AF4S31 Strategic Financial Management For Ratio Analysis

Answer:

Introduction:

Financial management is a process which is used by the external and internal stakeholders of a business to measure the current position and future forecasting of a business. In the scenario of strategic financial management, proper strategies are maintained by the financial manager and top level management of the company to maintain the financial position. The strategies are prepared by the companies after measuring the current result of the business and the proposed outcome of the business in near future. A better strategy regarding the financial policies of the business makes it easier for the business to grow faster and meet the common goals of the business (Kurov and Stan, 2016). Strategic financial management report focuses on the present and past data of the business through its various techniques such as cost of capital, capital budgeting, ratio analysis, trend analysis etc to identify that whether the business is able to meet the future and common goals of the business or not.

Case overview:

In the report, a case of AYR co has been studied in order to identify the best proposal for the business. The case explains that there are 2 opportunities in front of the business, Aspire and Wolf. In both the projects, the initial investment is same but the return from both the proposals is different. Now, it is a task for AYR co to identify that which project is best for the purpose of higher return and achieve the goal of the business. In the report, capital budgeting technique has been applied firstly in both the projects to reach over a conclusion that which project is best for the company. And further, the different capital sources of the business have been studied along with their cost of business. This examines that how would the current and potential shareholders of the company be impacted after improving the debt value or share value for the future investment of the business.

Capital budgeting tools:

Capital budgeting is a technique which is used by the financial manager of a business to identify the best project or investment proposals among the various available projects. There are various tools of capital budgeting which offers different outcome and used in different circumstances, such as, net present value is calculated to identify that whether the project would be able to make profits or not (Romney, Steinbart, Zhang and Xu, 2006). On the other hand, internal rate of return brief that the total return from the project is higher than cost of capital or lesser than that. In addition, payback period describe that how much time would it take to the business or the investors to get back the invested amount. The capital budgeting tools of AYR co on Aspire and Wolf are as follows:

Net present value:

Net present value is a capital budgeting tools which measures the net profit of the project through considering the net present value of all the cash outflows and inflows of the project. If the NPV of the project is positive then the project must be accepted by the business otherwise vice versa (Shapiro, 2015). The net present value calculations of Alpha and wolf are as follows:

Calculation of Net Present Value (Project Aspire)
Years	Cash Outflow	Cash Inflow	Factors	P.V. of Cash Inflow	P.V. of Cash Outflow
0	$ 2,390,000		1.0000		$ 2,390,000
1		$ 623,000	0.9091	$ 566,364
2		$ 665,328	0.8264	$ 549,857
3		$ 664,403	0.7513	$ 499,176
4		$ 699,570	0.6830	$ 477,816
5		$ 1,253,063	0.6209	$ 778,054
	Total			$ 2,871,267	$ 2,390,000
NPV= Total Cash Inflow-Total cash outflow				$ 481,267

The calculations of project Aspire brief net profit of $ 4,81,267. The net cash outflow of the business is $ 2,390,000 and the inflow of the business is $ 28,71,267. It explains higher inflows than the outflow of the business and thus, the project must be accepted by the business.

Further, the same tool has been applied on the project wolf and the following result has been got:

Calculation of Net Present Value ((Project Wolf)
Years	Cash Outflow	Cash Inflow	Factors	P.V. of Cash Inflow	P.V. of Cash Outflow
0	-$ 2,250,000		1.000		-$ 2,250,000
1		$ 847,600	0.909	$ 770,545
2		$ 768,350	0.826	$ 635,000
3		$ 768,384	0.751	$ 577,298
4		$ 768,273	0.683	$ 524,741
5		$ 768,019	0.621	$ 476,879
	Total			$ 2,984,464	-$ 2,250,000
NPV= Total Cash Inflow-Total cash outflow				$ 734,464

(Kiran and Singh, 2014)

The calculations of project Wolf brief net profit of $ 7,34,464. The net cash outflow of the business is $ 22,50,000 and the inflow of the business is $ 29,84,464. It explains higher inflows than the outflow of the business and thus, the project must be accepted by the business.

On the basis of net present value calculations on both the projects, it has been found that the outcome from Project Wolf is higher than the project Aspire and thus the project Aspire must be chosen by the business.

Internal rate of return:

Internal rate of return is a capital budgeting tools which measures the total return from the particular projects. It decides a particular percentage when the net present value of the business is zero. If the internal rate of return of the project is higher than the cost of capital of the business than the project must be accepted otherwise vice versa (Jaumotte, Lall and Papageorgiou, 2013). The internal rate of return calculations of Alpha and wolf are as follows:

Calculation Of IRR (Project Aspire)
Years	Cash Outflow	Cash Inflow	Net cash inflows
0	-$ 2,390,000		-$ 2,390,000
1		$ 623,000	$ 623,000
2		$ 665,328	$ 665,328
3		$ 664,403	$ 664,403
4		$ 699,570	$ 699,570
5		$ 1,253,063	$ 1,253,063
IRR		16.81%

The IRR calculations brief 16.81% internal return of the business. Whereas, the case explains that the average cost of capital of the business is 10%. The internal rate of return of the business is higher than the cost of capital. So, it is recommended to the business to accept the proposal.

Further, the Wolf project has been evaluated. The calculations are as follows:

Calculation Of IRR ((Project Wolf)
Years	Cash Outflow	Cash Inflow	Net cash inflows
0	-$ 2,250,000		-$ 2,250,000
1		$ 847,600	$ 847,600
2		$ 768,350	$ 768,350
3		$ 768,384	$ 768,384
4		$ 768,273	$ 768,273
5		$ 768,019	$ 768,019
IRR		22.32%

The IRR calculations brief 22.32% internal return of the business. Whereas, the case explains that the average cost of capital of the business is 10%. The internal rate of return of the business is higher than the cost of capital. So, it is recommended to the business to accept the proposal (Kaplan and Atkinson, 2015).

On the basis of internal rate of return calculations on both the projects, it has been found that the return from Project Wolf is higher than the project Aspire and thus the project Aspire must be chosen by the business.

Payback period:

Payback period is a capital budgeting tools which measures the total retime in which the business would be able to get the entire cash outflow of the business. It brief the total time period in which the project would be at break-even point. If the lower the payback period of a business, the better the investment position would be. The payback period calculations of Alpha and wolf are as follows:

Calculation Of Payback period (Project Aspire)
Years	Cash Outflow	Cash Inflow	Cash flows	CF
0	-$ 2,390,000		-$ 2,390,000	-$ 2,390,000
1		$ 623,000	$ 623,000	-$ 1,767,000
2		$ 665,328	$ 665,328	-$ 1,101,673
3		$ 664,403	$ 664,403	-$ 437,270
4		$ 699,570	$ 699,570	$ 262,301
5		$ 1,253,063	$ 1,253,063	$ 1,515,364
				3.63

The above calculations explain that the total time period in which the investment would be got back by the AYR co is 3.63 years. It says that in the 3.63 years, the company would be at break-even level. After it, the entire cash inflow is the profit margin of the business. The payback period is lesser than the total time period of the project and thus it is a good option to make investment.

Further, the analysis has been done on project wolf which is as follows:

Calculation Of Payback period (Project Wolff)
Years	Cash Outflow	Cash Inflow	Cash flows	CF
0	-$ 2,250,000		-$ 2,250,000	-$ 2,250,000
1		$ 847,600	$ 847,600	-$ 1,402,400
2		$ 768,350	$ 768,350	-$ 634,050
3		$ 768,384	$ 768,384	$ 134,334
4		$ 768,273	$ 768,273	$ 902,607
5		$ 768,019	$ 768,019	$ 1,670,626
				2.83

(Gali, 2015)

The above calculations explain that the total time period in which the investment would be got back by the AYR co is 2.83 years. It says that in the 2.83 years, the company would be at break-even level. After it, the entire cash inflow is the profit margin of the business. The payback period is lesser than the total time period of the project and thus it is a good option to make investment.

On the basis of payback period calculations on both the projects, it has been found that the Project Wolf is better than the project Aspire due to lower payback period and thus the project Aspire must be chosen by the business.

Analysis and evaluation:

Recommendation:

On the basis of the evaluation on project Wolf and project Aspire, it has been found that both the projects would offer positive returns to the business as well as the return level is also higher than the total cost of capital of the business. Along with that, the breakeven point would also be achieved by the business within the time frame of the project. Still, if both the projects are compared with each other than the project wolf is more favourable for the business rather than project Aspire.

The overall evaluation lead to the conclusion that the project Wolf must be chosen by the business over project Aspire to improve the overall performance and get higher return. The recommendation to AYR co is for project Wolf. Because the overall performance of project Wolf is better than the project aspire.

Justification:

The project Wolf is recommended to the business because of the better performance of the project rather than the Project Aspire. If the net present value case is taken into the concern than the calculations of project Aspire brief net profit of $ 4,81,267 and calculations of project Wolf brief net profit of $ 7,34,464. It leads to the conclusion that the outcome from Project Wolf is higher than the project Aspire and thus the project Aspire must be chosen by the business

Further, the IRR calculations brief 16.81% internal return of the project Aspire. And the IRR calculations of project Wolf brief 22.32% internal return of the business. Whereas, the case explains that the average cost of capital of the business is 10% (Gambacorta and Signoretti, 2014). It leads to the conclusion that the return from Project Wolf is higher than the project Aspire and thus the project Aspire must be chosen by the business

Further, the payback period calculations have been done on both the projects. The payback period calculations of project Aspire explain that the total time period in which the investment would be got back by the AYR co is 3.63 years. While the total time period of project Wolf in which the investment would be got back by the AYR co is 2.83 years. It leads to the conclusion that the Project Wolf is better than the project Aspire due to lower payback period and thus the project Aspire must be chosen by the business (Grinblatt and Titman, 2016).

Thus, the project Wolf has been recommended to the business over project Aspire. Because in all the capital budgeting techniques, the outcome of project Wolf is better than the project aspire.

Summary of other factors:

Further, a study has been done on various other factors which are required to be evaluated and measure while making decision about the performance of the company. The financial factors are not enough for a business to make decision about the acceptance or not acceptance. A business is also required to focus on other relevant items such as technological factors, economical factors, environmental factors, industry level, competition in the industry and other threats of the business while making decisions about the particular project. It makes it easier for the business to measure all the factors and accept better project from the industry for the betterment of the business and meet the common goals, objectives etc of the business (Horngren et al, 2015).

In case of AYR co and the available projects of the business, it has been found that the performance of the projects must also be measured on the basis of their associated technology, the advancement in the industry, the demand of the customers, the durability and demand constant in the business etc. the evaluation brief that both the projects are almost similar and thus the factors would not impact much on the business and their performance (Bandy, 2013). So, it is concluded that the project Wolf is better option for AYR co. and the investment into the Project Wolf would help the business to improve the overall performance.

source of finance 

A business is always required some funds to run and maintain the business. Without the funds, it is not possible for a business to run the business (Bierman and Smidt, 2012). A business could raise the funds from various internal and external sources such as bank loan, owner’s investment, shares, debentures etc.

Equity and debt:

Equity and debt are the external sources of a business through which a public company raise the funds to improve the performance of the business. Equity shares are sold along with the ownership in the business. Equity holders are offered dividend amount against their investment which is almost all the time higher than the cost of debt of the business. Further, the debentures are borrowings of the company which must be repaid by the business within a set period of time (Bandy, 2013). The debt holders of the business are paid the interest amount against their loan in the business. The debentures could be expensive in a small company due to the risk and return trade off.

Equity and debt funds are decided by the business on the basis of their needs and the nature of the business (Borio, 2014). A business is required to increase the equity and debt level of the business in an optimal way so that the risk and return level of the company could be managed.

Cost of each sources:

Cost of capital is the total cost which a company is required to pay against the total funds of the business. The cost of raising the funds through equity is called cost of equity and the cost of raising the funds through debt is called cost of debt.

Cost of equity:

Cost of equity is the total part of the capital structure of a business. Cost of equity is the total return which measures the total return that has been demanded by the investors and shareholders of the business. Shareholders bear the risk of ownership in the business and against that, they wish for better return from the company (Deegan, 2013). Cost of equity of a business is usually described as an annual % of the business.

Cost of debt:

Further, the cost of debt is the total average % which is paid by an organization to debt hodler against their obligations in the business. These typically involve the bank loans and the bonds. Cost of debt of a business is usually described as an annual % of the business (Gitman and Zutter, 2012).

Analysis effect:

In case of AYR co, the current weighted average cost of capital of the business is 10%. While the equity capital and debt capital of the business is $ 20 million and $ 18 million respectively. It leads to the study that the market share of funds of the company is 52.63% and 47.37%.

Capital Employed		$ million
	Equity holder funds	20
	Long term debt	18
Total		38

For evaluating the impact on the cost of capital of the business, it is assumed that the debt interest rate of the business is 9% and the book value of each debt is $ 100. The cost of each source of the business has been calculated on the basis of that and it has been found that the cost of equity and debt is 6.59% and 3.41% (Brigham and Ehrhardt, 2013).

In the current case, it is suggested to the business to improve the funds through debt as it would lead to the business towards less cost. If the debt funds would be raised by the business than the total weighted average cost of capital of the business is 9.84%.

	Ordinary shares	Debt	Total
Cost of Finance	12.52%	7.20%
Market Weights	49.69%	50.31%
WACC (weighatge of weight and cost	6.22%	3.62%	9.84%

(Du and Girma, 2009)

Thus, it is recommended to the business to raise the next funds through debt only. It would lead to the business towards less cost and thus the profits of the business would be higher.

Impact on current and potential stakeholders:

If the company would raise the funds through debt source than the shareholders of the business would not be affected much. However, a few reductions would take place in the cost of equity of the business because of the decrement in the total weight of equity in the business (Fernandes, Lynch and Netemeyer, 2014). Though, if the business would raise the funds through equity source than the total cost of capital of the business would be higher. So, the business is recommended to raise the funds through debt source only.

Conclusion:

To conclude, project Wolf must be chosen by the business over project Aspire to improve the overall performance and get higher return. The recommendation to AYR co is for project Wolf. Further, the business is also suggested to evaluate various related factors to manage the performance and the position of the business. In addition, the business requires fund to invest into project Wolf which must be raised through debt sources to manage the risk and cost level of the business.

References:

Bandy, G. 2013. Financial management and accounting in the public sector. Oxon: Routledge.

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.

Borio, C., 2014. The financial cycle and macroeconomics: What have we learnt?. Journal of Banking & Finance, 45, pp.182-198.

Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.

Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.

Du, J. and Girma, S., 2009. Source of finance, growth and firm size: evidence from China (No. 2009.03). Research paper/UNU-WIDER.

Fernandes, D., Lynch Jr, J.G. and Netemeyer, R.G., 2014. Financial literacy, financial education, and downstream financial behaviors. Management Science, 60(8), pp.1861-1883.

Galí, J., 2015. Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

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Jaumotte, F., Lall, S. and Papageorgiou, C., 2013. Rising income inequality: technology, or trade and financial globalization?. IMF Economic Review, 61(2), pp.271-309.

Kaplan, R.S. and Atkinson, A.A., 2015. Advanced management accounting. PHI Learning.

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Romney, M.B., Steinbart, P.J., Zhang, R. and Xu, G., 2006. Accounting information systems. Pearson Education.

Shapiro, A.C., 2015. Capital budgeting and investment analysis. Prentice Hall.