University Finance Report: RP PLC Funding and Investment Strategies

This report analyzes the funding options available to Residential Properties PLC (RP PLC) for the acquisition of an unlisted business. The report begins by highlighting the importance of retained earnings as a source of funding, emphasizing their flexibility and lack of dilution to ownership. It then applies the pecking order theory to evaluate the suitability of debt and equity financing, considering factors such as asymmetric information and the costs associated with each method. The analysis extends to different types of debt, including bank loans and venture capital, and various equity financing methods like private equity and public share issues. The report stresses the importance of a balanced approach to debt and equity. The investment appraisal decision is also discussed, covering financial, environmental, legal, and risk factors, including required rate of return and net present value (NPV). The report concludes with a recommendation for RP PLC to prioritize debt financing, with a proper investment appraisal to ensure the project's viability and alignment with the company's overall strategy.

Running head: INVESTMENT ANALYSIS
Investment Analysis
Name of the Student
Name of the University
Author Note

1INVESTMENT ANALYSIS
Abstract
This report contains an analysis of the acquisition of a new business by RP PLC. It begins with
the importance of retained earnings in funding an acquisition. After that, using the pecking order
theory, it identifies the best source of funding amongst debt and equity. The investment appraisal
is undertaken by considering various factors that are essential in determining the profitability of
an investment. It concludes with an overview of the discussions made in the report.

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Table of Contents
Introduction..................................................................................................................................2
Importance of retained earnings...................................................................................................2
Decision on method of Financing................................................................................................2
Investment Appraisal Decision....................................................................................................5
Conclusion...................................................................................................................................6
References....................................................................................................................................7

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Introduction
In the given situation, Residential Properties PLC is planning to acquire an unlisted
business that allows the company to establish itself in a new geographical region. However, the
company is not able to generate enough cash from its internal sources for the acquisition of the
new business. This may be due to the lack of sufficient retained earnings generated by the
company.
Importance of retained earnings
The major importance of using retained earnings is that it does not dilute the ownership
of the company. They are also flexible and can be used according to the requirements of the
company. The other aspect of retained earnings is the aspect of opportunity cost of capital.
Investing through retained earnings provides the shareholders with a chance to make additional
investments from the profits earned by the firm (Lazonick 2014). This is much better than
distributing the revenues among the shareholders and making the funds unavailable for
investment. In case of economic slowdown or a financial crisis, it has been found that firms find
it difficult to pay off their debts on a regular basis. To avoid this problem, it is better to fund a
new investment using retained earnings (Khan and Yusop Adom 2015). For a company looking
to constantly innovate its business and invest in the research and development activities,
availability of retained earnings makes the process much smoother and risk-free when compared
to a company that takes debt and other external financing to invest in activities of similar nature.
Decision on method of Financing
The pecking order theory is one of the most prominent financial theories that is related to
the capital structure of a company. It was popularised by Stewart Myers and Nicolas Majluf in
the year 1984, who suggested that firms follow a hierarchy in considering the sources of

4INVESTMENT ANALYSIS
financing for their business (Serrasqueiro and Caetano 2015). It suggests that internal financing
or retained earnings is the most common form of financing preferred by the business. It is
followed by debt financing which is later followed by equity form of financing. The major
concept on which this theory has been proposed is asymmetric information. Asymmetric
information or the lack of availability of the same amount of information to all the parties is the
reason for imbalances in the transaction powers of parties. Retained earnings are the most
suitable form of earnings as they come within the organisation and hence reduce the asymmetry
in information available to the parties. This is not the case with the other two sources of funds as
they involve a certain amount of expenses like issue costs and transaction costs to obtain the
required information. However, in case of RP plc, the retained earnings are not sufficient and the
firm needs to use the other two methods of financing for funding its takeover. The retained
earnings are followed by the debt source of funding due to a variety of reasons. The major one
being that the issuance of debt is an indicator of the company’s stock being undervalued and also
indicates the confidence of the management of the company in the performance levels of the
organisation. In most of the cases, it has also been found out that the cost of debt of a company is
much lower than its cost of equity. Another reason for issuing debt is the lack of access to formal
capital markets by companies (Robb and Robinson 2014). In case of private borrowings obtained
from external sources, there are mostly two types of borrowings. They are bank loans and funds
from venture capitalists. Bank loan is a traditional method of funding a business in which the
business acquires the required funds from a bank and has to pay back the loan along with an
annual interest charged by the bank. On the other hand, venture capital is a more modern form of
financing the capital expenditure of a firm. It usually provides financing to small businesses or
start-up businesses that are considered to have the potential to grow. They start off by providing

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a loan to the business for financing its activities. However, at some point, this loan is converted
into the equity capital of the firm. Due to the limitations imposed by the formality of the banking
sector, venture capitals have become more prominent in recent years (Adawo and Atan 2013).
These venture capital funds are also available in the form of government venture capital funds
and private venture capital funds. The value added by the government funds has been found to be
much higher than that done by the private funds (Luukkonen, Deschryvere and Bertoni 2013). A
type of venture capital that is available in the market is provided by angel investors. Equity
shares are the shares of the company that are issued to raise funds from investors looking to gain
ownership in the company. This is a more flexible form of raising funds than the debt source of
funding as the company does not have to pay an annual fixed amount of interest rate to the
shareholders. However, the cost of equity is much higher as investors expect significantly high
returns on their investments than other outlets of investments available to them. There are
various methods in which a company can issue its shares in the stock market. They include
private equity, crowd funding of shares, issue of bonds or loan stocks and public issue of shares.
Of all these forms, public issue of shares is the most common form of issue. In this, the company
generally invites public to subscribe for the amount of shares issued by it. After they take up the
subscription, the company allots the shares to them on a predetermined basis. Private equity is
one that is issued to the already existing shareholders and no invitations are allowed from
outside. Crowdfunding of equity is a method in which the shares of the company are made
available for issue through online (Mollick 2014). It is also subject to all regulations that govern
securities and finances issue. Bonds or loan stocks are a form risky sources of investments where
the funds are procured by a company by providing its shares as a collateral against the amount of

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loan taken by it (Wang and Wu 2014). This has a double benefit for the investors as they receive
interest and gain control of the shares until their loan is repaid.
While each source of financing has its set of benefits and drawbacks, it sometimes
becomes difficult to determine the best source of financing. It has been stated that a good mix of
debt and equity is essential for a firm to thrive properly in the long run. In case of a firm opting
for debts, there have been indications that taking the debts from a wide range of sources is
necessary for a firm to become highly profitable and less risk prone. This ensures that the
business of the firm does not get affected by a single event (Colla, Ippolito and Li 2013). Hence,
in case of RP PLC, it is advisable for the firm to obtain its source of funding from debt as it is
less costly and diversifies the risks faced by the firm. Obtaining the funds from private banks is
most beneficial as the costs of issue are much less than borrowing from a private bank.
Investment Appraisal Decision
Investment appraisal is a series of techniques that are available to an investor to
determine the attractiveness of a particular investment. The appraisal consists of a variety of
factors like financial, environmental, legal and risk factors. The most commonly used financial
factors are the required rate of return and the Net Present Value (NPV) of an investment. The
required rate of return suggests the amount of returns that an investment should generate to make
it profitable. NPV is the present value of the investment after considering the inflows and
outflows generated by the investment (Moten Jr and Thron 2013). An investment should only be
taken up if its NPV is positive as it indicates that a particular project is profitable. Every
investment has a financial risk associated with it. This is the risk of losing all the money that has
been put in by the investor. Hence, an investor needs to consider this fact and invest only a
limited amount that they can afford to lose. These risks include default on the part of debtors, a

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sudden change in the existing marketing conditions and loss of profits. The other aspect to
consider is whether a particular investment is an overall good fit for the strategy of the
organisation or not. The final aspect to consider is whether the company has sufficient resources
to make the investment a success or not. This is essential as the company can avoid going
bankrupt in the future due to the investment.
Conclusion
From the above discussion, it can be suggested that retained earnings are the best source
of funding a capital expenditure due to their flexibility. However, in their absence, RP PLC
should consider raising the necessary funds through debts as it helps the business in maintaining
a good balance between debt and equity. It should also consider all the risks faced by it and
conduct a proper appraisal of its investment opportunities to ensure that it is capable of taking up
that particular investment. It should also fit the overall strategy and financial objectives of the
firm and have a positive NPV.

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References
Adawo, M.A. and Atan, J.A., 2013. Graduate unemployment in Nigeria: Entrepreneurship and
venture capital nexus. Journal of Economics and Sustainable Development, 4(9), pp.75-81.
Colla, P., Ippolito, F. and Li, K., 2013. Debt specialization. The Journal of Finance, 68(5),
pp.2117-2141.
Khan, A. and Yusop Adom, A., 2015. A test of the pecking order theory of capital structure in
corporate finance. Accounting & Taxation, 7(2), pp.43-49.
Lazonick, W., 2014. Profits without prosperity. Harvard Business Review, 92(9), pp.46-55.
Luukkonen, T., Deschryvere, M. and Bertoni, F., 2013. The value added by government venture
capital funds compared with independent venture capital funds. Technovation, 33(4-5), pp.154-
162.
Mollick, E., 2014. The dynamics of crowdfunding: An exploratory study. Journal of business
venturing, 29(1), pp.1-16.
Moten Jr, J.M. and Thron, C., 2013. Improvements on secant method for estimating internal rate
of return (IRR). Int. J. Appl. Math. Stat, 42(12), pp.84-93.
Robb, A.M. and Robinson, D.T., 2014. The capital structure decisions of new firms. The Review
of Financial Studies, 27(1), pp.153-179.
Serrasqueiro, Z. and Caetano, A., 2015. Trade-Off Theory versus Pecking Order Theory: capital
structure decisions in a peripheral region of Portugal. Journal of Business Economics and
Management, 16(2), pp.445-466.

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Wang, H. and Wu, Z., 2014. Convertible bonds with higher loan rate: Model, valuation, and
optimal strategy. In Abstract and Applied Analysis (Vol. 2014). Hindawi.