Analysis of the Production Plant Project and Its Perspectives - Assignment Example

The Final Report for CEO and CFO Initial Public Offering: Superior Inc. has been planning to go public with an Initial Public Offering (IPO) in the stock exchange. This was considered to encompass the company’s future expansions. As equity financing is an effective way to generate more finance for investments, IPO is on the top of the list, when considering additional sources of income. As a new investment, the company is also evaluating a new production plant project. Some of the key factors to be analyzed in making a final decision regarding IPO are Profitability and the Capital Structure of the company. These aspects are presented in the following section: Profitability: The company has recorded high profits 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). The company is effective in generating profits from revenue. This profitability is a very important measure as it indicates the effectiveness of the company in maximizing shareholder wealth. The high earning capacity of the firm will make it very appealing to the potential shareholders (Samuels et al, 2000). Gearing Ratio: 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. This is a clear indication that the company has been underutilizing its borrowing capacities. An optimum gearing ratio (debt to equity 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. It is imperative that the company utilizes its borrowing ability and raises additional capital in terms of debts. This will make the company highly geared for future expansions and improve the confidence of shareholders on the firm. Recommendation for IPO: 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 the 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 Production Plant Project: The proposal for the new production plant has to be financially justified for Superior Living to invest in the project. Hence 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. These measures will help identify whether the project will increase the firm’s value and if so, by how much. The results of the investment appraisal analysis are discussed in the following sections. Net Present Value (NPV): The Net Present Value (NPV) for the project at three hurdle rates (10 %, 15 %, and 18 %) was 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 $ 790 K and $ 470 K respectively. Hence it is evident that the project’s NPV is positive and 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 %. Payback Period: The payback period, though not a prominent method to be considered when dealing with future cash flows, is the simplest of all methods. It indicates the period taken for the project to generate cash flows equivalent to the initial investment. The cash flow from the project has been computed at around $ 1.4 million whereas the initial outlay is about $ 4 million. The estimated data given have revealed that the project has a payback period of about 3 years. The useful life of the project is estimated to be 5 years. This method does not consider the cash flows generated after the payback period. The only indication that the project is profitable is that the payback period is lesser than the life of the project. Hence the result indicates that the project is favorable. Internal Rate of Return (IRR): The Internal Rate of Return (IRR) for the project has been computed to be 23.1 %. The IRR is the rate that corresponds to the cost of capital at which the NPV is zero. As this rate is significantly higher than the actual cost of capital (10 %) and also the other two hurdle rates (15 % and 18 %), it is evident that the project will not incur any losses even when the discount rate goes up to 23.1 %. Modified Internal Rate of Return (MIRR): 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 reinvestment 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. Recommendations: 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. To raise the necessary initial outlay, Superior can choose to raise funds by issuing new shares or by borrowing long term loans. 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 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 the initial public offering. Also, the production plant project should be accepted by Superior Living. References 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