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Question 1

Critically evaluate the significance of the optimal structure of capital for an organization to maximize value for the shareholders

Question 2

Illustrate your knowledge in optimizing the value for the shareholders by suggesting solutions to the two scenarios that follows:

Scenario 1

Octopus Ltd has a paid up capital of RM160 million of RM1 each. It is considering the different options that it has to raise capital of RM 104m for the planned expansion of its operations, in view of the increasing demand for its products in the market. It has two

options:

i) It could take a long term loan at an interest rate of 10% a year, or

Ii) Issue rights to the existing shareholders in the ratio of 1:4 at a discounted price of RM2.60.

The company has no long-term borrowings. In the year to 31 December 2017, the operating profit (net profit before interest and taxation) was RM60m and it is expected that this will increase by 30% during the forthcoming year. The business is listed on the KL Stock Exchange and the share price as at 31 December was RM3.00.

If the first option is taken, it is estimated that the PE ratio will fall by 10% by the end of the forthcoming year. However, if the second option is taken, the PE ratio is expected to remain the same. Assume tax is at 25%.

You are required to:

1. a) Calculated the market value of an ordinary share in Octopus plc in one year’s time assuming:

(i) A rights issue is made

(ii) A loan issue is made.

1. b) Comment on your findings.
1. c) Discuss two sources of short-term financing and two sources of long-term financing that could be employed by firms.

Scenario 2

The consultant for Octopus Ltd. identified three projects. The estimated initial expenditure and the expected cash flow are presented below.

0 (80,000) (20,000) (20,000)

1 26,600 4,600 11,200

2 26,600 6,200 8,600

3 26,600 8,000 6,600

4 26,600 10,000 0

It can be assumed that in all other respects such as risk profiles for all the projects are completely comparable. Octopus Plc has a cost of capital of 10%.

You are required to:

1. a) Determine

i)Payback period;

ii)Accounting rate of return

iii) Net Present Value;

of the three projects.

1. b) Compare your results and advise the company which of the three projects the company should undertake. Your advice should explain why you regard your choice as the best.
1. c) Identify the advantages and disadvantages of any two tools of investment appraisal used above.

Instructions for the Management Report:

Your report (not exceeding 3500 words) should incorporate the following:

1. a) A concise overview of the nature of the tasks required for all the question as an introduction

(b) Main Body Each question of the sub task, using appropriate sub-headings.

(c) Conclusion and Recommendations for all the tasks assigned

(d) Citations and References - both in-text and end of the chapter

## Solution 1: Critical Evaluation of Significance of Optimal Capital Structure for an Organization to Maximize the Value for Shareholders

The purpose this report is to examine the use of various capital budgeting techniques and investment appraisal techniques to evaluate the two given scenarios. One scenario is related to investment appraisal methods for evaluating options of financing for increasing the shareholder value. Another scenario is related to the application of capital budgeting methods such as payback, net present value and accounting rate of return to evaluate the given three projects. On the basis of analysis best financing option and projects are being selected from scenario 1 and scenario 2 respectively.

Critical Evaluation of Significance of Optimal Capital Structure for an Organization to Maximize the Value for Shareholders

Optimal capital structure of an organization can be referred as adequate mix of debt and common stock that results in maximization of company stock and reducing the cost of capital. The decision of capital allocation is regarded as the most critical responsibility of the Chief Financial Officer (CFO) as the value created for shareholders is based on such strategic decision-making (Martin, 2011). The major objective of the CFO in this regard is to develop a best possible capital structure that reduces the financial risk of default and results in improving the cash inflows for creating large returns for the shareholders. In this context, it is essential for CFO to determine the ability of a business entity to meet the debt obligations and its effectiveness to use tax shield. The use of debt and equity during capital structuring decision must be made by considering such abilities of an entity (Ghosh, 2012). The optimal capital structure is referred to as the best capital allocation decision made by a company that results in minimizing the weighted average cost of capital and enhancing the market value. The reduction in the cost of capital will result in maximizing the market value and thereby creating larger returns for the shareholders. The business entities tend to adopt more use of debt in comparison to the equity as the cost of debt financing is regarded to be lower than equity finance. This is because entities tend to gain a tax benefit while dividend payments by adopting the use of equity finance need to be paid from after-tax income (Peterson and Fabozzi, 2002).

However, the company should place a limit on the amount of debt it should incorporate in its capital structure as it will lead to an increase in the financial obligation that is paying the interest amounts. As such, it will ultimately lead to an increase in the financial risk to the shareholders due to fluctuations in the cash flow realized by an entity. The increasing use of debt in the financial structure can prove to be beneficial for the companies that have consistent cash flows to maximize the returns realized by the shareholders. Thus, it can be said that optimal capital structure for the companies having consistent cash inflows will be higher percentage of debt and less use of equity. On the other hand, the business companies having fluctuations in the cash flows will consist of lower percentage of debt and higher proportion of equity (Martin, 2011).

## Solution 2: Financing Decision

There are two scenarios given in question 2 and both needs to be evaluated in order to provide knowledge in optimizing the value of shareholders:

Part A:

Given Information for both the options

 Paid Up Capital 160,000,000.00 Book Value per share 1 RM Total number of shares 160000000 Amount to be raised 104000000.00 EBIT 60000000.00 Tax Rate 25% Market price of ordinary share 3.00

Part A (i): Option: When right issue is made

 Evaluation of option: When right issue is made Market value of ordinary Share market price per share*total number of shares As calculation has to be after year of the option is taken so in that case there is need to take factors. Factors to be considered: Change in earnings Increase in number of shares Tax impact change in PE ratio Ratio in which right issue is made 1.4 New shares issued under right issue 40000000 Current number of ordinary shares 200000000 Change in EBIT 30% Existing EBIT RM     60,000,000.00 New EBIT RM     78,000,000.00 Interest Payment RM                             - Existing tax expenses @ 25% RM     15,000,000.00 New Tax Expenses @ 25% RM     19,500,000.00 Existing EAT or Net profit RM     45,000,000.00 New EAT or Net Profit RM     58,500,000.00 Existing EPS RM                        0.28 New EPS RM                        0.29 Existing PE Ratio Existing MPS/Existing EPS Change in PE Ratio No change New PE Ratio 10.67 Times New MPS RM                        3.12 Market Value of ordinary shares when right issue is made RM  624,000,000.00

Part A (ii): Option: When right issue is made

 Evaluation of option: When loan issue is made Market value of ordinary Share market price per share*total number of shares As calculation has to be after year of the option is taken so in that case there is need to take factors. Factors to be considered: Change in earnings Increase in number of shares Tax impact Interest expenses Total amount raised through long term loans 104000000.00 Interest Rate 10% Interest Expenses 10400000.00 Change in EBIT 30% Existing EBIT RM     60,000,000.00 New EBIT RM     78,000,000.00 Interest Payment RM     10,400,000.00 Existing EBT RM     60,000,000.00 Current EBT RM     67,600,000.00 Existing tax expenses @ 25% RM     15,000,000.00 New Tax Expenses @ 25% RM     16,900,000.00 Existing EAT or Net profit RM     45,000,000.00 New EAT or Net Profit RM     50,700,000.00 Existing EPS RM                        0.28 New EPS RM                        0.32 Existing PE Ratio Existing MPS/Existing EPS 10.67 Times PE ratio reduced Reduced by 10% New PE Ratio 9.60 Times New MPS RM                        3.04 Market Value of ordinary shares when loan issue is made RM  486,720,000.00

Part B: Comment on the finding gathered from the above analysis

The decision that has to be taken is to optimize the shareholders value through evaluating the different options to raise the capital for expansion purpose. The two options that have been provided in the scenario 1 are long term financing options and these are options are issue of right shares and long term loan at fixed interest rate of 10%. The required amount of capital that Octopus Limited needed to finance the expansion plan is RM 104 million. The decision was to chose one option that has highest market value of ordinary shares through evaluating the both the options of financing (Baker and Nofsinger, 2010).

The evaluation of both the options have provided following information:

 Comparasion of both the financing options Various Parameters When right issue has been used When loan issue is made Price Earning Ratio 10.67 9.60 EPS RM                       0.29 RM                        0.32 MPS RM                       3.12 RM                        3.04 Market Value RM  624,000,000.00 RM  486,720,000.00
 As the decision has to be based on the market value of ordinary shares it is highly recommended that Octopus Plc to chose right issue for the purpose of making the funding for expansion purpose.

Part C:

Two sources of short-term financing and two sources of long-term financing that could be employed by firms

The short-term sources of finance can be referred as the financing needs of a company for small period of time that is usually less than a year. This type of financing need of a business corporation is also referred as working capital financing that is mainly used to finance the inventory, accounts receivables and others. This type of financing option is mainly used by a business corporation requiring quick loan for meeting the operational expenses that will be repaid within a year.

Short-term Financing Source

The major sources of short-term financing options available to a business corporation can be discussed as follows:

Accounts Receivables

This method of financing is used by businesses mainly to borrow up to 90 per cent of the amount they owned in their outstanding invoices. In this method, a business entity usually takes the invoices to the banks providing discounting facilities and they make a payment in exchange of a small fee. The bank collects the due amount from the customer in a future date. The method is largely used by the businesses that provide large amount of credit. Such businesses can carry out their operational activities without relying on customers to pay the bills (Martin, 2011).

Bank Overdraft

The overdraft agreement enables a business corporation to gain funds to a specific limit from the bank. The businesses are required to pay the security in the form of some collateral and also are required to pay an interest amount daily on a variable rate on the outstanding debt. The business corporations that possess the ability of replying the funds taken quickly then they can adopt the use of overdraft agreement as a potential source of financing.

Long-term Financing Source

Long-term financing can be referred as the use of financing methods by a business corporation that have the time-frame of more than a year. Thus, it converts the sources of financing options that borrows funds for a longer period of time. The business may require such type of finances for expansion, diversification or innovation in the business operations. As such, it can be said that the use of such type of financing options enables a business entity to gain capital for meeting its long-term objectives and to manage the financing risk in a better way. The major types of long-term financing option that can be used by a business corporation are discussed as follows:

## Conclusion and Recommendations

Long-term loan

The business companies having long-term growth plans and higher credibility often adopts the use of loans that are taken from a bank to repay in longer period of time. The loans are usually taken by a business entity for meeting adequately the working capital needs. The use of bank loans enables a banking corporation to pay back it within a time frame of more than one year. This type of funding method is used by businesses to gain access to large amount of capital that does not need to be repaid immediately. The businesses are required to pay interest on the loan amount at regular intervals of time usually on a monthly basis. Bank loans are usually provided at a cost that is generally the interest amount paid by a banking corporation (Ghosh, 2012).

Equity Issue

Equity capital is also regarded as major source of long-term finance used by a business corporation that is raised in exchange for the share of ownership. This type of financing method gains funds from the owners of a business who possess a significantly control over its operational activities. The funds are realized by the investors who possess company shares and are paid divided in return of the amount contributed by them in the capital structure of a business entity. This type of financing method is also known as equity capital or share capital and the major advantage to a firm by using this type of financing method is that it does not have an obligation to redeem the equity shares (Shim, 2012).

This scenario is related to the application of capital budgeting technique to evaluate the three projects (A, B and C) through using payback, accounting rate of return and net present value. Octopus Limited is considering three projects which have different life cycle period and different cash inflows and outflows. So, it can be said that all the projects are mutually exclusive project and has no link with each other (Batra and Verma, 2014).

Cash flow generated by the different projects has been provided below:

 Year Project A Project B Project C 0 \$ (80,000.00) \$ (20,000.00) \$ (20,000.00) 1 \$   26,600.00 \$      4,600.00 \$   11,200.00 2 \$   26,600.00 \$      6,200.00 \$      8,600.00 3 \$   26,600.00 \$      8,000.00 \$      6,600.00 4 \$   26,600.00 \$   10,000.00 \$                   -

Part A (i): Payback Period

 Year Project A Project A Cash Flows Cumulative Cash Flows 0 \$ (80,000.00) \$    (80,000.00) 1 \$   26,600.00 \$    (53,400.00) 2 \$   26,600.00 \$    (26,800.00) 3 \$   26,600.00 \$          (200.00) 4 \$   26,600.00 \$      26,400.00 Payback period 3.0075
 Year Project B Project B Cash Flows Cumulative Cash Flows 0 \$ (20,000.00) \$    (20,000.00) 1 \$      4,600.00 \$    (15,400.00) 2 \$      6,200.00 \$      (9,200.00) 3 \$      8,000.00 \$      (1,200.00) 4 \$   10,000.00 \$         8,800.00 Payback period 3.1200 or 3 years 44 days
 Year Project C Project C Cash Flows Cumulative Cash Flows 0 \$ (20,000.00) \$    (20,000.00) 1 \$   11,200.00 \$      (8,800.00) 2 \$      8,600.00 \$          (200.00) 3 \$      6,600.00 \$         6,400.00 4 \$                   - Payback period 2.0303 or 2 years 11 days

Part A (ii): Accounting Rate of Return

 Accounting rate of return of Project A Year Project A Cash Flows 0 \$ (80,000.00) 1 \$   26,600.00 2 \$   26,600.00 3 \$   26,600.00 4 \$   26,600.00 Initial Investment \$   80,000.00 Depreciation \$                   - Salvage Value Assumed to be zero Average investment \$   40,000.00 Annual Depreciation (Initial Investment − Scrap Value) ÷ Useful Life in Years \$   20,000.00 Average Accounting Income Year Cash inflows Depreciation Net Cash inflows 1 \$      26,600.00 \$        20,000.00 \$              6,600.00 2 \$      26,600.00 \$        20,000.00 \$              6,600.00 3 \$      26,600.00 \$        20,000.00 \$              6,600.00 4 \$      26,600.00 \$        20,000.00 \$              6,600.00 Total \$            26,400.00 \$      6,600.00 Accounting Rate of Return (A) Average accounting income /Average Investment 16.50%

 Accounting rate of return of Project B Year Project B Cash Flows 0 \$ (20,000.00) 1 \$      4,600.00 2 \$      6,200.00 3 \$      8,000.00 4 \$   10,000.00 Initial Investment \$   20,000.00 Depreciation \$                   - Salvage Value Assumed to be zero Average investment \$   10,000.00 Annual Depreciation (Initial Investment − Scrap Value) ÷ Useful Life in Years \$      5,000.00 Average Accounting Income Year Cash inflows Depreciation Net Cash inflows 1 \$         4,600.00 \$          5,000.00 \$                (400.00) 2 \$         6,200.00 \$          5,000.00 \$              1,200.00 3 \$         8,000.00 \$          5,000.00 \$              3,000.00 4 \$      10,000.00 \$          5,000.00 \$              5,000.00 Total \$              8,800.00 \$      2,200.00 Accounting Rate of Return (B) Average accounting income /Average Investment 22.00%

 Accounting rate of return of Project C Year Project C Cash Flows 0 \$ (20,000.00) 1 \$   11,200.00 2 \$      8,600.00 3 \$      6,600.00 4 \$                   - Initial Investment \$   20,000.00 Depreciation \$                   - Salvage Value Assumed to be zero Average investment \$   10,000.00 Annual Depreciation (Initial Investment − Scrap Value) ÷ Useful Life in Years \$      6,666.67 Average Accounting Income Year Cash inflows Depreciation Net Cash inflows 1 \$      11,200.00 \$          6,666.67 \$              4,533.33 2 \$         8,600.00 \$          6,666.67 \$              1,933.33 3 \$         6,600.00 \$          6,666.67 \$                  (66.67) 4 \$                      - \$                           - Total \$              6,400.00 \$2,133.33 Accounting Rate of Return (C) Average accounting income /Average Investment 21.33%

Part A (iii): Net present Value

 Net Present Value Project A Year Project A PVF @ 10% Present Value Cash Flows 0 \$ (80,000.00) 1.000 \$      (80,000.00) 1 \$   26,600.00 0.909 \$        24,181.82 2 \$   26,600.00 0.826 \$        21,983.47 3 \$   26,600.00 0.751 \$        19,984.97 4 \$   26,600.00 0.683 \$        18,168.16 NPV (A) \$          4,318.42
 Net Present Value Project B Year Project B PVF @ 10% Present Value Cash Flows 0 \$ (20,000.00) 1.000 \$      (20,000.00) 1 \$      4,600.00 0.909 \$          4,181.82 2 \$      6,200.00 0.826 \$          5,123.97 3 \$      8,000.00 0.751 \$          6,010.52 4 \$   10,000.00 0.683 \$          6,830.13 NPV (A) \$          2,146.44
 Net Present Value Project C Year Project C PVF @ 10% Present Value Cash Flows 0 \$ (20,000.00) 1.000 \$      (20,000.00) 1 \$   11,200.00 0.909 \$        10,181.82 2 \$      8,600.00 0.826 \$          7,107.44 3 \$      6,600.00 0.751 \$          4,958.68 NPV (A) \$          2,247.93

Part B: Comparison of Results/Findings

 Comparison of Results Methods Project A Project B Project C Payback Period 3 years 3 days 3 years 44 days 2 years 11 days Accounting Rate of return 16.50% 22.00% 21.33% Net Present Value \$             4,318.42 \$         2,146.44 \$          2,247.93

In regards to payback period method, Project C must be selected as it has very payback period among all three given projects. Project that has higher accounting rate of return must be selected, therefore project B must be consider when evaluating the project on the basis of accounting rate of return. On the basis of net present value, Project A must be considered as it has very net present value as compared to all three projects.

In my opinion, Project C is the best choice as it has almost same accounting rate of return as project B and has also lowest payback period which is the biggest factor to consider it for project investment. Although it has lower net present value as compared to Project A but one thing that should be considered here is that Project A requires high value of investment while project C requires only one fourth of investment as compared to project C. So in my context, best choice is to select the project C. Accounting rate of return and payback period ignores the time value of money but the comparison has to be made in same context as all projects are evaluated under same method capital budgeting (Deegan, 2013).

NPV

• The use of Net Present Value (NPV) enables a business manager to undertake the long-term investment decision by determining the present value of the projected future income
• It enables a business manager to compare the future returns to be realized by two projects and select the project with maximum returns
• It takes into account the time value of money for determining the future worth of a project
• It also takes into account the cost of capital and the inherent risk while make future projections

• The major drawback of the method is that it determines the potential feasibility of a project on the basis of assumptions about the cost of capital of a firm
• It is also not regarded to be a suitable method for making a comparison of the two projects that are of varying size
• The project manager can often face difficult while calculating the appropriate discount rate
• It is not useful in taking an accurate decision when the initial amount of investment of two projects is not equal (Götze, 2015)

Payback

• The method is relatively easy to implement and determine the feasibility of a project
• It helps in making an evaluation about the risk associated with a project as the project with less payback period is regarded to have less risk

• The method does not take into account the concept of time value of money
• It does not consider the cash flow realized after the pay-back period in maintaining capital structuring decisions (Erickson, 2013)

Conclusion

The complete analysis of both the scenarios it is highly recommended to Octopus to select long term debt financing in scenario 1 and Project C in scenario 2. This recommendation is based on calculation performed in both the scenarios as per the information provided. While making analysis all the factors affecting the scenarios are being listed and taken into consideration for analysis purpose. The recommendations are based on the facts and figures provided in the scenarios and no other information has been used to make the analysis. In scenario 1, long term debt financing has been recommended because it provided highest market value of ordinary shares despite of decrease in net earnings. Long term loan financing option creates a fixed charge of interest expenses on the profits of the company but this option also helpful in increasing the value of shareholders. In scenario 2, Project C is recommended to the Octopus Plc despite of lower NPV as compared to Project A because it lowest payback period and also provides highest (almost) accounting rate of return among all three projects which is very important factor to be consider. Although my choice ignores the time value of money but one thing is certain that project A requires cash outflow of RM 80000 give net present value of RM 4318 in 4 years while project C gives RM 2247 in 3 years with investment of only RM 20000. Keeping in this mind the project C has been recommended to the company.

References

Baker, H.K. and Nofsinger, J.R. 2010. Behavioral Finance: Investors, Corporations, and Markets. John Wiley & Sons.

Batra, R. and Verma, S. 2014. An Empirical Insight into Different Stages of Capital Budgeting. Global Business Review, 15 (2), pp. 339-362.

Brigham, E. 2012. Fundamentals of Financial Management. Cengage Learning.

Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.

Erickson, K.H. 2013. Investment Appraisal: A Simple Introduction. K.H. Erickson.

Ghosh, A. 2012. Capital Structure and Firm Performance. Transaction Publishers.

Götze, U. 2015. Investment Appraisal: Methods and Models. Springer.

Martin, G. 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley & Sons.

Moles, P. and Kidwekk, D. 2011. Corporate finance. John Wiley &sons.

Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.

Shim, J. 2012. CFO Fundamentals: Your Quick Guide to Internal Control. John Wiley & Sons.

Whittington, R. 2015. Wiley CPA excels Exam Review 2015 Study Guide (January): Business Environment and Concepts. John Wiley & Sons.

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