders (Bhat, 2010; Bierman and Smidt, 2003). Reference List Bhat, S., 2010. Financial management. New Delhi: Excel Books India. Bierman, H. and Smidt, S., 2003. Financial Management for Decision Making. New York: Beard Books. Chandra, P., 2008. Financial management. New Delhi: Tata McGraw-Hill Education. Next Plc, 2015a. Annual Report 2015. [online] Available at: < http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/reports-and-results/2014/NEXT%20Annual%20Report%202015%20FINAL%20Web.pdf > [Accessed 30 June 2015]. Next Plc, 2015b. Annual Report 2014. [online] Available at: < http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/reports-and-results/2014/Next%20AR2014%20web.pdf > [Accessed 30 June 2015]. Next Plc, 2015c. Annual Report 2013. [online] Available at: < http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/latest-news/2013/ar2013.pdf > [Accessed 30 June 2015]. Shenoy, D., 2015. What Is Retained Earning? What Are Its Advantages And Disadvantages? [online] Available at: < http://www.publishyourarticles.net/knowledge-hub/economics/what-is-retained-earning-what-are-its-advantages-and-disadvantages/4742/ > [Accessed 30 June 2015]. Tirole, J., 2010. The theory of corporate finance. New York: Princeton University Press. Appendix 1: Payback Period Appendix 2: Net present Value Read More