Lecture 2 Capital

8/11/2019 Lecture 2 Capital

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Whitewater LimitedConsulting Engineers & Scientists

FINANCIAL ASPECTS OF PROJECT ENGINEERINGAND CONTRACTING

PROJECT APPRAISAL FOR BIOPROCESS

Prof George Solt

CAPITAL


The oldest profession?

Humans in Africa72,000 years agoemployedpyrotechnology toincrease the qualityand efficiency ofstone toolmanufacturing.

Science 2010

A rare photograph of an early Chemical Engineer


Trade

Any form of trade requires


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Companies

Philosophical influences on company

operation include:Culture

Religion

Politics

Economic theory


What is it?

Capital is an accumulated sum ofmoney which is invested for long-termbenefit

It is somebodys savings or it may beborrowed from a bank, in which casethey got it by borrowing other peoplesor companies savings

Money spent on anything else iscurrent expenditure


What is it?

Buying a house is capital expendituremade for the long-term gain of living

rent-free money is usually

borrowed as a mortgage and thelender gets the money from people

who put their savings into a savingsaccount.


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What is it?

Money spent on a holiday is not a

capital expenditure - the sun-tanfades quickly


What is it?

When it comes to small sums, however,there is something of a grey area

A computer is a capital outlay to a one-

man company but petty cash (currentexpenditure) for a large one

All ventures need capital of two types:Fixed Capital and Working Capital


Whats it for?

A corner shop is

a relativelysimple businessmodel


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Whats it for?

Opening a shop needs cash to buy thepremises and fittings

These things are not readily turned backinto cash again, so theyre called FixedAssets and the money is Fixed Capital

Then it needs money in the till, forpaying wages, bills and buying stock forsale

This should be turned into cash soon soits called Working Capital


Whats it for?

Contracting requireslittle fixed capital

Offices, machinery,cars, etc can all berented

The work force ishired for specific

contracts


Whats it for?

As down the glen came McAlpine's men

With their shovels slung behind them'Twas in the pub they drank the subAnd out in the spike you'll find them

They sweated blood and washed down mudWith pints and quarts of beer

And now we're on the road again

With McAlpine's fusiliers

Dominic Behan 1962


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Whats it for?

A flexible workforce

Does everything get

subcontracted to whitevan man?


Whats it for?

Contracting needs a lot of workingcapital to pay employees buy

materials, hire machinery, and so on,while the contract proceeds.


Whats it for?

Typically contractors need 1 workingcapital for every 5 of annual turnover

A company which trades at a rate

greater than its working capital is ableto support will sooner or later becomeinsolvent even if it is running profitably

Trading when knowingly insolvent is a

criminal offence


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Whats it for?

Companies normally retain some of theirprofit to increase working capital

In addition most rely on bank loans tosupplement that so that they can achieve aturnover higher than they could sustain using

only their own cash

Many small contractors find that shortage of

working capital limits the turnover which theymight otherwise achieve


Where does it come from?

Raising capital


Where does it come from?

A company can raise capital by issuingand selling more shares or by

borrowing

Selling shares means selling a part ofthe company and giving some of theprofits to the shareholders


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Capital from Shares

When a company is first formed it musthave some nominal share capital

Issued share capital face value

Share premium

It may also have shares which have notbeen issued

At a General Meeting a company canauthorise the creation of a new trancheof shares for sale


Capital from Shares

For a plc share issue is via a financecompany who under-write the new shares that is, they guarantee to take up any unsoldshares at an agreed minimum price but ifthe public takes an optimistic view theoutcome can be very satisfactory for thecompany

If a private limited company raises newshares, it is usually for some known purpose,which means there is no doubt that they willbe taken up


Loans

If you dont haveenough money you

have to hire someand that meanspaying rent for it itscalled INTEREST and

isnt always popular.


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Loans

A lender is reasonably entitled to getsome return for giving up the use of

his money, but what is reasonable ?

Historically its about 1% to 3 % pafor an absolutely cast-iron safe loan


Whats it for?

Banks want to see fixed assets as aguarantee that they will recover at least

some of their loan if the company fails

Most contractors have few fixed assetsso banks have to feel very confident oftheir future before they will lend them alot of money


Loans

which isthe only sort

of loan thatbanks really

like!


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Interest

Inflation 2 %

Risk 2 %Administration 1 %

Real return 2%

Interest rate 7%


Banks

Banks borrow money at one interestrate, and lend it at a higher one

The Bank of England is the UK

Governments central bank


Banks

The Bank ofEngland sets theBase Rate which

is (more or less)the interest rate atwhich other bankscan borrow money


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Banks

LIBOR

London Interbank OfferedRate

Rate for unsecured loansbetween banks fromovernight to one year

Average of rates offered byworlds top banks

Calculated daily by Reuters


Banks

Project engineeringdepends on financebeing availablewhen needed

Once the necessaryloans for a projectare agreed, thebanks can producemoney the instant

that it is needed

St Albans Abbey


Banks

Banks are essential toany engineeringenterprise so its

important to keep onthe right side of theBank Manager.


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Capital from Loans

The company now takes out a 1mloan at 6% interest, and passes the

1m on to the shareholders, at 10 pershare so shareholders funds reduce to1m.

The working capital remainsunchanged at 2m, so the companygoes on making 500,000 profit

However, it has to pay 6% interest onthe loan, which reduces the net profit to440,000 - 4.40p per share.


Capital from Loans

Now the shareholders funds are only1m, but the return on that has gone upto 44% and the shareholder hasreceived 10 per share which he canreinvest.

This shows why companies aregenerally financed by a mix of investedcapital and bank loans.


Capital from Loans

In this example, the return on shareholdersfunds was 25%

Now suppose the company hadnt returned

any money to the shareholders but used theloan as an addition to the working capital.

If that allowed it to increase its turnover to15m then, with the same profitability of

25%, the companys profit is 750,000 -60,000 loan interest = 690,000 a returnof 34.5%.


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Capital from Loans

With the increased profit the company

will probably pay a proportionally biggerdividend, which should make theshareholders even happier.

This also shows why contractingcompanies often use a high overdraft toboost their working capital


Capital from Loans

The important thing is to get the balancebetween share capital and loan capital right

If a company borrows so much on loans thatit is crippled by the interest payment, it will gounder, like Marconi plc did

Capital gearing is the ratio of loan capital tototal capital (loan capital plus share capital)and should be


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The Contracting Business

A Contractor typically depends on a fewrelatively large projects

Work in hand at any given moment varies

Expenditure on individual projects is irregular(The S curve)

Payment for work tends to come in relativelylarge sums, at irregular intervals

This means a contractor needs a relativelylarge amount of working capital



A contractors work can be carried outwith a minimum of fixed capital - noneed to own factories or machinery everything can be rented.

Even some of the staff can be free-lance, taken on for a specific contract.



As little fixed capital is needed, itsrelatively easy to set up a contractingcompany. That means competition

remains fierce, and margins low.The typical contractor has no Bread

and Butter work the future is alwaysuncertain.

Its an exciting life.

Too exciting, sometimes.


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Summary

Borrowing money means paying interest

Interest pays for inflation, risk and admincosts before producing any real return to thelender

Banks usually refuse to lend any money ifthey see a significant risk. If the risk is slight,they may lend some, but only at high interestrates.

Companies with few fixed assets to serve assecurity have difficulty raising loans.


Summary

To start a business you first have to raisesome capital.

Contracting needs little fixed capital, butdepends on having enough working capital.

Companies must take care that their turnoverdoesnt exceed the level which its workingcapital will support.

Companies are financed most efficiently by ajudicious mix of share capital, accumulatedprofit, and bank loans.

Documents

Lecture 2 Capital