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  • Subject Name : Financial Management

Executive Summary

One of the prominent areas of long term decision making is access to investments that help in the commitment of funds and thereby helps in the purchase of land, buildings, plants, and machinery. Investment in product development and new markets can lead to immense growth opportunities. The business needs to consider the prospect up to a certain extent as an over-reliance on the might limit the pursue of the options.

Further, a business must have the capability to earn a higher income from the investments. Investment decisions are complex and thereby the firm should have reasonable decision making. The report discussed the importance of investment appraisal techniques and tools and the report contains a discussion on Pear Limited. The discussion and scope of the report are based upon the company Pear Limited. The result from the analysis is that Pear limited should use own funds such as retained earnings and go for equity issue. It should vouch for a mechanism that will have minimal finance costs.

Contents

Introduction.

Part I - Investment Appraisal

Payback period.

Discounted Payback Period.

Accounting Rate of Return.

Net Present Value.

Internal Rate of Return.

Profitability Index.

Part II: Sources of Finance.

Retained Earnings.

Bank Lending.

Leasing.

Government assistance.

Franchising.

Part III: Working Capital 

Part IV: Recommendations and Conclusion. 

References.

Introduction

The main aim of financial management is to enhance the value of the firm. This brings the concept of capital budgeting to the forefront. It is concerned with the problems of long assets that are needed by the firm. Hence, capital budgeting helps the identification of the investments that have a favorable impact on the value of the stock. This has been done with the aid of investment appraisal tools like the pack back, discounted payback, ARR, NPV, and the IRR. The presence of funds requires proper decision making in terms of the investment pattern. The funds need to be invested logically to optimize investment returns. Thereby, it can be commented that the funds need a proper evaluation of the various alternatives through techniques like investment appraisal and capital budgeting.

The spending on different assets should be influenced by the motive of safety, liquidity, and profitability. Hence, a balance between the three will lead to an optimum result. The investment decision should be completed after assessing the inflow and outflow of funds followed by the tenure of the investments, presence of risk, and the cost of obtaining funds (Bellandi 2017). The business must understand the focus of the investment because it brings the maximum of the potential.

Even a difficult project should be subjected to investment appraisal as it will endorse a better answer to trace the best mechanism to attain the goals. The report aims to provide an in-depth analysis of the investment appraisal techniques. The report is divided into three parts where the initial part is the research on different appraisal techniques followed by the critical analysis of the sources of finance. The last part deals with the working capital that helps the company to operate smoothly followed by the conclusion.

Part I - Investment Appraisal

In recent times there are many investment opportunities that keep on coming to the corporate that involves a large amount of investment which is hard-earned money of the investors and management should make the best use of its resources. Thus many methods for evaluating the investments are there through which we can decide whether to invest in the same or not. These methods help us to determine whether this investment will be beneficial for the company. Each evaluation technique evaluates different angles of the proposed investment and gives different insights to help in final decision making. The various types of investment appraisal techniques are Payback Period, Discounted Payback Period, Accounting Rate of Return, Net Present Value, Internal Rate of Return, Profitability Index, etc. The use of different methods depends upon management decision and preference of the deciding factor. The brief of the different methods are given below:

Payback period

It is the most simple and easy method of investment appraisal. It is easy to understand also. It generally determines the number of years or period the initial investment will take to recover. It is a very traditional method and the main disadvantage of the same is the no consideration of the time value of money which is very essential due to the inflation rate (Deegan 2016). The formula for calculating the payback period is subtracting the cash outflow with the respective cash inflow from year 1 and when the balance becomes zero the corresponding period is the year of payback. It is so simple that people from backgrounds other than finance can also understand it easily.

Advantages

  • Simple to use and easy to understand.

  • Quick Solution.

  • Preference to liquidity

  • Useful in case of uncertainty.

Disadvantages

  • Ignores Time value of money.

  • Not all cash flows covered

  • Not realistic & ignores profitability.

  • Neglects the projects return on investment.

Discounted Payback Period

The discounted payback period is the advanced version of the payback period which is the same as the payback period as it includes the time value of money. This covers the main disadvantage of the payback period method (Carlon 2019). The difference between the payback period and the discounted payback period is that the payback period uses the cash flows from the project whereas this method uses the discounted cash flow for calculation of the payback period (Carlon 2019). Thus this is the actual period when the investment will be repaid in the real terms.

Advantages

  • Simple to use and easy to understand.

  • Considers the Time Value of Money.

  • Useful in case of uncertainty.

Disadvantages

  • Not all cash flows covered

  • Not realistic & ignores profitability.

  • Neglects the projects return on investment.

Accounting Rate of Return

The accounting rate of return is the rate of return expected from the project. It also is calculated without discounting that is the profit that company will earn on investing in the project without time value of money (Sherman 2015). This is very simple and helps to ascertain the profit or return from the project.

Advantages

  • Computation of ARR is simple and straightforward to compute.

  • The main focus is on the net operating income. It is used by the interested parties to assess the management performance

Disadvantages

  • ARR does not consider the time value of money. This method assumes that a dollar in hand is equal to the dollar received

  • Cash is vital for the business. Hence, generation of higher cash inflow leads to investment opportunities in other projects. However, it stress upon accounting net profit instead cash flow

  • Not regular over the life of the project. Hence, a project might be desirable in one stage while undesirable in another

Net Present Value

Net present value is the most commonly used method of investment appraisal. It is simple and also takes consideration of the time value of money. This very essential as the purchasing power of the money decreases as time passes due to inflation and other factors. This is called the time value of money. The expected rate or required rate of return from the shareholders is to be calculated which is a difficult task but without it, the net present value cannot be calculated. The management may assume the rate of return at which the cash flows of the project are required to be discounted (Shuli 2011). Thus using the present value discounting table the cash flows both inflows, as well as outflows, are discounted and brought to the present value.

This means that the cash flow at a specific time period is discounted in such a manner that the present value is received. The present value means the current price or the purchasing power of that money (Ferris, Noronha & Unlu 2011). It is simply the amount of money that if invested today will amount the specific amount at that time at the return of the rate of discount. Thus when all the cash inflows and outflows present value is computed the difference between the both is known as the present value. This net present value helps in the decision making to the management. The positive present value represents that the project is able to earn the return more than the discounting rate and the project should be accepted.

The negative net present value represents that the project is not able to earn the required rate of return from the project that is the discounting rate and the project should be rejected. If the net present value of the project is zero that means the project is able to earn the expected rate of return by the management and the project should be accepted (Gowthrope 2011). The decision of the management may depend upon other factors also like some nonmonetary factors which may lead to a different decision as suggested by the method. This is very useful for management in decision making and helps easy evaluation of the projects.

Advantages

  • Assumption of Reinvestment.

  • Accepts conventional cash flow pattern.

  • Consideration of all Cash Flows.

  • Good measure of profitability.

Disadvantages

  • Sunk cost is not considered

  • Opportunity cost estimation is an issue

  • Determination of the required rate of return is difficult.

Internal Rate of Return

The internal rate of return is the rate that is project will generate. The discounted cash flows are compared with the initial investments, thus rate brings the discounted cash flow in par with the initial investments. At this point, the net present value is zero as the rate is calculated with the trial and error method to find the rate at which the discounted cash flow is equal to the initial outflow of funds (Lapsley 2012). This means the present value of the cash inflow is equal to the present value of the cash outflows.

Advantages

  • Return is easy to understand.

  • Considers the Time Value of Money in calculation.

  • Consideration of all Cash Flows.

  • Good measure of profitability.

Disadvantages

  • It ignores the size of the project.

  • It also ignores the timing of the cash flow as to when it is generated.

  • It is problematic in modern cash flow pattern having multiple Internal Rate of Return, it is best in conventional cash flow method only.

Profitability Index

The profitability index calculated the return per unit of money invested. That is the profit per unit of initial cash outflows. The calculation is done by dividing the present value of cash inflows by the initial outflow of cash. It is a different presentation of the net present value. It also helps in the case when the decision between various projects is required to be taken. The decision of choosing the investment in a project as done by comparing the profitability index and the project with the highest index is preferred over the other projects (Laux 2014).

Advantages

  • Return is easy to understand.

  • Considers the Time Value of Money in calculation.

  • Helps in the comparison between different projects.

  • Good measure of profitability.

Disadvantages

  • Size the project is ignored

Thus we have understood the various methods of evaluating the projects and take the final decision on the project. The management can make decision on the basis of analysis and results of the investment appraisal techniques that the project will be able to meet the required rate of return of the management and based on which required actions to be taken (Madura & Fox 2011).

Part II: Sources of Finance

Pear Ltd is to do a huge investment in building this production facility. Since the net present value of the project is positive that means the project is able to earn or expected to earn more than the required rate to the company of 12%. The decision should be in favor of continuing the production facility development. The second step is to determine the sources of funds from where the required investment is required to be done. There are various sources from which funding may do that is either an internal source of financing and external sources of financing.

The internal sources include retained earnings, equity capital issue, etc. and on the other hand, external financing includes bank loans, hire purchase, debentures, etc. Different sources of finance have different obligations and cost associated with it and should choose that source which has fewer obligations with low cost of capital. This will hamper the cost of capital and thus the required rate of return from the project. The lower the cost of capital the higher the net gains from the project and higher the benefit to the stakeholders of the company and its management (Melville 2013). Let us discuss some of the sources of finance which can be used by Pear Ltd:

Retained Earnings

The retained earnings are the most secured source of the funds available to any company. The cost of the capital is not zero as it may seem. The retained earnings are the profits of the existing shareholders of the company not distributed as dividends and can be considered as an additional investment by the shareholders of the company (Mersland & Urgeghe 2013). The cost is the same as the cost of the equity but the advantage is that it does not require cash outflow and is readily available. Thus it is a self-dependence source of funds and does not require approaching any third party for approval.

It does create any fixed charge on the profits of the company thus it is beneficial and appropriate for the projects which will generate return after a period of time on which investment is required to be done now. This saves the interest expense during the development phase of the project. Since it is the internally generated fund it does not require compliance of any formalities or huge documentation, which involves cost and time associated with it.

The disadvantage of such a source of funds is that the shareholders who have earned the profit for the period are deprived of it as the profit is not distributed as dividends and reinvested in the company (Mersland & Urgeghe 2013). This gives the powers in the hands of the management to use the money of the shareholders and thus chances of the misuse of the money also arise. This process increases the equity in the company and may lead to overcapitalization that is excess of capital blocked in the company. Thus it is the most secure and effective source of funds and should be used prudently to maintain the confidence of various stakeholders.

Bank Lending

The most common form of outside funding is through the bank and other institutes. The funds are available for both long as well as short term financing. The short term financing can be obtained in the form of the overdrafts, cash credits, bill discounting, etc and long term finance can be in the form of hire purchase, loan for working capital, purchase of the fixed assets, etc. This variety of financing options is available with the banks to the corporate (Petersen & Plenborg 2012). The advantage of the bank loan is that it does not take part in the ownership of the company and the powers of managing the company remain with its management.

The obligation of the bank loans ceases as soon as the loan has been paid off and relationship or obligation hamper the company in the long run. The option is available to get the loan at a fixed rate as well as on a floating rate (Petersen & Plenborg 2012). The decision depends upon the interest rate fluctuation estimation of the loan taker. If the expectation that the interest is going to rise than the fixed rate of interest will be preferred and on the other hand when the rate of interest is expected to fall the floating rate option will be chosen.

The hedging against fluctuating interest rates can be done as per the requirements. Apart from this advantage bank loans also have certain disadvantages that it is difficult to obtain as lots of documentation is required to be done and good track records are checked by the bank before granting such loans and advances. The bank loans also require certain security against which the loan is granted (Madura & Fox 2011). The directors of the company many times provide their personal assets as security and in case of any adverse situation, the personal liability of the directors also arises as the personal assets are at stake.

Leasing

The major expense of today’s business setup is done in the form of fixed assets. This involves large sums to be paid at the initial stage. A better alternative to this will be acquiring the assets on lease. In this arrangement, the asset is owned by someone else but on payment of fixed monthly premium is used by the company (Vernimmen 2017). The testing equipment of 2.5 million can be taken on the lease so that full amount need not be paid at the start of the project but in installment over the use of the asset when the return will also start from the project.

Government Assistance

The government in order to support some trade areas or for up-gradation of some geographically backward areas gives various incentives and subsidies. This is available for selected areas and trade options but the setting up of the business as per government guidelines benefits the initial ventures as well as further growth of the company (Vernimmen 2017). The government is also supporting new ideas by investing and supporting venture capitalists.

Franchising

The franchising is becoming popular in recent years. It is the method by which the brand and setup of the given business are used by anyone who is ready to pay a fixed initial fee and entre the business. This is the procedure by which a brand is made available in various corners of the world without investing large amounts in the setup. The Franchisee also gets the guidance and help from the experienced player of the business in which he is willing to invest (Hitchner 2016). Thus both parties have mutual benefits in this arrangement. The business expansion via this method is very cost-effective and also the responsible and reliable person is there to manage the business. The company is already in this business line having a 30% market share thus the goodwill of the company can be used and some contracts would benefit the company.

Thus out of various options the Pear Ltd should check are available to it and the option which will have most benefit as it is a long project on which revenue will start to generate after or more than 2 years till than the cost has to be the beard and at higher the interest the less is the effective return from the investment. The company should keep its overall cost of capital below 12% as at this point the net present value is coming as positive.

Part III: Working Capital

The working capital is an essential element of company funding and financial planning. The working capital is the difference between the current assets and liabilities of the company. It is the funds blocked in the regular operating cycle of the company (Beaver, Correia & McNichols 2012). The funds are blocked in the form of inventories, account receivables, prepaid expenses paid, and many others. The source of financing the working capital to some extent is done by creditors and other payables, bank overdrafts, etc. But this source does not fully cover the working capital investment. The working capital cannot be withdrawn as this will hamper the smooth running of the business (Beaver, Correia & McNichols 2012).

In the given case the company is planning for capital investment in a project thus the minimum funds should be blocked in working capital as this will reduce the dependence on an external source of funds and also does not increase the burden on company profits. The company should use its resources in the most efficient and effective manner so as to ensure the proper flow of funds to meet its short term obligations as when they become due.

Working Capital Management is an ongoing and essential responsibility of the management. The control of the working capital can be attained from ratio analysis. The major ratios which help in controlling the working capital are the current ratio, receivables ratio, and inventory ratio (Peirson et al 2015). Thus the monitoring of the cash flows, current assets, and current liability is required to be done.

The working capital management helps the company to improve its earnings and profitability through the best use of its resources. The management of inventory ensures that there is a required amount inventory present and no excess or shortage of inventory occurs. This ensures that funds are not engaged in the form of inventory. The management of the trade receivable ensures the timely collection of the funds from the debtors and reduction in the chances of the bad debts (Atril 2014). The management of the trade payables ensures that the goodwill of the entity is maintained and undue additional finance charges are not charged on the company and the bargaining power of the company is good so as to fetch the materials at best prices (Sherman 2015).

It depends upon industry to industries the amount of working capital employed by the entity. Thus the Pear Ltd should make effective use of the above strategies to gain in the long term growth of the company.

Part IV: Recommendations and Conclusion

From the above case study, it is clear that the Company is planning to make a huge investment that will make its market share to 1.5 times from now. Thus within 3 years of production, the market share will keep on growing, since the industry is also growing at a much higher rate the benefit of such growth will also be received by the company. The Company is having the positive net present value keeping the discounting rate as 12% and projection up to 7 years from now. The project is promising and the company as shown by its budget should invest in the project.

For investing in the project the company should use its own funds like retained earnings and go for equity issues if required. The machinery required may be taken on hire purchase or lease agreement. If further required the company may also go bank lending. The source of finance should be such that the finance cost is least.

The company should properly run the operation of its existing as well as new units to make the best use of its available resources. The working capital not only smoothens the cash flow but also is very cost-effective and increases the profitability of the company. The company should use just in time inventory method to reduce the amount invested in the inventory and its storing. The credit to the customers should be monitored and reduced and on the other hand, the credit terms from the suppliers should be increased in the initial stage. Thus all these small steps will effectively make the project successful. 

References

Atril, P. (2014). Financial Ratios. In: Financial Management for Decision Makers, (7th Edition). Pearson Education Limited, p. 70.

Beaver, W.H., Correia, M., McNichols, M.F. (2012). Do differences in financial reporting attributes impair the predictive ability of financial ratios for bankruptcy? Review of Accounting Studies, 17(4)

Bellandi, F. (2017) Materiality in financial reporting. Bingley: Emerald Publishing Limited.

Carlon, S. (2019). Financial accounting: reporting, analysis and decision making (6th ed). Milton, QLD John Wiley and Sons Australia, Ltd

Deegan, C. M. (2016) Financial accounting. 8e edn. North Ryde, N.S.W.: McGraw-Hill Education.

Ferris, S.P., Noronha, G. & Unlu, E. (2010). The more, merrier: an international analysis of the frequency of dividend payment. Journal of Business Finance andAccounting, 37(1), 148–70. doi: 10.1111/j.1468-5957.2009.02174.x

Gowthrope, C. (2011). Business accounting and finance for non specialists (3rd ed.), South Western

Hitchner, J. R. (2016) Financial valuation. 4th edn. Somerset: John Wiley & Sons

Lapsley, I. (2012). Commentary: Financial Accountability & Management. Qualitative Research in Accounting & Management. 9(3), 291-292

Laux, B. (2014). Discussion of The role of revenue recognition in performance reporting. Accounting and Business Research. 44(4), 380-382. doi: 10.1080/00014788.2014.897867

Madura, R., & Fox, J 2011, International financial management, South Western

Madura, R., & Fox, J. (2011). International financial management, South Western

Melville, A. (2013). International Financial Reporting – A Practical Guide (4th ed). Pearson, Education Limited, UK

Mersland, R., & Urgeghe, L . (2013)International Debt Financing and Performance of Microfinance Institutions, Strategic Change. 22, 36-47, DOI 10.1002/jsc.1919.

Mersland, R., & Urgeghe, L. (2013). International Debt Financing and Performance of Microfinance Institutions. Strategic Change, 22, 36-47.

Peirson, G, Brown, R., Easton, S, Howard, P. & Pinder, S. (2015). Finance, 12th ed. North Ryde: McGraw-Hill Australia.

Petersen, C. and Plenborg, T. (2012). Financial statement analysis, Harlow, England: Financial Times/Prentice Hall.

Sherman, E. (2015). A manager's guide to financial analysis : Powerful tools for analyzing the numbers and making the best decisions for your business (6th ed) Ama Self-Study 

Sherman, E. (2015). A manager's guide to financial analysis : Powerful tools for analyzing the numbers and making the best decisions for your business (6th ed) Ama Self-Study 

Shuli, I. (2011). Earnings management and the quality of the financial reporting. Perspective of Innovation in Economics and Buisness (PIEB), 8 (2), 45- 48. doi: 10.15208/pieb.2011.28

Vernimmen, P. (2017) Corporate finance : theory and practice. Fifth edn. Hoboken: Wiley.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Financial Management Assignment Help

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