Aveneu Park, Starling, Australia

Birmingham bank loan. 1) medium term: ·

Birmingham
City University

Introduction
to Finance

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Course
Work

Question
1

There are two sources of business finance internal and
external. The domestic sources of funding are:

·        Retained profits,

·        Issuing shares.

The external sources of finance are divided into three
categories: long term, medium term, and short term.

    Long-term sources
of finance:

·       shares,

·         debentures,

·       grants,

·         long-term bank loan.

1)     medium term:

·        leasing,

·        hire purchase,

·        medium-term
loan.

2)    short-term:

·       bank
overdraft,

·       bank
loan,

·       creditors,

·        debt factoring.

Each source of finance has advantages and disadvantages.
The benefits of funds from investors or shareholders are potentially more funds
will be available, and it enables large scale of investments. On the other
hand, the disadvantages of funds from investors or shareholders are that it is
expensive; the control of the company has to be shared; the value of the shares
can fall and rise, affecting company’s value.

A company can reduce its WACC
by cutting debt financing costs, lowering equity costs and capital
restructuring. Equity cost is the return on investment that shareholders expect
to earn from the company. If you reduce a given risk, it reduces equity cost.
For example, if a particular risk on future net cash flow is linked to poor
market segmentation, you can reduce the risk by implementing proper market
segmentation strategies. The cost of debt is the interest rate applied on loans
borrowed from banks and non-bank financial institutions. Cutting the costs of
debt begins with lowering the costs of non-payments. If the interest rate debt
is higher than the interest rate of alternative capital, your company could
source the alternative capita; and pay off the debt. A company can review the
structure of its debt in a bid to reduce WACC. One option of capital
restructuring involves substituting debt for equity because it translates to
lower costs after taxation.

Cost of Equity is the rate of
return required to persuade an investor to make a given equity investment. It
is the rate of return that could have been earned by putting the same money
into a different investment with equal risk. There are two ways of determining
the Cost of Equity. The formula of Cost of Equity is:

 

 

Table 1.1 is showing the Cost of Equity of GNCC Capital and
MAGNET.

 

Cost of Equity

GNCC Capital

MAGNET

14.89%

12.67%

Table
1.1

 

 

 

From the information above, we can conclude that GNCC has a
higher Cost of Equity Ratio. There are some advantages and disadvantages
regarding dividend growth model for measuring the cost of capital. The Dividend
Growth Model is easy to use and understand, but it does not apply to companies
that don’t pay dividends. Also, it assumes that dividends grow at a constant
rate over time. The Dividend Growth Model is also quite sensitive to changes in
the dividend growth rate, and it does not explicitly consider the risk of the
investment.

 

Preference
shares represent a special type of ownership interest in the firm. They are
entitled to a fixed dividend but subject to availability of profit for
distribution. Retained earnings, used as a part of the capital structure of a
business firm, are the part of the earnings available to common shareholders
not paid out as dividends or the earnings lowed back into the firm for growth.
“The most important source of long-term finance for most corporations is
retained earnings.” Arnold (2013), p.702

 

Cost of preference share capital is that part of the cost
of capital in which we calculate the amount which is payable to preference
shareholders in the form of a dividend with a fixed rate. The formula of cost
of preference share capital is:

 

 *
100

 

or

 

 *
100

 

where:

 

 = Annual preference dividend

 

 =
Net proceeds = Par Value of Preference Share Capital – Discount – Cost of
Floatation or NP = Par Value of Preference Share Capital + Premium

 

Table 1.2 represents the Cost of Preference Share Capital
of GNCC Capital and MAGNET for the year ended 31 December 2016 is:

 

100

 

 

 

 

Cost of Preference Share Capital

GNCC Capital

MAGNET

7.62%

8%

Table
1.2

 

 

 

   Debt is the
cheapest way of financing a company. The Cost of Debt is usually based on the
company’s bonds. Bonds are the company’s long-term debt and are the company’s
long-term loans. Cost of Debt is the return that lenders require on the firm’s
debt. D. Hillier, I. Clacher, S. Ross, R. Westerfield, B. Jordan (2016) The
following factors determine the cost of debt:

·       the
prevailing interest rates;

·       the
risk of default (and expected rate of recovery of money lent ion the event of
default).

·       the
benefit derived from interest being tax deductible.

The Cost of Debt , is the current market rate
of return for a risk class of debt. The cost to the firm is reduced to the
extent that interest can be deducted from taxable profits:

 

 

G. Arnold (2013)

To calculate a company’s cost of debt, we will need to
know:

·       interest
rate it pays on its debt;

·       marginal
tax rate.

The formula of cost of debt is:

 

 

Table 1.3 represents the Cost of Debt of GNCC Capital and
Magnet for the year ended 31 December 2016.

 

Cost of Debt

GNCC Capital

MAGNET

7.5%

7.5%

Table
1.3

 

 

 

We are getting the same answer. We can conclude that GNCC
and MAGNET have an equal cost of debt.

 

          “The average
cost of capital can be calculated by taking the cost of the individual elements
and then weighting each element in proportion to the target capital structure (by
market value) of the business.” (Atrill, 2017, p.359) The formula for WACC is:

 

 

Where:

 = market value of the firm’s equity (market
cap);

 = market value of the firm’s debt;

 = total value of capital (equity plus debt);

 = Market Value of the Firm’s Preference Shares
Capital;

 = percentage of capital that is equity;

 = percentage of capital that is debt;

 = Percentage of Capital that is Preference
Shares;

  = cost of equity (required rate of return);

 = cost of debt (yield to maturity on existing
debt);

 = tax rate.

To calculate the WACC, we first need to know:

1)    the cost
of equity,

2)    the cost
of debt,

3)    the
cost of preference shares.

 Table 1.4 represents
the WACC of GNCC Capital and MAGNET for the year ended 31 December 2016.

 

Weighted Average Cost of Capital
(WACC)

GNCC Capital

MAGNET

11.42%

14.88%

Table
1.4

 

 

 

 If we compare GNCC’s
WACC with MAGNET’s WACC, we can see that MAGNET’s WACC is higher. Therefore,
investors prefer to invest in MAGNET because they have a higher return on their
investment.

   

WACC is an essential
instrument for calculating a company’s value. In contrast to other methods for
measuring a company’s value, WACC uses a discount rate for calculating the NPV
of business. Investors and managers use WACC to evaluate investment
opportunities, as it is considered to represent the firm’s opportunity cost. A
company’s cost of capital is merely the cost of money the company uses for
financing. If a company only uses current liabilities and long-term debt to
finance its operations, then it uses debt, and the cost of capital is usually
the interest rate on that debt. Three factors determine the cost of debt:

·       The
prevailing interest rates.

·       The
risk of default (and expected rate of recovery of money lent in the event of
default).

·       The
benefit derived from interest being tax deductible.

Glen Arnold (2013)

 

Question
2

Financial ratios are mathematical comparisons of financial
statement accounts or categories. These relationships between the financial
statement accounts help investors, creditors, and internal company management
understand how well a business is performing and of areas needing improvement.
Ratios are easy to understand and simple to compute. Financial ratios are often
divided up into seven main categories:

·        liquidity,

·       solvency,

·       efficiency,

·       profitability,

·       market
prospect,

·       investment
leverage,

·       and
coverage.

Profitability ratios show a company’s overall efficiency
and performance. Profitability ratios are divided into two types: margins and
returns. All of these ratios indicate how well a company is performing at
generating profits or revenues relative to a particular metric. Efficiency
ratios measure the ability of a business to use its assets and liabilities to
generate sales. Liquidity ratios analyse the ability of a company to pay off
both its current liabilities as they become due as well as their long-term
liabilities as they become current. However, financial ratios have limitation.
The main limitations are:

·       Many
vital assets such as the company’s reputation, skills of the workforce and
market penetrations. (Chartered Institute of Internal Auditors)

·       The
information is historical

·       Each
organization chooses the most appropriate accounting policies for their
particular situation. Which results in affected reported profits/surpluses as
well as a statement of financial position values.

·       Non-current
assets can be valued either by historical cost or revalued amount.

The working capital ratio,
also called the current ratio, is a liquidity ratio that measures a firm’s
ability to pay off its current liabilities with current assets. The working
capital ratio is essential to creditors because it shows the liquidity of the
company. The formula of the Working Capital Ratio
is:

 

 

Table 2.1 represents the Current Ratio of Benitez PLC for the years ended 31 December
2014 and 2015 is:

 

 

Current Ratio of Benitez PLC

2014

2015

2.049

2.046

Table
2.1

 

 

Therefore, for every pound of liability the company has  pounds of assets.

In 2014 the company could cover its liabilities more
easily.

Return on capital employed or
ROCE is a profitability ratio that measures how efficiently a company can
generate profits from its capital employed by comparing net operating profit to
capital employed. The formula of ROCE is

 

Table 2.2 represents the ROCE for the years ended 31
December 2014 and 2015.

 

Return on Capital Employed of Benitez PLC

2014

2015

48.9

21.98

Table
2.2

 

 

 

In 2015 Benitez PLC we can see a significant decrease in
return on the capital employed ratio. Return on capital employed is a ratio
which can tell us how efficiently a company is using its labour force. The
concept of diminishing marginal returns can explain why with increasing the
number of employees a company is experiencing lower profit margins.

Net profit margin is the
percentage of revenue left after all expenses have been deducted from sales.
The formula of net profit margin is

 

 

Table 2.4 Represents the Net Profit Margin of Benitez PLC for
the year ended 31 December 2014 and 2015.

 

NPM of Benitez PLC

2014

2015

23.33%

16.67%

Table
2.4

 

Net Profit Margin for the year ended 31 December 2014:

 

 

Net Profit Margin for the year ended 31 December 2015:

 

 

Asset turnover is
profitability ratio. It can tell us how efficiently a company is using their
assets. The highest the asset turnover the better a company is using their
assets. The formula of asset turnover is

 

 

Table 2.5 Represents the Net Profit Margin of Benitez PLC for
the year ended 31 December 2014 and 2015.

 

Asset Turnover of Benitez PLC

2014

2015

107.14%

67.42%

Table
2.5

 

Asset Turnover for the year ended 31 December 2014:

 

 

Asset Turnover for the year ended 31 December 2015:

 

 

In 2014 the Asset Turnover of Benitez PLC is 107.14
percent, which means that Benitez’s assets are making 7.14 % of revenue. Benitez
PLS is experiencing a negative margin of 0.9 times in Asset Turnover from 2014
to 2015. 

The ratio Trade Receivables’ Collection
Period represents the time lag between a credit sale and receiving payment from
the customer. The formula of RCP is:

 

 

Table 2.5 Represents the Collection Period Ratio of Benitez
PLC for the year ended 31 December 2014 and 2015.

 

Collection Period Ratio of Benitez
PLC

2014

2015

113.6 days

310.3 days

 

Collection Period Ratio for the year ended 31 December 2014:

 

 

Collection Period Ratio for the year ended 31 December
2015:

 

 

From the data, we can see that in 2014 the RCP was 113.6
days and in 2015 is increasing with 196.7 days – significant increase. High
receivables collection period may indicate that your customers may no longer
intend to pay or may be unable to pay, which can cause severe problems for
business. We can decrease the length of your credit terms with customers to
minimize risk and increase payment expectations. To reduce the RCP, we might
run credit checks on customers and ensure that our contract paperwork is legally
sound.

The Quick Ratio or Acid Test
Ratio is a Liquidity ratio that measures the ability of a company to pay its
current liabilities when they come due with only quick assets. The formula of
Acid test ratio is

 

 

Table 2.5 Represents the Collection Period Ratio of Benitez
PLC for the year ended 31 December 2014 and 2015.

 

Acid Test Ratio of Benitez PLC

2014

2015

1.268

1.310

 

 

Acid Test Ratio for the year ended 31 December 2014:

 

 

Acid Test Ratio for the year ended 31 December 2015:

 

 

The higher Quick Ratios are more favourable for companies
because it shows there are more current assets than current liabilities. A
company with a Quick Ratio of 1 indicates that quick assets equal current
assets. This also suggests that the company could pay off its current
liabilities without selling any long-term assets. An Acid Ratio of 2 shows that
the company has twice as many current assets than current liabilities.

Ray Proctor defines financial
ratios as the comparison between two numbers. The financial ratios are divided
into several categories, such as:

·       liquidity,

·       solvency,

·       efficiency,

·       profitability,

·       market
prospect,

·       investment
leverage,

·       also,
coverage.

Current ratio, also known as
liquidity ratio and working capital ratio, shows the proportion of current
assets of the business concerning its current liabilities. Net profit margin is
the percentage of revenue left after all expenses have been deducted from
sales. Asset turnover is a financial ratio that measures the efficiency of a
company’s use of its assets in generating sales revenue or sales income to the
company. A collection period is the average number of days required to collect
receivables from customers. The quick ratio is a measure of how well a company
can meet its short-term financial liabilities.

 

References

Peter Artill. (2017) Financial Management for Decision
Makers, 8th Edition. London: Pearson.

 

J. Collins, N. Collins. (2010) Corporate Governance and
Risk Management, 2nd Edition. London: Chartered Institute of
Internal Auditors.

G. Arnold. (2013) Corporate Financial Management, 5th
Edition. Harlow: Pearson.

 

D. Hillier, I. Clacher, S. Ross, R. Westerfield, B. Jordan.
(2016) Corporate Finance, 2nd Edition. New York: McGraw-Hill.

 

R. Proctor. (2012) Managerial Accounting: Decision Making
and Performance Improvement, 4th Edition. Harlow: Pearson.

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