Accounting and Corporate Finance - Essay Example

? Accounting and Corporate Finance Accounting and Corporate Finance Part A a) Define eachtechnique Net Present Value In simple words, the Net Present Value refers to the value of a future amount today. It basically helps in finding out whether a project is profitable or not. It requires finding out the present value of each future cash flow discounted at a specific value, which is the cost of capital of the project given in the form of a percentage. It follows the principals of having discounted cash flows. The formula to find out the Net present value precisely can be written as: Cash flow (today i.e. year 0) + Cash flow (1 year from now) [/1+r (cost of capital)]^1 + Cash flow (2 years from now)/](1+r)^2 Cash flow refers to the amount of expected cash to be received at a certain point in time X years from now. Cash flows can either be negative or positive. An inflow of cash is a positive cash flow such as an income whereas an outflow is represented with a negative sign and denotes an outgoing cash amount due to for instance expenditure. If the NPV of a certain project equals zero, it denotes that the project is a break-even project; working at no profit-no loss. In simple words it means that the amount of capital invested is exactly equal to the return that would be generated by undertaking the project. A project should be taken up or initiated only if the net present value is at least zero or greater than zero. Even though the calculations of Net Present Value are fairly simple and convenient, it is still quicker to use a financial calculator for these calculations because if there are a large number of cash flows, it will become very inconvenient and time consuming to make the calculations with the formula (Brigham et al, 2010). IRR (Internal rate of Return) IRR is the value where the NPV is equal to zero. It is the optimal value where a project is most beneficial. IRR can gauge the profitability of a proposed investment by taking into consideration the concept of discounted cash flows. IRR is not as easy to calculate as Net Present Value especially if each cash flow is different every year therefore it needs to be calculated using financial calculator. If not, then it is done on the basis of trial and error. The IRR can also be calculated in Microsoft Excel but it begins with guessing. IRR is very closely related to Net Present Value and it marks the next step to the calculation of Net Present Value. The IRR is the yield at which the investments constitute of cash outflows and inflows that occur at a certain time period in a fixed amount (Helfert, 2001). Profitability Index: Profitability Index is basically a measure of the per dollar value of the initial investment spent on a project. This means that if a project’s PI is 1, then the project will give a break-even value of return in comparison to the initial spending done on it. If the value is below 1.0, it means that the project is going to incur a loss and the investment done on it will be greater than the relative return it will give back over the years. If the Profitability Index is greater than 1 then the project can be accepted as it will be giving a profit. For mutually exclusive projects, the project with the higher Profitability Index is a better option. It is calculated as: Present Value of future cash flows/initial cost (ACCA, 2008). Discounted Payback Period: Payback period is another technique used to measure the viability of projects in terms of the number of years that it takes to pay back an initial investment. It is measured in number of years till recovery and the following formula can be used to measure it. No. Of years prior to full recovery+ Unrecovered cost at beginning of year/Cash flow during full recovery year (Kinney et al, 2009). b) Discuss the results for the numerical examples NPV Year CF Project First CF Project Second 0 (1000) (1000) 1 500 500 2 600 400 3 700 300 4 800 100 Project First: (1000)+ 500/1.10^1+600/1.10^2+700/1.10^3+800/1.10^4 = -1000+ 454.54+ 495.86+ 525.92+ 546.41 NPV= 1022.73 Project Second: (1000) + 500/1.10^1 + 400/1.10^2+ 300/1.10^3+ 100/1.10^4 = -1000+454.55+ 330.58+ 225.39+ 68.30 NPV= 78.82 You are also interested to briefly compare, contrast the four techniques, and explain about the popularity of the techniques among users. According to the example for NPV, the project with the higher NPV is to be chosen because it gives a higher return on the value of money spent on it in terms of future values. The higher the value of the Net Present Value keeping all other things constant, the better that project is in terms of profitability in the future. Therefore it is wise to choose the first project with incremental case flows per year as it gives a much greater value than the second project. IRR Project First Using a Financial Calculator, first of, press the compound button and fill in the cash flow editor, add -1000 as the first value and the subsequent values thereafter which are 500, 600, 700 and 800, after which solve for IRR. It gives the value of 47.62%. Project Second Again, using a financial calculator, open the cash flow editor and add -1000 as the first value and then the proceeding values of 500, 400, 300 and 100. Simply press the solve button for IRR. The answer you get is: 14.5% When comparing the results of these two, it is clear that the project with the greater IRR indicates a greater return on investment where NPV equals zero. Profitability Index: Present Value of future cash flows/initial cost Project First 1022.73/1000 =1.022 Project Second 78.8/1000 = 0.0788 The project with the Profitability Index greater than zero should be chosen as the higher the PI, the higher will be the ranking of the project. It actually means that per dollar spent, the first project is giving a profit of 0.022 per dollar whereas the second project is not giving out any profit. Payback Period Project First: Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 -1000 500 600 700 800 Cumulative Cash flows -1000 -500 100 800 1600 1 600-500/600 =0.16 0 0 Payback Period = 2.16 years Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 -1000 500 400 300 100 Cumulative Cash flows -1000 500 -100 200 300 1 1 300-200/300 =0.33 0 Payback Period = 3.33 years c) With reference to above, compare and contrast the four techniques by discussing their advantages and disadvantages. Explain why IRR may be more popular among users? Even though there are many techniques to measure the profitability and viability of projects but some of them are termed as more accurate than others owing to their calculations and ways of measurement. Normally the two most commonly used methods are discussed of, more often than others. These are the Net present value and the IRR. They are somewhat interlinked as well and when NPV is positive and gives a green signal, then IRR is also positive and acceptable for a project. Net present Value signifies the amount by which the project will increase or decrease existing wealth. However when mutually exclusive projects are in question, both these methods need to be performed along with others to get the most accurate results. There can be a conflict of opinion when considering NPV and IRR. It is widely accepted that when conflicts arise between the two methods then clearly, the Net present Value should be used over Internal Rate of return. The Internal Rate of Return tells by how much a project’s cost of capital covers the initial spending. Both these methods are superior to the Payback and Profitability Index as there are flaws with both these methods. In payback period, discounted cash flows are ignored and the value of the same amount of money today is considered no different than the same amount of money after x years let us assume 4 years. However the value of a certain amount of money is much greater than the actual value of money after four years. Other than this, the value of cash flows other than the payback period is not taken into consideration. The payback is blamed for telling no more than he time period in which the money initially invested will be paid back. It ignores everything else which is more important than the time period. The profitability index also is not a solely reliable source to determine whether a project should or shouldn’t be undertaken. It ignores other factors leaving profitability alone. However as per the source given in the question, IRR is used more widely than Net Present Value. The reason for this could be that Internal Rate of return is actually based on the results on Net Present Value, where the answer is factually an interest rate that corresponds to the zero Net Present Value. Since it involves two concepts- NPV and IRR both, the IRR is most commonly used nowadays followed closely by Net Present value. NPV is a determinant of the earnings of a project as per a desired return. However IRR tries to determine a desired rate for a specific project which makes it go a step ahead of the NPV. Owing to the fact that both of them are valid and reliable, both these methods are used frequently (Tang et al, 2003). While making accept/reject decisions, normally firms take all of these in to account and many more including Multiple Internal Rate of Returns for multiple IRRs, Discounted payback method, Accounting rate of return and Modified Internal rates of return. Where Net Present Value (NPV) is a measure of judging profitability of a future project in today’s terms, Internal Rate of Return (IRR) is a scale of defining margins of safety on a particular investment. Profitability Index measures the risk of a project like IRR. Payback period measures the risk and liquidity both of a project but does not take real values of cash flows into account. A longer payback period is an indication of money tied up in an investment for too long increasing the risk associated with a project (Tang et al, 2003). Part B: Investment ratios a) Define and explain in detail four ratios concerning earnings or dividends that can be used while considering investment in the shares of a company. 1) Earnings per share As indicative of its name, the EPS is a measure of the profit earned per each share of common stock. This measure indicates the extent of profitability of a company. It is one of the most significant indicators of share price and gives rise to the Price/Earnings ratio. It is calculated with the following formula: Net Income- Preference Dividends/Average of Total shares issued An important point to note here is that an average of shares issued is used instead of total shares to make this calculation more authentic because shares might fluctuate at a certain point or at a specific period of time therefore it is wiser to use an average (Bull, 2008). . For instance a company earns a net income of 50 million Dollars and pays 5 million dollars as preference dividends and has 20 million shares, than the Earnings per share would be: 50-5/20= $2.92 2) Market Price per share This ratio shows indicates the amount of money an investor is ready to pay per dollar of profit. It is calculated as: Price per share/Earnings per share If a firm has a strong standing in the financial market, and is stable in its growth then it is likely to have a higher market price per share or price/earnings ratio. It is a clear indicator of willingness to pay investors of a company a profit. A higher ratio would be considered good when comparing the two forms. It measures the price of a share in comparison with the yearly profit earned by a firm on each share (Bull, 2008). 3) Dividend per share Dividend per share is defined as the amount of dividend to be paid per every ordinary share issued. It is the entire sum of dividends paid per year divided by ordinary shares issued: DPS= D/S Giving out a higher dividend per share means that a company is confident enough to pay out its investors because it expects to grow and is stable. Here what is being talked about is the cumulative dividend which needs to be paid out, not the one that has been paid. It would also exclude any special dividends paid out as per the dividend policy. The higher this value, the better it is for the company (Bull, 2008). 4) Par value per share In simplest words, par value means a stated face value of a share, a value at which the share was issued. This value stays constant regardless of the market price. It is initiated as the minimum price of a financial instrument at which it will be sold. If the price of a share in the market exceeds the par value, it means that it is being sold at a premium whereas if it is being sold at a price lower than its face value, it means that the shares are being sold at a discount and is a negative indicator mostly. The higher the par value of a share, it is a strong indicator of its confidence level in the market that the share will be sold at a higher price (Bull, 2008). b) Advise the tutor and make your recommendation giving appropriate reasons for your advice. Ratio Analysis is an important factor in determining the health of a company as well as its likely future trends based on its past results. There are different varieties of ratios which measure a firm from different angles and perspectives. These include profitability ratios, liquidity ratios, debt management ratios and market value ratios. The profitability ratios measure a firm’s profitability and include measurements like profit margin on sales, gross profit margin, net profit margin, return on total assets and return on total equity. Liquidity ratios measure the extent to which a company’s assets are easily convertible to cash and whether the company is liquid enough to pay off its debts today if it has to. These ratios include the current ratio; the ratio of assets to liabilities. Acid test ratio which measures actual liquidity in real terms excluding stock which is the least liquid commodity of all and asset turnover ratio which measures sales in terms of total assets. Debt management ratios measure the extent to which the company is indebted. Finally, the Market Value Ratios measures past trends of investors and predict future performance of the company based on those historical and current trends. This form of measurement is volatile to market trends and subject to rapid changes as well. These Market Value ratios that include EPS, DPS and MPS depend on the other 3 sets of ratio analysis. If the profitability and liquidity of a company are high and the company is in a strong position to pay of its debts easily, then it is highly likely that the company will have greater investor trust and a stable position in the market. Ultimately, the stock prices of the firm’s shares will then also be high attracting investors to invest in a firm that promises future profitability, stability and consistent growth. These ratios basically measure investors’ willingness to invest in a certain company and weighing the benefits they will receive on investing in a certain company that is likely to give them better future prospects. The following information is about two companies Alpha and Beta with information and statistics regarding Market Value Ratios of the 2 companies which include earnings per share, market price per share, dividend per share and par value (face value) of the shares. Investors will expect a greater return in whichever company they invest and would want a higher value as compared to other companies that could be potential competitors of that company. In this case investors would be happy to invest in a company that will give them a higher return to them per share they buy. They would also want that the company they invest in has a higher market value than the rest and its shares are being sold at a greater value than its face value and that of a competitor company. Any investor would consider it a good option to spend his money where he can expect the highest return per share in terms of dividend to be received on each share bought (Chen et al, 1981). Alpha Beta Earnings per share 36 pence 48 pence Market Price Per Share 504 pence 384 pence Dividend Per Share 10 pence 30 pence Par value per share ?1 ?1 The Earnings per share for Alpha at 38p is less than that of beta at 48p. This indicates that Investors who invest in Beta Company earn a higher value per share for each ordinary share. This shows that the profitability of Beta is higher than that of Alpha. The market price per share of Alpha is very high indicating a steady growth whereas it is lesser for Beta at 384p. Alpha is being sold at a greater market price than Beta meaning that it is probably being sold at a premium. A higher market price is an indicator of growth and stability. However market price keeps changing and could change within days. Dividend per share is higher for Beta than for Alpha at 30p as compared to Alpha’s 10p. This means that Beta is paying its investors higher than Alpha per share issued. Par value per share of both companies is the same at 1 dollar. In comparison of the two companies, the benefit that investors will get s greater for company Beta which means that it is a safer option in terms of considering doing an investment (Bull, 2008). References (2008). ACCA, 2008/09. Paper F9, Financial management (FM). Wokingham, Kaplan Publishing. BRIGHAM, E. & EHRHARDT, M. (2010). Financial Management Theory and Practice. United States of America: Cengage Learning. BULL, R. (2008). Financial ratios: how to use financial ratios to maximise value and success for your business. Amsterdam, CIMA. CHEN, K. H., & SHIMERDA, T. A. (1981). An Empirical Analysis of Useful Financial Ratios. Financial Management. 10, 51-60. HELFERT, E. A., & HELFERT, E. A. (2001). Financial analysis tools and techniques : a guide for managers. New York, McGraw-Hill.  KINNEY, M. R., & RAIBORN, C. A. (2009). Cost accounting: foundations and evolutions. Mason, OH, USA, Thomson/South-Western. TANG, S., & TANG, H. J. (2003). TECHNICAL NOTE : THE VARIABLE FINANCIAL INDICATOR IRR AND THE CONSTANT ECONOMIC INDICATOR NPV. The Engineering Economist. 48, 69-78. Read More