Financial Management: Long-Term Finance and Investment Appraisal

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Financial Management
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Table of Contents
Question 2 – Long term finance: Equity finance.............................................................................4
Question 3 Investment Appraisal Techniques...............................................................................10
Reference List................................................................................................................................17
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Question 2 – Long term finance: Equity finance
(a) Lexbel plc generates earnings after tax (PAT) of 20 per cent on shareholders’ funds. Its
current capital structure is as follows:
The estimated earnings generated within an organisation = the entire shareholders’ fund *20%
Lexbel Plc’s present capital structure = Ordinary share capital + reserves in hand
Ordinary share capital = £300000 (50 pence for every share)
Reserves in hand = £400000
Hence, capital structure = 300000+400000 = £700000
Therefore, the business concern presently holds = 700000 ÷ 0.5 = 1400000
(b) Determine the:
(i) Number of shares to be issued:
In the table below, the number of shares the company wants to issue on the three given issue
prices have been presented:
Price of Issue = £1.8 Price of Issue = £1.6 Price of Issue = £1.4
Amount desired by the
company ÷ price of the shares
= 180000÷1.8
= 100000 shares
Amount desired by the
company ÷ price of the shares
= 180000÷1.6
= 112500 shares
Amount desired by the
company ÷ price of the shares
= 180000÷1.4
= 128571 shares
Table 1: Showing the number of shares to be issued by the company at three different issue
price
(ii) Theoretical ex – rights price
In the table below, theoretical ex- rights prices of the company has been presented:
Particulars Issue price = Issue price Issue price
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£1.8 = £1.6 = £1.4
Valuation of shares prior to right issue (I) 600000x1.9
= 736842
600000x1.9
= 736842
600000x1.9
=736842
Amount obtained through right issue (II) 100000x1.8
=180000
112500x1.6
= 180000
128571x1.4
= 180000
Amount of shares successive to issue of right
shares (III)
600000+1000
00
= 700000
shares
600000+112
500
=712500
shares
600000+128
571
=
728571share
s
Theoretical ex-rights price (I + II ÷ III) £1.89 £1.85 £1.81
Table 2: Showing the theoretical ex rights price of the company
(iii) Expected earnings per share
In the table below, the expected earning of the shareholders have been presented:
Particulars Issue price =
£1.8
Issue price =
£1.6
Issue price =
£1.4
The amount of profit distributed to every
ordinary shareholder of Lexbel Plc (I)
700000x20%
= 140000
700000x20%
= 140000
700000x20%
= 140000
Number of shares presented as right issue (II) 100,000
shares
112,500
shares
128,571
shares
Expected earnings per share (I ÷ II) 140000÷1400
00
= £1.4
140000÷1125
00
= £1.24
140000÷1000
00
= £1.09
Table 3: Showing the expected earning of the shareholders
(iv) Form of the issue for each rights issue price
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An invitation to present shareholders of the company to buy the additional shares of the company
is known as right issue. Precisely can be defined as a process where the shareholders for every
four shares purchases owned by them one shares of the company. The management of Lexbel Plc
does the right issue at three different prices quoted as 1.4, 1.24 and 1.09. On considering these
prices closely it can be concluded that the company has preferred to do the right issue at
discounted price. The market price of the shares is less than the prices that the existing
shareholders have quoted. This establishes that the company desires to do right issue at
discounted rate. Hence, a conclusion can be drawn that Lexbel Plc has done right issue at a price
that stands less than the ex dividend market price. This form of issuing the right shares at
discounted price is quite common and is practised immensely by private limited companies.
(v) Presentation of your results in a tabular form and critical evaluation of the best option
among the three right issues
Particulars Issue price = £1.8 Issue price = £1.6 Issue price = £1.4
 Number of shares
issued
100,000 112,500 128,571
 Expected
earnings per share
£1.09 £1.24 £1.4
 Theoretical ex-
rights price
£ 1.81 £ 1.85 £ 1.89
Table 4: Tabular presentation showing three right issues at different issue prices
The process where the existing shareholders for every 4 shares held by them purchases one share
is known as right issue. In the study done above, Lexbel Plc is issuing the shares at a discounted
rate. On close evaluation of the tabular presentation given above it can be observed that the
company wishes to issue shares at £ 1.81, £ 1.85 and £ 1.89 prices. On basis of detailed
calculation, it can be concluded that the best quoted price by the management is £ 1.81. The
company issues only 100000 shares for £ 1.81. Moreover, the expected earning from the issue
made at £ 1.81 is the highest. On the other hand, the expected earning from £1.6 is £1.09 and the
expected earnings from £1.4 is 1.24 which is considerably lower than 1.4. This makes it most
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appropriate price to issue the shares the issue price of £ 1.89. The company is doing the right
issue at discounted price which is immensely practised in the other companies. Moreover, right
issues are generally done on discounted prices.
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(c) Critically discuss the advantages of scrip dividends from the point of view of the
company and the shareholders, ensuring the response draws upon relevant academic
research within this highly topical area of financial management.
Every public listed company at the end of each year pays dividend to its shareholders or
investors. Distribution of earnings of the company is known as dividend. However, Albrecher
and Cani (2017) states that payment of dividend is the primary approach of the companies to
return back the cash or the assets to its shareholders. The owner of the company decides on how
much he has to retain and what amount has to be given through payout of dividends. Recently,
many companies are practicing scrip dividend. The process of a company giving their
shareholders the choice of either receiving a dividend in cash or equivalent in additional shares
of the company instead of automatically giving their shareholders a cash dividend is known as
scrip dividend. The new scrip is generally issues in the ratio to the scrip already held, for the
shareholders that select the scrip option. The subject of scrip dividend is a large part of
discussion in the area of financial management. In this research, our study concentrates on the
advantages of paying scrip dividends to the shareholders from both the viewpoint of the
shareholders and the company.
As Feito-Ruiz et al., (2018) suggests that in the case of scrip dividend the company enjoys
considerable benefit as their ability to retain cash for investments in future is fulfilled. On the
other hand from the shareholder’s or investor’s point of view, the ones who want to reinvest their
dividends can have the benefit of saving their cost of transaction. Zelalem (2018) stated that scrip
dividends are issued directly by the company so there is no cost of brokerage or stamp duty.
While in case of cash dividend an investor has to bear the cost of stamp duty and brokerage. This
is a benefit to the shareholders as they do not need to pay any amount of brokerage and stamp
duty on the dividends allocated to them. It has been observed that due to this reason the
shareholders or the investors are more inclined to the system of scrip dividends payment.
However, as per Feito-Ruiz et al., (2018) the companies need to put a proper check on this
system. As an excessive payment of dividend through scrip system would lead them to issue
many shares which in turn would result in suspension of their earnings per share.
As stated by Lasfer (2015) when the company has deficit in cash reserves due to decrease in cash
flow, increase in operational loses and due to limited access to external sources of finance it
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shifts to scrip dividend. As this is an effective way to maintain and increase the level of cash
reserves in the company. Moreover, reputed companies shy away from holding low payout ratio.
This is the major reason that the firms or companies facing financial constraints never opt for
paying cash dividends. In order to avoid the embarrassment of having low payout ratio, often a
company opts for scrip dividend. As through this system of payment of dividend the company
pays additional shares to the shareholders instead of paying them cash.
According to Lasfer (2015), the shareholders who prefer cash dividends receive cash and also
experience suspension of their shares. On the other hand, the shareholders who opt for script
dividend may not receive cash but they are able to avoid the dilution of their stake or ownership.
Instead they own the additional shares received of the company as scrip dividend. Furthermore,
Huerga and Rodríguez Monroy (2018) stated that scrip dividend offers tax advantage to the
investors. Personally scrip dividend can be treated as income by the investors and they can avail
the exemptions available through the deductions. In addition to all these, Bernhart and Mai
(2016) opined that through this system of dividend payment companies provide an option to the
investors to have their own say in the case of dividend payment. The company lets the
shareholders to make up the mind of their own. The companies provide the shareholders with
enough time of 2 to 4 weeks to choose their one option of the two. In order to strip this option the
investors need to sell their call option in the secondary market. The recent trend in the European
Securities lending market shows the growing usage of scrip dividend by the companies.
Thilakasiri and Fernando (2015) have stated that investors are inclined towards scrip dividend
mainly because of the implicit option of free call being attached to the distribution of scrip
dividend. Moreover, the strategy of repurchasing through derivatives and volatility assures the
company a lower price of repurchase. This price reduction helps the company in improvisation
of the capital ratios and in increment of the net value of the equity shares. In addition to this the
companies are able to avoid the dilution of shares. Therefore, scrip dividend has proved to be
highly advantageous both for the company and the shareholders or the investors.
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Question 3 Investment Appraisal Techniques
a. Calculate using the following investment appraisal techniques, and provide brief
recommendations as to the economic feasibility of acquiring the machine:
i. The Payback Period
Payback period
= Last year constituting negative cash flow (cumulative) + (Cash flow amount during the last
year constituting negative cash flow / Amount of cash flows in the consecutive year)
= 3+ (51500/89500)
= 3+ 0.57541
= 3.575 years
= 3.58 years (in approximate)
ii. The Accounting Rate of Return
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Total cash inflowing 89500 89500 89500 89500 89500 89500
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(-) 20% depreciation 64000 51200 40960 32768 26214.40 20971.5
(+) Scrap value 0 0 0 0 0 32000
Total amount of
accounting profit
25500 38300 48540 56732 63285.60 100528.5
Thus,
Total depreciation over the years = 236114
Total inflow in cash = 89500*6 = 537000
Therefore,
Net profit in total = 55481.016
Average investment = 32000+320000 / 2 = 176000
Hence,
Accounting rate of return
= 100 * 55481.016 / 176000
= 31.52%
= 32% (in approximate)
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iii. The Net Present Value
Therefore,
Net present value
= Present valuation of inflows - Present valuation of outflows
= 384181.5 - 320000
= 64181.5
iv. The Internal Rate of Return
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Recommendations for Happy Meal Limited on the investment
As stated by Alkaraan (2017), prior to making decisions relating to investments, it is necessary
that the economic viability of the investment that a company is considering to make is examined.
Utilisation and application of the differing methods one uses for investment appraisal provides
assistance in ascertaining the economic viability of investments and the returns, which could be
obtained through them. The economic viability of the organisation Happy Meal Limited’s
potential investment on machine has been examined above using four diverse methods. It can be
obtained from the application of all these four methods that the accounting rate of return will be
32% if the investment is made and the internal rate of return would turn out being 17.29%. On
the other hand, the net present value will be £64181.50, which is positive in nature and the
payback will be 3.58 years, which is considerably low and satisfactory in nature.
As per payback period’s rule on decision-making, investments with low payback are preferred
being accepted in a company (Jafari and Valentin, 2018). On the other hand, when the net
present value is considered, it has to be ensured that the investments made in a company have
positive net present values (Adusumilli et al., 2016). Considering these two decision rules
associated with investment appraisal, one can find out that the period of payback of the
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