Financial Management Report Example
(Besley & Brigham, 2008)
b. Capital Allowances
Net Value (pre discounting) of the Projects
Net Present Value of the Projects using WACC (6.34%) as the Discount Rate
The two projects under consideration of Chantelle Ltd. show a negative Net Value. When the inflows from the projects over the next four years are compared with the initial investment a negative figure arises showing a net loss. Therefore, considering Net Value both projects are unadvisable for the company.
The second method used to evaluate the projects is Net Present Value (NPV) which takes into consideration the risk associated with the project and also the time value of money as both projects provide a return over 4 years (Graham & Smart, 2012). The discount rate used for both the projects was reflective of the rate of return that the shareholders expect in order to continue financing through the current capital structure. This rate is thus, the Weighted Average Cost of Capital (WACC) of the business, calculated in the previous parts. Therefore, if the projects result in a positive NPV when discounted using the WACC, the business would be giving its shareholders a return greater than expected from the market. The shareholder’s equity would then be increasing (Roche, 2005).
Since the NPV of both the projects is negative, it is clear that neither should be taken up by Chantelle Ltd., as even after considering time and risk the initial investment in both the projects is greater than the returns. Project A has resulted in a greater loss after tax as its inflows are smaller in amount than Project B over the four years.
d. Net Present Values (NPV)
The Net Present Value method of investment decision making measures the addition to shareholders’ current wealth that would result if a project is undertaken. It calculates the benefit from an investment based on the anticipation of future benefits (Narayannan & Nanda, 2004). Therefore, the NPV method of investment appraisal takes into account major elements affecting the value of the cash flows – the risk of the project and the time value of money. To incorporate these factors the future cash inflows are discounted back to the current period using a rate of return that has been decided based on the cost of capital that is being invested. In most cases such a rate is the WACC (Weighted Average Cost of Capital) that can be derived using the market rates of return on equity and debt financing options. The discount rate can be up-scaled or down-scaled to adjust for the level of risk associated with the project involved (Jackson, Sawyers, & Jenkins, 2009).
Along with encompassing the time value of money and the risk the NPV is also a clean and quick method of project evaluation which focuses on maximizing the firm’s value through guiding investment decisions. Profitability of the investment is given priority thus making it a useful tool of investment appraisal. Many businesses still use the NPV among other more sophisticated methods of appraisal, as it provides managers a concrete number to base their investment decision on and to compare the return of various projects (Gallo, 2014).
However, like every other method, the drawbacks of NPV should be kept in mind when calculating the profitability of a project. Firstly, the discount rate used to appraise the project is highly subjective as some managers consider a certain rate suitable whereas other stakeholders may have a varying view of the appropriate rate of return expected by the shareholders. Moreover, it is important to remember all through that that the cash flows derived are based on expectations of the future and are not guaranteed inflows. Sudden changes in environmental factors can result in changes in the expected cash flows of the project. The liquidity constraint that cash flows expected cannot be recorded as profits made is also ignored by the NPV model, which focuses on financial performance as the sole measure of project viability (Nortcott, 1998).
Therefore, it is always recommended that NPV be used in conjunction with other investment appraisal methods to arrive at conclusive decisions that are not only based on numbers derived from estimations of the future.
The liquidity ratio of the company does not appear to be very promising as it denotes that to pay off £1 of current liabilities the company only had £0.72 of current assets (easily convertible to cash) available in 2012 and this amount further fell to £0.57 in 2013. An ideal current ratio has a value of 2:1 (Khan & Jain, 2010).
The equity investors will find this business a grim investment opportunity as the business appears to be sliding into bankruptcy. The equity investors will find that funds invested will be mostly likely used to pay trade creditors for past purchases or to make interest payments for funds that were previously borrowed. Such a liquidity position discourages investors especially because the current ratio is further deteriorating.
Employees of the company will fear that in the future no cash may be available to pay their salaries or wages thus spreading a sense of insecurity amongst the workforce. It should be noted that a deteriorating ratio is highly alarming for the staff that could very soon have wages overdue.
The Return on Capital Employed (ROCE) by the business appears to be sufficient as the ratio is denoting that the invested amount has been giving a reasonable profit. This can be said by comparing the ROCE to the WACC of the company. The company is generating a return on capital much greater than the cost of capital (6.34%). However, an area of concern is that this rate has declined over the two-year period under observation.
Employees are positively affected by thriving ROCE figure such as that of Marks & Spencer Group plc. as this provides assurance that the company is performing well and employees will be regularly paid. There may even be chances of bonuses and profit-sharing, while a general sense of job security and well-being prevails.
The fixed asset turnover ratio denoted that Marks & Spencer has used its property, plant, and equipment a little less effectively in 2013, than in 2012. This shows that every pound invested in fixed assets has resulted in an earning of approximately £2 in 2013. This does not appear to be a very high figure and the company needs to make more out of its assets rather than simply let such investment lay idle.
For equity investors such a ratio would only matter if the company belongs to a manufacturing industry where fixed assets are necessary items of production. If that is the case then this ratio suggests inefficient management of fixed assets and may discourage investors. In cases where fixed assets play a supporting role such a ratio may be satisfactory (Albrecht et al, 2008).
For the employees such low-lying fixed asset turnover ratios may suggest the requirement of greater efficiency in the usage of machinery, by ensuring that machines do not lie idle and those that are extra or obsolete are removed from the premises to make free cash that is held up inefficiently. Efficient usage of plant and equipment may also require introduction of training programs for the employees to ensure better management of resources.
The Gearing ratio is indicative of the extent to which a business is financed by debt. A high gearing ratio suggests that the business is greatly dependent on loans and other sources of debt and less on equity. This harms the long-term sustainability of the business. For Marks & Spencer this figure is quite high and the business appears to be too dependent on debts.
For equity investors such a high gearing is a very discouraging factor as it shows a business at high risk. Also servicing such finance often eats into the retained profits of such a business. This results in lesser cash reserves left for re-investment in the business, thus stunting its growth or resulting in another cycle of long-term borrowing to pay off loans that have become current.
Employees also feel marginalized in a business with a high gearing ratio. Any bad turns in the economy can result in the collapse of the business or in severe downsizing. It is important to note that even promotions and pay raises may remain threatened while the business is in such a highly geared condition (Spencer & Stradling, 1998).
c. Ratio Analysis
Ratios have for long been tools of analysis for financial analysts. The financial statements of companies are often studied on the basis of ratios. Numbers on their own may not provide great detail, but when studied in the form of ratios, these figures are studied in relative terms. Two quantities are bought together and expressed in relation to each other thus making sense out of the financial statements (Hall, 2007). However, ratios on their own may also not be very helpful unless benchmark ratios are known or trends are being studied. Ratios are often compared with those of other firms, with those of the same firm in different years, and with industry averages. Ratios thus, reveal not only the performance of organizations but also, their efficiency and growth over time. Ratios have been divided into several categories to identify which areas of a company’s performance are being studied – liquidity, profitability, efficiency, and investment ratios are just a few.
Ratios are capable of summarizing huge volumes of financial data into a few comparative figures, and draws a relationship between present financial performance and that of the past. Ratios have been providing management with a sound basis for decision-making and analysis over the years (Debarshi, 2011).
Ratio analysis is highly dependent on the quality of the financial statements from which these are prepared. The authenticity of such information may often come into question, making the ratios unworthy of study. Similarly, it is important that once ratios have been conducted these are compared with similar ratios and across similar categories. Since ratios are a depiction of the present and the past, it may not always be advisable to predict the future using the same. Varying accounting practices may make it difficult to compare ratios. Lastly, ratios simply highlight quantitative short-comings and may not be a good guide of qualitative changes in the business (Hall, 2007).
3.a. Budgeting has always been the manager’s way of planning ahead. Past performance is studied to generate trends and these trends help managers to predict the future. However, today predicting the future may not be as easy as it used to be. Predictability does not leave margin for changes and sadly enough there are inevitable changes in the business environment of today. These changes not only render the budgeted predictions useless but also require a radical change in business policy (Morlidge & Player, 2010).
Bringing a business enterprise face-to-face with these changes in a sudden surge of events is not desirable but is the likely impact of being over dependent on budgeting in today’s business environment. Various areas of budgeting can fall prey to sudden environmental changes. Many managers feel inability to adapt has been a result of improper application of IT tools, but blind use of these tools can result in further havoc for the business.
b. Using these budgeting tools, however, many organizations still believe that centralized budget planning can help to minimize redundancies and reduce misappropriation of funds. On a period of three months such plans fall into place and often help the managers believe that their method of planning and control are working. Not knowing that such budgetary control is putting the organization on the path to failure is often an issue for managers and it is only a matter of time that rapid change takes its toll and businesses realize that budgets were never falling into place and predictability now requires strong algorithms which take into account several factors in a rapid changing environment (Morlidge & Player, 2010).
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