Corporate Accounting: Optimum Capital Structure and Investment Proposal

This report discusses the concepts and techniques of corporate accounting for deciding the ways of raising capital and analyzing the viability of investments in new proposed products. It also provides calculations and recommendations for the company's financial proposal and investment proposal.

CORPORATE ACCOUNTING

TABLE OF CONTENTS
TABLE OF CONTENTS................................................................................................................2
INTRODUCTION...........................................................................................................................1
REPORT..........................................................................................................................................1
Financial Proposal.......................................................................................................................1
Investment Proposal.....................................................................................................................5
CONCLUSION................................................................................................................................8
REFERENCES................................................................................................................................9

INTRODUCTION
Corporate accounting refers to the branch of accounting that deals with recording of
accounting transaction of the companies for the preparation of financial statements such as
income statement, cash flow statement, balance sheet, analysis and also for the interpretation of
financial results of the companies. Corporate accounting also helps the enterprise in ensuring a
optimum capital structure analysing the cost of every option. With use of corporate accounting
managers also take various investments decisions about the profitability of the proposed
investments. Present report i based over application of concepts and techniques of corporate
accounting for deciding the ways of raising capital that is optimum. It will also provide the
company about the viability of investments in new proposed products by measuring the cash
flows that will be generated by the company. This will enhance the understanding about the
concepts of various accounting tools for effective decision making. Concepts will be explained
through the numerical examples in the report.
REPORT
Financial Proposal
Current Scenario of the company
Current Capital Structure €m
Issued Share Capital: 150,000,000 Ordinary Shares of 50c
each 75
Long-term debt 105
Company is currently having a capital structure of issued share capital valued at 50c that
equals to 75 million and with the debt capital of 105 million. Company is having higher of the
debt capital in comparison with the equity capital. Cost of equity of the unlevered firm is 12%
and the cost of long term debt is 4%. Company is having optimum capital structures as the
market value of shares is €1.25 each (Mulatinho and et.al., 2019).
Cost of capital is measured using Modigliani & Miller Proposition II approach with taxes
under all the three scenarios.
M&M approach is the most commonly used approach in the corporate world. It was
developed by France Modigliani & Merton Miller in the year 1985. The main idea behind the
concept is that it does not affect the overall value of the firm. The second proposition was given
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by them for the real world conditions stating that cost of equity of the firm is having directly
proportional relation with leverage level. Presence of the tax shield affect relationship through
making cost of equity less sensitive to leverage levels. Extra debts also increases the chances of
default of company, investor are less prone to the negatively reacting to company taking
additional leverages as this increases tax shields which boosts the value (Jonick and Benson,
2018).
Financial Proposal
1. Under the Existing capital structure.
WACC in the existing capital structure
WACC Amount
Market Value of Equity (E) 187.5
(150*1.25)
Market Value of Debt (D) 105
Debt after tax (D-t) 68.25
Total value of Unlevered Firm 292.5
(105 +187.5)
Return on Unlevered equity (Ro) 12%
Return on debt (Rd) 4%
Tax Rate 35%
Return On Equity (Re) 14.91%
Ro + D/E(1-t)(Ro-Rd)
Value of levered firm (VL) 255.75
(187.5+68.25)
WACC 11.63%
E/VL*Re +D/VL*Rd(1-tc)
Under the current capital structure of company it is having equity capital and debt capital
with total capital of 292.5 million. As per the M&M approach the value of levered firm is
measures after considering the tax rate. As per this approach cost of equity of calculated
considering the market value of equity on the basis of 1.25 per share and the cost of debt after
tax. The combined capital of debt and equity gives the value of levered firm. Weighted average
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cost of capital is measures using the market values of equity and debt capital according to their
capital contribution in the company. The weighted average cost of capital of the company under
the existing structure that is before raising the additional funds is 11.63%. It is the optimal capital
structure. If company proposes to raise further finance the cost of capital should be near to the
existing cost of capital. Company has two options of raising capital only through debt or only
through capital.
2. If only equity option is adopted.
WACC Equity only
Market Value of Equity (E) 237.5
(187.5 + € 50
m)
Market Value of Debt (D) 105
Debt after tax (D-t) 68.25
Total value of Unlevered Firm 342.5
(237.5 + 105)
Return on Unlevered equity (Ro) 12%
Return on debt (Rd) 4%
Tax Rate 35%
Return On Equity (Re) 14.30%
Ro + D/E(1-t)(Ro-Rd)
Value of levered firm (VL) 305.75
WACC 11.69%
E/VL*Re +D/VL*Rd(1-tc)
If the company plans to accept only to raise equity option. The cost of equity will be
making the organisation more sensitive to the market risk. Raising the funds through equity will
decrease the required return rate of return over equity to 14.30% from the existing rate of
14.91%. This means the rise of equity will decrease the required rate of return over equity in
proportion to the debt (Zeff, 2018). The new cost of capital under option will increase slightly to
11.69%. This means that there would not be cost high to company if it raises funds only through
the equity capital. It will raise the current level of equity of 187.5 million to 237.5 million as per
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the market value of equity shares. Cost of market debt is unchanged under this option. Under this
option company will not be available with any of the extra tax benefits as in case of debt capital.
3. If only debt capital is adopted.
WACC Debt only
Market Value of Equity (E) 187.5
(150*1.25)
Market Value of Debt (D) 155
Debt after tax (D-t) 100.75
Total value of Unlevered Firm 342.5
(187.5 + 155)
Return on Unlevered equity (Ro) 12%
Return on debt (Rd) 4%
Tax Rate 35%
Return On Equity (Re) 16.30%
Ro + D/E(1-t)(Ro-Rd)
Value of levered firm (VL) 288.25
WACC 11.51%
E/VL*Re +D/VL*Rd(1-tc)
If company plans to raise funds only using debt capital for the proposed financial plan it
will have the following implications. Company usually adopts the debt option for raisig funds as
the cost of debt is lower than the cost of equity. Also using the debt option company is available
with the tax shields as specified under the M&M approach. However raising funds only through
the debt option can also be harmful for the company. If company uses this option the prposed
required rate of return on equity will rise to 16.31% from the existing rate of 14.91%. the rise is
seen due to the proportional increase in debt capital as it reduces the cost of capital due to the tax
benefits available with it. If company adopts this option the cost of capital of the company will
be 11.51% which is lowest under all the three scenarios. Raising funds only through debt option
will be decreasing the cost of capital but the require rate of return and financial risks associated
with the business will also rise.
Recommendation
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Under the current capital structure company is having the cost of capital of 11.63%. From
the option of only debt or only equity it will be having the lowest cost of capital under debt.
Under the MM approach the cost of equity will decrease in equity option. While in the debt
option cost of equity will rise to 16.30%. Though the option of debt appears to be more
beneficial due to its lower cost of capital. But at the same it will also be raising the required rate
of return over equity also. The financial risks will also raise drawing the profitability and aspect
of growth down (Allen, Ramanna, and Roychowdhury, 2018) On the other equity option will be
more even when the tax benefits are not available. Required rate of return is decreased due to the
share of profits in larger proportion of shareholders without bring the profitability of the
company. This will also not increase the financial risks of the business as the proportion of debt
is decreased with rise in equity capital of company.
Investment Proposal
Company is planning to produce new product Azam. The proposed investment plan
requires the business of to purchase the new machinery costing 250000 with the residual value
that will be achieved. The company is required to analyse the viability of the proposed plan of
the business.
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Calculations of cash flows from the proposed business.
New Production plan for Azam
Statement of Cash Flows
price per unit Year 1 Year 2 Year 3 Year 4 Year 5
Units 10000 10000 10000 10000 10000
Selling Price 22 220000 220000 220000 220000 220000
Cost of Sales
Direct Labor 5 50000 50000 50000 50000 50000
Material 4.5 45000 45000 45000 45000 45000
Variable Overheads 2.5 25000 25000 25000 25000 25000
Contribution 10 100000 100000 100000 100000 100000
Rent 0.8 8000 8000 8000 8000 8000
Manager's Salary 0.7 7000 7000 7000 7000 7000
Depreciation 5 50000 50000 50000 50000 50000
Add : Depreciation
allowance 1.25 12500 12500 12500 12500 12500
Head office cost 2.5 25000 25000 25000 25000 25000
Net Profit 2.25 22500 22500 22500 22500 22500
Add: Depreciation 37500 37500 37500 37500 37500
Net Cash flows 60000 60000 60000 60000 60000
If the company is planning to produce the new product Azam. The production of the
product will involve both variable and fixed costs. The variable costs of the company includes
the cost of labour, material and variable overheads of the company. on the other fixed of the
company comprises of rent, manager’s salary, depreciation and the head office expenses that are
charged at 1.25 per hour.
Deprecation is calculated on straight line basis assuming the expected useful life of 5
years with no residual life. This makes the annual charge of 50000 for deprecation of the
machine. The machine is purchased solely for the production of Azam. Company is available
with annual capital allowance of 25% that will decrease the charge of depreciation by 25%.
For getting the net cash flows from the proposed business depreciation will added back to
the yearly profits of company at the rate at which was previously deducted. This gives the annual
cash flows of 60000 from the proposed business (Hoang and Joseph, 2019).
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Measuring the profitability of proposed investment using investment appraisal techniques.
Cash Flows for the year.
Year
Net Cash
flows
1 60000
2 60000
3 60000
4 60000
5 60000
Investment option under the three discounting rate 8%,10% & 12%.
Computation of NPV
Year
Cash
inflows
PV factor
@ 10%
Discounted
cash
inflows
PV
factor @
12%
Discount
ed cash
inflows
PV
factor
@ 8%
Discounted
cash
inflows
1 60000 0.909 54545.45 0.893 53571.43 0.926 55555.56
2 60000 0.826 49587 0.797 47831.63 0.857 51440.33
3 60000 0.751 45079 0.712 42706.81 0.794 47629.93
4 60000 0.683 40981 0.636 38131.08 0.735 44101.79
5 60000 0.621 37255 0.567 34045.61 0.681 40834.99
Total
discounted
cash
inflow 227447 216287 239563
Initial
investment 250000 250000 250000
NPV (Total discounted cash inflows
- initial investment) -22553 -33713 -10437
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Computation of Payback period
Year
Cash
inflows
Cumulative cash
inflows
1 60000 60000
2 60000 120000
3 60000 180000
4 60000 240000
5 60000 300000
Initial
investment 250000
Payback
period 4
0.2
Payback
period
4 year and 2
months
Recommendation
The above methods show that the proposed plan of producing Azam by purchasing
machinery of 250000 would not be profitable for the company. From the net present value
approach it is assessed the NPV of the project is negative under all the three options. This shows
project will not be able to cover the initial cost of capital with the future cash flows.
Using the payback period that do not uses the time value of money concepts it is assessed
that it will take 4years and 2 months to recover the initial cost of machine. This is the last year of
production which suggests project will be earning negligible profits during its tenure. Therefore
the proposed production plan should not be adopted.
CONCLUSION
Under the financial plan it should raise capital using only Equity option. As this is the most
beneficial option with slight increase in its overall cost.
Under the investments plan it is identified that it should not adopt the production plan. as
company will not be profitable for the company.
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REFERENCES
Books and Journals
Allen, A.M., Ramanna, K. and Roychowdhury, S., 2018. Auditor lobbying on accounting
standards. Journal of Law, Finance & Accounting, Forthcoming.
Zeff, S.A., 2018. An Introduction to Corporate Accounting Standards: Detecting Paton's and
Littleton's Influences. Accounting Historians Journal, 45(1), pp.45-67.
Hoang, T.C. and Joseph, D.M., 2019. The effect of new corporate accounting regime on earnings
management: Evidence from Vietnam. Journal of International Studies, 12(1), pp.93-104.
Mulatinho, C.E.S. and et.al., 2019. Convergence of Accounting Standards to International
Standards and Earnings Management in Brazilian Companies. In International Financial
Reporting Standards and New Directions in Earnings Management (pp. 256-273). IGI
Global.
Jonick, C. and Benson, D., 2018. The New Accounting Standard for Revenue Recognition: Do
Implementation Issues Differ for Fortune 500 Companies?. Journal of Corporate
Accounting & Finance, 29(2), pp.22-33.
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