Financial Management: Wandering Lights Limited - Essay Example

Financial Management Question Wandering Lights Limited Financial analysis is essential for evaluating the working plan of a business on expected profits and financial ratios. While undertaking such an exercise, it is important to determine the adequate funds required, as also to conduct Research and Development programme, to establish and maintain an organization in order to make it operate effectively. Major Calculations: 1. Estimated Sales Forecast- (During the Year ended 31/12….) Year Unit Sales Average Unit  Selling Price(in ₤) Total Sales (in ₤) 2008 100,000 70 70,00,000 2009 110,000 70 77,00,000 2010 120,000 70 84,00,000 2011 90,000 70 63,00,000 2012 80,000 65 52,00,000 2. Financial Summary of Wandering Lights Limited –(During Current Year) Particulars Amount (in ₤) Net amount(in ₤) Share Capital. Less: Amount utilized for developing solar and wind powered lighting systems. Balance Working Capital requirements Total Amount held by Wandering Lights Limited Plant and Machinery at Cost ₤1,500,000 ₤1,125,000 ₤3,375,000 3,75,000 ₤1,000,000 13,75,000 3. Calculation of Depreciation of Machinery.(Purchase Price of Plant&Machinery costs₤3,375,000) Year Depreciation (on Straight line basis.)(in₤) Amount After Depreciation.(in ₤) 2008 75,000 33,00,000 2009 75,000 32,25,000 2010 75,000 31,50,000 2011 75,000 30,75,000 2012 75,000 30,00,000 Total 3,75,000 Notes to Accounts: A. Straight line basis of Depreciation: Under this method, the amount of depreciation charged for each year through out the life of Asst is equal. i.e. ₤ 3, 75,000/5 Years (From 2008 to 2012) = ₤ 75,000 per year. B. Total Cost of Acquisition_ Total Depreciation= Book Value of Asset. Therefore, ₤3,375,000_ ₤ 3, 75,000= ₤30, 00,000. 4. Budgeted (Estimated) Balance Sheet as on 31st December…………… Liabilities Share Capital. Additional Working Capital. ₤1,000,000 Add: Addition incurred yearly base- ₤400,000 Overdraft. Provision for Depreciation. TOTAL Amount in ₤ ₤1,500,000 ₤14,00,000 ₤25,000 ₤75,000 Assets Plant and Machinery:- At cost-₤ 3,375,000_ Less: Depreciation-₤ 3,75,000 Plant & Machinery after Depreciation. Amount in ₤ ₤ 30,00,000 ₤ 30,00,000 ₤ 30,00,000 Assumptions. 1. Additional working capital incurred during the year 2007 is ₤1,000,000; there after it is ₤400,000 one year later. 2. Assume provision for depreciation is usually provided yearly basis. (i.e. ₤75,000per year.) 5. A. Estimated Cost Sheet. (31/12/2008)[Assume that Company is producing 1, 00,000 units during each budgeted year]. Particulars. Amount in₤ Net Amount in₤ Direct Material. Direct Labour Prime Cost. Add: Overheads- Variable. Fixed cost. Total Cost Add: Profit. Sales ₤25*1,00,000 ₤20*1,00,000 ₤1*1,00,000 25,00,000 20,00,000 45,00,000 1,00,000 13,50,000 59,50,000 10,50,000 70,00,000 5. B. Estimated Cost Sheet. (31/12/2009)[Assume that Company is producing 1, 10,000 units during each budgeted year]. Particulars. Amount in₤ Net Amount in₤ Direct Material. Direct Labor. Prime Cost. Add: Overheads- Variable. Fixed cost. Total Cost Add: Profit. Sales ₤25*1,10,000 ₤20*1,10,000 ₤1*1,10,000 27,50,000 22,00,000 49,50,000 1,10,000 13,50,000 64,10,000 12,90,000 77,00,000 5. C. Estimated Cost Sheet. (31/12/2010)[Assume that Company is producing 1, 20,000 units during each budgeted year]. Direct Material. Direct Labor. Prime Cost. Add: Overheads- Variable. Fixed cost. Total Cost Add: Profit. Sales ₤25*1,20 ,000 ₤20*1,20 ,000 ₤1*1,20,000 30,00,000 24,00,000 54,00,000 1,20,000 13,50,000 68,70,000 15,30,000 84,00,000 5. D. Estimated Cost Sheet. (31/12/2011)[Assume that Company is producing 90,000 units during each budgeted year]. Direct Material. Direct Labour Prime Cost Add: Overheads- Variable. Fixed cost. Total Cost Add: Profit. Sales ₤25*90,000 ₤20*90 ,000 ₤1*90,000 22,50,000 18,00,000 40,50,000 90,000 13,50,000 54,90,000 8,10,000 63,00,000 5. E. Estimated Cost Sheet. (31/12/2012[Assume that Company is producing 80000 units during each budgeted year]. Direct Material. Direct Labour Prime Cost. Add: Overheads- Variable. Fixed cost. Total Cost Add: Profit. Sales ₤25*80000 ₤20*80,000 ₤1*80000 20,00,000 16,00,000 36,00,000 80000 13,50,000 50,30,000 1,70,000 52,00,000 Assumptions 1. Assume that variable OH per units cost ₤1per unit. 2. Fixed cost remains same every budgeted year. Calculation of NPV: Net Present Value= Cash flow at the end of the year (Difference between cash in flow and outflow) Year Cash in flows(₤) Discount Factor 12% Present Value(₤) 2008 70,00,000 0.8929 62,50,300 2009 77,00,000 0.7972 61,38,440 2010 84,00,000 0.7118 59,79,120 2011 63,00,000 0.6355 40,03,650 2012 52,00,000 0.5674 29,50,480 Total 2,53,21,990 Assume that here inflow is taken as the sales value of every year. Under NPV, initial investment is taken as cash outflows. NPV method is taken in to account in case of time value of money. It uses the discounted cash flows. A project should be accepted if the NPV is positive, otherwise it should be rejected. Internal Rate of Return (IRR) - It is the sum total of cash inflows after discounting, which is equal to the discounted rate of cash out flows. The IRR technique is crucial for taking the capital investment decision. A particular project should accept IRR, only if it is greater than Cut-off rate, otherwise such project should be rejected. In case of Wandering Lights Limited, it is better to adopt NPV method rather than IRR method, because while assessing the financial viability, technical feasibility, and taking the appropriate capital budgeting decision of Wandering Lights Limited, it is suitable to undertake NPV as the capital budgeting decision. Question 2 Financing of investment Wandering Lights Ltd has decided to launch a new product in the market. The product is garden lights. For the production of the new product the company has to introduce new plant and machinery in the business. The estimated cost of the plant and machinery is ₤3375000. In order to install the new plant and machinery the company additional fund has to be brought into the company as the capital is not sufficient to install the new facility. Wandering lights have two options before them to finance their project. Either they can issue new share or it can borrow funds. Borrowing is the method in which the company borrows fund from any institutions or banks as loans upon an agreement to pay interest at a fixed rate. Borrowings also may be in the form of different securities issued by the company. The companies have different methods for borrowing money. “There are two main methods by which a company can borrow money: (1) by issuing fixed-income (debt) securities – like bonds, notes, bills and corporate papers – and (2) by taking out a loan at a bank or lending institution.” (When companies borrow money. 2007). Wandering lights can depend on either of the following methods for financing the new project. Most common type of debt financing is taking loan from banks. Loan from banks bear a fixed interest per year which the company is obliged to pay. The company can choose even a short term or long term loans. Short term loans are for a period of 1 to 5 years whereas the long term loans are for a period of 10 – 20 years. Issue of share capital is the next method by which the company can bring in additional capital. This method is used when the authorized capital is not issued by the company fully. The company issues the rest of the capital to the already existing shareholders or as a fresh issue to the public. Share capital does not bear a fixed interest obligation on the company. Return on capital is required to be paid only during the period of profits. Impact of the methods on the capital structure of Wandering Lights Ltd The use of any of the two methods will have necessary impact on the capital structure of the company. “A healthy proportion of equity capital, as opposed to debt capital, in a companys capital structure is an indication of financial fitness.” (Loth 2006). A company’s capital structure generally consists of a combination of both debt and equity capital. Though these two methods are used it cannot be said that any one of these methods are very good for the capital structure. A proper mix of both the methods will make a better capital structure for the company. The impact of borrowed fund is that interest on the loans will have to be paid by the company. But comparatively this will improve the financing capacity of the business. A low rate of the capitalization ratio is very much favorable for the capital structure of the company. The capitalization ratio represents the usage of more of equity fund compared with the debt fund. Therefore, for financing the new plant and machinery for Wandering Lights Ltd it is advisable to have more of issued capital. Take over option for Wandering Lights Ltd Wandering Lights Ltd has received a take over option by Golden Glow Plc, a company that is operating in the similar industry. Take over option put foreword by Golden Glow Ltd may be the acquisition of majority of the stake or a stake below 50% in Wandering Lights Ltd. The acquired company and its share holders will face both positive and negative impact after the takeover. The share holders of Wandering Lights Ltd will have to face both advantages and disadvantages due to its acquisition by Golden Glow Plc. Advantages If Golden Glow is a company that is very much specialized in the industry and the one which has a very good market share and reputation among the public the share value of Wandering Lights will increase. This is because in such a case Golden Glow would more technology in the production process that will increase the quality of the product and ultimately the profits of the company. Increase in the share value of the company will help the share holders to earn better returns. The acquisition process will increase the assets of the company. Increase in the assets of the company will improve the financial strength of the company that will ultimately be beneficial to the shareholders. Disadvantages Though there are many advantages for the share holders of Wandering Lights Ltd when it is acquired by Golden Glow the shareholders will also have to face certain disadvantages. When Golden Glow acquires majority of the stake in Wandering Lights the share holders of Wandering Lights will have limited control over the affairs of the company. Golden Glow will manage the affairs of the company to their advantage. The share holders of Wandering Lights will have to face the manipulations made by Golden Glow Plc. Question 3 Effect of Risk factors Decision making is a process that involves greater risk. Risk is a crucial factor that should be considered while making decisions. The statement says that larger firms are more prone to the effect of risk factors in the decision making process. But in the real context risk factors almost common to both type of business. Large business enterprises employ a greater amount of capital for its functioning. Therefore, the flow of those funds is depended on the decisions at the treasury level or the financing level of the business. As far as smaller business is concerned the fund employed is comparatively low. But the employed fund may be higher when that particular business is concerned. Therefore, the risk factors are almost similar irrespective of the size of the organization. Question 4 There is a strange paradox in this area of finance: in order for the market to remain efficient there has to be a large body of investors who believe it to be inefficient…….There is a grey area which stands between trading on insider knowledge and trading purely on publicly available information." This particular phrase is mentioning that in order to make the market more efficient, it is essential to improve the investment capacity of the share holders. For the purpose of eliminating the inefficiency, investors should provide focus on improving the financial investment, that means the investors are eager to take up the risks of investment. “Investor credulity and systematic mis-pricing in general suggest a possible role for regulation to protect ignorant investors, and to improve risk sharing.” (Investor Psychology in Capital Markets. 2001 P.4). The concept of financial investment and risk factor is closely related. “An effective appraisal mechanism of various sources of funds available to a company must be instituted in the company to achieve its main objectives. Such a mechanism is required to evaluate the risk, tenure and cost of each and every source of fund.” (Financial Management. 2004 P.231). Bibliography Financial Management. 2004. Board of Studies. The Institute of Chartered Accountants of India. Sources of Finance. Introduction. P.231. Investor Psychology in Capital Markets. (2001). Evidence and Policy Implications. Introduction. P.4. http://www.econ.nyu.edu/user/bisina/kent_hirshleifer_subrahmanyam.pdf LOTH, Richard (2006). Evaluating a Companys Capital Structure. [online]. Investopedia. Last accessed 16 November 2007 at: http://www.investopedia.com/articles/basics/06/capitalstructure.asp When companies borrow money. (2003). How do companies borrow money. [online]. Investopedia. Last accessed 16 November 2007 at: http://www.investopedia.com/articles/basics/03/091903.asp Read More