Exclude inflation and take the cash flows in year 0 terms. A market research study, undertaken by a well-known firm of consultants, has revealed scope to sell an additional output of , units per annum. The price and cost structure of a typical disc net of royalties is as follows. The working capital balance will remain constant after allowing for inflation of materials.
Retail Price Index 6 per cent Disc prices 5 per cent Material prices 3 per cent Direct labour wage rates 7 per cent Variable overhead costs 7 per cent Other overhead costs 5 per cent Note. You may ignore taxes and capital allowances in this question.
There are three additional considerations associated with including taxation: Good — Any investment in a capital asset will give rise to a capital allowance. Take care and read the question carefully. Net trading revenue — The inflows and outflows from trading 2. Tax allowance — separate working for the capital allowances 4. Investment 5. Residual value 46 www. There is a single technique that we must learn in detail, any alternative technique will be simpler and will have to be explained fully be the examiner.
Required: Calculate the writing down allowance and hence the tax savings for each year. Cash flow Year 0 1 2 3 4 Tax www. Required: Calculate the net present value NPV. It is estimated that the total fines it may incur over the next four years can be summarised by the following probability distribution all figures are expressed in present values.
Unlike fines, expenditure on pollution control equipment is tax- allowable via a 25 per cent writing-down allowance reducing balance. The rate of corporate tax is 33 per cent, paid with a one-year delay. A European Union Common Pollution Policy grant of 25 per cent of gross expenditure is available, but with payment delayed by a year. These transactions have no tax implications for Blackwater. Current production is 10, tonnes per annum, but is expected to grow by 5 per cent per annum compound.
It can be assumed that other production costs and product price are constant over the next four years. No change in working capital is envisaged. Blackwater applies a discount rate of 12 per cent after all taxes to investment projects of this nature. All cash inflows and outflows occur at year ends. Required: a Calculate the expected net present value of the investment assuming a four-year operating period. Briefly comment on your results. The asset will be replaced but we aim to adopt the most cost effective replacement strategy.
The key in all questions of this type is the lifecycle of the asset in years. Cash inflows from trading revenues are not normally considered in this type of question. The assumption being that they will be similar regardless of the replacement decision. The operating efficiency of machines will be similar with differing machines or with machines of differing ages. The assets will be replaced in perpetuity or at least into the foreseeable future. Due to: 1. Wider economic factors e.
Company specific factors a Lack of asset security b No track record c Poor management team. Soft capital rationing Internally imposed by senior management. Lack of management skill 2. Wish to concentrate on relatively few projects 3.
Unwillingness to take on external funds 4. Only a willingness to concentrate on strongly profitable projects. Single period capital rationing There is a shortage of funds in the present period which will not arise in following periods. Note that the rationing in this situation is very similar to the limiting factor decision that we know from decision making.
In that situation we maximise the contribution per unit of limiting factor. Key working: Profitability index P. Example 9 Required: Which project s should we invest in to maximise the return to the business given the projects are now non-divisible? Key There are three possible types of profit maximising mix each of which must be considered in isolation and then compared with each other.
They are that the investment must include either: 1. Project A 2. Project C, 3. Example 9 But projects A and C are mutually exclusive. Required: What is the optimal mix of projects? Multi-period capital rationing A more complex environment where there is a shortage of funds in more than one period.
This makes the analysis more complicated because we have multiple constraints and multiple outputs. Linear programming would have to be employed. Details of three possible investments, none of which can be delayed, are given below.
Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-related illness. Required: a Determine the best way for Horge Co to invest the available funds and calculate the resultant NPV: i on the assumption that each of the three projects is divisible; ii on the assumption that none of the projects are divisible.
Long timescale 2. Outflow today, inflow in the future 3. Large size in relation to the size of the company 4. Strategic nature of the decision. Techniques available: 1. Sensitivity analysis 2. Expected values 3. Adjusted discount rates 4. Sensitivity Analysis A technique that considers a single variable at a time and identifies by how much that variable has to change for the decision to change from accept to reject.
The net cash inflow p. Volume is estimated at 10, units. Required: a Should we accept or reject the investment based on NPV analysis? The measure of average return is then assumed to be the value that we should use. It has recently suffered falling demand due to economic recession, and thus has spare capacity.
It now perceives an opportunity to produce designer ceramic tiles for the home improvement market. Estimated operating costs, largely based on experience, are as follows. Returns from the project would be taxed at 33 per cent. It can be assumed that all operating cash flows occur at year ends.
Required: a Assess the financial desirability of this venture in real terms, finding both the net present value and the internal rate of return to the nearest 1 per cent offered by the project. Assume no tax delay. Discuss your results, suggesting appropriate management action. In simple terms this means that the rate reflects either the cost of borrowing funds in the form of a loan rate or it may reflect the underlying return of the business i. An individual investment or project may be perceived to be more risky than existing investments.
In this situation the increased risk could be used as a reason to adjust the discount rate up to reflect the additional risk. Payback As discussed earlier in the notes payback gives a simple measure of risk. The shorter the payback period, the lower the risk. Key information 1. Required: Should the company lease or buy the equipment? Other considerations 1. Who receives the residual value in the lease agreement? It is possible that the residual value may be received wholly by the lessor or almost completely by the lessee.
There may be restrictions associated with the taking on of leased equipment. The agreements tend to be much more restrictive than bank loans. Are there any additional benefits associated with lease agreement? Many lease agreements will include within the payments some measure of maintenance or other support services. Ordinary shares 1. Owning a share confers part ownership. High risk investments offering higher returns.
Permanent financing. Post-tax appropriation of profit, not tax efficient. Marketable if listed. Advantages 1. No fixed charges e. No repayment required. Carries a higher return than loan finance. Shares in listed companies can be easily disposed of at a fair value. Issuing equity finance can be expensive in the case of a public issue 9see later.
Problem of dilution of ownership if new shares issued. Dividends are not tax-deductible. A high proportion of equity can increase the overall cost of capital for the company. Shares in unlisted companies are difficult to value and sell. Preference shares 1. Fixed dividend 2. Paid in preference to before ordinary shares. Paid out as an expense of the business pre-tax. Risk of default if interest and principal payments are not met. Security Charges The debtholder will normally require some form of security against which the funds are advanced.
This means that in the event of default the lender will be able to take assets in exchange of the amounts owing. Covenants A further means of limiting the risk to the lender is to restrict the actions of the directors through the means of covenants. These are specific requirements or limitations laid down as a condition of taking on debt financing.
They may include: 1. Dividend restrictions 2. Financial ratios 3. Financial reports 4. Issue of further debt. Types of debt Debt may be raised from two general sources, banks or investors. Bank finance For companies that are unlisted and for many listed companies the first port of call for borrowing money would be the banks.
This is a confidential agreement that is by negotiation between both parties. Traded investments Debt instruments sold by the company, through a broker, to investors. Typical features may include: 1. Interest is paid at a fixed rate on the nominal or par value. The debt has a lower risk than ordinary shares.
It is protected by the charges and covenants. Unsecured loans No security meaning the debt is more risky requiring a higher return. Mezzanine finance High risk finance raised by companies with limited or no track record and for which no other source of debt finance is available. A typical use is to fund a management buy-out.
Funds are released without any loss of use of assets. Any potential capital gain on assets is forgone. Grants 1. Often related to regional assistance, job creation or for high tech companies. Important to small and medium sized businesses ie unlisted. They do not need to be paid back. Remember the EU is a major provider of loans. Retained earnings The single most important source of finance, for most businesses the use of retained earnings is the core basis of their funding.
Warrants 1. An option to buy shares at a specified point in the future for a specified exercise price. The warrant offers a potential capital gain where the share price may rise above the exercise price. The holder has the option to buy the share. On a future date at a pre- determined date. Convertible loan stock A debt instrument that may, at the option of the debtholder, be converted into shares. The terms are determined when the debt is issued and lay down the rate of conversion debt: shares and the date or range of dates at which conversion can take place.
The convertible is offered to encourage investors to take up the debt instrument. Sharia Law is however not codified and as such the application of both Sharia Law and, by implication, Islamic Finance is open to more than one interpretation.
Prohibited activities In Shariah Law there are some activities that are not allowed and as such must not be provided by an Islamic financial institution, these include: 1. Gambling Maisir 2. Uncertainty in contracts Gharar 3. Prohibited activities Haram Riba Interest in normal financing relates to the monetary unit and is based on the principle of time value of money. Sharia Law does not allow for the earning of interest on money. This is called Riba and underpins all aspects of Islamic financing.
Instead of interest a return may be charged against the underlying asset or investment to which the finance is related. This is in the form of a premium being paid for a deferred payment when compared to the existing value. There is a specific link between the charging of interest and the risk and earnings of the underlying assets. Another way of describing it is as the sharing of profits arising from an asset between lender and user of the asset.
DVM 1. Loan notes 2. CAPM 2. Bank debt 3. Preference shares 70 www. These will be of use both in terms of assessing the financing of the business and as a cost of capital for use in investment appraisal. Risk and return The relationship between risk and return is easy to see, the higher the risk, the higher the required to cover that risk.
Importantly this helps as a starting point to the calculation of a cost of capital. Overall return A combination of two elements determine the return required by an investor for a given financial instrument. Risk-free return — The level of return expected of an investment with zero risk to the investor.
Risk premium — the amount of return required above and beyond the risk- free rate for an investor to be willing to invest in the company Risk-free return The risk-free rate is normally equated to the return offered by short-dated government bonds or treasury bills. The government is not expected we would hope! The risk-free rate is determined by the market reflecting prevailing interest and inflation rates and market conditions.
This may be calculated in one of two ways: 1. Dividend valuation model The valuation of the share in terms of the cash returns of dividends into the future. The cash inflow is normally an perpetuity to reflect the permanent nature of the share capital. Perpetuity formula Cash inflow p. A dividend of 40p per share has just been paid and there is expected to be no growth in dividends.
Required: What is the cost of equity? A dividend of 15p is about to be paid. There is expected to be no growth in dividends. Required: a Estimate the rate of growth in dividends. Example 5 Mascherano Ltd paid a dividend of 6p per share 8 years ago, and the current dividend is 11p.
A dividend of 40p is just about to be paid. Required: Estimate the cost of equity. The basis of the CAPM is the adoption of portfolio theory by investors. Portfolio theory Risk and Return The basis of portfolio theory is that an investor may reduce risk with no impact on return as a result of holding a mix of investments. The risk that can be eliminated by diversification is referred to as unsystematic risk. This risk is related to factors that affect the returns of individual investments in unique ways, this may be described as company specific risk.
The risk that cannot be eliminated by diversification is referred to as systematic risk. To some extent the fortunes of all companies move together with the economy. This may be described as economy wide risk.
The relevant risk of an individual security is its systematic risk and it is on this basis that we should judge investments. Non systematic risk can be eliminated and is of no consequence to the well-diversified investor. Implications 1. If an investor wants to avoid risk altogether, he must invest in a portfolio consisting entirely of risk-free securities such as government debt. If the investor holds only an undiversified portfolio of shares he will suffer unsystematic risk as well as systematic risk.
Individual shares will have systematic risk characteristics which are different to this market average. Their risk will be determined by the industry sector and gearing see later. Some shares will be more risky and some less. The security market line The security market line gives the relationship between systematic risk and return. We know 2 relationships. CAPM is a single period model, this means that the values calculated are only valid for a finite period of time and will need to be recalculated or updated at regular intervals.
CAPM assumes no transaction costs associated with trading securities 3. This is particularly so if the company has changed the capital structure of the business or the type of business they are trading in. The market return may change considerably over short periods of time.
CAPM assumes an efficient investment market where it is possible to diversify away risk. This is not necessarily the case meaning that some unsystematic risk may remain. Additionally the idea that all unsystematic risk is diversified away will not hold true if stocks change in terms of volatility. As stocks change over time it is very likely that the portfolio becomes less than optimal.
CAPM assumes all stocks relate to going concerns, this may not be the case. Kuyt Ltd has a beta of 1. Required: What is the cost of capital? We would expect this to be lower than the cost of equity. The value of debt is assumed to be the present value of its future cash flows. Terminology 1. Loan notes, bonds and debentures are all types of debt issued by a company. Gilts and treasury bills are debt issues by a government. This is known as the coupon rate.
It is not the same as the cost of debt. Debt can be: i Irredeemable — never paid back ii redeemable at par nominal value iii or redeemable at a premium or discount for more or less. Interest can be either fixed or floating variable. All questions are likely to give fixed rate debt.
Kd for irredeemable debt Irredeemable debt is very rare. The reason for learning the valuation is that it gives a quick way to calculate the cost of debt if the current market value and the redemption value of the debt are the same see example Required: What is the net of tax cost of debt? Technique 1. Identify the cash flows 3. Kd for redeemable debt when redeemed at current market value We could just use the technique outlined above but if the current market value and the redemption value are the same instead the irredeemable debt formula can be used.
In this situation the holder of the debt has the option therefore the redemption value is the greater of either: 1. The share value on conversion or 2. The cash redemption value if not converted. Alternatively the loan notes may be converted at that date into 25 ordinary shares. Non-tradeable debt A substantial proportion of the debt of companies is not traded.
Bank loans and other non-traded loans have a cost of debt equal to the coupon rate adjusted for tax. Preference shares are normally treated as debt rather than equity but they are not tax deductible. Required: What is the cost of the preference shares? The project is insignificant relative to the size of the company; 2. An ordinary dividend of 40 cents per share has just been paid and dividends are expected to increase by 4.
The current ex div preference share price is Required: a Calculate the current weighted average cost of capital of Olachika plc. Less risky to investor 2. Tax efficient www. As gearing rises the impact will increase Ke at an increasing rate. Cost of debt There is no impact on the cost of debt until the level of gearing is prohibitively high. When this level is reached the cost of debt rises. Perfect capital market exist where individuals and companies can borrow unlimited amounts at the same rate of interest.
There are no taxes or transaction costs. Personal borrowing is a perfect substitute for corporate borrowing. Firms exist with the same business or systematic risk but different level of gearing. All projects and cash flows relating thereto are perpetual and any debt borrowing is also perpetual. All earnings are paid out as dividend.
Debt is risk free. Big idea The increase in Ke directly compensates for the substitution of expensive equity with cheaper debt. Therefore the WACC is constant regardless of the level of gearing. Debt in this circumstance has the added advantage of being paid out pre-tax. The effective cost of debt will be lower as a result. The company benefits from having the highest level of debt possible. A suggested order is as follows: 1st retained earnings 2nd bank debt rd 3 issue of equity.
Normally we can use the WACC providing that risk has not changed. The assumptions underpinning CAPM must hold: 1. Rational shareholders 2. Shareholders are well diversified 3. The project is an investment in its own right. Key point The project is assessed on its ability to earn a return in relation to its own level of risk.
Advantages over use of WACC 1. Possible to assess all projects providing the level of risk beta can be determined. By considering only systematic risk we have a better theoretical basis for setting a discount rate. It reflects the position of large companies which are likely to be well.
A new project has arisen with an estimated beta of 1. Required: a What is the required return of the project? Example 2 Johnson plc Johnson plc is an all equity company with a beta of 0. The project has a beta of 1. If we introduce debt financing the level of risk will rise and hence the cost of equity Ke will rise. The asset beta will be the same for all companies in the same industry.
Equity beta Identify a suitable equity beta — we need a value from a company in the similar industry. This beta will probably include gearing risk if the company has any debt finance. De-gear Use the formula given to strip out the gearing risk to calculate the asset beta for the project. Average asset beta To calculate a meaningful asset beta it is useful to use a simple average of a number of proxy asset betas.
This way a better assessment of the level of systematic risk suffered by the industry is calculated. Re-gear Re-work the same formula to add back the unique gearing relating to the project. Example 3 Voronin plc Voronin plc is a matruska doll manufacturer with a equity:debt ratio of The company is considering a rag doll manufacturing project.
The following three companies are currently operating in the ragdoll industry. Company T L C Equity beta 1. Required: What would be a suitable cost of capital to apply to the project? Its current equity beta is 0. Corporate debt is considered to be risk free. There are two basic measures: 1. Return on Equity. Return on capital employed — ROCE A measure of the underlying performance of the business before finance.
It considers the overall return before financing. It is not affected by gearing. Capital employed The total funds invested in the business, it includes Equity and Long-term Debt. Return on equity — ROE A measure of return to the shareholders. It is calculated after taxation and before dividends have been paid out. It will be affected by gearing. Below are the financial statements given the project has been funded in either manner. There are two basic considerations: 1. Cost Any finance will incur servicing costs, debt will require interest payments and equity will require payment of dividends or at least capital growth.
On the basis of cost of servicing we would always pick debt over equity. Debt should be less expensive for two reasons: 1. Tax Debt is tax deductible because the debt holders are not owners of the business. Equity however will receive a return after tax because they receive an appropriation of profits. Risk The debt holder is in a less risky position than the shareholder. If there is lower risk then the debt holder should be willing to expect a lower return. The lower risk is due to two factors: 1.
Fixed coupon — A legal obligation to pay interest. Security — Charges or covenants against assets. Risk — from the perspective of the company Risk may be split into two elements: 1. Business risk. Financial risk. Business risk Business risk is inherent to the business and relates to the environment in which the business operates.
Competition 2. Market 3. Legislation 4. Economic conditions. If the company is financed using equity, it carries no financial risk. This is because it has no need to pay shareholders a return dividend in the event of a poor trading year. If the company finances itself using debt as well as equity then it must generate sufficient cash flow to pay interest payments as they fall due. The greater the level of debt, the greater the interest payments falling due and hence the higher the risk of default.
This is financial risk. There are two measures of gearing: 1. Operating gearing Risk associated with the level of fixed costs within a business. The higher the fixed cost, the more volatile the profit. The level of fixed cost is normally determined by the type of industry and cannot be changed. Financial gearing Risk associated with debt financing. The company can decide the level of financial risk it wishes to take on. The effect of risk is cumulative: if a company already has high operating gearing it will have to be more conservative with its financial gearing.
There are two measures: 1. Capital Gearing — a balance sheet measure. Interest Cover — a profit and loss account measure. Capital gearing The mix of debt to equity. Debentures and loans, 2. Equity 1. Ordinary share capital 2. The company shall also maintain a prudent level of liquidity, defined as a current ratio at no time outside the range of the industry average as published by the corporate credit analysts, Creditex , plus or minus 20 per cent.
The buildings have been depreciated since acquisition at 4 per cent per annum, and most of the machinery is only two or three years old, having been purchased mainly via a bank overdraft. The interest rate payable on the bank overdraft is currently 9 per cent. The finance director argues that Newsam should take advantage of historically low interest rates on the European money markets by issuing a medium-term Eurodollar bond at 5 per cent. The dollar is currently selling at a premium of about 1 per cent on the three-month forward market.
According to the latest published credit assessment by Creditex, the average current ratio for the industry is 1. The summarised financial accounts for Newsam plc for the year ending 30 June 20X4 are as follows. The current financial statements of Arwin are as follows.
Required: a For each financing proposal, prepare the forecast income statement after one additional year of operation. There are 6 million ordinary shares in circulation. Required: What is the EPS? The industry type 2. Shareholder expectations 3. The investment opportunities 4. Tax 5. Dividend policy. Dividend Yield The cash return from holding a share. It is theoretically irrelevant because it only considers part of the return available to the shareholder the other part being the capital gain or increase in share price.
Own funds 2. Retained earnings 3. Friends and family 4. Business Angels 6. Private placing. Stock markets — considerations The Stock Exchange suggests the following 7 considerations: 1. Prestige 2. Growth 3. Access 4. Visibility 5. Accountability 6. Responsibility 7. Methods of obtaining a listing Fixed price offer for sale Offered to the general public at a fixed price.
It has the potential to raise the highest possible price for the company by being offered to the widest possible market. The problem is the cost associated with floatation which can be prohibitive. Offer for sale by tender Investors are able to bid for shares and the shares are issued only to those investors who have bid at the striking price or above. Stock exchange introduction Shares are introduced to the exchange without any new shares being issued.
Rights issues A rights issue is the right of existing shareholders to subscribe to new share issues in proportion to their existing holdings. This is to protect the ownership rights of each investor. Low cost 2. Protect ownership rights 3. Rarely fail. Theoretical ex-rights price TERP The new share price after the issue is known as the theoretical ex-rights price and is calculated by finding the weighted average of the existing market price and the issue price, weighted by the number of shares ex-rights.
Value of a right The new shares are issued at a discount to the existing market value, this gives the rights some value. Take up buy the rights 2. Sell the rights 3. A bit of both 4. Do nothing. Example 2 A shareholder had 10, shares in Marcus plc before the rights offer. Required: Calculate the effect on his net wealth of each of the following options: a Take up the shares, b Sell the rights, c Do nothing.
It is proposed that the rights issue funds raised will be used to redeem some of the existing loan stock at par. Determine the effect of each of these actions on the wealth of the investor. This includes: 1. Investment 2. Raising finance 3. Banking and exchange 4. Cash and currency management 5.
Risk 6. The management of currencies and cash flows, and complex strategies, policies and procedures of corporate finance. Corporate objectives 2. Liquidity management 3. Investment management 4. Funding management 5. Currency management. Centralisation vs. Modern practice would suggest the decentralised route where there is little or no head office intervention in the workings of an autonomous division.
This runs contrary to treasury practice where large companies tend to have a centralised function. Advantages of centralisation 1. Avoid duplication of skills of treasury across each division. A centralised team will enable the use of specialist employees in each of the roles of the department.
Pooled investments will similarly take advantage of higher rates of return than smaller amounts. Pooling of cash resources will allow cash-rich parts of the company to fund other parts of the business in need of cash. Closer management of the foreign currency risk of the business.
Greater autonomy of action by individual treasury departments to reflect local requirements and problems. Closer attention to the importance of cash by each division. Profit centre vs. Cost centre — A function to which costs are accumulated. Profit centre — A function to which both costs and revenues are accounted for.
Advantages of using a profit centre 1. The prices charged by the treasury department measure the relative efficiency of that internal service and may be compared to external provision. The treasury department may undertake part of the hedging risk of a trade thereby saving the company as a whole money. The department may gain other business if there is surplus capacity within the department.
Speculative positions may be taken that net substantial returns to the business. Disadvantages of using a profit centre 1. Additional costs of monitoring. The treasury function is likely to be very different to the rest of the business and hence require specialist oversight if run as a profit making venture. The treasury function is unlikely to be of sufficient size in most companies to make a profit function viable. The company may be taking a substantial risk by speculation that it cannot readily quantify.
In the event of a position going wrong the company may be dragged down as a result of a single transaction. The debts of the company are effectively sold to a factor. The factor takes on the responsibility to collect the debt for a fee.
The factor offers three services: 1. Debt collection 2. Financing 3. Credit insurance. The factor is often more successful at enforcing credit terms leading a lower level of debts outstanding. Factoring is therefore not only a source of short-term finance but also an external means of controlling or reducing the level of debtors.
Invoice discounting A service also provided by a factoring company. Selected invoices are used as security against which the company may borrow funds. This is a temporary source of finance repayable when the debt is cleared. The key advantage of invoice discounting is that it is a confidential service, the customer need not know about it. Trade credit The delay of payment to suppliers is effectively a source of finance.
Overdrafts A source of short-term funding which is used to fund fluctuating working capital requirements. Its great advantage is that you only pay for that part of the finance that you need. The overdraft facility total limit is negotiated with the bank on a regular basis maybe annually. The bill of exchange is simply an agreement to pay a certain amount at a certain date in the future. No interest is payable on the note but is implicit in the terms of the bill.
Hire purchase The purchase of an asset by means of a structured financial agreement. Instead of having to pay the full amount immediately, the company is able to spread the payment over a period of typically between two and five years. Finance lease A type of asset financing that appears initially very similar to hire purchase. Again the asset is paid for over between two and five years typically and again there is a deposit initial rental and regular monthly payments or rentals.
The key difference is that at the end of the lease agreement the title to the asset does not pass to the company lessee but is retained by the leasing company lessor. This has important potential tax advantages covered later in the course.
Operating lease In this situation the company does not buy the asset in part or in full but instead rents the asset. The operating lease is often used where the asset is only required for a short period of time such as Plant Hire or the company has no interest in acquiring the asset simply wishing to use it such as a company vehicle or photocopier.
The nature of the business, 2. Certainty in supplier deliveries, 3. The level of activity of the business, 4. Flexible — only borrow 1. Secure — no need to what is needed constantly replenish 2. Cheaper — liquidity 2. Lower financing risk preference 3. Easier to source 3. Matching funding to need Fluctuating current assets Short-term Assets funds Short-term funds or Permanent Long-term current assets funds Non-current Long-term assets funds Time www.
This would mean that half of the current assets are financed by current liabilities and therefore half by long-term funds. Similarly the ideal quick ratio is Current ratio A simple measure of how much of the total current assets are financed by current liabilities. A safe measure is considered to be or greater meaning that only a limited amount of the assets are funded by the current liabilities. A safe measure is considered to be meaning that we are able to meet our existing liabilities if they all fall due at once.
Output increase are often obtained by more intensive utilisation of existing fixed assets, and growth tends to be financed by more intensive use of working capital. Overtrading companies are often unable or unwilling to raise long-term capital and thus tend to rely more heavily on short-term sources such as overdraft and trade creditors.
Debtors usually increase sharply as the company follows a more generous trade credit policy in order to win sales, while stock tend to increase as the company attempts to produce at a faster rate ahead of increase demand. Overtrading is thus characterised by rising borrowings and a declining liquidity position in terms of the quick ratio, if not always according to the current ratio. Symptoms of overtrading 1. Rapid increase in turnover 2. Fall in liquidity ratio or current liabilities exceed current assets 3.
Sharp increase in the sales-to-fixed assets ratio 4. Increase in the trade payables period 5. Increase in short term borrowing and a decline in cash balance 6. Fall in profit margins. Overtrading is risky because short-term finance may be withdrawn relatively quickly if creditors lose confidence in the business, or if there is general tightening of credit in the economy resulting to liquidity problems and even bankruptcy, even though the firm is profitable. The fundamental solution to overtrading is to replace short-term finance with long- term finance such as term loan or equity funds.
Assessing credit status 2. Terms 3. Day to day management. Assessing credit status The creditworthiness of all new customers must be assessed before credit is offered, it is a privilege and not a right. Special Thanks! The Textbook. About Mr. Analyze the results of the calculations All investments begin with an element of risk. Total risk aversion will in essence mean that no investment can take place.
However, the degree of risk in a business investment is generally associated with returns on the investment. In the production process it is the aim of the entrepreneur to be not only creative and take the risk involved in putting together the other elements of the production process, but to also minimize t his risk as much as possible, while at the same time gauging the feasibility of the venture. The aim of investment appraisal and the methods used in the section is to determine the degree of risk involved in the investment.
Prior to targeting and securing a source of finance, entrepreneurs have a medley of tools at their disposal that serve to minimize this risk. It is also in the interest of the individuals or institutions providing the source of finance to be appraised of the risks they are taking, thereby making them more open to providing the requested resources.
Banks and other lenders often want to be appraised of the prospects of the investments and in this light, investment appraisal should be taken as a first critical step. Although this information does serve the purpose of highlighting specific outcomes between projects there are specific limitations and certain advantages that need to be clearly understood. Unfortunately a shorter payback period does not necessarily mean that Project One is a more desirable investment. The payback method does not consider what transpires beyond the payback period.
It ignores all cash flows that occur after the payback period. To illustrate, let us take a look at Project One and Two once again in Figure New sports stadium to be build, international event coming to town, change in legislation, etc. Figure 3. Under these circumstances payback is not a true measure of the profitability of an investment. As a result, the tool may not accurately estimate the value of the project whose benefits occur after the initial investment costs are repaid.
In this second scenario, assume that Project One becomes useless in the 5th year , once again illustrating limitation to the uses of the payback method. In addition associated risks of an investment and the opportunity costs of capital are not accounted for in this methodology. These exclusions mean that decisions are made on an absolute basis and thereby potentially overvalue the investments. However, another major limitation is that the payback method ignores the time value of money.
In other words, the future cash flows must be recalculated to represent their present value. This important topic will be explored in the next section. The shortcomings of the Average Rate of Return are that the profits are averaged over the period being considered while the time value of money is also ignored. However, the longer the period of time in which the returns are determined the more significant becomes the time value of money. Does not include time value of money.
ARR does not differentiate this. Study Aid. Jeremy Bracken, Sep 1, , PM. Unit 3. Organizations 1. Management 1. Unit 3 - Finance 3. If funds are indeed loaned towards the investment, the objective will be to repay them as soon as possible. This is primarily on account of the costs associated with a loan, interest. Therefore, the investment appraisal method used to calculate the expediency in the repayment of a loan is known as the payback period. This method has its limitations and advantages which we shall also examine.
However, the payback period allows entrepreneurs to choose between two or more projects and to calculate to the second, hour, week, month or year when the investment can be paid back. Through a simple calculation we can determine that it will take two years to repay the investment.
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