THE LEGAL ELEMENTS of FINANCING in BUSINESS

Balance sheet: This financial information sheet is very important as it illustrates the company's financial status and stability, as it summarises how the company is being operated, as well as listing its liabilities and assets (Alexander and Britton, 2004). The term balance sheet explains its intention of presenting financial data as its two parts are intended to balance and show equality, and would normally include the following information: (International Labour Office, 1991) Current assets Fixed assets Current liabilities Long-term liabilities Shareholders' equity Current assets: These differ from fixed assets as these could be sold or used within one year, and are listed on the balance sheet in order of their increasing liquidity value, so are normally ordered as stock, debtors and cash. Therefore, the financial strength of a company is represented by its current assets, but it also demonstrates its operating efficiency and its competitive position with other companies. However, the value levels of current assets need to be sufficient for companies to operate on a day-to-day basis, but if these become insufficient then the company will need to find an external source of funds, such as loans that are termed debts. According to Shapiro and Balbirer (2000), there are five different types of current assets: Cash and equivalent high liquidity items, Investments over the short-term and long-term, Accounts that will be received, Inventories of stock held, and Expenses that are pre-paid. Fixed assets: These would include assets that the company would not intend to sell within one year, so could not be used to operate the business or exchanged or sold for cash. Therefore, these may be regarded as the company's property, such as building structures or land (Ross et al., 2007). However, these fixed assets can also be subject to subdivision into two types: (Vanhorne and Wachowicz, 2008) Tangible assets: These exist physically and contribute to the company's overall financial value, and would normally include building, bank deposit, machinery and land assets. Intangible asset: These are different from tangible assets as they do not visibly exist as a physical form or directly contribute to the company's financial value. Therefore, these are listed on the balance sheet differently. This may be explained by a company purchasing a patent to protect its products' design rights, as the purchase of the patent remains an asset that is intangible. However, its purchase may lead to generating revenue at a later date indirectly. Goodwill is another intangible asset that gives credibility and indirect value to a company. Therefore, a company's intangible assets should be: Identified, Controlled, and Used to improve profit margins. Current liabilities: Current liabilities are those that need to be repaid or clear within one year, and usually relate to short-term loans taken from external sources, so demonstrates a company's liabilities or debts. These would often include the interest that needs to be paid to clients for any deposits invested with the company, short-term loans and any outstanding accounts that remain unpaid (Watson and Head, 2009). Long-term liabilities: Long-term liabilities would normally describe all long-term loans from external sources, where liability for repayment extends more than one year. However, if the final repayments will be completed for long-term loans within the forthcoming year, these would be reclassified as current liabilities, but a simple definition of long-term liabilities would be long-term debts. Some company's take short-term loans or debts to finance specific work activities, but renew these on an annual basis, so when this pattern is established, the practice would be defined as long-term liabilities (Alexander and Britton, 2004). Shareholders' equity: This represents the company's total worth, and the claim by shareholders on the company's finances when all loans, debts and credits have been paid (Banks, 2010), although this equity is also known as owners' equity. Needles et al. (2008) explain that the formula shown below for calculating shareholders' equity may be adopted.

Stockholders equity = Total assets - Total liabilities

Or

Shareholders equity = Share capital + Retained earnings - Treasury shares

These formulas would produce the company's net worth, stockholders' equity and share capital, which are all similar terms. Shareholders' equity is shown on the balance sheet, and two sources will determine the data for this formula calculation. Firstly, financial data relating to the selling of stock and the investors payments for these, and secondly any retained earnings. Retained earnings are likely to be company profits not paid to shareholders. Both sources of financial data generate the value of shareholders' equity.

Part 1

The items for the balance sheet for SHU plc is shown in the table below that present end-of-year values for 2008 and 2009, and shown in thousands of pounds, and expenses and revenues for each of these years are shown as profit and loss items. This data also includes all taxes paid for each year. 2008 2009 Revenue £4,000 £4,100 Costs of goods sold 1,600 1,700 Depreciation 500 520 Inventories 300 350 Administrative expense 500 550 Interest expense 150 150 Central and local taxes 400 420 Accounts payable 300 350 Accounts receivable 400 450 Fixed assets 5,000 5800 Long term debt 2,000 2,400 Notes payable 1,000 600 Dividends paid 410 410 Cash and marketable securities 800 300

1.1 Balance Sheet

The balance sheet shown below presents the financial statement for SHU for 2008 and 2008, which produces the second part of question A that calculates shareholders' equity. Assets 2009 2008 Liabilities 2009 2008 Current assets Current liabilities Cash equivalents 300 800 Due debt for payment Receivables 450 400 Accounts payable 350 300 Inventories 350 300 Other current liabilities 600 1000 Other current assets Total current assets

1100

1500

Total current liabilities

950

1300

Fixed assets 5800 5000 Long term debt 2400 2000 Tangible fixed asset Deferred income taxes Property, plant and equipment Other long term liabilities Less accumulated depreciation Net tangible fixed assets 5800 5000

Total liabilities

3350

3300

Intangible fixed assets Good will Other intangible assets Total intangible fixed assets Share holders equity 3200 2760 Total fixed assets

5800

5000

Retained earnings 350 440 Other assets

Total share holder's equity

3550

3200

Total assets

6900

6500

Total liabilities and share holders equity

6900

6500

1.2 Shareholders' equity

When all liabilities have been deducted, shareholders' equity demonstrates a company's net worth (Pinto and CFA Institute, 2010), and this value is shown on the balance sheet after calculating the financial data. The formula suggested by Needles at al. (2008) calculates shareholders' equity as below:

Shareholders equity = Total assets - Total liabilities

Therefore, this financial data will be taken from the balance sheet shown above and the calculations for both years are: Shareholders' equity (2009) = £6,900,000 - £3,350,000 = £3,550,000 Shareholders' equity (2008) = £6,500,000 - £3,300,000 = £3,200,000

1.3 Net working capital

This is also known as working capital ratio and net working capital, and represents a simple difference between current assets and current liabilities, and Needles et al. (2008) present the following formula for this calculation:

Net working capital = Current assets - Current liabilities

Net working capital (2008) = £1,500,000 - £1,300,000 = £200,000 Net working capital (2009) = £1,100,000 - £950,000 = £150,000 In comparing these two years, the net working capital has reduced, as current assets were greater than the decrease of current liabilities.

1.4 Profit and loss statement

SHU plc statement of profit and loss for 2008 and 2009 (Values are in thousands of pounds) 2008 2009 Net sales 4,000 4,100 COGS 1,600 1,700 Selling, G &A expenses 500 550 Depreciation expenses 500 520 EBIT (4,000 - 1,600 - 500 - 500) = 1,400 (4,100 - 1,700 - 550 - 520) = 1,330 Net interest expense 150 150 Taxable Income (1,400 - 150) = 1,250 (1,330 - 150) = 1,180 Income Taxes 400 420 Net Income (1,250 - 400) = 850 (1,180 - 420) = 760 Allocation of net income dividends 410 410 Addition to retained earnings (850 - 410) = 440 (760 - 410) = 350 This profit and loss statement shows the net income of SHU plc, and the earnings before interest and tax (EBIT) is calculated by taking the operating revenue value and deducting the operating expenses value, and then adding non-operating income. Therefore, the net sales of SHU plc demonstrate its operating revenue, and operating expenses are deducted from this, such as expenses of depreciation, general and administrative (G&A) expenses, selling expenses and the cost of goods sold (COGS). These calculations result in the EBIT value, but interest expenses will also need to be deducted, as well as deducting tax to achieve the net income value. When the net income has been determined, the value of the dividends to be paid to shareholders is defined, as well as how much will be retained by the company. These retained earnings are also known as reinvested earnings of the company. These retained or reinvested earnings are regarded as the investors' share of the earnings of the company, but retained by the company for commercial reasons rather than distributing these to these investors. In contrast, losses incurred by the company are described as accumulated losses or retained losses, and these would also be included in the balance sheet within the shareholders' equity section. SHU plc had reinvested earnings of £350,000 for 2009, and these reinvested earnings, as well as common stock, contribute to calculating the total shareholders' equity. However, if there is a decrease in reinvested earnings, and over a two-year period the total shareholders' equity remains the same, shareholders' equity will increase.

1.5 Earnings per share

The formula to calculate earnings per share is described by Tracy (2004) as the following: Earnings per share = net income ÷ number of outstanding shares To calculate the earnings per share formula for each year, the financial data of net income for 2008 of £850,000 and net income for 2009 of £760,000 is used, as well using the data of the total number of shares, which are 500,000. Earnings per share (2008) = £850,000 ÷ 500,000 = £1.70 Earnings per share (2009) = £760,000 ÷ 500,000 = £1.52

1.6 Price per share of SHU's stock

Total shareholders' equity = £2,900,000 + ( £350,000 + £3,200,000 ) + £200,000

A = £6650000

Price per share = Total shareholders' equity ÷ numbers of shares

= £6,650,000 ÷ 500,000

= £13.30

Part 2 SHU plc is interested in constructing a large shopping centre near the train station in Sheffield and has asked for an investment appraisal to help the board decide whether or not to accept this project. Therefore, the investment appraisal will use the following information and guidance given by SHU plc: The proposed construction will begin in 2012 and be completed in 4 years. There will be four phases for this construction. The life of the project is 15 years. Each level will have 12,000 sq.ft. area, and all four levels total an area of 48,000 sq.ft. Rental income will be based on £15 per sq.ft. starting in year 5. Estimated construction costs will be based on £13 per sq.ft. at 2012 values. Statutory costs are estimated to be £48,000. Professional fees are based on 3% of the construction costs. Land acquisition will cost £2,000,000 Rental income will be based on an increasing rate of occupancy of 25% each year for the first four years from year 5. Maintenance costs will start in year 5 costing SHU £950,000 each year. 3% inflation rate is predicted for calculating costs and revenues. The payback period must within 9 years, which is a requirement of SHU plc. However, Investment needs to be fully understood before a solution to this part of the assignment can be attempted, but can be simply described as the method of buying large capital items for companies.

Investment appraisal:

Companies need an investment appraisal to judge whether invested funds will give value for money, but can also determine the potential value of the company based on other investments. Investment appraisal can be applied is several different ways, such as payback period, accounting rate of return (ARR), internal rate of return (IRR), profitability index, net present value (NPV) and cash flow.

Payback period:

This is well established method to calculate how long it will take to repay the amount initially invested (Ross et al., 2007), which is the case of SHU plc is a maximum of 9 years. Many companies use this method for screening projects that are unsuitable. However, Kinserdal (1998) argues that payback period method has disadvantages, such as not considering profits arising after the payback period, and it does not consider time value of money. Kinserdal (1998) also suggest other aspects that analysts should consider when using payback period method, such as: Investment capital is tied up during the payback period, Liquidity is enhanced for short-term payback, Longer periods for payback expose potential risks, Short-term payback periods have greater reliability, Simple and easy calculation are possible for this method, and Most companies understand this method and is widely adopted.

Accounting rate of return (ARR):

ARR calculates the value of a project over its useful life, by calculating average profit over time, and indicates the potential value of the investment and is simple to understand (Ross et al., 2007).

Internal Rate of Return (IRR):

IRR calculates the rate of return that the project is forecasted to achieve, so if the IRR is higher than the targeted rate of return, the project should be adopted. Therefore, when several projects are being considered, the project with the highest IRR would normally be selected (Ross et al., 2007), but some weaknesses are exposed by this method, such as: The relative size of investments is not considered, This is difficult to use for projects without established cash flows or for selecting exclusive projects, and Changes to discount rates over the project's life cannot be included within IRR calculations.

Profitability index:

According to Warren (1998), this is a profit investment ratio, as the method defines the mutual relationship between investment costs and its benefits for a proposed project. The formula for calculating the profitability index is: PI = Present value of the cash flows in the future / the initial investment. The results indicate whether an investment is recommended or not recommended.

Net Present Value (NPV):

NPV is calculated by finding the difference between the present value of outflows of cash and the present value of cash flows, and the results indicate whether a project should be accepted or declined (Ross et al., 2007). In addition, the NPV method shows sensitivity to future cash inflows for the purposes of investment appraisal and the following formula is used for this calculation:

2.1 Perform an Investment appraisal for the proposed project

Initial investment made for the project. £13.00 per sq.ft. construction cost is increased by a 3% inflation rate each year. Initial investments made in the project: Construction costs: 1styear £ 13.00 12,000 sq. ft 156000.00 2ndyear £ 13.00 + 3% of £ 13 = £ 13.39 12,000 sq. ft 160680.00 3rdyear £ 13.39 + 3% of 13.39 = £ 13.7917 12,000 sq. ft 165500.40 4thyear £ 13.79 + 3% of £ 13.7917 12,000 sq. ft 170465.40 Professional fees on the construction cost 3% of 652646.00 Land acquisition cost: Statutory costs: Total investment in the project: The payback period method is used in the table shown below by analysing expected cash flows of the project's life. Revenue of the project: Rentals expected: Years Rent / sq ft (a) Total area in sq ft (b) Cost (a)*(b)=c Revenue after maintenance 5thyear £ 15.00 25% *48,000=12000 £ 180000 £ 130000 6thyear £ 15.00 + 3% of £ 15 = £ 15.45 50% *48,000=24000 £ 370800 £319300 7thyear £ 15.45 + 3% of £ 15.45 = £ 15.9135 75% *48,000=36000 £ 572886 £519841 8thyear £ 16.39 100% *48,000=48000 £ 786720 £732084 9thyear £ 16.88 48,000 £ 810321.60 £754046.15 10thyear £ 17.39 48,000 £ 834720 £776756.29 11thyear £ 17.91 48,000 £ 859680 £799977.38 12thyear £ 18.45 48,000 £ 885600 £824106.31 13thyear £ 19.00 48,000 £ 912000 £848661.50 14thyear £ 19.57 48,000 £ 939360 £874121.35 15thyear £ 20.16 48,000 £ 967680 £900484.20 From these calculations it is seen that SHU plc's investment in the project of £2,720,225 is achieved between years 9 and 10, but SHU Plc expects that pay back is 9 years or less. Therefore, by the justification of the calculations above, the project cannot be recommended to SHU plc. These calculations show that after 9 years 4.09 months the invested amount would be paid back, but as this period exceed the 9-year limit set by SHU plc, the project would not be accepted. £2,455,271.15 received in year 9 £3,232,027.44 received in year 10 Amount invested was £2,720,225 So, £2,720,225 - £2,455,271.15 = £264,953,085 £3,232,027.44 - £2,720,225 = £511,802.44 The cash flow in one year is £776,756.29 calculated by the difference in the calculations above. When this is divided by 12, we get the monthly cash flow. £776,756.29 / 12 = £64,729.69 / month. So the total payback period is 9 years and 4.09 months, and so the payback period has been exceeded and SHU plc will reject this project and this investment appraisal recommends rejection based on the requirement of SHU plc to achieve payback within 9 years. The professional fee based on percentage costs of the construction would be £652,646, the statutory costs are likely to be £48,000 as well as land acquisition costs, which demonstrate the initial investments. Each year construction costs will be affected by 3% inflation that needs to be added to the £13.00 sq.ft. costs. In addition, inflation would also influence maintenance costs that begin in year 5, which would be deducted from the total rent revenue. The estimated occupancy rate is 25% for year 5 and increasing by another 25% each year over the following three years, and in year 6 rents would be subject to a 3% inflation-related increase. This investment appraisal has used payback period method, as its focus on cash flow is easily understood, but it should be noted that this method does not account for time value and there is no consideration of risk; therefore, decisions cannot be taken regarding maximising value. There are also other factors that justify why this project should be rejected, such as investing this capital in 4% bonds that would give a better rate of return on the investment than the construction project. So, if 4% is taken as the interest (r) and the time t is taken as 9, by calculating the amount at year 9 by using the compound interest formula, the amount received is £3,871,728. This is much higher than the revenue in the payback at year 9 (£2,455,271.45). This calculation is shown below. Compounding interest formula: P = C (1 + r) t =2720225*(1+0.04)^9 =3871728 These calculations have shown there are different options for investing capital, and construction project may not always offer the best solution. Also, land costs might appreciate or depreciate in value over time due to volatile market conditions, and the proximity of the train station might expose the shopping centre to future problems if the rail network changes or buildings need to be extended, which may lead to the need to demolish the shopping centre. Also, shoppers and businesses may be deterred from using this proposed shopping centre due to noise and vibration from train freight, as well as parking problems. In conclusion, the project is not recommended. SHU plc may wish to balance this recommendation against some other influencing factors, such as the payback period only needs to be extend by another 4 months, and the projected income after this period up to the 15-year life of the project is considerable. Also, as the land is adjacent to the railway station it should have a high demand and could be sold at a significant profit in the future. Furthermore, if there is a high level of interest in renting the shopping centre units, the rents could be raised more, but the risks will also expose potential risks. So, as consultant I would like to recommend that SHU Plc. does not accept this project, and to invest the amount in funds or private initiative projects that would provide higher revenue. Part B This business opportunity would mean that the construction of a four-storey shopping centre would become a fixed asset of SHU plc if it decides to accept this project. However this is a large capital investment for the company as costs of construction are estimated to be £2,720,225, but it only accepts projects that repay the initial investment within 9 years. As a result, the recommendation of this report is that the company rejects this project, but if it reconsiders its payback deadline or intends to accept a similar project, it requires advice on the optimum funding source for this capital investment. This decision is difficult as there are many options for seeking funding from many financial institutions and specialist groups, but these charge differing levels of charges, costs and may have time limitations for repayment, so this report will analyse this range of options and make a recommendation to SHU plc for the best choice of funding source. These funding options include: (HSBC.com.hk accessed 16 December 2010) What is needed financially? - This project requires the construction of a shopping centre, but capital needs may change over time, so overdrafts are not appropriate, as long-term capital finance would be better. What will the project achieve? - A business plan should describe the project's objectives, profit and cash flow forecasts, as well as potential risks. How much and how long? - The investment appraisal should show the total construction costs and the optimum time length for the debt to be repaid. Which options? - Each project will require a unique solution. What are the risks? - High charges and interest rates will influence profits and cash flow, and the repayment methods may be inappropriate. The finance costs are likely to be based on risk assessments, so will vary between different projects. Often companies use equity finance to fund development opportunities, as cash flow and profit margins are not affected. Therefore, investment funds can be sourced from overdrafts, bank term loans, asset based finance, receivable finance, invoice discounting, angel funding and venture capital. Finance methods would include external finance that may be short-term or long-term, but companies can also source funds from internal finance methods for similar periods. Other methods include assistance from government and finance specifically for small and medium companies. External finance - financial institutions offer short- and long-term loans for business opportunities, but external finance would also include angel investors and venture capitalists that buy company stocks. Personal savings - company owners can invest in their own company, but remains external finance as the company has to repay this investment. The amount will determine the time for repayment, but this is not suitable for SHU plc. Commercial banks - these offer overdrafts for short-term needs or bank loans for longer-term needs, but will be subject to high commercial interest rates dependent on the perceived risk of the project, and is not suitable for SHU plc. Building societies - although similar to banks and offer mortgages to purchase real estate, this is not suitable for SHU plc. Factoring services - this trade credit is used as short-term finance to buy supplies to convert into products that can be sold, when the loan is repaid, and this is not suitable for SHU plc. Share issue - by selling shares a company can raise capital, and when it makes a profit, this is repaid to its investors, but as a long-term option, this is not suitable for SHU plc. Debentures - this is for very long periods and for large amounts of funds, so this is not suitable for SHU plc. Venture capital - investors are guaranteed returns on their investments if they can offer the capital investment, and is similar to the issue of shares, and is not suitable for SHU plc. Leasing and hire purchase - occupiers use a property and pay rent, but never own the property and this is not suitable for SHU plc. Hire purchase - the occupier makes instalment payments, but does not own the property until the final payment is made and is expensive, so this is not suitable for SHU plc (Teachnet-uk.org accessed 14 December 2010). Internal financing - this offers a company the flexibility of financing its own projects and may be short- or long-term finance. There are savings in costs as interest charges, fees and transaction charges are not applicable, as these funds come from depreciation or retained earnings. If depreciation is adopted as a method of internal financing then other advantages are exposed as when cash flow increases, the company can devalue assets values over time. Then, when the assets are depreciated, the tax liability of the company also reduces. Long-term financing - retained profits can be used as surplus funds for funding projects, so long as profits are assured. Short-term financing - stock levels can be reduced, creditors can be paid late and credit controls need to be strict. Reducing stocks - stock can be sold to create investment capital for other projects, but is a short-term solution and is depended on the interest levels of buyers. Delaying payments due - debt is increased and the company's reputation is damaged. Reducing stock levels - if payments to workers are delayed, workforce relationships are damaged despite raising funds, but this is a bad option (Teachnet-uk.org accessed 14 December 2010).

Funding sources evaluation

Selecting the best source for funding construction projects is difficult, as costs and charges vary according to the risk exposure of the loan, and although SHU plc may wish to consider all these options for sourcing funding, consideration needs to be given to charges and costs over the long term for these loans. SHU plc is recommended not to accept this project, as repayment of the investment cannot be made within 9 years, which is a requirement of the company. Nevertheless, if the company accepts another similar project or reviews this current proposal, then I recommend to the company that the best funding option would be internal financing and to use the depreciation method. If this action were taken asset values would be depreciated and tax payments would reduce, and the company would avoid potential risks and charges from external financial institutions.

Conclusion

This assignment has examined the importance of finance for successful business operations that has examined construction projects, and rates of return on investments when investment opportunities arise, as well as methods and terminology used to justify whether or not to accept potential projects. The first task required me to construct a balance sheet for 2008 and 2009 for SHU plc and to explain the importance of each of the elements of this financial information sheet. This financial information included the calculation of shareholders' equity that was £2,600,000 in 2009 and £1,900,000 in 2008. In 2008 net working capital for SHU plc was £200,000 and in 2009 it was £150,000. This shows a reduction due to a decrease in current assets that was more reduced that the decrease of current liabilities. I then constructed a profit and loss statement for 2008 and 2009, and in 2009 the reinvested earnings as £350,000. Also, this financial statement showed that shareholders' equity increased between 2008 and 2009 from £1,900,000 to £2,600,000, which was due to paid-in capital and common stock that increased from £1,460,000 to £2,250,000. In contrast, during this period retained earnings reduced from £440,000 to £350,000. The calculation presented in this investment appraisal also demonstrated that in 2008 the earnings per share was £1.70 and for 2009 it was £1.52, and the price per share was shown to be £4.90 per share. The investment appraisal examined the proposed new shopping centre in Sheffield near the railway station, and SHU plc invited me to examine the relevant information and its company's requirements and to make recommendations to the company within the investment appraisal whether it should accept or reject this development opportunity, as well as to give advice about sources for finance for this project. This investment appraisal analysed differing methods and presented their advantages and disadvantages. Payback period method is widely used and is simple to calculate, but has weaknesses as no values are allowed for cash flows, there are no risk adjustments, maximising wealth is not included and time value of money is not considered. This report examined other methods, such as net present value, cash flows, internal rate of return, profitability index and accounting rate of return. This assignment evaluated this proposed construction project with payback method and calculated the cash flow estimates for 15 years. The conclusion of this investment appraisal is that I recommend SHU plc to reject this shopping centre project. The justification for this recommendation is that the investment cannot be repaid within 9 years, which is required by the company, as this is only achieved after a further 4 months. Therefore, a higher rate of return for this investment could be achieved from investing in a 4% bond over the same time period. However, the board may wish to reconsider this option as the cut off point is extended by only 4 months, and the investment appraisal calculations have shown considerable revenue is likely in the following years until the life of the project ends. Nevertheless, there is greater exposure to risk over a longer period that must also be noted. If SHU plc reconsiders this shopping centre construction project or another similar project, the optimum source of funding should be found, as many options for taking loans exist commercially. This report has also discussed and analysed the options for funding capital project by giving their advantages and disadvantages. However, the best sources may be different for different projects, so these need to be examined carefully. Therefore, if SHU plc decides to accept this project or another similar project the recommended financing method is internal financing and adopting the depreciation method, as finance costs and tax liabilities are both reduced.

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