There are different sources of finance in the world of business today. Any individual or groups of people who aim at starting their own business are given choices over a range of financial sources that they can use to fund their businesses. This then calls for a clear analysis of the financial sources which they choose to take concerning the implications and impact for those decisions. In addition to that it is important to consider the cost that is associated with the sources and the viability of the project in relation to the finances they undertake. In this case, we are going to identify various financial sources that the business can take, the implications in the short and the long term for the business’ financial statements, the costs and how the pricing decisions are to be affected.
The report is going to look into the details of the financial sources namely, personal savings, credit, loans, leases overdrafts and so on. We are going to look at a complete evaluation of these sources, analyze the cost and what that means to the planning and long term survival of the business. Also the study is going to consider the impact on the financial statements and the general budgeting that the business. In a nutshell, the choice of the financial source to fund the business depends on the various circumstances that the business is facing and what it aims to achieve. Because the decisions of taking the long term funding of the business are irreversible and have effects that can’t be turned around it is best for a clear analysis and correct decisions to be taken from the first day. The report will be divided into four parts which will highlight all the dynamics surrounding the business.
Task 1: Sources of Finance for the Business
The MMC company right now has an equity share base of 4 000000 (million) pounds and has a plan for an additional 3 000000(million) more through various means. It has three initial options that include offering of additional shares in entirety option, a partial share-partial debenture option, partial share-partial loan option and preference share option. The earning per share right now is approximately 19 pounds which translates to a fifth of each share in returns. Each of the four options that is at the disposal of the company is supposed to give the best in form of return and convenience to the company. The least leveraged option is the all equity option because it uses all the money from its own sources while the most leveraged is the loan option which has a highest chance of making the business bankrupt. We are going to look at each of them on what comprises of them, their merits and demerits as well as the implications of the company’s future.
All equity financing Options
The first merit of financing a business using all equity option is the fact that there is no external connection and there is guaranteed commitment to the business. It is easier to budget and make drastic changes in the business planning without having to consult from the outside. Secondly, the business angels and investors who put the money in the business through this form may be at a position to bring in new contacts to the business hence more opportunities in future transactions according Smith (2011, 45).
In addition to that the equity financing is not highly leveraged. This means it does not utilize the external money very much. According to experts businesses that depend on the outside may find it hard to pay debts hence attract bankruptcy which at times may make it difficult to find future lenders and financiers.
However there may be several disadvantages especially the fact they are demanding, costly and time consuming. The means may also render the business powerless due to the influence that the investor may have on the business. In addition to that there may be legal and regulatory conditions that may be very stringent especially on matters of initial public offers, subscription and so on.
A bond is a financial instrument that acknowledges an existence of a debt. It is on e of the most customized instrument which takes many forms like, naked debentures, registered, redeemable convertible debentures and so forth. There are merits that are associated with this kind of bond first which is fist the control of the company is not surrendered to the financiers, it is easily redeemable and the holders get a lower rate of return. On top of that, the tax that is deducted from the debenture returns is usually low.
However there are disadvantages that are associated with this kind of instrument namely the cost of rising the initial debenture value is high. The debentures are of high denominations hence the common low businesses are unable to buy them.
They are the most commonly used business instruments which are also much customized to fit into consumer demands. They are very accessible from banks to other financial institutions and charge interest from 8-12% in the agreed period of time. The fist merit is that the terms of the loan are made by both partners through tangible financial documents evidence. This makes it easier for planning.
Secondly the loan is limited to the security that is provided. In case of default there are legal provisions in many countries which bar the provider from taking property past the agreed security. However one disadvantage is the length that may be taken to pay the loan back may make the business pay more due to the constant revision of the interest according to the prevailing levels of depreciation by Smith (2011, p68).
They are shares that receive a preference over the ordinary shares. They receive dividends and repayment and the rate here is fixed. They are very easy to rise at the process is direct and it is cheaper to raise the capital compared to the bank loans.
However due to the fact that the rate is fixed, any profit increase doesn’t increase the preference shares value.
The best option for MMC COMPANY
The best option for the company is to diversify its sources of finances in order to spread the risk. The reason for saying this is that when a company uses most of its sources from internal sources or equity from its shareholders there is a high chance that if the business goes under the losses will have a bigger impact than when the business uses alternative means.
However when the company opts to use the finances that are related to debt or loans from external sources or in business terms, leveraging, it lowers the complete risk impact because of the limited liability clause that is stipulated in the company act.
This company should go for the last option because of the benefit that it will accrue from the lower tax cuts to the reduced cost. The use of this type of instrument makes it possible for the company to raise the funds with minimal collateral and repayment is also on a better terms. In addition to that the use of debentures guarantees the company to be redeemable and convertible which necessitates flexibility (Guru.com, 2011).
Cost of Finance
The business financing sources all have a return for their providers. Before taking any commitments of undertaking the sources it is important that the dynamics of such sources be taken into consideration. This dynamics include the length of repayments, the conditions that are associated with the sources as well as the cost of operating the sources. We are going to analyze the costs of the above mentioned sources of finances and the implications of taking each of them to the company.
The Equity Financing Option
Although it may be hard to calculate the equity financing in a standardized manner, it is obvious that all investors expects that the required rate of return be within a specific range of percentage. This is through the condition that the cost of capital is lower the return on the capital. Normally in the calculation of the equity cost the company compares the equity cost to other investments with a similar profile of risk to determine the general market costs. Then a comparison is made to get the cost of that particular equity.
In terms of the formula, the cost of a given security is found by adding the expected risk free rate of return and the premium expected for the risk. The reason for taking the general market risk is because the security operates in a stocks market that is dynamic and changes all the time. Because the values of shares change it is important to calculate each share with reference to the general price (Smith, 2011, p pp112).
Cost of equity = risk-free rate of return + premium expected of that risk.
Using the earning per share in the above example, the net earnings for the company is 750000 pounds and the extra shares are 30000 then the earnings per share is 25 pounds.
The Use of Debentures and other forms of debt
Debentures being the debt instrument they are have the same approach through which the rest of the financial instruments possess as we have seen above. The company may issue the instrument in premium or discount means over or below the price that the instrument has. So in calculating the cost we use the formula;
Interest /principle multiply by 100 in order to get the cost before tax adjustment. After the 50% tax is adjusted, and then the interest is divided by the net profit to get the cost in precision. In this case the answer shows that the
This shows that the debt instruments are better off in terms of initial costs but very challenging especially if there is a risk of financial turmoil because of the leverage level that is undertaken, Guru.com 2011.
Use of loans
These are long term financial instruments which have an interest ratio which is either being adjusted on a regular basis or constant depending on the loan agreement. In this case the interest rate is 9% of 2 million that is to be financed by the loan. The answer of this shows that the loan can be the most costly especially if the loans are adjusted upwards to meet the inflation costs.
In summary the current situation of MMC limited requires a certain mix of both the debt and equity. The costly source in this study shows that they are the least risky while the ones which seem to be the lesser costly carry out the most risk of all (Guru.com, 2011).
Importance of Financial Planning
Just like in the aspect of everyday life financial planning is a vital point through which the business survives. The fundamental reason for planning is because it provides for a structure through which a company can project its cash flow in such a manner that future hiccups are not experiences. The financial planning especially in companies such as MMC limited entails analysis of financial reports and projection based on data that is precise. The importance of financial planning can be seen from the perspectives of the company’s assets and liabilities position, income and profit as well as the stakeholders’ perspectives.
A well planned financial plot is able to measure the asset base that is at the disposal of the company in comparison with the outstanding liabilities in order to make relevant decisions. The acquisition of new assets and liability depends on the decisions that are taken which should not only look at the implications that follows them but also the long term effect on the financial statement.
The income and profit margins are supposed to be maintained at certain levels in order for the business to survive. Proper planning of what instrument of financing the business will bring the most income is as vital as the profit projections. The investors on the other hand always have expectations that the company will not only break eve but also make a good profit. This means that the planning aspect of the business should take centre stage as it involves many people.
There are several decision makers in any company who depend on the information they receive from the financial statements as well as reports of the business they receive. They include the directors, the shareholders, and the government as well, as the investors. They have vested interest from their perspectives depending on the role they have on the business. So it is important that the financial management make good choices in terms of budgeting allocations as well as the financial sources (Guru.com, 2011).
This is a precise look of the resources that are available in relation to the financial task that is to be undertaken to decide what costs are to be allocated to what task and in what quantities.
In the case of Zimglass limited, there are five materials which are required to complete the task each its own uniqueness namely A, B, C, D, E. because of the scenario that is being experienced all the units in stock have to be replaced citing a number of reasons.
Material A has no provisions shown concerning the book and realizable values, no stock in the stores as yet but the replacement value is 16 pounds.
Material E is substituted with D which is best used for other jobs. It is not currently in stock but it is costing 15 pounds per unit.
Material B on the other hand is frequently used replacement cost per unit is 15pounds per unit whereby 600 of the required 1000 units are to be replaced.
Material C and D have no use in this contract.
Because the unit cost is not given we take 16 pounds as the cost of acquisition hence
Cost of A- 1000x 16= 16000
Cost of B- (1000×12) = 12000
Add 15x 600= 9000
Cost of unit E= 300x 15- 4,400
The grand total cost in pounds is therefore 41500 pounds. With the contract in offer at 60000 the contract can be taken. The unit costs of the usable materials added by the replacement costs are lower than the contract amount in unison hence the business can be able to make a profit.
Calculation of Net present Value
Net present value is the way used by the business to show what the projected cash flows are for one to decide whether to invest or not. Both the business A and B were calculated using the following formulae.
The formula is
Net Cash Flow
(1+ discount rate) ^t (time)
In project A
In the first year we make- 2500
In project B
This was calculated to the end of the three years and then compared. In this exercise the calculations were done on manual paper and the best business to invest in is scenario the best business is the second because it provides for a good cash flow which grows over time.
These ratios show whether the business is able to provide returns.
Return on sales or profit margin = net profit /sales x 100
160/6000x 100= 2.67
Return on assets = Net profit / total assets x 100
160/3400x 100= 4.6 %
Return on equity = net profit/ net worth x 100
160/ 2000x 100= 8%
This ratios are all positive meaning that the business inflow is favorable than the outflow.
On the other hand the liquidity ratios measure how the company can be able to pay its current obligations. They include
Current ratio = total current assets/ total current liability
This ratio shows that if all assets are liquidated the business is able to pay for its liabilities.
The business performance is impressive. This is indicated by the fact that the income and revenues are more than the expenditures and other cash outflow. The income statement is testament to this. In this study we have seen the sources of finances and the main criteria of choosing them. The implication of these sources is that the financial statements as well as the various ratios show that the good planning and decisions are important.