Effects of High Interest Rates on the Financial Profitability of PQR plc and its Qualification as a Blue-chip Company

BUSINESS FINANCE ECONOMY

Executive Summary

This report looks at the effects of high interest rates on the financial profitability of PQR plc and its qualification as a blue-chip company. These suggested factors are; Net present value, Payback period, Target financial ratios, and FTSE 100 rival benchmark. Recommendations cover finance strategies, equity and retained profits, optimal capital structure where dilution and investor loyalty are of significance.

Introduction

This report compares PQR plc.’s financial strength given current economic conditions, particularly amplified interest rates. They include the NPV technique for risk evaluation of investing in opportunities, examined by the methods of comparing indicators of its financial statements, and ratio analysis. Furthermore, the study also has sought to compare PQR with FTSE 100 indices with the focus to determine whether the company as well can be associated with the blue-chip company.

Findings

Task – 1

a) Explanation of the Issue: High Interest Rates

High interests are more specific to an economic environment within which the cost of debts is high this is attributed to central monetary authorities the effort to cure inflation or stabilize an economy. Take for example the Bank of England when it wants to counter inflation it increases interest rates, which in turn leads to increased cost of borrowing among the population and companies. High interest rates leads to high costs of borrowing that leads to low consumption rate, credit and as such the investment in the economy (Allais, 2024, p. 177). It makes a direct effect on the corporate as well as personal investment hence affects business operations.

b) Impact on PQR plc and Threat to Blue-Chip Status

High interest rates raise the cost of borrowing and thus directly impacts PQR plc’s profitability where the organisation ends up reaching less viability of the growth investment. This reduces the sales revenue pulling down the financial performance even with lower consumer spending. High interest rates also hike up the gearing ratio of the company financial risk escalates and a credit rating indicating susceptibility may result. Sustained downturn may necessitate reductions in dividend distribution that would demoralize investors and seek other more attractive investment opportunities (Standing, 2019, p. 47). This can lead to contraction in the EPS, thus eradicating the bid by PQR to become a blue-chip maker and consequently facing the danger of having its status in the FTSE 100 index diminished, thus erasing a respectable market image.

Task – 2

a) Calculation of NPV

To get the NPV of the proposed investment, it is necessary to identify the cash inflow and cash outlay for each year and then discount the cash inflow and outlay by using cost of capital of the company.

Initial Investment:

Purchase of new machinery: £2,400,000

Cash Inflows:

Revenue from sales:

Year 1: 25,000 units × £80/unit = £2,000,000

Year 2: 25,000 units × £84/unit = £2,100,000

Year 3: 25,000 units × £88.20/unit = £2,205,000

Year 4: 26,000 units × £92.61/unit = £2,411,860

Tax savings from depreciation:

Depreciation per year: = £600,000

Assuming a tax rate of 30%, tax savings = £600,000× 30% = £180,000 per year

Cash Outflows:

Production costs:

Direct material: 25,500 units × £8/unit = £204,000 per year

Direct labour: 25,500 units × £10/unit = £255,000 per year

Variable overheads: 25,500 units × £12/unit = £306,000 per year

Fixed production costs: £250,000 per year

Total production costs: £1,015,000 per year

Net Cash Flows:

Year 1: £2,000,000 - £1,015,000 + £180,000 = £1,165,000

Year 2: £2,100,000 - £1,015,000 + £180,000 = £1,265,000

Year 3: £2,205,000 - £1,015,000 + £180,000 = £1,370,000

Year 4: £2,411,860 - £1,015,000 + £180,000 = £1,576,860

Discounting Cash Flows:

Using a discount rate of 15%, we can calculate the present value of each net cash flow:

Year 1: = = £1,013,043.48

Year 2: = £943,129.42

Year 3: = £883,628.95

Year 4: = £832,685.61

NPV Calculation:

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows

NPV = (£1,013,043.48 + £943,129.42 + £883,628.95 + £832,685.61) - £2,400,000

NPV = £3,672,487.46 - £2,400,000

NPV = £1,272,487.46

Based on the NPV calculation, the proposed investment in the ZAC product is financially viable, as it has a positive NPV of £1,272,487.46. This indicates that the project is expected to generate a return in excess of the company's cost of capital.

b) Calculating the Payback Period

Payback Period is the time it takes for a project's cash inflows to equal its initial cash outflows.

Step 1: Determine the cumulative cash flows:

Year	Cash Inflow	Cumulative Cash Flow
1	£1,165,000	£1,165,000
2	£1,265,000	£2,430,000
3	£1,370,000	£3,800,000
4	£1,576,860	£5,376,860

The cumulative cash flows become positive in year 3.

Payback Period = Year before payback +

Payback Period = 3 +

Payback Period = 3 +

Payback Period = 3 - 1.022

Payback Period = 1.978 years

The payback period for the project is approximately 2 years. This means that the initial investment of £2,400,000 is expected to be recovered within 2 years.

c) Analysis of Both Methods

While the NPV method is actually a measure of profitability taking into consideration the times value of money and presenting the whole picture, while the payback period only gives us the time of recovery and does not consider cash flows beyond that period of time (Dai et al., 2022, p. 188). I also support the Financial Managers decision to apply NPV to estimate long-term project benefits, as opposed to the Accounting Rate of Return.

Task – 3

a)Statement of Profit and Loss

Statement of Profit and Loss for the Year Ended 31 December 2023
Account	£000
Sales Revenue (I)	21,309
Cost of Sales
Opening Inventory	641
Purchases	9,317
Closing Inventory	-627
Cost of Sales (II)	9,331
Gross Profit (I - II)	11,978
Distribution Costs	-3,852
Administrative Expenses	-2,975
Operating Profit	5,151
Finance Costs (Loan Interest)	-150
Profit Before Tax	5,001
Corporation Tax	-507
Profit for the Year	4,494

b) Statement of Changes in Equity



Statement of Changes in Equity for the Year Ended 31 December 2023
Particulars	Share Capital (£000)	Retained Earnings (£000)	Total Equity (£000)
Balance at the Beginning of the Year	7,000	2,537	9,537
Profit for the Year		4,494	4,494
Dividends Paid		-450	-450
Balance at the End of the Year	7,000	6,581	13,581





c) Statement of Financial Position

Statement of Financial Position as of 31 December 2023
Particulars	£000
Non-Current Assets
Buildings at Cost	5,000
Less: Accumulated Depreciation (1,000)	4,000
Motor Vehicles at Cost	5,500
Less: Accumulated Depreciation (600)	4,900
Equipment at Cost	10,000
Less: Accumulated Depreciation (3,000)	7,000
Total Non-Current Assets	15,900
Current Assets
Trade Receivables	1,546
Closing Inventory	627
Cash & Cash Equivalents	185
Total Current Assets	2,358
Total Assets	18,258
Equity and Liabilities
Equity
Share Capital	7,000
Retained Earnings	6,581
Total Equity	13,581
Non-Current Liabilities
5% Bank Loan	3,000
Current Liabilities
Trade & Other Payables	1,010
Accruals	160
Corporation Tax Payable	507
Total Current Liabilities	1,677
Total Liabilities	4,677
Total Equity and Liabilities	18,258

Task – 4

a) Calculation of Ratio

Ratio Analysis for PQR plc

1. Gross Profit Margin

Gross Profit Margin = ×100

Gross Profit: £11,978,000

Sales Revenue: £21,309,000

Gross Profit Margin = ×100 = 56.2%

2. Operating Profit Margin

Operating Profit Margin = ×100

Operating Profit: £5,151,000

Operating Profit Margin = ×100 = 24.2%

3. Return on Capital Employed (ROCE)

ROCE = ×100

Capital Employed: Total Equity + Non-Current Liabilities = £13,581,000 + £3,000,000 = £16,581,000

ROCE = ×100 = 31.1%

4. Current Ratio

Current Ratio =

Current Assets: £2,358,000

Current Liabilities: £1,677,000

Current Ratio = = 1.41: 1

5. Inventory Holding Days

Inventory Holding Days = × 365

Closing Inventory: £627,000

Cost of Sales: £9,331,000

Inventory Holding Days = × 365 = 24.5 days

6. Trade Payables Days

Trade Payables Days = × 365

Trade Payables: £1,010,000

Purchases: £9,317,000

Trade Payables Days = × 365 = 39.6 days

7. Interest Cover

Interest Cover =

Finance Costs: £150,000

Interest Cover = = 34.3 times

8. Gearing Ratio

Gearing Ratio = ×100

Gearing Ratio = ×100 = 18.1%

b) Comparison with FTSE 100

1. Gross Profit Margin = The gross profit margin of PQR plc (56.2%) is significantly higher than the FTSE 100 average of 30%, indicating strong profitability and effective cost control in producing goods.

2. Operating Profit Margin = PQR plc’s operating profit margin (24.2%) is higher than the FTSE 100 average of 20%, suggesting good control over operating expenses and higher efficiency compared to the average company in the index.

3. Return on Capital Employed (ROCE) = The ROCE of PQR plc (31.1%) is higher than the FTSE 100 average of 25%, indicating that PQR plc is utilizing its capital effectively to generate profits.

4. Current Ratio = The current ratio of PQR plc (1.41:1) is lower than the FTSE 100 average of 2.5:1, suggesting that the company may have less liquidity compared to its peers, potentially indicating a higher risk in meeting short-term obligations.

5. Inventory Holding Days = The inventory holding days for PQR plc (24.5 days) are close to the FTSE 100 average of 25 days, suggesting efficient inventory management.

6. Trade Payables Days = The trade payables days for PQR plc (39.6 days) are slightly below the FTSE 100 average of 40 days, indicating that PQR plc is managing its payables efficiently, maintaining a similar payment cycle as other companies in the index.

7. Interest Cover = The interest cover of PQR plc (34.3 times) is significantly higher than the FTSE 100 average of 9 times, indicating that PQR plc has strong earnings relative to its interest obligations, reducing the risk of financial distress.

8. Gearing Ratio = The gearing ratio of PQR plc (18.1%) is lower than the FTSE 100 average of 25%, indicating a relatively low level of debt compared to equity, which suggests a conservative approach to financing.

Task – 5

By Issuing 1,000,000 new shares at £2/share, there will be £2,000,000 which will cater most of the £2,400,000for machinery. This option eliminates the use of borrowed capital and hence limits the amount of interest that an entity would have to pay in the light of prevailing high interest rates. This also ensures that the company’s gearing ratio is kept at check and is essential in retaining investors’ confidence keeping PQR plc among the blue chip companies.

However, the use of new shares has the disadvantage that the percentage of the company owned by the shareholders decline. This may be in the form of a reduction in the earning per share (EPS) and therefore bad news to the investors, thus leading to a reduced price per share (Kahan and Rock, 2020, p. 1771). Also, the utilization of equity financing in the sole exclusion of other sources can be perceived as the firm lacking proper leverage.

This is probably the best course for equity financing to be accompanied by other method such as use of retained profits or part of the need capital secured through long term borrowing at reasonable interest rates. This would enable PQR plc to manage dilution effects effectively, retain financial manageability, and ensure that the benefits of leverage are properly utilized to safeguard shareholder value and financial stability.

Conclusion

The financial ratios calculated for PQR plc show higher profitability and more conservative capital policy the company. The recommendation outlines the use of issuing new equities together with retained profits as sources of funds; this helps spread debts, ensures sustainable business growth and protects the interest of shareholders. It is clear that very high prices mean that blue-chip status entails actions that limit the damage that high interest rates can produce.

Reference

Allais, M. (2024) ‘Economy and Interest: A New Presentation of the Fundamental Problems Related to the Economic Role of the Rate of Interest and Their Solutions.’ University of Chicago Press. Available at: https://books.google.co.in/books?hl=en&lr=&id=HsEXEQAAQBAJ&oi=fnd&pg=PR7&dq=High+interests+are+more+specific+to+an+economic+environment+&ots=W6ueVEv6t5&sig=EG84219DtJYi19-HO8S1X15r8Fc&redir_esc=y#v=onepage&q=High%20interests%20are%20more%20specific%20to%20an%20economic%20environment&f=false

Dai, H., Li, N., Wang, Y. and Zhao, X. (2022, March) ‘The analysis of three main investment criteria: NPV IRR and payback period.’ In 2022 7th International Conference on Financial Innovation and Economic Development (ICFIED 2022) (pp. 185-189). Atlantis Press. Available at: https://www.atlantis-press.com/proceedings/icfied-22/125971510

Kahan, M. and Rock, E.B. (2020) ‘Index funds and corporate governance: Let shareholders be shareholders.’ BuL rev., 100, p.1771. Available at: https://heinonline.org/HOL/LandingPage?handle=hein.journals/bulr100&div=54&id=&page

Standing, G. (2019, June) ‘Basic income as common dividends: Piloting a transformative policy.’ In Progressive Economy Forum (Vol. 12). Available at: http://www.revistaprimerapiedra.cl/PDF/documentos/PEF_Piloting_Basic_Income_Guy_Standing2019.pdf