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Possible Sources of Funds: Madison Plc

Introduction

Madison PLC could get funds to finance its operations from different sources. However, selecting the right source requires a proper understanding of different characteristics of possible funding sources. Indeed, as the IASTATE (2011) argues, there is no single source of funds for all businesses. The possible sources of funding for Madison PLC include retained earnings, public deposits, share issue, debentures, and seeking a loan from a commercial bank. In this section of the report, we investigate these financial sources

Retained Earnings

Using retained earnings to finance Madison’s expansion plans implies using the company’s financial reserves to do so. In other words, Madison would be using its profits to finance its operations.

Merits

The main advantages of using retained earnings to finance Madison’s expansion plan is the permanent nature of the funding source. Similarly, this funding source does not involve any interest, dividend, or floatation cost; instead, it has a greater degree of operational freedom and flexibility and may lead to an increase in the market price of the company’s equity shares (Rigby 2011).

Demerits

Using retained earnings to finance Madison’s expansion plans may cause increased shareholder dissatisfaction, as some of them may be unhappy about not receiving dividends. This source of funds also has a lot of uncertainty as business profits often fluctuate and may lead to the suboptimal use of funds because many the company may not recognize the opportunity cost associated with its use (IASTATE 2011).

Public Deposits

Since Madison is a Public Limited Company, it could seek funds from the public through public deposits. People who are interested in offering their money to the company in this way could do so by filling up a prescribed form, which would allow Madison to give them a deposit slip as an acknowledgement of the debt.

Merits

The main advantage associated with using public deposits to finance the company’s operations is its relatively simple procedures of obtaining deposits (presence of few restrictive conditions) (IASTATE 2011). The cost of borrowing from public deposits is also relatively lower than borrowing from commercial banks. Public deposits also do not have any implications on the assets of a company, as would be the case if Madison sought a loan from a commercial bank. Therefore, Madison could use its assets as security to get loans from other sources.

Demerits

This type of funding source could be unreliable, as the public may not respond effectively when a company needs money. The collection of money through public funds may also be ineffective if Madison requires huge capital inflows to finance its expansion plan (Rigby 2011).

Share Issue

Getting money from a share issue is a plausible source of funds for Madison PLC because it is a public limited company. The advantages and disadvantages of using the share issue appear below

Merits

A company is not obligated to issue dividends to the shareholders (especially equity shares). Since equity capital exchanges for part of a company’s ownership, Madison does not have to pay it back unless the company is insolvent. This way, it has a “permanent” capital pool to finance its operations. Lastly, sourcing funds through equity capital provides credit worthiness to the company when it seeks alternative sources of funding. This way, it improves the company’s profile (Rigby 2011).

Demerits

Compared to other sources of raising revenue, using equity shares to finance Madison’s expansion plan is a costly undertaking. Formalities and procedural delays associated with sourcing for revenue through share capital slows down the process of getting finances. This way, the company may suffer delays in financing its expansion plans (IASTATE 2011).

Debentures

Madison could also use Debentures to finance its expansion plans. This funding source has a fixed rate of interest. Simply, Agar (2005) describes this funding source as an acknowledgement by a company that it has borrowed money and intends to pay it back within a specified time. Based on this description, debenture holders are creditors to a company. Some of the advantages and disadvantages that Madison could experience by seeking funds through this method appear below

Merits

Debentures are fixed charge funds and do not necessarily affect the computation of company profits. Since debenture holders do not enjoy any voting rights in the organization, Madison would not suffer from a diluted control of the company (IASTATE 2011). Lastly, issuing debentures to raise capital is a relatively cheaper affair compared to issuing share capital, as the interest rates on debentures are tax deductible (Agar 2005).

Demerits

Sourcing of funds through debentures is only relatively practical when the company is making good sales and has a relatively stable earning potential. Furthermore, since debentures have a fixed interest rate attached to them, they may have a permanent burden on the company’s earning potential (Agar 2005). If Madison issues redeemable debentures, it may pay interest, even during periods of financial difficulty. Lastly, debentures may reduce Madison’s borrowing capacity.

Loans from Commercial Banks

Firms often borrow money from financial institutions to finance their operations. Madison could do the same. Through a loan facility, the company could get capital to pay back in lump sum or in instalments. In exchange, the company may have to offer collateral or provide some form of security to get the loan. The merits and demerits of pursuing this form of raising capital appear below

Merits

A loan facility from a commercial bank could provide timely capital for Madison because banks do offer loan facilities promptly. As opposed to other types of capital sources, companies enjoy secrecy about their operational information, which they reveal to commercial banks because the latter maintains high levels of confidentiality. Getting a loan facility is also easier, using this funding source, compared to other funding sources because there is no need for formalities to raise funds.

Demerits

Commercial banks often lend money to banks for short periods. Requests for extension of loan repayment time are often costly and uncertain. Since banks require information about a company before lending money to them, the loan approval process may be protracted. Lastly, banks often impose strict terms and conditions on borrowers before lending money to them. This may make normal business working difficult (Rigby 2011).

Recommendations

Madison could manage the above-mentioned sources of finance by consulting with the relevant stakeholders to select the best alternative source of finance for its operations. It should also maintain its financial records for future evaluation to increase its creditworthiness and reputation. Such a practice could be useful if the company chooses to approach commercial banks for loans (GULATI 2015).

The goal of working capital management is to ensure that a company has enough money to meet its debt obligations and finance its operational expenses (Rigby 2011). Working capital management involves different aspects of financial management, including the management of accounts receivables, inventory management, and cash management (Sagner 2010). Efficient working capital management could help improve a firm’s cash flow by providing financial protection from unplanned expenditure. It could also help companies insulate themselves from liquidity problems. Based on this analysis, efficient working capital management not only allows companies to manage their liquidity problems, but also gives them enough flexibility to exploit existing market opportunities. In the real world setting, efficient capital management often trades off with other operational aspects of a company, including cash flow management and customer service. In this regard, it is difficult to separate working capital management from organizational processes. Instead, managers should appreciate its cross-functional nature across different operational management processes (GULATI 2015).

Adjusted Forecast for Madison Platform.

Year 0 1 2 3 4 5
Sales revenue 6,386 7,791 9,271 10,847 12,366
Component A (355) (550) (842) (1,095) (1,499)
Component B (1,373) (1,950) (2,340) (2,832) (3,063)
Overheads (192) (234) (278) (325) (519)
STO 1 (294) (300) (294) (288) (282)
STO 2 (170) (171) (166) (161) (156)
CF 4,002 4,586 5,351 6,146 6,847

NPV Computation

Formula is NPV = (investment) + CF1/(1+k)1 + CF2/(1+k)1 + CF3/(1+k)1….

-8,500 + 4,002/(1+0.13)1 + 4,586/(1+0.13)2 + 5,351/(1+0.13)3 + 6,146/(1+0.13)4 + 6,847/(1+0.13)5 = 23,234

Adjusted Forecast for Madison Super.

Year 0 1 2 3 4 5
Sales revenue 5,665 6,695 7,931 9,013 10,094
Component A (701) (832) (988) (1,144) (1,404)
Component B (1,113) (1,560) (1,028) (2,184) (1,460)
Overheads (283) (335) (397) (451) (504)
STO 1 (294) (300) (294) (288) (282)
STO 2 (170) (171) (166) (161) (156)
CF 3,104 3,497 5,058 4,785 6,288

NPV Computation

-5,500 + 3,104/(1+0.14)1 + 3,497/(1+0.14)2 + 5,058/(1+0.14)3 + 4,785/(1+0.14)4 + 6,288/(1+0.14)5 = 30,267

Based on a comparison of the NPV values for Madison Super and Madison Platform, the best alternative to choose is Madison Super because it has a higher NPV.

Support of Recommendation through Internal Rate of Return (IRR) Technique

The IRR is another method for evaluating investment proposals. Analysts use this technique by finding an interest rate of an investment proposal that equals to zero. An evaluation of the above case study through the IRR technique also demonstrates that Madison Super option as the best choice for the company to pursue in its expansion plan. To demonstrate this fact, we need to understand the formula for IRR, which appears below

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 +… +Pn/(1+IRR)n

Madison Platform

0= -8,500 + 4,002/(1+0.17) + 4,586/(1+0.17)2 + 5,351/(1+0.17)3 + 6,146/(1+0.17)4 + 6,847(1+0.17)5

Madison Super

0 = -5,500 + 3,104/(1+0.20) + 3,497/(1+0.20)2 + 5,058/(1+0.20)3 + 4,785/(1+0.20)4 + 6,288(1+0.20)5

The above analysis shows that Madison Super is the best alternative because its rate is much higher than the returns of the Madison Platform alternative

Alternative Investment Assessment Models

Although the NPV technique is the most commonly used method for evaluating investment proposals, other techniques, like the accounting rate of return, payback technique, and the internal rate of return, could also perform the same tasks (McKeown 2012). The NPV and the internal rate of return are superior techniques for evaluating investment proposals because they consider all the cash flow for the entire investment period and account for the time value of money. We analyse these techniques in further detail below

Accounting rate of return

This technique uses accrued accounting information to evaluate investment proposals. However, it is ineffective in giving us an accurate assessment of Madison’s investment proposals because it ignores cash flows and fails to account for the time value of money (GULATI 2015).

Payback – the payback method is useful in evaluating Madison’s investment proposals because it points out projects with the shortest payback time. However, this technique is not useful to our analysis because it ignores the time value of money and has an assessment period that is limited to the time the project starts until the business recovers all the capital (GULATI 2015).

Internal Rate of Return

Unlike the payback technique, the internal rate of return uses discounted cash flows to evaluate investment proposals. The period of assessment also differs because it covers the entire life of the project. This technique is limited to the fact that it is mostly useful to exclusive projects. Similarly, it may overstate the rate of return (GULATI 2015).

Madison could also use the break-even analysis to evaluate its investment decisions. The break-even point occurs when a firm is able to match its revenues with its expenditures. The break –even analysis could help the company understand when it could make a profit, for its two investment options. To illustrate how this technique works, we could use the example of a Pizzeria, which seeks to expand its operations using two international marketing strategies. The first strategy entails using a franchise model to expand its operations, while the second strategy entails a direct entry strategy to achieve the same goal. The distinction between the two expansion plans stems from understanding the positions of their fixed and variable costs on the graphs below. The first graph shows the break-even analysis of the direct entry strategy.

Direct Entry Strategy

Franchise Model

A comparison of the franchise model and the direct entry strategy reveals that the direct entry strategy would require the organization to sell 2,250 units of pizza for $25,000 to make a profit. Comparatively, the franchise model would require the company to sell 1,500 units of pizza for $30,000 for the company to break-even. Comparatively, the franchise model emerges as the most appealing strategy to use because it is more profitable and requires the sale of less units of pizza to reach the break-even point. Comparatively, the direct entry strategy is less desirable because it takes the company more effort to sell more units of pizza to realize profitability.

Madison should consider many factors before making its investment decisions. Factors like time value of money and period of investment maturity appear in the above examples. Other issues that the company should consider include the importance of its cash flow to its operations because if the company’s operations were sensitive to fluctuations in the company cash flow, it would be difficult for it to make capital-intensive investment decisions. The opposite is true because if the company’s operations were not sensitive to cash flow fluctuations, it would be easier for the company to indulge in capital-intensive ventures. This issue also highlights the importance of considering the company’s threshold of absorbing cash flow volatility because if the threshold is low, it may not be free to indulge in risky investments. Alternatively, if its threshold for financial volatility is high, it may be easy for the company to engage in riskier investments.

A ratio analysis could help us understand which company, between Puteaux France and Melia Spain, that Madison should invest in. For purposes of this analysis, the two most important ratios we will evaluate to decide the best company to invest in would be the return on equity and return on assets financial ratios.

Ratio Puteaux France Melia Spain
Return on equity 0.21 (2011)
2.05 (2012)
0.19 (2013)
0.1 (2011)
0.2 (2012)
0.4 (2013)
Return on Assets 0.09 (2011)
0.03 (2012)
0.01 (2013)
0.08 (2011)
0.02 (2012)
0.01 (2013)

Based on the above ratio analysis, we find that Puteaux France has the most profitable financial ratios. In this regard, it is the best choice for Madison to invest.

Other important Factors to consider for Ratio Analysis

Other important factors we would consider for the ratio analysis include the debt obligations of the company and the asset turnover ratio. The debt obligation ratio is an important index to consider in this analysis because a high debt obligation makes a company undesirable for investments. The asset turnover ratio is also an important factor to consider in this analysis because low asset turnover rations decrease the desirability of a company for investments.

References

Agar, C 2005, Capital Investment & Financing: a practical guide to financial evaluation, Butterworth-Heinemann, London.

GULATI 2015, Financial Management, McGraw Hill Education (India) Pvt Ltd, London.

IASTATE 2011, Sources of Business Finance, Web.

Rigby, G 2011, Types and Sources of Finance for Start-up and Growing Businesses: An Instant Guide, Harriman House Limited, London.

McKeown, W 2012, Financial Planning, Google eBook, John Wiley & Sons, London.

Sagner, J 2010, Essentials of Working Capital Management, John Wiley & Sons, London.

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