Study On Preparing Financial Plans For The Company Finance Essay - Free Essay Example

The business plan consists of a narrative and several financial worksheets. The real value of creating a business plan is not in having the finished product in hand; rather, the value lies in the process of researching and thinking about your business in a systematic way. The act of planning helps you to think things through thoroughly, study and research if you are not sure of the facts, and look at your ideas critically. It takes time now, but avoids costly, perhaps disastrous, mistakes later. In this case the cash and carry company Bailey Wholesale owned by 4 young directors for last 20 years. The company is not listed on the stock exchange. Two of the directors work in the company, one as a Chief Executive and other as Chief Financial Officer, the other 2 are not employed in the company. Currently the company owns the branches in UK mainly in Midlands. In the next 4 years the company wishes to open more branches in UK and Mumbai. Cash inflow means the money which business is generating from its operation. Normally cash is coming in from receipts from sales, increase in bank loan; proceed of share issue and asset disposal. If customers dont pay at time of purchase, some of your cash flow is coming from collections of accounts receivable. From the company cash inflow forecasts it is clear that company is generating money from its operations. The figures gradually increasing from 2011 to 2014 to meet its liabilities. If more money is coming in than is going out, you are in a positive cash flow situation and you have enough to pay your bills. If more cash is going out than coming in, you are in danger of being overdrawn, and you will need to find money to cover your overdrafts. This is why new businesses typically need working capital, in the form of a loan or line of credit, to cover shortages in cash flow. The problem we can see from this forecast cash flow statement is that company total outflow is greater than total inflow. SHORT FALL The actual return will be less than the expected return, or, more properly, the return needed to meet ones investment goals. The cash flow needs constant monitoring and planning to make sure you always have enough ready cash to meet your costs on time. Unless your cash flow is managed effectively and any shortfalls anticipated in advance, even profitable businesses can find themselves in serious financial difficulties. Although business is generating money but that money is not enough to meet its liabilities. As we can see from above forecast graph the company shortfall is increasing and in 2014 the shortfall rises up to 7 million. CONCLUSION: As shown in graph, there will be deficit during the years. The total outflow (XXIII) is greater than total inflow (XXII). Solution to the above can be in terms of higher retained profit, by reducing dividend rate or additional debt funding. Since return on capital (XXVI) is higher than cost of debt funding (XXVIII), retaining profit with reduced dividend rate will be the good option. TASK II The company is intending a significant investment in net asset in the next 4 years. Explain how the company could calculate its cost of capital and then use this figures to determine whether the investment will increase shareholder wealth. The cost of capital is defined as the rate of return that providers of capital demand to compensate them for both the risk and time value of their money. The cost of capital is specific to each particular type of capital a company uses. At the highest level these are the cost of equity and the cost of debt, but each class of shares, each class of debt securities, and each loan will have its own cost. It is possible to combine these to produce a single number for a companies cost of capital, the WACC. Cost of equity The cost equity, often referred to as the required rate of return on equity, is most commonly estimated using capital asset pricing model. It is also implicitly estimated when using valuation ratios, as differences in the cost of equity is a key component of differences in the ratings at which different companies and sectors trade. A company may have several classes of shares, in which case each will have its own required rate of return. Their weighted average is the cost of equity. Cost of debt The cost of debt can be estimated in a similar manner to equities. It is also common to compare yield spreads with other similar securities, which roughly corresponds to the use of valuation ratios for equities. Estimating the cost of capital for unlisted debt is more difficult. It is also an important problem because most companies, including almost all listed companies, have significant amounts of unlisted debt. One approach is to estimate the cost of the debt by comparing it to the yield on the most similar listed debt. If necessary rates can be adjusted for term and riskiness. If the debt has been recently issued or is repayable on demand it is reasonable to assume that it is worth close to its book value, and therefore the cost of debt is simply the nominal interest rate. The same applies if the debt pays a floating interest rate and there has been no significant change in its riskiness since it was borrowed. INVESTMENT ASSESMENT TOOLS: Following are four basic tools which are in practice throughout the world Accounting rate of return (ARR): calculated by dividing average profit by average investment as a percentage. It is often used internally because it can measure the performance of the project and help in selecting the project. It is rarely used by the investors because this based on numbers that includes non cash items and it does not take into account the time value of money. Payback period (PP): is the time taken to recover the initial investment. Net present value (NPV): is the difference between the sum of the discounted cash flow which are expected from the investment and the amount which is initially invested. NPV is used to calculate the value an investment will result in. If NPV is positive the project should be undertaken. Internal rate of return (IRR): is the rate of return that makes the sum of present value of future cash flows and the final market value of an investment equal its curr ent market value. The cost of capital (XXIX) is greater than % cost of debt funding (XXVIII). The total investment require during the next 4 years is As company is intend to open more branches in UK and Mumbai. The investment during the next four years is 45 million (10m+10m+10m+15m). DEBT FUNDING PLAN The total debt funding planned for next 4 years is The total debt funding planned to open new branches is 18 million (4m+4m+4m+6m). The percentage of long term debt to net asset is 40%. ADDITIONAL RETURN: The total additional return require to open new branches is The total additional return of business from its operation is 16million (1m+3m+4m+8m) and percentage of additional return on additional investment is 35.56%. SHAREHOLDER WEALTH: Recently investors are showing increase interest in share holder values. The most popular measure for value-based is Economic Value Added (EVA). The theory of Economic Value Added suggested that companys aim should be to maximize the wealth of its shareholders because they expect a good return on their investment. Proponents for EVA regard this concept as an important management tool without highlighting its drawbacks. On the other hand, very little criticism has come about that has dealt with the problems of EVA, and the criticism that has come about has kept to fairly insignificant details (Mà ¤kelà ¤inen 1998, p. 1). The basic concept of EVA is that a companys shareholders must get the return that compensates the risk taken i.e if the value of EVA is 0, shareholders should be happy. The calculation of EVA will give the same results as Discounted Cash Flow (DCF) or Net Present Value (NPV), both of which are considered as best analysis tools for determining shareholder value. They include time value of money, cost of equity and are protected from common accounting distortions; however, they are solely based on cash flows and hence cant be used for performance evaluation (Mà ¤kelà ¤inen 1998, p. 3). EVA as a Performance Measure: The firm should have a positive NPV to attract shareholders i-e the projects internal rate of return should be higher than the cost of capital. The internal rate of return cannot be estimated by practical performance measuring and thus some other tool should be used to estimate the rate of return to capital (Mà ¤kelà ¤inen 1998, p.5). Although the ROR is some form of ROI; however, the problem is that no accounting rate of return can produce an accurate estimate of the underlying true rate of return (Mà ¤kelà ¤inen 1998, p. 5). These accounting errors also have an effect on EVA like other performance measuring tools, however it is still widely used for this purpose because in addition to measuring performance this help the management and employees to understand the cost of equity capital (Mà ¤kelà ¤inen 1998, p. 12) EVA vs. Traditional Performance Measures Conceptually, EVA is superior to all other performance measures because it realizes the cost of capital and, hence, the riskiness of a firms operations (Lehn Makhija 1996, p. 34). Additionally, EVA has been developed so that maximization of shareholder value can have a target set to it. Traditional measures such as IRR and ROI do not work in the same way as EVA. The maximization of any accounting rate or accounting profit will inevitably lead to undesirable outcome. NPV vs. IRR Both are performance measuring tool for a business but the main difference is that NPV is the cash valve where as IRR is the percentage return on the capital. Hence NPV is a tool for investors to predict the return on their capital and IRR does the same for the business manager. NPV is a good tool to access the returns on long term investment where as IRR is better in accessing the short term projects. Return On Equity (ROE) ROE suffers from the same shortcomings as ROI as it does not include risk and hence there is no comparison. Simply increasing leverage can increase ROE causing a more severe shortcoming than ROI because the company cannot tell if shareholder wealth is being created or destroyed by the level of ROE. Earnings per Share (EPS) Simply investing more capital into the company raises EPS. If additional capital is cash flow, the EPS will rise if the rate of return on the invested capital is positive. If the additional capital is debt then the EPS will rise if the rate of return of the invested capital is just above the cost of debt (Mà ¤kelà ¤inen 1998, p. 18). However, invested capital is usually a mix of debt and equity (cash flow) and the EPS will rise only if the rate of return on the invested capital is somewhere in between the cost of debt zero. Therefore, EPS is not a good determinant of corporate performance and remains a common bonus base (Mà ¤kelà ¤inen 1998, p. 18). CONCLUSION Since the cost of debt funding is less than the cost of capital, investment with debt funding will improve shareholders wealth. TASK III Calling upon finance theory critically appraise the companys policy on long term borrowing. In your answer make clear what factors the company should consider in order to decide whether 40% gearing is either a safe or optimal level of long term borrowing. Gearing refers to the relationship between long term borrowings to owners equity. In simple terms it tell us what proportion of long term finance came from loans and what from share holder. Its a sign of firm exposure to financial risk. This shows how much the company owes (debt) compared to its size (equity) and is calculated by dividing total borrowings (current and long term) by net assets and is expressed as a percentage. Greater a gearing greater is the risk. Financing a business through borrowing is cheaper than using equity because lender requires low rate of return then share hol ders and profitable business pays effectively less for debt capital than equity. Gearing is one of the most significant factors to consider before investing and creditors of the business look carefully at a companys gearing ratio before offering a loan. If the business is already highly geared there is high risk of being unable to meet interest charges and repaid the loan. Financing cost: interest on loan, greater the borrowing greater the interest paid and for longer. This takes major part of operating profit and effect directly on bottom line. Now a days issue of gearing is not in spotlight because interest rate is 0.5%, which mean financial cost is very low and has less impact on companies which are highly geared. But in the feature this will not remain same as interest rate increase in medium term due to high inflation and have direct impact on operating profit of the high geared companies.