Evaluation of Investment Opportunity of Nexus Plc - Essay Example

Evaluation of Investment Opportunity of Nexus Plc Nexus plc is a leading automotive industry in UK, which is in a position to improve its production efficiency by taking appropriate investment decisions. Estimated Sales Forecast Year Number of units Produced Per unit price(in ₤) Total sales(in ₤) 1 2000 ₤204 408000 2 2600 ₤204 530400 3 3200 ₤204 652800 4 3800 ₤204 775200 5 4500 ₤204 918000 6 5000 ₤204 1020000 7 3400 ₤204 693600 8 2800 ₤204 571200 9 1800 ₤204 367200 Financial Summary Particulars Working capital investment. Plant and Machinery. Amount ₤20000 ₤750000 It is very clear that with the help of new plant and machinery so bought by Nexus plc, it is possible for the company to enhance the volume of production apart from revamping the entire production process. During each year (i.e. year 1 to year 9) the fixed overhead is estimated at ₤58000. Calculation of Depreciation of Machinery. [Purchase cost of P&M ₤750000] Year Depreciation (on Straight line basis.)(in₤) Amount After Depreciation.(in ₤) 1 6666.66 743333.34 2 6666.66 736666.68 3 6666.66 730000.02 4 6666.66 723333.36 5 6666.66 716666.70 6 6666.66 710000.04 7 6666.66 703333.38 8 6666.66 696666.72 9 6666.66 690000.06 Total 59999.94 Notes to Accounts:- A. Straight line basis of Depreciation: Under this method, the amount of depreciation charged for each year throughout the life of Asset is uniform. i.e. ₤ 60000/9 Years (From year 1 to year9) = ₤ 6666.66per year approximately. B. Total Cost of Acquisition - Total Depreciation= Book Value of Asset. Therefore, ₤750000_ ₤ 60000= ₤690000. Evaluation of investment opportunity of Nexus plc. In any case of financial investment decision, it is crucial to give emphasis on the investment opportunity of a particular project, whether it is beneficial or not. Therefore, the finance manager assumes importance, and is responsible for effective utilization of funds. But all those funds are procured at a certain cost and after entailing a certain amount of risk. If there is a failure in the proper utilization of funds, the running of the business will turn out to be meaningless. The funds are to be invested in a proper manner, and then the enterprise is able to produce optimum results without affecting its financial solvency. The financial implications of each decision to invest in various fixed assets are to be properly analyzed. Therefore, while taking an investment decision, it is necessary that the finance manager should possess sound knowledge of the techniques of capital budgeting. In addition to this, it is also necessary to give emphasis for the effective maintenance of adequate working capital. As far as the working conditions and the projected financial scenario of Nexus Plc are concerned, the investment decision of Nexus Plc is quiet important. “The global economic recovery in 2004 led to a rise in interest rates around the world, which coincided with a surge in commodity prices caused by strong demand and uncertain supply. Although inflationary pressures were kept at bay, a divergence of domestic conditions in 2005 led to a variation in international monetary policy that helped equities to rally and bond market performances to be wide-ranging.” (Economic Highlights for the Year. 2005). In addition to this, it is also important to evaluate the concept of corporate governance while taking investment decision. Moreover, the concept of capital budgeting is an effective tool for taking appropriate investment decision. At the time of taking adequate investment decision, the Weighted Average Cost of Capital (WACC) is crucial. Cost of capital is an important concept that determines the effective running of a business entity. The measurement of cost of capital of each source of finance also helps to evaluate the overall cost of capital of the entity as a whole. The composite of overall cost of capital of a firm is the weighted average cost of several sources of funds. Weights are taken as the proportion of each source of fund in the entire capital structure. While considering the financial aspect of investment decision, the analysis of overall weighted cost is significant. For this, each and every investment procedure is financed from a collection of funds which may represent various sources from which the required funds have been raised. Therefore, the investment decision shall be made with reference to the overall cost of capital. The Weighted Average Cost of Capital (WACC) is calculated by using the following step by step procedures; 1. Calculating the cost of specific sources of funds, it may be either cost of debt, or cost of equity etc. 2. Multiplying the cost of each source by its proportion in capital structure. 3. Adding the weighted component costs to get the firm’s WACC. So, WACC of an organization should be expressed as- K0= K1 W1 + K2 W2+………………..; Where, K1, K2 are component costs and W1, W2 are weights. Likely, in case of WACC, weights are either book value weights or market value weights. For calculating WACC, the equity or ordinary share capital of Nexus plc, is ₤12000000 (such as 12m ordinary shares @₤1); Cost of Debenture ₤8m*₤96, i.e. ₤8000000.(such as the face value of debenture is ₤96.) retained earnings or reserves made by the Nexus during the year is ₤1000000. Cost of debt after tax= Annual interest rate/Net proceeds of debentures/* (1_tax rate.) Cost of Debt = ₤640000/7680000*(1_30%) i.e. ₤640000/7680000*(0.7) Therefore, Cost of Debt = 5.83%. Notes: Here, discount factor of 8%debenture is ₤8000000*8%; Tax rate= 30% i.e. 30/100= 0.3 Cost of Equity capital= Dividend/Market price*100 Here the dividend costs to ₤1800000; Equity capital-₤12000000 Debenture- ₤8000000 Reserves- ₤1000000 The proportion is equity capital is 0.57, debt is 0.38, reserve is approximately 0.05 Assume the after tax cost of three items as 0.18, so weighted cost will be- Source Proportion After tax cost Weighted Cost Equity capital 0.57 0.18 0.1026 Retained earnings. 0.05 0.18 0.009 Debt. 0.38 0.18 0.0684 TOTAL 0.18 So, WACC is 18%, but the calculation is based on assumptions. Net Present Value-(NPV) Under NPV, initial investment is taken as cash outflows. NPV method is taken in to account in case of time value of money. It uses the discounted cash flows. A project should be accepted if the NPV is positive; otherwise it should be rejected. Therefore, here 18% is taken as the discount factor for computing the net present value of the project of Nexus plc for the 9 estimated years. Likewise, the concept of NPV is different from that of both acquisition and lease financing. Acquisition means take over of one business by another business. But leasing is a general contract between the owner and user of the asset over a specified period of time. Leasing helps to eliminate the immediate cash out flow, which is crucial as far as the investment decision, is concerned. Leasing is an alternative to the purchase of an asset out of own or borrowed funds. Lease Financing Leasing is an important term used in the field of finance nowadays. In this concept, the asset is initially purchased by the lessor or leasing company and thereafter it is leased to the user or lessee company, which pays a specified rent at periodical intervals. Lease rentals can be deducted for computing the total income under the Income Tax. Buying has the advantages of depreciation allowance and interest on borrowed capital being tax deductible. Thus, an evaluation of two alternatives is to be made in order to take an appropriate decision. “Finance leasing is a flexible, tax efficient way for your business to acquire the assets it needs without using up cash reserves. You may also realize some value at the end of the term. With finance leasing, the asset finance lender retains ownership of the assets purchased, but you can sell them on their behalf at the end of the term and keep most of the proceeds.” (Finance Lease). Every finance manager is responsible for taking adequate decisions in an effective manner, and on the basis of such decisions, the financial statements are prepared. Procurement and effective utilization of funds are crucial tasks faced by the finance manager. While taking decisions, it is necessary to consider the risk, cost, and control aspects. Finance manager is responsible for- Estimating the requirements of funds. Decision regarding the capital structure. Investment decision. Dividend decision. Supply of funds to almost all parts of the organization or effective cash management procedures. Evaluating the financial performances. Dealing with various financial negotiations. Keeping in touch with the stock exchange quotations and behavior of share prices. In addition to this, an effective finance manager is also responsible for maintaining and regulating a proper control over lease finance also. “In lease finance cases, the minimum amount recoverable shall be based on the date on which the account became doubtful or the date, on which the assets of the unit were taken over/repossessed by the Corporation, whichever is earlier. The amount shall be the principal outstanding as on the cut off date as per the capital recovery method plus the actual expenses incurred by the Corporation recoverable from the party up to the date of settlement. The Corporation must restrict the watch and ward as well as other expenses to the extent of interest (prevailing rate) on the principal amount from the date, the amount became doubtful till the date of settlement.” (Lease Finance Cases.1. 1999). Therefore, it becomes apparent that it is a crucial function to take the appropriate investment decision in an effective manner for the overall development and operational efficiency of an organization. Moreover, it is also beneficial to evaluate the financial viability as well as the technical feasibility of an entity as a whole. Bibliography Economic Highlights for the Year. (2005). Reports and Accounts. Investment Manager’s Report. [online]. The Equity Partnership Investment Company PLC. Last accessed 19 November 2007 at: http://www.epicip.com/Epic_PLC/PDFs/EPIC_R&A2005.pdf Finance Lease. [online]. Vantis. Last accessed 19 November 2007 at: http://www.vantisplc.com/Vantis/Services/AssetFinance/FinanceLease.htm Lease Finance Cases.1. (1999). Settlement formula Amount and cut off date. [online]. HSIDC. Last accessed 19 November 2007 at: http://www.hsidc.nic.in/fs.htm Read More