Study on the Return on Capital Employed Finance Essay

Return on capital EmployedA (ROCE) is a financial measure that measures the performance of a company as to how it generates cash flow relative to the capital it has invested in its business. It is defined asA net operating profit less adjusted taxesA divided byA invested capitalA and is usually expressed as aA percentage. When the return on capital is greater than theA cost of capitalA (usually measured as theA WACC), the company can create or destroy on its value terms. The ROCE for Iggle Plc is 35% and while for Piggle is 20% which means that the return on the capital employed is over 15% more for Iggle Inc and it is a healthy company to invest when compared for long term investment.

Return on Equity :

It is one of the most crucial profit indicator to the shareholders of the firm. It is the relation between Net Income / Average Equity, Net Income is the income after the Profit after Tax. Return on Equity for Iggle Plc is 20% and for Piggle Plc is 10% which says that iggle plc gives more return to the shareholder on the money employed by them when compared to piggle Plc. Iggle Plc is a better option for investment considering long term investment.

Average Settlement period for debtors :

The average settlement period or average time taken for debtors to pay the amount outstanding. For Iggle Plc the Average settlement period is 78 days and for Piggle it is 45 days. It means that the debtors take longer time to repay to Iggle than to Piggle. Means they have longer credit period and it also shows the soundness of Iggle Plc.

Average Settlement period for creditors :

The average settlement period or average time taken by the business to pay its creditors. Iggle Plc is 85 days and for Piggle Plc it is 45 days, which means the money lenders of Iggle Plc have provided more number of days for them to pay of their credit. It may be because of their goodwill or strong relationship with buyer. It shows a positive relationship of Iggle Plc with it suppliers.

Gross Profit Margin :

Gross Profit Margin ratio shows the profits relative to sales after deduction of direct production costs. It is the relation between Gross Profit / Net Sales, where Net Sales = Sales- Excise Duty. Gross Profit margin for Iggle Plc is 44% and for Piggle Plc is 27% which means that Iggle Plc is more efficient for production operation and the relation between production costs and selling price. Since calculation of Gross Profit shows the efficiency of Iggle Plc in production related activities making it more efficient.

Fixed Asset Turnover Ratio :

It is also known as Sales to Fixed Asset Ratio and it measure the efficiency and the profit earning capacity of the firm. Fixed Asset Ratio is relation between Cost of Sales / Net Fixed Assets. Fixed Asset Turnover Ratio for Iggle Plc is 15 times which means ratio is high. Higher the ratio, greater is the intensive utilization of fixed assets. While for Piggle it is just 3 times which means lower is the intensive utilisation of the fixed assets.

Capital Gearing Ratio :

It is related with the solvency ratio and is usually used to analyze the capital structure of the firm. It refers to the proportion of relationship between equity share capital and other funds bearing funds and loans. Capital Gearing Ratio sets relation between Equity Share Capital / Fixed Interest Bearing Funds. Capital Gearing Ratio for Iggle is 65% while for Piggle Plc is 15% which means that the capital structure of Iggle Plc is stronger when compared to Piggle. And Equity Share Capital holds much stronger than the other funds and loans. Current Ratio : It is the ability of the enterprise to meet its current obligations. It involves the relationship between current assets and current liabilities. In case of Iggle Plc, Current Ratio is 1.8 : 1 which means that the firm has current assets which are 1.8 times the current liabilities. While in case of Piggle Plc, current ratio is 2.9:1, which means that the firm has current assets which is 2.9 times its current liabilities. Since the Ideal Current .Ratio being 2.1, Piggle Plc has a better ability to meet its short term debts and is more healthy. Acid Test Ratio : It is also known as Quick Test Ratio. It also shows the relationship between the current assets and current liabilities deducting the inventories out of current assets. It is named as Quick test as it gives the abilities of the firm to pay its liabilities with relying on the sale and recovery of inventories. Iggle Plc, Acid Test Ratio 0.6 :1, after deducting the inventory out of the lot the firm has current assets just 0.6 times when compared to liabilities. Piggle Plce, Acid Test Ratio 2.9:1 which shows that piggle plc is more prominent in meeting out the current liabilities.

Price Earning Ratio :

It is calculated by taking the market price of the stock by dividing it by earning per share. If we consider that Iggle P/E ratio when compared with one share is 6/1 (60%) and while for Piggle Plc P/E Ratio is 10/1(100%), then we can conclude that the price earning capacity of Piggle Plc is more than Iggle. The P/E ratio method is useful as long as the firm is a viable business entity and its real value is reflected in its profits.

Net Profit margin (PBT)

It shows the earnings left for shareholders as a percentage of net sales. It tells the over all efficiency of the firm. It is the relationship between Net Profit and Net Sales. Net Profit Margin for Iggle Plc is 15% as compared to Piggle Plc which is 9%. Profit for Iggle is more in terms of Net Sales than Piggle which shows the efficiency of Iggle in production, administration, selling, pricing and tax management.

Stock Holding Period

Stock holding period states that for how long the inventory was lying in the stock. It is the relation between 365 / average inventory turnover. For Iggle plc Stock Holding period is 88 days while for Piggle it is 21 days. It means there is lack of demand for Iggle goods in the market when compared to Piggle Plc. Inference : Based on the above data in relation with the ratio analysis, I would like to advice all potential investors that Iggle Plc is stronger when compared in relation to Gross Profit Margin Ratio, Net Profit Margin, Average Settlement Period for both debtors and creditors, Return of Capital Employed and ROE, Capital Gearing Ratio as all these ratios where related to the long term investment decisions and showed the positivity toward the stakeholders. While Piggle Plc is better off meeting with the short term requirement with its Current and Acid Test ratio. Since both the companies are software companies it is much prone to market innovation and technology up gradation. These ratios being a source of information states a stable position for Iggle Plc when compared to Piggle Plc. Part 2 Piggle Plc is making investment appraisals of two potential long-term projects namely A and B. Since the initial investment for both the projects are £2m, so both the projects would be considered in terms of the profitability and long term returns. Capital expenditure decisions occupy a very important place in corporate finance like, these decisions once taken has far reaching effects which proceeds over a long term period and influences the risk taking complexion of the company. Moreover, it involves huge amount of money are capital decisions once taken are irreversible and also involves opportunity cost of various equivalent or much fruitful viable investment opportunities. Piggle Plc before taken up any decision regarding Project A or Project B should scrutinize the opportunity in terms of initial investment and returns considering the time value of money, Cost-Benefit Analysis.

Evaluation Criteria

Non - Discounting Discounting Criteria Criteria (doesn't include time value of money) (includes time value) Pay back period ARR Net Present Value Internal Rate of Return

Decisions based on the Payback Period

Initial Investment being £2m Payback Project A= 4 years Project B =5 years The Payback period measures the duration of time which is required to recover the initial investment involved in the project. It doesn't include the time value of money and is based on simple calculations. Project A = 4 years Project B = 5 years According to the Pay Back Period Project A should be accepted since the money of £2m invested initial in the project is recovered in the first 4 years, while in Project B it would be recovered in 5 years being Rs.4,00,000 as net annual cash Flow for 5 years. However, it may even approve and go for Project B because since the Pay Back Period doesn't consider time value of money so The decisions based on the Pay Back Period are not wise decisions, coz it doesn't consider the time value of money. The basic conclusion drawn of the payback method is as quickly the cost of anA investmentA can be recovered, the project is considered as more desirable. I would suggest Piggle Plc should not base their decisions of rejecting or accepting the Projects Pay Back Period as it may become riskier for them to revert back once they go ahead with approving the Projects.

Decisions based on Accounting Rate of Return :

Accounting Rate of Return is the method of estimating theA returns rate from an investment using a simple straight-line approach (doesn't consider time value of money). The rate of return is determined when profit is divided by the number of years invested, then by the investment cost. This method is simple and is used by major decision makers for project approvals. Accounting Rate of Return (ARR) = Average Profit After Tax Average Book Value of the Investment Project A ARR = 15% Project B ARR = 20% Considering the average capital invested the average profit for Project B is more than Project A. Since the Accounting Rate of Returns also considers the depreciation amount after lessoning that the average profit after depreciation is involves, which in itself shows the viability of the decision. Piggle Plc must move ahead with the decision of accepting Project B for Capital Budgeting Decisions. Unlike, if Piggle Plc considers the concept of rate of return familiar and easy to work with rather than absolute quantities it should move ahead with accepting Project B.

Decision based on Net Present Value :

The Net Present Value is equal to the present value of future cash flows and any immediate cash outflow. In the case of Piggle Plc, the immediate cash flow will be investment (cash outflow in terms of annual cash flow for the number of year) and the net present value will be therefore equal to the present value of the all the future cash inflow subtracted by initial investment. Decisions based on the NPV considers factors like Discounting rate, no. Of years, inflations, interest rate. The general criterion based on the Net Present Value is that if the Net Present Value comes as Positive after deducting from Initial Investment is accepted or else if it is negative it is rejected. In case of Piggle Plc the Initial Investment is £2m And the Net Present Value for Project A 145 Project B 120 Since the NPV after considering the time value of money and future cash inflow is positive for both the projects. The NPV is a conceptually sound criterion of investment appraisal since time value is considers. Piggle Plc can go with approving both Project A and Project B based on the above statistics but it should go ahead with accepting Project B because capital decisions and Net Present Value represents the contribution to the wealth of the shareholders and stakeholders, maximising NPV is viable and correct stating the objective of investment decision making which is "maximising shareholders wealth".

Decisions based on Internal Rate of Return :

Internal rate of return considers the time value of money. Internal Rate of Return is that rate of interest at which the Net Present Value of a Project is equal to zero, or it is the rate which equates the present value of cash outflows to the present value of cash inflows. Under the Net Present Value method of discounting rate is known (the firm's cost of capital) under IRR this rate which makes NPV as zero has to be traced out. In case of Piggle Plc Internal Rate of Return Project A = 16% Internal Rate of Return Project B = 13% Both Project A and B can be approved based on the IRR because at different rate of 16% and 13% which is the IRR the projects are capable of nearing to the Initial Investment all factors being the same. Only external facts like technical and market appraisal decision would make me approve Project A since the IRR is 16%. Both the Projects are viable and difficult to choose between mutually exclusive projects that doesn't differ significantly in terms of outlays. Conclusion : If i have to choose between the two Projects summarising all the Investment Methods I would go ahead with Project B since the ARR is more of Project B and also supporting the time value of money with Net Present Value is positive and more for Project B.

Part 3

The Main Sources of finance that are available for Piggle Plc to finance the chosen Project will majorly include : Sources for the Initial Investment or Cash Outflow Firms needs finance mainly for two purpose : To fund the long term decisions For meeting the working capital requirement Since these are long term decisions for Piggle Plc may decide the future decisions and setting up of the firm, expansion, diversification, consolidation and other major capital expenditure decisions. By the nature of the Project of Piggle Plc, long term sources of funds become the best suited means of funding. Factor to be considered here for an investment decision will be proper asset-liability management. Sources of finance available with Piggle Plc are: RAISING CAPITAL : Piggle can issue three types of capital - equity, debenture and preference capital and can be distinguished on the basis of the risk, return and ownership pattern. Equity Capital : Majority of the capital can be raised through equity capital and hence they will become the owners of the company. They will get residual profits after having paid the preferential shareholders and others creditors. One of the added benefit which Piggle Plc would have with raising up of Equity Capital is that the issuing firm doesn't have fixed obligation for dividend payment but offers permanent capital with limited liability for repayment. Preference Capital : Can also raise a part of Capital by Preference capital. However this is similar to equity capital except few differences like preference dividend is not tax deductible. They earn a fixed rate of return for their dividend payment. If Piggle Plc is not able to pay the dividend in a particular year, preference shareholders get arrears in dividend for the cumulative period Cumulative or Non Cumulative Preference Shares Redeemable or Perpetual preference shares Convertible or non Convertible Preference Shares Debenture Capital : Piggle Plc can go raising debenture capital as a marketable legal contract whereby Piggle Plc promises to pay its owner, a specified rate of interest for a defined period of time and to repay the principle amount at the maturity of the period. There are other types of debenture capital Non Convertible : Wherein after the maturity period the same wont be converted in equity shares and will be redeemed back with principle amount Fully Convertible : At the end of the maturity period the same will be converted into Equity Share Capital at once or in instalments Partly Convertible Debentures : At the end of the maturity period some part of the debentures would be redeemed back with the principle amount and partial will be converted into equity capital. The same being previously decided.

PUBLIC ISSUES

Companies issue securities to the public in primary market through IPOs and get them listed on stock exchanges. Stocks and securities are then traded in secondary market.

TERM LOANS

It is one of the major sources of debt finance and repayable in more than one year but less than 10 years involves a rate of interest. For approving through the Term Loan Piggle Plc has to first mortgage or by way of depositing title deeds of immovable properties. Advantage of this source of finance is its post-tax cost, which is lower when compared to equity and preference capital.

PRIVATE PLACEMENT

Private placement method of financing involves direct selling of securities to a limited number of institutional investors of high net worth investors. It involves low cost, access to funds faster, few procedural formalities.

EURO ISSUES

Piggle can float their stocks in foreign capital markets. Companies are going global and can issue Global Depository Receipts , Euro Convertible bonds which are issued abroad and listed and traded on a foreign exchange. Once converted to equity can be traded on domestic exchange. Part 3 (ii) Major Budgeting techniques which Piggle Plc should incorporate to support the running of the chosen Project Successfully are should involve

Budgeting techniques :

Pay Back Period : It is the cumulative time which is used to recover or recoup the initial investment in terms of years without considering the time value of money. Since this method is easy the initial decision of Piggle could be based on Pay Back Period Internal Rate of Returns : IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project's initial cash outflow. It considers the time value of money and will provide an exact idea for Piggle and it is the most used capital decision technique. Net Present Value : It is based on the time value of money. It is the present value of all the cash inflows deducted by the initial investment. Profitability Index : It is also known as Cost Benefit Ratio. It considers the Present Value of the Future Cash Flows to the Initial Investment. Piggle Plc can directly approve or disapprove a Project based on the Benefit Cost Ratio. If the BCR > 1, accept the project, if the BCR < 1, reject the project. These are the four techniques on which Piggle Plc should choose the project running.

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