Managing Capital And Financial Assets
Managing Capital and Financial
Assets
As Competition Bikes considers expansion into Canada, it must decide if the initial investment is worth the potential return. This report will recommend the capital structure that will maximize shareholder return, analyze the capital budget and areas of concern, recommend how to obtain and manage working capital for the expansion, and evaluate the options of merging with vs. acquiring Canadian Biking.
A1. Capital Structure
Capital structure refers to how a company finances its operations. In general, this financing comes from two sources: debt and equity. In this case, Competition Bikes needs to finance its expansion and is considering five capital structure alternatives, which include various combinations of bonds and stock. To determine which capital structure provides the greatest return for shareholders, the metric used for comparing the different capital structures will be earnings per share (EPS). The following table shows the projected earnings per common stock share for each year, and for each alternative capital structure, based on a moderate forecast for Canadian Biking’s earnings before interest and taxes (EBIT). The highest earnings per share for each year are highlighted in yellow.
ACCT16500 Financial Accounting & Reporting As Competition Bikes considers expansion into Canada, it must decide if the initial investment is worth the potential return. This report will recommend the capital structure that will maximize shareholder return, analyze the capital budget and areas of concern, recommend how to obtain and manage working capital for the expansion, and evaluate the options of merging with vs. acquiring Canadian Biking.
A1. Capital Structure
Capital structure refers to how a company finances its operations. In general, this financing comes from two sources: debt and equity. In this case, Competition Bikes needs to finance its expansion and is considering five capital structure alternatives, which include various combinations of bonds and stock. To determine which capital structure provides the greatest return for shareholders, the metric used for comparing the different capital structures will be earnings per share (EPS). The following table shows the projected earnings per common stock share for each year, and for each alternative capital structure, based on a moderate forecast for Canadian Biking’s earnings before interest and taxes (EBIT). The highest earnings per share for each year are highlighted in yellow.
JET2 TASK 3 3
The recommendation is to use the capital structure of 50% preferred and 50% common stock. Because there is no interest to be paid, all of the money raised can be kept within the company. Looking at the table above, it is easy to see that this structure will consistently provide Competition Bikes with greater earnings per share than the other options. It also provides preferred stockholders with dividends of $15,000 annually. A1a. Analysis of the data shows that the next best choice would be the 20% bonds and 80% common stock as it produces the same EPS for years 9 and 10 and comes pretty close in the remaining years. The 40/60 and 60/40 splits between 12% bonds and common stock lag behind the 50% preferred/50% common split for all years. This is primarily because increasing the amount of 12% bonds increases the amount of interest paid. Going with straight 12% bonds is the least attractive option because it results in the largest amount of interest being paid out which significantly decreases value for stockholders. For example, in year 9, the interest paid out would be $72,000, which is almost equal to the projected earnings of $75,446. That ratio improves in subsequent years, but still lags far behind the stock only option.
A2. Capital Budget Concerns
Capital budgeting is the process by which a company makes decisions that involve “cash inflows and outflows beyond the current year” (Hilton, 2011). This requires the use of discounted-cash-flow analysis, which allows a company to factor in the timing of cash inflows and outflows. It is usually done in one of two ways: the net present value method (NPV) or the internal rate of return method (IRR) (Hilton, 2011). These methods can guide a company’s decision making process because if the result of the net present
JET2 TASK 3 4
Value calculation is positive, the proposal is likely to be a good investment. The proposal is also likely to be a good investment if the internal rate of return equals or exceeds the cost of obtaining the capital (the hurdle rate). Competition Bikes is working with two models that project five years’ worth of expected annual sales in both low demand and moderate demand environments in the Canadian market. Using both the net present value and the internal rate of return methods, we can evaluate the risk associated with both scenarios, and whether the company should proceed with the expansion. Using the low demand projections for Canadian Biking, the NPV is negative ($26,740) at the end of the five-year period. This is very concerning for Competition Bikes as this means that they would not realize any return on the expansion investment for many years (if at all). Additionally, 5 years after the initial investment of $600,000, the cash flow is expected to be $540,532. This means the IRR is only 8.7%, which does not meet the company’s hurdle rate of 10%. Using the moderate demand projections, the NPV is positive, but only by $2,243. If the company experiences even a small downward shift in demand from their moderate projections, the NPV could easily become negative. The IRR in this case is 10.1%. This meets the hurdle rate of 10%, but only just. Even small fluctuations in demand could result in a rate of return that falls below 10%. It is important to look at the entire range of the calculated net present values for both models. It starts with negative $26,740 on the low end and moves up to positive $2,243 on the moderate end. The actual sales are likely to fall somewhere in between these two numbers. It turns out that 92% of that range falls on the negative side. This
JET2 TASK 3 5 represents significant risk for Competition Bikes because there is only an 8% chance that the net present value will be positive. Pursuing expansion under these conditions is not recommended.
A3. Working Capital
In order to expand operations, adequate working capital is essential for any company. To obtain additional working capital, Competition Bikes is already considering equity financing through the issuance of stock. It could also consider working with a venture capitalist, or allocating some of its available cash and cash equivalents from year 8 for the expansion project. Equity financing options are appealing because they do not require the company to incur additional debt, or the interest and repayment deadlines that go along with it. The downside is that ownership becomes diluted. However, Competition Bikes has a debt ratio of 46.2%, so it certainly has room to consider debt-financing options as well. They could apply for a Small Business Administration loan through the US government or establish a line of credit with a bank using existing facilities as collateral. Both of these options come with repayment obligations and the added expense of interest. If the expansion is not profitable, there is the possibility of defaulting on a loan, losing the collateral, and damaging prospects for future credit. Once Competition Bikes has obtained the necessary working capital, it must be diligent in properly managing it. This means properly managing the two things that determine working capital: current assets and current liabilities. For example, when evaluating assets in the flexible budget, direct materials had an unfavorable efficiency variance of $100,000. The company should look at streamlining its inventory
JET2 TASK 3 6 management system as well as the production process to improve efficiency and minimize waste. Working capital is preserved for other uses when it is not tied up in old inventory and scrap. Competition Bikes could also better manage working capital by improving its collection of accounts receivable. It has an average collection period of 43.8 days. If that is reduced to 30 days it will increase cash inflows and working capital. Competition Bikes can also review its contracts and look into negotiating better terms with suppliers and transporters. This will improve working capital for the expansion by decreasing cash outflow. Competition Bikes is faced with the decision of whether to buy or lease the facility in Canada. To preserve the greatest amount of working capital, the company should choose leasing, as it is the option that requires the least amount of cash. Over the five-year period, buying the facility would require $50,000 for the down payment plus $65,444 in interest, and the overall cost would be $399,774.
Alternatively, the overall cost of leasing the facility is only $283,752. Competition Bikes also needs to consider the possibility of failure in this new market. It makes more sense to lease the facility early on and preserve working capital for other expenses. If the venture proves successful, then Competition Bikes can exercise the option to buy the facility at the end of the five-year period.
The recommendation is to use the capital structure of 50% preferred and 50% common stock. Because there is no interest to be paid, all of the money raised can be kept within the company. Looking at the table above, it is easy to see that this structure will consistently provide Competition Bikes with greater earnings per share than the other options. It also provides preferred stockholders with dividends of $15,000 annually. A1a. Analysis of the data shows that the next best choice would be the 20% bonds and 80% common stock as it produces the same EPS for years 9 and 10 and comes pretty close in the remaining years. The 40/60 and 60/40 splits between 12% bonds and common stock lag behind the 50% preferred/50% common split for all years. This is primarily because increasing the amount of 12% bonds increases the amount of interest paid. Going with straight 12% bonds is the least attractive option because it results in the largest amount of interest being paid out which significantly decreases value for stockholders. For example, in year 9, the interest paid out would be $72,000, which is almost equal to the projected earnings of $75,446. That ratio improves in subsequent years, but still lags far behind the stock only option.
A2. Capital Budget Concerns
Capital budgeting is the process by which a company makes decisions that involve “cash inflows and outflows beyond the current year” (Hilton, 2011). This requires the use of discounted-cash-flow analysis, which allows a company to factor in the timing of cash inflows and outflows. It is usually done in one of two ways: the net present value method (NPV) or the internal rate of return method (IRR) (Hilton, 2011). These methods can guide a company’s decision making process because if the result of the net present
JET2 TASK 3 4
Value calculation is positive, the proposal is likely to be a good investment. The proposal is also likely to be a good investment if the internal rate of return equals or exceeds the cost of obtaining the capital (the hurdle rate). Competition Bikes is working with two models that project five years’ worth of expected annual sales in both low demand and moderate demand environments in the Canadian market. Using both the net present value and the internal rate of return methods, we can evaluate the risk associated with both scenarios, and whether the company should proceed with the expansion. Using the low demand projections for Canadian Biking, the NPV is negative ($26,740) at the end of the five-year period. This is very concerning for Competition Bikes as this means that they would not realize any return on the expansion investment for many years (if at all). Additionally, 5 years after the initial investment of $600,000, the cash flow is expected to be $540,532. This means the IRR is only 8.7%, which does not meet the company’s hurdle rate of 10%. Using the moderate demand projections, the NPV is positive, but only by $2,243. If the company experiences even a small downward shift in demand from their moderate projections, the NPV could easily become negative. The IRR in this case is 10.1%. This meets the hurdle rate of 10%, but only just. Even small fluctuations in demand could result in a rate of return that falls below 10%. It is important to look at the entire range of the calculated net present values for both models. It starts with negative $26,740 on the low end and moves up to positive $2,243 on the moderate end. The actual sales are likely to fall somewhere in between these two numbers. It turns out that 92% of that range falls on the negative side. This
JET2 TASK 3 5 represents significant risk for Competition Bikes because there is only an 8% chance that the net present value will be positive. Pursuing expansion under these conditions is not recommended.
A3. Working Capital
In order to expand operations, adequate working capital is essential for any company. To obtain additional working capital, Competition Bikes is already considering equity financing through the issuance of stock. It could also consider working with a venture capitalist, or allocating some of its available cash and cash equivalents from year 8 for the expansion project. Equity financing options are appealing because they do not require the company to incur additional debt, or the interest and repayment deadlines that go along with it. The downside is that ownership becomes diluted. However, Competition Bikes has a debt ratio of 46.2%, so it certainly has room to consider debt-financing options as well. They could apply for a Small Business Administration loan through the US government or establish a line of credit with a bank using existing facilities as collateral. Both of these options come with repayment obligations and the added expense of interest. If the expansion is not profitable, there is the possibility of defaulting on a loan, losing the collateral, and damaging prospects for future credit. Once Competition Bikes has obtained the necessary working capital, it must be diligent in properly managing it. This means properly managing the two things that determine working capital: current assets and current liabilities. For example, when evaluating assets in the flexible budget, direct materials had an unfavorable efficiency variance of $100,000. The company should look at streamlining its inventory
JET2 TASK 3 6 management system as well as the production process to improve efficiency and minimize waste. Working capital is preserved for other uses when it is not tied up in old inventory and scrap. Competition Bikes could also better manage working capital by improving its collection of accounts receivable. It has an average collection period of 43.8 days. If that is reduced to 30 days it will increase cash inflows and working capital. Competition Bikes can also review its contracts and look into negotiating better terms with suppliers and transporters. This will improve working capital for the expansion by decreasing cash outflow. Competition Bikes is faced with the decision of whether to buy or lease the facility in Canada. To preserve the greatest amount of working capital, the company should choose leasing, as it is the option that requires the least amount of cash. Over the five-year period, buying the facility would require $50,000 for the down payment plus $65,444 in interest, and the overall cost would be $399,774.
Alternatively, the overall cost of leasing the facility is only $283,752. Competition Bikes also needs to consider the possibility of failure in this new market. It makes more sense to lease the facility early on and preserve working capital for other expenses. If the venture proves successful, then Competition Bikes can exercise the option to buy the facility at the end of the five-year period.
No comments:
Post a Comment