BirminghamCity UniversityIntroductionto FinanceCourseWorkQuestion1There are two sources of business finance internal andexternal. The internal sources of funding are:· Retained profits,· Issuing shares.The external sources of finance are divided into threecategories: long term, medium term, and short term.1) Long-term sources of finance:· shares,· debentures,· grants,· long-termbank loan.2) medium term:· leasing,· hire purchase,· medium-termloan.
3) short-term:· bankoverdraft,· bankloan,· creditors,· debtfactoring.Each source of finance has advantages and disadvantages.The benefits of funds from investors or shareholders are potentially more fundswill be available, and it enables broad scope of investments. The drawbacks offunds from investors or shareholders are that:· it is costly;· the supervisionof the company has to be shared; · thevalue of the shares can decrease and increase, affecting company’s value.A company can reduce its WACCby cutting debt financing costs, reducing equity costs and capital reestablishment.
Equity cost is the return on investment that shareholders expect to earn fromthe company. If you lessen a given risk, it reduces equity cost. For example,if a particular risk on future net cash flow is associated to poor marketsegmentation, you can reduce the risk by implementing proper marketsegmentation strategies. The cost of debt is the interest rate enforced onloans borrowed from banks and non-bank financial institutions. Cutting thecosts of debt begins with lowering the costs of non-payments. If the interestrate debt is higher than the interest rate of alternative capital, your companycould source the alternative capita; and pay off the debt. A company can reviewthe structure of its debt in a bid to reduce WACC. One option of capital reconstitutioninvolves substituting debt for equity because it translates to lower costsafter taxation.
Cost of Equity is the rate ofreturn required to persuade an investor to make a given equity investment. Itis the rate of return that could have been earned by putting the same moneyinto a different investment with equal risk. There are two ways of determiningthe Cost of Equity.
The formula of Cost of Equity is: Table 1.1 is showing the Cost of Equity of GNCC Capital andMAGNET. Cost of Equity GNCC Capital MAGNET 14.89% 12.67% Table1.
1 From the information above, we can conclude that GNCC has ahigher Cost of Equity Ratio. There are some advantages and disadvantagesregarding dividend growth model for measuring the cost of capital. The DividendGrowth Model is easy to use and understand, but it does not apply to companiesthat don’t pay dividends. Also, it assumes that dividends grow at a constantrate over time. The Dividend Growth Model is also quite sensitive to changes inthe dividend growth rate, and it does not explicitly consider the risk of theinvestment. Preferenceshares represent a special type of ownership interest in the firm. They areentitled to a fixed dividend but subject to availability of profit fordistribution. Retained earnings, used as a part of the capital structure of abusiness firm, are the part of the earnings available to common shareholdersnot paid out as dividends or the earnings lowed back into the firm for growth.
“The most important source of long-term finance for most corporations isretained earnings.” Arnold (2013), p.702 Cost of preference share capital is that part of the costof capital in which we calculate the amount which is payable to preferenceshareholders in the form of a dividend with a fixed rate. The formula of costof preference share capital is: *100 or *100 where: = Annual preference dividend =Net proceeds = Par Value of Preference Share Capital – Discount – Cost ofFloatation or NP = Par Value of Preference Share Capital + Premium Table 1.
2 represents the Cost of Preference Share Capitalof GNCC Capital and MAGNET for the year ended 31 December 2016 is: 100 Cost of Preference Share Capital GNCC Capital MAGNET 7.62% 8% Table1.2 Debt is thecheapest way of financing a company. The Cost of Debt is usually based on thecompany’s bonds.
Bonds are the company’s long-term debt and are the company’slong-term loans. Cost of Debt is the return that lenders require on the firm’sdebt. D. Hillier, I. Clacher, S. Ross, R. Westerfield, B. Jordan (2016) Thefollowing factors determine the cost of debt:· theprevailing interest rates;· therisk of default (and expected rate of recovery of money lent ion the event ofdefault).
· thebenefit derived from interest being tax deductible.The Cost of Debt , is the current market rateof return for a risk class of debt. The cost to the firm is reduced to theextent that interest can be deducted from taxable profits: G. Arnold (2013)To calculate a company’s cost of debt, we will need toknow:· interestrate it pays on its debt; · marginaltax rate. The formula of cost of debt is: Table 1.3 represents the Cost of Debt of GNCC Capital andMagnet for the year ended 31 December 2016. Cost of Debt GNCC Capital MAGNET 7.5% 7.
5% Table1.3 We are getting the same answer. We can conclude that GNCCand MAGNET have an equal cost of debt. “The averagecost of capital can be calculated by taking the cost of the individual elementsand then weighting each element in proportion to the target capital structure(by market value) of the business.
” (Atrill, 2017, p.359) The formula for WACCis: Where: = market value of the firm’s equity (marketcap); = market value of the firm’s debt; = total value of capital (equity plus debt); = Market Value of the Firm’s Preference SharesCapital; = percentage of capital that is equity; = percentage of capital that is debt; = Percentage of Capital that is PreferenceShares; = cost of equity (required rate of return); = cost of debt (yield to maturity on existingdebt); = tax rate. To calculate the WACC, we first need to know:1) the costof equity,2) the costof debt,3) thecost of preference shares. Table 1.
4 representsthe WACC of GNCC Capital and MAGNET for the year ended 31 December 2016. Weighted Average Cost of Capital (WACC) GNCC Capital MAGNET 11.42% 14.88% Table1.4 If we compare GNCC’sWACC with MAGNET’s WACC, we can see that MAGNET’s WACC is higher. Therefore,investors prefer to invest in MAGNET because they have a higher return on theirinvestment.
WACC is an essentialinstrument for calculating a company’s value. In contrast to other methods formeasuring a company’s value, WACC uses a discount rate for calculating the NPVof business. Investors and managers use WACC to evaluate investmentopportunities, as it is considered to represent the firm’s opportunity cost. Acompany’s cost of capital is merely the cost of money the company uses forfinancing.
If a company only uses current liabilities and long-term debt tofinance its operations, then it uses debt, and the cost of capital is usuallythe interest rate on that debt. Three factors determine the cost of debt:· Theprevailing interest rates.· Therisk of default (and expected rate of recovery of money lent in the event ofdefault).· Thebenefit derived from interest being tax deductible.
Glen Arnold (2013) Question2Financial ratios are mathematical comparisons of financialstatement accounts or categories. These relationships between the financialstatement accounts help investors, creditors, and internal company managementunderstand how well a business is performing and of areas needing improvement.Ratios are easy to understand and simple to compute. Financial ratios are oftendivided up into seven main categories: · liquidity, · solvency,· efficiency,· profitability,· marketprospect, · investmentleverage, · andcoverage.Profitability ratios show a company’s overall efficiencyand performance.
Profitability ratios are divided into two types: margins andreturns. All of these ratios indicate how well a company is performing atgenerating profits or revenues relative to a particular metric. Efficiencyratios measure the ability of a business to use its assets and liabilities togenerate sales. Liquidity ratios analyse the ability of a company to pay offboth its current liabilities as they become due as well as their long-termliabilities as they become current. However, financial ratios have limitation.
The main limitations are:· Manyvital assets such as the company’s reputation, skills of the workforce andmarket penetrations. (Chartered Institute of Internal Auditors)· The informationis historical· Eachorganization chooses the most appropriate accounting policies for theirparticular situation. Which results in affected reported profits/surpluses aswell as a statement of financial position values.
· Non-currentassets can be valued either by historical cost or revalued amount. The working capital ratio,also called the current ratio, is a liquidity ratio that measures a firm’sability to pay off its current liabilities with current assets. The workingcapital ratio is essential to creditors because it shows the liquidity of thecompany. The formula of the Working Capital Ratiois: Table 2.1 represents the Current Ratio of Benitez PLC for the years ended 31 December2014 and 2015 is: Current Ratio of Benitez PLC 2014 2015 2.049 2.
046 Table2.1 Therefore, for every pound of liability the company has pounds of assets. In 2014 the company could cover its liabilities moreeasily. Return on capital employed orROCE is a profitability ratio that measures how efficiently a company cangenerate profits from its capital employed by comparing net operating profit tocapital employed. The formula of ROCE is Table 2.2 represents the ROCE for the years ended 31December 2014 and 2015. Return on Capital Employed of Benitez PLC 2014 2015 48.9 21.
98 Table2.2 In 2015 Benitez PLC we can see a significant decrease inreturn on the capital employed ratio. Return on capital employed is a ratiowhich can tell us how efficiently a company is using its labour force. Theconcept of diminishing marginal returns can explain why with increasing thenumber of employees a company is experiencing lower profit margins. Net profit margin is thepercentage of revenue left after all expenses have been deducted from sales.
The formula of net profit margin is Table 2.4 Represents the Net Profit Margin of Benitez PLC forthe year ended 31 December 2014 and 2015. NPM of Benitez PLC 2014 2015 23.33% 16.67% Table2.4 Net Profit Margin for the year ended 31 December 2014: Net Profit Margin for the year ended 31 December 2015: Asset turnover isprofitability ratio. It can tell us how efficiently a company is using theirassets.
The highest the asset turnover the better a company is using theirassets. The formula of asset turnover is Table 2.5 Represents the Net Profit Margin of Benitez PLC forthe year ended 31 December 2014 and 2015. Asset Turnover of Benitez PLC 2014 2015 107.14% 67.42% Table2.5 Asset Turnover for the year ended 31 December 2014: Asset Turnover for the year ended 31 December 2015: In 2014 the Asset Turnover of Benitez PLC is 107.
14percent, which means that Benitez’s assets are making 7.14 % of revenue. BenitezPLS is experiencing a negative margin of 0.9 times in Asset Turnover from 2014to 2015. The ratio Trade Receivables’ CollectionPeriod represents the time lag between a credit sale and receiving payment fromthe customer.
The formula of RCP is: Table 2.5 Represents the Collection Period Ratio of BenitezPLC for the year ended 31 December 2014 and 2015. Collection Period Ratio of Benitez PLC 2014 2015 113.6 days 310.3 days Collection Period Ratio for the year ended 31 December 2014: Collection Period Ratio for the year ended 31 December2015: From the data, we can see that in 2014 the RCP was 113.6days and in 2015 is increasing with 196.7 days – significant increase.
Highreceivables collection period may indicate that your customers may no longerintend to pay or may be unable to pay, which can cause severe problems forbusiness. We can decrease the length of your credit terms with customers tominimize risk and increase payment expectations. To reduce the RCP, we mightrun credit checks on customers and ensure that our contract paperwork is legallysound.
The Quick Ratio or Acid TestRatio is a Liquidity ratio that measures the ability of a company to pay itscurrent liabilities when they come due with only quick assets. The formula ofAcid test ratio is Table 2.5 Represents the Collection Period Ratio of BenitezPLC for the year ended 31 December 2014 and 2015. Acid Test Ratio of Benitez PLC 2014 2015 1.
268 1.310 Acid Test Ratio for the year ended 31 December 2014: Acid Test Ratio for the year ended 31 December 2015: The higher Quick Ratios are more favourable for companiesbecause it shows there are more current assets than current liabilities. Acompany with a Quick Ratio of 1 indicates that quick assets equal currentassets. This also suggests that the company could pay off its currentliabilities without selling any long-term assets. An Acid Ratio of 2 shows thatthe company has twice as many current assets than current liabilities.Ray Proctor characterizefinancial ratios as the comparison between two numbers.
The financial ratiosare divided into several categories, such as: · liquidity,· solvency,· efficiency,· profitability,· marketprospect, · investmentleverage, · also,coverage.Current ratio, also known asliquidity ratio and working capital ratio, shows the proportion of currentassets of the business concerning its current liabilities. Net profit margin isthe percentage of revenue left after all expenses have been deducted fromsales. Asset turnover is a financial ratio that measures the efficiency of acompany’s use of its assets in generating sales revenue or sales income to thecompany.
A collection period is the average number of days required to collectreceivables from customers. The quick ratio is a measure of how well a companycan meet its short-term financial liabilities. ReferencesPeter Artill. (2017) Financial Management for DecisionMakers, 8th Edition.
London: Pearson. J. Collins, N. Collins. (2010) Corporate Governance andRisk Management, 2nd Edition. London: Chartered Institute ofInternal Auditors.G. Arnold.
(2013) Corporate Financial Management, 5thEdition. Harlow: Pearson. D. Hillier, I. Clacher, S. Ross, R. Westerfield, B. Jordan.
(2016) Corporate Finance, 2nd Edition. New York: McGraw-Hill. R. Proctor. (2012) Managerial Accounting: Decision Makingand Performance Improvement, 4th Edition.