Financial Management of Organisation

Financial
Management

INTRODUCTION
Finance is the life line of any business organisation in long term survival and enhance the
profitability of its business operations. Finance management is about to raising the money,
managing and application of funds in doing its business operations efficiently and effectively.
The management of finance is essential activity in an organisation in order to achieve its finance
related goals and objectives. This report provides the understanding of net present value, pay
back period and accounting rate of return by solving some numerical problems. This also
provides information about how a business firm may find out its internal rate of return for
evaluating its performances. In this report various questions is given related to financial
management for better understanding of this. This report provides information about calculation
of cost of capital and another related aspects (Renz, D.O. and Herman, R.D. eds., 2016Arnold, 2012).

Question 1
(a) Calculation of book value and market value of WACC:
It is required for every company to calculate cost of capital which is a rate of return that
an enterprise has to pay to satisfy fund providers. This involves various models by which a
company determine certain risks involved in the business process like WACC, CAPM, dividend
growth etc. Weighted average cost of capital includes weighting cost for individual sources of
finance, cost of equity, debt (Alemis and Yap, 2013).
Overview of given problem in question 1: The finance director of Kadlex plc is currently
reviewing capital structure of her company. The firm is not financing well due to which cost of
capital (WACC) is minimised. She feels that by issuing more debt the company will be able to
reduce its cost of capital for which an issue of 15m of 11 per cent bonds have been issued. They
are sold at 5% premium to par value and will be matured after seven years. It is required to
calculate market, book value WACC as well as new cost of capital after considering the
proposed changes by the finance director.
WACC: It is defined as the average cost of company's sources of finance like equity,
bonds etc. weighted according as per the proportion of each cost. WACC is calculated by
multiplying cost of equity and debt to the weighted market value of both equity and debt (Kim
and Chatterjee, 2013).
= Cost of equity* [MV of equity/MV of equity + MV of debt + MV of preference
shares] + cost of debt* [MV of debt/MV of equity + MV of debt + MV of preference shares]
+ cost of preference shares* [MV of preference shares/MV of equity + MV of debt + MV of
preference shares]
=
Market value of equity in firm: 20000*2.65 = 53000 + 5000 = 58000
Market value of preference shares: 10000*0.75 = 7500
Market value of debt in firm: 15000*107/100 = 16050
Cost of equity: 24.8 (1 + g)/2.65 + g =
Cost of debt: 10/1.07 = 9.35
Cost of preference shares: d/0.75 =

B) Cost of capital:
Given: 15m of 11% bonds @ 5% premium after 7years
Share price: 2.85
Pref share price:
Tax: 30%
WACC:
Market value of equity in firm: 20000*2.85 = 57000 + 5000 = 62000
Market value of preference shares: 10000*0.68 = 6800
Market value of debt in firm: 15000*
Cost of equity: 24.8*(1 + 0.2)/2.85 + 0.2 = 9.75
Cost of debt: 11(1-0.3)/1.07 = 7.2
Cost of preference shares: d/0.75
(c) Integration of sensible level of gearing into capital structure:
There is a huge impact of the selection of a good structure of capital in overall
profitability and long term survival of company. Therefore, it is necessary to focus on the capital
structure of any business organisation. There is also necessary to have inclusion of debt portion
(gearing) in a capital structure in a sensible manner. By inclusion of gearing proportion may
enhance the volume of production and ultimately profits of the company may be increased
(Parker, 2012).
Therefore, a capital structure should required to have also debt portion to reduce the
weighted average cost of capital (Moutinho, L. and Vargas-Sanchez, 2018).
(d) Effect of short termism on bankruptcy and agency problem:
Short termism refers to focusing on short term results by ignoring the long term interest.
Short-term performance coerces on investors can trigger in an extra emphasis on its parts on
periodic earnings, with giving few attention to strategy, fundamentals and long-term value
establishment. Bankruptcy is a legal process by which business organisations may be declares
as insolvent if any organisation is unable to pay its outstanding debt. The process of bankruptcy

may be started by by applying any application to an authorised authority which is constituted for
this purpose.
There is huge impact of short termism on the bankruptcy, as in this condition, business
organisation becomes bankrupt due to focusing its funds on the short therm goals. Due to this,
company's fund become zero. A short termism also effect the agency business and creates
problem related to this. Therefore, it is required that business shall understand this term and its
benefits and weaknesses, so that it can effectively and efficiently utilise its funds (Finn,
O’connell and Fitzpatrick, 2013).
Question 3
(a) Evaluation of various investment appraisal techniques:
These are the techniques which are useful for the company in evaluation of various
capital projects for assessing the viability of these projects for the benefit of company. Appraisal
techniques help the company in drawing conclusions regarding whether a given project shall be
selected or not. Various investment appraisal techniques includes pay back period, net present
value, internal rate of return and so on (Habib and Islam, 2013).
Overview of given problem in question 3: Happy meal Ltd. Is a food manufacturer which plans
to purchase a new machine having costing of £320,000. This machine will generate annual cash
inflow £105000 as well as cash outflow of £15500 for each of its six years. Depreciation is
charged on the machine on reducing method at rate of 20%. the residual value shall be estimated
at the rate of 10% of the original cost of the machine.
The above sum is evaluated by applying different types of investment appraisal
techniques which are as follows:
Pay back period:
In normal term, pay back period may be defined as a average period of time which shall
be required for recovering its investment amount from the given project (proposal). This is
important method for accepting of an investment proposal if there is shorter payback period
(Brandimarte, 2014). The payback period of any investment proposal is calculated by dividing the

investment amount with annual cash flow. Calculation of Payback period of the given problem
are as follows:
Calculation of Payback Period for Happy Meal Ltd.
Particulars (£)
Initial Investment (given) 320000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Annual Cash Inflows (given) 105000 105000 105000 105000 105000 105000
Less: Annual Cash Outflows
(given)
15500 15500 15500 15500 15500 15500
Net Cash Inflows* 89500 89500 89500 89500 89500 89500
Payback Period** 3.58 years
* Net Cash Inflows = Annual Cash Inflow – Annual Cash Outflow
** Payback Period (in years) = Initial Investment / Net Cash Inflows
Recommendation:
After observing the above solution, it is clearly stated that it is beneficial to purchase the
new machine because Happy Meal Ltd. has recovered its investment amount only in the period
of 3.58 years and afterwards it may generate profits from utilising this machine up-to the life of
machine which 6 years (Hasnan, Rahman and Mahenthiran, 2012).
Therefore, company should purchased the new machine.
Accounting rate of return:
It is also known as average rate of return which may used by the company for evaluating
the viability of any investment proposal. Accounting rate of return is a percentage rate of return
expected on an investment or asset as compared to initial investment cost.
Calculation of Accounting rate of return for Happy Meal Ltd.
Particulars (£)
Initial Investment
(given)
320000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Annual Cash Inflows 105000 105000 105000 105000 105000 105000

Less: Annual Cash
Outflows
15500 15500 15500 15500 15500 15500
Net Cash Inflows 89500 89500 89500 89500 89500 89500
Less: Depreciation2 64000 51200 40960 32768 26214.4 20971.52
Net Cash Inflows after
depreciation
25500 38300 48540 56732 63285.6 68528.48
Average accounting
profit1
50147.68
Initial Investment 320000
Accounting Rate of
return3
15.67
1 Average Accounting Profit = (sum of all net cash inflows)/Number of Years
3Accounting Rate of Return = Average Accounting Profit / Initial Investment
Working Notes:
Calculation for depreciation on new machine purchased by Happy Meal Ltd.
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Opening balance 320000 256000 204800 163840 131072 104857.6
Less:Depreciation
(20% WDV)
64000 51200 40960 32768 26214.4 20971.52
Closing Balance 256000 204800 163840 131072 104857.6 83886.08
Recommendations:
From the above calculation related to accounting rate of return, it is clearly evident that
accounting rate of return (15.67%) is more than cost of capital (12%) which is good for the
company.
Therefore, Happy Meal Ltd. should purchase the new machine.
Net Present Value (NPV):
It is a method which is used by the company for capital budgeting, which means for
selecting appropriate investment proposal by calculating the NPV (Fabozzi, Focardi, Rachev and
Arshanapalli, 2014). This method may be defined as a difference between the present value of cash

inflows and present value of cash outflows for given period of time (McElroy and Van Engelen,
2012). For the above given case, calculation of NPV are as follows:
Cash inflow (A) PV factor at 12% (B) Discounted Cash inflows (C)2
89500 0.893 79923.5
89500 0.797 71331.5
89500 0.712 63724
89500 0.636 56922
89500 0.567 50746.5
89500 0.507 45376.5
Discounted Cash inflow 368024
Less: Initial investment (320,000)
NPV £48024

NOTE: Cost of capital of 12% furnished in the sum itself which is taken as the discounting rate
for calculating the present value of cash inflows.
Recommendations:
After observing the above solution related to NPV, it is clearly evident that there is a
positive net present value in this scenario which is £48024. Therefore, Happy Meal Ltd. should
purchase this new machine for better results for its future profitability.
Internal Rate of Return:
It is a rate which is hidden in the project which is calculated and used to estimate the
profitability of potential investments. It is also called as discount rate which is used to plan any
business organisation's future growth and expansion. At internal rate of return, total inflows of an
company are equal to its total investment (outflows) (CGFM, 2016). This may be calculated for
Happy Meal Ltd. which is as follows:

Working Notes:

Estimating Higher and Lower Discount Rates using Hit-and-Trial Method:
(i) NPV at 10% discount rate (NPV):
Cash inflow (A) PV factor at 10%1 (B) Discounted Cash Flow2 (C)
89500 0.909 81355.5
89500 0.826 73927
89500 0.751 67214.5
89500 0.683 61128.5
89500 0.621 55579.5
89500 0.564 50478
Discounted Cash Flow 389,683
Less: Initial Investment 320,000
NPV £69683
(ii) NPV at 14% discount rate (NPV):
Cash inflow (A) PV factor at 14%1 (B) Discounted Cash Flow2 (C)
89500 0.877 78491.5
89500 0.769 68825.5
89500 0.675 60412.5
89500 0.592 52984
89500 0.519 46450.5
89500 0.456 40812
Discounted Cash Flow 347,976
Less: Initial Investment 320000
NPV £27976
Recommendations:

After observing the above solutions, it is clearly evident that there is a positive internal
rate of return in this scenario. Therefore, company should purchase the new machine.
(b) Benefits and limitations of above mentioned investment appraisal techniques:
There are different benefits for using different appraisal techniques as well as there some
weaknesses in these techniques (Kaplan and Atkinson, 2015). Some of benefits and weaknesses of
these techniques are as follows:
Payback period: Benefits – It is very easy to compute and also very easily understandable without
requiring any expert knowledge. An investor is primarily consider the protection of origin
investment rather than profit and payback period supports such concept. It helps the
company in identifying the risk of lower return from the investment.
 Limitations – Main weakness of such technique is that it does not consider time value of
money, as a consequent, it does not give a accurate decision in some circumstances. It
ignore the cash-flows which are occurred after the payback period which is also essential
in decision making process and it is not realistic techniques because it ignores the
profitabilty concept (Akgün, Imamoglu, Keskin and Kocoglu, 2014).
Accounting rate of return: Benefits – Simple and easy to calculate such method and also understandable to every
key stakeholders. It consider total savings which a company may earn within whole life
of the project. It also help company in measuring current performance of its operations.
 Limitations – It is not suitable because it creates confusion when one calculates return on
income (ROI) and other calculates ARR. The external factors which a company should
consider for its profitability shall not be considered by this method. The main weakness
of this technique is that it does not consider the cash flows which are more important than
accounting income (Mitchell, 2017).
Net Present Value: Benefits – Most important benefits of using NPV is that it uses concept of time
importance. It apply assumption of reinvestment which means that future cash inflows
are invested every time when they received and it is more reliable, easy to understand.
 Limitations – The main weakness of NPV that it requires guessing about future cash
flows and requires estimated cost of capital which may be not certain and may be change

in future. Net present value method may be biased against long term projects, such as
R&D and new products (Dyreng, Mayew and Williams, 2012).
Internal rate of return: Benefits – The main benefit of this technique is use of time value of money concept and
it is very simple to understand this technique and also easy to visualise. There is no
requirements of finding or determining hurdle rate(i.e. Required rate of return).
Limitations – Economics of scale is not considered while calculating the internal rate of return. It
is based on impractical implicit assumption of reinvestment. One of the disadvantage of using
this technique is that it ignores the mutually exclusive project. There is mix of positive and
negative future cash flows (Deering, 2014).
CONCLUSION
From the above report it is concluded that financial management has a huge impact on
profitability of an business organisation. For selecting a investment proposal in long run
perspective, there shall be required to have knowledge about various appraisal techniques such as
NPV, IRR and so on which gives proper understanding and recommendations for viability of the
project (i.e. whether it is selected or rejected). Company shall require to have full knowledge
about the weighted average cost of capital and other related aspects before accepting the plan of
right issue and bonus issue. It is also concluded and interpreted that cash flow are very essential
requirement in most of the appraisal techniques. Therefore, company should have knowledge
about calculation of cash flows.