Fundamentals of Finance - Essay Example

Fundamentals of Finance A. Calculation of specific cost of each form of financing: In this particular case, it is necessary to evaluate the fundamentals of finance handled by Swindon Plc.It is necessary to consider the significant decisions being taken by Swindon plc, and the method of depreciation applied by Swindon is MACRS (Modified Accelerated Cost Recovery System). Under this method of depreciation, it is necessary to consider the asset class lives which should be less than the actual life of the asset, so that the salvage value of such assets should be zero. If a particular property is utilizing for a period of five years or more then the depreciation rate should be calculated in accordance with this manner- First year-20%; Second year-32%; Third year-19.20%; Fourth and fifth year-11.52%; Last year or sixth year- 5.76%. So, by using this method, during the last or sixth year, the value of the specific asset so depreciated will be zero. (Salzmann. 2007). Rate of Depreciation of Swindon Plc under MACRS Method. YEAR MACRS % Applicable 1 20% 2 32% 3 19.20% 4 11.52% 5 11.52% 6(Final Year) 5.76% The Overall Summary of Drill and Platform of Swindon Plc. Particulars A) Cost of existing platform. Total selling price after 5years. Amount (in £) £10000000 £3500000 A) Cost of new drill and platform. Add: Installation charges. Total cost of Drill&Platform. Total selling price of new platform and drill. £14000000 £1000000 B) £15000000 £4000000. B. Evaluation of Financing situation related to Break Point: Retained earnings means the amount of profit held by an organization, and that should be utilized for meeting the several requirements, except the payment of dividend. Break even point is a point at which the total cost and income equals, so at this point there should not be the question of profit or loss arises. So, the exhaustion of retained earnings also strongly related to the fundamental financing decisions and its implications. Break Even Point (BEP Output) in Units= Fixed Expenses/Contribution per unit.(C) Assume, fixed expenses (F) costs £60000; selling price per unit £15; variable cost per unit £10. Therefore, BEP= F/C per unit. Contribution (in unit) = Selling price per unit_ Variable cost per unit. i.e. £15_£10=5 BEP= £60000/5= 12000 Units. At this 12000units, there will be no profit or loss. That is Sales (12000*15) £180000 Less: Variable cost (12000*10) £120000 Contribution £60000 Less: Fixed costs. £60000 Profit/Loss Nil. C. Weighted Average Cost of Capital (WACC): The composite of overall cost of capital of a firm is considered as the weighted average cost of several sources of funds. Weights are taken as the proportion of each source of funds in the overall capital structure of an enterprise. WACC is computed through a step by step process, such as Calculating the cost of specific sources of funds, then multiplying the cost of each source by its proportion in capital structure, and adding the weighted component costs. That is, K0= K1 W1 + K2 W2+……; here, K1, K2 etc. are component costs and W1, W2 etc. are weights. Cost of Equity- Ke= d1/P0 Where, Ke= Cost of equity. D1= Annual Dividend. P0= Market value of equity (ex dividend) OR Ke= D/NP Where, D= Dividend NP= Net proceeds. Assume total number of equity shares is 1000 shares, £35/share, £35000 is the equity capital or NP. While Dividend is £1750, i.e. 5% of £35000, and the cash dividend is £3.25/ share, i.e. 1000 shares @£3.25/ share is amounted to £3250. Ke= £1750+£3250/£35000= 14.285% Cost of Preference shares- Kp= PD+ (RV_NP)/N/(RV+NP/2) PD= Annual preference dividend. RV= Redemption value of preference shares NP= Net proceeds an issue of preference share N= Life of preference shares. Assume that the number of preference shares issued is 500 shares. NP=£50000 (500*£100/share) PD= 6% of the par value, i.e. 6%of £50000= £3000. RV= Redeemed at a premium of £102/share, i.e. £51000 is the redeemed value, and premium amount is £1000. N= Number of years, assumed to be nil or the preference shares are being redeemed within one year. Under irredeemable preference shares= PD/PO. Here, PD= Annual Preference dividend; and PO= Net proceeds in issue of preference shares. Kp= PD/PO= £3000/ £50000=6% Cost Of Debt= Kd= I/NP*(1_T) Where, Kd- Cost of debt after tax. I - Annual interest rate. NP- Net proceeds of debentures. T - Tax rate. In this case if Debentures are issued at par value- Kd= £65/£1,000*(1-40%) = 3.9% If flotation cost is paid as 2% of par value. Kd= £65/£980*(1-40%) = 3.979% Cost of Reserves/Retained earnings- In this case, Swindon Plc is expected the retained earnings as £100,000. Estimated Statement Showing Weighted Average Cost of Capital. Particulars Amount in (£) Proportion After taxation cost Weighted costs. Equity capital Retained earnings Debt. TOTAL 5,00,000 2,00,000 3,00,000 0.50 0.20 0.30 0.18 0.18 0.065 0.09 0.036 0.0195 0.1455 WACC=14.5% Workings- 1. The component costs before tax are: Equity capital 18%, Debt 10%. 2. WACC: - After tax cost of debt= Kd (1-T) =10 %( 1_0.35) =6.5%. D. Impact of Book value Weights and Market value weights under WACC: Weights may be of two kinds, book value weights and market value weights. However these weights fluctuate frequently and fluctuations are wide in nature. Both the concept of book value and market value is differ, because book value of the firm or book value weights remains constant, but the market value weights are goes on fluctuating. But it is better to adopt market value weights than the book value weights, because the book value weights remains stable, it should not taken in to consideration the changing market value of debt and equity. a) Project’s Initial investment- It refers to the total out flows used to undertake the projects in a most effective manner. Each project involves certain investments and commitment of cash at a certain point of time; it is the cash outflow. Under this project, initial investment is assumed to be £3,500,000; cost of existing machine is utilizing for the five years. b) Operating Cash Flows- It refers to the adjustment of net profit and other expenses like depreciation, profit on sale, interest expenses etc. for obtaining the operating profit before working capital changes. It is summarized as- Estimated Cash flow statement showing Cash flows from Operating Activities…… Cash flow from operating activities Net Profit Adjustment for: Depreciation. Operating profit before working capital changes. £150000 £120000 £270000 c) Terminal cash Flows- it refers to the disposal value of a project, with or with out any taxable amount related with the overall sales of the project. It should include the gathering of working capital investments required in the initial outflows. Here, Swindon plc is expected to sell the new machinery after 5years for £4M where as the existing machine at the end of the fifth year is expected to generate £2.5M, through which it is possible to recapture the working capital investment. References SALZMAN, Mary (2007). Accounting Site. MACRS (Modified Asset Cost Recovery System) Method. [online]. Bella Online. Minerva WebWorks LLC. Last accessed 30 November 2007 at: http://www.bellaonline.com/articles/art48923.asp Read More