Finance Case

Task A:

Scenario:

ABC Training with an annual turnover £ 25 million, is contemplating relocating to new premises. Two possible sites are available with slightly different features and aspects. The re-location will help them to be able to meet clients' needs more effectively.

Location A:

Investment required for the move = £10 million

The location is in the heart of the city centre and an estimated increase of 25% is expected if this option is chosen.

Deciding the location

The first part of the scenario requires a decision to be made on either choosing location 1 or location 2.

Choosing location 1 would require an investment of £ 10,000,000 with a benefit of 25% increase in sales per year.

10,000,000 x 25/ 100 = £2.5 million

Choosing location 2 would require an investment of £8,000,000 with a benefit of a 10% increase in sales per year.

8,000,000 x 10/100 = £800,000

Taking option 1 provides an opportunity cost of

2,500,000 - 800,000 =£1,700,000 million. So this would mean taking location 1 provides more profits with an opportunity cost of £1.7 million more. ACB should choose location 1. The second part of the task is to evaluate the different costs of the sources of finance given for option.

Issuing of new 1 million shares at £10 each would raise the total of £10 million pounds required for the relocation

1,000,000 shares x £10 = £10 million

Cost benefits of issuing shares to raise finance.

* The company will avoid using its retained profits

* Retained earnings can be used for other purposes such as: pay out its profits between the existing share holders, Invest into stocks etc.

* By holding its retained earnings the balance sheet will not be affected.

* Avoids taking bank loans and re-paying the interest.

* Dividends on shares only need to be paid if the company makes a profit.

Cost disadvantage of issuing shares to raise finance

* New shares means present shareholders ownership is reduced.

* There may not be any buyers (no demand) for the new shares, leaving the company with insufficient funds for the venture.

* When a company announces the issue of new shares it leads to speculations that the company has financial problems and that the firm may be entering into risky businesses.

* New shareholders expect the share value to increase so that they can sell the shares at a later date earn a profit.

* New shareholders expect to receive a return on the investment in the form of dividends.

* Issuing shares has costs involved such as administrative and legal costs.

* Time factors meaning that to raise finance in this way will not always be immediate it takes time to arrange and to receive buyers of the new shares.

Bank loan £10 million at 7% interest rate per annum for 10 years

Costs for the bank loan source of finance would be:

10,000,000 x 7% / 100 = £700,000 per annum

Over a period of 10 years £0.7million x 10 years = £7,000,000

Total interest rate payable over 10 years for the amount borrowed = £7million

So the bank loan of £10m investment receives 25% profit of £2.5m minus7% interest

£2.5m profit - 0.7% interest = £1.8 million net profit

Opportunity cost £2.5m - £1.8m = £0.7 million

Therefore £2.5 million is the gross profit after interest payments of £0.7million net profits are £1.8 million, to calculate in percentage terms:

Percentage profit: £1.8m net profit x 100 = 72% profit earned £2.5 m gross profit

Cost benefits of the bank loan source of finance are:

Companies can take advantage of Tax Relief on the profits before deducting the interest. In this case:

Tax Relief:

Gross profit = £2.5 million

Interest charge = £0.7 million

Net profit =£1.8 million

Tax without interest payments means the gross profit £2.5 million would be taxable. Due to interest payments now Tax Relief can be applied, only the net profit £1.8 million is taxable.

Another benefit of the bank loan means that the company will maintain its retained earnings and would not need to issue new shares to raise the finance. When retained earnings are untouched it indicates on the cash flow statement that the company has no cash flow problems. Cash flow is important for the firm to run smoothly, to purchase raw materials, payment of wages and meeting other operating costs.

Cost disadvantages of bank loan as a source of finance

* Commercial loans usually carry high interest rates.

* Opportunity cost means that instead of paying £0.7 million in interest payments a year the business could do something else with this money such as marketing & promotion which could generate further profits for the company for example £1million. Taking the loan and paying interest means that the opportunity to earn this possible £1million is lost.

* Another disadvantage is security, if the loan is secured on assets of the business, then the company has limitations as to what it can do with that asset, such as selling it would not be possible if it is held as a security.

Use retained earnings a balance of £25million last year's balance sheet