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Capital Structure: Corporate Finance Add in library

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Question:

Describe about the Capital structure for Corporate finance?
 
 

Answer:

Different Sources of Finance

In the given scenario a business will be established. The principle task is to forecast the required amount for investment.  Therefore, it is important to identify the different sources funds for financing the business activities. A corporation will be established for manufacturing and retailing high quality doors and windows for commercial purpose.  The business plan indicates that total £ 500,000 will be required for supporting the business activities. This amount is basically start up cost and it need to be sourced from external as well as internal sources of fund. In order to acquire the capital, the corporation can utilize the internal sources of finance such as personal savings and family contribution.  On the other hand, the external sources of fund for starting this business will be bank loan, bond and lease financing (Berk and DeMarzo, 2007). In the following table, the different sources of finance have been mentioned along with the proportion.

Sources

Amount

Percentage of Total Fund

External Sources

 

 

Bank Loan

 £      300,000.00

60.00%

Fixed debentures

 £        50,000.00

10.00%

Lease

 £        75,000.00

15.00%

Internal Sources

 

 

Personal Savings

 £        35,000.00

7.00%

Family Contribution

 £        40,000.00

8.00%

   

 

Total

£      500,000.00

100%

From the above table, it has been found that the external sources will be the major source of fund for starting the business. The internal sources of fund are only 15% of the total capital.

Implication of Different Sources of Finance

In this scenario, five different sources of finance have been chosen. This section will focus on discussing the legal and financial implication of each sources of finance

External Sources:

Bank Loan:

Bank loan is thee principle source of finance for starting up the business. 60% of the total fund has been lent by the bank. This amount will be majorly spent for building infrastructure and acquiring fixed assets. In this case, the loan must be repaid to the bank at a certain interest rate. It will be counted as the long term liability of the company. The company will start repaying once it starts generating profit. It is expected that the company will repay the principal and interest within 5 years by making quarterly payments. Failing to pay the loan amount will be subject to the decision of the bank and legal steps can be taken by the bank in case of significant delay in repayments.

Fixed Debentures:

Debentures will be issued by the organization for raising debt capital which will contribute in acquiring 10% of the required fund. Debenture owner will be considered as the long term creditors of the corporation. The company has to pay a fixed rate of interest per annum regardless of the profit or loss of the company. The debenture holder must be paid the entire amount within the predetermined tenure. Any violation from the payment terms will lead the company to face legal consequences.

Lease:

Fixed asset of the company will bought by the leasing company o behalf of the company and it will be provided to the company. In this case, the ownership of the asset will remain with the leasing company. Throughout the leasing period, the company needs to pay rent. Finance lease has been chosen by the company (Artikis, 2007).

Internal Sources:

Personal Savings:

Personal savings is employed funding the start up costs of the new business. This is personal savings which will not be directly paid back to the investor or the business owner. The business owner will get certain portion of the profit once the company starts gaining.  

Family Contribution:

Family members of the owner have contributed for supporting the business activities. The business must pay back the amount within the promised tenure. However, no interest will be charged by the family members in this case (Berk and DeMarzo, 2007).

 

Evaluation of Appropriate Sources of Finance

This section will focus on discussing the advantages as well as disadvantages of each source of finance chosen for starting up the business.

Bank Loan:

Advantages

Large amount has been arranged from this source.

Long period has been allowed for repaying the loan.

As the company is seeking a long term investment, bank loan is appropriate for this project.

The bank does not interfere in how the money is spent within the organization.

Tax benefit can be availed.

Disadvantages:

Collateral is required for getting loan.

The amount needs to be repaid within the pre-determined tenure.

The company needs to bear the cost of interest.

High amount of loan will affect the gearing ratio of the company (Brealey, Myers and Marcus, 2004).

Fixed Debentures:

Advantages:

The ownership of the company is not diluted by issue of debenture.

The debenture interest is considered as expenditure and tax benefit can be availed.

If the company has surplus fund, the debenture can be redeemed.

Disadvantages:

The amount needs to be paid to the debenture holder regardless of the financial position of the company.

The interest amount needed to be paid within the agreed date.

Lease:

Advantages:

The company needs not to pay the huge amount for purchasing the assets.

The lease amount paid to the leasing company is pre-determined and it is fixed over the time.

Inflation has no impact on the lease rent.

Disadvantages:

In case of lease, the ownership of asset remains with the lessor.

The lease contract cannot be terminated according to the will of the lessee.

Personal Savings:

Advantages:

Formal paperwork and procedure is not required.

The money needs not be paid back to the owner.

The company needs not to pay interest.

Disadvantages:

Large amount of fund is not available.

The owner is losing opportunity cost.

Family Contribution:

Advantages:

The amount can be received easily.

The company needs not to bear the cost of interest.

The lenders will be lenient in terms of paying back the amount (Harrison and Horngren, 2001).

Disadvantages:

The opportunity cost will be lost.

The amount will be small.

 

Identification and Analysis of Cost of Finance

The cost of finance in case of the discussed scenario will be explained in this section. In case of bank loan, the cost of finance will be the rate of interest. The company has chosen to opt fixed debenture. Hence, the cost of debenture will be fixed rate of interest that needs to be paid to the debenture holders. In case of lease rent, the cost of finance can be calculated with the aid of lease rent, lease tenure and the asset value. Thus, the cost of external sources can be calculated. The cost of internal sources will be difficult to calculate. The cost investing capital of the owners and the cost of amount contributed by the family members can be referred the opportunity cost. In this case, opportunity cost can be considered as same as the risk free rate of interest or the interest rate of the government bonds. In order to calculate the overall cost of capital of the company, Weighted Average Cost of Capital (WACC) can be estimated. It means the cost of capital for each source of capital will be multiplied with the weight or the proportion (Madura and Madura, 2008).

Importance of Financial Planning

Financial planning is considered to be very important for the success of an organization. Financial planning is associated with pre-designing financial activities of the company on the basis of the present market situation along with the organizational goals. Financial planning helps in forecasting the financial activities of the company depending on the current economic factors and organizational goals.  Therefore, budget is developed which ensures effective allocation of resources. All the activities are carried out by keeping parity with the budget. The financial planning of an organization helps in indicating the desired level of sales, profit and growth of the company. The other departments such as production, marketing etc act accordingly for meeting the financial objectives. Additionally, financial planning ensures that appropriate sources of fund have been chosen by the company. Investment planning is another important activity that helps in ensuring success of the organization.

Required Information for Decision Making

For making rational decision, the management requires some significant and authentic information. First of all, the factors of macro environment must be accessed. For example the economic condition, demand, level of rivalry in the market must be analyzed by the organization for making right decision. Additionally, the information relating to the particular project such as forecasted cash flow, discount rate or cost of capital must be known by the management for making an informed decision which will be favorable for the organization (Smart, Megginson and Gitman, 2004).

Impact of Different Source of Finance on Financial Statement

Different sources of finance have distinct implication on the financial statement. In case of bank loan, debenture, the company will be including the interest amount as items of expenditure. Therefore, tax benefit will be obtained in these cases. However, the two internal sources of finance will not have any influence on the financial statement of the company.

Preparation of Cash Budget for Hollywood Conservatories Ltd:

Particulars

June

July

August

September

Opening Balance

 £    130,000.00

 £      29,000.00

 £     100,000.00

 £       103,000.00

Sales

 

 £   150,000.00

 £     156,000.00

 £       135,000.00

Cash Purchase

 £      55,000.00

 £      46,000.00

 £       86,000.00

 £          74,000.00

Credit Purchase

 £                     -  

 £                     -  

 £       28,000.00

 £          36,000.00

Rent

 £      15,000.00

 £                     -  

 £                       -  

 £          15,000.00

Other Expenses

 £      22,000.00

 £      24,000.00

 £       30,000.00

 £          38,000.00

Repayment of loan

 £        9,000.00

 £        9,000.00

 £          9,000.00

 £                         -  

Total Expense

 £    101,000.00

 £      79,000.00

 £     153,000.00

 £       163,000.00

Cash in hand

 £      29,000.00

 £   100,000.00

 £     103,000.00

 £          75,000.00

 

From the above, table the cash position of Hollywood Conservation Ltd can be estimated for four months. It has been found that the company will be able to maintain significant amount of surplus cash over the four months. Cash is necessary for undertaking the day to day activities of the organization. However, it must be considered that holding huge amount of cash does not have a positive implication of the company. In case of Hollywood Conservation Ltd, the cash balance is very high. It implies that the cash has not been properly utilized and the surplus cash is too high. Hence, the company must focus on utilizing the additional cash in some other activities for generating income (Smart, Megginson and Gitman, 2004).

Price Calculation      

Price setting is considered to be one of the most important activities of an organization. The cost of product is given. First of all, the total profit will be calculated when 800 units are sold. From the following table, it has been found that total profit will be £ 27,600.

Particulars

Amount

Variable cost per unit

 £                         65.00

Fixed cost per unit

 £                         50.00

Total cost per unit

 £                       115.00

   

Selling price per unit (Profit@ 30%)

 £                       149.50

Profit per unit

 £                         34.50

Profit for 800 units

 £                 27,600.00

 

It has been stated that the fixed cost can be completely recovered when the company manufactures 800 units. Further production will lead to additional fixed cost. Hence in case of production of units beyond 800 units, the selling price is calculated. It has been found that the selling price per unit is £ 214.50. Additionally, the profit for producing further 400 units has been calculated. It has been found profit in case of additional 400 units will be £ 19,800. Moreover, the total profit when 800 units and additional 400 units are sold has been estimated to be £ 47,400. 

Particulars

Amount

Variable cost per unit

 £                         65.00

Total fixed cost

 £                 40,000.00

fixed cost per unit

 £                       100.00

Total Cost per unit

 £                       165.00

Selling price per unit

 £                       214.50

Profit per unit

 £                         49.50

Profit for additional 400 units

 £                 19,800.00

   

Total profit

 £                 47,400.00

 

Identification of the Best Investment Proposal

In the given scenario, the company has been considering three investment proposals. This section will focus on evaluation of the each project in order to make a rational investment decision. In this case, net present value and payback period are the two tools that has been used for assessing each project.

Evaluation of Project A:

Cash Flow

Year

Amount

PVF

PV

Cumulative cash flow

Outflow

0

-£      60,000.00

1

-£ 60,000.00

-£ 60,000.00

Inflow

1

 £      20,000.00

0.909091

 £  18,181.82

-£ 40,000.00

Inflow

2

 £      18,500.00

0.826446

 £  15,289.26

-£ 21,500.00

Inflow

3

 £      26,000.00

0.751315

 £  19,534.18

 £    4,500.00

Inflow

4

 £      32,500.00

0.683013

 £  22,197.94

 £  37,000.00

Net Present Value

 £  15,203.20

 

Payback  Period (Years)

2.83

 

 

Evaluation of Project B:

Cash Flow

Year

 Amount 

PVF

 

Cumulative cash flow

Outflow

0

-£      65,000.00

1

-£ 65,000.00

-£ 65,000.00

Inflow

1

 £      24,750.00

0.909091

 £  22,500.00

-£ 40,250.00

Inflow

2

 £      24,750.00

0.826446

 £  20,454.55

-£ 15,500.00

Inflow

3

 £      24,750.00

0.751315

 £  18,595.04

 £    9,250.00

Inflow

4

 £      24,750.00

0.683013

 £  16,904.58

 £  34,000.00

Net Present Value

 £  13,454.17

 

Payback Period (Years)

2.63

 

 

Evaluation of Project C:

Cash Flow

Year

 Amount 

PVF

 

Cumulative cash Flow

Outflow

0

-£      45,000.00

1

-£ 45,000.00

-£ 45,000.00

Inflow

1

 £      20,000.00

0.909091

 £  18,181.82

-£ 25,000.00

Inflow

2

 £      15,000.00

0.826446

 £  12,396.69

-£ 10,000.00

Inflow

3

 £      12,500.00

0.751315

 £    9,391.44

 £    2,500.00

Inflow

4

 £      25,000.00

0.683013

 £  17,075.34

 £  27,500.00

Net Present Value

 £  12,045.28

 

Payback Period (Years)

2.80

 

 

From the above three tables, the net present value and payback period of each project have been calculated. Net present value refers to the total cash flow in terms of present value. The discounting rate has been considered as 10% in these projects. Higher amount of positive NPV value indicate greater financial feasibility of the project. In this case, it has been found that project A has the highest Net Present Value of £ 15,203.20.  Hence, among these three projects, project A is considered to be most attractive (Ross, Westerfield and Jordan, 2004).

Payback period is calculated for estimating the time period within which the initial investment can be recovered. It must be noted that the payback period do not consider the present value of cash flow. In case of these three projects project B has the minimum payback period, i.e. 2.63. Lower payback period indicates greater attractiveness of the project.

However, the result of Net Present Value and payback Period indicate contradictory results. Project be A has the highest net present value which indicates best option for investment. On the other hand, the payback period of project A has been calculated to be highest among these three projects. Hence, project is A is the least attractive project in terms of payback period. However, in making final decision, NPV must be taken into consideration as it uses present value which is more rational.  Hence, it can be concluded that project A must be chosen among these three projects (Madura and Madura, 2008).

 

Explanation of Financial Statements

Financial statements are analyzed for evaluating the financial performance of the organization. The major income statements include income statement, cash flow statement, balance sheet and statement of changes in equity.

Income Statement:

Income statement demonstrates how an organization has been managing the activities for generating profit. The major components of the income statement are sales, expenditure and net income of the firm.

Balance Sheet

Balance sheet is a comprehensive statement of the assets and liabilities of the firm. It reflects the position of the company in terms of its assets and obligations. Balance sheet is presented to the bank as a reliable basis (Harrison and Horngren, 2001).

Cash Flow Statement

Cash flow statement clearly indicates the cash generated as well as utilized by the company from operational activities, investment activities and financing activities. It helps in demonstrating the cash position of the company.

Statement of Change in Equity

Statement of changes in equity helps in estimating the equity of the owner in revaluating the assets along with the funds of the company such as reserve fund, welfare fund etc.

Comparison Appropriate Format of Financial Statement

The format of financial statements is different in case of different types of business such as sole proprietorship, corporation and partnership. In the following table, the formats of two major financial statement income statement and balance sheet have been compared.

Type of Business

Income Statement

Balance Sheet

Sole Proprietor

Ø  The income statement is not complicated.

Ø  The owner pays the income tax and it has not been shown in the income statement of the firm. 

Ø  The profit and loss of the firm has been reported without dividend.

Ø  Balance sheet is considered to be the statement of the equity of the owner.

Ø  In balance sheet equity refers to the equity of the owner. 

Ø  In the balance sheet drawings are not considered as the expenditure and these elements are not included in the income statement too.

Partnership

Ø  In this case, the income statement is complicated as there are several owners.

Ø  Personal income tax is paid by the owners. Hence, it is not demonstrated in the income statement.

Ø  The dividends are shared among the partners.

Ø  Balance sheet is considered to be the equity of the owners. 

Ø  In the balance sheet, equity in the assets segment demotes the equity of the owners.

Ø  In the balance sheet, interest on capital account, shares, profit, drawings etc are recorded.

Corporation

Ø  Income statement of corporation or public limited company is the most complicated one.

Ø  Corporation is considered to be a legal entity and it has to pay tax on the business activities exhibited in the income statement.

Ø  Profit or gain must be published by the corporation (Davies, Boczko and Chen, 2008).

Ø  Balance sheet is considered to the statement of retained earnings.

Ø  Equity refers to the equity of the shareholders.

Ø  The change in the equity of the business must be recorded in the balance sheet.

Ratio Analysis

 

Distribution  ('000)

Retail ('000)

     

Gross Profit

 £                10,400.00

 £      12,430.00

Revenue

 £                40,870.00

 £      26,540.00

Gross Profit Margin

25.45%

46.83%

     

Net Profit

 £                  5,850.00

 £         2,950.00

Revenue

 £                40,870.00

 £      26,540.00

Net Profit Margin

14.31%

11.12%

     

Current Asset

 £                  2,510.00

 £         5,070.00

Current Liabilities

 £                  1,950.00

 £         2,950.00

Current Ratio

1.287179487

1.718644068

     

Current Asset

 £                  2,510.00

 £         5,070.00

Inventories

 £                  2,420.00

 £         2,370.00

Current Liabilities

 £                  1,950.00

 £         2,950.00

Quick Ratio

 £                          0.05

 £                 0.92

     

Long term loans (Debt)

 £                  2,000.00

 £         3,170.00

Capital  (Equity)

 £                  3,000.00

 £         5,500.00

Gearing Ratio

0.666666667

0.576363636

 

 

Gross profit margin is estimated to be higher in case of retail. On the other hand, net profit margin is estimated to be higher in case of distribution (Hansen and Mowen, 2005). Current ratio helps in depicting the capability of the company to meet the short term obligations by current assets. In both the cases, current ratio is higher than 1 and it has a positive implication. Quick ratio is estimated to be better in case of retail compared to distribution.  Gearing ratio indicates the ratio between debt and equity.  The debt to equity ratio is lower in case of retail which indicates that debt is lower and risk is lower (Coombs, Hobbs and Jenkins, 2005).

 

References:

Artikis, G. (2007). Capital structure. [Bradford, England]: Emerald.

Berk, J. and DeMarzo, P. (2007). Corporate finance. Boston: Pearson Addison Wesley.

Brealey, R., Myers, S. and Marcus, A. (2004). Fundamentals of corporate finance. Boston, Mass.: McGraw-Hill Irwin.

Coombs, H., Hobbs, D. and Jenkins, D. (2005). Management accounting. London: SAGE Publications.

Davies, T., Boczko, T. and Chen, J. (2008). Strategic corporate finance. London: McGraw-Hill Higher Education.

Hansen, D. and Mowen, M. (2005). Management accounting. Mason, OH: Thomson/South-Western.

Harrison, W. and Horngren, C. (2001). Financial accounting. Upper Saddle River, NJ: Prentice Hall.

Madura, J. and Madura, J. (2008). International corporate finance. Australia: Thomson.

Ross, S., Westerfield, R. and Jordan, B. (2004). Essentials of corporate finance. Boston, Mass.: McGraw-Hill/Irwin.

Smart, S., Megginson, W. and Gitman, L. (2004). Corporate finance. Mason, Ohio: Thomson/South-Western.

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