THE THREE FINANCIAL

DECISIONS OF ANY
BUSINESS
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INVESTMENT DECISION
FINANCING DECISION
DIVIDEND DECISION
Which projects will add the most value to the business?
OBJECTIVE: Find the most value adding projects to
invest in
THE THREE FINANCIAL DECISIONS
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OVERVIEW
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 competitors business.
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.
If there are no investment opportunities, the cash must
be returned to shareholders as dividends in order to
maximize shareholder value.
How will I pay for these investments by raising capital in the
form of debt and equity?
OBJECTIVE: Minimise the cost of raising capital for these
investments
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
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INVESTMENT DECISION
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.
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)
Project value is based on cash flows generated and the
timing of these cash flows.
The value of adding a new shop is +2,917 in todays 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.
Which projects will be value adding to London Coffee Co?
2013A 2014E 2015E 2016E
Initial Cost -5,000
Cash Flows +2,000 +4,000 +6,000
Present Value of +1,667 +2,778 +3,472
Cash Flows @ 20%
Net Present Value +2917
PROJECT 1: London Coffee Co adds a new shop
2013A 2014E 2015E 2016E
Initial Cost -1,000
Cash Flows +200 +400 +750
Present Value of +167 +278 +434
Cash Flows @ 20%
Net Present Value -122
PROJECT 2: London Coffee Co opens a mobile
kiosk
THE THREE FINANCIAL DECISIONS
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FINANCING DECISION
London Coffee Cos 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 companys investment decision that the minimum
required return from investors was 20%. This reflects the mix of
debt and equity in the business.
London Coffee Cos 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.
How will London Coffee Co pay for investments and its operations?
2013A 2014E 2015E 2016E
Initial Cost -1,000
Cash Flows +200 +400 +750
Present Value of +167 +278 +434
Cash Flows @ 20%
Net Present Value -122
USES OF FUNDS
Current assets
Cash and cash equivalents 500 6,926 15,733
Accounts Receivable 400 600 800
Inventories 1,000 1,200 1,400
Other Current Assets 2,000 3,000 4,000
Long-term assets
Deferred taxes 1,000 1,500 2,000
Goodwill 2,000 2,000 2,000
Property, plant and equipment 30,000 28,000 26,200

SOURCES OF FUNDS
Current liabilities
Short-term debt 0 0 0
Accounts payable 3,000 4,800 5,600
Income taxes payable 2,000 4,598 7,475
Long-term liabilities
Long-term debt 15,000 14,000 13,000
Provisions 500 750 1,000
Equity
Common stock 100 100 100
Share premium 11,000 11,000 11,000
Retained earnings 5,300 13,978 19,598
Total Equity 21,400 25,078 31,058
Total Assets 42,900 49,226 58,133
2013 2014 2015
Actual Forecast Forecast
Total Liabilities 21,500 24,148 27,075
THE THREE FINANCIAL DECISIONS
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DIVIDEND DECISION
London Coffee Co has exhausted all of its value-
adding 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 companys cash flow position. Jenny
however believes the increase in dividends is a sign
that the companys 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.

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 & (2,500) (3,000) (3,500)
Administration
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 2014 2015
Actual Forecast Forecast
London Coffee Co - Income Statement
2013 Dividends Paid: 20% of Net Income
= 356
1. TAX
2. SIGNALLING
Dividend Payout
factors: