Financial Management - Assignment

FINANCIAL MANAGEMENT

1

INTRODUCTION
Financial Management relates to set of activities concerned with planning, managing and
guiding finance processes like acquisition and usage of business funds (Allen, Hemming and
Potter, 2013). Main aim of financial management is ensuring maximum or adequate return to
company's shareholders by focusing on their expectations, earning capacity and value of shares.
If funds are not handled correctly, an organisation will experience obstacles that could have a
serious impact on its growth and progress. Financial management in any entity is a essential task.
In order to attain organisational targets as well as objectives, it is the method of scheduling,
arranging, managing and tracking economic assets. The study evaluates aspects of capital
structure, sources of funds and techniques of investment appraisals in context of Kadlex Plc,
Lexbel Plc and Happy Meal Limited respectively. Study also includes merits and demerits of
scrip dividends, right issue and techniques such as NPV, payback period, IRR etc.
TASK 1
Capital Structure and Cost of Capital:
Capital structure of a company defines its solvency and liquidity position. Cost of capital
is computed by companies to asses the cost of funds employed through different means.
Consideration of capital structure along with cost of capital determines the effectiveness of
potential and existing managerial and business decisions. Businesses using the cost of capital
measurement externally to assess how well a business project is worth the asset expense, and
shareholders who use it to evaluate if an asset is worth the threat relative to the exchange. Capital
cost relies on the funding mechanism in use. Cost of Capital is indeed the essential yield to
render a investment budgeting initiative valuable, like constructing a new factory. In this context
Kadlex Plc is evaluating its funding structure to optimise WACC or Weighted Average Cost Of
Capital. Following described steps are calculations to assess the same, as follows:
First Step: Assess the growth (g)
Years Pence
1st 21
2nd 23
3rd 25
4th 27
2

5th 28
Here in above formula g implies to growth, n is symbol of years, S0 is first dividend whereas Sn
is last year distributed divided (Auber and Grudnitski, 2011).
Note: For calculation purpose years is considered as 4 not 5 because dividend showing increment
of 4 times.
Second Step: Computation of each funding source's rate:
 Cost of Equity (Ke ):
Ke = (Sn*[(1+g)+g]) / P0
Ke = [28*(1+0.075)+0.075] / 2.65 = (28 x 1.15 ) / 2.65 =12.15 %
Here, Ke Cost of equity
Sn First Divided
g Growth Rate
P0 Ex divided
 Preference Share (Kp):
Kp= (j)/Pf
Kp = 7 / 75 = 9.33 %
Here, Kp Cost of Preference Shares
j Preferential dividend
Pf ex dividend preference share price
Irredeemable Bonds' cost or Debt's cost:
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Kdir = [i x (1 – t )] x (Po / Pn)
Kdir = ([0.10*(1-0.30)])*(100/107) = 0.0654 or 6.54%
Here, Kdir Cost of Irredeemable Bonds
i interest amount on debt
t Corporate tax's rate
P0 Initial bond price
Pn Current bond price
(a) Assessment of WACC based on Market Value and Book Value for Kadlex Plc:
Book Value (£'000) Market Value (£'000) Proposed Value
(£'000)
Equity (Shares+Reserves)
£20,000+£5,000=£25,000
(No. of shares* Market price)
20000*£2.65= £53,000
20,000*£2.85=
£57,000
Preference
Shares
£10,000 10,000*£0.75=£7,500 10,000*£0.68=£6,800
Irredeemable
Bonds
£15,000 £15,000*£107/£100=£16,050 £15000*£107/£100=
£16,050
Total Capital £50,000 £76,550
New Bonds - - £15,000*£105/£100=
£15750
Total - - £95,600
WACC (Based on Book Value) {[Ke*BVe]+[Kp*BVp]+[Kd*BVd]} / Total Capital
WACC = {[0.1215 x £ 25,000] + [0.0933 x £ 10,000] + [0.0654 x £ 15,000]} / £ 50,000
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=> 4951.5/50000= 0.099 or 9.9%
5

WACC (Based on Market
Value)
{[Ke*MVe]+[Ke*MVp]+[Ke*MVd]} / Total Capital
WACC = {[0.1215 x £53000] + [0.0933 x £7500] + [0.0654 x £16050]} / £76550
= 8188.92 / 76550 = 0.10697 or 10.70%
(b) Kadlex Plc revised cost of capital after proposed changes with finance director proposal:
Proposed Growth [↑by 20%] 0.075 x 1.2 = 0.09 i.e. 9%
Equity (Ke ) [(28*(1.09))+0.09]/2.85=0.1074 or 10.74%
Preference (Kp ) [(7/68)]= 0.1029 or 10.29%
Irredeemable Bonds (Kd) [10(1-0.30)]*100/107= 0.0654 or 6.54%
New Bonds (Kd) [0.11(1-0.30)]*100/105= 0.0733 or 7.33%
Proposed WACC
{[0.09 x £57,000] + [0.1074 x £6,800] + [0.0654 x £16,050] + [0.0733 x £15,750] / £95,600 =
8064.47 / 95600 = 0.0844 i.e. approx 8.44%
(c) Critical analysis of integrating new capital:
Proposed WACC after making all changes is 8.44% whereas WACC applying market
value is 10.70%. Which implies that Kadlex can effectively minimise overall cost of capital by
2.26% [calculated as 10.70 % - 8.44 %]. So proper integration of projected structure of capital
into current capital's structure can lead to reduction of 2.26% in Kadlex Plc. If new proposed
structure adopted by Kadlex, than company can apply 2.26% part saved of costs in effectively
utilisation of various resources like making fund investment in new profit making projects.
(d) Effect of Short-termism on Agency Problem and Bankruptcy:
Short-termism is a scenario in which a business entity tends to concentrate on short-term
initiatives or goals to maintain current earnings at a cost of reducing or eliminating long-term
income or advantages (Brigham and Houston, 2012). Below illustration exhibiting true aspect of
the Short-termism on Agency Problem:
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In case a Financial Executive Advisor has funding of 50 million to make investment and
company is able to:
1.Get return of 5 million within 1 Year
2.Get return of 20 million within 3 Years
3.Get return of 25 million within 5 Years
Naturally Financial Executive Director will choose 5 million return in one year option as
in this option money will be in hand within year. Another perspective is that their career and
position in company are not secured so they go with self interest instead of company's benefits.
Such circumstances implies to “Agency Problem” in which stake of shareholders are ignored for
making self growth and development by corporates. The impacts of this phenomena can be
disastrous on a corporation's bankruptcy. Unrelentingly pursuing short-term earnings can
generate a major gap between corporation's goal and its activities, because short-termism is
created when executives tend to misuse their equities and powers, the firm might not be prepared
to include their creditors with interest and dividends payments (Brooks and Mukherjee, 2013).
TASK 3
Investment Appraisal techniques:
A company indulges in a series of projects for the clients and makes some hard capital
budgeting decisions in its lifetime (Scarborough, 2016). Every organisation faces some
constraints related to capital, efficiency and labour which makes it unreasonable for the business
to undertake every project offered to it. Organisations use investment appraisal techniques such
as payback period, NPV, IRR or internal rate of return and accounting rate of return to appraise
the feasibility of investment decisions.
Happy meal limited wishes to buy a new heavy machinery costing £3,20,000 with a
salvage value of 10% of the cost, depreciation at 20% as per reducing balance method. The
calculations for the investment using above mentioned appraisal techniques are done as :
(a) Determination of economic feasibility of project using following investment appraisal
techniques:
The Payback Period:
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A Payback period implies to specific time period which an entity may take to retrieve
cost incurred on an project or investment. It can also be understand as time period in an
investment or project reaches at break-even (Madura, 2011).
Calculation of Payback Period for Happy Meal Limited
Particulars Amount(£)
Initial Investment 320000
Particulars Year 1 Year
2
Year 3 Year 4 Year 5 Year 6
Cash Inflows (yearly) (given) 105000 10500
0
10500
0
105000 105000 105000
Less: Cash Outflows (yearly)
(given)
15500 15500 15500 15500 15500 15500
Net Cash Inflows1 89500 89500 89500 89500 89500 89500
Payback Period (in years)2 3.58
1Net Cash Inflows is the difference between Cash inflows yearly (even) and Cash Outflows
(even) yearly.
2Payback Period is calculated by dividing initial investment by net cash inflows for Happy Meal.
Recommendation:
Since Payback Period is less for recouping the initial cost incurred in purchasing the
machine, it is feasible to take invest in it.
The Accounting rate of Return:
Accounting Rate of Return or ARR is an appraisal technique that analyses the relation
between the investment required to initiate a given project and the generated expected
accounting revenues (Madura, 2011).
Computation of Accounting rate of return for Happy Meal Limited
Particulars Amount
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Starting or Initial Investment
as given
320000
Particulars Period 1 Period
2
Period 3 Period
4
Period
5
Period 6
Annual Cash.. .. ..Inflows
( As given)
105000 105000 105000 105000 105000 105000
Less: Annual Cash Outflows 15500 15500 15500 15500 15500 15500
Net annual Cash Inflows 89500 89500 89500 89500 89500 89500
Less: Depreciation @ 20% 57600 46080 36864 29491.
20
23592.
96
18874.3
7
Net annual Cash Inflows after
providing depreciation
31900 43420 52636 60008.
80
65907.
04
70625.6
3
Average net accounting profit
(= Net annual Cash inflows –
Average amount of
Depreciation)
54082.9
1
Initial Investment (as given) 320000
Accounting Rate of return 16.90
Accounting Rate of Return is computed by dividing Average Accounting Profit by Initial
Investment in respect of Happy Meal.
Working for Depreciation:
Calculation for depreciation on new machine purchased by Happy Meal Limited
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Cost of new machine 320000 230400 184320 147456 117964.
80
94371.8
4
Less: Salvage Value @ 10% 32000 0 0 0 0 0
Net cost of new machine 288000 230400 184320 147456 117964.
80
94371.8
4
Less: Depreciation @ 20% 57600 46080 36864 29491. 23592.9 18874.3
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2 6 7
Carried forward balance as cost of
machinery
230400 184320 147456 117964
.8
94371.8
4
75497.4
7
Average Depreciation of new
machinery3
35417.0
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Recommendation:
As ARR is 16.9% i.e. positive and favourable so it is viable to purchase such machinery.
The Net Present Value:
It help to determine the effectiveness and viability of any investment through present
value of its projected cash in and out flows (McKinney, 2015). Under it Discounting Factors are
used to assess the present value of overall investment. Following is NPV calculation in context
of Happy Meal Ltd, as follows:
Cash .. .. ..inflow .. ..PV .. ..factor @.. ..12% Disc... ..Cash.. ..Flow
89500 0.892 79834
89500 0.797 71331.5
89500 0.711 63634.5
89500 0.635 56832.5
89500 0.567 50746.5
89500 0.506 45287
Discounted Cash Flow 367666
Less - Initial investment 320000
Net Present Value 47666
Note: Discounting factor @ 12% is taken as it is cost of capital, for discounting cash flow .
Recommendation:
A positive NPV shows that Happy Meal should purchase the machine.
The Internal Rate of Return (IRR):
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Internal Rate of Return referred as level or benchmark where NPV would always be
Zero. It help to compare two projects with positive NPV. Computation of Internal Rate of
Return:
.. .. ..Particulars
Initial.. .. ..investment 320000
Discount.. .. ..Rate :.. .. ..Lower (a) 12.00%
Discount.. .. ..Rate : Higher.. ..(b) 18.00%*
.. .. ..NPV@.. .. ..12% discount rate 47666
NPV..@.. .. ..18% discount rate -41439.31
Deviation.. ..in discount rates [(B)-(A)] 6.00%
Internal.. ..Rate of Return.... 15.21%
IRR= (i) + [(lower discount rate-higher discount rate) *{Net Present Value (a)/ (Net
present Value (a)-Net Present Value (b)}]
Working Notes:
Calculation of Discounted Cash Flows and NPV under IRR when discount rate is 12%:
Cash inflow PV factor at 12% Disc. Cash Flows
89500 0.89 79834.00
89500 0.80 71331.50
89500 0.71 63634.50
89500 0.64 56832.50
89500 0.57 50746.50
89500 0.51 45287.00
Discounted Cash Flows 367666
less:- Initial investment (given) 320000
Net Present Value (a) 47666
Calculation of Discounted Cash Flows and NPV under IRR when discount rate is 18%:
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Cash inflow PV factor at 18% Disc. Cash Flows
89500 0.85 75847.46
89500 0.72 64277.51
89500 0.61 54472.46
89500 0.52 46163.10
89500 0.05 4736.53
89500 0.37 33153.62
Discounted Cash Flows 278650.69
Less:- Initial Investment 320000
Net Present Value -41349.31
Recommendation:
As IRR at discounting rate of 12% is positive so it is advised to Happy Meal to purchase
machine.
(b) Merits and demerits of various investment appraisal techniques :
Payback period: This relates to the specific time-frame required to retrieve funds spent
on an any particular investment. It help to derive break-even point by determining most
appropriate paying period. Time-period requisite by cash-inflows to be equivalent to cash-
outflows is particularly expressed as period of pay-back. The payback period demonstrates how
long the recovery of an investment requires for a corporation. This sort of assessment enables
companies to compare alternative investment possibilities and determine on a venture that will
return their investment in the smallest point of time if they consider that parameters important.
Merits : It helps in quick decision-making to the managers. The drawing of inferences is
easy in payback method. Lower the payback period, lower will be the risk. In the given problem
the payback period is short, which means the project will generate returns in the short run
(Moutinho, 2011).
Demerits : This method undermines the time value of money and doesn't count the role of
time in calculating money. Capital investment is not a single investment strategy. It requires
investments at different time zones and at different rates. The level of inflows vary in a firm
which makes payback period redundant at times (Pearson. Zhang and Zheng, 2015).
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Accounting rate of return: ARR or Accounting rate of return is specific percent return
anticipated from an investment with comparison initial investment. ARR divides revenue
(average) from a specific project by organisation's first time investment to get the ratio or return
which could be anticipated over project's life. ARR not emphasise upon money's time value and
cash flows that could be vital aspect of maintaining an organisational process.
Merits : It is pretty easy to comprehend like the Payback period. It consists of average
accounting profit and initial investment to understand the financial feasibility of the investment.
An ARR of 16.9% signifies great feasibility of the investment as higher ARR means , better
feasible prospects.
Demerits : This method also ignores time value of money and it is the only constraint this
approach has. This approach considers profits instead of cash flows to calculate the feasibility.
Organisations use various methods to calculate profits which can show varying data under ARR.
Net present value: Net Present Value is indeed a discounting technique concerned with
capital budgeting in which an investment's profitableness is effectively assessed by analyst. It
could be assessed by analysing major deviations among cash-flow yield through cash outflows.
Figures retrieved through discounting all outflows of cash and inflows in respect of capital
budgeting process by selecting effective cost of capital or rate of return that leads to positive
NPV. Following are the key points describing drawbacks and benefits of respective method, as
follows:
Merits : This method entertains time value of money. To identify the feasibility of the
investment the proposed project provides future cash flows and discount rates using WACC rate
method. A positive NPV of $47666. A positive NPV suggest better prospects for the investment.
Demerits : calculation of discount factorial can be confusing in the case if inadequate data
is provided to ascertain cost of capital. It may lead to variation in results where the size of the
projects are different.
Internal rate of return: An Internal rate of return relates to a specific metric which is applied
in technique of capital budgeting with an objective of effectively projecting profitability to be
occurred out of an investments. It is simply am assessment tool to asses an investment's rate of
return. It is mainly used in case net present value of a proposal is nil or zero. Moreover it applied
to appraise the real viability of an proposal of investment. It emphasises upon assessing more
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