BUSINESS FINANCE

BUSINESS FINANCE

SEMESTER 1 (2019 20)

INDIVIDUAL COURSEWORK(COMPONENT 2) (FIRST SIT)

Students are simply required to provide a full and complete answer (including calculations and discussion). The submission should be split into the five sections of the assessment.

Students should note that they must comply with the University requirements around Academic Misconduct.

Component 2 represents 70% of the overall module mark for Business Finance.

BACKGROUND TO CASE STUDY:

Following graduation ten years ago, you joined a large accounting firm on their graduate scheme.  You successfully completed the professional accounting exams over the course of the next three years.  Since then, you have operated within a number of areas and now look after some key clients on behalf of the accounting firm.

One such client is Mega Power, the manufacturer of motors and other small parts for grinding and milling machines.You have acted as their dedicated accountant for the past six years.

PART 1:  THE EARLY DAYS:

Shortly after becoming involved with the business, Mike, Julie & Andrew, the three partners, met with you to discuss a number of issues which had arisen.  At this stage they had been running the business for several years and built up a solid client base.  Things had been running very well until a major client, Metal Design Limited, went into liquidation.  As a result, Mega Powerincurred a loss of £10,500.  At that time, Mike, Julie & Andrew asked you whether they could claim back the money from the company or from any other source, including the preference or ordinary shareholders

Based on the conversation with you at that time, they shared that they were aware of other businesses suffering financial difficulties.  This could create the risk of further losses from clients in the future.  They asked if you would recommend whether or not it would be preferable for them to form a company, rather than their existing partnership.

Required:

Prepare a full response to the following questions raised by the partners:

PART 2: GROWTH OF THE BUSINESS:

It is now six years since your first meeting with Mike, Julie & Andrew.  Since then, the business has gone from strength to strength.  Following your initial advice, they did form a limited company, Mega Power Limited.  Mike, Julie & Andrew are the directors and shareholders.  They now have clients from across the world. Their business has grown so strongly that they now need to enhance the machinery which they use themselves in their own production.

They have identified two possible machines which would increase production and set them up for further business over the coming years.  One requires a considerably higher outlay at the start but would appear to generate much bigger returns. They have provided their estimates to you and have asked you to evaluate each machine project and make a recommendation as to which machine Mega Power Limited should buy.

Estimates for the two machines are as follows:

Machine 1 (£)       Machine 2 (£)

Cost (immediate outlay)                     900,000      450,000

Expected annual net profit (loss) to be generated:

Year 1                                                          320,000          100,000

Year 2                                                (148,000)       (10,000)

Year 3                                                150,000      64,000

Expected residual value                     150,000           60,000

The company has an estimated cost of capital of 10 per cent and employs the straight-line method of depreciation for all fixed assets when calculating net profit. Project 1 requires additional working capital of £140,000 immediately whereas project 2 requires an injection of working capital of £45,000 at the start of year 2. The company has sufficient funds to meet all capital expenditure requirements, and working capital is fully recovered at the end of project lives.

You are now preparing a report ahead of your meeting with Mike, Julie & Andrew.  You want to be clear with your recommendation and so you aim to provide them with a range of forecasts to help them to make the best decision.

Required:

You are preparing your report for Mega Power Limited.  To enable the company to choose the best option, you are including a number of capital appraisal techniques. As part of your report, therefore:

Calculate for each machine:

• The net present value (8 marks)

• The approximate internal rate of return (6 marks)

• The payback period (4 marks)

• State which, if any, of the two machines the directors of Mega Power Limited should accept, and why. Share any concerns which you might have regarding the estimates.

(7 marks)

Total for PART 2:  25 marks  

PART 3: FINANCING CONSIDERATIONS:

As can be seen from the information provided, both machines would involve a significant capital outlay at the start.  As their accountant, you are concerned that the company has fully considered this.  You have mentioned the challenge to Mike, Julie & Andrew and they have indicated that the company does not have sufficient cash to pay for the machine.  Mega Power Limited will, therefore, need to raise the finance to pay for whichever machine they choose.  You have been asked to outline the options available to the company, explaining the advantages and disadvantages of each to the company.

Mike, Julie & Andrew have also pointed out that Mega Power Limited has existed for a number of years.  Since formation, their turnover has increased significantly.  The company is enjoying particular success in providing parts to the Chinese market.  They envisage the need for additional finance to be a continuing theme over the years to come.  They wonder whether it is now time to float the company to form Mega Power PLC.

Required:

PART 4: COST OF CAPITAL:

You have submitted your report covering PARTS 2 & 3, and have discussed your findings with Mike, Julie & Andrew.  In completing your calculations, you have used a 10% cost of capital.  Mike, Julie & Andrew do not understand what this relates to.  You are now asked to explain what the term cost of capital means and how it is calculated.

Required:

                                                                           Total for PART 4: 10 marks 

PART 5: ILLUSTRATION OF WEIGHTED AVERAGE COST OF CAPITAL:

In preparing your report for PART 4, you wish to draw on another company to explain the effect of the financial structure on the cost of capital for a business. You have identified Lean Engine PLC, a quoted company involved in a similar trade to Mega Power Limited.

The financial structure of Lean Engine PLC is as follows:

1. £40m of 50p ordinary shares with a market value of £1.50 per share. Dividend per share last year was £0.15 and the dividend has grown by 10% over the past 5 years.
2. £10m of 10% £1 preference shares with a market value of £1.20 per share. These preference shares were issued at a cost of 5%.
3. £10m of 8% Bank Loan.
4. £15m of 6% Loan Stock, not redeemable for many years to come. The market price of each unit is presently £90.

Corporation Tax in the UK is 25%.

Required:

                                                                            Total for PART 5: 25 marks

PART 6: GENERAL PRESENTATION (Note to Students):

The presentation of this report should be formatted in a professional manner.  Marks will therefore be allocated to the overall structure of the answer in each section, the clarity of the language used and correct referencing in line with university guidelines.

Marks will be allocated as follows:

  Total marks allocated for PART 6: 20 marks

OVERALL MARKS FOR ASSIGNMENT:  120 MARKS