MOD003319 Business Finance and Garden Rite Ltd
Questions:
GardenRite Ltd (“GRL”) owns and operates three factories in London, Birmingham and Manchester producing valves and fittings for garden hoses. The company last year had turnover in excess of £50 million.
The company is managed by Dean, the grandson of the founder. Dean owns 25% of the shares in the company, while the remaining 75% is split between three other grandchildren, Hashim, Dale and Faf.
Most of GRL’s clients are large retailers in the UK and EU. Two key customers are C&P DIY Ltd and BricoFrance SA, which are both large chains of DIY and garden centres in the UK and France.
The other shareholders are concerned about the business. Although there seems to be plenty of work coming in and the last year has been reasonably profitable (Operating profit was £5 million last year before interest and tax), the company’s debt has increased to £18 million from £16 million the year before. Dean has started talking about the need for the other shareholders to invest more money to reduce the debt.
The company is owed £1.5 million pounds for a series of large orders placed by C&P last year. There is also an outstanding dispute about a £2 million consignment for BricoFrancecompleted in 2015. This has led to payment being withheld while negotiations continue between lawyers and technical specialists.
There is a further problem that Dean believes the BricoFrance issue arose from faulty workmanship by a contractor which GRL engaged in 2015. He has refused to pay the contractor who is now threatening legal action. Because this area of work has been suspended, a large stock of materials and supplies has built up at the company’s London site. Dieter insists that the company needs to have this level of stock for when the dispute is sorted out. He is also reluctant to press his key customers too hard for payment.
The other shareholders have approached GRL’s accountants to review the situation.
Requirements:
i. Using the reading list provided on the VLE, explain:
a. what is meant by Profit and Cashflow and how they are different
b. what is meant by Working Capital and in particular, the meanings of
Receivables, Inventory and Payables
c. how changes in Working Capital affect Cashflow
ii. Apply the concepts in (i) above to this company to show how the way the company is being managed might be reflected in its financial results. You should use hypothetical numbers (ie ones that you make up yourself) to illustrate your answer.
iii. Analyse and recommend what steps should now be taken to improve this company’s cashflow through better Working Capital management.
Part 2
Continuing with GRL, Dean is contemplating investing in a new facility in either Leeds or Bristol. Both will involve a significant investment, and, assuming the issues noted above are sorted out, the shareholders have the resources to finance either project but not both.
The Leeds venture would involve construction on a derelict site from scratch which will cost £10m and would operate for 9-10 years before substantial further investment would be required.
The Bristol venture involves taking over an existing but slightly out of date plant. This will need about £6 million investment and will have an expected useful life of 5-6 years.In the past, to assess the financial viability of new projects, the company has only considered profitability. At present, it does not have any formal procedure for assessing
capital projects.
Requirements:
i. Using the reading list provided on the VLE, explain:
a. what is meant by capital budgeting and summarise the purpose and key stepsof the process
b. how the following investment appraisal methods are calculated, what they seek to show and the advantages and disadvantages of each method.
i. payback period
ii. net present value
iii. internal rate of return
ii. Apply the concepts in (i) above to compare the alternative investment options. You should use hypothetical numbers (ie ones that you make up yourself) to
illustrate your answer.
iii. Analyse and recommend which project should be pursued by the company, using your answer in (ii) to support your argument.
Answers:
Part 1:
i.a) Depicting what is meant by profit and cash flow, while identifying the difference:From the evaluation it could be identified that cash flow and profits are a crucial aspect of the organisation, which could help in identifying the overall financial viability of the company. In addition, the overall cash flows are mainly identified to be one of the aspects, which include both inflow and outflow of the organisation. Moreover, daily operation for the organisation is mainly recorded with relevant transaction, which is reflected on both profit and cash flow statement. Moreover, overall cash flow statement of the organisation mainly represents the relevant cash transaction that is been conducted by the company over the fiscal year. Bertilorenzi (2014) mentioned that the use of cash flow and profit statement mainly allows the organisation to determine the relevant financial strength, which could be conducted to support its endeavours.
However, there are significant difference between profit and cash flow, which are depicted as follows.
- The major difference between cash flow and profit is the relevant valuation of the transactions that is been conducted by the company. The cash flow statement mainly indicates the overall cash transaction that is been conducted within the organisation. However, the profit directly states the value, which is derived after deducting revenue from total cost.
- Cash flow is mainly identified to be relevant transactions of cash that comprise of both receipts and payments conducted in cash. On the other hand, profit value comprises of both cash and credit transaction that is been conducted by the company on current fiscal year.
Working capital management is mainly identified to be the relationship between firm’s short term liabilities and short term assets. Moreover, with the help of working capital companies are mainly able to identify the overall capital, which is needed for completing their activities. In addition, the overall working capital management could eventually help in depicting the required funds, which will be needed by the organisation for maintain the required level of work flow. Brassell and King 2013) mentioned that working capital is mainly identified by subtracting the overall current assets from current liabilities. Furthermore, the derivation of working capital is essential for the management, as it helps in forming the relative budgets, which could support its future endeavours.
Receivables are mainly the overall amount of payments, which needs to be taken by the company. The receivables are mainly recorded in the financial balance sheet under current asset section. The receivable mainly indicates that the company has right to receive cash as adequate services and goods is been provided to the consumer.
Inventory is mainly considered to be one of the overall stored goods, which comprises both finished and raw material products. These inventory are mainly considered under the overall current asserts, as it is considered to be assets, which might be sold for acquiring the required level of cash for company’s operations (Carraher and Van Auken 2013).
Payables are mainly considered the overall payments that need to be conducted by the company to its lenders. These payable are mainly listed under current liabilities, which directly help in reflecting the overall short term liabilities that need to be paid by the organisation.
i.c) Depicting how changes in working capital affect cash flow:The overall change in working capital directly affects cash flow statement of the organisation, as relevant transaction in the working capital is reflected in the cash flow statement. The changes in working capital could directly result in cash flow statement, as an increment or decline would affect its short term cash flow. Furthermore, if negative change in working capital is conducted then relevant short term borrowings are relatively increased within the organisation. This increment in short-term borrowings mainly increases the overall cash flow of the organisation (Cole 2013). Therefore, it could be estimated that with changing working capital overall cash flow of the organisation is affected. Increment in working capital mainly raises the overall current assets, which directly needs additional cash, which ties the cash condition of the organisation. However, increment in working capital could increase the cash availability position of the organisation, which could be utilised in different projects.
Furthermore, it could be estimated that company’s working capital is mainly identified to be a core part of its daily operations, which needs relevant evaluation by the management. Therefore, it is estimated that any kind of changes in the working capital can directly reflect on the cash availability and cash flow of the organisation. Any kind of increment and current liabilities result in reduction in working capital and provide the company with adequate cash balance so forth its activities. Diebold (2015) mentioned that improvements in working capital allow the organisation to conduct activities smoothly to increase its productivity level.
ii) Depicting the way in which the company should be managed might be reflected in its financial result:
|
Income Statement |
Amount |
|
Turnover |
50,000,000 |
|
Cost of sales |
35,000,000 |
|
Gross profit |
15,000,000 |
|
Administrative expenses |
10,000,000 |
|
Operating profit |
5,000,000 |
|
Balance Sheet Statement |
Amount |
|
Inventory |
500,000 |
|
Receivables |
700,000 |
|
Cash |
650,000 |
|
Current assets |
1,850,000 |
|
Noncurrent assets |
950,000 |
|
Total assets |
2,800,000 |
|
Payables |
850,000 |
|
short term debts |
750,000 |
|
Current liabilities |
1,600,000 |
|
noncurrent liabilities |
850,000 |
|
Total liabilities |
2,450,000 |
|
Net assets |
350,000 |
|
Equity |
|
|
Common stock |
350,000 |
|
Total equity stock |
350,000 |
From the evaluation of above table’s relevant financial position of the company could be identified. This might help in understanding the overall financial position of the organisation while conducting its operations. The use of hypothetical numbers mainly helps in understanding the financial condition and measures used by the organisation to conduct it operations. Adequate use of high turnover is mainly essential for the company to increase their profitability from operations, which could support activities (Glukhov and Glukhov 2013). Therefore, maintenance of adequate working capital is needed by the organisation, as it might help in improving its activities. The adequate use of receivables, payables, and inventory could eventually help in generating the required level of revenue to support its activities.
iii) Depicting the relevant steps that could be taken to improve the overall cash flow through working capital management:
From the evaluation of case study relevant loopholes in the current operation capability of the company can be identified. The company is using a lawsuit from its customers and sellers, which is draining the overall profitability of the organisation. Firstly, it is advisable for the organisation to close out the cases with both with customers and sellers, as it might reduce its reputation among potential customers. Furthermore, this move could eventually allow the organisation to control the unwavering customers due to court case. The second measure that could be used by the Organisation is the improvement of its debt accumulation (Harrison 2013). This reduction in debt could eventually have the organisation to reduce the excessive cash outflow that is hampering ability to support future endeavour. Lastly, the accumulation of inventory that is currently being conducted by the organisation is hampering its cash reserves, which is directly related to company's ability to support its future activities. After following the relevant recommendations the organisation could eventually increase its operational capability and generate higher income.
Part 2:
i.a) Depicting the meaning of capital budgeting and summarising the steps of the process:Capital budgeting is mainly identified as a planning process, which allows the organisation to determine viability of long term investments. Moreover, capital budgeting is relevantly compared with investment appraisal techniques which allows organisations to detect viability of any kind of projects. Therefore, with the help of capital budgeting organisations are able to Allocate adequate resources to a particular project and reduce the excessive wastage of essential resources. Hence, capital budgeting is identified to be formal method with relevant techniques, which allows organisations to maximize firm value. Jorda, Schularick and Taylor (2016) mentioned that the major significance of capital budget is that it allows the company to detect viability of the project, while excluding all the irrelevant investment options.
The key steps of capital budgeting process are depicted as follows.
Evaluating potential opportunities:
However, capital budgeting mainly needs to evaluate the potential condition of the opportunity, which might allow the organisation generate higher returns from investment. Capital budgeting directly helps reorganization to explore available opportunities that could provide higher return from investment. After the detection of the most viable investment option reorganization starts to evaluate cost and benefits incurred by the project (Kraemer, Lang and Gvetadze 2013).
Estimation of implementation and operating cost:
This process mainly involved all the relevant internal and external research, which directly indicates the overall operating and implementation cost that would be needed for the project. Determination of the cost and expenses required in project could eventually help in determining viability of the project in comparison to other investment opportunity. Therefore the overall cost involved in implementation of the project is evaluated in the process of capital budgeting. Moreover, it allows the organisations to gauge into the benefits and losses that could come from implementation action (Li 2015).
Estimation of cash flow:
Budgeting process also involved estimation of cash flow or benefits that could be provided by the identified project. Capital budgeting mainly directs the organisation to review past successful projects and the relevant cash flow that was generated after completion of the projects. The estimation directly helps organisation to identify viability in the cash flows after conducting relevant expenses on the project.
Assessing risk:
Estimation of risk associated with the project are directly included in the risk assessment section, where all the relevant problems and losses that would be obtained by the organisation is adequately mentioned. All the relevant degrees of risk are determined in this process as it allows the organisation to understand the benefits that could be provided by the project and take adequate decision (Maxwell 2017).
i.b) Depicting the advantage and disadvantage of the investment appraisal method:
The overall investment appraisal method such as payback period, internal rate of return and net present value has both advantages and disadvantages, which directly allow the organisation to make adequate investment decisions. The relevant investment appraisal techniques could eventually allow the organisation to generate the required level of profitability from operations (McLean and Zhao 2014). The significance and limitation of the investment appraisal techniques are depicted as follows.
Payback period:
|
Advantages |
Disadvantages |
|
· Payback period directly allow the organisation to easily identify the years within which investment capital will be recovered · The use of payback period mainly allows the managers to make quick evaluation quick evaluation regarding small investment. |
· The major drawback of the payback period is that it ignores time value of money. · The company’s overall internal rate of return could be adequate but still not qualify for the minimum payback period. · Payback period does not allow the organisation to detect viability of the project, as it does not comprehend the changing value of the cash inflow due to inflation. |
Net present value:
|
Advantages |
Disadvantages |
|
· Net present value method mainly allows the organisation to comprehend the changes dollar value of future cash glow in current date. · The NPV valuation also allows the organisation to compensate for time value of money and detect viability of the future cash flow. · The consideration of cost of capital is mainly conducted in NPV, which allow the organisation to detect viability of the investment option. |
· The NPV valuation mainly requires different type of guess work to derive the cost of capital and inflation rate to discount the future cash flows. Hence, the estimation of cost of capital is a viable action, where any low value or higher value could nullify viability of the investment option. · The NPV valuation is not useful in comparing two projects with different life and investment criteria. |
Internal rate of return:
|
Advantages |
Disadvantages |
|
· The major advantage of using the internal rate of return is that it provides the most accurate rate of return that is provided by the project. · The IRR directly allows the management to sneak peek into the return that might be provided from investment. |
· The major disadvantage that could be hindering operations of IRR is the ignorance of economies of scale. · The second limitation of IRR is the dependency on investment in other projects. The IRR valuation could only be conducted if other projects are evaluated in comparison with other investment options. |
ii) Comparing the alternative investment concepts with relevant hypothetical numbers:
|
Leeds Venture | ||||
|
Year |
Expenses |
Income |
Cashflow |
Cumulative cash flow |
|
0 |
(10,000,000) |
|
(10,000,000) |
(10,000,000) |
|
1 |
|
1,750,000 |
1,750,000 |
(8,250,000) |
|
2 |
|
1,750,000 |
1,750,000 |
(6,500,000) |
|
3 |
|
1,750,000 |
1,750,000 |
(4,750,000) |
|
4 |
|
1,750,000 |
1,750,000 |
(3,000,000) |
|
5 |
|
1,750,000 |
1,750,000 |
(1,250,000) |
|
6 |
|
1,750,000 |
1,750,000 |
500,000 |
|
7 |
|
1,750,000 |
1,750,000 |
2,250,000 |
|
8 |
|
1,750,000 |
1,750,000 |
4,000,000 |
|
9 |
|
1,750,000 |
1,750,000 |
5,750,000 |
|
10 |
|
1,750,000 |
1,750,000 |
7,500,000 |
|
|
NPV |
752,992.43 |
|
|
|
|
IRR |
12% |
|
|
|
|
Payback period |
5.7 years |
|
|
|
|
Discounting rate |
10% |
|
|
|
Bristol Venture | ||||
|
Year |
Expenses |
Income |
Cashflow |
Cumulative cash flow |
|
0 |
(6,000,000) |
|
(6,000,000) |
(6,000,000) |
|
1 |
|
1,450,000 |
1,450,000 |
(4,550,000) |
|
2 |
|
1,450,000 |
1,450,000 |
(3,100,000) |
|
3 |
|
1,450,000 |
1,450,000 |
(1,650,000) |
|
4 |
|
1,450,000 |
1,450,000 |
(200,000) |
|
5 |
|
1,450,000 |
1,450,000 |
1,250,000 |
|
6 |
|
1,450,000 |
1,450,000 |
2,700,000 |
|
|
NPV |
315,128.01 |
|
|
|
|
IRR |
12% |
|
|
|
|
Payback period |
4.1 years |
|
|
|
|
Discounting rate |
10% |
|
|
From the overall evaluation it could be identified that Net present value is mainly; identified to be one of the most viable option of the project. Therefore, from the relevant valuation it could also be detected that companies with investment appraisal techniques are able to segregate viable project with non-viable projects. However, the valuation of IRR does not allow the organisation to detect the actual viability of the project, as it might help in detecting actual viability of the project. The overall payback period is mainly detected to understand viability of the investment to return overall capital. From the relevant evaluation NPV is mainly identified to be one of the basic measures, which could be used by the company to detect the actual viability of the investment option (Peirson et al., 2014). Using the hypothetical value investment option of Bristol Venture could be used as its return on investment is same as the other, where NPV is positive.
iii) Analysing and recommending the project should be pursued by the company:
From the overall evaluation it could be recommend that the use of net present value could eventually help the organisation gather the relevant information regarding viability of the project. In addition, the use of NPV could eventually help in detecting actual financial satiability that will be projected by the investment. Therefore, seeing the overall evaluation of hypothetical numbers the use of Bristaol Ventuire could eventually be conducted by the company for generating the required level of profitability from operations.
References and Bibliographies:
Bertilorenzi, M., 2014. Business, finance, and politics: the rise and fall of international aluminium cartels, 1914–45. Business History, 56(2), pp.236-269.
Brassell, M. and King, K., 2013. Banking on IP?: The Role of Intellectual Property and Intangible Assets in Facilitating Business Finance: Summary of a Report for the Intellectual Property Office. Intellectual Property Office.
Brassell, M. and King, K., 2017. Banking on IP?: The role of intellectual property and intangible assets in facilitating business finance. Published by The Intellectual Property Office of the United Kingdom.
Carraher, S. and Van Auken, H., 2013. The use of financial statements for decision making by small firms. Journal of Small Business & Entrepreneurship, 26(3), pp.323-336.
Cole, R.A., 2013. What do we know about the capital structure of privately held US firms? Evidence from the surveys of small business finance. Financial Management, 42(4), pp.777-813.
Diebold, F.X., 2015. Forecasting in economics, business, finance and beyond. University of Pennsylvania, USA.d
Glukhov, E.V. and Glukhov, V.V., 2013. Meaning and essence of scientific concept" business finance" in market-oriented economy. World Applied Sciences Journal, 25(10), pp.1405-1408.
Harrison, R., 2013. Crowdfunding and the revitalisation of the early stage risk capital market: catalyst or chimera?.
Jordà, Ò., Schularick, M. and Taylor, A.M., 2016. The great mortgaging: housing finance, crises and business cycles. Economic Policy, 31(85), pp.107-152.
Kennickell, A.B., Kwast, M.L. and Pogach, J., 2016. Small businesses and small business finance during the financial crisis and the great recession: New evidence from the survey of consumer finances. In Measuring Entrepreneurial Businesses: Current Knowledge and Challenges (pp. 291-349). University of Chicago Press.
Kraemer-Eis, H., Lang, F. and Gvetadze, S., 2013. European Small Business Finance Outlook June 2013 (Vol. 18). EIF Working Paper 2012.
Li, X., 2015. Accounting conservatism and the cost of capital: An international analysis. Journal of Business Finance & Accounting, 42(5-6), pp.555-582.
Maxwell, D., 2017. Valuing Natural Capital: Future Proofing Business and Finance. Routledge.
McLean, R.D. and Zhao, M., 2014. The business cycle, investor sentiment, and costly external finance. The Journal of Finance, 69(3), pp.1377-1409.
Peirson, G., Brown, R., Easton, S. and Howard, P., 2014. Business finance. McGraw-Hill Education Australia.
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