Investestment Proposal I Feel Honoured

Investestment Proposal

I feel honoured and highly placed to be allowed to review the proposal of the manufacturing division of the company, Warner plc. And I give kudos to my boss, MS Weetman for this privilege. This company was established on the crucible of hard work and the propensity to make profit while making the products of the company available to the teaming populace. The portfolio of the company was never lack luster but the trend for some years now has really challenged the continued propensity of this company to make tangible profit. From the current trends in the financial stability of the company, the most recent balance sheet of the company shows the Warner plc has a debt of 10 million pounds which in its own has different composites. A three-year bond is one of the composites of the debt the company acquired by borrowing.

It is also noted that the company has thirty million ordinary shares of which all the post tax earnings are paid out as dividend to the shareholders. Not done with the list of happenings in the company, the company had already spent a whooping £2 million in developing the new technology-driven vacuum cleaner. In addition to that expense, £1 million was disbursed on market survey for this product but the report from the market was that of low market performance for the selected goods despite the forecast of good market situation. However, one of the surveys conducted by the company has allayed the fear of further declining company fortune. The manufacturing division of the company has decided to relocate to Turkey from the UK in search for a greener pasture. In view of the financial posture of the company and the performance of the company, is the proposal of the manufacturing division of the company a viable one?

In determining whether a company has the wherewithal to pursue the goal and plans of a company, the company's balance sheet must be strong enough so as to prove to would-be investors that the company has the financial strength to cushion the effect of any downturn in the market (Adekola et al. 2008; Balkyte, Tvaronaviciene 2010; Tvaronaviciene et al. 2009). The manufacturing division made it know that on relocating to Turkey, the government grant will take care of any tax liability on the investments. In the Opinions of Modigliani and Miller (1958, 1963), in a tax-free environment emphasis should not be placed on market value as regards capital structures. If however there are no tax waivers, a positive relationship thus exists between the value of the company and the level of debt.

There are different approaches to be assumed in determining the viability of the proposal of the manufacturing division of the company. It is divided into four sections: calculating the weighted average cost of capital for Wanna plc; advice the company on the based on the initial estimate of WACC; proffering recommendation to the company and sources of log-term finances for the company.

i. Estimating the "Weighted Average Cost of Capital" (WACC)

Weighted Average Cost of Capital is one of the very important parameters used in deciphering the financial strength of a company. It is used in assessing the internal monetary issues of the company as well as evaluating the true worth of the company in the stock market. In financial and monetary decision making such as that presented by the manufacturing division of this company, WACC is used as a scale of reference in checking the financial outlay of a company. It is used in estimating the possibility of expenditure in view of the current financial state of the company. It is therefore a rate of return of on an organization's or company's capital needs, weighted in proportion to the amount each item requires from the total company's capital.

WCCC = E x Re

D x Rd x (1 - tax rate)

VV

It is assumed that:

E

= % of finance that is equity

V

Re

= Cost of the company's equity

D

= % of finance that is debt

V

Rd

= Cost of company's debt

D

= this is the current market value of the company's debt

E

= this is the current market value of the company's equity

In calculating WCCC appropriately, the cost of equity and that of the debt must be calculated separately. Two major approaches can be used in calculating this. One is dividend growth approach while the second one is capital asset pricing model (CAPM). The first to make use of is the dividend growth approach.

P1 = D2

Re -- g

It is assumed that the parameters above are as follows:

P1 = prevailing market stock in the specified period 1

De = Dividend in period 2.

Re = cost of equity g

= the rate at which dividend is growing

However, when calculating dividend paying shares, we make use of the formula below:

Rc = D2

Po + g

The second approach which is capital asset pricing model (CAPM) can, as well be used as represented below:

Rc = Rf + ?ex (Rm -- Rf) where Rf and Rm are risk free rate and market return.

Cost of debt = company's bond before tax ( 1 -- tax rate)

= 7% ( 1 -- 0.04)

= 6.72%

cost of Equity = risk free rate + beta (market rate of return -- risk free rate)

it is assumed that risk free rate is 6%, market rate of return is 7%

cost of debt

= 6% + 1.3 ( 7% - 6%)

= 7.3%

WACC

= 20% (6.72) + 20% (7.3)

= 1.344 + 1.46

= 2.804%

ii. Advice Given to the Company Based on the Initial estimate of WACC

Making use of weighted Cost of Capital as a basis in estimating the feasibility of a company's project is very important. WCC has as its bases the company's capital structure. The company's financial structure is composed of financing both debts and the company's equity. The company's equity can be in the form of preferred equity and common equity while the debt can be in the form of bonds which of course, the company has. It is a common knowledge that companies raise money from debt and equity (Carland, Jim, and JoAnn Carland 1998). WCC is the cost associated with the either increasing the company's debt and/or equity. The value of WCC is important because it is used in evaluating the net present value of a project. It is as well used in knowing the value of an asset. Above any other consideration, in order for a project to be considered, the value obtained from WCC must be higher that the cost of financing debts or the cost of financing equity. In this regard, the company must be able to make profits from any of its ventures.

Two approaches are mostly adopted in using WCC. It is mostly preferable to first issue debts which may be in the form of bonds before attempting to raise the company's equity. The effect of this is to lower the value of WCC. As it is know that ever business has some level of risks ascribed to it, certain percentage of risk factor should be introduced as a risk management strategy. Considering the value of WCC for the company, it stands at 2.804% which means that the company's debt portfolio is high. Before the company can embark on any capital-intensive venture, additional source of funding is needed.

iii. Recommendation on the new projects

As mentioned earlier, one of the importances of using WCC is appraising the feasibility and worthiness of a project. Based on the request of the manufacturing division of the company, a market survey costing £ 1 million and product development of £ 2 million; acquisition of production plant amounting to £ 30 million really needs high-level consideration. A recent market survey indicated that the proposed new product will fall short of sales expectation by 20%. Also considering the income statement forecast for the new product, the first two years are expected to have sales of £75 million with the adjoining years experiencing drops in sales. It is though noteworthy that variable cost will keep declining over the years. The profit margin for the product fell to a point of negative in the latter part of the years according to the forecast income statement. It is also worth considering that the company has 30 million ordinary shares. Warner plc pays 30p/share. This amounts to £9 million paid to shareholders as dividend. Considering the financial posture of the company, the company is left with no other fund to executive the proposed project. By taking the cumulative proposed expenditure of the company on the new product, the capital requirement can not be met be the company based on the financial strength of Warner plc.

Regarding the relocation of the Manufacturing Division to Turkey from UK, it is proposed that it will gulp an amount equal to £ 30 million. This is considered as spending without the probability of making commensurate profit. The market structure of Turkey is quite different from that of the UK. The cultural composition of Turkey is not a guarantee of making proportional sales. The reasons for the low performance of the company's product could as well reverberate in Turkey. If the UK market that the company is accustomed to has failed to yield expected returns, the viability of the company's product in Turkey is doubtful. However, considering the expectation of government grants that will offset the company's tax liability; the venture assumes a would-be profit generator. The company cannot bank on this tax relief as a basis to carry on with the proposed relocation to Turkey. The reason for that being that the amount accruable from the tax relief is on a portion of the entire expenditure of the company. The long run effect of this is still profitable to the company.

Based on the outlay of the company and the capital requirement of the new product, combined with the possible market performance of the proposed new product, it is not advisable for the company to pursue executing these projects as it will further push the company to more vulnerable financial condition.

iv. Sources of finances

There are actually different reasons to consider sources of finances. Certain parameters serve as guidelines: (i) the amount required comes first, followed by (ii) the timeframe the finance is needed. Subsequently, (iii) the security in the disposal of the company and (iv) the preparedness of the business owners to relinquish some level of ownership in return for investment. This could be in order to kick start a business or to finance company's projects. Universally, finances are made available by finance institutions. This comes in the form of borrowing from the bank which is paid back with interests. This source of financing is available to any company that has the required collateral and/or good credit rating. Considering this source of finance for Warner plc may not be feasible. It has been continuously hard for the company to get loans from these finance institution. This is due to the company's lack luster financial stand and credit rating. Bank overdraft would have also been considered but the financing needed by the company is for longer period of time. This is still an area can be explored in addition to other areas. Nonetheless, there are still other sources of financing available. It should not be forgotten that the shares of the company is £3.

Business angels: Just as the name implies, these are 'angels'. They are very wealthy individuals that are ready to dish out cash in exchange for some of the company's equity. These angels take a lot of risk with the hope to owning a part of the company's equity. If the company eventually fails, they lose all their money and investments. Approaching the business tycoons comes to play when companies need huge amount of money to finance heavy projects. Approaching these angels is dependent upon some conditions:

The company must relinquish some of the company's equities

Good communication is required with these business angels. They will also request that they have a hand in the running of the company. This is necessary so as to safeguard their investments

The company must have a good track record of business operation. These angels will not give their monies to those who are not sure of what they are doing. Warner plc must set the record straight if considering this these business angels as an option.

The company must have good and experienced management team

Debentures: These are also another long-term source of financing open to business outfits. Debentures is like a bond or long-term loan issued to the public by the company. It has the uniqueness of fixed interest rates through out the period of this long-term loan. Members of the public whom the debentures are issued to invested in the company. They receive interest irrespective of whether the company makes profit or not. They are however not a co-owner of the company. The amount invested in the company is repaid to them over a period of years. There are no security or collateral requirements in order to access debentures.