Financial Decision Making - Assignment Example

Financial Decision Making Answer 1.a 2 Answer 1.b 5 Answer to the Question No 2 7 Part 3- a) 12 Part 4 15 Reference 18 Bibliography 19 Answer 1.a The company has already prepared sales forecast as well as forecast of monthly income and expenditures. Using these information forecasted cash flow for the six months (January 2010 to June 2010) is prepared as followed. As per the information provided by the company, operating cost contains depreciation (£200) per month. Depreciation being a non-cash item should be segregated from the total operating expense. Hence while cash payment of operating cost; depreciation amount is subtracted from total operation cost. It is assumed that total sale is as a credit sale and according to the company’s policy debtors pay the amount in the next month. Purchase is also made at credit and the creditors allow a credit period of 2 month. After preparing the projected profit and loss account for the first six months (January 2010-June 2010) it appears that the company will have a gross profit of £61,950. As per the company’s policy, cost of sale remains at 65% of the total sales and thus the gross profit is calculated 35% of the sales. It is also assumed that operating cost is not included as a part of cost of sales, so it is subtracted from the gross profit to calculate net profit for the period of six months. All other indirect expenses for six months are also subtracted from the gross profit to derive the net profit. It is found that net profit for the six month period will be £2000. While preparing balance sheet for the period ending June 2010, closing balance of cash on June 2010 is present as cash in hand. The debtor amount represents the sales figure for the month of June 2010. As no information is provided for the sales figure for the month of June onwards, hence the balancing figure of the asset is assumed to be the stock retained by the company for future resale. While calculating account payable to the creditors, purchase figure for the month of May as well as June is used. Answer 1.b To determine the short term liquidity of the company current ratio is calculated. Current ratio is calculated as current assets divided by current liabilities. The current ratio is just 1.41, so the company’s short term liquidity position is not much sound. It might be just enough for the company to keep it solvent, but if there is a sudden increase in liability, the company might face problems to meet the increased obligations. For better understanding of the liquidity position of the company, quick ratio is calculated. It is calculated as current assets less stock, divided by current liabilities. As the quick ratio is less than 1, hence the company possess the risk of short term liquidity crisis. The long term solvency state of the company is calculated with the help of debt – equity ratio. As the company does not have any long term debt, hence the risk of long term solvency is almost absent. As discussed while preparing the cash flow, the company always has a positive cash balance that reduces the risk of liquidity crisis. However, the idle cash also indicates a poor cash management. Therefore the company should revive its cash management policies. Answer to the Question No 2 Case 1. The risk premium is 3.2 % a) Newbuild Plc has a capital structure, comprised of debt and equity. The equity amounts to £ 4 million and its equity holders expect a 15 % return on the investment. The firm’s debt value has amounted up to £ 6 million with after tax cost of 8 %. The weighted average cost of capital is calculated as follows. WACC = Debt/ (Debt + Equity) * Cost of Debt + Equity/ (Debt + Equity) * Cost of Equity. In this case, the risk premium is considered to be 3.2 %. The WACC has been calculated to be 10.80 %. Adding the risk premium, the risk adjusted cost of capital has come to 14 %. This has been taken as the discount factor to calculate the present value of the cash flow. b) Plan A * All figures are in £ Plan A has its initial cash out flow of £ 3 million. From the next year onwards cash inflow has taken place. The taxation amounts were deducted from the second year. The free cash flow has been calculated at a discount rate of 14 %. The net present value for all the cash flows turned to be around £ 5,09,610. Plan B * All figures are in £ Around £ 2.5 million has been the initial demand of this project, Plan B. The time period for this project extends to 9 years. With the same discount factor, in this case, the net present value has calculated to be around £ 5,05,575. As the organization is concerned with the net present value of these projects and the decision would be taken based on the same. Looking at the above calculations for the two plans, it seems that plan A is more acceptable than the Plan B. Both the projects have positive net present values. However, plan A has higher net present value than that of plan B. Comparing the two projects, the first project, plan A, is recommended to the concerned authority. Case 2. The risk premium is 5.2 % c) The managing director of Newbuild Plc has expressed his concern about the risk taking ability of the projects. As the market is changing rapidly, there can be variation even in the risk premium figures. The company would like to know how a change in the risk premium would affect the decision making. In this case, the risk premium has been considered to be 5.2 %. The risk adjusted WACC has come to 16 %. Plan A * All figures are in £ In the six years time period, plan A has a total net present value of around £ 3,86,745, discounted at a cost of capital adjusted with the higher risk premium. Plan B * All figures are in £ On the other hand, plan B has a positive net present value of £ 3,89,413, which is higher than that of plan A. Looking at the two projects at a higher risk premium, it seems that plan B is more preferable than the first one. The managing director has made a comment that even a 2 % change in the risk premium can change the decision, which has proved to be quite true. At the first instance when the risk premium has been 3.2 %, plan A was recommended to the board; while in this case, when the risk premium is considered to be 5.2 %, plan B is more preferable among the two projects. So, decisions change with the change in the risk premium as that incorporates changes in the discount factor to calculate the net present value of the projects. Part 3- a) The gross profit margin of Sainsbury Plc is 5.48% and of Tesco Plc is 7.76%. Similarly the operating profit margin of Sainsbury Plc is 3.56% and of Tesco Plc is 5.90%. This shows that the profitability position of Tesco Plc is superior to Sainsbury Plc. It indicates that the production efficiency of the former is better as compared to the latter. The high operating profit margin of Tesco Plc highlights operational efficiency. It shows that the company has managed its operational costs efficiently resulting in high profit margins. The current ratio of Sainsbury Plc is 0.55 and of Tesco Plc is 0.78. A high current ratio signifies good liquidity position. Even in terms of liquidity Tesco is better placed than Sainsbury. The current ratio of Tesco is close to 1 suggesting that the company is capable of taking care of its short term obligations. The Quick ratio of Sainsbury is 0.33 and of Tesco is 0.81. A high acid-test ratio suggests that the company has high liquid assets that can be easily converted into cash. Tesco Plc generated a Return on Capital Employed (ROCE) of 12.25% and Sainsbury generated a return of 8.63%. Even on this parameter Tesco outperformed Sainsbury. The high return generated by Tesco indicates that the company is able to utilize the capital base efficiently and is thus creating wealth for the shareholders. A high ROCE attracts more number of investors. The investors usually invest in companies taking this factor into account. The Stock turnover days of Sainsbury is 14 days and of Tesco is 19 days. This indicates the number of days for which the stock remains tied up in the inventory. A high stock turnover period is not desired as this implies that the funds of the company remain blocked in the stock for high periods of time (Bized-a, n.d.). Creditors Payment period of Sainsbury is 50 days and of Tesco is 62 days. This indicates the average time taken to pay the creditors. This needs to be taken care by the company management since it delay in getting payment can lead to disturbances in working capital management. The company must ensure timely payments as a rise in this ratio can lead to cancellation of credit facilities (Bized-b, n.d.). b) Financial analysis assists in comparing the performance of two firms belonging to the same industry. Like a high profit margin suggests efficient cost management as well as efficient pricing. In terms of profitability Tesco looks more favourable than Sainsbury as the former exhibits high gross profit margin as well as operating profit margin. This indicates that the management of Tesco is managing its operating costs efficiently resulting in high margins. Besides profitability financial analysis helps in comparing the liquidity strength of the company i.e. whether it is capable of taking care of its short term obligations. A high current ratio in the case of Tesco is indicative of its sound liquidity position. The return generated by the company on the capital employed in the business highlights the amount of wealth that the company is able to create for its investors. A high ROCE makes the business attractive. The investors are usually lured by the earnings that the company is able to generate for its shareholders. If the company generates high returns, as in the case of Tesco Plc, then the investors take interest in the stock of the company. Moreover at the time of granting credit the banks and other financial institutions take the liquidity ratio and profitability margin into consideration. A high ratio can enable the company to get an easy access to credit thus boosting its expansionary prospects. Part 4 a) i) The profit if US dollars are purchased spot on January 1 is €14904.44. ii) The profit if US dollars are purchased at the forward rate available at January 2010 is €6349.66. iii) The profit if US dollars are purchased at the spot Price on April 1, 2010 is €10624.6. b) The Sterling loan equivalent to €5m can expose Importing gmb to various kinds of risks. As the loan is denominated in Sterling the value of the payment that is made by the company towards instalment is subject to exchange rate risks. If there is any fluctuation in the exchange rate the amount of payment that is made by the company also gets impacted. Like, if the value of Sterling appreciates agianst Euro then the company will have to shell out extra Euros to purchase Sterling. But if the value of Sterling depreciates against Euro then the company will have to shell out less Euros to purchase Sterling. In other words if the value of Sterling appreciates the Euro outflow of the company will increase and if the value of Sterling depreciates the Euro outflow of the company will decrease. Besides exchange rate risk the company is also subject to interest risk. As the loan that the company has taken is based on a variable rate any rise in the rate of interest will increase the monthly interest burden of the company. To minimize the exchange rate risks the company can buy forward contracts, buy call option on foreign currency. In the case of a forward contract the company makes a contract that will enable it to purchase a specified amount of foreign currency or in this case Sterling, at a specified exchange rate known as ‘forward rate’. The purchase of a forward contract does not require any immediate outflow but this is binding in nature. Like in the event of a favourable movement in the currency the company has to honour the forward contract. Unlike forward contract call option is not obligatory. This involves the payment of a premium at the beginning. Buying a call option gives the buyer of the option the right to buy the foreign currency at a pre-determined exchange rate without any obligation to do so. In the event of any favourable movement in the currency the buyer of the call option can let the call option lapse and buy at the spot rate prevailing in the market. To mitigate interest rate risk the company can enter into a plain vanilla swap. Generally a firm with “interest rate sensitive” assets can exchange “floating rate payments for fixed rate payments” (Madura, 2008, pp. 517). Reference Bized-a. No Date. Stock Turnover ratio. Available at: http://www.bized.co.uk/learn/business/accounting/busaccounts/notes/sto-th1.htm [Accessed on July 24, 2010]. Bized-b. No Date. Creditors Payment Period. Profitability, Solvency and Performance Ratios. Available at: http://www.bized.co.uk/learn/business/accounting/busaccounts/pizza/pr.htm [Accessed on July 24, 2010]. Madura, J. 2008. International Financial Management. Cengage Learning. Bibliography Patterson, S., C. The cost of capital: theory and estimation. USA: Greenwood Publishing Group, 1995. Read More