Investment Appraisal - Assignment Example

? An Analysis of a Case Study on Investment Appraisal An Analysis of a Case Study on Investment Appraisal Question Tyneside gravel organizations are an organization that is in the growth stage in the organization development cycle. This is especially because it’s in the growth stage that an organization is characterized with a need to expand in terms of its size and the number of customers. The growth stage is also evidenced by the existence of sufficient resources that will be enough for the organization to open up to new opportunities. Tyneside gravel organization is currently faced by three main decisions. The first decision that Tyneside organization needs to consider is the need to expand as a way of meeting the demand of more customers. Through expansion it will be possible for the organization to open up to more opportunities. The organization needs to make a stable decision on the need to expand especially because one the area they seek to move in doesn’t have enough sand and gravel which would only add to the inconveniences (McEvoy, 2012). Tyneside gravel organization also needs to make a decision about having a similar stand especially for the autocratic managing director who fears taking into new and innovative methods which are mostly useful in adding to the success of any business. Tyneside organization is also faced by a third and very important decision of choosing between the most viable expansion site between Cleadon Hill and Burdon Farm through a consideration of various factors such as market and cost of leasing. Market is one of the major factors that affect the success of a particular organization because it affects both internal and external efficiency thus making it necessarily for Tyneside Gravel to put it into consideration. The issue of the market should be considered relative to Claedon Hill especially based on the fact that one of the management has secured a promise with a top contractor in the region to buy from the company should they decide to take on the Claedon Hill farm. By having the Claedon Hill as a site the company is more assured of a constant income since it will be able to make 240000 tons per year for the first year which is an assured estimate due to the Mowlem agreement. The company also estimates market sales of about 200000 tons per annum for the next three years. Lease is also a factor that the Tyneside Company should consider on the basis of the actual cost of the lease and the amount the company would spend on development of the lease and the time taken for the development as this is likely to affect the viability of the company in future. On signing the Claedon Hill lease Tyneside company will have to part with 500000 dollars which will be paid immediately while the time taken to develop the site will be a year which will cost the company 95000 dollars including the installation of machinery required for use in the site. The Tyneside Company on the other hand should also be able to analysis the Baldon Farm market which has a number of customers within the site but its viability will highly depend on securing more customers on the south. Market sales figures are expected to attract a 300000 tons buying power per annum. On a more positive trend the company expects to have a build on its market by the fifth year of about 900000 tons per year which is expected to continue over the remaining part of the project. The cost of lease in the Baldon Farm too will take into account the actual cost at the time of immediate lease, cost of development and the time that will be taken to end the work. The firm has been offered a deal to pay 700000 dollars at the initial lease coupled with the cost of development which is expected to be about 400000 dollars especially because the area is remote and requires more of infrastructural development. Question 2 Operational risks Every business that seeks to expand its ground is faced by several challenges that are commonly referred to as business expansion risks. Competitive business expansion risk refers to a risk that a business faces in putting out its products to a new market where other players dealing with the same products exist. Tyneside Gravel for example seeks at putting up a new site at the South where it had not previously exploited and may therefore have to deal with other sand and gravel dealers who were previously located at their sought out locality. Strategic business risk of expansion is likely to face an organization especially if fails to meet up its laid out objectives for gaining ground following the expansion. Operational business expansion risk on the other hand refers to a type of risk that goes beyond financial and market wide risks to take into account the risks that Tyneside gravel organization may face challenges resulting from breakdowns in its internal processes, poor management and staff errors or interference to its systems. Solutions SWOT analysis is an important business strategy that helps a business to understand its strengths, weaknesses, threats and opportunities to understand their position in the market and be able to gain a competitive advantage. Tyneside Gravel as an organization can use its financial strengths to navigate their opportunity for expansion to overcome the threats of divided management and the weakness of not being familiar with their new site (McEvoy, 2012). A solution to dealing with the competitive risk that the organization faces is to be able to design its organization in a way that the customers come first as this will help in improving efficiency in quality of products and services. By understanding the needs and expectations of their customers, Tyneside Gravel will manage to emerge top of their competitors and become a leading sand company in the area. The company also faces a strategic business risk which can be eliminated by having managers who are more united in a common organizational mission and vision. Currently the company has a group of directors who follow their own opinions more for their own satisfaction other than for the sake of advancing the performance of the company. Strategic risk can be dealt with by starting with the director who prefers constancy to change which is most necessary for growth and development of companies. Strategic business risk of expansion which is likely to face the business can also be dealt by putting in place measures in advance that will help in ensuring a procedure has been laid down that clearly states how potential challenges will be solved. Operational risk can be dealt with by reviving the company’s management that is majorly dependent on inside competition in the sense of having the best job in a way that makes it difficult for members of the top management to focus on the goals that have been put forwards by the organization. An organization success both in the short run and long run is mostly dependent on the efficiency and unity of the management team. Question 3 Cash Flow Presentation Analysis Tyneside cash flow presentation takes an incremented cash flow format, which makes it difficult for cash inflows and outflows to be correctly identified. This is especially because at the end it presents the discounted cash flow other than the net income of the company. By using incremental cash flow the company makes the mistake of including opportunity costs, indirect effects and takes in the position of the business in both ends of having the business and being without it. This can be corrected by having Tyneside organization using the incremental cash flow and the accounting income as a way of catering for both ends. Claedon hill project incremental cash flow takes into account lease and development and includes all indirect costs Tyneside Company will incur should they choose this project. This can be corrected by using a cash flow that only takes into perspective only the cash inflow of the project, free cash flow and the initial cost of lease. Claedon hill project cash inflows also show a great variation in figures for example the first year cash inflow is 415000 dollars while the fifth year shows a 51000 dollar cash inflow. This can be corrected by having more realistic cash inflows which do not indicate variations that are too large. The Baldon Farm incremental cash flow also indicates a weakness of taking into account to many factors in the cash inflows especially for the first three years where the inflow is negative as a result of zero productivity. This can be corrected by having a cash flow that considers the years when production is taking place. Question 4 Financing decision versus the investment decision There is a difference between Tyneside Gravels investment and financing decision. The company investment decision seeks at investing funds in any of the two sites with the objective of earning a percentage increase in its value depending on the project with the most favorable net present value. Its financial decision on the other hand seeks to acquire financial assistance from outside where the company has put up a bank loan in its cash flow incase of Bardon Farm project. The issue can be corrected by having one of the above to avoid a situation of inflow and outflow of cash which is the case incase of having both. The company for example shows an addition to the initial cost of lease to other costs that are incurred within the business and therefore takes into perspective all indirect effects that are taken in the cashflow which develops a sense of unrealism. The solution rather would be the use of a net income in cash flows as this would help in ensuring wrongful decisions are not arrived at within Tyneside Gravel Company. By the use of cash flows the company should be able to narrow its scope of financial decisions to a total of cash inflow over the life of the project, initial project cost and the free cash over the life of the project. This is therefore a better method for the company to determine its net present value as it doesn’t have to consider the indirect costs and opportunity costs as is the case with incremental cash flow. Question 5 Cash Flows Evaluation The net present value of 121.11 has a payback period of 4.54use it gives a better profitability index of 0.47 % with the low rate of return of on the investment. It implies that if the rate of return is increased, the performance of this project can exceed the current profitability index. The crossover rate is 12.35 percent, which places the present values of the two projects at a uniform net present value of 161.95 percent. Incidentally, using a rate of 14 percent as a crossover rate, the first project attains the initial net present value of 121.11 and the second project maintains 94.10. Therefore, the best NPV in the two projects is 225.45 pounds, while the best internal rate of return is 19.98 percent. In the two projects, the best profitability index is 11%. This is because it provides the best net present value for the two projects. Crossover rate is defined as the cost of capital that equalizes the net present value of two. In essence, it is the crossing point or the point of intersection where the NPV of one project crosses over the other project. Crossover rate is very essential for preparing analysis report on capital budgeting since it provides information to the investing firm about a case scenario during the period when the present feasible project stop being feasible. Question 6 Risks associated with selection of either investment This is the decision the firm is making, the owner and the management, with the face of continued growth Answer: project 1 Incase the firm chooses the Cleadon Hill investment, it faces the challenge of having an unstable market which will be dependent on whether it is able to acquire a new construction site in the near future. The need for land to be restored to its original state is also a tough challenge for the organization as it will have to stop its work long before the expiry of the lease to meet up this requirement. The sales at Cleadon Hill will only begin after a year of preparing the site which will most likely affect the company’s position. Answer: project 2 Baldon garden on the other hand presents a major challenge to the company especially because its development will take almost two years within which no sales and profits will move in the company. This will therefore greatly affect the cash flows of the company in the long run owing to the two years of zero production. The company management is also faced by a challenge of financing as the cost of lease is quite high and therefore internal financing would not be enough leading to a need for a loan. The risks of external borrowing precede the risks of internal borrowing thus making it more complicated for the company. Baldon Farm project also faces a risk of market failure especially because it’s located in a remote area which not only adds on the cost of infrastructural development but also places its viability on a narrow end especially because it solely depends upon winning South Shields customers. Question 7 Advice to the Management The best project for Tyneside Gravel to consider is the Claedon Hill construction site. This is because the company will lease at a lower cost, finish on the development of the site within one year and use its own internal financing, as is evident in the above discussed case, based on the 12.35% cross over rate. Question 8 Issues with forecasting methods and how to minimize them Answer 1 Through sensitivity analysis it will be possible for the company to analyze how the profitability of the chosen project will affect the company sales and costs. Scenario analysis on the other hand will use various assumptions against the project chosen. Answer 2 Tyneside Gravel as a company in the growth stage needs to realize the need for having the right decision as a way of eliminating problems such as having the wrong forecasts in terms of overestimated or underestimated figures. Conflict of interests which is a visible problem especially in Tyneside Gravel where the management are normally divided should be eliminated as this is likely to affect the viability of the project. Tynaside gravel may also face the problem of bias in coming up with estimates and forecasts and its therefore necessary for this bias to be sufficiently eliminated. By using the right selection criteria it will be possible for the company to take the most viable project in terms of profitability and expenses efficiency. Answer 3 Optiminism refers to the ability of a company to make decisions on the basis of a positive intuition while persinism is decision making that takes on a rather negative sense of understanding circumstances. Answer 4 The company should be rather optimistic but at the same time they have to put in place measures that can help answer to uncertain and unpleasant circumstances such as the recession as this is likely to make assist the company a great deal in coping with uncertainty. Answer 5 Tyneside Company can also look at sensitivity by a consideration of how hard the process of choosing a project is and appreciating the difference in the projects profitability, market sales and the associated costs of supporting the projects. Answer 6 Sensitivity analysis can be used in the Tyneside Company to provide a complete analysis that will assist in the comparison of the projects effects on costs, profitability and sales. Scenario analysis on the other hand would bring in a number of assumptions upon which they will measure the two projects. Answer 7 By putting optimistic and pessimistic cases it would be possible for the company to change the cost of lease and development and the sales after 5 years to the end of the project. Question 9 As the financial advisor my argument would be based on the viability of the project chosen in terms of profitability, cost of leasing and development and the expected return on the investment coupled with the net present value. My justification would be the selection of the project with the highest positive NPV, notable market share and fair cost of lease and development. The company should be able to change its management approach to expansion. The company should also be able to use cash flows that are appropriate to avoid erroneous accounting. The project chosen should be after a complete budget analysis. Reference McEvoy, C. P. (2012). Tyneside Gravel CO ltd: Case study on Investment Appraisal. London: LoughBorough University of Technology. Read More