Cost of Finance and Planning

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CEE HND Business

Course Title: Managing Finance

Semester: April July 2010

Time: Morning Batch

Assignment Title

Cost of Finance

&

Financial Planning

Rashida Yvonne Campbell


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Contents Page

Assignment Description 3

Deciding the location 4

Cost of Issuing Shares 4

Cost of Bank Loan 5

Cost of Retained Earnings 7

Cost of Competitor investment 8

Recommendation 9

Quartz Corporation 10

Altitude Training Centre 11

Task BFinancial Planning 13

Capital Structure 14

Dividend Decisions 15

Investment Decisions 16

Budgeting 17

Working Capital 17

Conclusion 18


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Deciding the locationThe first part of the scenario requires a decision to be made on either choosing location 1,

or location 2.

Choosing location 1 would require an investment of 10,000,000 with a benefit of 25%

increase in sales per year.Calculation: 10,000,000 x 25 = 2.5 million (2,500,000)

100

Choosing location 2 would require an investment of 8,000,000 with a benefit of 10%

increase in sales per year.

Calculation: 8,000,000 x 10 = 800,000 million (0.8 million)

100

Taking option 1 provides an opportunity cost of

Calculation: 2,500,000 800,000 = 1,700,000 million (1.7 million)

Therefore taking location 1 provides more profits a t an opportunity cost of 1.7 million

more. ACB should choose location 1. The second part of the task is to evaluate the different

costs of the sources of finance given for option A, B, C and D.

A Issuing of new 1 million shares at 10 each would raise the total of 10

million pounds required for the relocation.Calculation: 1,000,000 shares x 10 = 10 million

Cost benefitsof issuing sharesto raise finance are:

y The company will avoid using its retained profitsy Retained earnings can be used for other purposes such as : pay out its profits

between the existing share holders , Invest into stocks etc.

y By holding its retained earnings the balance sheet will not be affect.y Avoids taking bank loans and re-paying the interest.y Dividends on shares only need to be paid if the company makes a profit

Cost disadvantage of issuing shares to raise finance are:

y New shares means present shareholders ownership is reduced.y There may not be any buyers (no demand) for the new shares, leaving the company

with insufficient funds for the venture.

y When a company announces the issue of new shares it leads to speculations that thecompany has financial problems and that the firm may be entering into risky

businesses.

y New shareholders expect the share value to increase so that they can sell the sharesat a later date earn a profit.

y New shareholders expect to receive a return on the investment in the form ofdividends.

y Issuing shares has costs involved such as administrative and legal costs.y Time factors means that to raise finance in this way will not always be immediate it

takes time to arrange and to receive buyers of the new shares.


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B Bank loan 10 million at 7% interest rate per annum for 10 years Calculation Costsfor the bank loan source of finance would be:

10,000,000 x 7% = 700,000 per annum or (0.7 million)

100

Over a period of 10 years 0.7million x 10 years = 7,000,000

Total interest rate payable over 10 years for the amount borrowed = 7 million

So the bank loan of 10m investment receives 25% profit of 2.5m minus 7% interest

Calculation:

2.5m profit 0.7% interest = 1.8 million net profit

Opportunity cost:

2.5m 1.8m = 0.7 million (700,000)

Therefore 2.5 million is the gross profit after interest payments of 0.7 million net profits

are 1.8 million, to calculate in percentage terms:

Percentage profit:

1.8m net profit x 100 = 72% profit earned

2.5 m gross profit

Cost benefits of the bank loan source of finance are:y Companies can take advantage of Tax Relief on the profits before deducting the

interest. In this case:

Calculation Tax Relief:

Gross profit = 2.5 million

Interest charge = 0.7 million

Net profit =1.8 million

Tax without interest payments means the gross profit 2.5 million would be taxable. Due to

interest payments now Tax Relief can be applied, only the net profit 1.8 million is taxable.

As an example if we take the Tax rate at 10% the calculation are as follows:

Gross profit 2.5m x 10% tax = 250,000

100

On 2.5 million tax payable i s 250,000

Net profit 1.8 x 10% tax = 180,000

100

On 1.8 million tax payable is 180,000

A difference of 250,000 -180,000 = 70,000 Tax Relief Benefit


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y Another benefit of the bank loan means that the company will maintain its retainedearnings and would not need to issue new shares to raise the finance. When

retained earnings are untouched it indicates on the cash flow statement that the

company has no cash flow problems. Cash flow is important for the firm to run

smoothly, to purchase raw materials, payment of wages and meeting other

operating costs.

Cost disadvantages of bank loan as a source of financey Commercial loans usually carry high interest rates.y Opportunity cost means that instead of paying 0.7 million in interest payments a

year the business could do something else with this money such as marketing &

promotion which could generate further profits for the company for example

1million. Taking the loan and paying interest means that the opportunity to earn

this possible 1million is lo st.

y Another disadvantage is security, if the loan is secured on assets of the business,then the company has limitations as to what it can do with that asset, such as selling

it would not be possible if it is held as a security.

C Use retained earnings a balance of 25million last years balance sheetIf the company decides to withdraw 10million from retained earnings of 25million

calculations are as follows:

25million retained earnings -10million for relocation = 15millionRetained earnings balance = 15 million

The term retained earnings refers to the organisations cumulative net income minus the

cumulative amount of dividends declared. To show large amounts or retained earnings onthe balance sheet is important for the c alculation of stockholders equity. If retained

earnings of 10m are used for the relocation assuming it will receive a benefit of 25%,

therefore:

10m x 25% profit = 2.5m gross profit with no interest payments (but other costs must be

deducted such as tax, working capital etc)

Therefore the balance of retained earnings needs to be considered again as part of the 25%

profit will be added to the total sum of the retained earnings from the last balance.

However it would take a long time before the company ben efited from the 25% profit

earned to reach its original balance of 25m.

Retained earnings are essential from the perspective of shareholders because the balance ofretained earnings are debited and credited to the current liabilities of dividends payable , the

declaration of cash dividends reduces Retained Earnings, an example of how it decreases is

as follows:


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Should the company decide to withdraw 10m from retained earnings as a source of finance

for the relocation project the statement would show as follows: (an example only)

Therefore when investors compare last years statement it appears more promising and

attractive to creditors than this years statement. It shows retained earnings as spent

elsewhere rather than in the form of higher dividends payment.

Cost benefits of using Retained Earnings as a source of finance

y The money is available no waiting time.y No need to pay interest rates on loans.y Goods for short-term usage.y Businesses have to pay tax on their earnings so reducing the amount of earnings by

investing elsewhere the amount taxable is reduced

Cost disadvantages of using Retained Earnings as a source of financey A business needs its earnings to pay for such things as wages, rent, materials, utilities

etc. Otherwise workers will leave and production will be reduced. Only through the

selling of goods will a company generate profit. Retained earnings are needs for

working capital for the survival of the company.

y Dividends need to be paid for the cost of the share capital. If this is not metshareholders lose loyalty in the company.

ACB Training Company

Statement of Retained Earnings 2009

Retained Earnings 2009 25,000,000

Net Income 1,000, 000

Total 26,000,000

Less Dividends 500,000


ACB Training Company

Statement of Retained Earnings 2010


Relocation project 2010 10,000,000

15,000,000

Net Income 1,000,000

Total 16,000,000

Less Dividends 500,000



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y Opportunity cost must be considered. If 10m of retained earnings is used forrelocation then this reduces the amount of capital for other projects. If the other

projects can generate a profit of 37% then the cost of using the 10m for relocation

is the 37% profit foregone.

y The total amount shown as retained earnings may not be the total amount that isavailable in cash. It may be in the form of assets or liquidity, or tied up in other

investments.

D Competitor Company will raise the finance for 80% of the profits.The calculations for this source of finance are as follows:

10m at 25% = 2.5m profit

If the competitor takes 80% of the profits the calculations are as follow:

2.5m profit x 80% to competitor = 2 million will go to the competitor

100

The remaining profit left for ACB Trai ning would be 500,000 (0.5m)

Therefore the opportunity cost = 2 million foregone

The competitors percentage profit for its investment would be:

2,000,000 x 100 = 20% profit

10,000,000

The percentage profit for ACB Training = 5%

Cost benefits of using competitor as a source of finance

y The competitor is no longer a competitor for example Sony -Ericson.y Both companies can join their resources together to improve and add value to their

products or services.

y The experience of two companies is better than one.y The risk of the 10 million has been shifted to the competitory When companies join in ventures they become larger and can take on more and new

projects

Cost disadvantages of using competitor as a source of financey Loss of majority of the profits.y Ownership is reduced.y Decision making is divided reducing the power and authority of the original owners.y May need to make redundancies as the number of employees increase when tw o

companies join.

y If the venture does not succeed the competitor can pull out of the contract and willhave obtained internal confidential information.


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RecommendationManagement must identify the "optimal mix" of financing the capital structure where the

cost of capital is minimized so that the firm's value can be maximized. It is important to

show that on the one hand a company pays out dividends and on the other hand they re -

invest its profits wisely in order to make new profits, but chooses the rig ht combination of

financial mix and considers the cost involved.

It would therefore be recommendable for ACB-Training to consider using a mixture of both

retained earnings and the bank loan. Withdraw 5 million from retained earnings and 5

million from the bank at an interest rate of 7%. This would result in the company benefiting

from reduced interest payments and the length of time for the loan. The percentage profit

the firm would make is greater. The reduction of 5 million from retained earnings of 2 5

million would be a more reasonable amount left on th e balance sheet of 20 million and 5

million shown as investment activities is more likely to be accepted by shareholders and

other creditors. This method also means that the opportunity cost enhances the financial

choices rather than hinder them.

Benefits for this decision are calculated below (as an example)

Bank Loan 5 million

Retained Earnings 5 million

5 million bank loan at 7% interest rate: 5,000,000 x 7% = 350,000 interest per annum

100

If ACB-Training relies on the bank for 5 million the total amount of interest payable for the

period of 10 years:

350,000 per annum x 10 years = 3.5 million

Rate of Return on 10 million: 10m x 25% = 2.5 million

Therefore gross profit: 2,500,000 million

Interest payable: 350,000

Net profit: 2,150,000

Percentage profit 5m Retained Earnings 2,150,000 x 100 = 43%

5,000,000

The banks percentage profit is: 350,000 interest x 100 = 7%

5,000,000

If ACB-Training relies on the bank for the full 10m the total amount of interest payable for

the period of 10 years:

10,000,000 x 7% = 700,000 per annum or (0.7 million)

100

Over a period of 10 years 0.7million x 10 years = 7,000,000

Total interest rate payable over 10 years for the amount borrowed = 7 million for the

10m borrowedcompared to 3.5 million for the 5m borrowed


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A major benefit of raising 5 million from the bank and 5 million from retained earnings is

the advantage of the leverage (gearing) effect. From the calculations above we can see the

benefits of the leverage effect:

10 million retained earnings gives a percentage profit of 25% as calculated below:

2.5m profit x 100 = 25%

10m retained earnings

5 million retained earnings gives a percentage net profit of 43% as calculated below:

2,150,000 net profit x 100 = 43%

5m retained earnings

The solution chosen according to the above findings is therefore to withdraw 5m from

retained earnings and 5m as a bank loan at 7%. This also spreads the risk, but allowing

ACB-Training to maintain a good level of retained earnings without reducing their ownership

control and power in decision making should they have chosen any of the above options.

Businesses are always requiring extra finance for a variety of reasons, usually for expansion

and growth. The impact of a financing option on the financial statements of the business will

affect different users of this information. Due to legal requirements financial movements of

the company must be reported in the balance sheets. Two companies have been chosen to

illustrate their methods for raising finance: Quartz a large global organisation and Altitude

Training Centre a small firm owned by 4 people.

http://www.principlesofaccounting.com/chapter%201.htm


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Analys ng the above information regarding Quartz Corporation wecan see that the

company has previously raised finance through share issues as now they areshowing

payment of dividends to shareholders and this has been deducted from the retained

earnings in the Statement of Retained Earnings It can be identified in the statement of

cash flows Quartz has withdrawn from itsearnings to fund in In

stin

ti

iti

s to

pu

h

s

l

nd

t $250 000. If the investing activities was not deducted thecash for

December would be352 000. Lets assume that the $250 000can generate aprofit of35

the profit would be

$250 000 x 35 = $87 000

100

ost financial managers would calculate to see if the percentage benefits are worth raising

funds from internal sources of thecompany. If the percentage on the return on investment

will provide a good return then using retained earnings is a better choice.The reasons for

raising thissource of finance avoids time delays interest payments and the profits

generated will be put bac into thecompany and not shared through alternative investors.If

a company has a good amount of retained earnings as for thecase of Quartz it is advisable

to raise its finance using its own retained earnings.

Another company operating in Dubai Academiccity is run and owned by4 people their

business isexpanding and they need to move from their small office to a larger office within

thesamecomplex. The four owners initially invested their own privatesavings to start up

the business. However for the new premises theychoose to raise finance through a long

term loan and retained earnings. Thecompanyexpects to receive additional increases of

40 generated from the new office premises. The interest rate payable is10 over 5years.

The financial statements are as follows

http://www.altitudetrain.com/

Retained Earnings as at 31 December 20XX

AED (Dirhams

Retained earnings 200 000

et income 100 000

300 000

Lesssharecapital 90 000

Retained earnings31 Dec 210

000

Statement ofcash flows31 December 20XX

AED (Dirhams AED

Retained earnings31 Dec 210 000Investing new ! ffices 100 " 000

Financed by:

Cash 60 " 000

Loan 40 " 000

100 " 000

Retained earnings1st

Jan 150 " 000


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This second example shows that the company has used two sources of finance to move to

the new office premises. The company has withdrawn 60,000 AED cash from retained

earnings and 40,000 AED as a bank loan. The total amount required is 100,000 AED with

expected increase in profits of 40%. The calculations are as follows:

40,000 AED bank loan at 10% interest: 40,000 x 10% interest = 4,000 AED

100

Rate of return 100,000 A ED at 40%: 100,000 x 40% = 40,000 AED

100

Therefore Gross profit: 40,000 AED

Interest payable -4,000 AED

Net profit: 36,000 AED

Percentage profit retained earnings: 36,000 AED x 100 =60%Taking advantage of the loan 60,000 AED

If Altitude Training Centre used all 100,000 AED from retained earning their percentage

profit would be:

40,000 x 100 = 40%

100,000

Again this example shows the leverage effect that companies can benefit from. Also the

other benefit of not using the total amount required from retained earnings is should the

company need further investors at a later stage in the future the balance sheet will show

that the company has plenty of cash. Cash offers protection against tough times, and it alsogives companies more options for future growth. Growing cash reserves often signal strong

company performance. The balance sheet, tells you how much a company owns (its assets),

and how much it owes (its liabilities). The differe nce between what it owns and what it

owes is its equity, also commonly called "net assets" or "shareholders equity". The balance

sheet tells investors a lot about a company's fundamentals: how much debt the company

has, how much it needs to collect from cu stomers (and how fast it does so), how much cash

and equivalents it possesses and what kinds of funds the company has generated over time.


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Task B:Write an essay on the importance of financial planning and how the needs of decisions

makers can be met?

Financial planning is the task of determining how a business will afford to achieve its strategic goals

and objectives. Usually, a company creates a Financial Plan immediately after the vision and

objectives have been set. The Financial Plan describes each of the activities, resources, equipment

and materials that are needed to achieve these objectives, as well as the timeframes involved.

Financial plan can be a budget, a plan for spending and saving future income. This plan allocates

future income to various types of expenses, such as rent or utilities, and also reserves some income

for short-term and long-term savings. A financial plan can also be an investment plan, which

allocates savings to various assets or projects expected to produce future income, such as a new

business or product line or shares in an existing business. In business, a financial plan can refer to

the three primary financial statements (balance sheet, income statement, and cash flow statement)

created within a business plan. Financial forecast or financial plan can also refer to an annual

projection of income and expenses for a company, division or department. A financial plan can also

be an estimation of cash needs and a decision on how to raise the cash, such as through borrowing

or issuing additional shares in a company. While a financial plan refers to estimating future income,

expenses and assets, a financing plan or finance plan usually refers to the means by which cash will

be acquired to cover future expenses, for instance through earning, borrowing or using saved cash

(retained earnings).

The steps to financial planning are:

y Deciding on the Capital structure and sour ces of long-term funds.y Dividend decisions; how much profit is to be retained or paid out.y Investment decisions; how much funds should be invested in each asset.y Management of budgetingy Working capital; purchasing of goods for trade, wages etc.

Financial planning is conducted by the financial manager and finance department of an

organisation. It involves the above four kinds of decisions.

Capital structure refers to the way an organisation has arranged its funding between

ordinary shares, preference shares, and debentures. Its importance is that shares pay

dividends which may be waived in bad trading years, whereas debentures pay interest

which cannot be avoided. Usually companies receive their long -term funds for investment

from these two main sources. How much capital a company requires is how much it should

rise through these two sources. Capital structure decision is regarding how much

percentage of capital is raised through equity or debt. It shows the overall investment and

financing strategy of the firm. Capital structure can be of various kinds, an example a capital

structure strategy is Horizontal Capital Structure#

this strategy is where the firm aims to

have zero debt in the structure mix. Expansion of the firm will raise finance through retainedearnings and equity. Capital structure reflects the firms strategy; it shows the risk profile of

the company, it acts as a tax management tool, helps to minimize risk and maximize profits.

Capital structure can be used to build up firms assets.


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How Capital Structure affects the needs of the different decision makers .

y Corporate strategy top managers and directors to make certain that the capitalstructure will assist in meeting the overal l vision of the company, its long term aims

in size and profitability.

y Stock-market decision makers need the information of a companys capital structureto decide whether to buy or sell.

y Shareholders require the capital structure of a firm; to determine w hether or not toinvest.

y Government also need the capital structure information for taxation purposes.y Other creditors such as banks require capital structure information when deciding if

it will finance a loan for the company.

Dividend decisions: is a decision made by the directors of a company. It relates to how

much of the profits should be retained, re-invested or paid out to shareholders. Decisions

are made about the amount and timing of any cash payments made to the company's

stockholders. The decision is an important one for the firm as it may influence its capital

structure and stock price. In addition, the decision may determine the amount of taxation

that stockholders pay. There are three main factors that may influence a firm's dividend

decision: Free-cash flow; Dividend clienteles and Information signalling.

Free cash flow dividends is when the firm simply pays out, as dividends, any cash that is

surplus after it re-invests in positive projects.

Dividend clienteles: If clienteles exist for particular patterns of dividend payments, a firm

may be able to maximise its stock price and minimise its cost of capital by catering to a

particular clientele. This model may help to explain the relatively consistent dividend

policies followed by most listed companies.

Information signalling: Managers have more information than investors about the firm, and

such information may enlighten their dividend decision making. Managers that have access

to information that indicates very good future prospects for the firm are more likely to

increase dividends.

How Dividend decisions affect different decision makers

y Investors can use this knowledge about managers' behaviour to inform their decisionto buy or sell the firm's stock, bidding the price up in the case of a positive dividend

surprise, or selling it down when dividends do not meet expectations.

y Stock market speculators and investorsy Competitors to scan on the companys success or failurey Internal and external shareholders

Investment Decisions: The investment manager has to make decisions on how the capital

and profits collected by a firm are spent. Decisions such as re-investment, purchasing of

more stock to secure future sales, or held back in savings, increase asset s, split the

investments into the various strategic business units to fund more projects such as research

and development. The investment manager must perform ongoing monitoring of

investments. The manager has to consider the rate of return, risk, safety, liquidity and the

time period.


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How investment decisions affect different decision makers

The key role belongs to the Investment manager of the company his choices will affect a

variety of different people and departments:

y Employees in the stock departmenty Research and development employees would require the investment decisions of

the company to confirm if they are going to receive funding for there research

y Human resources need investment funding for the head count for the number ofemployees each division and is allowed

y Sales managers acquire the knowledge of investment decisions, should theinvestment manager decide not to fund in new or more products the sales team

would no longer be able to make bonuses from these products. Travelling would also

be reduced

y Creditors and banker also use the information of the investment decisions acompany has made. So bankers can determine level and length of any loans.

y Business development units like marketing rely on investments from within its ownorganisation to fund future marketing venture s

y Project managers also rely on investment funding and need to know the decisions ofthe investment manager regarding current and future projects.

Budgeting:

Budgeting is part of the financial planning process; it explains in monetary terms the plan for

the income, expenditure and capital investment (buying fixed assets). Budgeting helps to

determine if a firm's long term investments such as new machinery, replacement machinery, new

plants, new products, and research development projects are worth pursuing. It ensures that no

department or individual spends more than the company expects. Steps to budgeting:

y Make judgements on the likely sales revenue for the coming yeary Set a cost ceiling that allows for an acceptable level of profit y The budget for the whol e company is then broken down into division, department or

by the cost centre.

y The budget maybe broken down further for each manager and gives them somespending power

y Budgets are then monitoredBudgeting helps to ensure the objectives of the organisation. It helps to compel planning

and decision making. It communicates ideas and plans to the company. It co -ordinates

activities. It gives a framework for responsibility. It establishes a system of monitoring and

control.

How budgeting decisions affect differ ent decision makers:

y Budgeting will affect all departments and divisions of the organisation y Suppliers are also affect by budgeting the companys choice of expenditure will

impact the amount of profit a supplier is able to make

y Directors need to agree on the master budget for the wholey Regional managers will rely on the budget decisions of the directors so they can

allocate a budget to each branch manager

y Branch managers rely on the previous decisions of budgets so they can divide thebudget between section managers

y Finally the shop floor workers help to meet the budget targets


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Working Capital

It is the day to day finance for running a business the formula is:

Current assets minus current liabilities = working capital

It is used for running costs, wages, raw materials and it also funds the credit offered to

customers (debtors) when making a sale. It is not the funds invested in fixed costs. If a firm

has too little working capital available it may struggle to finance increased production

without straining its liquidity position. If a firm has too much capital, in the short -term it

may not be able to afford the new machinery that could boost efficiency. Managers need to:

y Identify costs involved in making products, this is the first step to decide the sellin gprice

y Work out how many products they need to sell to make a profity Find out how much capital they need and the best way to obtain the capitaly Keep a tight control over the way in which the firms money is spent

How working capital affects different decision makers

All the organisational employees, departments, divisions, sections, all the way down to the

shop floor will base their decisions according to the way the working capital has been

planned. The main decision makers that it will affect are

y Suppliers, because too little working capital means not enough capital to pay bills ontime

y Banks, because the business will find it difficult to get loans if it has insufficientworking capital

y Stock department needs enough working capital to order more stocksy Employees will all be affected if there is not enough working capital to pay wages.

There are a range of people who are interested in the financial data and planning that a

company produces such as shareholders, creditors, competitors, governments/regulato rs,

auditors, employees, suppliers, customers, partners etc. They all base their decisions

according to the organisations financial planning. The main function of the financial plan is

to ensure objectives of the firm are being met. This is ultimately in the form of profits.

Although financial planning is complex it requires sophisticated using tools, techniques,

computer programs, decision making tools. The end result is basically to guarantee that

money and capital raised for the business is invested wise ly in order to receive a return in

the form of profits.

Documents

Cost of Finance and Planning