Financial Management - Nirvana - Case Study Example

Executive Summary Investment opportunity depicts some stern threat to the success of failure of business since it entails the investment of cash capital to a venture opportunity that can either realize positive return or loss to the firm. In this regards, a company need appraise investment alternative that is best for invest regarding less risk and high returns. The appraisal of an investment opportunities entails the use of best foresting tool such as the use of net present value in order to ascertain the future cash flows in year and make an investment decision of whether to investment on a project or not based on the positive or negative nature of a return , the use of sensitivity analysis which is useful in understanding the effect of change in variation as a result of change in independent variables in order to ascertain whether the project will drastically impact by small change in changes. The use of cash flow budget will be necessary since; it will provide a general understanding of whether an investment opportunity will either generate the positive or negative return on investment. The above investment appraisal tool are therefore important for our analysis since it provide a precise and reliable outcome for investment decision making which in turn would mean that the going concern of the company can be guaranteed since, investment of positive return would lead to increase in return hence available of excess cash for diversification of portfolio and growing the company capital base (Weygandt, Kieso and Kimmel, 2010). Table of Contents Executive Summary 0 Table of Contents 1 Statement of business problem 2 Background to finance concepts 3 Net Present Value 3 Capital Gain 3 Renovation of Building 4 Contribution Margin 4 Beta 4 Sensitivity analysis 4 Assumptions 5 Analysis of both proposals 6 Reference list 10 Statement of business problem Nirvana is a country with a tropical climate famous for its secluded beaches and lush mountainous rainforests. Halcyon Pty Ltd (Halcyon) is a private company based in Nirvania, which currently runs five intimate and discreet resorts in both mountain and beach locations. Due to past success and increasing demand, Halcyon is considering investment in a sixth additional resort. Halcyon conducted an initial feasibility study and the investment decision to be made weighs the alternatives of investing in either a cliff-top resort with breathtaking ocean views or a secluded resort hidden within the tropical rainforest. Both alternatives require Halcyon to acquire land and existing buildings and refurbish those buildings to meet international resort standards. The purpose of this report is to provide financial analysis, a summary of the main finance concepts included in the analysis and an investment recommendation to Halcyon. Halcyon has management capacity for only one new resort at this time and seeks a recommendation based on the profitability and cost-effectiveness of each investment (Coyle and Graham, 2000). Background to finance concepts Net Present Value Net Present Value (NPV) is arguably the most important appraisal tool used in our analysis. NPV considers the value of future cash flows, in present day terms, by allowing for a discounting factor, and considering your initial outlay of funds. NPV will determine if the investment yields positive or negative results in today’s dollars and provides an easy way to identify whether to accept or reject a project. NPV= {Cash flows*discounting factor-less initial outlay} Establishing the worth of a project is an intricate exercise since there is a diverse approach to appraising the worth of future cash flows. Because of the time value of money, the money in the current value is similar to value in the future. This is because the earning might be potential is made using the current cash at the intervening moment and due to inflation. The discounting rate constituent of the net present value formulae is an approach to account for this. Corporations might frequently have a diverse approach of ascertaining the discounting rate. The frequent approach for establishing the discounting rate entails the expected returns of the venture with same risk or the cost of borrowing cash to fund the project (Ehrhardt and Brigham, 2013). Capital Gain A capital gain is a gain or profit realized from the disposal of a capital asset. The gain is your sale price less your original purchase price or cost base. The cost base will also take into account any capital expenditure made on your asset. In Nirvana, there is no special capital gains tax. However, capital gains are taxed as part of ordinary corporate income tax at the time of the gain. Both investment proposals have a life of 12-15 years, and capital gains may be made at the end of that period. Renovation of Building Renovations of existing buildings before use would amount to capital expenditure and would go towards your cost base for taxing of any capital gains. This is because, where the building is new and renovated, and subsequently the precise or service of the building is increased, the law would deem the renovation cost as capital cost and will be included in appraising the total cost of the asset (Ehrhardt and Brigham, 2013). Contribution Margin An investment decision includes analysis of the contribution margin. The contribution margin shows how individual or unit profit from sales contributes to the fixed costs. Where there are already fixed costs, the contribution margin will determine which investment is the most profitable overall to the business. An ideal investment alternative will be the one with the highest contribution margin since, it depicts that business can be in a position to finance its daily operation efficiently which is an indication of an efficient working capital management (Coyle and Graham, 2000). Beta The Beta is a coefficient or multiplier that indicates the volatility of returns– for a particular investment - about the market. Beta is importantly used as part of the Capital Asset Pricing Model (CAPM) that describes the relationship between risk and return. Beta is used in the CAPM in working out the overall cost of equity. The cost of capital is a discounting rate used calculating the present value of company future cash flows. Holding other factors constant, the higher the value of Beta the higher the discounting rate and therefore a lower present value of future cash flows and Beta(Weygandt, Kieso and Kimmel, 2010). Sensitivity analysis This is a tool for establishing the extent to which a proposed investment will vary with altered assumptions. The approach is employed within specific limits that are dependent on certain input variables. Sensitivity analysis is an attempt to forecast a range of potential outcomes based on varying inputs or assumptions. For example, you may make assumptions about inflation, or property values which turn out to be inaccurate. The benefit of sensitivity analysis is in establishing the effect of the real outcomes based on differing inputs. Here our sensitivity analysis can look at how the project investment outcomes differ if say inflation or rates of income tax changed. In this case, we will use sensitivity analysis to ascertain the responsiveness of net present value to variables employed in calculating the net present variables(Albrecht et al., 2008). Assumptions In conducting our analysis, we have made the following assumptions. Growth rate: There shall be a steady growth rate for cash flows in both investment alternatives remaining consistent. The discounting factor: The discounting factor will be based on the capital asset pricing model. This is calculated as follows: CAPM= {Returns + Beta (Risk premium)}. The CAPM values are also deemed to be the discounting factor, and it is assumed that no other external factors will affect the value of discounting for both investment alternatives. Effect of inflation: It is expected that the inflation rate will grow in line with the current average or that fluctuations will be within a manageable range not having a significant impact on project outcomes (Ehrhardt and Brigham, 2013). To minimize the forecast risk on the investment decision, we will explore the impact of changing inflation rates as part of the sensitivity analysis. External environment: The external environment includes the competition and regulatory environment. Our assumption is that the company will not have a significantly changed competitive landscape, and the compliance and approvals of local authorities for the license to operate will be efficient and predictable (Ehrhardt, 2008). Available capital for investment It is assumed that there will be capital available for investment, including the ability to adequately obtain finance. Hence, capital constraints will not be a limiting factor for our analysis. Analysis of both proposals Analysis of both proposals {See the attached excel file} Sensitivity Analysis We examined the impact of the 1% decrease in the discounting factor and the inflation rate on the net present value for Cliff Resort and Rainforest and then make an investment decision regarding best project regarding sensitivity to variations. Summary of the outcome of band with assessment Cliff Resort Net Present Value (99%) 90,062,779.55 Net Present Value (100%) 89,686,651.68 Percentage change (%) 0.4% Rainforest resort Net Present Value 161,519,657.91 Net Present Value (100%) 160,772,471.21 Percentage change (%) 0.5% From the above sensitivity analysis, it is apparent that the change in discounting factor and inflation rate by 1% would lead to higher change for Rain forest (0.5%) unlike the change for cliff resort which will change by {0.4%). The implication is that; the rainforest will realize high returns and net present value with least change in sensitivity analysis unlike the variation and cash flow for cliff resort (Michael, 2008). This justifies the reason why the company must invest in rain forest resort as an ideal investment alternative to the company regarding high return (Aravossis, 2006). From the above net present value and net profit analysis for each investment alternative, it can be observed that rainforest resort is the best investment alternative since, the investment will realize a net present value of $161,519,657.91 with a projected net profit from the investment of $84,931,180.87. This value is quite high as compared to the net profit and net present value of Cliff Resort, which depict a value of $50,116,403.49 for net income and $89,686,651.68 for net present value respectively. The net present values for both investment alternative is by 9% discounting factor which arrives at working out the capital asset pricing model (CAPM). The formulae for CAPM are {risk free rate+ Beta (Risk Premium). Equivalent Annual cash flow (EAQ) EAC= {1(Npv)/(1-(1+r)^-n) Cliff Resort Rainforest Resort NPV 89,686,651.68 160,772,471.21 R 9% 9% r(NPV) 8071798.65 1,786,360,791 1-(1+r)^-12 64.4% 72.5% EAC $12,524,800 $ 2,462,376,931 From the above analysis, it can be observed that Cliff Resort depicts the least EAC. It can be advised that rainforest an ideal venture alternative which is in compliance with the above results of the net present value analysis. Given the fact that the capital as a limiting factor, the company could have considered investing in both investment alternatives since, both ventures depict positive net present value and net profit which would mean that investment in either of the project would yield the positive return in the form of profits within the shortest time possible (Alastair, 2000). As a risk-averse investor, the company should, therefore, consider investing in a volatile investment that will yield high return within the shortest time possible in which case, rainforest would be the very best investment alternative for the company. Recommendation From the above net present value and net profit analysis for each investment option, it can be observed that rainforest resort is the best investment choice since, the investment will realize a net present value of $161,519,657.91 with a projected net profit from the investment of $84,931,180.87. This value is quite high as compared to the net profit and net present value of Cliff Resort, which depict a value of $50,116,403.49 for net income and $89,686,651.68 for net present value respectively. The net present values for both investment alternative is by 9% discounting factor which arrives at working out the capital asset pricing model (CAPM). The formulae for CAPM are {risk free rate+ Beta (Risk Premium). Given the capital as a limiting factor, the company could have considered investing in both investment alternatives since both ventures depict positive net present value and net profit which would mean that investment in either of the project would yield the positive return in the form of profits within the shortest time possible(Coyle and Graham, 2000). As a risk-averse investor, the company should, therefore, consider investing in a volatile investment that will yield high return within the shortest time possible in which case, rainforest would be the very best investment alternative for the company. Reference list Alastair, G. (2000) Cash Flow Forecasting and Liquidity - Page 21, New York: Cengage Learning. Albrecht, W., Stice, J., Stice, E. and Swain, M. (2008). Accounting: Concepts and applications. 10th ed. Mason, Ohio: Thomson/South-Western, p.901. Aravossis, K. (2006) Environmental Economics and Investment Assessment, London: Cengage Learning. Coyle, B. and Graham, A. (2000). Cash flow forecasting and liquidity. Chicago: Glenlake Pub. Co., p.21. Ehrhardt, M. (2008) Corporate Finance: A Focused Approach - Page 554, London: Cengage Learning. Ehrhardt, M., and Brigham, E. (2013). Corporate Finance: A Focused Approach. 5th ed. London: Cengage Learning, p.554. Fabozzi, P.P.&. (2014) Capital Budgeting: Theory and Practice, London: Springer. Jerry, W. (2009) Managerial Accounting: Tools for Business Decision Making, London: Jonh Wiley. Fabozzi, P.P.&. (2014) Capital Budgeting: Theory and Practice, London: Springer. Jerry, W. (2009) Managerial Accounting: Tools for Business Decision Making, London: Jonh Wiley. Mocciaro, D. (2014) Managerial irresponsibility and firm survival. Pivoting the company, New York: Cengage Learning. Schuster, U.G.‎.N.&. (2015) Investment Appraisal: Methods and Mode, New York: Cengage Learning. Swain, M. (2015) Budgeting for Public Managers, New York: Cengage Learning. Read More