Business Finance Assignment: Case Analysis of Aquila Shoe

Question

Task

Consider a business that you would like to work for at some point.
Imagine that you are the new owner of this business. Write a business finance assignment answering the following questions to show your understanding of how firms function and the issues that owners and managers encounter.

1. Name the business and give a description/overview of your understanding of how the business functions. i.e what it does, how it does it and where it makes its revenue.
2. Explain a specific major financial decision that you may need to make as the owner/manager of this business.
3. Describe the structure of the business and contrast the positives and negatives of this structure with alternative typical business structures in Australia.
4. Discuss any potential Agency issues that you may encounter if you choose to hire a manager for your business and suggest a way that you could use to overcome these.
5. You have the opportunity to expand by taking over a rival business. Describe three (3) factors that you must take into consideration when deciding whether to purchase this business. Explain why each is important.

6. The owner of the rival business agrees to sell to you. He will take payment one of three different ways. Using the information below, calculate which payment option would make more financial sense to you and state which you should accept. Use formulas not tables, and show working. Make a definite statement as to which option should be chosen.

   Hint: You need to use your skills calculating the PV of future cash flows.

   Option 1: An upfront Payment of $100,000 and a single fixed payment in 1 year of $35,000.

   Option 2: An upfront Payment of $20,000 followed by further payments of $10,000 at the end of each month for the following 12 months.

   Option 3. No upfront Payment. 50% of profit for the next two years, payable semi-annually as the profits is earned.

   The expectations that you have for the new business and the financial economy are as follows:

   Expected profits for the purchased business will be $140,000 in year 1, and $160,000 in year 2. Assume profits are earned in a consistent manner throughout the year.

   Expected annualised interest rates are flat from cash out for 1 year at 5% and then rise to 6% at 1.5 years and to 7% for the 2 year.

7. Think about the scenario described in question 6 and your eventual answer. Explain the risks that are faced by the Seller of the business in accepting your offer. In particular, use your understanding of Agency Risk and mention how Ethical behaviors in business might apply here. Hint: The seller is relying on the new owner (you) to?
8. You just sold your car for $18,000. You have deposited it into your bank account. You are keen to invest the funds for one year as you are concentrating on your studies for the moment. Which of the following options for depositing the funds will earn you more interest over the coming year? Show your calculations including formula.
   • Fixed Interest rate of 3% paid at maturity.
   • 2.9% Interest rate compounded and reinvested on a monthly basis.
   • 2.8% Interest rate compounded and reinvested on a daily basis.
9. Explain the effect that using compounding interest rates versus simple interest rates have on the return from an investment.

10. a. Name and describe an example of an annuity that is commonly encountered by businesses in the Australian economy.

    b. Calculate the Present Value of the following Annuity Payment.

    $12,000 paid in arrears for 25 years. Assume that the current yield curve shows a 25 year bond rate of 6% p.a.

    Tip: Look at Topic 3. Seminar 3 notes explain this and then use the spreadsheet called NPV to check your calculations.

11. It is common in Australian Finance for Annual Percentage Rates (APR’s) to be quoted when discussing the level of interest.

    • Why would it be better for interest rates to be quoted as Effective Annual Rates (EAR) instead?
    • Calculate the EAR in the following situation: APR 7%, Interest Calculated/Paid Monthly.

12. What are the two components of Holding Period Return? Calculate the HPR of the following share investment in NAB. Assume that the Share was held for exactly 3 months and one dividend was received with any attributable franking credit included in the total of the Dividend received. Purchase Price $23. Dividends received $2.50. Sale Price $26.50.

    Show the total profit amount and the HPR as a percentage gain on the investment.

13. Calculate the Expected returns on the following investment. In one year the probabilities of the following outcomes are as follows. A return of $25,000 is 30 % likely. A return of $50,000 is 40 % likely. A return of $100,000 is 20% likely. A return of $10,000 is 10% likely.
14. As an accountant you have a client who does not like to take a large amount of risk with their investments. They have some money to invest and they ask you to tell them your thoughts on which asset classes are the least risky through to those that are most risky. They are considering investments in Property, Shares or Bonds.
    • What will you tell them about the relative historical risks of these investments and their returns?
    • From you understanding of the investment markets, what general rule could they use to reduce the risk of their portfolio?
15. The CAPM model divides the risks that investors encounter into two categories. Identify and briefly discuss these.

Answer

1. Herein business finance assignment, the case of Aquila Shoe is examines which is an Australian shoe manufacturing company that manufactures premium shoes for men. This company is located in Abbotsford, Victoria, Australia. Earlier, the company only manufactured Children's shoes, which later changed its focus to men's shoes, and started manufacturing quality shoes for men. The meaning of the term Aquila is an eagle in Italian. This termed was given to the company as a mark of power and strength (Aquila, 2020). Today there is approximately 25 Aquila store in Australia, which are located NSW and Victoria and the few others in Perth, Brisbane, and Adelaide, which employs around 100 employees. Today the company has moved on to the internet and has changed its website to an e-commerce site. Other social media platform is also used by the company, which includes Facebook and Twitter. For the convenience of the customer, free delivery has also been introduced, which is very appealing to the customers. Aquila manufactures a very high and premium quality shoes for men, who are loved by the customer (Sotiropoulos, 2018). Aquila focuses on retail business and has been investing money and time to keep the retail stores very friendly to the customers. Aquila trains its employees in such a way that the staff works hard to satisfy the customers and not lose them to another retailer. In recent years Aquila has made significant growth in its economy; the profit has been of the highest level. Aquila is ranked 3rd among its competitors. The company earns most of its revenue from the retail stores 25 retail stores.

2. Financially a company needs to be strong in order to survive in the current situation where the competition is very high. All the decisions that are made in order to expand the boundaries of the business, a company has to invest some capital. Without being financially strong, a company cannot survive. Today the scenario of the business is such that everybody is moving towards technologies. With the help of technologies, companies have done wonders in earning profit. Technologies can also be very helpful in shoe manufacturing companies; some companies have started using technologies such as Augmented and Virtual Reality, smart footwear, shoe Knitting technologies, etc. Using this kind of technology, shoe-manufacturing companies have taken the shoemaking process to the next level (Finkel, 2019). Technologies, along with the internet, can do wonders for the company. To use all the technologies mentioned above, the investment needs to be massive, and this decision should be taken considering all the risks. In order to survive in the competitive world, Aquila Shoes needs to make some important financial decisions. Considering the current position of the company, the company is financially stable and efficient enough to make a huge decision (Thinking Capital, 2018). The decision of investing millions of dollars in technology has to be taken carefully, considering all the risks involved. Being the owner of the company, one has to decide whether a particular decision is right for the business, it will make a profit, and what is the risk it poses to the business.

3. Aquila is a shoemaker company in Australia. The structure of the company starts with a Chairman, who is the supreme head of the organization. Under him falls the different heads or the managers of the different departments. Taking the example of Aquila, this organization falls under the business structure Company (Page, 2020). Here there is a Chairman, which is the supreme head of the company, the Chairman is also referred to as Director or the President, the under him there are many departments who have their separate head. The departments, which come under the supervision of the Chairman, are managing director, executive manager, general manager, marketing manager, sales manager, financial manager. There are some positive and some negative points in this kind of business structure. Comparing the structure with a Sole trader, an alternative business structure, we can find the following points:

Advantages

• The liability used is limited compared to Sole Trader, where the liability used is more.
• The selling and passing of the owners are very easy, which is not the case in the alternative structure.
• The losses in the company structure can be easily carried forward by evaluating the probability of future profit, whereas, in the sole trader structure, one cannot carry on with the losses as only one individual is involved.
• The company structure is a well-understood and accepted structure all over Australia. Disadvantages
• Setting up the company structure is difficult as it requires a huge maintenance cost compared to the Sole trader (Companybug, 2018).
• The command or the complete control over the company cannot be retained.

4. Hiring a manager may cause a potential agency problem. The problem arises when the incentives and the method of working become the priority of the agent, which is the manager in this case. The agent, which is the manager, may work according to his interest, which may not match with the interest of the owner (Moffat, 2018). This kind of risk is faced very frequently in companies; the interest of the principal, which is the owner, and the interest of the agent, which is the manager, does not match. The agent works according to his interest, which is profitable for the agent. The potential agency problems are not possible to be eliminated, but it can be minimized to a certain extent. The minimization of the problem can be done by regulating the relationship between the agent and the principal. This can be done by signing a contract between the owner and the manager; the contract should contain all the terms and conditions cited properly in the contract. The help of incentives can also minimize the problem arising from the potential agency. The agent, which is the manager, in this case, can be given good incentives to work to his fullest extent. The incentives can be given based on the performance of the manager (Sharma, 2017). For example, if an agent working for the company is paid according to the work the agent does and not according to the hours worked, the agent will be forced to work in the interest of the owner.

5. Buying an existing business is not easy; one has to do many types of research based on the type of the business, the position of the business in the society, and a lot more. The three most important things to be considered are:

• Due Diligence: The detailed understanding of the business needs to be done before buying a business. Due diligence can be very helpful in doing that. Due diligence helps to identify the potential risk that can be faced after buying the business, which might leave an empty space from where the competitors can make the owner of the business (Singh, 2019). It helps the owner to be aware of the necessity of identifying the things which can protect the liabilities from being purchased. Properties related problems can also be identified with the help of Due diligence.
• Price: The important aspect to consider before buying a business is the price. The current market value of the business being sold should be evaluated, and the price which the owner of the business bring sold should be compared considering the value which one is willing to pay for the business. The data suggests that the business is always bought for 15 to 20 percent below the price, which the seller has proposed.
• Funding: The best time to secure a deal is when the department the business functions it is in its growing phase. It is always recommended to check the sector is in a growth phase or in its decreasing phase.

6. Calculation of Present Value factor = 1/(1+r)^n

Option A

Present Value of Cash Flow = Present Value Interest Factors X Future Cash Flows

= (100,000*1) + ((1/(1+.05)^*35000)

= $ 133,333

Option B

Present Value of Cash Flow = Present Value Interest Factors X Future Cash Flows

= (20,000*1) + (10,000* ((1-(1/ (1+0.05)^12))/0.05))

= $ 108,633

Option C

Present Value of Cash Flow = Present Value Interest Factors X Future Cash Flows

=(35,000* (1/(1+0.05)^0.5)) + (35,000* (1/(1+0.05)^1)) + (40,000* (1/(1+0.06)^1.5)) + (40,000* (1/(1+0.07)^2))

= $ 139,080

Option C should be selected as it offers the highest present value.

7. The agreement, which the seller has signed, covers a huge amount of the warranties and arrangement. This includes the details of the employees, financial details of the company, the important assets, and the liabilities, the details of the trades and the partners of the company are also mentioned in the agreement. The buyer depends on the details provided by the seller. If the buyer of the company suffers loss and he finds out that the details provided by the seller were incorrect, then the buyer claims the damage from the seller. The seller faces a risk of getting damage claims if he has not made a disclosure letter. Disclosure letter contains some exceptions, i.e., if the seller wants to impose some exceptions in the warranties, then he can do that in the disclosure letter; this prevents the buyer from claiming the damage in that warranties. Although making a disclosure letter takes much time, sellers must go through the process and make a disclosure letter.

Ethical behavior means that honesty is the main principle, i.e., people are honest with co-workers and customers. This can apply in the selling, and the purchasing of the business as this procedure depends on trust. A seller who believes and follows ethical behavior will face a minimal amount of risk as the owner has disclosed all the possible threats buying the company may possess. On the other hand, if the owner who is selling the business does not believe in ethical behavior, then he might face considerable risk.

8. a) Fixed interest rate = Interest rate * Principal

= 3%*18000

= $ 540

Amount = Principal + Interest

= 18000+540

= $18,540

b) Amount = P(1+r/n)^nt

Where P = Principal

N = Number of compounding

T = Time period

R = Rate

Therefore Amount = =18000*((1+0.029/12)^12)

= $18,529

c) Amount = P(1+r/n)^nt

Where P = Principal

N = Number of compounding

T = Time period

R = Rate

Therefore Amount = =18000*((1+0.028/365)^365)

= $18,511

9. Interest can be calculated by two methods that are simple interest rate and compounding interest rate. Simple interest is calculated on the total amount that is the principal of an investment, whereas the calculation of the interest contracts in the Compounded interest rate method. The interest is calculated on the total amount or the principal along with interest on that amount. Although simple interest is simpler to calculate than the compounded interest rate, when returns are involved, compound interest seems to be of more profit as the funds can grow faster and the returns could be more.

10. a) A Deferred Annuity helps money to grow by keeping the money in the account for a longer period of time, but it's tax-free only until the time it is withdrawn. Over time it can build up into a huge payment, like Retirement Accounts.

b) Present Value of Annuity = PMT x ((1 – (1 / (1 + r) ^ -n)) / r)

The variables in the equation represent the following:

• P = the present value of annuity
• PMT = the amount in each annuity payment (in dollars)
• R= the interest or discount rate
• n= the number of payments left to receive

Therefore, Present value of annuity = 12000*((1-(1/(1+.06)^25))/.06

= $153,400

11. a) The Effective Annual Rate (EAR) is used to calculate the actual amount we will owe or receive once compounding is considered, where as the Annual Percentage Rate (APR) helps us to calculate the total amount of interest to be paid on the borrowed amount each year. Hence Effective Annual Rate (EAR) is better to be used instead of an Annual Percentage Rate (APR).

b) Effective Annual Rate (EAR) = (1+i/n)-1

= (1+0.07/12)-1

= 0.58%

12. Income and Capital Appreciation are the two major components of the Holding Period Return (HPR).

Holding Period Return (HPR) = ((Income + (end of period value - original value)) / original value) * 100.

HPR of NAB = ((2.50 + (26.50-23)) / 23 * 100

= 26.09%

Annualized HPR for Fund NAB = (0.2609+1)1/3?1

= -0.83%

Total amount of Profit = (26.50-23)

= $ 3.50

13. Calculation of Expected Return

Expected Return = $ 48,500

14.
a) The client, before investing in property, shares, or bonds, will have to understand the relative historical risk associated with such investments. Market risk is the first risk that the client must consider because of the declining value in economic developments that potentially affects the entire market (OSC, 2018). Liquidity risk is another associated risk where the client might not be able to sell the investment at a fair price and ultimately sell it at a lower price. While investing in bonds, it is essential to consider that the bond issued by the company or the government faces financial difficulties that will lead to the return of low or no interest, and sometimes the principal amount is not paid.

b) For the client to reduce the risk of their investment portfolio, the cardinal rules of investing can be used. The client can invest for value by purchasing profitable businesses at reasonable prices. In addition to that, it is important to be patient and allow the investments to grow to gain higher returns (Irvine, 2018). Lastly, it will be crucial to diversify the investments as this will ensure the spread of capital amongst different types of industries, companies that will reduce the risk of an investment portfolio.

15. The CAPM model divides the risks that investors encounter into two categories.

The CAPM or Capital Asset Pricing Model is a model that shows the relation between the expected return of the asset and its systematic risk. This model was introduced by William Sharpe in 1970 (Juneja, 2015). It follows the following formula:

ERi=Rf + ?i (ERm - Rf)

ERi = Expected return of investment; Rf = Risk-free rate; ?i = Beta of the investment; (ERm - Rf) = Market risk premium

The risks in this model of investment are categorized as systematic risks and unsystematic risks, which have been discussed below.

Systematic risks
This type of risk is the more generic kind of risk that depends on the overall tendencies of the market. These kinds of risks cannot be avoided in any investment plan. Examples of systematic risks are recessions, fluctuating interest rates, etc.

Unsystematic risks
These are more particular kinds of risks that arise from movement in the values of individual stocks. It has less to do with the more generic tendencies of the market. This kind of risk has some chances of being removed through the diversification of a portfolio. However, it is not a full-proof method, and the investors are much wary of this type of risk.

References
Aquila (2020). About - Aquila’s Brand History | Aquila. [online] www.aquila.com.au. Available at: https://www.aquila.com.au/about-aquila [Accessed 14 Jan. 2021].

Companybug (2018). Sole trader advantages and disadvantages - Company Bug. [online] Company Bug. Available at https://www.companybug.com/advantages-and-disadvantages-of-a-sole-trader/ [Accessed 14 Jan. 2021].

Finkel, D. (2019). How Successful Business Owners Look at Financial Decisions. [online] Inc.com. Available at: https://www.inc.com/david-finkel/how-successful-business-owners-look-at-financial-decisions.html [Accessed 14 Jan. 2021].

Irvine, R. (2018). 5 Cardinal Rules for Successful Investing. [online] Keystone Financial. Available at: https://keystocks.com/investment-strategy/5-cardinal-rules-for-successful-investing/ [Accessed 14 Jan. 2021].

Moffat, R. (2018). Agency Risk | Risk-First. [online] Risk-First Software Development. Available at: https://riskfirst.org/risks/Agency-Risk [Accessed 14 Jan. 2021].

Mullins Jr, David.W. (2014). Does the Capital Asset Pricing Model Work? [online] Harvard Business Review. Available at: https://hbr.org/1982/01/does-the-capital-asset-pricing-model-work [Accessed 14 Jan. 2021].

OSC (2018). Types of investment risk | Understanding risk | GetSmarterAboutMoney.ca. [online] GetSmarterAboutMoney.ca. Available at: https://www.getsmarteraboutmoney.ca/invest/investing-basics/understanding-risk/types-of-investment-risk/ [Accessed 14 Jan. 2021].

Page, A. (2020). Types of Business Structures in Australia | Small Business Start-ups. [online] Knox Taxation and Business Advisory. Available at: https://www.knoxtax.com.au/business-structures-australia/ [Accessed 14 Jan. 2021].

Sharma, A. (2017). Managing risks when hiring the right fit! [online] People Matters. Available at: https://www.peoplematters.in/article/recruitment/managing-risks-when-hiring-the-right-fit-16939 [Accessed 14 Jan. 2021].

Singh, A. (2019). 9 Factors That’ll Help You Choose The Right Business Location. [online] myHQ Digest. Available at: https://digest.myhq.in/factors-choose-right-business-location/ [Accessed 14 Jan. 2021].

Sotiropoulos, D. (2018). From the source: Luke Longo, CEO, Aquila. [online] Inside Retail. Available at: https://insideretail.com.au/news/from-the-source-luke-longo-ceo-aquila-201805 [Accessed 14 Jan. 2021].

Thinking Capital (2018). How to make critical financial decisions for your business | Thinking CapitalTM. [online] Thinking CapitalTM. Available at: https://www.thinkingcapital.ca/resources/how-to-make-critical-financial-decisions-for-your-business/ [Accessed 14 Jan. 2021].