FINANCIAL MANAGEMENT: LONG TERM FINANCE, EQUITY FINANCE, INVESTMENT APPRAISAL TECHNIQUES

FINANCIAL MANAGEMENT

2020-21

QUESTION 1. LONG TERM FINANCE: EQUITY FINANCE

A) LEXBEL PLC’S RIGHT ISSUE

Whenever a company issues new shares, it provides a preferential right to its existing shareholders before the common public to avail such shares at a different price, i.e. right issue price. The said right is subjective and proportional. Such an issue of shares is termed as a right issue. The shareholders get a facility of buying shares in proportion to their existing shareholding (Kendirli and Elmali, 2016).

i) CALCULATION OF NUMBER OF SHARES TO BE ISSUED

The number of shares to be issued under a right issue reflects the number of shares that will be provided in place of raising the capital to be raised against the right shares, it is calculated as follows:

Number of shares to be issued = Capital to be raised/ Right issue price

II) CALCULATION OF THEORETICAL EX-RIGHT PRICE

theoretical ex-right price of shares is such a theoretical price that is carried by the shares of the company immediately after the right issue is made. It is calculated as follows:

Theoretical Ex-right Price = {(Right shares*issue price) + (Old shares*Market price)}/ (Number of right shares + Number of old shares)

iii) CALCULATION OF EXPECTED EARNINGS PER SHARE

Earnings per share (EPS) refers to such amount of earnings or profits made that each existing share earns. It is calculated in the following manner:

Expected Earnings per Share = Earnings available to equity shareholders/Total number of shares

iv) CALCULATION OF FORM OF THE ISSUE FOR EACH RIGHT ISSUE PRICE

The form of the issue for each right issue price refers to the current shares held against the right shares. It is calculated as follows:

Form of the issue for each right issue price (i.e. current shares against right shares) = 1/Number of right shares*Number of existing shares

v) CRITICAL EVALUATION OF THE BEST OPTION

Lexbel plc has equity of £700,000 presently structured as share capital of £300,000, i.e. 1,200,000 shares of 25p, and reserves of £400,000. The company earns a return of 20% after-tax on the given funds currently and such return will continue to be the same even after the company raises its capital. The company is planning to increase its funds by the way of issuing more shares in the name of the right shares. At present, the ex-dividend market price of each share of the company existing in the market is £1.90. The new shares are being planned to be issued at the best price out of the following three: £1.80, £1.60, and £1.40.

When evaluated on different grounds, the different right-issue prices reflected different outcomes as presented in the above table. When evaluated keenly, the right issue price of £1.80 seemed to be the most appropriate as there will be only 100,000 shares required to be issued at this right issue price which is the least number of shares needed to be issued amongst all the provided options. Lesser number of share issues means a lesser dilution of the voting power of the shareholders and lesser dilution of profit earned on each share. Such dilutions adversely influence the value of the stock (Danielyan, 2016). Thus, such right issue price is being preferred which provides the least dilution and it is suggested to go with the right issue price of £1.80 as given by the finance director.

B) CASH DIVIDEND AND EQUIVALENT SCRIP DIVIDEND

Dividend refers to such amount or share of profit that the company provides to its shareholders with an intention of sharing its profits and paying returns to the said investors upon the investments made by them in the company’s business. It can be paid yearly or more or less frequently than that, depending on several factors like profits of the business, retained earnings, future plans, condition of the economy, etc. David and Ginglinger (2016) assert that while framing their pay-out policies, business managers consider dividend stability as a significant factor. Dividends play a crucial role in maintaining the value of the business in the market. Any decline or omission of dividend steeply deteriorates the value of the business. Thus, the businesses try to avoid such declines and omissions. But on the other hand, the businesses might not be always feasibly liquid to provide the dividends in cash. To combat such a situation, equivalent scrip dividends have been introduced where the shareholders have the option of availing cash or scrip dividend, depending on their choice. KANAKRIYAH (2020) explains scrip dividends in his Journal of Asian Finance, Economics, and Business as liability profits. Such dividends are provided to the shareholders in the face of a certificate, in lieu of cash. It means that the shareholders are provided additional shares of the amount of dividend earned by them. This prevents the outflow of cash from the business and thus, liquidity is also kept intact. This kind of dividend is advantageous to the shareholders and the company both

Advantages of equivalent scrip dividend to shareholders:

• The shareholders have a choice of preferred dividends in any form. Choosing a scrip dividend helps them preventing dilution of their ownership, power, and rights which happens when new shares are introduced (Feito-Ruiz et al., 2020).

• The shareholders also save different costs related to share acquisition like payment of stamp duty, commission, or any other transaction costs (Feito-Ruiz et al., 2020).

• The tax advantage is also a major benefit that can be availed due to scrip dividends but not cash dividends (Wall Street Mojo, 2021).

Advantages of equivalent scrip dividend to company:

• The company is able to maintain its liquidity as it is saved from paying cash immediately. This saved cash can be utilised elsewhere (Wall Street Mojo, 2021).

• The company is saved from the cash arrangement when a scrip dividend is preferred by the shareholders which also removes the worry of the arrangement of funds for cash dividend (Kaplan, 2020).

• The capital gearing ratio of the company declines with the introduction of further share capital which opens the doors of further borrowing (Kaplan, 2020).

• Scrip dividends increase the share capital of the company while maintaining proportional ownership for the shareholders (Wall Street Mojo, 2021).

Scrip dividends are beneficial to the company as well as the shareholders. However, they might carry some drawbacks as well but the benefits created by it definitely inspire to promote such kind of dividend.

QUESTION 2: INVESTMENT APPRAISAL TECHNIQUES

A) INVESTMENT APPRAISAL TECHNIQUES AND RECOMMENDATIONS TO THE BUSINESS

Whenever a capital investment decision is to be made by a business, different appraisal techniques are applied to make the best possible decision since such decisions are significant and involve a crucial amount of investment in them. In the presented situation, a food manufacturing company, Happy Meal ltd., is considering the purchase of new machinery for £320,000. With the introduction of the said new asset, an annual cash inflow of £105,000 and an annual cash outflow of £15,500 are expected constantly for six years, i.e. till the machine will be useful. The company has a cost of capital of 20%. The proposal of the introduction of machinery is assessed on various scales by the way of applying different investment appraisal techniques below:

i) Payback Period Method

Payback period = 3 years + 38,000/89,500 = 3.42 years.

Happy Meal Ltd. is expecting to realise its investment in 3.42 years as per the above calculations which means that the new machine will take said time to repay the business the outflow made as the initial investment. Such a period seems to be fine as the business will be able to recover its total investment and the inflows will constantly keep flowing even after such recovery. Thus, it is recommended to introduce such machinery in the business.

ii) Accounting Rate of Return

*the book value of the machine at the end of its useful life is different from its salvage value of £32,000.

Accounting Rate of Return (ARR) = Average annual profit/Average investment

= (369,686/6)/ (440,686/2)

= 27.96%

The ARR of the given food manufacturer is 27.96% which means that the business will earn 27.96% for each pound that is being invested in the new machine. The cost of capital, i.e. the expected rate of return of the business is 12% and as per the calculations made under this technique, the machine is providing returns to the business much higher than the expected one. Thus, on the basis of the ARR method, the introduction of the given machinery is feasible.

iii) Net Present Value Method

The net present value of the given machinery on the basis of inflows and outflows associated with it is positive, i.e. £64,247.5. This amount is the current value of the net cash flows that the machine will provide over its useful life of six years. The provided cash flows are discounted at a rate of 12% to adjust the risk and consider the time value of money. After all these considerations, the net present value achieved is positive which depicts that introduction of such a machine will be appreciable.

iv) Internal Rate of Return Method

Internal Rate of Return (IRR) = Lower Rate + {NPV at lower rate/ (NPV at lower rate – NPV at higher rate)}*(Higher rate – Lower rate)

= 18 + [4821.5/{4821.5 – (-3630.5)}]*(19 – 18)

= 18.57%

The calculations made under the IRR technique provide that the introduction of new machinery in Happy Meal ltd. will make more money than the amount of investment. The IRR as calculated is 18.57%, which is higher than its cost of capital. This supports that the said new machinery should be introduced in the business.

B) PROS AND CONS OF DIFFERENT INVESTMENT APPRAISAL TECHNIQUES

All the investment techniques applied above carry positive and negative traits that come out as benefits and limitations of such techniques. Here are the pros and cons of these different investment appraisal methods:

i) Payback period method:

The payback period technique is a simple technique of appraising a potential project by the way of calculating the period within which the project will repay the costs invested in it (Chadha and Sharma, 2019).

Benefits of payback period method:

• This is a simple method to use and easy to understand (Banerjee, 2016).

• This appraisal model is preferable in smaller projects as it is least complex (Banerjee, 2016).

Limitations of payback period method:

• This method pays no heed to the cash flows that are generated post to payback period (Anabtawi, 2018).

• It does not takes into account the time value of money.

• Projects with longer life cannot be trustily appraised under this technique (Anabtawi, 2018)

• This technique is uncertain and ignores the risk factor (Anabtawi, 2018).

ii) Accounting rate of return method:

The accounting rate of return method calculates such a rate of return at which a project reflects to provide returns. It relies on the accounting profits generated by the project (Goyat and Nain, 2016).

Benefits of accounting rate of return method:

• The computation of the accounting rate of return is simplified (Anabtawi, 2018).

• The method derives accounting profits from the financial information to make the calculations (Riahi-Belkaoui, 2016).

Limitations of accounting rate of return method:

• This method is complex to be applied with different sizes of profits (Anabtawi, 2018).

• This method also does not consider the time value of money (Riahi-Belkaoui, 2016).

• It relies on accounting profits and does not consider cash flows (Riahi-Belkaoui, 2016).

iii) Net present value method:

The net present value method lets to know the current value of the returns, i.e. the cash flows, which are expected by a project to generate. The positive or negative values obtained from its calculation helps to decide whether to go with the proposal or not (Riahi-Belkaoui, 2016).

Benefits of Net present value method:

• This method focuses on the timing of cash flows (Anabtawi, 2018).

• It does not make assumptions regarding the reinvestment of cash inflows

• It accounts for risks borne by the proposal.

• It considers the time value of money

• Projects with longer lives can also be evaluated appropriately using this technique (Kengatharan, 2018).

Limitations of Net present value method:

• This is a complex method to use.

• It does not consider sunk cost

• This method does not consider managerial flexibility (Kengatharan, 2018).

iv) Internal rate of return method:

The internal rate of return is that rate at which the net existing value turns to zero. It means this rate turns the current value of all cash inflows equal to the current value of all cash outflows. It is calculated after trial and error and compared with the rate of the cost of capital of the business to understand the viability of the project (Uwah and Asuquo, 2016).

Benefits of Internal rate of return method:

• It contemplates the time value of money.

• It considers the timing of cash flows expected in the future.

Limitations of Internal rate of return method:

• It does not consider the size of projects

• The comparison of cash flows is made against the amount of investment (Magni, 2020).

• It does not consider the costs that may arise in the future and influence the profits (Magni, 2020).

• It assumes that the inflows will be reinvested in the business, that too at the same IRR.

The different appraisal techniques as discussed above have their own significance in the valuation of potential projects. All of these carry some limits as well as benefits that cannot be ignored. Choosing the right technique that goes along with the different factors associated with a proposal is necessary as then only apt investment decision making can be performed. Sometimes, the payback period technique gets suitable when the proposal is on a small scale and a quick decision is to be made; sometimes net present value technique gets more significant when a detailed evaluation of a long-term project is to be made. The conclusion is that all the techniques are good when used in appropriate conditions and the decision-makers must use their expertise and judgments as well while evaluating any investment proposal.

REFERENCES

Anabtawi, A.N. (2018). The Extent of Using and Trusting Capital Budgeting Methods in Projects Appraisal in Palestinian Corporations. Modern Applied Science, 12(6).

Banerjee, S. (2016). Contravention Between NPV & IRR Due to Timing of Cash Flows: A Case of Capital Budgeting Decision of an Oil Refinery Company. American Journal of Theoretical and Applied Business, 1(2), p.48.

Chadha, S. and Sharma, S.K. (2019). Capital budgeting practices: a survey in the selected Indian manufacturing firms. International Journal of Indian Culture and Business Management, 18(4), pp.381-390.

Danielyan, V. (2016).  A Study on how to solve the problem of stock dilution (Doctoral dissertation, KDI School).

David, T. and Ginglinger, E. (2016). When cutting dividends is not bad news: The case of optional stock dividends. Journal of Corporate Finance, 40, pp.174-191.

Feito-Ruiz, I., Renneboog, L. and Vansteenkiste, C. (2020). Elective stock and scrip dividends. Journal of Corporate Finance, 64, p.101660.

Goyat, S. and Nain, A. (2016). Methods of Evaluating Investment Proposals. International Journal of Engineering and Management Research (IJEMR), 6(5), pp.278-280.

KANAKRIYAH, R. (2020). Dividend Policy and Companies’ Financial Performance. The Journal of Asian Finance, Economics and Business (JAFEB), 7(10), pp.531-541.

Kaplan. (2020). Scrip dividends. (Online) available at: https://kfknowledgebank.kaplan.co.uk/scrip-dividends-#:~:text=There%20can%20be%20a%20number,hence%20increase%20its%20borrowing%20capacity.. Last accessed on 27 January 2021.

Kendirli, S. and Elmali, M.E. (2016). The effects of right offering announcements on returns of shares of deposit banks traded in istanbul stock-exchange. Journal of Economic Development, Environment and People, 5(1), pp.74-82.

Kengatharan, L. (2018). Capital Budgeting Theory and Practice: A review and agenda for future research. American Journal of economics and business management, 1(1), pp.20-53.

Magni, C.A. (2020). Investment Decisions and the Logic of Valuation. Springer International Publishing.

Riahi-Belkaoui, A. (2016). Capital Budgeting and Leasing.

Uwah, U.E. and Asuquo, A.I. (2016). Capital budgeting processes and wealth maximization objectives: Implications for firms in Nigeria. Research Journal of Finance and Accounting, 7(10), pp.73-85.

Wall Street Mojo. (2021). Scrip Dividend. (Online) available at: https://www.wallstreetmojo.com/scrip-dividend/. Last accessed on 27 January 2021.