Understanding Role of Financial Management in Business Entities

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Question 2

(a) Long term finance: Equity finance

(A) Issue of Right share:

The issue of rights means the granting of rights to the present stakeholders of corporations as well as enabling them to buy additional securities directly from the company on a discounted rate rather than buying secondary market shares (Sahi, 2013). The total amount of new shares to be acquired is based on current assets of the shareholders. The issue of rights gives exclusive treatment to current stakeholders where they have legal capacity to buy shares at a lower price before or on a particular date. In the aspect of above Lexbel company, it can be find out that they are planning to issue right share among their current stakeholders so that their need of funds can be fulfil. Herein, underneath some calculations are done regards to issue of right share such as:

 

 

Lexbel plc wishes to rise: 180000GBP

Current ex-dividend market-price of Lexbel plc: 1.90GBP

Three assorted rights-issue prices recommended by corporation's finance director: GBP1.80, GBP1.60 and GBP1.40

Right issue of Lexbel plc
Aggregate (no.)Ordinary shares ( @ 50 for each)	300000 Pounds
Add: Aggregate Reserve	400000 Pounds
Whole Sum	700000 Pounds
Profit Post taxation ( 700000 pounds x 20 percent)	140000 Pounds

(b) Calculation of followings:

(I) Number of shares to be issued = (Aggregate Funds to be elevated / right issue prices)
Descriptions	Amount (in pound except shares)	Amount (in pound except shares)	Amount (in pound except shares)
Exist number of share	600000	600000	600000
Fund to be raised (A)	180000	180000	180000
Suggested right issue prices (B)	1.80	1.60	1.40
Number of shares to be issued (A/B)	100000	112500	128571

(ii) Theoretical ex price:

Theoretical ex-rights price indicates security value given by a particular rights bid. The sell rights are typically only available to current stakeholders and only available for a quick amount of time (approximately 30 days). Usually, rights agreements give stakeholders the option of purchasing an equitable amount of shares at discounted rate on a specified price (Loughranand, McDonald, 2014). The component that each shareholder must obtain focuses on the current stakes in corporation of stakeholders. The goal is to produce additional capital, with preference given to current shareholders. The security rights offerings could be a frequent occurrence for investors, as they can create potential ground for settlement through duration of right being granted.

Particulars	Condition (i)	Condition (ii)	Condition (iii)
Recommended right issue prices	1.8pound	 1.6pound	 1.4pound
Fund to be raised	180000 pounds	180000 pounds	180000 pounds
Number of shares needed to issue	1 lac shares	1.125 lac shares	128571.43shares
Pre right issue	1140000	1140000	1140000
Post right issue*	1320000	1320000	1320000
Theoretical ex-right price	1.89	1.85	1.81

*Calculation of post right issue= [(600000*1.90) +180000] = 132000

(iii) Anticipated earnings per share- (Number of shares before issue of rights * Theoretical ex-right price)/ current market price.

Market price= 1.9

Number of share= 600000

Return on shareholder fund= 140000 pounds

Particulars	Amount (in £)	Amount (in £)	Amount (in £)
Requested right issue prices	 £1.80	 £1.60	 £1.40
Fund to be raised	180000	180000	180000
Number of shares needed to issue	100000	112500	128571.43
Pre right issue	1140000	1140000	1140000
Post right issue	1320000	1320000	1320000
Theoretical ex-right price	1.89	1.85	1.81
One right value*	0.01	0.05	0.09
Fair value of each share*	95238.1	97297.3	99447.51
Bonus fraction*	50390.53	52593.14	54943.38
Expected earnings per share (EPS)	596842	584211	571579

Working Note:

*Calculation of one right value:

1.90-1.89= 0.01

1.90-1.85= 0.05

1.90-1.81= 0.09

*Calculation of Bonus fraction:

95238.1/1.89= 50390.53

97297.3/1.85= 52593.14

99447.51/1.81= 54943.38

*Calculation of fair value of each share:

180000/1.89= 95238.1

180000/1.85= 97297.3

180000/1.81= 99447.51

*Calculation of EPS:

600000X1.89/1.90= 1134000/1.90= 596842

600000X1.85/1.90= 110000/1.90= 584211

600000X1.81/1.90= 1086000/1.90= 571579

(iv) Form of issue of right issue price:

Particulars	Amount (in pounds)	Amount (in pounds)	Amount (in pounds)
Suggested right issue prices	1.80	1.60	1.40
Fund to be raised	180000	180000	180000
Number of shares to be issued (A)	100000	112500	128571.43
Exist number of share (B)	600000	600000	600000
Ratio of new share to existing one (B/A)	6	5.33	4.67
Issue of right share hold by present shareholder	Issue of 1 for 6 right share hold	Issue of 9 for 48 right share hold	Issue of 3 for 14 right share hold

Critical evaluation:

In accordance of above mentioned table this has been assessed that, in the sense of the issue of right shares, there are three alternatives which are as follows:

• The first situation is regarding to option of 1.80 pounds for each share are needed to be issued of 100000 shares of each share. So stakeholders should allocate pro-rata one share for available 6 shares.
• The second situation is regarding to option of 1.60 pounds for each share are needed to be issued of 112500 shares of each share. So stakeholders should allocate pro-rata 9 shares for available 48 shares.
• The third situation is regarding to option of 1.40 pounds for each share are needed to be issued of 128571.43 shares of each share. So stakeholders should allocate pro-rata 3 shares for available 14 shares.

(v) Analysis of suitable option among three alternatives.

In accordance of above analyzed three alternatives, this can be find out that option one is better among all three alternatives. This is so because under it, shareholders will be more beneficial.

(c) Evaluate the importance of scrip divided in context of shareholders or companies

Scrip dividend- Scrip dividend described as new shares which are provided to shareholders by business instead of a regular dividend (Willcocks, 2013). Companies who have very little cash available to pay cash dividends, a scrip dividend may be used for the purpose of maintaining shareholders interest in company. Stockholders could also be offered scrip dividends as an alternative for nominal dividends in order to perform their dividend payments slowly into more shares. This is an effective way to save money by not having to pay for stock provider cash dividend payouts. Scrip dividends associated with common stock enable the issuing company retain and enable stakeholders to increase their corporate investment. So overall, scrip dividends are beneficial for those companies who do not have enough amount of cash funds. Herein, this is important to know that scrip dividend is not only beneficial for companies but also it is useful for stakeholders also. Below importance of this dividend is mentioned in such manner:

Benefit of scrip dividend for shareholders-

• One of the key advantage of scrip dividend for shareholders is that they can gain tax advantage by implementing option of share instead of cash dividend.
• As well as this is beneficial for shareholders in order to increase their rights in a particular company. The stakeholders can raise their shareholding without paying any extra transaction cost.
• The scrip dividend is useful for shareholders to increase equity stake without paying any extra payment for this like cost of stamp, commission charges etc.
• This allows shareholders to achieve financial benefit because of time gape of cash dividend (Collum, Menachemi and Sen, 2016).
• This dividend contributes to shareholders in order to increase their retaining power and for enhancing assets value. In addition, due to compound interest, the market price of scrip dividend also raise which benefit to shareholders significantly.

So these are the key importance of scrip dividend for shareholders and they can gain futuristic benefit from this dividend.

Benefit of scrip dividend for companies:

• The scrip dividend is useful for companies in the case when they do not have enough amount of cash to pay their shareholders. As well as it protects the cash position of business finance entities.
• This dividend is useful for companies in order to manage cash position because they can offer shares to their stakeholders instead of cash dividends.
• In addition, if companies issue scrip dividend then their leverage and gearing condition can be enhanced that leads to improvements in borrowing efficiency of business entities.
• An organization with a high brand equity and a large market positioning can offer this form of dividend even with low cash resources if the organization guarantees that the majority of the dividend goes with an alternate share (Badolato, Donelson and Ege, 2014).
• Another benefit here is that lower scrip dividend issue usually does not greatly diminish the firm's share price. On the other hand, if companies issue lower cash dividend then it may lead to negative impact on goodwill.

 

QUESTION 3

(a) Investment appraisal technique

(I) Payback Period= Investment / cash flow

inflow

Particulars	Amount
Initial investment	275000
Cash inflow (A)	85000
Cash outflow (B)	12500
Cash flow (A-B)	72500
Payback period	3.79 years

(II) Accounting rate of return= Average annual profit / Initial investment * 100

Particular	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Cash In-flow	85000	85000	85000	85000	85000	85000
(-) Cash out-flow	12500	12500	12500	12500	12500	12500
Net Cash flow	72500	72500	72500	72500	72500	72500
(-) Depreciation (on the basis of straight line method @ 15%)	38958.33	38958.33	38958.33	38958.33	38958.33	38958.33
Net Cash flows after depreciation	33541.67	33541.67	33541.67	33541.67	33541.67	33541.67
Initial investment	275000
Accounting rate of return	12.20%

Working Notes:

Calculation of depreciation:
cost of machine (A)	275000
scrap value (B)	41250
Life of machine (C)	6 years
Depreciation [(A-B)/C]	38958.33

(III) Net present value= Discounted cash flow- initial investment

Years
	NPV= Discounted cash flow – initial investment
	Initial investment=	275000
	Net Cash flow	PV factor @ 12%	DCF
	Year 1	72500	0.892	64670
Year 2	72500	0.797	57782
Year 3	72500	0.711	51547
Year 4	72500	0.635	46037
Year 5	72500	0.567	41107
Year 6	72500	0.506	36685
Scarp ValueÂ	41250	0.506	20872
DCF			318700

Net Present value (NPV) = 318700 - 275000

= 43700

(IV) IRR (Internal Rate of Return): Internal Rate of Return (IRR) = LDR + PV of LDR – Initial investment / PV of HDR – PV of LDR (HDR – LDR)

= 12 + (318703 – 275000) / (254881 – 318703) * (20 – 12)

= 12 + 43703 / -63881 * (8)

= 12 + ( -0.68) * 8

= 12 – 5.44

= 6.56 %

Working Note:

Recommendation-

• Payback period- On the basis of calculated value of payback period, this can be recommended that Love-well company should acquire the machine. This is so because estimated time period is suitable that is 3.79 years.
• Accounting rate of return- The calculated value of ARR is 12.20% which is higher and enough to recover to cost of investment. Thus, Love-well company should acquire the new machinery.
• Net present value- If NPV of any project is showing positive value then companies should acquire that project. In the aspect of above company’s new machinery value of net present value is of 43700 pounds. So they should acquire that machinery.
• Internal rate of return- The IRR of above company’s project is of 6.56% that is enough for them to recover cost of investment. Hence, they should initiate to buy new machinery.

On the basis of above analysis, this can be recommended to Love-well company that they should go with new machinery as it will be beneficial for them.

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(b). Critical evaluation of investment appraisal techniques with the help of its benefits & drawbacks

(a) Payback period- This is one of the simplest technique of investment appraisal in which time period is calculated that can occur to cover cost of investment (Linnerooth-Bayer and Hochrainer-Stigler, 2015). In this technique if value of computed payback period is lower than it is considered better. It is computed by different formula as per the cash flows. In the aspect of above Love-well this technique has been applied in order to calculate payback period of their machinery. It has some limitations and benefits which are as follows:

Benefits:

• As above stated in definition that this method is very simple to use and calculate. Due to which users can easily can assess efficiency of projects.
• As well as this method is beneficial for companies in order to do comparison of different projects.

Limitations:

• The main drawback of payback period method is that it does not consider time value of money factor.
• In addition, under this method cash flow is ignored after covering cost of investment. So it does not focus on all cash flows of a project which is a huge drawback (Sweeting, 2017).

(b) Accounting rate of return- It is a type of technique in which average net income of any particular project is computed as a rate. If rate of return of any project is higher, then that should be accept by companies. Under this technique average value of net profit is being used to assess accounting rate of return. In the Love-well limited company, this technique has been applied to know efficiency of their project.

Benefits:

• Similar as above method, this is very simple to use and calculate as under it no major data are needed. The formula of ARR requires value of average net profit and investment which can be assessed easily (Baxter and Yezegel, 2013).
• By help of this method, companies can clearly analyze profitability of a project in a quick manner.

Drawbacks:

• The drawback of this method is that it neglects the time factor during calculating value of rate of return.
• As well as under this method external factors are also neglected which can affect profitability of projects.

So these are the key issues of accounting rate of return method which makes produced outcome less reliable.

(c) Net present value- It can be defined as a type of method in that present value of a particular project is being calculated (Schaeck and Cihák, 2014). In this method, discounted factor is also considered so that accurate value of any financial project can be assessed. Under it, if value of any project is showing positive result then that project should be accepted by company. In the aspect of above Love-well company, they apply this technique in order to analyze efficiency of their project.

Benefits:

• In this method, all the cash flows are being considered for calculating present value of any project (Attaoui and Poncet, 2013).
• Another benefit of this technique is that under it risk factor is also considered such as monetary risk, operating risk etc. By considering these projects, it becomes easier to companies to know actual condition of any project.

Drawbacks:

• The main problem of this technique is that under it, some data for calculation are assumed like cost of capital (Ramiah, and Moosa, 2014). Due to this efficiency of different projects cannot be measured effectively.
• As well as this technique is not suitable for those projects whose size is different from each other. Because of it, this becomes difficult for companies to analyze efficiency of those projects which have variant size of cash flow during a particular time frame.

(d) Internal rate of return- This technique is one of the effective investment appraisal method which is used by companies in order to analyze project whether it is beneficial or not. Basically, it is based on the discounted time frame that analyze NPV of project and then characterize cash flow (Singh and Song, 2013). In the above Love-well limited company, they have applied this technique with an aim of determining efficiency of their project. Underneath, its benefits and drawbacks are mentioned such as:

Benefits:

• This method, consider time value of money factor whether cash flows are even or uneven.
• As well as under it, profitability of projects is considered during entire life of projects. Due to this actual level of project’s profitability is evaluated.

Drawbacks:

• The main drawback of this method is that it involves some complex calculations which cannot be performed easily by users.
• Along with outcome of net present value and internal rate of return can be different when projects are of different sizes and time frame (Singh and Song, 2013).

CONCLUSION

On the basis of above project report, this can be concluded that financial management has a vital range of scope. As well as it consists different kinds of techniques that can be applied as per the nature of business operations. The project report is based on two tasks in which first task is about equity financing which concludes that shareholders should go with first option as it can be beneficial for them. While second task is about investment appraisal technique in which all techniques are applied to calculate efficiency of given project. In overall analysis of all techniques this can be concluded that Love-well plc should acquire the machinery.

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