The Profitability of the Business - Essay Example

Investment decisions are decisions that should be considered with clear minds since they either indicate whether one will stay in business or not. We therefore use ratios in determining whether to take up certain investment opportunities. This project uses cash on cash ratio, DSCR, NPV and IRR to determine whether a project of purchasing a house is worthwhile to venture in. the use of pro forma financial statement analysis is also used to find out whether the projected cash flow from the project reflect viability of the business or otherwise. The analysis is found to support the profitability of the business, hence Alexander, is advised to take up the project. Introduction Edward Alexander wants to invest in real estate, thus building equity based future. He believes that increasing his return would be best done by managing his own investment. He thinks that paying someone for rent is a not a smart idea since it’s simply a waste of money. Alexander wants to invest in the popular Beacon Hill area and thus he initiated a thorough search about the area. He found out that the value of the area is increasing rapidly due to the natural advantages surrounding it such as Charles River and public parks. The properties were listed in the market from $299,000-2.4 million dollars. The rent for a one bedroom apartment in that area ranges between $1100-1600 per month and the two bedroom apartment ranges from $1600-$2100. Alexander has $80,000 cash and the required investments about 21.5%. Thus, Alexander needs $70,000 in cash. Alexander decided to invest in a complex priced at $350,000 that needs renovation of $165,000, he decided to invest his $80,000 and get a $19,000 from an investor and take a mortgage loan of $450,000. Taking into consideration of miscellaneous costs and fees that totaled $549,000, consequently, a mortgage higher than $450,000 would result in a higher interest of $2000 during renovations. This paper will analyze Alexander’s options with regard to this property. And provide forecast of the most important financial ratios. The cases regarding to Alexander Edward, who is a graduate from Harvard College, and recently working in a biotech firms since four years. Due to the good knowledge of the location, and his perspective to give a hand in real estate business included their urge to have a home a good location, he started to explore the location with all possible sources. The business in the sector is on its peak and growth is very good since last ten years. The home liked by Alexander is almost priced at $500,000 to $700,000 category. To avail a home it need to take a personal loan or mortgage loan, as the savings in hands are $80,000. The recent availability of a home for sale, costing an asked price of 350,000 and it will need some additional expenditures of reconstruction and renovation. This cost of renovation is 165,000. The property is according to the desires of Alexander, with four floors and suitable location. Now it is the project purchase this property by means of loan with its viability to its future benefits. Summary Project Statistics Sources of investment, expense, operations and finance cost are some of the basic categories of the project statistics. Equity and debt are the two possible sources of investment, with equity contributing to $99,000 debt contributing to $450,000 to the investment. Legality costs and renovation costs are some examples of other uses of money involved. In addition, a $24,700 of IDC cost with $1,300 of tax and a $4,500 finance cost are involved. There are a total four floors in the house project where 3 of those floors have 2 bedrooms and a single floor with only one bedroom. i. Cash-on-Cash Minimum results of 13.38 are arrived at when a generic cash on cash analysis is carried out and this result is considered to be good for the investment. With this analysis, a maximum cash on cash of up to 25.42 can be achieved. The cash on cash obtained is responsible to show us the return on investment on the first year. It therefore adds up to a ratio that is favorable for the health of a business. ii. DSCR The current Debt-service coverage ratio is estimated to be 1.28, though this value can rise up to 1.52 in the future. The recommended ratio is always supposed to be higher than 1, however, in our situation, the figure is higher than 1 but to the lower side. This ratio can be used to predict that the project’s future has an increasing trend. It is therefore advisable for Alexander to carry on with the project since the ratio is promising to meet the debt obligation and yield higher profits. iii. Quantitative Risk Analysis To measure the quantitative risk analysis of the project, we use the monetary values of the variability and the information regarded as sensitive about the case. The monetary outcomes can be measured using the values of the Net Present Value (NPV), Debt Paying Ability, and the bearableness of the returns of the return on investment. In the case of this project, all the three figures above are positive hence a positive image of investment is depicted by the quantities. The case sensitive information which is the second tool used for this analysis, consists of information that is related to decision making on the alternative investment and possible benefits to the project. Such are the measures being taken in consideration by Alexander and so far, all seem favorable to invest in the project. Sources and Uses i. Projected Expenses and Rent According to the projections by Alexander, one bedroomed apartment will be rented at $16,000 per month while a 2 bedroomed apartment will be rented at $2,000 per month. A consideration has been put in place that the rent is bound to increase by 2% annually as the vacancy also increases by 5% annually. ii. Presentation of Annual Expenses Alexander will use $2,600 on Janitor, $2,130 on heat expenses, $1,000 on electricity, and $1,200 on water. He will remit $7,800 as property tax and $2,600 on insurance. A 5% of the rent value annually will be used in management and repairs and a 2% consideration is put in account for the annual increase in expense. The tax rate is at 30% and his bank loan is expected to be $450,000. Forecast and Analysis i. Pro Forma Income Statement Pro forma income statement is acting upon certain assumptions that are economy, firm, and industry related. According to the forecast results, such factors will not change significantly during the next period. As has been seen, the federal fund rate also will increase from 0 to 25% by 2015 and this clearly indicates that there will be a slow increase in the economic status. When the income statement of another firm in the same industry, Myrtle, was looked at, it indicated a 20% return on investment. This is lower than the one for this project. The forecasting was on the income statement was done based on the pro forma. According to this report, the net income is reported to increase every year while the revenue and expenses also increase by about 2% every year. A straight line method was used to calculate depreciation for over 30 years. There are no accrued expenses since Alexander pays for all his expenses every year. ii. Pro forma Balanced Sheet The initial cash that was used for the project was equated to the working capital which is $9,300. A model was then built that would make the balance sheet figures to be calculated using the cash flow statement. The current assets that increase every year is as a result of the increase in the cash balance. Depreciation on the other hand decreases the non-current assets and the project doesn’t intend to purchase any new investment in the near future. The debt that was equal to $450,000 at the beginning of the year is reducing yearly as Alexander is paying back the loan each year. The total assets are equated to the working capital since current liability has no amount remaining. It is still all the same when the value of current assets is used in place of working capital. It is a good indication for Alexander about the short-term liquidity position, hence no liquidity risk. The value of the fixed assets can be seen to decrease as a result of the depreciation and the loan amount also decreases due to annual repayment. Fixed assets would consequently have a high ratio due to fixed assets to the long-term liabilities. The ratios of liability and equity decrease with the subsequent increase in liabilities and equity. iii. Cash Flow Statement The cash flow statement is derived from the income statement already prepared and the balance sheet. An operating cash flow is constructed starting from income before tax and adjusting for all the non-tax items which include depreciation and the working capital. An assumption of no capital expenditure is considered for investing cash flow as it was not in Alexander’s plan. For us to reach the free cash flow available for the equity holders, we need to consider debt principle repayment, after the repayment of all the debt obligation. The assumption here is the cash flow that will go to both equity and debt holders. Recommendation There are several risks that the project is faced with. Some risks are systematic while others are unsystematic. It is therefore recommended that Alexander should invest the extra cash into working capital for him to reap maximum profits. It is a fact that the financial position of Alexander enables him to meet all the financial obligations he faces. It is therefore my recommendation that he should go for the project and invest in it. The project seem favorable looking at the financial statements. It is therefore appropriate that ratios such as cash on cash and DSCR be used in measuring the project profitability. This is even more appropriate to real estate business. The amount of cash realized before taxation should not be relied upon as they are not adequate measures of profitability. Since other measures such as NPV and IRR show positive progress for the project, it is best to be cautious when initiating the business just in order to have some level of profitability and riskiness of the business. When the decision on the project are based on the two measures, NPV and IRR, it is still true that it is worth purchasing the property. Read More