Response to Q1a
Strategy 1: Aggressive. As per strategy 1, the Total funds requirements are to be divided into permanent and seasonal requirements based on the premise that permanent requirements are essential and the seasonal requirements vary and hence the permanent requirements need to be allocated out of the total monthly requirements based on Polly’s assessment of short term and long term average monthly requirements as shown below.
Strategy 2: Conservative. For Strategy 2, the conservative funding requires Polly to allocate the whole amount to Permanent requirements with long term funds equal to $1,500,000 and the seasonal requirements to be fulfilled only in emergency cases.Thus in each month the Permanent requirements amount to $1,500,000 while there are no seasonal requirements .
Strategy 3: Trade-off. For strategy 3, An amount equal to $4,500,000 needs to be funded with long term funds and the rest with short term funds. Thus the funding requirements will be reflected as in the table below
Response to Q1b
As per Polly’s assessment, the short term financing costs are 6% and Long term financing costs are 10%.
Thus as per strategy 1(aggressive), the total financing costs are as follows:
Total Short term Financing costs = 6% X Total annual Short term fund requirements
Total Short term Financing costs=6% X $45,000,000=$2,700,000
Total Long term financing costs= 10%XTotal annual long term fund requirements
Total Long term financing costs=10%X$18,000,000=$1,800,000
Total financing costs = $2,700,000+$1,800,000=$4,500,000
As per strategy 2 (Conservative),
Total short term financing cost= 6%X0=0
Total Long term financing costs=10%X18,000,000=$1,800,000
Total financing costs are $1,800,000
As per strategy 3(Trade off),
Total short term financing cost=6%X$21,000,000=$1,260,000
Total long term financing cost=10%X$42,000,000=$4,200,000
Total financing costs are=$1,260,000+$4,200,000=$5,460,000
Response to Q2
Expected annual average current assets= $6,000,000
Net working capital=Current Assets-Current liabilities
Net average annual working capital= Average annual current assets-average annual current liabilities .
Also, Average annual current liabilities=Average annual seasonal financing
And Average annual seasonal financing= Total seasonal financing/12
As per strategy 1,
Total seasonal financing= $45,000,000
Total current liabilities=$45,000,000
Average annual seasonal financing=$45,000,000/12=$3,750,000
Net average annual working capital= $6,000,000-$3,750,000=$3,250,000
As per strategy 2,
Total seasonal Financing=0
Total current liabilities=0
Average annual seasonal financing=0
Net Annual working capital=$6000,000
As per strategy 3,
Total seasonal financing =$21,000,000
Total current liabilities=$21,000,000
Average annual seasonal financing=$21,000,000/12=$1,750,000
Net average annual working capital= $6,000,000-$1,750,000=$4,250,000
Response to Q3
The profitability risk trade-off
Net working capital=Current Assets-Current liabilities
Also, cost of financing is the cost of acquiring working capital. Thus an increase in working capital is proportional to an increase in the current assets and a decrease in the current liabilities.
Thus the risk and profitability as related to the cost of working capital can be tabulated as below
As per Aggressive Strategy (1), the firm would borrow from $1,500,000 to $9,000,000 according to the seasonal requirement schedule shown above, at the prevailing short- term rate. The firm would borrow $1,500,000 or the permanent portion of its requirements at the prevailing long term rate .
Also, as per this strategy, the total cost of acquiring working capital is $4,50,000 which is high, thus Profitability and risk associated are low.
As per Conservative strategy(2), the firm would borrow for seasonal requirements only in the cases of emergency and thus the short term requirements shall be met with the balance of the permanent funds let after funding the long term requirements. The firm would borrow $1,500,000 or the permanent requirement at the prevailing long term rate .
Also, as per this strategy, the total cost of acquiring working capital is $1,800,000, which is low, thus the profitability as well as the risk of doing business in this case are high .
As per trade-off strategy (3), the firm would borrow from $1,500,000 to $6,000,000 according to the seasonal requirement schedule shown above. The firm would borrow from $1,500,000 up to $4,500,000 or the permanent portion of its requirements at the prevailing long term rate. Also, as per this strategy, the total cost of acquiring working capital is $4,60,000 which is the highest, thus Profitability and risk associated are lowest.
Recommended strategy. In this case, the lowest costs associated with Strategy 2, the conservative strategy, make it the most favourable. Possibly a unique combination of low costs but high profitability make it attractive but also warrant greater risk .
Response to Q4
Prime Interest rate = 2.5%
Overdraft premium rate = 3.5%
Total interest rate = 6%
Thus Annual Interest cost = 6% X $ 9,00,000 X 365/365= $54,000
Average unused balance = Overdraft limit – Average annual overdraft
Thus average unused balance = $1,500,000 - $900,000=$6,00,000
Therefore Commitment fee = 0.5% X Average annual unused balance
Commitment fee = 0.005 X $6,00,000=$3000
Total costs = Interest cost + commitment fee = $54,000 + $3,000=$57,000
Thus effective annual interest rate = ($57,000/$900,000) x 100= 6.34%
Case2: Report
Report to: Fletcher Peters
As requested, my report regarding the alternative methods of financing the seven companies is attached.
I have discussed the various options available for each company, including its effect on working capital, and then recommended the option I consider to be the most appropriate for the given circumstances.
Mistral Yachts
Discussion of company
Mistral Yachts is a private company founded in 1970 to build quality Yachts. The company’s current debt ratio is higher than the industry average of 36%. The shares are owned by ten partners and none of them have the financial strength to put additional funds into the business. The business is thus hard pressed for funds. The company has a decent profit of $1,200,000 after tax. However, in order to succeed in the future it needs an additional $6,500,000 in near future to fund the expansion and stay competitive.
Viable financing options
The company can not afford long term financing options and also does not need the finance to be very expensive which is the usual condition for a fast and easy financing. Thus the various viable options for Mistral yachts are Preference shares and ordinary shares with private placement. The company must not go for ordinary shares with rights offering as the existing shareholders do not have any funds to invest. Additionally, the company can go for a bank overdraft to meet its short term finance needs for business expansion .
Recommendation
The most appropriate financing method for the company would be a mix of Ordinary shares with private placement and a bank overdraft facility, which will serve the need based finance needs of the company.
Impact on working capital
The recommended financing option for the company will help it increase its working capital with an optimum cost of acquiring the capital. The bank overdraft is a relatively easy and reasonably priced option and the shares with private placement can help finance the business expansion in a moderate fashion .
Kemmerer Wines Ltd.
Discussion of company
Kemmerer Wines Ltd. Is a financially stable company with high equity to debt ratio. The company wants to establish a new plant in a new location and the company is already listed on the stock exchange with good earnings and dividends per share. The company needs additional $3.3 million for the new winery.
Viable financing options
The company being stable enough can go for long term bank loans as well as offer additional shares and debentures to the existing equity. Another good option can be the preference shares or ordinary shares with rights options. The company can also easily get a loan on its equity and may partially go for factoring .
Recommendation
The most appropriate option for the company would a mix of ordinary shares with rights options along with a bank loan or bonds on its equity.
Impact on working capital
The recommended finance option would indeed increase the working capital and increase the liquidity of the company to a greater extent with a moderate cost of acquiring and maintaining the capital .
Orchard Fresh Canning Company
Discussion of company
The Orchard Fresh Canning Company is a canned fruit company selling on a 60 day credit. In contrast, the raw materials and fruits are purchased within 30 days period. Thus there is a considerable time lag between receivables and payables. Thus the company is obviously in need of short term, working capital loans to finance its day to day operations . The company has a long term mortgage loan to be serviced. The increase in demand calls for an expansion and additional funding for the company and the same is estimated at $550,000.
Viable financing options
The various appropriate financing options for the company are factoring as it has greater accounts receivables than usually the accounts payable and can afford to sell its accounts receivable to limited extent. Additionally, it can go for a bank overdraft facility. Another option is to go for a long term mortgage bank loan which is an appropriately non expensive option given its apparent lack of liquidity .
Recommendation
For a company like Orchard Fresh, a combination of the Factoring and the bank overdraft facility will be most appropriate. The former will take advantage of its supposed favourable accounts receivable position, while the latter will be beneficial as a moderately priced, and readily available and flexible financing option, given its existing mortgage loan from bank .
Impact on working capital
The recommended finance option for this company will serve to help manage the working capital better and will help capitalize on its current assets in the short term, which it is in need of especially with additional fund requirements for business growth .
Parson Healthcare Ltd.
Discussion of company
Parson Healthcare is a financially stable company and listed on the stock exchange. The share value growth reflective of the business growth is 7% and is higher than the industry average of 5%. However, the debt ratio of the company is much higher at 42% than the industry average of 25%. Also, the price to earning ratio of the company shares is much lower at .058 as compared to industry average of 0.15. This makes the company less profitable, though liquidity is not much of a problem due to faster growth. In order to further fuel expansion, it needs $5 million in cash .
Viable financing options
The company can go for a partial leasing arrangement for operations and do the Marketing itself as it has an established business and fast growth. A leasing arrangement can do away with operational expenses and bottlenecks. Another viable option for it is to go for a long term bank loan with over drafting facility as an inexpensive means of financing, since the company is currently low on profitability .
Recommendation
Considering the overall condition of the company, it will be advisable for it to go for a long term bank loan with over drafting as owing to its assts and fast growth, it will easily get bank finance on a comparatively low to moderate cost of acquiring funds .
Impact on working capital
The recommended finance option is going to improve increase a the working capital in both short run as well as on a relatively longer term with a lower end cost of acquiring working capital .
Silver Hill Mining Company
Discussion of company
The Silver Hill mining company is a financially strong company with lower than industry average debt ratio as well as Total assets worth $120 million. The shares earning to price ratio is well within the industrial average limit of 8 to 13 per share. Thus the profitability is decent. The company needs an initial finance of $12 million to finance the acquisition of mining rights to ascertain the viability of mining in a given area. This is a risky investment and warrants a low cost and fast available option. If successful, another $12 million are required to expand the mining operations into the area .
Viable financing options
The company can go for the preferential shares or the ordinary shares with private rights offering option. For the additional $12 million, the company may go for a combination of ordinary shares with private placement and bank overdraft.
Recommendation
The company must go for ordinary shares with private rights offering as this will maintain the equity as well as help acquire fast but moderately priced finance given the fact that the company is already into shares which are earning a decent price. Additionally a bank overdraft facility may be suitable for the additional $12 million if the project is found viable .
Impact on working capital
The net impact on the working capital would be to strengthen the liquidity part and also a ready and abundant availability for such a huge project.
The Way Bowling Lane and Bar
Discussion of company
The Way Bowling Lane and Bar is supposedly a new Entrepreneurial venture. As the business owner of the supposed business, Bud Greer has a fair knowledge of the market and is confident of succeeding in the business. He already has access to a building available at a low cost and ideal for the ten pin bowling business. He needs $2,00,000 for the business out of which he has $50,000 from his savings thus he needs an additional $200,000 for the business .
Viable financing options
Since this is a new business, and the fund requirement is not on a very higher side, the best way for Bud would be to borrow from friends and/or relatives. Also he can go for debts with warrants for share purchases, later on.
Recommendation
In this case for starting the business, it is recommended that Bud should borrow from family/friends as this is the safest and easiest method of finance in the given circumstances. Once the business builds up a little, he can apply for a short term bank loan and also get an overdraft facility .
Impact on working capital
Initially, the business will require the working capital to limited extent as this is a service oriented business. Thus the working capital needs can initially be met with the recommended finance option for the business .
GC Engineering Ltd.
Discussion of company
GC Engineering Ltd is dealing in latest computerized technologies. Although it is a big company in terms of assets, its financial health is currently not in best condition. The company’s debt ratio is slightly higher than industry average and the shares are selling slightly below the industry average. The growth is slowing owing to rising fuel prices and high currency exchange rate owing to its 70% export oriented business. It needs an additional $10 million to support a business growth at desired level .
Viable financing options
The most viable options for the company at this stage are the ordinary shares with the private placement option as a fast and moderately priced finance option. Also, it might go for a Debt with warrants for share purchases along with a partial bank loan .
Recommendation
The recommended finance option for the company is floating ordinary shares with private placement option as it will help build assets that can further be used as a finance option for expansion.
Impact on working capital
The working capital requirements of the business are high as the business expansion requires huge funds for starting and managing routine operations. The recommended option will serve to provide finance for working capital to the company with ease and at a moderate price and this will build up reserve working capital .
References
Gitman, L. J., Juchau, R., & Flanagan, J. (2010). Principles of Managerial Finance. Pearson Higher Education AU.
Hill, R. A. (2013). Working Capital Management, Theory and Strategy. Retrieved from Bookboon.com: http://www2.aku.edu.tr/~icaga/kitaplar/working-capital-management.pdf
Padachi, K., Howworth, C., & Narasimhan, M. S. (2012). Working Capital Financing Preferences:The Case of Mauritian Manufacturing Small and Medium Sized Enterprises(SMEs) . AAMJAF, 125-157.
