Finance Report: Investment Appraisal, Capital Structure Analysis

This finance report provides a comprehensive analysis of investment appraisal techniques, capital structure, and beta. It begins with a detailed calculation of net present value (NPV) for two machine investment options, comparing their profitability and recommending the machine with the higher NPV. The report then calculates the average rate of return (ARR) for both machines, comparing them to a target ARR. The report then discusses the importance of decision-making in business, highlighting the use of investment appraisal techniques like NPV and ARR. Next, the report explores the concept of beta in finance, explaining its role in comparing company returns with market returns, and calculating the cost of equity for two companies with different betas. Finally, the report examines capital structure, discussing the advantages and disadvantages of raising capital through equity and debt, and recommending the most suitable methods for a hypothetical company, Digitech, considering factors such as growth, size, profitability, and risk.

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Finance

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Table of Contents
Task 1...............................................................................................................................................3
a)..................................................................................................................................................3
b)..................................................................................................................................................4
c)..................................................................................................................................................5
Task 2...............................................................................................................................................5
Task 3...............................................................................................................................................7
Task 4...............................................................................................................................................9
References......................................................................................................................................11

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Task 1
a)
Calculation of net present value
French machine
Particulars Year 1 Year 2 Year 3 Year 4 Total
Units 30000 40000 50000 60000
Selling price 20 20.8 21.63 22.50
Marginal cost 15.6 16.22 16.87 17.55
Contribution per unit 4.4 4.576 4.7590
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4.9494
Contribution in value 132000 183040 237952 296964
Fixed production
overheads
20000 21200 22472 23820.3
Maintenance cost 20000 27300 34965 43013.3
Profit 92000 134540 180515 230131 637186
Depreciation 119425 119425 119425 119425
Cash inflows 211425 253965 299940 349556
PVF @ 8% 0.926 0.857 0.794 0.735
PV of inflows 195764 217734 238102 256934 908534
PV of outflow 477700
Net present value PV of Inflows-PV of outflows 430834
German machine
Particulars Year 1 Year 2 Year 3 Year 4 Total
Units 30000 40000 50000 60000
Selling price 20 20.8 21.63 22.50
Marginal cost 15.6 16.22 16.87 17.55
Contribution per unit 4.4 4.576 4.7590
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4.9494
Contribution in value 132000 183040 237952 296964
Fixed production
overheads
20000 21200 22472 23820.3
Maintenance cost 20000 31500 43570 56248.5

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Profit 92000 130340 171910 216895 611145
Depreciation 107500 107500 107500 107500
Cash inflows 199500 237840 279410 324395
PVF @ 8% 0.926 0.857 0.794 0.735
PV of inflows 184722 203909 221805 238440 848877
PV of outflow 430000
Net present value PV of Inflows-PV of outflows 418877
From the above calculation, the net present value which will be available by the two machines is
ascertained. It can be noted that it is higher for the French machine amounting to £430834
whereas German machine will bring the net present value of £418877. According to the rules,
the project which will be provided with the higher net present value should be selected as that
will be beneficial for the business. In the given case the French machine will be chosen as that is
having higher NPV (Žižlavský, 2014). The machinery is costly but the maintenance cost which is
to be incurred in relation to the same is lower than that of the German machine.
b)
Calculation of average rate of return
French machine
Calculation of ARR
Particulars Amount
Average profit 159296
Average investment 477700
ARR 33.35%
German machine
Particulars Amount
Average profit 152786
Average investment 430000
ARR 35.53%
The target which is set by the company and was required to be attained is 25% in terms of the
average rate of return. It was required that it shall be achieved and then only the company will be
able to manage its position in the market (Zhu and Niu, 2016). From the calculations, it can be
noted that both the machines are providing the return above the target set and this shows that the

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company will be able to attain the required success. ARR is 33.35% and 35.53% for the French
and German company respectively and there will be higher returns which will be earned by the
installation of any machine.
c)
The decision making is an important aspect in every business and they are made on the basis of
various methods which are available. There is the need to follow the several investment appraisal
techniques in order to make the decision about investments which are required to be made. There
are various areas which shall be taken into consideration in this process such as the future value
and the time value of the money should be covered (Chen, Li, and Reynolds, 2012). In the given
case manager is in favor of the average accounting rate of return method. This is a simple
approach in which calculations are made in an easy manner and the profitability which will be
maintained with the investment is identified (Pasqual, Padilla, and Jadotte, 2013). Although it is
the simple method it ignores the time value of the money which is involved and also has
inconsistency involved. The calculations are made on the basis of the accounting information and
cash flows are not taken into account.
In comparison to the ARR, there is another approach which is used and is more efficient which is
identified to be net present value (Easton and Monahan, 2016). The calculation is the little
complex but in this, the time value of money is considered which provides the accurate value as
to the amount which will be earned by the proposal. By the help of this decisions, making will be
carried effectively and as the time is considered so the period of investment will not be affecting
the net present value which will be determined (Tappura et al., 2015). Therefore in order to make
the accurate decision net present value should be used which covers all the important aspects that
are neglected in the average accounting rate of return method.
Task 2
Beta is the factor by which the return of the company can be compared with the complete market
returns. The market beta is usually 1 and then the comparison is made with the beta of the
company to make any decisions. This represents the systematic risk which is involved in the
business and with that volatility is also taken into account. The companies with a higher beat will

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be considered to involve more risk than others (Barberis et al., 2015). It depends on the various
factors such as risk and volatility which is different for all the companies and it makes the beat to
be variant in all cases. By the help of this, the impact which will be made due to the change in
the market stock is taken into account. The investment decision can be made by this and the
company which is riskier will be chosen by the optimistic people. The two companies have
different beta because of the difference in the level of the systematic risk which is involved.
Lower beta represents that company is less volatile and there will be less change in the value of
the stock.
By the difference, the decision is made by using the risk which is involved in the stock. There
will be consideration of all the factors and the investors will be able to have the proper
analyzation of the situation. The investors will be choosing the same on the basis of the risk
which they are ready to undertake. The capital asset pricing model will be further used in order
to determine the cost of equity which will also be helping in the decision making (Zabarankin,
Pavlikov, and Uryasev, 2014). This is the best approach as the company will be making the use
of various factors in this and also the calculation which is made in this is easy to calculate and
understand. The answer which will be derived from it will be accurate and can be used for the
making of decisions. The rate is affected by the change in the beta and so it will also be different
for both the companies (Ai, Croce and Li, 2012). The calculation of the same involves the use of
a formula which consists of the risk-free rate, beta, and market rate. The calculations in respect
of both the companies are presented below:
Severn Trent:
Ke = Rf + b (Rm – Rf)
Ke = 2.5 +0.89 (12-2.5)
Ke = 2.5 + 8.455
Ke = 10.955%
Glencore plc:
Ke = 2.5 +1.22 (12-2.5)

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Ke = 2.5 + 11.59
Ke = 14.09%
It can be noted that companies with different beta provide a different rate of return. This is due to
the level of risk which is involved with both the companies. In the given case although the beta
of Glencore is higher the return which will be available on the same is also at a high level
whereas the return provided by Severn is low. Due to this, the investors who are ready to take
risk will be investing in the Glencore and by that, they will be earning more.
Task 3
In the business, capital is the main requirement which is needed to perform the operations in an
effective manner. There are various sources which can be used for this purpose and all of them
are required to be identified and evaluated in an efficient manner. All the advantages and
disadvantages will be considered and the one which will be provided with the maximum benefits
will be chosen (Hornuf and Schwienbacher, 2017). There are internal as well as external sources
which are available and for the large finances usually external sources are taken into
consideration. The main among them are issuing the equity or by long term debts. Both have
their set of merits and demerits which are affected by certain factors. There is the need to
consider the growth, size of the business, profitability, risk and several other aspects. By taking
them into account the best among all will be chosen.
In the undertaking of the operation the funds will be required and for that shares can be issued in
the market. The investors will be buying the shares and that will bring the funds to the company.
It is the capital of the company and can be used for any purpose (Covas and Den Haan, 2012).
They are own capital and not the debt for the business and so the risk of the company in relation
to repayment is eliminated. This is the amount which will not be repaid and the company will be
having all the rights on the same. There will be no restrictions or limitations in relation to them
and so can be used for various purposes. This is the method in which there is no obligation to
issue a certain fixed amount. The company can issue as many shares they want as per the needs
and requirements. The manner in which amount will be charged is also decided by them together
with the timing of the issue (Bell, Rilatotchev and Rasheed, 2012). Even after the initial public

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offer, the company has the power to issue additional shares for the raising of the required funds.
In this, there are various types of shares which are included out of which some give buyers the
power to vote and receive the dividends. This is not a compulsory requirement and the company
can avoid the dividend payment in case of cash shortage. This provides the business with the
flexibility which is not available in other sources. There are certain demerits also of using this
source which involves a higher amount of cost which is incurred in the process of raising funds.
There is no tax benefit which is received for the amount of the dividends which is paid but the
same can be availed in case of debts in which interest is required to be paid. The process which is
involved in the share issue is complex and in that certain amount is required to be paid to the
agency which has helped in selling and distributing shares. The control is also shared which is
not the case with the loans and also the information about the company is disclosed.
The company will be receiving various advantages for the raising of the amount with the help of
a loan. There is no cost involved in this process and so the company will be saving that amount
which is otherwise incurred. The ownership in this method remains with the company which is
the main advantage of this approach. The amount can be borrowed as and when required and
there will be tax benefit which will also be availed (Abdulsaleh and Worthington, 2013). The
loans will only be available when the company will have good credits and functioning. There is
the repayment which is required to be made at the fixed time together with the interest and no
relaxation is available in the same. All the additional charges which are included shall be
evaluated in advance and then only the decision shall be taken.
From the discussion, it is understood that all the methods have certain merits and demerits.
Digitech will be choosing among them by considering all of them and in addition to that various
others, aspects will also be considered. The amount required and the duration for which the same
is needed will have to be considered (Brown and Floros, 2012). The current gearing level will
also be included and if the company has high debts in the present situation then capital raising
will be opted. The current level of the profits and reserves will also be considered and then the
decision will be taken. All of the aspects which are required to be noted are discussed and will be
used for the final selection of the source of funds.

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Task 4
In the competitive market, there are various strategies which are required to be adopted to deal
with competitors. In the given case the director is in favor of the acquisition of competitors
whereas the CEO wants to grow in a careful and organic manner. They have a disagreement on
the strategy which is required to be adopted for the purpose of attaining growth.
The acquisition of the competitors can be made by which the competition which is available in
the market will be reduced to a certain extent. By the help of this, the business will be expanded
and it can carry on the operations in the different sector and location also (Shi and Prescott,
2012). There is the expansion which will be made in terms of the product line and with that the
new markets which are available can be entered. The process will be risky but not as much as the
other measures. In this system, the products which are sold by the competitors and the market are
already ready and no extra effort will be required to be made. The consumers are already aware
of the product which is being provided and so promotion will be needed and this will save a lot
of costs which will otherwise be incurred on the various processes and programs which are
launched. There should be proper goals which are required to be attained as then only the
operations will be carried in an effective manner and the targets will be attained. There will be
need to establish the bond with the people associated with that company as some of them will be
dissatisfied with the acquisition and may harm the company (Zhou and Li, 2012). The company
will be getting access to new competencies and resources by this as the employees who are
involved will be having different skills. They will be able to manage the tasks in a better manner
for which the resources were not available earlier. The risk is involved that whether the
employees of both the companies will be able to connect with each other or not. If this will not
be made possible then conflicts may arise among them.
There is the risk that the results which were expected are not received and this will cause the loss
which will have to be borne by the company (Younge, Tong and Fleming, 2015). There are
various issues which arise due to integration and they all will have to be managed which is a
complex process. There is a difference in the culture and difference may arise because of the
different working cultures.

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Another concept which is provided by the CEO of organic growth is an internal strategy which
will be implemented by making changes in the internal process of the company. There will be
diversification which will be made and for that the employees will be given the required training
so that they can perform in an even better manner. This will be increasing the productivity of the
business by which growth will be made possible (Kumar, Gaur and Pattnaik, 2012). The quality
of the products will be focused and that will help in making the consumers satisfied so that they
are retained and will be using more of the products. There will be need to bring innovation in the
business so that new facilities are provided and that will be attracting more customers. There will
be research which will be performed and in that all the new methods and technology will be
determined. They will be taken into consideration and involved in all the processes which are
undertaken in the business. They will be using the same in providing the services to the
consumers with new changes. This will be increasing the level of satisfaction and the same will
be benefitting the company as more will get involved with the business. It will be required that
consumers shall be provided with such services which are not available for them and any other
competitors are not providing them with the same. This will be attracting them and they will not
be going towards other entities (Chen and Yu, 2012). The customers will be retained and that
will be an advantage for the company. This is the approach in which no external source will be
used and all of the steps will be taken in the internal processes of the business.
This method will also be facing certain issues such as the employees will need to be trained and
that will require the incurring of the high cost. The company will be taking the risk that whether
the diversification will be made in an effective manner or not. If the company will not be able to
adopt the new technologies then it will be affecting the overall performance of the business and
also the trust of the consumers will be broken.
Both the method have been analyzed which have been provided by the director and CEO and
there benefits and demerits have been ascertained. It has been identified that the acquisition of
another firm will be making the process easier but that will be involving the risk also. Various
factors will be required to be noted (Chen and Chu, 2012). The growth will be possible by the
same as that will be covering the larger part of the market and the number of consumers and
products will be added to the business. The strategies are evaluated and they will be beneficial
for the business by taking them into account in a proper manner.

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