Critical Evaluation of Capital Structure and Investment Appraisal Process

Capital Structure and Cost of Capital

Q1 – Capital Structure Newham plc is a food manufacturer which has the following long-term capital structure:

£1 ordinary shares (fully paid)   2,500,000
Share premium account            1,000,000
Retained profit                          1,400,000
8% preference shares                1,200,000
10% debentures (secured)         2,600,000

The directors of the company wish to raise further long-term finance by the issue of either preference shares or debentures. One director, who supports the issue of debentures, believes that, although a debenture issue will increase the company’s gearing, it will reduce the overall cost of capital.

Required:

A.Critically evaluate the arguments for and against the view that the company’s overall cost of capital can be reduced in this way. The views of Modigliani and Miller should be discussed in answering this part of the question.

B. Critically evaluate the major factors which the directors should consider when deciding between preference shares and debentures as a means of raising further long-term finance.

C.Critically evaluate the major factors which will influence the amount of additional debenture finance that Newham plc will be able to raise.

Q2(a) – Investment Strategy and Process:
Bowers Holdings plc has recently acquired a controlling interest in Shaldon Engineering plc, which produces high-quality machine tools for the European market. Following this acquisition, the internal audit department of Bowers Holdings plc examined the financial management systems of the newly acquired company and produced a report that was critical of its investment appraisal procedures

The report summary stated:

Overall, investment appraisal procedures in Shaldon Engineering plc are very weak. Evaluation of capital projects is not undertaken in a systematic manner and post-decision controls relating to capital projects are virtually non-existent.

Required: 

Prepare a report for the directors of Shaldon Engineering plc, critically analysing what you consider to be the major characteristics of a system for evaluating, monitoring and controlling capital expenditure projects. What procedures should a business adopt for approving and reviewing large capital expenditure projects?

Q2(b) – Investment Appraisal Methods

The directors of XYZ plc wish to expand the company’s operations. However, they are prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the expansion programme. 

Three possible investment opportunities have been identified. Only £400,000 is available in cash and the directors intend to limit the capital expenditure over the next 12 months to this amount. The projects are not divisible (that is, cannot be scaled down) and none of them can be postponed. The following cash flows do not allow for inflation, which is expected to be 10 per cent per annum constant for the foreseeable future.

Arguments for and against reducing Cost of Capital

Expected net cash inflow (including residual values)

Project:     Initial Investment     Year 1     Year 2         Year 3    
A -        350,000                 95,000         110,000     200,000           
B -        105,000                45,000          45,000         45,000
C -        35,000                 40,000          25,000         125,000.

The company’s shareholders currently require a return of 15 per cent nominal on their investment. Ignore taxation. Required: Calculate the expected net present value and profitability indexes of the three projects and comment on which project(s) should be chosen for the investment, assuming the company can invest surplus cash in the money market at 10 per cent. (Note: you should assume that the decision not to borrow, thereby limiting investment expenditure, is in the best of its shareholders.) (15 marks).

In this section students should demonstrate knowledge and understanding of capital structure. Students should critically evaluate arguments for and against the view of reducing the company’s cost of capital by either preference shares or debentures. Critically evaluate the views of Modigliani and Miller in answering this question. Students should critically evaluate the main factors in considering between preference shares and debentures as a means of raising further long-term finance. Students should also critically evaluate major factors that will influence the amount of additional debenture finance. Relevant calculations should be performed, including all relevant workings. Within the discursive element of the question’s students should critically evaluate the views of Modigliani and Miller, through accessing a wide range of academic literature and reference as per Harvard referencing requirements. The response should aim to incorporate empirical findings from an international perspective regarding capital structure. 

Within this section of the assessment students should demonstrate understanding and knowledge of investment strategy and process in a report format. Students should also demonstrate understanding and knowledge on investment appraisal methods and calculate the expected net present values (take inflation rate into account) and profitability indexes and advise XYZ plc with your recommendations of the three projects. The evaluative element of the assessment should clearly provide evidence of wider reading that is sensibly integrated within the work as per Harvard referencing requirements

To obtain a high mark, you should:

a) Make your assignment concise, precise and well-presented and structured;

b) Draw logical conclusions from financial information; 

c) Synthesize information in a coherent and useful way;

d) Show evidence of key text and background reading; 

e) Incorporate your knowledge into an integrated piece of work; 

f) Demonstrate critical understanding of corporate finance. 2. Harvard standard referencing is required for the assignment. 3,000 words overall. (Plus or minus 10%)