If LCCW manages to decrease fixed assets by 200mln, than its turnover will increase till 0.913 and operating profit share must be 26.29%, that is 5% lower than the current
ROCE = 24% = (OP/S )* (S/TA) = 26,29%* 0,913
We can see that by reducing the capital employed. (ROCE) will increase. To improve capital employment, we can look at the volume of fixed assets, current assets and investments.
Through the off-balance-sheet analysis, we can see there are few methods to reduce the costs in our case:
- The company could conduct reorganization and sell some of the assets. Concentration on single site would reduce the expenditures on labour, equipment and etc. These actions must lead to fixed assets downsizing – costs of one site expanding should be lower than income from closing another one. Costs of 1 unit production on expanded site must be lower after rationalisation.
- Location rationalisation provides operating expenses downsizing (insurance, keeping, maintenance, and depreciation), which, in its turn, will also increase operating profit share.
- Less stock holding and its quicker turnover would reduce the costs like security, insurance, lighting, heating, maintenance, and depreciation.
- The company also could reinvest the extra money to gain extra return.
- Instead of getting more shareholders, the company could think of getting long-term loan from the bank; there is about 6% interest rate on average and the rate of dividend is higher than that.
The last two methods have relative higher risks than others. In the system of costs and risks, secured borrowing, i.e. pledging assets as security for loans, overdrafts and debentures will command a lower rate of interest than unsecured borrowing. (Chadwick, 2002, page 55)
Thus, if location rationalisation will decrease assumes fixed assets by 50mln (till 4750mln), reduce cost for $1 of product from $0.643 till $0.6 due to transportation and storage savings, personnel redundancy and decreasing operating costs (till 389mln) than even with the present realisation level (4200mln) ROCE will be 27.41%.
Realisation Costs 2520mln (0.6*4200)
Gross Profit 1680mln (4200-2520)
Operating Costs 380mln
Operating Profit 1300 mln
Operating Profit share30.95% (1300/4200/%)
Fixed assets turnover 0.884 (4200/4750)
ROCE 27.36% (30.95*0.884)
Proposed rationalisation
The methods of reducing costs could be disposing of asset the surplus to requirements. This would reduce depreciation, insurance, maintain security. Less expenditure then net profit would increase. However, if demand highly increases, then company need to purchase new machinery and also might need to spend money on staff training.
Concentrate production on single site would increase the bargaining power over their suppliers and reduce the fixed costs and variable costs such as rental, communication, stock holding, transportation, etc; also better responds to suppliers and customers. Higher productivity would keep profits increasing. However, the company does not have production diversification; concentrate on single site then risks would be increase; such like government changes the trading policy or natural disaster, etc would seriously affect and damage the company.
Better understanding of the market and consumer needs would be benefit to the company. Highly management responds and flexibly with market changes would allow the company offer better deals than their competition and increase the product turnover due to less cost of stock holding. According cost intensity (R & D expenditure) to the company that it would reduce the net income in short term. Therefore, the CEO has to explain to their shareholders the negatively influence in short term but this would create a long term value and sustainable growth. Also, suitable price strategy needs to be considered. Obviously the company does not want to sell their products too cheap to increase their market share and might be end up with the price war.
Lower the costs of capital in terms allow the investors of company to get their money back quicker and keep investing, also enable to generate a satisfactory return for the investors.
Reduce cost of capital
“Cost of capital is defined as "the opportunity cost of all capital invested in an enterprise”.()Including Common Stock, Preferred Stock Bonds (debt), and Retained Earnings - (profit the company makes, but does not give to the shareholders in the form of dividends). The companies have several ways to acquire the cost of capital, so they will measure the opportunity cost of all source of capitals which contain debt or equity. In the financial point of view, companies try to acquire the lower cost of capital to develop the business and maximize the value of company, but they also should consider and evaluate the risks of cost of capital source. It is called the optimal capital structure (the lower Weighted Average Cost of Capital), which composes of the portfolio of the debt, preferred stock, common stock and so on. Generally, an increase of gearing ratio may decrease WACC and reduce the cost of capital, because interest on debt is tax deductible. However, higher gearing will result in higher risk of financial burden.
In our case, it is difficult to make a judgment without much information on the firm and economy. Hence, we should make some assumption.
20x9 the total capital =equity +debt= 4.5million=3.8million (equity)+0.7million
Assume:
KD: rate of return on debt=10％
KE: rate of equity capital =ROE=12％
Corporate tax=30％
Expected annual cash flow=1million
Calculation ：
The proportion of equity =3.8/4.5=84％
The proportion of debt=0.7/4.5=16％
The cost of capital : KD after tax=10％ (1-30％)=7％
WACC= 84％*12％+16％*7％=11.2％
The total value of firm = expected annual cash flow/WACC= 1/11.2％=8.93m
If the company increases the proportion of debt from 16％ to 20 ％, WACC is 11％ and the cost of capital reduces and the value of the firm maximize.
In addition, company repurchases stock from the market and it also will reduce the cost of capital, but it should notice the limitation number of repurchase stock according to the corporation law. In this case, it is hard to judge because it does not show the accurate share capital figure, but in 20x7 the shareholders equity is 3.3 million ponds and in 20x9 the shareholders equity is 3.8 million ponds, so from this data it presents that the safe maximum of repurchase stock is 0.5 million (3.8-3.3).
Also, disclosing more information to analysts in the public also reduces the cost of capital. For uninformed investors of holding the stock the risk will increase due to the private information because informed investors are better able to shift their portfolio weights to incorporate new information.
Write down the value of stock and fixed assets
If the company writes down the value of their stocks and certain fixed assets by significant amounts, the profits and the return on capital employed will be influenced significantly. First of all, the writing down of certain fixed assets can cause the increase of depreciation expense, so the profit can be reduced.
According to this formula:
Gross profit=Net sales – cost of sales / Net sales-(opening stock +purchasing- closing stock)
If the value of stocks is written down, the closing stock will decrease. So the cost of sales will increase with the decrease of the closing stock. Therefore, the gross profit can be reduced finally.
Moreover, in terms of the following formula:
ROCE = NPBIT / Total Asset (Current assets + Fixed assets)×100%
As we can see, because the value of their stocks and certain fixed assets are written down by significant amounts, both current assets and fixed assets can be reduced by the same amount. Hence, ROCE will increase with the decrease of total assets.
Issue the lower dividend
Share price are based on investors’ assessment of the business future, and investors assess the return on their investment by investment ratios, including dividend payout ratio, dividend yield ratio, earning per share and price earnings ratio. The price earning ratio is the measure of market confidence of business in the future. Therefore, businesses have a higher share price relative to their recent historic earnings (high price earning ratio).
P/E=Market value per share/Earning per share
As higher P/E ration, the greater confidence in the future business it raises, so the more investors are willing to invest more money. However, some industries tend to pay out lower dividends, because their development of industry relies on the higher investment such as pharmaceutical business or they invest heavily in the future to some extent at the expense of current profit. In these situations, their share prices remain the same even though lower dividends are proposed, because their future is regarded as economically brighter. Higher price earning ratio also arise where business have recent low earning and low dividend. As a result, share price is not always direct positive relation with dividend.
In this case, Lee Chew Cheng Wong Chemical Company is a mature company, so the relation of dividend and share price could be positive.
EPS=PAT-PD/NO. of Ord. Shares
20x9 EPS=1.02=510-110/NO. of Ord. Shares
Number of ordinary shares issued≒392
If Lee Chew Cheng Wong Chemical Company wants to pay a lower dividend
Assume Dividend =60
20x9 EPS=510-60/392=1.14
Therefore, issuing the lower dividend leads the higher EPS.
In this formula, P/E=Market value per share/Earning per share
If the EPS ratio increases from 1.02 to 1.14, the P/E ratio will become smaller.
The smaller P/E ratio means the less confidence of business future, so the market price will drop.
As a result, if the company pays a lower dividend per share in the 20x10 year, it will impact the confidence of business future, so the P/E ration will go down and the market price will reduce.
Introduce Activity Based costing
Activity-based costing is an apporach to dealing with indirect costs that treats all costs as being caused or driven by activities. Although the cause and effect relationship is used in total absorbtion costing, the cost centre of ABC is not production or service department, but activities. Compared to absorpting costing approach, ABC provides a more common-sense approach for assigning overheads to products, services, jobs, distribution channels and so on. According to R.S.Kaplan, ABC could be better described as a resource consumption sysytem. It is to predetermine indirect costs and divided into various categroies( resource cost ). Each categroies allocated or apportioned by appropriate resource cost drivers, and it is founded on the belief that activities cause the costs and that the cost objects create the demand for those activities. ABC causes management to focus on what creates the demand for the resource and the redevelopment or elimination of excess resources. If the most overheads can be analysed and cost drivers identified, it is possible to gain much clear insights into the costs that are caused activity by activity. As a result, fairer and more accurate product costs can be allocated, and costs can be controlled more effectively. Overall,the ABC approach arises seven basic benefits of this company. Firstly, it makes possible to determine total production costs traced to out put. Secondly,targeting areas needs the attention of managenment. Thirdly, it encourages the consideration of alternative methods of production. Fourthly, it highlights the operational efficiency and inefficiency. In addition, it identifies the financial benchmarks for activity performance. Also, it generates more information to measure and reward performance and prioritizes activities for cost reductions. Finally, it provides a common managerial framework among support activities. () However, quite a number of cost drivers cause time consuming and expensive to apply, so adopting the activity-based costing the cost drivers should be appropriate and effective. In this way, the Lee Chew Cheng chemical company can control cost effectively and provide a competitive price in the market.
Capital Expenditure Budget
Budgeting is allocating resources between different company departments – sales and distribution, production, purchasing, R&D, marketing, finance, administration (Chadwick L., 2002). Budgeting control is establishment of budgets, relating responsibilities to executives, and auditing results of activity in comparison to planned. Its decision model is search – strategic plan – screening – definition – evaluation (risk and uncertainty, inflation, taxation, hurdle rates, strategic fit; techniques – payback (profitability, constraint, uncertainty), accounting rate of return, net present value, internal rate of return) – transmission – authorization – monitoring – post audit – assumptions (Pike R.H., Wolfe M.B., 1988).
There are two kinds of budgets – cash and capital that forecast cash flow and expenditures. Cash budget aimed to light if cash is available in needed time, when will be shortage and surplus. It is producing budgeted balance sheet and cash flow by gathering opening balance, forecasted sales and purchases during each period and allocating them to expenses (Chadwick L., 2002).
Generally, capital budgeting is divided into long and short-range (Jones R.L., Trentin H.G., 1971), fixed – remains unchanged, and flexible – changes as activity requires (Chadwick L., 2002). Long-range depicts trends in capital and is made for 3-5 years. It is developed like: a) top management makes forecast of the industry and a firm; b) heads of divisions are after informed about forecast and are asked to outline their needs of capital facilities; c) it is analysed by board, approved and continually revised (Istvan D.F., 1970).
Short-range capital budget matches the cost of expenditure proposals with the funds available (year or 2, quarter, week). Generally two types are used. Rationing –limited funds are divided among best proposals – a) financial officer determines amount of available funds; b) departments submit proposals; c) finance department matches them with amount available; d) apportioning total funds to various divisions.
Financing budget – borrowing or issuing new equity securities – a) divisions submit requests; b) financials analyse availability of funds and in case of lack – plan acquisition of necessary funds (Istvan D.F., 1970). Choice of items for inclusion in annual capital budget depends on degree of urgency and necessity, comparative advantage of different schemes (Court H.P., 1961).
However, capital expenditure budgeting requires control in dollar and time dimension. Firstly, company monitor actual figures and planned, secondly, in case of gap re-evaluate and find a reason, and finally have procedures to handle a gap. After the end of selected period it is advisable to conduct postaudit aimed to measure actual results (profitability or years to return capital invested), compare these results with predicted, take action regarding any differences between the two (Istvan D.F., 1970).
Thus, for our analysed company Lee Chew Cheng Wong because of reorganisation we suggest departments make a plan of capital usage, propose how to reduce capital expenditure after reorganisation and describe necessary increase to successfully reallocate resources, equipment and move production. That would require a short and long-range planning and control of efficiency procedure creation – budgeting.
Conclusion
Overall, the ratio analysis discussed the problems with the current financial activities. In view of this situation, the Chief Executive should in order to implement some actions to reduce the unnecessary expenditures, deal with the redundancy and invest in different areas which we have suggested above. Staff training and use e-commence IT system such like online dealing business would cost money, but the company would be more efficiency and effectively, therefore that would save lots of time, communication costs and higher production in the long term. Furthermore, manager’s decision is very important; both benefits and risks need to be considered; poor decision-making might land the company in a predicament. By improving the financial performance, the company would be able to add more value and be more successful in the future.
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