Corporate Investment Decisions - Case Study Example

Executive summary An investment opportunity is seen by Nem limited and thus the company is going to realize profit from investment based from Net present value approach in terms of the discounted cash flow. The ore deposits is 30 tones and the demand is estimated to increase for the next 4 years to period ending 2016.Chiana is one of the ;largest customer of the product and contribute o 60% of the demands. This positive trend and thus investment is ground to earn a constant return due to high demand of the product in the market. The source of capital of the new investment is ideal since the company is going to diversify the outlay in four distinctive financiers in order to reduce the lending interest rate and increase the level of finance. This therefore is going to make business go strong in terms of finance hence the new project will not interfere existing business operation in term of operation risk. Introduction Nem limited intends to invest in ore mining in south Africa Saharan since, An opportunity has risen in ore mining in which the business is going to realize from investment based on cash flow analysis that depicts positive net present value as well as the value of ore deposit and time it takes before the material becomes obsolete. The project will require an initial investment outlay of 200 million dollars and intends to rise in the following financial structure by the shareholders and debt holder of the business investment Millions Equity 40,000 US Bank syndicate (10%) 60,000 Chinese still producer (9%) 60,000 Japan Korea government 40,000 Total capital 100,000 Financial analysis Pros and cons of the valuation method VP of operation approach This an approach that considers the weighted average cost of capital in valuing the returns of the investment both present and future. The approach is ideal since it considers both debt and equity in valuing the stock returns hence there is a reduction of investment risk. The disadvantage of the model is that it assumes that the current economic condition will remain the same into unforeseeable future which is not real thus acting as a limitation to the model. Accounting officer This is an approach that uses the existing data to ascertain the viability of investment, the net advantage of the model is that the theoretical data will provide accurate result since there is real data can be used in making a conclusion on the same and considering the viability of investment. The disadvantage of the model is that, it cannot be used in assessing how future trend will affect the current data and judgment made on the investment hence this is not an ideal for ascertaining an investment who returns is to be realized in near future. External consulting firm Employing the work of an expert implies that the result generated will relied upon for decision making since expert in a field will provide data that is accurate with less error due to experience they poses in the field in this case the business will make certain investment decision of whether to invest on the project or not (McMenamin 2002). The disadvantage of the approach is that it require huge sum as consultation fee. This amount will put the business in financial problem where the investment turn out to be unacceptable since the business is going to pay for their effort expended on the project whether the Project turns out to be worthwhile for investment or not. Internal analyst This approach only considers the equity in relation to its cost of capital and thus disregards other cost of debt capital. This is a risk approach to be undertaken since if the company disregards the cost of debt. The result will be misleading and thus the company will be in a fix in terms of debt repayment and investment return if clear investment is not ascertained. The advantage of the model is that it consider the cost of equity in relation the value of the equity and thus the model consider only equity as a source of investment Attractiveness of Iron ore as an investment opportunity to NEM Ltd This is an attractive investment opportunity to the business since, According to feasibility study performed by Drexel corporation, it was ascertained that their 30 is million tons of ore deposit and the demand of the product will remain high for the next four years (2016).This is a strong indication to Earth mining limited that investment in this new opportunity will not lead to Incremental cost and, loss to the business but creation of incremental profit since material are readily available. Vp operation is deem an ideal method of valuing the net present value of the investment since the model considers the weighted average cost of capital in concluding on the discounted value. The advantage of weighted average cost of capital is the model considers both debt and equity valuation approach which is considered as value of a levered. In valuing am investment opportunity, debt and equity valuation is considered ideal since a levered firm commands high value with low component cost of capital, the model also considers the risk free rate of return, this is the rate at which an investment should be realized devoid of other external factors that might the returns of investment (Serfas 2010). Levered firm therefore is an ideal approach in valuing the returns of an investment hence VP approach will be optimal as an appraisal tool. Other approach may not be ideal since they all consider an assumption of the returns rather than use theoretical approach in valuing the securities (Röhrich 2007). Also the approach is not justifiable since it cannot consider future performance if the same method is used in ascertains both the present and future financial situation and factors that would affect returns of an investment unlike the VP approach does. This is a limitation and placing reliance on the methodology would be misleading and might render the investment unworthy for venture, In this case, VP approach is ideal since future performance can be ascertain in present years and judgment made on whether to invest on the project or based on the viability of the investment present and future years as generated by the Vp analysis. Value Added by the design of financing package The design of financing package would lead to risk reduction to the business inform of inadequate funds since, The company is going to diversify the source of funds in which case the interest on loan is different and low in both financiers. Interest rate on loan is going to be repaid starting in the year 2015, this will give the company an ample to time realizes profit from investment and to ensure that the business attain a strong business environment in which the investment takes place (Ryan 2007). This financing package is ideal to the business since it reduce the overall operational risk and thus the company will be certain of the low interest rate to be repaid in the near future in different financiers. Areas to concentrate on in negotiating a better deal with customers and lenders Debt repayment Debt repayment is an ideal are to place reliance since, the lenders of the loan will want to know time it takes for their loan and interest to repaid fully .A good loan repayment should be the one that is affordable and easily repayable and thus providers of the loan will be willing to finance the company when they are certain that the business will generate profit from their investment and repay their loan and interest within the stipulated time frame of loan agreement. The customer of the product are as well concern on the status of the company and how the debt repayment is going to be paid without reducing or not paying them dividend. A good investment that will attack company customer is one that will pay the debt easily and within stipulated time since this depicts the financial stability of the company in repaying the debt as well dividend to shareholders (Northcott 1992). The customer to the company is also part of the financiers and they both demand the interest on loan repayment as well as dividend as shareholders to the company. Therefore where an investment is able to meet the obligation of debt holders as well those of the shareholders is deem worthwhile for investment since the investment is viable. Investment viability Based on the information generated from the analysis of the venture, It can be concluded that NEM should make an investment in ore mining since the company is going to realize profit from investment and thus the company is going to increase its capital base as will retained earnings .This is depicted by the positive net present value that is realized from the cash flow. Also it is ascertained that the ore deposit is 30 million tons and the demand of the product will increase in the market for the next 4 years without competition (Northcott 1992). These factors are good indication that the investment is viable and the business is going to realize profit from investment will enjoy the supernormal profit till 2016 before the rate of demand of ore product changes. Sensitivity analysis at $80 per ton VP of operation method Accounting officer External consulting Internal analyst Price of the ore $80 per ton $80 per ton $80per ton $80 per ton Cost of capital 14% 24% 24% 24% NPV $83 million -$28million -$26.24 million $-26.24 Million Sensitivity analysis at price of $100/ ton VP of operation method Accounting officer External consulting Internal analyst Price of the ore $100 per ton $100 per ton $100per ton $100 per ton Cost of capital 14% 24% 24% 24% NPV $206.91 million 41.42million $41.42 million $-41.41 Million Conclusion and recommendation Conclusion From the above sensitivity analysis of price changes in relation to cost of capital and NPV using different approach, it can be concluded that VP of operation stills gives the highest NPV of $ 83 million at price of $870/ton and NPV of $206.91 at a price of $100/ton. It can as well be depicted that the VP of operation approach has a high value with low cost of capital. This is ideal for investment since it implies that the financing strategies are levered under the Modigliani and miller proposition (McMenamin 2002). In this case the net advantage of a levered firm is that it commands a higher value with low cost of capital implying that the business will be repaying less interest and debt in relation to returns from the investment hence the business operational risk is not compromised. The risk of VP of operation approach is that the model does not consider other systematic risk and unsystematic risk that affect the operation of the business as well as achievability of the anticipated project and its cash flow generation (Jerald E. Pinto 2010). The business can use other discounting method in ascertaining the viability of the venture such as the accounting rate of return {ARR) and internal rate of return (IRR) since both approach considers time value of money in discounting future cash flow into year one and making judgment as to project viability. Recommendation Having satisfied with the forecast and cash flow of the proposed business venture, the next step is to execute the business deal immediately. The company within a month should have establish the mining equipment to be purchased and put into practice together with the personnel with relevant expertise in order to get down business into operation (Gedde 2002). After 30 days of initial start up, the business should be progressing gradually and thus full administration should be in place and the subsidiary in operation. This strategy will help thus help the business meet its deadline within the stipulated time frame and avoids consequence of poor planning and execution of the project. Reference list Gedde, Ross. Valuation and Investment Appraisal - Page 75. 2002. Jerald E. Pinto, ‎Elaine Henry, ‎Thomas R. Robinson. Equity Asset Valuation . 2010. McKinsey & Company Inc., ‎Tim Koller, ‎Marc Goedhart. Valuation: Measuring and Managing the Value of Companie. 2010. McMenamin, Jim. Financial Management: An Introduction -. 2002. Northcott, Deryl. Capital Investment Decision-Making - Page 51. 1992. Pogue, Michael. Corporate Investment Decisions: Principles and Practice . 2010. Röhrich, Martina. Fundamentals of Investment Appraisal: An Illustratio. 2007. Ryan, Bob. Corporate Finance and Valuation. 2007. Serfas, Sebastian. Cognitive Biases in the Capital Investment. 2010. Uwe Götze, ‎Deryl Northcott, ‎Peter Schuster. Investment Appraisal: Methods and Models . 2007. William Megginson, ‎Scott Smart. Introduction to Corporate Finance, Abridged Editiion. 2008. Read More