Apc308 Financial Management

This document provides solutions for financial management problems including calculation of book value and market value cost of capital, minimizing the cost of capital using gearing in the capital structure, and evaluating the effect of short termism on bankruptcy and agency problem in a company.

Apc308 FINANCIAL
MANAGEMENT

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
SOLUTION 1...................................................................................................................................1
a) Calculation of Book Value and Market value cost of Capital (WACC) for Kadlex plc.........1
b) Cost of Capital of company as per the new structure of Kadlex plc.......................................4
c) Minimising the cost of capital using gearing in the capital structure......................................7
d) Evaluating the effect of short termism on bankruptcy and agency problem in company.......8
SOLUTION 2...................................................................................................................................9
1 & 2 Number of Shares to be issued and theoretical ex right price ..........................................9
3. Calculating expected value of earnings per share ...................................................................9
4&5. form of an issue for price of each right issue & Presenting all the three options of the
right issue in the tabular form .....................................................................................................9
Companies are required to offer choice between the cash dividends and scrip dividends to the
shareholders. Advantages of scrip dividend..............................................................................10
CONCLUSION..............................................................................................................................12
REFERENCES..............................................................................................................................13

INTRODUCTION
Finance is the life blood of the business. Every business has limited resources of finance
where the requirements are unlimited. It is necessary for every business organisation to manage
its financial resources efficiently. Financial management is defined as organic function of
business organisation (Financial Management, 2019). Financial management refers to planning,
raising, controlling and for administering funds used for business. It is also defined as
operational business activity which undertakes the responsibility of obtaining and effectively
utilizing funds that are effective operations. Present report is about the sources of finance
available to business (Baker and Wurgler, 2015). For every finance company has to bear cost.
Costs of different sources of capital like debt and equity together known as Weighted average
cost of capital of business. It will also be revealing about the scrip dividends and their
advantages. It will also be revealing that the business should adopt the best finance sources that
will be benefiting company in long run. It is important for every organisation to have proper
understanding of financial management so that required funds are available to the company at
minimal cost.
SOLUTION 1
a) Calculation of Book Value and Market value cost of Capital (WACC) for Kadlex plc.
Weighted Average Cost of Capital as per book value and Market Value.
Weighted Average Cost of Capital
As per Book Value
Value Weight Cost Weight*Cost
Value of Equity 20000 44.44% 53.60% 23.82%
Value of BOND 15000 33.33% 7.00% 2.33%
Value of Preference share 10000 22.22% 7.00% 1.56%
Total Capital 45000 100.00% 67.60% 27.71%
1

As per Market Value
Value Weight Cost Weight*Cost
Value of Equity 20000 44.44% 53.60% 23.82%
Value of BOND 15000 20.97% 7.00% 1.47%
Value of Preference share 10000 9.80% 9.33% 0.91%
Total Capital 45000 100.00% 49.01% 25.01%
Cost of Capital
Cost of Equity (Ke)
Book Value
Market
Value
0 Year 1 Year
Expected dividend 0.28 0.336 0.336
Current stock price 1 2.65
Growth Rate 20.00% 20.00%
Cost of equity
= Expected Dividend
in 1 year ÷ Current
Stock Price + Growth
Rate
Cost of Equity 53.60% 32.68%
Cost of Preference Share Capital (Kp)
Cost of Preference
Capital
Book Value Market Value
Dividend per share 0.07 0.07
2

Net proceeds 1 0.75
Cost of Preference
Share Capital 7.00% 9.33%
Cost of Debt (Kd)
Cost of debt 10.00%
After tax debt (1 – 30%)
Cost of debt 7.00%
Capital Structure of Kadlex as on 31 December 2017
Capital Structure
Book Value Market Value
Current Value of Equity
Number of shares 20000 20000
Price per share 1 2.65
Value of Equity 20000 53000
Current Value of Debt
Number of Bonds 150 150
Price per bond 100 107
Value of BOND 15000 16050
Current Value of
Preference Capital
Number of Preference Shares 10000 10000
3

Price per share 1 0.75
Value of Preference share 10000 7500
Total Value of Debt and Equity
Total Value of Debt and
Equity
Book Value Market Value
Value of Equity 20000 53000
Value of BOND 15000 16050
Value of Preference share 10000 7500
Total Capital 45000 76550
Calculation of Weights
Weights
Book Value Market Value
Weight of Equity
Equity 20000 53000
Total Capital 45000 76550
Weight 44.44% 69.24%
Weight of Preference
Capital
Preference Capital 10000 7500
Total Capital 45000 76550
Weight 22.22% 9.80%
Weight of Debt
Debt 15000 16050
4

Total Capital 45000 76550
Weight 33.33% 20.97%
b) Cost of Capital of company as per the new structure of Kadlex plc
Weighted average cost of capital
Weighted Average Cost of Capital
Book Value Value Weight Cost Weight*Cost
Value of Equity 57000 72.34% 31.79% 22.99%
Value of BOND 15000 19.04% 8.00% 1.52%
Value of Preference share 6800 8.63% 10.29% 0.89%
Total Capital 78800 100.00% 50.08% 25.41%
Cost of Capital
Cost of Equity (Ke)
Cost of Equity
Expected dividend 0.336
Current stock price 2.85
Growth Rate 20.00%
Cost of equity = Expected
Dividend in 1 year ÷
Current Stock Price +
Growth Rate
Cost of Equity 31.79%
Cost of Preference Share Capital (kp)
5

Cost of Preference
Capital
Dividend per share 0.07
Net proceeds after selling 0.68
Cost of Preference Share
Capital 10.29%
Cost of Debt (kd)
Cost of debt
Maturity Period 7
Par Value 100
Net
proceeds(Par+Premium) 105
I 11
Premium 5
Mp 7
I+(premium/Mp) 11.71
P 100
np 105
P+np/2 102.5
Tax Rate (1-0.3) 0.7
Cost of Debt Capital 11.43%
After tax debt 8.00%
Capital Structure of Company of company under the proposed new plans
6

Value of Equity
7

Number of shares 20000
Price per share 2.85
Value of Equity 57000
Value of Debt 15000
Value of Preference
share
Number of Preference
Shares 10000
Price per share 0.68
Value of Preference
share 6800
Total Capital
Total Value of Debt and
Equity
Value of Equity 57000
Value of Debt 15000
Value of Preference share 6800
Total Capital 78800
Calculation of Weights
Weight of Equity
Equity 57000
Total Capital 78800
Weight 72.34%
8

Weight of Preference
Capital
Preference Capital 6800
Total Capital 78800
Weight 8.63%
Weight of Debt
Debt 15000
Total Capital 78800
Weight 19.04%
Recommendations over the projections of finance director.
The finance directors has propose to reduce the cost of capital by issuing new debts. The
cos of debt will be increased to 11% from 10%. Also company will be repurchasing some of its
equity shares from the proceeds which will be raising the share price to £2.85. The overall cost
of capital of company using the new projections will be 25.41% that is lower than the current
book value cost of capital but higher than the market value cost of capital. Therefore the
projections made by finance manager should be adopted as it will increase the share value by
reducing the cost of capital of company(Barkai, 2017).
c) Minimising the cost of capital using gearing in the capital structure.
Cost of capital is defined as rate of return which business must earn before generating the
values. Before profits are turned by company sufficient income must be generated for covering
the cost of capital used for funding its operations. It consists of both cost of equity and cost of
debt that are used for financing a company. Cost of capital largely depends on type of finance
company has chosen. The sources of finance will determine capital structure of company. Every
company tries to have the best mix which will be providing adequate funding that minimizes cost
of capital of company.
Cost of capital of the company can be minimized by making an optimal capital mix. Two
of the main sources of raising funds are equity and debt financing. Companies reduce their cost
of capital by cutting down its debt financing, lowering its equity or by capital restructuring
9

(Berger, Chen and Li, 2018). Cost of debt refers to interest rates applied over borrowed loans
from bank or non bank banking institutions. The coupon rate of debentures or bonds are the cost
of capital. Cutting cost of capital will be lowering cost of non payments. If alternative capital is
available at lower interest rates than it could be sourced for repaying the debts.
Cost of debt can be increased for lowering the cost of capital of company. The cost of
equity investment is much higher in comparison to the cost of debts. Equity has high risks in
comparison to other sources of capital. Company can avail the benefit of tax reduction in the
debt capital that reduced the cost of debt which ultimately reduced the cost of capital of
company. Debt capital is cheaper source of finance in comparison to equity. Debt instrument are
also used by the companies for getting the tax benefits for payment of interests. If a company is
having high equity it will be having higher cost of capital (Gatsios, and et.al., 2016). For
reducing the cost of capita organisation can raise debt capital for purchasing back the equity
capital. Buy back of equity shares will be increasing the price per share and wealth in aggregate
of company. This way gearing can be used in the capital structure for minimising cost of capital.
At the same time company should ensure that it does not raises debt beyond a benchmark as after
that the interest cost will be raising higher. Debt involves greater risk of default and higher
interest payment can affect the operations of company.
d) Evaluating the effect of short termism on bankruptcy and agency problem in company.
Short termism is suffered by people excessively over the short term results on cost of
long term interests and objective of company. It is also defined as concentration over short tern
benefits for profits sacrificing the long term security. Short termism is an significant concern
faced by companies. This is demanding companies to maximise heir short term profits ignoring
the long term effects and consequences (Harjoto, and Jo, 2015). Short termism in company
could destroy wealth generation, impede innovation and even to bankruptcy. It may cause
potential harm to business if not covered by company within time.
The short termism if not dealt effectively can lead to even bankruptcy of company. For
instance companies for earning the short term earnings or for increasing the sales from existing
products may not focus over other operations of business. Company may stop it spending over
the research and developments of new products which is essential for future, as existing products
is earning high revenues. Introduction of new substitute can enormously affect the sales and
10

revenues. Also company is not available with new innovation that can help it to regain its market
share. Company might not have enough funds to spend over research and development that can
lead the company towards bankruptcy (Johnstone, 2016). Companies for earning the short term
benefits of the adopt heavy finance from banks and financial institutions above their capacity. At
times companies are not able to derive the expected returns from the investments over long run
and ultimately goes bankrupt. Therefore organisations should earn short term profits thereby
focusing over the long run benefits that a project could generate. In the long run company can
benefit from the projects that may be no generating adequate results over short term. Therefore
companies are required to make proper analysis before investing over the short term benefits.
Agency is termed as the relation between an agent and principal. Asymmetric
information may arise conflict of interest in company. Conflicts arises where parties of business
have separate interests like management and the shareholders. Conflicts arise when shareholders
demand for short term returns from the company. Management of company always put efforts
for driving the company towards success and growth keeping a long term perspective. If the
management on shareholder's demand start focusing over the sort term benefits than it may lead
to bankruptcy (Vartiainen, and et.al., 2019). Companies should focus over the lone term benefits
thereby achieving the short term returns of company.
SOLUTION 2
Long term: Equity finance
1 & 2 Number of Shares to be issued and theoretical ex right price
Particulars Right issue prices
At 1.80 At 1.60 At 1.40
Funds to be issued 180000 180000 180000
Number of shares to be issued 100000 112500 128571
New share after right issue 700000 712500 728571
Current market price 1.9 1.9 1.9
Rights issue share price 1.8 1.6 1.4
Theoretical ex-share price 1.89 1.88 1.88
11

3. Calculating expected value of earnings per share
Particulars Right issue prices
At 1.80 At 1.60 At 1.40
Total shareholders fund 880000 880000 880000
Net Profit after tax @ 20% of
shareholders fund 176000 176000 176000
New share after right issue 700000 712500 728571
Expected Earning Price Per Share 0.251 0.247 0.242
4&5. form of an issue for price of each right issue & Presenting all the three options of the right
issue in the tabular form
Particulars Right issue price at 1.80
600000 ordinary shares at 0.50 p 300000
100000 new shares at 1.80 180000
Value of 700000 shares 480000
Ex- rights value per share 0.686
Particulars Right issue price at 1.60
600000 ordinary shares at 0.50 p 300000
112500 new shares at 1.60 180000
Value of 712500 shares 480000
Ex- rights value per share 0.674
Right issue price at 1.40
12

Particulars
600000 ordinary shares at 0.50 p 300000
128571 new shares at 1.80 180000
Value of 728571 shares 480000
Ex- rights value per share 0.659
Right Issue
Right issue refers to an invitation the existing shareholders of company for purchasing
the new additional shares of company. This kind of issues give the existing shareholders the right
to securities known as right. In a right issue existing shareholders can purchase the shares of
company at a discounted price than that is available in the market to general pubic. Through
rights issue company gives shareholders a chance of increasing their shares. Right issue could be
defined as way for cash strapped for raising the capita for paying their own debt. Right issues are
generally offered by company for raising the additional capital for meeting the current financial
obligations (De Lange, 2016). Companies may also issue right shares for carrying out the new
investments plans for a new project.
In the present case company has planned to issue right shares at price that would be most
beneficial for the company. It has proposed three prices at which the shares could be issued.
Right issue will make the shares price to go down therefore the price at which shares would be
least affected should be issued. Company shall issue right shares at £1.80 as this will not reduce
the share values and also per share value is highest in the available option. Company could go for
other options as aggregate value of the shareholders will be unaffected by the split of values
between number of shares.
Theoretical ex right price refers to estimated share price of company after he right issue.
It is estimated as weighted average price of each share of new as well as existing shares.
Companies uses right issue for offering new shares to existing shareholders at discounted price.
This is calculated for knowing the stock prices after the issue of right shares as issue increases
number of outstanding shares.
13

Companies are required to offer choice between the cash dividends and scrip dividends to the
shareholders. Advantages of scrip dividend.
Dividend refers to distribution of the rewards from earnings to the shareholders of company.
Payment of dividend is decided and declared by the board of directors of company. Company is
required to pay some proportion of their profits to the shareholders as every shareholder makes
investment in company for earning a required rate of return. Though value of shares is increasing
the wealth of shareholders but still return in form of dividend is essential for retaining and
attracting new investors. Along with time span forms of dividend are changing. Today
companies are giving choices for dividends in the form of scrip and cash dividends.
Cash Dividend
Cash dividend refers to payment by company to its shareholders from the profits in form
of cash. This is also termed as transfer of economic value to shareholders from company rather
than using the money for operations of company. This decreases share prices of company around
the rate of dividend. Shareholders receiving cash dividend are required to pay tax on value of
distribution that lowers its final value. For some people cash dividends are much beneficial as
they provide them with regular income (Halla, Wagner and Zweimüller, 2017). Companies that
pay cash dividend are regarded as financially strong and healthy. The cash dividends may disturb
the cash flows of company that could be better utilised elsewhere.
Scrip Dividend
Scrip Dividends refers to issue of new shares in place of dividend. Scrip dividends may
be issued by company when they do not have enough cash available for issuing the cash
dividends but payment of return is essential to shareholder. This dividend is also offered as an
alternative t cash dividends so that payments of dividend are rolled automatically in more shares.
In a scrip dividend companies give option to shareholders for receiving dividends in form of cash
or stocks. It is different from stock dividend as in that company directly issues shares without
giving choice for receiving cash. Companies are increasingly moving towards scrip as it helps in
relating the cash funds that could be used effectively in the operations of company.
Advantages of Scrip Dividends
To Shareholders
The shareholder have an option of making choice between the cash or shares dividends.
Shareholders receiving the shares in form of dividends are not required to pay tax on dividends
14

that is received by them. Choices enable the people to choose as per their needs for instance old
people may choose the cash dividend for meeting their living expenses. Investors may choose for
increasing their stock exposures for having future price appreciations (Mazumdar, 2019).
Shareholders are not required to pay the transaction cost or commission charges on shares.
To Company
Scrip dividend helps company in saving its cash. Every shareholder that elects shares
over cash saves cash of company. The cash saved by company could be utilised in other
productive operations that will help in generating revenues. Cash saved can be used by company
in paying the interest to the debt holders. When a cash dividend is paid economic value is
transferred from company to the shareholders.
CONCLUSION
Financial management is very essential for the organisation to keep a proper management
of the financial funds of company. Today the business organisation for their expansion plans
have to under take finances. There are various sources of finances that are available to the
company through which finances could be raised. It is concluded that companies must have an
optimal capital mix so that the cost of capital is minimum. Companies are required to ensure that
mix of debt and equity is adequate so that company can earn required rate of return from the
available capital. Companies can use debt financing for reducing their cost of capital where
companies are more of the equity capital that is having high cost. There are situations when
company for expansion plan may require additional funds. Companies must first offer the
securities to its existing shareholders before issuing it in market. Right issues are available to the
shareholder of company at discounted prices. Raising funds through right issue will decrease the
share prices as the outstanding number of shares will be increased.
REFERENCES
Books and Journals
Baker, M. and Wurgler, J., 2015. Do strict capital requirements raise the cost of capital? Bank
regulation, capital structure, and the low-risk anomaly. American Economic Review,
105(5). pp.315-20.
Barkai, S., 2017. Declining labor and capital shares. University of Chicago.
15

Berger, P.G., Chen, H.J. and Li, F., 2018. Firm specific information and the cost of equity
capital. Feng, Firm Specific Information and the Cost of Equity Capital (April 2, 2018).
Gatsios, R.C., and et.al., 2016. Impact of adopting IFRS standard on the equity cost of brazilian
open capital companies. RAM. Revista de Administração Mackenzie, 17(4). pp.85-108.
Harjoto, M.A. and Jo, H., 2015. Legal vs. normative CSR: Differential impact on analyst
dispersion, stock return volatility, cost of capital, and firm value. Journal of Business
Ethics, 128(1). pp.1-20.
Johnstone, D., 2016. The effect of information on uncertainty and the cost of capital.
Contemporary Accounting Research, 33(2). pp.752-774.
Vartiainen, E., and et.al., 2019. Impact of weighted average cost of capital, capital expenditure,
and other parameters on future utility‐scale PV levelised cost of electricity. Progress in
Photovoltaics: Research and Applications.
De Lange, S.L., 2016. A new winning formula? The program matic appeal of the radical right. In
The Populist Radical Right (pp. 101-120). Routledge.
Halla, M., Wagner, A.F. and Zweimüller, J., 2017. Immigration and voting for the far right.
Journal of the European Economic Association, 15(6). pp.1341-1385.
Mazumdar, S., 2019. Procedural Aspects of Rights Issued and Public Issue of Shares. Journal of
Capital Market and Securities Law, 2(1), pp.1-5.
Online
Financial Management. 2019. [Online]. Available through :
<https://www.managementstudyguide.com/financial-planning.htm>
16