Principles And Applications Of The Financial Management - Assignment Example

Principles And Applications Of The Financial Management Introduction The decision to invest now or later is a matter that requires careful consideration in relation to the returns to be obtained and both the current and future rate of inflation. This issue relates to the time value of money which is an important factor in investment decisions. In fact (Titman et al 2011) indicates that time value analysis has implications for investment decisions. Alternatives Available In the case of our business there are several alternative investment options available from which an informed choice can be made. They are: i. Constructing new office building now at a cost of $4,000,000 from funds the business currently has; ii. Investing the $4,000,000 until 2017 when the business is ready to start construction of the building, at which time it would either use all of the $4,000,000; or iii. Obtain a bank loan for $2,000,000 to help finance the cost. The returns or expenditures on the various options need to be calculated and assessed in order to arrive at the best decision. The return on investment for the 4 year period is approximately 11 per cent which represents a total of $434,872. Table 1 below shows the calculations. Option - Invest the $4,000,000 and construct building in 2017 Year Amount Interest   2013 4,000,000 3.50% 4,000,000 2014 4,000,000   4140000 2015 4,140,000   4284900 2016 4,284,900   4434871.5 Interest accumulated ($4,434,872 - $4,000,000)     434,872 ROI     11% Table 1 This return of 11 per cent is considered low when the inflation rate is taken into consideration. The forecasted inflation rate for 2013, 2014, 2015, 2016 and 2017 was 1.7, 1.8, 1.9, 2.0 and 2.2 respectively (IMF 2013). This represents inflation of 9.2% for the 5 year period and 7 per cent from 2013 to 2016. (See Table 2 in the Appendix for calculations). Therefore the real return on the $4,000,000 if invested would be 4 per cent (11% minus 7%). If the building is constructed in 2017 the estimated value to construct it would be $4,415,252. See Table 2 for additional information. Computation of Value of Building in 2017 Year Amount Rate Value 2013 4,000,000 2.50% 4,000,000 2014 4,000,000 2.50% 4100000 2015 4100000 2.50% 4202500 2016 4202500 2.50% 4307563 2017 4307563 2.50% 4415252 Increase in value     415,252 Table 2 The table indicates that the change in value represents an increase of $415,252. Based on the interest calculated in Table 1 this would suggest that if the $4,000,000 was invested enough interest would be earned to cover the expected increase in the value of the building. In fact, there would be an excess of $19,620 ($434,872 - $415,252). This money could be used for something else. Here, the assumption is that the value and cost to construct are one and the same. If the building is constructed by using some of the money on hand in addition to 30 year loan of $2,000,000 at an interest rate of 5 per cent, it would cost a net of 1.5% more if an equal amount is invested. Money is available and there is no indication at this time that there are any other uses to which it could be put. In fact, it would represent a net cost to the business if a loan is taken. Additionally, there is no guarantee that the interest rate on $2,000,000 would be the same as that indicated for the $4,000,000 investment. Assessment of Options If the decision is made to invest now, the company would be able to earn rent from the property starting April 2014. The total rental income is expected to be $330,000 over the period April 2014 to December 2016. This represents a return of 8.25% over the period. This return is 2.75% less than that which would have been received if the amount was invested and the building is constructed in 2017. However, if construction starts in January 2017 then it would take some time for the building to be completed. If the completion date for the building is at the end of the year then an additional 12 months of rental income needs to be added for comparative purposes. An additional 12 months would make building from own resources the best option. There is no indication of the completion date for the building if it is started in 2017. This has to be taken into consideration in arriving at a decision. Additionally, there is no certainty that the inflation rate will be the same or even close to what has been forecasted. The fact is, however, that nothing is certain and one has to assume that things will happen in line with what has been predicted. If the decision is made to construct the building in 2017, this would involve a choice of either borrowing some of the money or using up our resources. When the cost of the loan is considered and the length of time that these payments would last, it appears that the option of borrowing $2,000,000 would be the least beneficial of all the options. See loan summary in Appendix 1 for details. Conclusion The best choice is to build now if an additional 12 months of rental income is likely. This would suggest profit of $450,000 which is approximately $15,000 more than the deposit option which represents the next best option. Borrowing at a higher rate than earnings would be very costly for the company. In fact, the company would be paying out approximately $10,740 each month for the next 30 years while receiving $10,000 for rental income. Furthermore, there is no certainty that the rental income will be the same or will increase. The economic situation that is now being experienced in the United States seems to suggest that there is the possibility that the rental income could fall at some point in the future. Thirty (30) years is a long time period and there are so many things that can happen within that time frame. There is just too much uncertainty involved in this option and so it should not be contemplated as shorter time periods are considered to be more predictable than longer time periods Appendix Loan Summary Loan Information   Summary       Loan Amount 2,000,000.00 Rate (per period) 0.417%     Annual Interest Rate 5.00% Number of Payments 360     Term of Loan in Years 30 Total Payments 3,865,117.01     First Payment Date 1/1/2017 Total Interest 1,865,117.01     Payment Frequency Monthly Est. Interest Savings (1.32)     Compound Period Monthly .     Payment Type End of Period . Monthly Payment 10,736.43 Table 3 Source: Vertex42.com References International Monetary Fund (2013). United States 2013 Article IV Consultation. Retrieved from: http://www.imf.org/external/pubs/ft/scr/2013/cr13236.pdf Titman, S., Martin, J.D., Keown, A.J. (2011). Financial Management: Principles and Applications. 11th ed. Pearson Education, Inc. Vertex42.LLC. (n.d.). Loan Amortization Schedule. Retrieved from http://www.vertex42.com/Files/download2/loan-amortization-schedule.html Read More