Business explained in 5 minutes.

THE THREE FINANCIAL DECISIONS OF ANY BUSINESS

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Tell the story behind the numbers

THE THREE FINANCIAL DECISIONS OVERVIEW

INVESTMENT DECISION Which projects will add the most value to the business? OBJECTIVE: Find the most value adding projects to invest in

FINANCING DECISION How will I pay for these investments by raising capital in the form of debt and equity?

Tell the story behind the numbers

Every decision that London Coffee Co makes which involves money has one goal: to increase value for the shareholders in the company. These decisions either take the form of an Investment, Financing or Dividend decision. London Coffee Co may consider Investments such as opening a new branch, expanding its product lines to new coffees or buying a competitor’s business.

OBJECTIVE: Minimise the cost of raising capital for these investments

In order to make these investments, the company has to raise finance, either a loan from the bank, equity from shareholders or a combination of both.

DIVIDEND DECISION

If there are no investment opportunities, the cash must be returned to shareholders as dividends in order to maximize shareholder value.

How much should I pay out in dividends to shareholders? OBJECTIVE: Return profits to shareholders when there are value-adding projects to invest in

THE THREE FINANCIAL DECISIONS Tell the story behind the numbers

INVESTMENT DECISION

Which projects will be value adding to London Coffee Co? PROJECT 1: London Coffee Co adds a new shop 2013A Initial Cost

2014E 2015E

2016E

-5,000

Cash Flows

+2,000 +4,000

+6,000

Present Value of Cash Flows @ 20%

+1,667 +2,778

+3,472

Net Present Value

+2917

London Coffee Co is deciding between two projects to expand its business (i) adding a new shop and/or (ii) opening a mobile kiosk. The initial cost of adding a new shop is £5,000 for the lease, equipment, furnishings and inventories. Expected cash flows in 2014-2016 are expected to be positive and increasing. The initial cost of opening a mobile kiosk is £1,000 for the fixed stand and till. Expected cash flows in 2014-2016 are expected to be positive and increasing.

PROJECT 2: London Coffee Co opens a mobile kiosk 2013A 2014E 2015E 2016E

London Coffee Co will only invest in projects that generate a return greater than its minimum required return by its investors of 20%. (see financing decision)

Initial Cost

Project value is based on cash flows generated and the timing of these cash flows.

-1,000

Cash Flows

+200

Present Value of Cash Flows @ 20%

+167

Net Present Value

-122

+400 +278

+750 +434

The value of adding a new shop is +£2,917 in today’s terms (net present value). The value of mobile kiosk is negative. London Coffee Co should therefore choose to add a new coffee shop over the mobile kiosk.

THE THREE FINANCIAL DECISIONS Tell the story behind the numbers

FINANCING DECISION

How will London Coffee Co pay for investments and its operations? USES OF FUNDS Current assets Cash and cash equivalents Accounts Receivable Inventories Other Current Assets Long-term assets Deferred taxes Goodwill Property, plant and equipment

Actual

Forecast

Forecast

2013

2014

2015

500 400 1,000 2,000

6,926 600 1,200 3,000

15,733 800 1,400 4,000

1,000 2,000 30,000

1,500 2,000 28,000

42,900

49,226

58,133

Current liabilities Short-term debt Accounts payable Income taxes payable

0 3,000 2,000

0 4,800 4,598

0 5,600 7,475

Long-term liabilities Long-term debt Provisions

15,000 500

14,000 750

13,000 1,000

Total Liabilities

21,500

24,148

27,075

Equity Common stock Share premium Retained earnings

100 11,000 5,300

100 11,000 13,978

100 11,000 19,598

21,400

25,078

31,058

Total Assets

2,000 2,000 26,200

SOURCES OF FUNDS

Total Equity

London Coffee Co’s financing decisions are related to how they will pay for investments such as adding a new shop and its general daily expenses. The company can use existing capital, take out a bank loan (debt) or sell equity. We saw in the company‘s investment decision that the minimum required return from investors was 20%. This reflects the mix of debt and equity in the business. London Coffee Co’s £36,400 total capital on its balance sheet (£15,000 long-term debt + £21,400 equity) is split 59% equity, 41% debt. Its shareholders expected an annual return of 25% on their equity (cost of equity). The bank has lent funds to the company at 12% interest (cost of debt). Lenders: £15,000 @ 12% annual return Shareholders: £21,400 @ 25% annual return Required rate of return: (% Equity x Cost of Equity) + (% Debt x Cost of Debt) Required rate of return: (59% x 12%) + (41% x 25%) = 20%

The company must choose a mix of debt and equity which minimizes the required rate of return to its investors. By reducing the required return, investment projects such as the new shop increase in value.

THE THREE FINANCIAL DECISIONS Tell the story behind the numbers

DIVIDEND DECISION

London Coffee Co - Income Statement Actual

Forecast

Forecast

2013

2014

2015

Sales

10,000

15,000

20,000

Cost of Goods Sold

(5,000)

(6,000)

(7,000)

Gross Profit

5,000

9,000

13,000

Selling General & Administration

(2,500)

(3,000)

(3,500)

Operating Profit (EBIT)

2,500

6,000

9,500

Interest Expense

(270)

(253)

(157)

Profit Before Tax

2,230

5,747

9,343

Tax

(446)

(1,149)

(1,870)

Net Income

1,784

4,598

7,475

2013 Dividends Paid: 20% of Net Income

= £356 Dividend Payout factors:

1. 2.

TAX SIGNALLING

London Coffee Co has exhausted all of its valueadding investment opportunities. In order to maximise shareholder value, the company must return any surplus cash to its shareholders as dividends. Michelle, one of the two shareholders in London Coffee Co prefers to receive stable dividend income each year. Jenny, the second shareholder would prefer not to receive dividends as she will be taxed heavily on it. Michelle sees growing dividend payments as a positive signal of the company’s cash flow position. Jenny however believes the increase in dividends is a sign that the company’s managers are unable to find high growth projects to invest profits in. London Coffee Co has to decide what its policy will be on dividends. It chooses to payout 20%, £356 of its annual net income to shareholders.