Effective Financial Management and Solutions to Glee Plc Finance Essay Essay

Glee plc is large listed company where their sport equipment products are doing well in the market but their profits are doing not well, the new investment that they are currently investing are in the problem. The company has a few of problems that they need to be improve, such as how and where to raise funds, reduce cost of capital by using balanced capital structure and the technique of investment appraisal to have more investment opportunities. Glee plc can go for long-term finance such as equity finance or debt financing to raise their company funds depending on their company financial condition, which the best suit of them will be the chosen one. Before making any investment, no matter what funds that Glee plc is taking, the cost of capital should be calculated first in order to get the minimum return to the cost of capital. The lower cost of capital will be the main objective. There are some arguments of capital structure debate such as, Traditional view and the Modigliani & Miller’s view in 1958 & 1963. There are four techniques of investment appraisal are bring to discuss also such as, payback period, net present value, accounting rate of return and internal rate of return. It is important to know how to manage the financial smartly, so that it only can achieve the company’s objective.

1.0 Introduction

Glee plc founded in 2005 and the company is the largest established listing company of manufacturing sports equipment based in Singapore.

Glee plc fails to manage their financial properly and their profit is underperforming. They do not know where to get the ideal sources of finance and do not aware about the important of having a balanced capital structure to achieve a low cost capital. Besides, they have no structured approach to appraising investment opportunities.

This report is to highlight to let the company aware of the dangers if they do not manage the above areas effectively. I will discuss the sources of finance, cost of capital, capital structuring and investment appraisal technique in order to improve Glee plc’s finance performance.

2.0 Sources of finance & Cost of capital

A various sources of long-term finance are where Glee plc can obtain the funds for further investment. As such, the cost of funds that undertake should have a minimum return or equal to cost of capital.

2.1 Sources of long-term finance

It is suggest that long-term finance is the most suitable for Glee plc because the payback period will be more than one year and sometimes it has no obligation for repayment. Two options to get the funds are equity finance and debt finance.

2.1.1 Equity finance

This financing money are comes from the shareholders where they sell its ownership to the outsider investors. Two equity finance sources are ordinary shares and retained earnings. Under ordinary shares, Glee plc may issue new share to the public where by using offer for sale, public issue and private placing or another way by rights issue to company existing shareholder. For retained earnings, the decision that Glee plc decide will not influence the shareholder.

The advantages are Glee plc need not do any re-payment of capital to the investors that wish to sell their shares. For dividends, it only requires to pay when company is in the profit year.

For the disadvantages, Glee plc may lose their ownership to other investors when they issue more shares. It is very expensive and wasting time, it may brings suffer to Glee plc business as it takes long time to bring to an attention.

2.1.2 Debt financing

This financing can obtain through outsider third parties while maintaining the wholly control of your business. Debt financing can be in term loan, bonds, convertible securities, leasing and issue warrants.

The advantages are Glee plc enables to maintain the ownership where there are no third parties involved. Besides, it has tax deduction benefits where the interest expenses on loan can be tax deductible.

For the disadvantages, the higher debt financing will lead Glee plc going into bankruptcy because the interest rate is still high. Glee plc will need to do repayment on time no matter there is profit or not.

2.2 Cost of capital

Cost of capital is the cost of debt and equity that undertaking capital budgeting. Whatever investment that Glee plc make, the funds that undertake should have a minimum return or equal to the cost of capital. Whichever sources of funds that Glee plc take into, it required to pay the cost because different types of sources fund will have different cost. As such, the cost should be at low by dealing with the mixture. The cost of capital will be such as, cost of debt, cost of preferred share capital and cost of equity. Lower cost is the objective.

The cost of debt (Kd) calculates the interest rate payment that Glee plc borrow money from. The cost of preferred share capital (Kp) is the required return rate where shareholder of Glee plc expected on. The cost of equity (Ke) calculates the cost of using equity finance in Glee plc. Kd is lower level of gearing because of its lower return and it is less expensive due to tax deductible on interest debt. Ke is high level of gearing because investor expecting higher return and is more expensive because of paying dividends. Besides, when Glee plc sell off the equity, you will be selling off your future share performance where this are too much more value compare to the normal interest debt that charge on Glee plc. This is why Ke is always higher than Kd.

2.2.1 Weighted average cost of capital (WACC)

WACC refer to average cost of Glee plc’s finance, the lower WACC is the greatest one. Each sources of capital should be determined first before Glee plc can determine the weighted average cost of capital (WACC). WACC will influence the market value and when WACC is lower, the share price will become higher. Therefore, Glee plc should determine the debt cost, preferred share capital cost and equity cost to let WACC become lower.

3.0 Capital structure debate

This will look on how Glee plc combine the debt and equity financing to look for an optimum capital structure as this concern shareholder wealth. It is important to reduce the WACC by lowest to maximize the shareholder wealth. Three capital structures that Glee plc should have looked on it are Traditional View, Modigliani & Miller’s View (Without tax 1958) and Modigliani & Miller’s View (With tax 1963). The debate then arises between both of these Views in order to achieve an optimum capital structure.

3.1 Traditional View

Traditional view points out that the higher debt in capital structure of a company, the lowest WACC it has because the cost of debt is lower than the cost of equity and enables it to use a lower discount rate for project appraisal, and thus increase the value of the company and shareholder wealth (University of Sunderland 2007). The graphs explain that when the gearing increase, the cost of equity will rise because the shareholders financial risk is increase and the cost of debt will also go upward when it at high gearing level. It shows an optimal point where the WACC is at the lowest point. As for market value, company’s debt and equity increased when cost of capital decreased.

Cost of capital (%)

Ke

WACC

Kd

0 Level of gearing (%)

Market value

Traditional View graphs

3.2 Modigliani & Miller’s View (M&M)

M&M have a different opinion towards Traditional view and their model come out with two views, M&M model without tax on 1958 and with tax on 1963.

3.2.1 Modigliani & Miller’s View without tax – 1958

M&M argue that a company’s total value and WACC as constant no matter what is the gearing level. How the company mix with debt and equity will not affect WACC. However, the criticisms on M&M model are there are no taxation, no costs involved in changing capital structure such as issue and dealing costs and there is interest rate applies to both borrowers and lenders (University of Sunderland 2007). The graphs explain that when the WACC remain constant, the market value of the company will remain constant as well. The WACC of geared company equal with WACC of ungeared company.

Cost of capital (%)

Ke

WACC

Kd

0 Level of gearing (%)

Market value

Level of gearing

Modigliani & Miller’s view without tax – 1958 graphs

3.2.2 Modigliani & Miller’s View with tax – 1963

A second version of M&M model that take taxation into account, where interest payment is allow for corporation taxes, which bring benefit to shareholders. It encourages company to “borrow as much as possible” basis because of the lower cost of debt capital and the WACC will drop because of the benefit tax very high. However, the criticism on this are capital market are perfect, enabling companies to raise finance whatever their current borrowing levels. Companies cannot raise additional debt finance without limit. In addition, they do become insolvent when they have so much debt that they cannot make interest payments or repay capital (University of Sunderland 2007). Below are the graphs.

Cost of capital (%)

Ke

WACC

Kd

0 Level of gearing (%)

Market value

Level of gearing

Modigliani & Miller’s View with tax – 1963 graphs

4.0 Investment appraisal

It could bring Glee plc into dangerous financial situation if it does not manage the above areas effectively. Glee plc could end up making lost or even worse end up bankruptcy. In order to make improvement to Glee plc’s financial performance, I would like to discuss about the types of investment appraisal available.

Investment appraisal are generally known as capital budgeting. It is a process of making investment for major capital projects. Usually, long-term investments are the most main concern decisions in any field of business because it expected to gain higher returns in future. Investment appraisals are carried out to make the comparison of the cost of investment of a project whether the investments are able to gain any yield returns over a period and examine whether it is worth it or not to investment.

It is important because it helps company to make smart long-term investments where the cash and assets are well invested in and generate the greatest returns for the projects. Besides, the risk of the investment in Glee plc’s new project can be measure out to minimize the risk.

Four types of technique investment appraisal that Glee plc should consider are payback period, Net Present Value (NPV), Accounting Rate of Return (ARR), and Internal Rate of Return (IRR).

4.1 Payback period

Is the technique to measure the duration of time that a project took to pay off its investment capital cost. Payback period shows how fast is the cash inflows deal with the cash outflows, the fastest return is the better one and then accepted.

For example, two alternative projects, Project A and B whose has the initial investment of £120,000 and each cash flow are as per table (refer appendix 1), which Project will be prefer? Project B will be chosen because Project B investment recovered fastest on the third year.

It has the merits of quick and basic calculation and the concept are easy to understand. Second, if Glee plc would like to buy the new machinery to replace the old one, the fastest payback on the investment is necessary.

The limitations are Glee plc cannot decide the duration of ideal payback time. It does not concern the time value of money. Furthermore, payback usually concern of cash flow only, it does not concern the profit of Glee plc’s business.

4.2 Accounting rate of return (ARR)

ARR is a method estimates the accounting rate of return of a project’s generates, as a percentage of the investment in the project. ARR concern more on the annual profit on the project rather than looking at the cash flow and can be use to compare the profits gained between several project, the highest percentage are the most attractive investment because it gives higher return.

For example, company X wants to buy a new machine. Two models machine available and no disposal value and the company’s average target of ARR is 35% (refer appendix 2). Which machine should the company X choose? Conclusion is to buy machine B because it gives highest ARR at 43.3%, which over the company’s average target at 35%.

It has the merits of simple understanding concept and calculation where it makes easy for your managers and investor because it uses the term profit. Furthermore, ARR looks into the overall of the project life.

The limitations are it does not concern the time value of money and the timing of the profits earned from a project. Besides, ARR does not have specified decision to guide your managers whether it is worth it or not to invest. The lack of strategies making an investment decisions are still subjective.

4.3 Net present value (NPV)

NPV is a technique that calculates all the relevant present value cash inflows and outflows that involved with an investment. Cash flow in the future years are adjusted to a present value by discounting the cash flows using suitable discount rate, therefore NPV technique takes time value of money into account. A positive NPV outcome is the project that should be focus on.

For example, two alternative projects, project A and B, using the cost of capital of 10% and the estimated cash flow are as per table (refer appendix 3), which of the two projects the NPV would choose? Project A will be choosing because it has a positive NPV.

The merits are it helps Glee plc to concern the overall project lifespan and have a time value of money. It also enables your managers to consider the risk of future cash flow and maximize the Glee plc’s shareholder wealth.

The limitations are it could be difficult to calculate where some of your managers might not be familiar with the NPV concept. Besides, NPV is hard to determine the accurate discount rate and cost of capital are required in order to calculate the NPV.

4.4 Internal rate of return (IRR)

IRR is a true interest rate earned by the investment over a project where the sum of discounted cash inflow is equal to discounted cash outflow. IRR is use to compare the rates or return and calculate the rate of return that reduces the NPV equal to zero. It concern breakeven point. When the IRR is higher, your project should best to be accepted.

For example, Company X is considering buying a machine at the cost of £120,000, which can save cost of £40,000 per annum for 5 years, resale value of £10,000 at the end of the fifth year. Yield return of 10%. Is the project should be taken? (refer appendix 4). Company X will buy the machine because the IRR shows higher at 21.80%.

The merits are it helps Glee plc concerns the time value of money and the cash flow of your project. Furthermore, the discount rate does not have to be specified before the IRR is calculated and cost of capital no need to calculate because the profitability of the project can be check without any calculation of cost capital.

The limitations are the calculation and the concept is hard to understand. IRR is not an ideal to make comparison between two projects because it can give a conflict answer.

Among the four techniques above, NPV is the best because when NPV is positive, it will generate more cash for your project and therefore it brings advantage if your company main objective is to maximize the shareholder wealth.

5.0 Conclusion

As conclusion, there is no right and wrong answer to choose which sources financing is the best. Either one or both can be choose depends on Glee plc’s company size and the company cash flow ability. Other factors to consider are such as, the cost of financing, duration of borrowings money and the company current gearing level. Cost can be reducing by dealing with the mixture and find out the WACC, the lowest WACC will be the best. No matter what decision financing Glee plc is making, as long to maximize the company shareholder wealth is the overall company main objective.

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