London Stock Market & Capital Budgeting - Essay Example

London Stock Market & Capital Budgeting INTRODUCTION Investment is a risky business. Many people prefer to work as employees because they do not havethe courage to gamble with the their money. For, it is not a laughing matter to borrow large sums of money to invest ones inheritance or lifes savings to open a restaurant, a grocery store, a bookstore, a manufacturing company and the like. The reason that only a few walk on the road of entrepreneurship is because they know that their risk will pay off handsomely for them. For, their feasibility study and business acumen gives them that added instinct that they will come out of the business at the end of the day winning. Winning in business is characterised by net profits. There are two ways of generating funds. They are borrowing and investing. The best place to invest funds is visiting the London Stock Exchange. The following paragraphs explains clearly why investing in capital assets is a risk that can be tailored to generate profits and not left to chance (Datta, and Jones 1999, 21). BODY QUESTION 1 The above computation shows that sales for the first year is £7,000,000. The direct materials and variable operating expenses amount is £2,500,000. The direct labor amount is £2,000,000. The factory overhead is arrived at by multiplying the direct labor amount by fifty percent. The amount arrived at is £1,000,000. The annual depreciation of £675,000 is arrived at by dividing the investment cost of the equipment amount of £3,375,000 by five years. The net profit result is £825,000.The cash inflow is arrived at by adding back the annual depreciation expense to the net income because there is no actual cash outflow generated by the depreciation expense. The net cash inflow computed for the first year is £1,500,000. This generates a first year present value using the net present value discount table for varying annual cash inflows is £1,485,000(Dayananda et al. 2002, 5). The above computation shows that sales for the second year is £7,700,000. The direct materials and variable operating expenses amount is £2,750,000. The direct labor amount is £2,200,000. The factory overhead is arrived at by multiplying the direct labor amount by fifty percent. The amount arrived at is £1,100,000. The annual depreciation of £675,000 is arrived at by dividing the investment cost of the equipment amount of £3,375,000 by five years. The net profit result is £975,000.The cash inflow is arrived at by adding back the annual depreciation expense to the net income because there is no actual cash outflow generated by the depreciation expense. The net cash inflow computed for the second year is £1,650,000. This generates a first year present value using the net present value discount table for varying annual cash inflows is £1,617,000. The above computation shows that sales for the third year is £8,400,000. The direct materials and variable operating expenses amount is £3,000,000. The direct labor amount is £2,400,000. The factory overhead is arrived at by multiplying the direct labor amount by fifty percent. The amount arrived at is £1,200,000. The annual depreciation of £675,000 is arrived at by dividing the investment cost of the equipment amount of £3,375,000 by five years. The net profit result is £1,125,000.The cash inflow is arrived at by adding back the annual depreciation expense to the net income because there is no actual cash outflow generated by the depreciation expense. The net cash inflow computed for the second year is £1,800,000. This generates a first year present value using the net present value discount table for varying annual cash inflows is £1,747,000. The above computation shows that sales for the fourth year is £6,300,000. The direct materials and variable operating expenses amount is £2,250,000. The direct labor amount is £1,800,000. The factory overhead is arrived at by multiplying the direct labor amount by fifty percent. The amount arrived at is £ 900,000. The annual depreciation of £675,000 is arrived at by dividing the investment cost of the equipment amount of £3,375,000 by five years. The net profit result is £675,000.The cash inflow is arrived at by adding back the annual depreciation expense to the net income because there is no actual cash outflow generated by the depreciation expense. The net cash inflow computed for the second year is £1,350,000. This generates a first year present value using the net present value discount table for varying annual cash inflows is £1,297,350. The above computation shows that sales for the fifth year is £5,200,000. The direct materials and variable operating expenses amount is £2,000,000. The direct labor amount is £1,600,000. The factory overhead is arrived at by multiplying the direct labor amount by fifty percent. The amount arrived at is £800,000. The annual depreciation of £675,000 is arrived at by dividing the investment cost of the equipment amount of £3,375,000 by five years. The net profit result is £125,000.The cash inflow is arrived at by adding back the annual depreciation expense to the net income because there is no actual cash outflow generated by the depreciation expense. The net cash inflow computed for the second year is £800,000. This generates a first year present value using the net present value discount table for varying annual cash inflows is £760,800. The above computation shows that sales for the entire five year period is £34,600,000. The direct materials and variable operating expenses amount is £12,500,000. The direct labor amount is £10,000,000. The factory overhead is arrived at by multiplying the direct labor amount by fifty percent. The amount arrived at is £5,000,000. The annual depreciation of £675,000 is arrived at by dividing the investment cost of the equipment amount of £3,375,000 by five years. The net profit result is £3,725,000.The cash inflow is arrived at by adding back the annual depreciation expense to the net income because there is no actual cash outflow generated by the depreciation expense. The net cash inflow computed for the entire five year period is £7,100,000. This generates a first year present value using the net present value discount table for varying annual cash inflows is £6,907,950. Conclusively, it is very profitable to proceed with the investment in the new equipment because the net present value is positive. On the other hand, a negative present value would indicate that it is not feasible to invest in the new high value capital investment amounting to £ 3,375,000. The above computation shows that present value of the cash inflows for the five year period is £6,907,950. The net present value of £3,532,950 is arrived at by decreasing the present value of cash inflows by the cost of the investment amounting to £3,375.000. The average five year period cash inflows is arrived at by subtracting the cost of £3,3750 cost of equipment investment by the net present value of zero. The internal rate of return occurs only if the net present value is zero. The average of net cash inflow for the past five years in the above table amounting to £6,907,950 is divided by five years to arrive at the average yearly cash inflow of £1,381,590. Then, the net present value of the five year cash inflows amounting to £3,375,000 is divided by the average annual cash inflow of 1,381,590 to arrive at the figure 2.44. Based on the above computation, the risk formula Net present value is not as good as using the internal rate of return because the cost of capital under the net present value is higher than the cost of capital of internal rate of return which is between twenty nine percent and thirty percent. This is arrived at by looking at the net present value at annuity of five years table (Padoa-Schioppa 2004, 27). QUESTION 2 The issuance of shares of stocks to finance major investments would affect the companys gearing ratio. the gearing ratio is arrived at by dividing the total debt by the total stockholders equity. It is the financial statement ratio that determines the ratio of the companys borrowed funds in relation to the total stockholders equity. The best gearing ratio is characterised by an equal or almost equal amount that is sourced from borrowings and the total stockholders investments. The above example shows that gearing ratio is 1.00. This is the best gearing ratio. Now, an investment in the capital equipment above amounting to £3,375,000 would increase the gearing ratio by seven percent. This is not good for the companys image when compared to the original gearing ratio of 1.00 because the gearing ratio has increased. Likewise, the companys issuance of shares of stocks in order to generate funds to buy the capital equipment above amounting to £3,375,000 would decrease the gearing ratio from the original 1.00 to the lower .94 would give a bad picture of the companys gearing ratio when it is compared with the original gearing ratio of 1.00. However, There are advantages of choosing between borrowing funds and issuing shares of stocks to generate funds if the company will have to choose between borrowing money or investing. The issuance of shares of stocks will increase the stockholders equity as well as the number of stockholders or owners of the company(Swanson, Srinidhi, and Seetharaman 2003, 14). The shareholders would be happy to invest in the company £3,375,000 because they would be able earn money from their investments through dividend income or earnings per share computations. On the other hand, the choice of borrowing money would not increase the stockholders equity base of the company because the lenders of the £3,375,000 would not be issued shares of stocks indicating that they will become one of the owners of the company. Instead, people prefer to lend their hard -earned scarce money resources to the company in exchange for earning interest income. Thus, the lenders will not be owners of the company but be the companys creditors. In case the company goes into bankruptcy, the company must first pay the creditors what the company owes. The company will distribute the available assets to the stockholders only after deducting the amount payable to the company creditors. Thus, the creditors will have lesser risk than the stockholders in case of bankruptcy proceedings. On the other hand, the companys stockholders of the company. The stockholders have the right to vote on issues that pertain to how the company should be run. Some of the issues include setting up a new branch, buying a new capital equipment, closing shop, adding another building, mergers or consolidations. The creditors have to voice on how the company operations should be run. In this case, it is lesser risk to be a stockholder than a creditor of the company(Citron et al. 1999, 167). The company, Eco Lighting Ltd., will have many advantages if they accept the bid of Golden Glow PLC to buy the company. One advantage is that the owners of the company (stockholders) will receive the cash value of their net assets. The net assets of the company are valued at the fair market value at the time of the buy date. Thus, the company, Eco lighting, will gain from the sale of their net assets. In addition, the company will be able to use the cash received to invest in another more lucrative business. Or, the company can set up another company in another location to engage in the same type of business because they are experts in this market segment. Some of the employees will benefit from the buy because they will be absorbed by the new owners, Glow PLC (Wright and Robbie 1999, 4). The company, Eco Lighting Ltd., will have many disadvantages if they accept the bid of Golden Glow PLC to buy the company. One disadvantage is that the owners will no longer be the owners of Eco lighting Ltd.. In addition, the Eco lighting company may be dissolved and renamed Glow lighting company. The new owners may not have the expertise to run their newly acquired company, Eco Lighting Ltd (Padoa-Schioppa 2004, 8). QUESTION 3 The quote “it is perhaps surprising that not all firms formally account for risk. If we bear in mind that the evidence relates to larger firms, it seems possible that little consideration of it will occur in the smaller firms… Risk is ever-present in decision making, as decisions only concern the future and the future is not known with certainty. Risk must formally be considered in each decision taken” is generally true in most instances. This statement applies to the normal business environment where the decision -making skills of the Treasury Manager in the increasingly complex business environment are required. The treasury manager is often hard -pressed to determine the best alternative to pick when given several capital investment situations (Murphy 2003, 33). For example, the treasury manager would often choose to implement the alternative that gives the highest net income or net present value. Also, the treasury manager must determine to put the scarce money resources of the company one of several alternative investments because the chosen alternative will give the company the least possible risk. Some of the difficult decisions that treasury managers have to face are buy a building ro construct a building, to expand to a new territory or not to expand at all, to choose the best mix of products A, B, C or D based on which product mix will generate the higher net profit, and to continue operating a department that is generating a net loss for the past year to continue operating it because the fixed cost of the closed department will be absorbed by the remaining open departments thereby increasing the over -all company net loss(Harrison, Dibben, and Mason 1997). Further, Treasury managers of huge companies will find it harder to gamble with the risk than a smaller company because the huge companies will investing LARGE sums of capital investment. On the other hand, the smaller companies will only be gambling or taking risk that is small because their capital investment would be small as compared with the capital investment of the big companies(Hood, Rothstein, and Baldwin 2004, 3). QUESTION 4 The quote “As with all Capital Markets in their secondary role, the Stock Exchange is basically a market place where securities of private firms and public bodies may be bought and sold” is generally true. the London Stock Market is the meeting place where the buyers (or investors) and the sellers of stocks listed in the stock exchange meet. The owners of stocks who want to divulge themselves of their stocks will offer a price that is usually higher than the price that they had bought or invested in the stock. Their main goal to generate profits from selling their stocks. On the other hand, the bidders or buyers or potential investors would try to give a bid price that is as reasonably low as possible. Both the bidders and the sellers of the stocks will then have to agree to an equilibrium price. Thus, the winning bidders would become the new stockholders of the companies listed in the London Stock Exchanges(Meek, and Gray 1989). The London Stock Market creates an environment that is conducive to the buying and selling of stocks. In addition, companies that have offered as publicly listed companies in the London Stock Exchange would have the opportunity to give everyone to become stockholders in the company. The London Stock Exchange in its secondary role as a market place for the purchase and sale of securities is very successful. As proof, the London Stock Exchange has been in operation for many years now. And, many companies freely list their shares of stocks in the London Stock Exchange to achieve their goal of generating funds through the investment process and not resort to borrowing funds. Based on the this research, it is very evident that competition of the past, the present or the future will not erode its reputation a bit. For, the secret to the London Stock Exchanges success is that the exchange has stringent rules and procedures that entices investors and stock offer makers to offer or bid for stocks listed in the exchange(Saudagaran, and Biddle 1995). CONCLUSION The issuance of shares of stocks to finance major investments would influence the companys gearing ratio. An increase in payables would not be good because it would increase the gearing ratio. An increase in investments would not be good because it would decrease the The quote “it is perhaps surprising that not all firms formally account for risk. If we bear in mind that the evidence relates to larger firms, it seems possible that little consideration of it will occur in the smaller firms… Risk is ever-present in decision making, as decisions only concern the future and the future is not known with certainty. Risk must formally be considered in each decision taken” is generally true in most instances. Further, Treasury managers of huge companies will find it harder to gamble with the risk than a smaller company because the huge companies will investing LARGE sums of capital investment. However, gearing ratio. In addition, the company, Eco Lighting Ltd., will have many disadvantages if they accept the bid of Golden Glow PLC to buy the company. And, the company, Eco Lighting Ltd., will have many advantages if they accept the bid of Golden Glow PLC to buy the company. And, the quote “As with all Capital Markets in their secondary role, the Stock Exchange is basically a market place where securities of private firms and public bodies may be bought and sold” is generally true. the London Stock Market is the meeting place for the buyers (or investors) and the sellers of stocks listed in the stock exchange to meet. Based on the this research, it is very evident that competition of the past, the present or the future will not erode its reputation a bit. For, the secret to the London Stock Exchanges success is that the exchange has stringent rules and procedures that entices investors and stock offer makers to offer or bid for stocks listed in the exchange. Works Cited Citron, David, Kennn Robbie, Mike Wright, Hans Bruining, and Arthur Herst. 1999. "7. Loan Covenants, Relationship Banking and Management Buy-Outs in Default: a Comparative Study of the Uk and Holland". In Management Buy-Outs and Venture Capital: Into the Next Millenium, ed. 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