The Construction of Building - Assignment Example

? Finance and Accounting of the of the Table of Contents Introduction 3 Question 3 Question 2 4 Question 3 5 Question 4 6 Conclusion 9 References 10 Introduction The project deals with a company located in Findlay, Ohio. The company has presently accumulated an amount of $ 40000000 in order to construct a new office building. Now the main question which arises is that whether the building would be constructed in the year 2013 or in the year 2017. If the building is started being constructed in the current week, then it would not be completed within 31st December 2013 and would require 3 months more to be rented. At that time, the rent would be $ 10000 per month. The next question which arises is that, whether the entire amount of $ 4000000 would be given from internal sources of financing or an external loan should also be taken. If external loan is taken, then it would be obtained to an amount of $ 2000000 having an interest of 5% per year. If the building is constructed in 2017, then the accumulated amount of $ 4000000 can also be invested and an interest on such investment @ 3.5% would be obtained. The cost of the building would also be incrementing by 2.5% per year. Return on Investment has been calculated by taking into consideration that the interest rate on the investment of $ 4000000 is 3.5%. Question 1 Return on Investment Particulars Amount (in $) Invested Amount 4000000 Return on Investment for the year 2013 (from October to December) 35000 Return on Investment for the year 2014 140000 Return on Investment for the year 2015 140000 Return on Investment for the year 2016 140000 Total Return on Investment 455000 Return on Investment (in Percentage) 11.375% The return on investment is a performance measure that is used for evaluating the efficiency and accuracy of any investment (Megginson & Scott, 2008). It is an effective performance measuring tool, which helps in taking appropriate decisions by the company (Rachlin, 1997). It helps in avoiding flaws in the managerial decisions taken by any company. If the accumulated amount of $ 4000000 is invested, then an annual interest @ 2.5 percent would be earned every year till 2017. The interest earned in the 1st year is 35000 and the interest earned in next three years is $ 140000 each year. Total interest earned is $455000. Return on investment is 11.375%. Question 2 Inflation rate is described as the continuous increase in the price level of goods and services. It is calculated as the annual percentage rise. Findlay is the name of a city in Ohio, United States. The Inflation rate of United States, as projected by International Monetary Fund, has been shown below: (International Monetary Fund, 2012) Within the time period of 2014 to 2018, the inflation rate as assessed by the Personal Consumption Expenditure Price Index would rise to some extent and then it would remain constant at a rate of 2 percent (CBO, 2013). Determination of the projected annual inflation rate of Ohio is also necessary. ‘The Ohio Department of Transportation’ has estimated the Inflation Rate of Ohio to be: High Most Likely Low 2013 8 % 5.7% 3% 2014 10% 5.5% 3.5% 2015 8.95% 5.9% 3.5% 2016 7.5% 4.5% 1.5% 2017 7% 4% 1% Question 3 It has been stated that the value of the building would be increasing by 2.5 percent every year starting from 2014. The increment has been shown in the following table: Particulars Amount (in $) Present value of the building 4000000 Value of the building in 2014 4100000 Value of the building in 2015 4202500 Value of the building in 2016 4307562.5 Value of the building in 2017 4415251.56 Net Increase 415251.56 It can be seen from the above mentioned table that the value of the building increased yearly. The value of the building in 2014 increased to $ 4100000. It increased to $ 4202500 in the year 2015. In the year 2016, the value increased to $ 4307562.5 and finally in the year 2017, the value increased to $ 415251.56. Question 4 Option 1 Paying the whole amount from the internal sources of financing 4000000     Net Profit from 1st April 2014 10000 Net profit for 2014 90000 Net Profit for 2015 120000 Net Profit for 2016 120000 Net Profit for 2017 120000 Using the first option i.e. financing the entire $ 4000000 out of internal sources of financing, the income earned during 2014 is $ 90000, and the income earned from 2015 to 2017 is $ 120000 each year. Option 2 Internal Sources of Financing 2000000 Bank Loan 2000000 Interest on bank Loan 100000 Net Profit from 1st April 2014 10000 Net profit for 2014 -10000 Net Profit for 2015 20000 Net Profit for 2016 20000 Net Profit for 2017 20000 Using the second option, the company has a loss of $ (10000) in the 1st year followed by an annual profit of $ 20000 in 2015, 2016 and 2017. Option 1 Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Cash Outflow 4000000         Cash Inflow   90000 120000 120000 120000 Net Cash Flow -4000000 90000 120000 120000 120000 Present Value Factor   0.833 0.694 0.579 0.482 Present value of Cash Inflows   75000 83333.33 69444.44 57870.37 Net Present value -3714351.852 Option 2 Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Cash Outflow 4000000         Cash Inflow 2000000 -10000 20000 20000 20000 Net Cash Inflow -2000000 -10000 20000 20000 20000 Present Value factor   0.833 0.694 0.579 0.482 Present value of cash inflows   -8333.33 13888.89 11574.07 9645.06 Net Present value -1973225.31 There are several factors that must be taken into consideration prior to making any investment decision (Besley & Brigham, 2008). The net present value would help to explain the present investment in terms of the amount of cash or money in future (Brigham, 2013). At the time of evaluation of the financial aspect of any business associated with selection of any one investment project out of two available options, the Net Present value method assists in making decision by finding out the financial implications of both the projects (Bhattacharyya, 2011). The net present value is also defined as the cycle of cash flow, including both cash inflow and cash outflow. Generally, the future cash flows are expressed in present values and these cash flows are termed as cash inflows. The net present value is always calculated by subtracting the initial investment or the initial cash outflow from the present value of all the cash inflows (Ehrhardt, 2013). In this study, net present value method has been used to find out that which option would be favorable for conducting the business. A time period of 4 years has been taken into consideration to find out the NPV based on both the options. It can be seen that the net present value using option 1 gives higher negative value as compared to option 2. Thus, option 2 should be adopted by the company, as it would help the business in getting back the invested amount in much lesser time as compared to option 1 (McAllister, 2009). So the company should finance its building construction by taking a loan of $ 2000000 and internal financing of $ 2000000. Conclusion The business would have a return on 11.375 percent, if it makes an investment of $ 4000000 till 2017. The value of the building would be rising to $ 415251.56 in 2017. However, if the accumulated money is invested and a return of 11.375 percent is obtained in 2017, then it would exceed the amount of money required in building construction. A time period of 4 years has been selected for computing the Net Present Value using both the options. However, option 2 should be adopted by the company as it would help the business in getting back the invested amount in much lesser time as compared to option 1. Thus, the business should invest $ 2000000 from internal source of financing and should take a loan of $ 20000000 at an annual interest of 3.5 percent. References Besley, S., & Brigham, E. F. (2008). Principles of finance. Connecticut: Cengage Learning. Bhattacharyya, D. (2011). Management accounting. New Delhi: Pearson Education India. Brigham, E. F. (2013). Financial management: Theory & practice. Connecticut: Cengage Learning. CBO. (2013). The budget and economic outlook: Fiscal years 2013 to 2023. Retrieved from http://www.cbo.gov/sites/default/files/cbofiles/attachments/43907-BudgetOutlook.pdf Ehrhardt, M. C. (2013). Corporate finance: A focused approach. Connecticut: Cengage Learning, 2013. Print. International Monetary Fund. (2012). Projected annual inflation rate in the United States 2011-2017. Retrieved from http://www.statista.com/statistics/244983/projected-inflation-rate-in-the-united-states/ McAllister, E.W. (2009). Pipeline rules of thumb handbook: A manual of quick, accurate solutions to everyday pipeline engineering problems. Oxford: Gulf Professional Publishing. Megginson, W. L., & Scott B. S. (2008). Introduction to corporate finance. Connecticut: Cengage Learning. Rachlin, R. (1997). Return on investment manual: Tools and applications for managing financial results. New York: M.E. Sharpe. Read More