Investment and sources of finance
A bakery wants to buy a new oven for 15.000 €. That is investing: spending money today to generate more cash in the future. But first it needs to get hold of that 15.000 €, which is raising finance. They are two different decisions and both have to be made well: what to spend on, and where to get the money to spend it.
Investing and raising finance: two sides of the same decision
Explain the difference between investment and finance, and classify these operations as one or the other: buying a new oven, taking out a bank loan, retaining part of…
Explain the difference between investment and finance, and classify these operations as one or the other: buying a new oven, taking out a bank loan, retaining part of the profits to expand the premises, and leasing a van with a purchase option.
An investment consists of paying an initial outlay today in exchange for receiving cash flows in the coming years. An ice cream parlour is studying a project that…
An investment consists of paying an initial outlay today in exchange for receiving cash flows in the coming years. An ice cream parlour is studying a project that requires an initial $15.000\ \text{€}$ and would generate $4.000\ \text{€}$ in the first year, $5.000\ \text{€}$ in the second and $6.000\ \text{€}$ in the third. Identify the initial outlay and the cash flows, and explain in your own words what the company must compare to know whether the investment is worthwhile.
Own and borrowed sources, internal and external
Sources of finance can be internal or external, equity or debt (own or external funds). Classify these four: a share capital increase among partners, self-financing…
Sources of finance can be internal or external, equity or debt (own or external funds). Classify these four: a share capital increase among partners, self-financing through retained earnings, a five-year bank loan, and machinery leasing.
An app start-up with no track record and no assets to offer as collateral needs $100.000\ \text{€}$, and an established factory needs $300.000\ \text{€}$ to renew…
An app start-up with no track record and no assets to offer as collateral needs $100.000\ \text{€}$, and an established factory needs $300.000\ \text{€}$ to renew machinery. Propose the most suitable financing source for each (venture capital or business angels versus a bank loan) and justify the choice according to risk, the guarantees required and the surrender of ownership involved.
Short- and long-term borrowed finance
External financing sources can be short-term (repaid in less than a year) or long-term. Classify these: the trade credit of a supplier that collects in 60 days, an…
External financing sources can be short-term (repaid in less than a year) or long-term. Classify these: the trade credit of a supplier that collects in 60 days, an eight-year bank loan, a credit facility to cover cash flow gaps, a ten-year bond issue and bill discounting.
A bakery needs a delivery van and is considering three options: a bank loan to buy it, leasing, or renting. Explain what each option consists of and give an advantage…
A bakery needs a delivery van and is considering three options: a bank loan to buy it, leasing, or renting. Explain what each option consists of and give an advantage and a disadvantage of each for an SME with limited cash flow.
Three criteria for deciding: payback, NPV and IRR
Explain in your own words what the Net Present Value (NPV) of an investment measures and what it means if it comes out positive, negative or zero. Also reason why future…
Explain in your own words what the Net Present Value (NPV) of an investment measures and what it means if it comes out positive, negative or zero. Also reason why future flows are discounted instead of being added directly to the outlay.
Explain what the Internal Rate of Return (IRR) of an investment is and what rule is followed when comparing it with the discount rate or with the cost of financing.…
Explain what the Internal Rate of Return (IRR) of an investment is and what rule is followed when comparing it with the discount rate or with the cost of financing. Apply it: is a project with an IRR of $8\ \%$ worthwhile if the bank charges $5\ \%$ for the loan? And if it charges $10\ \%$?
An investment requires an initial outlay of $20.000\ \text{€}$ and generates annual cash flows of $5.000\ \text{€}$ for six years. a) Calculate its payback period. b)…
An investment requires an initial outlay of $20.000\ \text{€}$ and generates annual cash flows of $5.000\ \text{€}$ for six years. a) Calculate its payback period. b) Explain what this criterion measures and what its main limitation is.
The cost of finance and the risk of borrowing
Two competing companies, ALFA and BETA, have total assets of $500.000\ \text{€}$ and a projected Earnings Before Interest and Taxes (EBIT) of $60.000\ \text{€}$. ALFA…
Two competing companies, ALFA and BETA, have total assets of $500.000\ \text{€}$ and a projected Earnings Before Interest and Taxes (EBIT) of $60.000\ \text{€}$. ALFA finances its assets with $80\ \%$ debt at an annual interest rate of $5\ \%$ and $20\ \%$ equity; BETA uses $20\ \%$ debt at $5\ \%$ and $80\ \%$ equity (ignore taxes). a) Calculate the return on equity (ROE) of both companies in the projected scenario and justify in which one financial leverage acts more strongly. b) Predict what will happen to the return on equity and the solvency of each company if a crisis reduces EBIT by $60\ \%$ (down to $24.000\ \text{€}$). Based on these results, interpret the concept of financial risk.
An industrial company has a financial structure composed of $60\ \%$ equity, whose shareholders require a return of $9\ \%$, and $40\ \%$ bank debt at a cost of $4\ \%$.…
An industrial company has a financial structure composed of $60\ \%$ equity, whose shareholders require a return of $9\ \%$, and $40\ \%$ bank debt at a cost of $4\ \%$. a) Determine the company's Weighted Average Cost of Capital (WACC) and explain why shareholders demand a higher return than the cost of bank debt. b) The company is evaluating two independent investment projects: Project A (IRR of $8\ \%$) and Project B (IRR of $6\ \%$). Justify which one(s) should be undertaken. c) The CEO proposes financing Project B by increasing the share of bank debt to $80\ \%$ to lower the weighted average cost and make it profitable. Critically refute this proposal by arguing the effect of indebtedness on the risk premium required by shareholders.
Back to the beginning: For the 15.000 € oven, the bakery must first check that the discounted future cash flows exceed the cost of buying it (a viable investment), and finance it over the long term through a loan or leasing so that the instalments are paid from the cash the oven itself generates month by month.