The Public Offering of Shares - Essay Example

Applied Finance for Decision Making Provide a final full 4-6 page report to the CFO and CEO which encompasses financial pros and cons and final recommendations for Superior going public and the new production plant. Be sure to include a discussion on what hurdles rates the production plant project would not pass, the debt versus no debt option (associated risk and impact to financial statements), and key financial metrics for the senior management team. Make sure your metrics include payback period, net present value, internal rate of return, and modified internal rate of return. Finally, be sure your recommendation is based on sound financial principles. The company has been planning to go public in the next 6 to 8 months with an initial public offering (IPO). This step was planned to further the company’s expansions. A new production plant project is also under consideration. The company has recorded high profitability ratios in the last few years. The net margin is computed for the company which is the ratio of the net profit available to the shareholders to the revenue generated from sales. Net Profit Margin = Net Profit / Sales Net Margin of Superior in Year 2003 is 11.77% ($29,414 / $ 250,000) which has increased by 0.70% when compared to the net margin in 2002, which came up to 11.05 % ($ 25078 / $ 227,000). It is evident that the company is effective in generating profits from the revenue. The high earning capacity of the firm will make it very appealing to the potential shareholders (Samuels et al, 2000). The gearing ratio of the company is very low (2% - 3%) over the three years. Though the long-term debt has increased by $400,000 over the three years, the debt to equity ratio has not increased. The company is not utilizing its borrowing abilities as an optimum gearing ratio would be around 50%. However, by going public, the company will be able to raise additional Equity capital within a short period. This will again lower the debt to equity ratios of the company. The company, with its plans for rapid expansions, can then effectively utilize borrowing and long term loans to finance its projects, as it will be easier to obtain debt when the gearing ratio is very low. The initial public offering, followed by raising capital in terms of debt, will create a very positive image in the minds of the investors. Superior Living will be rightly taken as the company with the aim of fast expansion and rapid growth. This speculation will drive more investors towards the company increasing the demand and thus increasing the company’s value. Hence it would be advisable for Superior Living to go ahead with the plan of initial public offering. However, care has to be taken to ensure that the desire for rapid expansion is put into action immediately and profitable new projects are taken up by the company (Burke and Wilks, 2007). The plant project was analyzed using investment appraisal techniques including, PayBack period, Net Present Value, Internal Rate of Return and Modified IRR. The project was also reviewed at various hurdle rates to examine its returns and its effects on the Net Present Value. The Modified IRR was also examined and for different cost of capital rates. The results of the investment appraisal are discussed in the following section. 1. The Net Present Value (NPV) for the project at three hurdle rates were examined. It indicates the present value of the discounted cash flows that will be generated by the project. Various discount rates were used to discount the cash flows (Samuels et al, 2000). The NPV at the cost of capital (10%) was found to be around $ 1.4 million. When the hurdle rate was increased to 15% and 18%, the NPV was found to be $ 790K and $ 470K respectively. Hence it is evident that the project’s NPV is substantial at various hurdle rates. However, as evident from the NPV values, the project will not be a very profitable one, in case the hurdle rate crosses 18%. Hence, the project was found to be profitable at all hurdle rates equal to or below 18%. 2. The payback period, though not a prominent method to be considered when dealing with future cash flows, has revealed that the project has a payback period of about 3 years. The cash flow from the project has been computed at around $ 1.4 million whereas the initial outlay is about $ 4 million. 3. The internal rate of return and modified internal rate of return were also computed for the project. The IRR has been found to be 23.1% for the project. The MIRR is the internal rate of return with the assumption that the cash flows are re-invested at a particular rate of return as and when they are generated (Lefly, 2007). The MIRR for the project was computed using the re – investment rate of 12%. The MIRR for various hurdle rates was found to 18%. This is consistent with the values found in NPV. Hence it is evident from the MIRR calculations as well that the maximum hurdle rate acceptable for the project is at 18%. As both the IRR and MIRR values are much higher than the cost of capital which is 10%, it is evident that the project would flair well. However, it has to be ensured that the hurdle rates stay below 18%, so that it is profitable to the investors. All the above metrics indicate that the production plant project is a very profitable one and hence it can be concluded that the firm can go ahead with the project. In order to raise the necessary initial outlay, Superior can choose debt to be a source. As discussed earlier, the gearing ratio of the company is lesser and raising finance for this project from debt will increase the debt to equity ratio. This will make the potential public investors to realize that Superior Living is geared for future growth and expansion. Moreover, the risks associated with debt financing are very less as the company’s current interest coverage ratio is very high. From the above discussions, it is clear that the company has to go ahead with the plan of initial public offering. Also, the production plant project should be accepted and financed by debt. Bibliography Burke, L. and Wilks, C., (2007), Management Accounting – Decision Management, 4th edn, CIMA Publishing Lefly, F., 1997, ‘Modified Internal Rate of Return: Will it replace IRR?’, Management Accounting, Vol. 75, No. 1, January 1997 Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 2000, Management of Company Finance, 6th edn, Thomson Learning, London Read More