The term of finance is backbone of any organisation and there must be a ongoing flow of funds in and out of a business entity. Money makes the wheels of organisation run properly. Financial management define as strategic planning, coordinating, guiding and dominating of financial undertakings in a business entity or an institute. There are consisting of different principles of management in which financial assets of a business, on the other hand it is playing significant role in fiscal management. Through this management an organisation proper arrange funds in every operational activities and allotted as per the requirement. Without this management company can not function properly and do not proper use of funds. Along with, it is helping in creating profit for a business entity and assuring an acceptable return on investment. It is mainly concentrated on the future requirement of funds to conduct operational activities that could be determined (Amanah, Rahadian and Iradianty, 2016). Need Assignment Examples?Talk to our Experts!
To complete this project report select first and third question. In first question cover calculation of cost of capital, changes in capital structure, minimise weighted average cos of capital. Along with critically determination effects of short termism and bankruptcy to assure about response. In third question analysis different investment appraisal techniques like pay back period, net present value etc. In addition, analysis the benefits as well as limitations of each investment appraisal techniques.
a) Cost of capital on book value and market value
The cost of capital is a cost of any organisation's funds (both debts & equity) or from an investors view which is necessary for particular rate of return as per the portfolio of an organisation's existing securities. This is calculated for the analysis cost of new projects of particular organisation. In every business entities all the securities are kept in organized way that known as capital structure. It is essential for every organisation because it supports to achieve all the objectives like higher profitability and large number of investors etc. To calculate cost of capital at market value and book value required to cover of all equities, debts etc. For this purpose require to examine financial statements of Kadlex Plc have analysed of weighted average cost of capital is lesser (Attig, Boubakri, El Ghoul and Guedhami, 2016). It is required to improve so director of the business issue new bonds at the market that impact on the determination that calculated below:
For year 1 to 5 the growth are 21, 23, 25, 27 and 28 individually.
Calculation of growth=
=0.0757 or 7.57%
(Here, g =growth, S0 =First dividend, n =number of years, Sn =Last dividend)
Computation of rate of growth for all the stocks is as follows:
Cost of irredeemable bonds:
=0.0654 or 6.54%
(Here, P0 =Initial Price, CT =Rate of Corporate tax rate, Kd =Cost of Irredeemable Bonds, Pn =Current Price, j =Rate of interest on bonds)
Cost of equities:
Formula= Ke =[Sn*(1+g)+g ])/P0
(Here, Sn =First dividend, P0 =Current share price of equity shares excluding dividend, Ke =Cost of Equity, g =Growth rate, )
Cost of preference share:
= 0.0933 or 9.33%
(Here, Pf =Current price of preference share excluding dividend, j =Dividend on preference shares, Kp =Total cost of Preference Shares)
Herein calculated weighted average cost of capital in order to know market as well as book value such as:
WACC calculations at market and book value are as follows:
WACC (Weighted average cost of capital) at market value:
Formula= [(Ke*MVe)+(Kp*MVp)+(Kd*MVd)]/Total Capital
= 0.1066 or 10.66%]
WACC (Weighted average cost of capital) at book value:
Formula= [(Ke*BVe)+(Kp*BVp)+(Kd*BVd)]/Total capital
=0.099 or 9.9%
MVp =Market value of all the preference shares
Mvd =Market value of debts of organisation
MVe =Market value of total equities
Kp =Total cost of preference shares before making changes
Ke =Total cost of equity before making changes
Kd =Total cost of debts before applying changes
BVp =Actual book values of preference shares
Bve =Actual book value of equities
BVd =Actual book value of debts for the organisation
Total capital =book + market value of all the securities
b. Recalculation of cost of capital of company
In the context of kadlex plc, the finance director apply some modification in cost of structure in business entity (Ferrando, Marchica and Mura, 2017). All the calculations have been done after the changes which is beneficial for a business. There are presented all the calculations in accurate manner such as: Order assignment help from our experts!
Formula: [(Ke*PVe)+(Kp*PVp)+(Kd*PVd)+(Kb*PVd)]/Total capital
For all the securities proposed cost's computation is as follows:
Proposed Growth(g) ( Increased by 20%)
=0.09 or 9%
=0.1074 or 10.74%
Preference shares (Kp)
=0.1029 or 10.29%
Irredeemable Bonds (Kd)
=0.0654 or 6.54%
New Bonds (Kd)
=0.0733 or 7.33%
Proposed WACC with changes =
=0.966 or 9.66%
c. Sensible level of gearing into the capital structure
From the above computation of cost of capital of company is 10.66% but after apply the changes by finance director reach on 9.66%. Through changes it is getting that when company apply modification so it impact on the capital structure that will be reduced by 1% that will be advantageous for business entity in order to save cost for potential period of time (Garcia, 2017). As per the saving all monetary sources supports business for future expenses and growth opportunities available in the market. An organisation wants to purchase new machinery in order to enhance profitability as well as productivity to formulate all the functional activities in effective way.
d. Effects of short termism on agency problem and bankruptcy
Short termism is outlined as an excessive concentrate on the entities that based on the short term outcomes instead of long term approaches. It is effected approach because it is focused on that place where high pressure from the investors in regard of the higher returns. As per the changing situation enhance quarterly income and do not focus on the different approaches that may supports to achieve positive outcomes in future period of time.
Agency problem is defined as conflict that arise in between managers and shareholders in term of organisational activities. The management of entity can work as an agent of security holders and liable for the execute different types of strategies that offer greater returns on investments. When they are not liable for the agency problem so it take place and show impact on the financial activities that related with the shareholders and don't take interest into in activities of entity that impact on the returns of shareholders (KaradaÄŸ, 2018). While bankruptcy can be outlined as procedure of legal activity in which a business became bankrupt because of have not personal assets as well as property. Along with they are paying attention for short mechanism after that results come as agency problem and bankrupt that impact on the short term requirements. Though, it develop condition of lack of funds for future and shareholders did not achieve ant returns and no finance bring out operations in future. As per the condition of short termism take place that create problem for the business entities in order to pay good returns as per the security purpose and long term profits cannot be generated because of this (Ma, Chen and Ampountolas, 2016).
Investment Appraisal Techniques
Investment appraisal is defined as collection of various kinds of techniques that applied by business entity to recognise the attractiveness of an investment. The reason behind to apply these techniques to determine the viability of particular assignment, event or portfolio decision and the value they generate. Such as Lovewell Limited is planning to purchase new machine in order to enhance productivity of an organisation (Ugoani, 2017). As per the reason require to determine the benefits of organisation and apply different investment appraisal techniques. All the details are discuss below:
Investment = £275,000
Annual Cash Inflow = £85,000
Cash Out flow = £12,500
Net Cash flow = Cash inflow – Cash outflow
= £85,000 - £12,500
Residual Value = 15% of the £275,000
= £41,250 added to year 6
Here is calculated total depreciation
= £275,000 - £41,250 added to year 6
After that calculated Annual depreciation
Pay Back period: It is amount that needed to generate back the cost of an investment. The payback period method mainly applied by business to determine projects or investments due to uncovering them, through determination of related risk (Micheni, 2017). It is known as easiest technique of an investment which is applied by most of the organisation. Through this method a manager able to take decision about investment in new machine or not due to direct them and analysis the time that will be found. Herein computed payback period of particular project:
Cumulative Cash flows
Payback = (57500/72500) + 3 Years
= 3.79 Years
Recommendation: As per the computation it is analysed that the payback period is 3.79 years for new machine. It means that Lovewell limited achieve profit in 4 years. This is less than planned target period about 6 years, thus, it is good reason to purchase new machine by company.
The Accounting Rate of Return: It is a kind of investment appraisal techniques that is utilised by business to analysis the annual profitability or revenues are earned by company through investments. In general way, this method is direct to all investors to examine rate of return that will be accomplished by them through investing in a particular project (Nicholson, Smith, Stewart and Hoye, 2018). This method is advantageous for lovewell limited because help to measure rate for invest into new machine and analysis increasing profits or not. There is calculated average rate of return for new machine such as:
Annual Profit = Annual Net Cash flow – Annual depreciation
Residue Value £41,250 added to 6 years
Average Profit = Total profit / Number of years
Total profit = 33,541.67 × 5 + £74,791.67 = £242,500.02
Average Profit = £242,500.02 / 6 = £40,416.70
Average capital invested = (initial cost + residual value) / 2
Average capital invested = (275,000 + 41,250) /2 = £158,125
The Accounting Rate of Return (ARR) = (average profit / average capital invested) ×100%
ARR = (40,416.70 / 158,125) × 100% = 25.56%
Recommendation: The above calculation shows that ARR project is 25.56% that means after invested of each pounds so return will be covered a profit of approx 25%. While, ARR is 25.56% is well above the expected and minimum rate of return as compare cost of capital for Lovewell limited is 12%. Thus, it is good investment for business to purchase new machine.
The Net present value method: This method is presented difference in between present value of cash inflows and the cash outflows in certain period of time. For the capital budgeting and investment planning used this method and determine the profit level for a projected investment or project (Odebiyi, 2017). On the basis of this method company decide of invested amount or not in particular project. For the the finance manager direct to all staff members and measure that 275000 pounds investment is beneficial or not..
Net Present Values (NPV) = £319,033.75 - £275,000 = £44,033.75
Recommendations: From the above calculation through NPV method project value is £44,033.75. There is getting positive NPV, it means through this project get expected return which is greater than the cost of capital so it is recommended that to purchase new machine.
The Internal rate of return: It is interest rate in which net present value of all cash flows (in positive and negative) from a project or investment same of zero. The internal rate of return is part of investment appraisal technique that is mainly applied by an organisation to examine awaited compound annually rate of return for proposed project (Setyawati and Suroso, 2017). In general terms, it is outlined as minimum discount rate that is utilised by manager of Lovewell limited in order to recognise project results that may be satisfactory or not. It is beneficial for company because it supports to machine that will be purchased to increase profitability of an entity.
IRR = R1 +
IRR = 12% +
NPV2 = £254,881.25 - £275,000 = -£20,118.75
IRR= 12 + = 12 + = 12 + 5.49 = 17.49 %
Recommendations: As per the calculation it is suggested that IRR is 17.49% for particular project. The rate of return is above expected minimum as compare of cost of capital for Lovewell Limited is 12%. Thus, It is economically good to purchase new machine for business.
b. Limitation and benefits of various investment appraisal techniques
There are different types of investment appraisal techniques that could be utilised through entity as per the reason of determining the proposed investment that will be able to get all positive outcomes for business or not. There are applied different types of techniques in Lovewell Limited to analysis that new machine purchase or not that supports to business and enhance the profit margin (Sumtaky, Chandrarin and Sanusi, 2018). There are discussed benefits of limitation of these techniques such as:
Pay Back period: There are mentioned some benefits and limitations of this technique in brief manner such as:
- Benefits: It is simplest technique of investment appraisal that applied by the entities to calculate pay back period. It means in how many times business get return and according to that they are taking effective decisions. In the context of uncertainty, concentrate on the effective technique that helps to take right decision on right time and get authentic outcomes. As per the calculation get result of pay back period liquidity is desirable that supports to management and assure about the decision making.
- Limitation: This method is not based on the realistic approach and it takes lot of time to measure time period for particular project. Along with some people ignores this method is not suitable for long term investments and provide results inaccurate manner. Order Finance Homework Help from our experts!
Accounting rate of return: To analysis different techniques require to know each technique of limitations and benefits in depth manner such as:
- Benefits: It is beneficial method because it provides clear view of profit margin and compute results on the basis of cash inflows. Through this technique analysis cost efficiency and competitiveness for several projects that would be help in take effective decisions (Thom, 2019). It fulfil all the requirements of investors, when people get interest into higher outcomes on invested amount in this entity.
- Limitation: This technique application fluctuated as per the situation so it is not helpful technique. According to this method ignore profit in that year when investors are invested amount. Such as, organisation can take interest to measure projects in the instalments so try to measure more than two time after that it provides right results for particular investments.
Net Present Value: Different benefits and limitations are defined of this method in regard of particular investment such as:
- Benefits: It is effective technique that helps to management to take right decision because of in this method concentrate on time of value at the time of calculations of present value. During to calculation focus on the NPV which is providing advantages in costs and investment opportunities that focused on the particular method that makes allowance for the timing of them (Van Deventer and De Klerk, 2016).
- Limitation: As per the this technique it is not applied in realistic way because it is difficult to understand by management and get right outcomes. Through this method is not analysis relative measurement of return in particular rate of return that could be accomplished by business in regard of investment that done already. The size of projects are same so that time not applied this technique for comparison both of them.
Internal rate of return: To analysis this method effectively require to analysis limitations and benefits in the context of company as follows:
- Benefits: The main benefits of this method that outcomes are easily interpret and simple to understand by management. This methods mainly based on the predication because of rate of return take by business on assumption basis. There are mainly focusing on the time value and analysis of profitability of particular method. Through computation get right and reliable rate of return that will be advantageous to business in decision making procedure.
- Limitation: When projects are compared with the another project so that time do not apply particular technique because it is not effective technique for comparison. All the external aspects like economic of scale are not focused in calculation at the time of internal rate of return. Different factors like future cost, time period and size of particular project are neglected that may lead for biased outcomes (Yang, 2017)..
As per the above report it has been concluded that financial management is important part of any business that helps to arrange fund and concentrated on manager to aware for all activities and control as per the requirements. For acquire grater returns from business require to take effective decision in context of business and must take on right time. Along with determine of weighted average cost of capital that is essential for managers to examine book value and market value. To apply effective approaches for effectiveness of an organisation it is critical for top authorities in order to determine effect of the short termism and bankrupt. Additionally analysis different types of investment appraisal techniques that help to determine which project is good of bad for the business.
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