Financial Management and Value of the Investment - Assignment Example

Financial Management Name Institution Financial Management Part A Question 1 a. Perth= 1st Year 300,000 2nd year 500,000 3rd year 500,00 4th year 600,000 and 5th year 600,000. Present value of the investment: Year amount PVIF@5% present value 1 S300,000.00 0.9524 S285,720.00 2 S500,000.00 0.907 S453,500.00 3 S500,000.00 0.8636 S431,800.00 4 S600,000.00 0.8227 S493,620.00 5 S600,000.00 0.7835 S470,100.00 S2,134,740.00 Rock Hampton: Year amount PVIF@5% Present Value 1 S480,000.00 0.9524 S457,152.00 2 S480,000.00 0.907 S435,360.00 3 S480,000.00 0.8636 S414,528.00 4 S480,000.00 0.8227 S394,896.00 5 S480,000.00 0.7835 S376,080.00 6 S100,000.00 0.7462 S74,620.00 S2,152,636.00 Adelaide: Year amount PVIF@5% Present Value 1 S450,000.00 0.9524 S428,580.00 2 S450,000.00 0.907 S408,150.00 3 S500,000.00 0.8636 S431,800.00 4 S500,000.00 0.8227 S411,350.00 5 S500,000.00 0.7835 S391,750.00 6 S120,000.00 0.7462 S89,544.00 S2,168,174.00 The calculation above is the present value of future inflows. The criterion to be used in selecting the best project (the most viable option) is selecting that project with the highest present value of all inflows. In respect to that, it is clear that the project at Adelaide is the most viable. This is because it has the highest present value. If we were to use the Net Present Value method, the project in Adelaide will have the highest present value. b. Perth year amount PVIF@4% PVIF@7% Present Value @4% Present Value @7% 1 S300,000.00 0.9615 0.9346 S288,450.00 S280,380.00 2 S500,000.00 0.9246 0.8734 S462,300.00 S436,700.00 3 S500,000.00 0.889 0.8163 S444,500.00 S408,150.00 4 S600,000.00 0.8548 0.7629 S512,880.00 S457,740.00 5 S600,000.00 0.8219 0.713 S493,140.00 S427,800.00 S2,201,270.00 S2,010,770.00 Rock Hampton year amount PVIF@4% PVIF@7% Present Value @4% Present Value @7% 1 S480,000.00 0.9615 0.9346 S461,520.00 S448,608.00 2 S480,000.00 0.9246 0.8734 S443,808.00 S419,232.00 3 S480,000.00 0.889 0.8163 S426,720.00 S391,824.00 4 S480,000.00 0.8548 0.7629 S410,304.00 S366,192.00 5 S480,000.00 0.8219 0.713 S394,512.00 S342,240.00 6 S100,000.00 0.7903 0.6663 S79,030.00 S66,630.00 S2,215,894.00 S1,692,486.00 Adelaide: year amount PVIF@4% PVIF@7% Present Value @4% Present Value @7% 1 S450,000.00 0.9615 0.9346 S432,675.00 S420,570.00 2 S450,000.00 0.9246 0.8734 S416,070.00 S393,030.00 3 S500,000.00 0.889 0.8163 S444,500.00 S408,150.00 4 S500,000.00 0.8548 0.7629 S427,400.00 S381,450.00 5 S500,000.00 0.8219 0.713 S410,950.00 S356,500.00 6 S120,000.00 0.7903 0.6663 S79,030.00 S66,630.00 S2,210,625.00 S2,026,330.00 From the calculations above, it is clear that the project at Rock Hampton which is the most preferred at 4%. On the other hand, the project that is more viable is that at Adelaide. The relationship between the discounting rate and the present value of project is that of inverse proportion. As the rate of discounting increase, the present value of the projects declines proportionately. Question 2 Discounting refers to the process of finding present value of inflows that are to happen in the future. The concept is used in assessing the viability of different project in order to choose the project that will yield the highest level of returns (Higgins, 2000). The concept can be applied when using methods like the Net Present Value. On the other hand, compounding is the process of seeking to ascertain the value of an inflow or investment in the future. Therefore, compounding involves finding the future value of present investment. An annuity simply refers to an inflow that happens continuously for a number of years. An ordinary annuity is one that occurs at the end of the year (Madura & Fox, 2007). That means that payment or reception of the money involved take place at the end of the year. In so doing, the time for the first discounting will be a period of one year. On the other hand, an annuity due refers to payment or reception that happens immediately a contract is brokered or at the beginning of the year. Therefore, the discounting for the first payment or instalment will be done at the period equivalent to zero. That means that first payment will be equivalent to initial investment. Question 3 In solving this problem, there are a number of assumptions to make relating the information that has been provided. First, we are calculating the amount of money to be saved 11 years from her 35th birthday. That means that the amount to be saved for purchase of the house is not included in this calculation. Similarly, the amount she has planned to bequest her son cannot be of any relevance when calculating the amount she is supposed to be saving. This is because the amount is estimated to be contributed for 10 years starting from the time she is celebrating her 35th birthday. amount to be saved before her 45th birthday Money to be saved for Purchase of a house Amount x PVFA PVIFA1@15%, 10 Present Value of 450,000 is given by: 450,000xPVIF@15%,10 450,000xo.2472=111,240 AmountxPVIFA@15%,10 Px5.0188=111,240 P=22,164.66 Annual Contributions=22,164.66 amount to be saved before her 45th birthday Amount to be saved for bequest of the son 2000 per month translates to 24,000 per annum Year amount FVIF@15%,10 future value 1 S24,000.00 4.0456 S97,094.00 2 S24,000.00 3.5179 S84,430.00 3 S24,000.00 3.059 S73,416.00 4 S24,000.00 2.66 S63,840.00 5 S24,000.00 2.313 S55,512.00 6 S24,000.00 2.0114 S48,274.00 7 S24,000.00 1.749 S41,976.00 8 S24,000.00 1.521 S36,504.00 9 S24,000.00 1.3225 S31,740.00 10 S24,000.00 1.15 S27,600.00 S560,386.00 The retirement benefits savings are supposed to be made on a monthly basis. Therefore, the number of period is supposed to increase while the rate of discounting is supposed to reduce proportionately. One of the assumptions to be made when calculating this amount is that she does not start saving immediately. That means that she starts saving one year after her 45th birthday. In order to calculate the amount of money she is supposed to have saved at 65, we must discount all her post retirement earnings. Since she is making monthly contributions for monthly receipts, we have to adjust the discounting rate to conform to monthly basis. Therefore, the annual rate being used (10%) will be divided by 12 (number of months per year). At the same time, the number of years shall be multiplied by 12. Rate, 10/12 Periods 25x12=300 110.09 10,000x110.09=1,100,902.80 Therefore, at the age of 65 years, the present value of her post retirement monthly earnings was 1,100,902.80. This amount represents the future value of all contributions she was making into the retirement benefit scheme. The most important thing therefore is to ascertain the monthly contribution she was making whose future value is given above. Monthly Contributions x FVIFA@15%, = 1,100,902.80  1,229.1 Monthly Contributions x 1,229.1 = 1,100,920.8 Therefore, monthly contribution required is 895.70 Part B The two firms to be used are Easton Investment Limited and Brambles limited. The cash flow statement provides information about the liquidity of the company. The cash flow focus on the cash outflows and inflows. Therefore, it is the cash flow that can reveal the firm’s ability to meet its short term obligations (Arnold, 2005). On the other hand, comprehensive income statement denotes the profitability of the enterprise. Whether the profits realized is liquid or not, the income statement cannot reveal that. The level of profits is determined by the operations that take place during the year. The more the expenses incurred the lower the profits for the period. The Difference in Cash Flow Statements The information available from the cash flow statement of Easton Investment and that of Brambles limited differs in a number of ways. First, as I had earlier stated, the cash flow is determined by the level of operations that are being undertaken. From the two statements of cash flow, we realize that during the financial year ending 2009, Easton Investment had a deficit while Brambles limited had a surplus. Easton had deficit of 3,547 as net cash at the end of the financial period. This represented a decline as compared to the previous year in which the company had a cash surplus of over 1 million. On the other hand, Bramble had a cash surplus of 141.9 million for the financial year ending 2009. This was an improvement as compared to the previous financial year in which the company had closed with a deficit cash balance. Easton had numerous operations during the previous year when compared to 2008. Therefore, the reduction in the level of transactions was a major determiner of the cash balance that has been realized. On an overall scale, since Easton Investment is a company operating in the financial sector, it is obvious that some assets are quite limited. The difference in the amount of cash flows at the end of the year is determined by the fact that items like sale of machineries and other related assets are not available when dealing with companies in the financial sector. They do not have a lot of assets since the company provides mainly services. On the other hand, the situation is completely different from Brambles limited which mainly deals in containers and other products. The company requires fixed assets to run its operations. At the end of the financial year, the transfers in sale and purchase of assets determine how the cash flow looks like. Difference in the Comprehensive Income Statement The information provided on the comprehensive income statement is sufficient in explaining the profitability of the two companies during the financial year 2009. Just like in the case of the cash flow statement, the income statement of the two companies is different in a number of ways. During the year ending 2009, Easton Investment made a loss of almost a million. This only indicates a worsening of the situation as compared to the results of the previous year. One of the major reasons behind the difference in profitability between the two companies is the size of the companies. Bramble is a big company as revealed by the amount of operations that the company undertook during the financial year ending 2009. Easton Investment is a medium size company whose activities during the year are very minimal as compared to that of Brambles limited. From the income statement of Easton, it is true that the sources of finances and expenditures are very limited compared to that of Bramble. Bramble is a multinational company leading operations in different countries including America and larger parts of Asia. The amount of profits is in millions and this is based on the number of transactions the company runs in many countries. The huge transactions that the company undertook indicate that this is a large enterprise. Therefore, the main cause of the difference in their profits is the size of the two companies. External User of the Information The financial statement provided in this case can be of great help to an external user. The income statement provided by Easton Investment has indicated the amount of earnings/loss per share. An investor may be quite interested in this information for decision making. The earnings per share are the value that many investors use when calculating the intrinsic value of shares (Shim, 2008). At the same time, it can be used to assess the amount of dividends the company is likely to pay out to its shareholders. At the same time, the information from the cash flow statements is very essential in assessing the liquidity of the company (Shim, 2008). An investor can use the cash flow statement to gauge the company’s ability to meet short-term obligations. The level of liquidity is also used to ascertain if the company will issue cash dividends to its shareholders. Whenever the company is facing liquidity challenges, it cannot issue cash dividends. Instead, the company may opt for bonus issue or share split (Arnold, 2005). Besides, the information available on the income statement is useful in determining share prices of the company. When the earnings of the company rise, the share price of the company’s stock is also likely to increase. Internal User The income statement and the cash flow statement provide rich information for internal purposes. First, the cash flow is used by financial analysts in the company when deciding on whether to issue cash dividends or not (Higgins, 2000). The legal framework surrounding issuing of dividends stipulates that cash dividends can only be issued when the company is liquid enough. At the same time, the Company’s Act states that dividends can only be paid out of current profits and not from any other sources. The law does not allow payment of dividends from reserves. Therefore, the income statement is essential in supplying this information. Similarly, the company will have to use the cash flow statement in setting the required credit policies. When a company realizes that it is sacrificing liquidity at the expense of profitability, it will have to adjust its credit policy. At the same time, the income statement splits down the income and expenses during the financial year which the company uses in analysing how to regulate those expenditures. The financial analysts of the company are able to spot abnormal expenditures and income when forecasting future cash requirements and performance. Therefore, the information provided on the income statement and cash flow statement is useful both to external users as well as internal users. Agency Problem The agency problem is prevalent in almost all companies that are limited by shares and by guarantee. The role of managing the affairs of the company has been handed to the managers of the company under the spear headship of the board of directors. The board of directors are supposed to act as the shareholders’ watchdog. The management is first answerable to the board of directors before being answerable to the shareholders themselves. An analysis of the financial statement of Bramble and other allied companies indicates that managers and directors of the company award themselves huge compensations. This is what has been the main cause of agency problem. The amount of compensation that the directors and management award themselves is not in proportion to the rate of performance of the companies. Whenever this is the case, the loss is transferred to the shareholders. The more these directors and the management award themselves huge bonuses and other rewards, the fewer shareholders receive in return. Whatever shareholders receive is in form of dividends. Since ordinary dividends are only paid out after all other charges have been taken into consideration, the ordinary shareholders receive lower or no dividends whenever a lot of costs are incurred. In most scenarios, ordinary shareholders resort to various means of trying to solve the agency problem. One way through which shareholders resort to is designing compensation programs of the company based on performance. Most of the contracts of the employees are reviewed on a regular basis in order to eliminate redundancy and encourage productivity throughout the company. With this, all employees including senior management will be more dedicated to performance. In this regard, compensations are set only when the company attains a certain level of financial performance. Another way through which shareholders have attempted solving the agency problem is by issuing firing threats. The management should be issued with a notice informing them to take caution in order to avoid being axed. At the same time, the management must be informed of the consequences that come with awarding themselves huge compensations at the expense of the company. They have to understand some of the implications including business combinations. Business combinations mean that the management will have either reduced powers or even lose their jobs. When the management is aware of this, they may be compelled to work hard for the sustenance of the company. References Arnold, G. (2005). Corporate Financial Management. Edinburgh: Financial Times. Brigham, E. & Ehrhardt, M. (2005). Financial Management: Theory and Practice. New York: South-West College. Higgins, R. (2000). Analysis of Financial Management. New York: McGraw-Hill. Madura, J. & Fox, R. (2007). International Financial Management. New York: Cengage Learning. Shim, J. (2008). Financial Management. New York: Barron’s Educational Series. Read More