Financial Management Report: Octopus Ltd Case Analysis

This report delves into financial management principles, focusing on capital structure, share valuation, and investment appraisal techniques. The report begins by critically evaluating the significance of optimal capital structure in maximizing shareholder value. It then proceeds to calculate the market value of ordinary shares for Octopus Ltd under different scenarios, including right and loan issues, providing detailed calculations and comments on the findings. Furthermore, the report discusses both long-term and short-term sources of finance, offering insights into equity share issuance, long-term loans, commercial paper, and factoring. Finally, the report applies investment appraisal tools, such as payback period, accounting rate of return, and net present value, to evaluate and compare investment projects, providing recommendations for project selection, and discussing the advantages and disadvantages of these tools. The report utilizes a case study approach to apply financial concepts to real-world scenarios, offering practical insights into financial decision-making.

Financial Management

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
MAIN BODY..................................................................................................................................1
QUESTION 1..................................................................................................................................1
Critically evaluating the significance of optimal structure of capital to maximize value of
shareholders.................................................................................................................................1
QUESTION 2..................................................................................................................................2
SCENARIO 1..................................................................................................................................2
a. Calculating the market value of an ordinary shares in the context of Octopus Ltd.................2
b. Commenting on findings.........................................................................................................2
c. Discussing two sources of finance under each category long and short term........................2
SCENARIO 2..................................................................................................................................4
a. Applying investment appraisal tools for project selection.......................................................4
b. Comparing projects and advising manager regarding the selection of best one......................6
c.) advantages and disadvantages of tools of investment appraisal.............................................6
CONCLUSION................................................................................................................................8
REFERENCE..................................................................................................................................9

INTRODUCTION
Financial management refers to the business activity which is undertaken by manager for
allocation and usage of monetary resources. In the context of business unit, financial
management is highly required for the attainment of goals and objectives. To manage the
monetary activities of the company which includes preparing, directing, financial management
used by the company? It includes activities such as buying, selling and to use money in the
organisation to achieve the best value of money. This present report will cover significance of
optimal structure of capital in organisation to maximize value of shareholders. Market value of
ordinary share is to be calculated and two sources of short-term financing and two sources of
long term financing is also to be explained in this report. Also calculation is provided of payback
period, accounting rate of return and net present value. Further, in this report, advantages and
disadvantages of any two tools is also be explained in this report.
MAIN BODY
QUESTION 1
Critically evaluating the significance of optimal structure of capital to maximize value of
shareholders
Optimal capital structure is the mix of debt and equity and preferred shares. It helps in
minimizing weighted cost of the firm which is of employed capital which helps in maximizing
total value which is of firm securities.(Faccio and Xu, 2018.) The result which is appeared as
minimum cost capital structure of the firm called as optimal capital structure. In a firm amount of
debt, which contained in optimal capital structure of company is refereed as debt capacity of the
firm. There are various factors which includes in optimal capital structure and debt capacity of
the firms. These factors may be business risk, tax structure of the company, potential financial
distress of the company which may include bankruptcy and also cost of agency. It also includes
role of capital structure policy which is for capital market of company and their performance.
For optimizing capital structure in company, managers operate in range of values of the
market. Company mainly raise their capital structure by use of debt rather than to use equity in
market because by this company will able to avoid negative signals to market. Company's
announcement regarding taking of debt in capital market is refereed as positive news and in a
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given time period if company raise too much capital than cost of capital debt, equity and stocks
will also get raised which result in increase of marginal cost of capital of company.
To maximize market value of the company, weighted average cost of capital is used by
company to estimate their debt and equity. It is said that lower cost of capital in company result
in greater present value of future cash flow of company. Debt is less risky than equity therefore,
company compensate debt investor rather than equity investor. For company debt is cheaper
because it provides tax relief on interest, because payment of dividend is paid after tax income.
But for company, amount of debt is must be in limit, because higher amount of debt leads to
higher payment of interest which leads in risk of bankruptcy. However, according to point of
view of shareholders, too much amount of debt in company will provide financial risk for
shareholders of the company by which they the amount they require from return of equity have
more chance with financial risk.(Dufour, Luu and Teller, 2018.) Therefore, it is necessary for
company to find point where the amount of debt is equals to marginal cost of the company.
QUESTION 2
SCENARIO 1
a. Calculating the market value of an ordinary shares in the context of Octopus Ltd
1. A right issue is made
Given: Ratio of 1:4 @ discounted price of 2.60
For example: 40 in against to 160
It is assumed that right shares are issued in the beginning of the year:
Right factor = Fair value per share immediately prior to right issue / Theoretical ex-right fair
value per share
Theoretical ex-right fair value per share = aggregate fair value of share immediately prior to the
exercise of rights + proceeds from exercise of the rights / number of outstanding shares after
right issue
= (3 * 160) + (40 * 2.6) / 200
= 2.92
Right factor = 3 / 2.92
= 1.027
Particulars Figures
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Net profit before interest and tax on 31/12/17 Rm 60m
Less: tax @ 25% 15
Profit after tax 45
On the basis of given case profit is expected to increase by 30% in the upcoming year
Particulars Figures
Net profit before interest and tax on 31/12/17 Rm 60m
EBIT on 31/12/2018 60 + (60 * 30%)
= RM 78
Less: tax @ 25% 19.5
Profit after tax 58.5
Basic earnings per share for the year ended on 31/12/17
= 45 m / (160 * 1.027)
= 0.273
Basic EPS for the year 31/12/2018 regarding right issue
= 58.5 / (160 + 40)
= 58.5 / 200
= 0.295
Computation of price-earnings ratio
Particulars Formula Figures
Market price per share (MPS) 3
Earnings per share (EPS) 0.28125
P/E ratio MPS / EPS 3 / 0.28125
= 10.66
As per the given case, P/E ratio will be decreased by 10%
Thus, P/E ratio = 10.66 – (10.66 *10%)
= 9.594
Market price = New P/E ratio * EPS
= 9.594 * 0.295
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= 2.830
2. A loan issue is made
Given that: Loan of RM 1074 @ 10%
Particulars Figures
Profit before interest and taxation 78
Less: interest 10.4
Profit before tax 67.6
Less: tax @ 25% 16.9
Profit after taxation 50.7
Number of shares outstanding 160
` 50.7 / 160 = 0.3168
P/E ratio 10.66
Market price 10.66 * 0.3168
= 3.377
b. Commenting on findings
Case scenario presents that exchange and share price of Octopus Ltd was RM 3 on 31st
December. Hence, for planned expansion Octopus Ltd wishes to raise funds either through right
issue or loan. Business entity of Octopus Ltd wants to assess one option which in turn enhances
shareholders wealth and share price significantly. The above depicted evaluation clearly exhibits
that share price will be RM 2.83 if right issue is made. On the other side, in the case of loan issue
share price will imply for RM 3.38 respectively. Hence, as per the results derived management
team of Octopus Ltd is advised to take resort of loan issue for meeting monetary requirements.
This in turn provides assistance to the firm in developing optimal capital structure and maximize
share price as well. Hence, loan issue will contribute in the growth and success of firm to a great
extent over other alternative.
c. Discussing two sources of finance under each category long and short term
For financing projects business unit requires fund which in turn can be generated through
the means of long and short term sources. As per the cited case situation, Octopus Ltd wants to
raise capital of RM 104 m for exploring its operations. In other words, Octopus Ltd can raise
funds by employing following sources:
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Long-term sources of finance: It includes sources which assist in meeting monetary
requirement for more than 5 years. For the purpose of growth, business unit needs to invest
money in fixed assets such as land & building, plant & machinery etc. In this regard, by using
long term sources of finance Octopus td can finance its capital expenditure effectually.
 Equity share issuance: Financial requirements can be met by Octopus Ltd though issuing
equity shares to the general public at large. It is recognized as a prominent source of
finance which helps in meeting monetary need significantly. Moreover, now investors
prefer to invest money in the shares of growing and leading firms which provides them
with higher return in the form of dividend (Sources of Finance, 2018). Hence, through
issuing shares Octopus Ltd can attract investors and thereby would become able to raise
finance. Such source of finance is highly effectual as it helps in fulfilling requirements at
low cost. Moreover, only placing advertisements firm can attract investors. Along with
this, it does not impose fixed financial burden in terms of interest payment. Moreover,
firm offers dividend only when it gets enough profit during the concerned accounting
year. Nevertheless, in the case of equity shares, firm has to provide investors with voting
rights. Hence, interference in decision making affects management’s decision pertaining
to business activities and operations.
 Long term loan: By applying in banking institution for loan Octopus Ltd can generate
funds according to the requirements. Banks prefers to offer funds to the leading firm with
the motive to generate more income in the form of interest. Thus, on the behalf of
collateral security manager of Octopus ltd can easily apply for loan and gets fund. This
financing source offers benefit to the firm under tax brackets (Long-Term & Short-Term
Financing, 2018). In other words, interest on loan comes under the category of tax
exemption which in turn maximizes profitability. Further, in bank loan, company can
repay amount in the form of instalments which offers convenience to it. However,
interest amount on loan is higher which in turn impacts company’s profitability in a
negative manner.
Short-term sources of finance: Business units usually take financial assistance for less than
one year for increasing inventory orders and daily supplies etc. Thus, Octopus Ltd can meet
funding requirements using the following sources such as:
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 Commercial paper: It may be presented as unsecured promissory note which helps in
meeting requirement pertaining to the period of 1 to 364 days. Such note is usually issued
by large sized corporations for raising money to fulfil short term obligations. Business
units with good credit rating can easily raise funds by selling commercial papers to the
investors (Sources of Short-Term and Long-Term Financing, 2018). Thus, using
commercial paper source Octopus Ltd would become able to meet monetary
requirements for short period.
 Factoring: Each business unit has some receivables pertaining to credit sales. Thus, by
discounting receivables from financial institutions Octopus Ltd can generate funds before
due date. Hence, such financial source offers opportunity to the firm in relation to getting
payment early on some discounting charges. In other words, bank charges some amount
for discounting bills which in turn imposes cost in front of the firm. However, by
undertaking such financial source Octopus Ltd can meet short-term monetary needs.
Hence, by employing all the above depicted sources Octopus Ltd can get funds and thereby
would become able to capitalize opportunities. Thus, company should consider purpose, cost and
benefits at the time of raising funds from long as well as short term sources.
SCENARIO 2
a. Applying investment appraisal tools for project selection
On the basis of cited case situation, business entity of Octopus Ltd has three proposals
from investment perspective such as project A, B and C. In this regard, by undertaking
investment appraisal tools firm can assess the proposal which helps in generating higher returns.
Payback period: Such method presents time period within which business entity will
recover initial investment. Hence, it assists manager in assessing time period after which firm
would become able to generate profit margin (Häcker and Ernst, 2017). In accordance with such
method, business owner should select project which has less payback period.
Computation of payback period
Year
Project
A
Cumulativ
e cash
inflows
Project
B
Cumulativ
e cash
inflows
Project
C
Cumulativ
e cash
inflows
1 26600 26600 4600 4600 11200 11200
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2 26600 53200 6200 10800 8600 19800
3 26600 79800 8000 18800 6600 26400
4 26600 106400 10000 28800 0 26400
Particulars Project A Project B Project C
Initial investment 80000 20000 20000
Payback period 80000 / 26600 = 3.01
years or 3 years
approx.
3 + 1200 / 10000
= 3.1 years or 3 years
and 1 month approx.
2 + 200 / 6600
= 3.03 years or 3
years approx.
Average rate of return (ARR): This method of investment appraisal presents average return
which will be generated by the firm from investment proposal or projects. ARR presents return
in the form of percentage which in turn associated with the concerned proposal (Konstantin and
Konstantin, 2018). As per the selection criteria’s business entity should select project which
offers high ARR.
Calculation of ARR
Year
Project
A
Project
B
Project
C
1 26600 4600 11200
2 26600 6200 8600
3 26600 8000 6600
4 26600 10000 0
Average
earnings
after tax 26600 7200 6600
Average
investment 80000 20000 20000
ARR 33.3% 36% 33.0%
Net present value: This discounting method of capital budgeting exhibits monetary return
which firm will get over initial investment. In the recent times, NPV method is highly significant
as it presents outcome referring time value of money concept (Kengatharan and Clamenthu,
2017)t. On the basis of such method, project with positive and higher NPV proves to be more
beneficial for the firm.
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Computation of Net present value (NPV)
Year
PV
factor
@
10%
Project
A
Discounted
cash
inflow
Project
B
Discounted
cash
inflow
Project
C
Discounted
cash
inflow
1 0.909 26600 24182 4600 4182 11200 10182
2 0.826 26600 21983 6200 5124 8600 7107
3 0.751 26600 19985 8000 6011 6600 4959
4 0.683 26600 18168 10000 6830 0 0
Total
discounted
cash
inflow 84318 22146 22248
Less:
Initial
investment 80000 20000 20000
NPV 4318 2146 2248
b. Comparing projects and advising manager regarding the selection of best one
Outcome of investment appraisal shows that owner of Octopus Ltd has to wait for 3 years
in the case of project A and C pertaining to initial investment recovery. On the other side, in
project B, manager will take 3 years and 1 month for recouping the figure of initial investment.
In the case of project A, B and C amount of initial investment accounts for 80000 & 20000
respectively. Hence, as per the results of payback period priority should be given to proposal A
& C over others. Further, ARR of project A & C is similar and accounts for 33% significantly.
However, in the case of project B, ARR implies for 36% respectively which in turn higher over
other proposals. Hence, as per the selection criteria of ARR, manager of Octopus td should invest
money in project B. Nevertheless, NPV of project C is higher in comparison to other alternatives
available. The above depicted table clearly exhibits that manager of Octopus ltd will 2248
significantly over the period of four years. In project A, NPV is higher and implies for 4318 but
in this firm needs to invest 80000. On the other side, by investing only 20000 in project C
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manager of Octopus Ltd will get high returns. Thus, considering all such aspects it can be
depicted that project C will prove to be more profitable for the firm.
c.) advantages and disadvantages of tools of investment appraisal
Investment appraisals is the process of doing capital budgeting to measure long term and
short-term investments of the company. In other words, investment appraisal tools include
payback period, net present value, average and internal rate of return which helps in evaluating
monetary opportunities. By using such tools firm can assess whether concerned investment
proposal or opportunity will aid in the growth of company or not. There are ten types of
investment appraisals tools. Here to provide advantages and disadvantages of investment
appraisals two tools are used that is Net present value and Accounting rate of return.
 Net present value
To measure profitability of investment done by company, net present value is the best method to
determine that profitability of the company.(Hopkinson, 2017. ) Advantages and disadvantage of
this method are as follows-
Advantages of net present value
It provides a basic idea about future investment of money's worth that its value in present
and future for doing investment in company. In this process, to determine capital cost of future
cash flow of the company is discounted by capital cost of that period. It also provides a view of
investment and its return in future of the company in terms of currency company wants to invest.
To also provides an idea about the risk which occurs in doing investment in the company (Hicks,
2017). NPV considers time value of money concept while evaluating opportunities. Hence,
referring such tool company can invest money in the most profitable project.
Disadvantages of net present value
Major disadvantage of net present value method is that it requires a guess work in which
is cost of capital is measure as too low than it result for company in making investments and if
cost of capital is measured as too high, it results in forgoing too many investments for company.
 Accounting rate of return
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Accounting rate of return is also known as average rate of return which is used by company in
doing capital budgeting investment decision in company.(Noreen, Brewer and Garrison, 2014.)
Advantages and disadvantage of this method are as follows-
advantages of accounting rate of return
It is known to be a simple method under which used in comparing capital projects of the
company.(Advantages And Disadvantages Of Accounting Rate Of Return,2018.) As this method
has easy calculation it is used by everyone by use of simple formula that is accounting rate of
return (ARR) = (average net income/ average investment) x 100. This method is also used to
calculate profitability which is beneficial for shareholders and owners. ARR tool of investment
appraisal provides high level of assistance in measuring and evaluating profitability associated
with the investment (Advantages and Disadvantages Of Accounting Rate Of Return (ARR),
2018). Easy calculability and simplicity in understanding is also recognized as the main benefit
associated with such tool.
Disadvantage of accounting rate of return
Major disadvantage is that it does not consider time value of money and also ignores cash
flow of company and it is calculated on the basis of profit of the company. ARR method also
does not consider terminal value of the project while evaluating opportunities and presenting
solution for decision making.
CONCLUSION
By summing up this report, it has been concluded that optimal capital structuring is highly
required within the firm for enhancing shareholders value. Moreover, inappropriate capital
structure places negative impact on profitability aspect. Besides this, it can be inferred that
business unit should keep in mind cost factor while making selection of long and short term
source of finance. Further, it has been articulated that owner of Octopus Ltd should select project
C over other alternatives available. Moreover, such project will aid in the profitability and
overall success to a great extent. Thus, focus needs to placed by the manager of Octopus ltd in
making investment in proposal C. it can be summarized from the report that NPV method of
investment appraisal is highly significant which in turn helps in choosing profitable project over
the other alternatives available. NPV method presents solution by taking into account time value
of money concept and thereby helps in taking appropriate investment decisions.
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