Financial Management

UGB231

Individual Assignment

Guided by: Mr. Bernard Joseph

Prepared by:

Name: Kaminie d/o Dalasubmanim

Intake: September 2010 – August 2012

NRIC No: 890719-07-5028

Student No: 109090030/1

Programme: UOS – BABM (2+0)

1

Executive Summary

This coursework is mainly discussed about Glee plc companies and how the

company is underperforming in terms of profit and new projects which are not going as

well as the Board of Directors hoped. Glee plc is one of the universal electric public

company engages in the manufacture and distribution of electrical home appliances

primarily.

The company is now facing some problems of not having a proper balanced

capital structure. To rise above this dangers there are some variable sources of finance

available for Glee plc to solve it. Furthermore there is a not only source of finance but

there are also cost of capital, optimum capital structure and finally investment appraisal.

Therefore, Glee plc has to go through three main areas about the issues which are

sources of finance where sourcing money can be done for a variety of reasons to solve the

problems. Traditional areas of need may be for capital asset acquirement such as new

machinery or the construction of a new building. Secondly, optimum capital structure is

about how Glee plc should have good debt capacity to borrow quickly on favorable in

terms to pursue an attractive opportunity. Moreover, investment appraisal is one of the

key areas of long-term decision-making that firms must undertake of investment that

need to commit funds by purchasing land, buildings, machinery and so on, in expectation

of being able to earn an income greater than the funds committed. In order to handle

these decisions, Glee plc have to make an assessment of the size of the outflows and

inflows of funds, the duration of the investment, the degree of risk attached and the cost

of obtaining funds.

The theories, models and techniques of the main areas above by which the

company could improve the performance will make a good choice for the company. So

Glee plc can have a proper balanced capital structure to achieve a low cost of capital.

2

Table of Content Pages

Executive Summary 1

1.0 Introduction 3

2.0 Overview of the Sources of Finance and the Cost of Capital 3

2.1 Equity and Debt Financing 3

2.1.1 Equity Financing 3

2.1.2 Debt Financing 4

2.2 Cost of Capital 4

3.0 Optimum Capital Structure 5

3.1 Traditional View 5

3.2 Modigliani & Miller’s View 7

3.2.1 Modigliani & Miller’s (1958) 7

3.2.2 Modigliani & Miller’s (1963) 8

4.0 Investment Appraisal Techniques 10

4.1 Payback Method 10

4.2 Accounting Rate of Return (ARR) 10

4.3 Net Present Value (NPV) 11

4.4 Internal Rate of Return (IRR) 11

5.0 Conclusion 12

6.0 Appendix 13

7.0 References 22

3

To: Board of Director

From: Senior Management Accountant

Date: 7th January 2011

Subject: Improving Performance of Glee plc in Financial Management

1.0 Introduction

Glee plc (GPLC) is one of the universal electric public company engages in the

manufacture and distribution of electrical home appliances primarily. GPLC company’s

products include a range of refrigerators, freezers, such as chest freezer, beverage cooler,

and wine cellar, and washing machines, both 2-tubs semiautomatic and automatic single

tub. GPLC is not performing as good as in terms of profit and new projects as the Board

of Directors hoped. Due to these troubles the projects of GPLC are not going well as they

don’t have the proper structure approach to evaluate. To improve the problems that

GPLC facing, there are three main areas to go through which are sources of finance,

optimum capital structure and investment appraisal.

2.0 Overview of the Sources of Finance and the Cost of Capital

There is two parts that have been covered in the next part which is about the sources of

finance and the cost of capitals which are consist of the cost of debt, the cost of equity

and the weighted average cost of capital. Besides that, preference share is another option

that can be included.

2.1 Equity and Debt Financing

2.1.1 Equity Financing

Sources of finance means for many businesses, the issue is about where to get funds for

investment in order to understand the various sources of finance

(http://tutor2u.net/business/finance/finance_sources_equity_introduction.asp,viewed on

6th December) There are three main methods where GPLC should raising equity in the

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company such as retained profits, right issues and new issues of shares to the public.

GPLC should come up with certain amount cash with them as this will help them to stay

away for the burden of debts. Besides, GPLC should consider the type of investors that

might offer valuable business assistant at the moment an in future as both of this two as

considered as advantages of equity finance. Moreover, the disadvantages are investors

expect more than they invest thus, GPLC should always consider the type of investors

they are going to deal with.

2.1.2 Debt Financing

Debt is borrowing money from an outside source with the promise to return the principal.

(http://entrepreneurs.about.com/od/financing/a/debtfinancing.htm, viewed on 6th

December 2010). Debt securities that take many forms, for example, term loan, bonds,

convertible securities debt with warrants and leasing besides taking out a bank loan. The

advantage is the interests that GPLC can repay is tax deductable which will be a good

option that is debt financing in this way. One of the disadvantages is if the loan payments

are not pay back it is impossible GPLC to make borrowing in the future even it is a

smaller amount.

2.2 Cost of Capital

The cost of capital is a key factor in choosing the mixture of debt and equity used to

finance. GPLC should use a mixture of debt and equity to reduce their cost. GPLC debt is

a mixture of loans, bonds (kd) and other securities (ATkd). Besides that, the cost of

equity (ke) is defined as the rate of return that an investor expects to earn for bearing

risks in investing in the shares of a company. (http://www.ventureline.com/accounting-

glossary/C/cost-of-equity-definition/, viewed on 6th December 2010). Furthermore, the

weighted average cost of capital (WACC) is used in finance to measure a firm's cost

of capital that has been used in GPLC as a discount rate for financed projects. Thus

the capital structure of a firm comprises three main components such as preferred

equity, common equity and debt.

5

3.0 Optimum Capital Structure

Optimum capital structure means the combination of a company's long-term debt,

specific short-term debt, common equity, and preferred equity. GPLC should keep the

cost low to undertake and may rise for establishing its business to keep it in control when

the operations are growing.

(http://www.premiumbusinesstraining.com/working_capital.php, viewed on 28th

December 2010)

An optimal capital structure refers to the particular combination which minimizes the cost

of capital, and maximizing the stock price. It's an important financial decision undertaken

by the managers of GPLC to have balanced capital structure. On the other hand, the

capital structure is said to be optimum structure when GPLC has selected such a

combination of equity and debt so that the wealth of GPLC is maximum. The objective is

therefore to find the capital structure that gives the lowest overall cost of capital and,

consequently, the highest company value. There are two types of view of debate on

capital structure which is Traditional view and Modigliani & Miller’s view. There are

two options under Modigliani & Miller’s (M&M) view which is without tax at the year of

1958 and with tax at the year of 1963.

3.1 Traditional View

Traditional view of capital structure means when a company starts to borrow, the

advantages be more important than the disadvantages. The cheap cost of debt is

combined with its tax advantage, will cause the WACC to fall as borrowing increases.

However, as gearing increases, the effect of financial leverage causes shareholders to

increase their required return where the GPLC cost of equity rises. At high gearing the

cost of debt also rises because the chance of the GPLC failure to pay on the debt is higher

where bankruptcy risk might happen. So at higher gearing, the WACC will increase. To

6

determine the optimum capital structure will be where the WACC is the lowest in the

graph.

Gearing level of GPLC represents how much debt is being used by in comparison to

equity. Both, equity and debt have their own benefits and costs. But, it does not really

matter whether company goes for debt or equity financing. This critique will analyze

whether there is a link between the debt levels and cost of capital of any company. M&M

theory suggests that cost of capital is unaffected by the gearing level of the GPLC under

certain assumptions. But, these assumptions do not hold true in practical world. The main

problem with the traditional view is that there is no underlying theory to show by how

much the cost of equity should increase because of financial leverage or the cost of debt

should increase because of default risk. (http://www.linkedin.com/answers/finance-

accounting/corporate-debt/FIN_CDT/563069-55715560, viewed on 28th December 2010)

The result is that GPLC should be able to identify a minimum WACC and an optimal

gearing, as shown on the graph below.

Graph 1: Traditional View

7

However, the extreme levels of gearing will incur higher cost of debt because of the

higher risk exposed by the debt providers. As debt increase, the cost of equity capital

increase at a higher level compared to the level increase in the cost of debt. When the cost

of capital is minimized, the market value of the firm’s debt and equity will be maximized.

The cost of debt starts off low because of the tax protect and its low risk. The cost of

equity rises gradually as the GPLC gears up. Overall, the WACC falls in the early stages

as the company gears up, because of the introduction of cheap, efficient debt. However as

bankruptcy worry bites, driving up the cost of debt and equity sharply, the WACC will

also start to rise.

3.2 Modigliani & Miller’s View

These professors have a different view than the Traditional View. Their studies can be

divided into 2 views which is Modigliani & Miller’s (M&M) at the year 1958 without

tax and Modigliani & Miller’s at the year 1963 which is after five years with tax.

3.2.1 Modigliani & Miller’s (1958)

According to M&M (1958), when there are no taxes and capital markets function well, it

makes no difference whether the firm borrows or individual shareholders borrow.

Therefore, the market value of a company does not depend on its capital structure.

Implications of M&M theory are that gearing is irrelevant and the firm’s value will be

determined by its project cash flows. The cost of capital does not change as gearing level

of GPLC should increase. As a firm increases its leverage, the cost of equity will increase

just enough to off-set any gains to the power.

This theory assumes that there are no taxes but in reality taxes do exist and also, in

practice, interest on debt is tax deductible where as cash flows on equity are not. This

theorem also assumes that there is no agency cost which is managers maximizes

shareholder’s wealth. Another assumption is that markets are perfect, in other words,

corporate insiders and outsiders have the same information.

8

(http://www.listedall.com/2009/05/modigliani-miller-approach-to-capital.html, viewed

on 30th December 2010) Below is the example of Modigliani and Miller (1958) graph

looks:

Graph 2: Modigliani & Miller’s (1958)

3.2.2 Modigliani & Miller’s (1963)

Weighted average cost of capital (WACC) is depending on cost of equity and cost of debt

and also market value ratios of equity and debt to firm value. M&M (1963) recognized

the effect of taxes by using assumption of none corporate tax and in this way corporations

were permitted to deduct interest in the form of expense.

M&M (1963) recognized that net of tax approach encouraged the firms to utilize 100

percent debt in capital structure but M&M (1963) discouraged 100 percent debt policy.

Some other sources were also there to generate the funds at lower costs like retained

earnings. In some conditions, retained earnings may be cheaper even tax status of

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shareholders under the personal income tax also considered.

(http://articlesforte.com/finance/basic-finance/miller-and-modigliani-theory-3776.html,

viewed on 30th December 2010) Example of Modigliani and Miller (1963) graph:

Graph 3: Modigliani & Miller’s (1963)

In conclusion, it appears that link between costs of capital and gearing levels of GPLC is

not irrelevant. But, it is difficult to understand the exact relationship between cost of

capital and gearing. Link between cost of capital and gearing level is not direct and

relative. Glee plc should look into all the associated factors like tax implications, agency

costs, default risk, bankruptcy costs, cost of servicing the debt, business risk before

deciding its capital structure.

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4.0 Investment Appraisal Techniques

Investment appraisal is extremely important because the capacity of production of the

economy depends on the capital available to produce. Investment appraisal is an

evaluation of the attractiveness of an investment proposal, which using four methods

such as payback method, accounting rate of return (ARR), net present value (NPV) and

internal rate of return (IRR).

4.1 Payback Method

The payback method is to evaluate an investment project. Besides that, according to

appendix 1.0 GPLC should choose Machine B since Machine B has a shorter payback

period than Machine A, it appears that Machine B is more desirable than machine A and

because the machine has a fastest return compare to Machine A.

There are a number of serious drawbacks to the payback method where it ignores the

timing of cash flows within the payback period and also the time value of money which

means that it does not take account of the fact that RM1 today is worth more than RM1 in

one year's time as an investor who has RM1 today can either consume it immediately or

alternatively by investing it. The payback method does have advantages, especially as an

initial screening device which means capital is occupied.

(http://www.accountingformanagement.com/

pay_back_method_of_capital_budgeting_decisions.htm, viewed on 30th December 2010)

4.2 Accounting Rate of Return (ARR)

The accounting rate of return (ARR) is a way of comparing the profits that expect to

make from an investment which is normally calculated as the average annual profit. The

higher the ARR, the more attractive the investment as GPLC can compare to their own

target rate of return. For an example, according to the example in the appendix 2.0,

GPLC can choose both equipment items because the both equipment X and Y is above

11

the company’s required return. However, equipment X is better. The ARR is widely

used to provide a rough guide to how attractive an investment as it is easy to understand.

Besides, ARR are based on profits rather than cash flow.

(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf, viewed on 30th

December 2010)

4.3 Net Present Value (NPV)

Net present value (NPV) compares the value of cash today to the value of that same cash

in the future. The net present value (NPV) of cash inflows exceeds the NPV of cash

outflows by RM 74,720, which means that the project will earn a discounted cash flow

(DCF) yield in excess of 15%. So, GPLC should therefore be undertaken according to the

case in the appendix 3.0. On the other hand, the advantages of net present value are

essential for financial appraisal of long-term projects which measures the excess or

shortfall of cash flows as NPV model is assumed. The disadvantage is adjustment for risk

by adding a premium to the discount rate thus making cost higher.

(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf, viewed on 30th

December 2010)

4.4 Internal Rate of Return (IRR)

The internal rate of return (IRR) which relative measure (%) in contrast to the total

measure resulting from NPV calculations. GPLC can be estimated the IRR as 19.8%

according to the example in appendix 4.0. The NPV should then be recalculated using

this interest rate that results equal to or very near or zero. The main advantage is that the

information it provides is more easily understood by managers, especially non-financial

managers. IRR also calculates an alternative cost of capital including an appropriate risk

premium and is not being used to rate mutually exclusive projects.

(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf, viewed on 30th

December 2010)

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5.0 Conclusion

As a conclusion, there are several areas that GPLC has go through to improve the

company of having a balanced capital structure to achieve a low cost of capital. The

important key areas are sources of finance, optimum capital structure and investment

appraisal to make as recommendation to improve GPLC to a good level.

Sources of finance is available from variety of sources but each source has its own

cost and benefits. It is important to choose an appropriate and cheap source of finance for

the smooth operation of GPLC. The thrust of this report has been to develop the

formation in order to solve financial capital structure. The main key areas in the sources

of finance are debt financing and equity financing.

The optimal capital structure is a critical decision for any organization. This

decision is important not only because of the need to maximize returns, but also because

of the impact such a decision has on an organization’s ability to deal with its competitive

environment. The tax deductibility of interest provides the opportunity to add to company

value by employing the correct amount of debt relative to equity. Consequently, the use

of debt is logical if interest is tax deductible and GPLC need to expect to realize the

benefit of that deduction. The higher the corporate tax rate GPLC must go on, the greater

the value of issuing debt.

The purpose of investment appraisal is to assess the forecast of a proposed

investment project. It is a method for calculating the expected return based on cash flow

forecasts of many, often inter-related, project variables. Risk emanates from the

uncertainty around GPLC projected variables. The evaluation of project risk therefore

depends, on the one hand, on the ability to identify and understand the nature of

uncertainty surrounding the key project variables.

The dividend policy such as the payment of dividend affects the market price of

share. If there is a debate in this issue, this theory is commonly accepted. WACC enters

the picture only to assess the impact of a new project on firm value, once it has been

accepted, and when a fixed debt ratio policy is in place.

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6.0 Appendix

Appendix 1

Example: Payback Period

Dell is deciding between two machines, Machine A and Machine B in order to add

capacity to its existing plant. The company estimates the cash flows for each machine to

be as follows:

Year Machine A (RM) Machine B(RM)

0 (5,000) (2,000)

1 500 500

2 1,000 1,500

3 1,000 1,500

4 1,500 1,500

5 2,500 1,500

Answer:

First it would be helpful to determine cumulative cash flow for the machine project A.

This is done in the following table:

Year Cash Flow (RM) Cumulative Cash Flow

(RM)

0 (5,000) (5,000)

1 500 (4,500)

2 1,000 (3,500)

3 1,000 (2,500)

4 1,500 (1,000)

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5 2,500 1,500

Payback period for Machine A = 4 years +

= 4 years 5 months

Answer:

First it would be helpful to determine cumulative cash flow for the machine project B.

This is done in the following table:

Year Cash Flow (RM) Cumulative Cash Flow

(RM)

0 (2,000) (2,000)

1 500 (1,500)

2 1,500 0

3 1,500 1,500

4 1,500 3,000

5 1,500 4,500

Payback period for Machine B = 1 year +

= 1 years 12 months

Machine B should be accepted because the machine has a fastest return compare

to Machine A.

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Appendix 2

Example: Accounting Rate of Return (ARR)

A company wants to buy a new item of equipment. Two models of equipment are

available, one with a little high power and better consistency than the other. The expected

costs and profits of each item are as below. The average annual profit should be

calculated after depreciation. It required deciding which equipment should be selected if

the company’s target accounting rate of return (ARR) is 25%.

Equipment item X (RM) Equipment item Y (RM)

Capital cost 90,000 160,000

Estimated Useful Life 5 years 5 years

Profit before depreciation

Year 1 50,000 50,000

Year 2 50,000 50,000

Year 3 30,000 60,000

Year 4 20,000 60,000

Year 5 10,000 60,000

Estimated disposal value Nil Nil

Answer: First it would be helpful to determine the four steps which are depreciation,

average annual profit, average investment and finally calculate accounting rate of return

(ARR) for Equipment item X.

Step 1: Calculate Depreciation

Depreciation =

=

16

= RM 18,000 per annum

Step 2: Calculate Average Annual Profit

Year Cash Flow (RM) Profit (RM)

1 50,000 32,000

2 50,000 32,000

3 30,000 12,000

4 20,000 2,000

5 10,000 (8,000)

Total 70,000

Average Annual Profit =

= RM 14,000 per annum

Step 3: Calculate Average Investment

Average Investment =

=

RM 45,000

Step 4: Calculate Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) =

=

= 31 %

17

Answer: First it would be helpful to determine the four steps which are depreciation,

average annual profit, average investment and finally calculate accounting rate of return

(ARR) for Equipment item Y.

Step 1: Calculate Depreciation

Depreciation =

=

= RM 32,000 per annum

Step 2: Calculate Average Annual Profit

Year Cash Flow (RM) Profit (RM)

1 50,000 18,000

2 50,000 18,000

3 60,000 28,000

4 60,000 28,000

5 60,000 28,000

Total 120,000

Average Annual Profit =

= RM 24,000 per annum

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Step 3: Calculate Average Investment

Average Investment =

=

RM 80,000

Step 4: Calculate Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) =

=

= 30 %

The company can choose both equipment items because the both equipment X

and Y is above the company’s required return. However, equipment X is better.

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Appendix 3

Example: Net Present Value (NPV)

ABC Plc has a cost of capital of 15% and is considering a capital investment project,

where the estimated cash flows are as follows:

Year Cash Flow (RM)

0 (now) (110,000)

1 70,000

2 90,000

3 50,000

4 40,000

Calculate the NPV of the project and assess whether it should be undertaken.

Answer: Initial it would be helpful to determine discounted cash flow. This is done in the

following table:

Year Cash Flow

(RM)

Discounted Factor

(15%)

Discounted Cash

Flow (RM)

0 (110,000) 1.000 (110,000)

1 70,000 0.870 60,900

2 90,000 0.756 68,040

3 50,000 0.658 32,900

4 40,000 0.572 22,880

Total 74,720

The net present value (NPV) of cash inflows exceeds the NPV of cash outflows by RM

74,720, which means that the project will earn a discounted cash flow (DCF) yield in

excess of 15%. So, it should therefore be undertaken.

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Appendix 4

Example: Internal Rate of Return (IRR)

Bee plc is trying to decide whether to buy a machine for RM 90,000 which will save

costs of RM30,000 per annum for five years and which will have a resale value of RM10,

000 at the end of year 5. If it is the company's policy to undertake projects only if they

are expected to yield a DCF return of 10% or more, ascertain using the IRR method

whether this project should be undertaken.

Answer:

Year Cash Flow

(RM)

Discount

Factor

(10%)

Discounted

Cash Flow

Discount

Factor

(20%)

Discounted

Cash Flow

0 (90,000) 1.00 (90,000) 1.00 (90,000)

1 30,000 0.91 27,300 0.83 24,900

2 30,000 0.83 24,900 0.69 20,700

3 30,000 0.75 22,500 0.58 17,400

4 30,000 0.68 20,400 0.48 14,400

5 40,000 0.62 24,800 0.40 12,000

Total 29,900 (600)

IRR = A +

= 10 % +

= 19.8 %

Appendix 5

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Example: Weighted Average Cost (WACC)

1) Debt = 0% , Equity = 100%

WACC: (0% 8%) + (0.2 20%)

= 0 + 4

= 4%

2) Debt = 40% , Equity = 60%

WACC: (0.4% 8%) + (0.6 15%)

= 3.2 + 9

= 12.2%

3) Debt = 50% , Equity = 50%

WACC: (0.5% 8%) + (0.5 30%)

= 4 + 15

=19%

7.0 References

22

(tutor2u, Equity Finance, viewed on 6th December 2010)

(http://tutor2u.net/business/finance/finance_sources_equity_introduction.asp)

(Daniel Richards, Debt Financing, viewed on 6th December 2010)

(http://entrepreneurs.about.com/od/financing/a/debtfinancing.htm)

(Ventureline, Cost of Equity Definition, viewed on 6th December 2010)

(http://www.ventureline.com/accounting-glossary/C/cost-of-

equity-definition/)

(Premium Business Training, Working Capital, viewed on 28th December 2010)

(http://www.premiumbusinesstraining.com/working_capital.php)

(Daniel D., Linked in, Finance Accounting, viewed on 28th December 2010)

(http://www.linkedin.com/answers/finance-accounting/corporate-

debt/FIN_CDT/563069-55715560)

(Listedall, Articles-Modigliani Miller, viewed on 30th December 2010)(http://www.listedall.com/2009/05/modigliani-miller-approach-to-capital.html)

(Bobbyshan, December 25, 2010, Miller and Modigliani Theory, viewed on 30th

December 2010)

(http://articlesforte.com/finance/basic-finance/miller-and-modigliani-theory-

3776.html)

(AccountingForManagement.com, Payback Method, viewed on 30th December 2010)(http://www.accountingformanagement.com/

pay_back_method_of_capital_budgeting_decisions.htm)

(Pamela Peterson-Drake, Florida Atlantic University, viewed on 30th December 2010)(http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf)

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