CEE – HND Business

Course Title: Managing

Finance
Semester: April – July
2010
Time: Morning
Assignment Title
Cost of Finance
&
Financial Planning

Tutor: Mr. Vijay Nair

Student: Rashida Yvonne
Campbell
Hand in date: 16th May 2010
Assignment: No. 2

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1
Contents Page

Assignment Description 3

Deciding the location 4

Cost of Issuing Shares 4

Cost of Bank Loan 5

Cost of Retained Earnings 7

Cost of Competitor investment 8

Recommendation 9

Quartz Corporation 10

Altitude Training Centre 11

Task B
Financial Planning 13

Capital Structure 14

Dividend Decisions 15

Investment Decisions 16

Budgeting 17

Working Capital 17

Conclusion 18

Task A:
Scenario

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ACB Training with an annual turnover £25million, is contemplating
relocating to new premises. Two possible sites are available with slightly
different features and aspects. The re-location will help them to be able to
meet client’s needs more effectively.
Location 1:
Investment required for the move = £10million
The location is in the heart of the city centre and an estimated increase of
25% is expected if this option is chosen.
Location 2:
Investment required for the move = £8million
Very close to city centre and business will increase by 10% if this option is
selected.

ACB Training private limited company formed 10 years ago by 5 ex-

lecturers. The 5 of them are the main shareholders but there is also a
shareholder who was a local business person who approached 2 of the
owners to run a training course for her company.
They have the following options to generate finance:
a) The management is thinking of generating the required finance by
issuing 1million new shares of £10 each.
b) One of the banks with which ACB has long financial relations has
sent a quote for the loan at interest rate 7% per annum for a
maximum of 10 years.
c) The retained earnings account showed a balance of £25 million in
the last year’s balance sheet.
d) One of the competitor companies has offered to help ACB but the
investors are expecting 80% share of the profit in the future
venture.
Evaluate the costs of the sources of finance. Also mention how the option
selected will reflect on company’s financial statement.

Task B:

Write an essay on the importance of financial planning and how the needs
of decisions makers can be met?

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Deciding the location
The first part of the scenario requires a decision to be made on either
choosing location 1, or location 2.
Choosing location 1 would require an investment of £10,000,000 with a
benefit of 25% increase in sales per year.
Calculation:10,000,000 x 25 = £2.5 million (2,500,000)
100
Choosing location 2 would require an investment of £8,000,000 with a
benefit of 10% increase in sales per year.
Calculation:8,000,000 x 10 = £800,000 million (£0.8 million)
100
Taking option 1 provides an opportunity cost of
Calculation:2,500,000 – 800,000 = £1,700,000 million (£1.7 million)
Therefore taking location 1 provides more profits at an opportunity cost of
£1.7 million more. ACB should choose location 1. The second part of the
task is to evaluate the different costs of the sources of finance given for
option A, B, C and D.

A Issuing of new 1 million shares at £10 each would

raise the total of £10 million pounds required for the
relocation.
Calculation: 1,000,000 shares x £10 = £10 million

Cost benefits of issuing shares to raise finance are:

• The company will avoid using its retained profits
• Retained earnings can be used for other purposes such as: pay out
its profits between the existing share holders, Invest into stocks etc.
• By holding its retained earnings the balance sheet will not be affect.
• Avoids taking bank loans and re-paying the interest.
• Dividends on shares only need to be paid if the company makes a
profit

Cost disadvantage of issuing shares to raise finance are:

• New shares means present shareholders ownership is reduced.
• There may not be any buyers (no demand) for the new shares,
leaving the company with insufficient funds for the venture.
• When a company announces the issue of new shares it leads to
speculations that the company has financial problems and that the
firm may be entering into risky businesses.
• New shareholders expect the share value to increase so that they
can sell the shares at a later date earn a profit.
• New shareholders expect to receive a return on the investment in
the form of dividends.
• Issuing shares has costs involved such as administrative and legal
costs.

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 • Time factors means that to raise finance in this way will not always
be immediate it takes time to arrange and to receive buyers of the
new shares.

B Bank loan £10 million at 7% interest rate per annum

for 10 years
Calculation Costs for the bank loan source of finance would be:

10,000,000 x 7% = £700,000 per annum or (£0.7 million)

100
Over a period of 10 years £0.7million x 10 years = £7,000,000

Total interest rate payable over 10 years for the amount borrowed = £7
million

So the bank loan of £10m investment receives 25% profit of £2.5m minus
7% interest
Calculation:
£2.5m profit – 0.7% interest = £1.8 million net profit

Opportunity cost:
£2.5m – £1.8m = £0.7 million (£700,000)

Therefore £2.5 million is the gross profit after interest payments of £0.7
million net profits are £1.8 million, to calculate in percentage terms:

Percentage profit:
£1.8m net profit x 100 = 72% profit earned
£2.5 m gross profit

Cost benefits of the bank loan source of finance are:

• Companies can take advantage of Tax Relief on the profits before
deducting the interest. In this case:
Calculation Tax Relief:
Gross profit = £2.5 million
Interest charge = £0.7 million
Net profit =£1.8 million

Tax without interest payments means the gross profit £2.5 million would
be taxable. Due to interest payments now Tax Relief can be applied, only
the net profit £1.8 million is taxable.
As an example if we take the Tax rate at 10% the calculation are as
follows:

Gross profit £2.5m x 10% tax = £250,000

100

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On £2.5 million tax payable is £250,000

Net profit £1.8 x 10% tax = £180,000

100
On £1.8 million tax payable is £180,000
A difference of £250,000 - £180,000 = £70,000 Tax Relief Benefit

• Another benefit of the bank loan means that the company will
maintain its retained earnings and would not need to issue new
shares to raise the finance. When retained earnings are untouched
it indicates on the cash flow statement that the company has no
cash flow problems. Cash flow is important for the firm to run
smoothly, to purchase raw materials, payment of wages and
meeting other operating costs.

Cost disadvantages of bank loan as a source of finance

• Commercial loans usually carry high interest rates.
• Opportunity cost means that instead of paying £0.7 million in
interest payments a year the business could do something else with
this money such as marketing & promotion which could generate
further profits for the company for example £1million. Taking the
loan and paying interest means that the opportunity to earn this
possible £1million is lost.
• Another disadvantage is security, if the loan is secured on assets of
the business, then the company has limitations as to what it can do
with that asset, such as selling it would not be possible if it is held
as a security.

C Use retained earnings a balance of £25million last

year’s balance sheet
If the company decides to withdraw £10million from retained earnings of
£25million calculations are as follows:

£25million retained earnings - £10million for relocation = £15million

Retained earnings balance = £15 million

The term retained earnings refers to the organisations cumulative net

income minus the cumulative amount of dividends declared. To show
large amounts or retained earnings on the balance sheet is important for
the calculation of stockholders equity. If retained earnings of £10m are
used for the relocation assuming it will receive a benefit of 25%,
therefore:
£10m x 25% profit = £2.5m gross profit with no interest payments (but
other costs must be deducted such as tax, working capital etc)
Therefore the balance of retained earnings needs to be considered again
as part of the 25% profit will be added to the total sum of the retained
earnings from the last balance. However it would take a long time before
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the company benefited from the 25% profit earned to reach its original
balance of £25m.

Retained earnings are essential from the perspective of shareholders

because the balance of retained earnings are debited and credited to the
current liabilities of dividends payable, the declaration of cash dividends
reduces Retained Earnings, an example of how it decreases is as follows:

ACB Training Company

Statement of Retained Earnings 2009

Retained Earnings 2009 25,000,000

Net Income 1,000, 000
Total 26,000,000
Less Dividends 500,000
Retained Earnings 2010 25,500,000

Should the company decide to withdraw £10m from retained earnings as

a source of finance for the relocation project the statement would show as
follows: (an example only)

ACB Training Company

Statement of Retained Earnings 2010

Retained Earnings 2009 25,000,000

Relocation project 2010 10,000,000
15,000,000
Net Income 1,000,000
Total 16,000,000
Less Dividends 500,000
Retained Earnings 2010 15,500,000
Therefore when investors compare last years statement it appears more
promising and attractive to creditors than this year’s statement. It shows
retained earnings as spent elsewhere rather than in the form of higher
dividends payment.

Cost benefits of using Retained Earnings as a source of

finance
• The money is available no waiting time.
• No need to pay interest rates on loans.
• Goods for short-term usage.

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 • Businesses have to pay tax on their earnings so reducing the
amount of earnings by investing elsewhere the amount taxable is
reduced

Cost disadvantages of using Retained Earnings as a source

of finance
• A business needs its earnings to pay for such things as wages, rent,
materials, utilities etc. Otherwise workers will leave and production
will be reduced. Only through the selling of goods will a company
generate profit. Retained earnings are needs for working capital for
the survival of the company.
• Dividends need to be paid for the cost of the share capital. If this is
not met shareholders lose loyalty in the company.

• Opportunity cost must be considered. If £10m of retained earnings

is used for relocation then this reduces the amount of capital for
other projects. If the other projects can generate a profit of 37%
then the cost of using the £10m for relocation is the 37% profit
foregone.
• The total amount shown as retained earnings may not be the total
amount that is available in cash. It may be in the form of assets or
liquidity, or tied up in other investments.

D Competitor Company will raise the finance for 80% of

the profits.
The calculations for this source of finance are as follows:
£10m at 25% = £2.5m profit
If the competitor takes 80% of the profits the calculations are as follow:
£2.5m profit x 80% to competitor = £2 million will go to the competitor
100
The remaining profit left for ACB Training would be £500,000 (£0.5m)

Therefore the opportunity cost = £2 million foregone

The competitor’s percentage profit for its investment would be:

2,000,000 x 100 = 20% profit
10,000,000
The percentage profit for ACB Training = 5%

Cost benefits of using competitor as a source of finance

• The competitor is no longer a competitor for example Sony-Ericson.
• Both companies can join their resources together to improve and
add value to their products or services.
• The experience of two companies is better than one.
• The risk of the £10 million has been shifted to the competitor
• When companies join in ventures they become larger and can take
on more and new projects

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Cost disadvantages of using competitor as a source of
finance
• Loss of majority of the profits.
• Ownership is reduced.
• Decision making is divided reducing the power and authority of the
original owners.
• May need to make redundancies as the number of employees
increase when two companies join.
• If the venture does not succeed the competitor can pull out of the
contract and will have obtained internal confidential information.

Recommendation
Management must identify the "optimal mix" of financing the capital
structure where the cost of capital is minimized so that the firm's value
can be maximized. It is important to show that on the one hand a
company pays out dividends and on the other hand they re-invest its
profits wisely in order to make new profits, but chooses the right
combination of financial mix and considers the cost involved.
It would therefore be recommendable for ACB-Training to consider using a
mixture of both retained earnings and the bank loan. Withdraw £5 million
from retained earnings and £5 million from the bank at an interest rate of
7%. This would result in the company benefiting from reduced interest
payments and the length of time for the loan. The percentage profit the
firm would make is greater. The reduction of £5 million from retained
earnings of £25 million would be a more reasonable amount left on the
balance sheet of £20 million and £5 million shown as investment activities
is more likely to be accepted by shareholders and other creditors. This
method also means that the opportunity cost enhances the financial
choices rather than hinder them.
Benefits for this decision are calculated below (as an example)

Bank Loan £5 million

Retained Earnings £5 million

£5 million bank loan at 7% interest rate: 5,000,000 x 7% = £350,000

interest per annum
100
If ACB-Training relies on the bank for £5 million the total amount of
interest payable for the period of 10 years:
£350,000 per annum x 10 years = £3.5 million

Rate of Return on £10 million: £10m x 25% = £2.5 million

Therefore gross profit: £2,500,000 million
Interest payable: £350,000

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Net profit: £2,150,000

Percentage profit £5m Retained Earnings £2,150,000 x 100 = 43%

£5,000,000

The banks percentage profit is: £350,000 interest x 100 = 7%

£5,000,000

If ACB-Training relies on the bank for the full £10m the total amount of
interest payable for the period of 10 years:
10,000,000 x 7% = £700,000 per annum or (£0.7
million)
100
Over a period of 10 years £0.7million x 10 years = £7,000,000
Total interest rate payable over 10 years for the amount borrowed = £7
million for the £10m borrowed compared to £3.5 million for the £5m
borrowed

A major benefit of raising £5 million from the bank and £5 million from
retained earnings is the advantage of the leverage (gearing) effect. From
the calculations above we can see the benefits of the leverage effect:

£10 million retained earnings gives a percentage profit of 25% as

calculated below:

£2.5m profit x 100 = 25%

£10m retained earnings

£5 million retained earnings gives a percentage net profit of 43% as

calculated below:

£2,150,000 net profit x 100 = 43%

£5m retained earnings
The solution chosen according to the above findings is therefore to
withdraw £5m from retained earnings and £5m as a bank loan at 7%. This
also spreads the risk, but allowing ACB-Training to maintain a good level
of retained earnings without reducing their ownership control and power
in decision making should they have chosen any of the above options.

Businesses are always requiring extra finance for a variety of reasons,

usually for expansion and growth. The impact of a financing option on the
financial statements of the business will affect different users of this
information. Due to legal requirements financial movements of the
company must be reported in the balance sheets. Two companies have
been chosen to illustrate their methods for raising finance: Quartz a large

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global organisation and Altitude Training Centre a small firm owned by 4
people.

http://www.principlesofaccounting.com/chapter%201.htm

Analysing the above information regarding Quartz Corporation we can see

that the company has previously raised finance through share issues as
now they are showing payment of dividends to shareholders and this has
been deducted from the retained earnings in the “Statement of Retained
Earnings.” It can be identified in the “statement of cash flows” Quartz has
withdrawn from its earnings to fund in Investing activities to purchase
land at $250,000. If the investing activities was not deducted the cash
for December would be £352,000. Let’s assume that the $250,000 can
generate a profit of 35% the profit would be:

$250,000 x 35% = $87,000

100
Most financial managers would calculate to see if the percentage benefits
are worth raising funds from internal sources of the company. If the
percentage on the return on investment will provide a good return then
using retained earnings is a better choice. The reasons for raising this
source of finance avoids time delays, interest payments and the profits
generated will be put back into the company and not shared through
alternative investors. If a company has a good amount of retained
earnings as for the case of Quartz it is advisable to raise its finance using
its own retained earnings.

Another company operating in Dubai Academic city is run and owned by 4

people, their business is expanding and they need to move from their

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small office to a larger office within the same complex. The four owners
initially invested their own private savings to start up the business.
However for the new premises they choose to raise finance through a long
term loan and retained earnings. The company expects to receive
additional increases of 40% generated from the new office premises. The
interest rate payable is 10% over 5 years. The financial statements are as
follows:

Statement of cash flows 31 December 20XX

Retained Earnings as at 31 December
20XX AED (Dirhams)
AED
AED (Dirhams) Retained earnings 31 Dec 210,000
Investing new Offices
Retained earnings 200,000
100,000
Net income 100,000 Financed by:
300,000 Cash 60,000
Loan
Less share capital 90,000 40,000
Retained earnings 31 Dec 210,000
100,000
http://www.altitudetrain.com/

This second example shows that the company has used two sources of
finance to move to the new office premises. The company has withdrawn
60,000 AED cash from retained earnings and 40,000 AED as a bank loan.
The total amount required is 100,000 AED with expected increase in
profits of 40%. The calculations are as follows:

40,000 AED bank loan at 10% interest: 40,000 x 10% interest = 4,000
AED
100

Rate of return 100,000 AED at 40%: 100,000 x 40% = 40,000

AED
100

Therefore Gross profit: 40,000 AED

Interest payable -4,000 AED
Net profit: 36,000 AED

Percentage profit retained earnings: 36,000 AED x 100 = 60%

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Taking advantage of the loan 60,000 AED

If Altitude Training Centre used all 100,000 AED from retained earning
their percentage profit would be:
40,000 x 100 = 40%
100,000

Again this example shows the leverage effect that companies can benefit
from. Also the other benefit of not using the total amount required from
retained earnings is should the company need further investors at a later
stage in the future the balance sheet will show that the company has
plenty of cash. Cash offers protection against tough times, and it also
gives companies more options for future growth. Growing cash reserves
often signal strong company performance. The balance sheet, tells you
how much a company owns (its assets), and how much it owes (its
liabilities). The difference between what it owns and what it owes is its
equity, also commonly called "net assets" or "shareholders equity". The
balance sheet tells investors a lot about a company's fundamentals: how
much debt the company has, how much it needs to collect from
customers (and how fast it does so), how much cash and equivalents it
possesses and what kinds of funds the company has generated over time.

Task B:
Write an essay on the importance of financial planning and how the needs
of decisions makers can be met?

Financial planning is the task of determining how a business will afford to

achieve its strategic goals and objectives. Usually, a company creates a Financial
Plan immediately after the vision and objectives have been set. The Financial
Plan describes each of the activities, resources, equipment and materials that
are needed to achieve these objectives, as well as the timeframes involved.
Financial plan can be a budget, a plan for spending and saving future income.
This plan allocates future income to various types of expenses, such as rent or
utilities, and also reserves some income for short-term and long-term savings. A
financial plan can also be an investment plan, which allocates savings to various
assets or projects expected to produce future income, such as a new business or
product line or shares in an existing business. In business, a financial plan can
refer to the three primary financial statements (balance sheet, income
statement, and cash flow statement) created within a business plan. Financial

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forecast or financial plan can also refer to an annual projection of income and
expenses for a company, division or department. A financial plan can also be an
estimation of cash needs and a decision on how to raise the cash, such as
through borrowing or issuing additional shares in a company. While a financial
plan refers to estimating future income, expenses and assets, a financing plan
or finance plan usually refers to the means by which cash will be acquired to
cover future expenses, for instance through earning, borrowing or using saved
cash (retained earnings).
The steps to financial planning are:
• Deciding on the Capital structure and sources of long-term funds.
• Dividend decisions; how much profit is to be retained or paid out.
• Investment decisions; how much funds should be invested in each
asset.
• Management of budgeting
• Working capital; purchasing of goods for trade, wages etc.
Financial planning is conducted by the financial manager and finance
department of an organisation. It involves the above four kinds of
decisions.

Capital structure refers to the way an organisation has arranged its

funding between ordinary shares, preference shares, and debentures. Its
importance is that shares pay dividends which may be waived in bad
trading years, whereas debentures pay interest which cannot be avoided.
Usually companies receive their long-term funds for investment from
these two main sources. How much capital a company requires is how
much it should rise through these two sources. Capital structure decision
is regarding how much percentage of capital is raised through equity or
debt. It shows the overall investment and financing strategy of the firm.
Capital structure can be of various kinds, an example a capital structure
strategy is “Horizontal Capital Structure” this strategy is where the firm
aims to have zero debt in the structure mix. Expansion of the firm will
raise finance through retained earnings and equity. Capital structure
reflects the firm’s strategy; it shows the risk profile of the company, it acts
as a tax management tool, helps to minimize risk and maximize profits.
Capital structure can be used to build up firms assets.

How Capital Structure affects the needs of the different decision

makers.
• Corporate strategy top managers and directors to make certain that
the capital structure will assist in meeting the overall vision of the
company, its long term aims in size and profitability.
• Stock-market decision makers need the information of a company’s
capital structure to decide whether to buy or sell.
• Shareholders require the capital structure of a firm; to determine
whether or not to invest.

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 • Government also need the capital structure information for taxation
purposes.
• Other creditors such as banks require capital structure information
when deciding if it will finance a loan for the company.

Dividend decisions: is a decision made by the directors of a company.

It relates to how much of the profits should be retained, re-invested or
paid out to shareholders. Decisions are made about the amount and
timing of any cash payments made to the company's stockholders. The
decision is an important one for the firm as it may influence its capital
structure and stock price. In addition, the decision may determine the
amount of taxation that stockholders pay. There are three main factors
that may influence a firm's dividend decision: Free-cash flow; Dividend
clienteles and Information signalling.
Free cash flow dividends is when the firm simply pays out, as dividends,
any cash that is surplus after it re-invests in positive projects.
Dividend clienteles: If clienteles exist for particular patterns of dividend
payments, a firm may be able to maximise its stock price and minimise its
cost of capital by catering to a particular clientele. This model may help to
explain the relatively consistent dividend policies followed by most listed
companies.
Information signalling: Managers have more information than investors
about the firm, and such information may enlighten their dividend
decision making. Managers that have access to information that indicates
very good future prospects for the firm are more likely to increase
dividends.
How Dividend decisions affect different decision makers
• Investors can use this knowledge about managers' behaviour to
inform their decision to buy or sell the firm's stock, bidding the price
up in the case of a positive dividend surprise, or selling it down
when dividends do not meet expectations.
• Stock market speculators and investors
• Competitors to scan on the company’s success or failure
• Internal and external shareholders

Investment Decisions: The investment manager has to make decisions

on how the capital and profits collected by a firm are spent. Decisions
such as re-investment, purchasing of more stock to secure future sales, or
held back in savings, increase assets, split the investments into the
various strategic business units to fund more projects such as research
and development. The investment manager must perform ongoing
monitoring of investments. The manager has to consider the rate of
return, risk, safety, liquidity and the time period.

How investment decisions affect different decision makers

The key role belongs to the Investment manager of the company his
choices will affect a variety of different people and departments:
• Employees in the stock department

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 • Research and development employees would require the
investment decisions of the company to confirm if they are going to
receive funding for there research
• Human resources need investment funding for the head count for
the number of employees each division and is allowed
• Sales managers acquire the knowledge of investment decisions,
should the investment manager decide not to fund in new or more
products the sales team would no longer be able to make bonuses
from these products. Travelling would also be reduced
• Creditors and banker also use the information of the investment
decisions a company has made. So bankers can determine level and
length of any loans.
• Business development units like marketing rely on investments from
within its own organisation to fund future marketing ventures
• Project managers also rely on investment funding and need to know
the decisions of the investment manager regarding current and
future projects.

Budgeting:
Budgeting is part of the financial planning process; it explains in monetary
terms the plan for the income, expenditure and capital investment
(buying fixed assets). Budgeting helps to determine if a firm's long term
investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing. It ensures that
no department or individual spends more than the company expects. Steps to
budgeting:
• Make judgements on the likely sales revenue for the coming year
• Set a cost ceiling that allows for an acceptable level of profit
• The budget for the whole company is then broken down into
division, department or by the cost centre.
• The budget maybe broken down further for each manager and gives
them some spending power
• Budgets are then monitored
Budgeting helps to ensure the objectives of the organisation. It helps to
compel planning and decision making. It communicates ideas and plans to
the company. It co-ordinates activities. It gives a framework for
responsibility. It establishes a system of monitoring and control.
How budgeting decisions affect different decision makers:
• Budgeting will affect all departments and divisions of the
organisation
• Suppliers are also affect by budgeting the company’s choice of
expenditure will impact the amount of profit a supplier is able to
make
• Directors need to agree on the master budget for the whole
• Regional managers will rely on the budget decisions of the directors
so they can allocate a budget to each branch manager
• Branch managers rely on the previous decisions of budgets so they
can divide the budget between section managers
• Finally the shop floor workers help to meet the budget targets

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Working Capital
It is the day to day finance for running a business the formula is:
Current assets minus current liabilities = working capital
It is used for running costs, wages, raw materials and it also funds the
credit offered to customers (debtors) when making a sale. It is not the
funds invested in fixed costs. If a firm has too little working capital
available it may struggle to finance increased production without straining
its liquidity position. If a firm has too much capital, in the short-term it
may not be able to afford the new machinery that could boost efficiency.
Managers need to:
• Identify costs involved in making products, this is the first step to
decide the selling price
• Work out how many products they need to sell to make a profit
• Find out how much capital they need and the best way to obtain the
capital
• Keep a tight control over the way in which the firm’s money is spent
How working capital affects different decision makers
All the organisational employees, departments, divisions, sections, all the
way down to the shop floor will base their decisions according to the way
the working capital has been planned. The main decision makers that it
will affect are
• Suppliers, because too little working capital means not enough
capital to pay bills on time
• Banks, because the business will find it difficult to get loans if it has
insufficient working capital
• Stock department needs enough working capital to order more
stocks
• Employees will all be affected if there is not enough working capital
to pay wages.

There are a range of people who are interested in the financial data and
planning that a company produces such as shareholders, creditors,
competitors, governments/regulators, auditors, employees, suppliers,
customers, partners etc. They all base their decisions according to the
organisations financial planning. The main function of the financial plan is
to ensure objectives of the firm are being met. This is ultimately in the
form of profits. Although financial planning is complex it requires
sophisticated using tools, techniques, computer programs, decision
making tools. The end result is basically to guarantee that money and
capital raised for the business is invested wisely in order to receive a
return in the form of profits.

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