Net Present Value and Internal Rate of Return - Assignment Example

Financial Management Question Net Present Value In evaluating the viability of the expansion of Bradford Renovation and Rebuild Ltd, the Net Present Value (NPV) method will be utilized. Economists argued that NPV is a better alternative in capital budgeting decisions because it takes into account the time value of money. The net present value (NPV) of a project represents the present value of the total cash inflows and outflows (Net Present Value 2006). The NPV can be calculated by discounting the cash flows according to the required rate of return. The NPV can be mathematically represented as: where Ct is the cash flow in time t, Co is the cash flow during the first year, and r is the required rate of return. Table 1 shows the cash inflow expected to be generated and the cash outflow expected to be incurred should the proposed expansion be undertaken. During the first year, the company will incur expenses to finance the purchase of the new plant and equipment costing 5,000,000. It is assumed that this amount will be a one time expense fully incurred during the first year. This report also recognized the need to recognize the investment in research and development already incurred by the company. The rationale behind this is to fully and adequately evaluate the profitability of the project. It should be noted that in order to come up with a proper valuation, the company should account for all the revenues and expenses generated by the project. Thus, it is inclusive of all the expenses incurred to bring the project in operation. Research and development cost of 900,000 should be accounted for because without it, the expansion will be impossible to pursue. Table 1. Cash Flow of Bradford Renovation and Rebuild Ltd.'s Proposed Expansion (2005-2010, in thousand) Cash Flow 2005 2006 2007 2008 2009 2010 Plant and Equipment (5,800) Research (900) Working Capital (1,800) 1,800 Sales Income 4,500 4 ,500 4,700 4,700 4,700 Wages (900) (940) (940) (940) (940) Raw Material (1,260) (1,320) (1,320) (1,320) (1,320) Overheads (300) (300) (300) (300) (300) Total Inflow/ (Outflow) (8500) 2,040 1,940 2,140 2,140 3,940 During 2005, the amount of 1,800,000 to cover additional working capital expenses is also included in the cash outlay required. However, management also expects that after five years, this amount will be freed up and can be readily used by other projects. Thus, Table 1 also shows that during 2005, the company will be needing 1,800,000 while this amount will be available during 2010. In the case of the overhead costs, this report decided to use the 300,000 per annum as estimated by the project development team advisor. This is deemed appropriate as allocating 50% of the wages is just an estimate. It should also be noted that depreciation expense will not be included in the computation of the NPV because cash flow is not directly affected by the account. As taxes and inflation are excluded in the analysis, tax shield from depreciation will not be considered. The computation for NPV is shown in Table 2. Since the company is using 14% as the required rate of return for the expansion, the cash flows are discounted at the same rate. According to the computation in Table 2, the NPV of the expansion using 14% cost of capital is (403.47). Table 2. Discounted Cash Flow and NPV for Expansion (2005-2010, in thousand) 2005 2006 2007 2008 2009 2010 Total Inflow/ (Outflow) (8500) 2,040 1,940 2,140 2,140 3,940 Present Value Factor (14%) 1.0000 0.8722 0.7695 0.6750 0.5921 0.5194 Present Value (8500) 1789.4 1492.8 1444.5 1267.0 2046.4 NET PRESE NT VALUE (403.47) Internal Rate of Return The internal rate of return is the cost of capital which equates the net present value of all cash flow to zero. The IRR can be computed by calculating the NPV at different interest rates. Utilizing this method, we come up with Figure 1 which shows that IRR is approximately 12%. Figure 1 . NPV at Different Cost of Capital Question 2. Prepare an informal report for the Board of Directors of Bradford Renovation and Rebuild Limited evaluating alternative choices of capital expansion or borrowing long term in order to finance future expansion of the firm. In the view of the future expansion of the Bradford Renovation and Rebuild Limited (Bradford), the company should be able to seek additional financing in order to raise the required capital outlay. It should be noted that the organization will be requiring at least 8,500,000 in cash in order to purchase new plant and equipment, finance research and development effort, and augment working capital. Without the additional fund, the company will not be able to pursue expansion. As with other business organizations, the company is faced with various options in financing its investment needs. The right side of the balance sheet shows how a company can possibly acquire the additional fund that it needs. Bradford can either acquire liability by seeking the help of its creditor or sell ownership of the company by issuing stocks. In terms of liability, the company can possibly acquire short-term or long-term debt. However, Bradford will be using the fund for investment whose returns will be generated in over a year; it will be more rational and appropriate to choose long-term borrowing. Another option, of course, is to issue additional stocks in the market for potential investors. This report opts to evaluate these two financing options by looking at their advantages and risks to Bradford. Long-term Borrowing Long-term borrowing is one of the most popular ways that businesses utilize in financing their investments. With this, the company can borrow a specific amount of money with a promise to pay at a certain maturity date. Interest is also paid at preset dates, usually quarterly. Long-term debt can be acquired from financial intermediaries like banks. The company can also issue notes payable or acquire bonds. Long-term debt is a preferred way of financing investments because it does not dilute the ownership in the company. In the case of Bradford, acquiring long-term liability will leave the stockholders in the company the same portion of ownership. However, it should also be noted that liability is one of the costliest way of financing investments. Financial intermediaries which issue long-term debt often require a lot of significant information about the nature of business and operation of a business organization. Before credit is extended however, creditors ask for the specific details of the investment where funding will be spent. They also often ask the expected returns of the investment as well as how the credit will be repaid. Creditors also ask for a detailed business plan and financial updates at regular intervals. Significant information about the current and future financial position of Bradford is expected to be required by creditors knowing that the company will be borrowing a large amount. Capital Expansion Capital expansion or the issuance of stocks is the second alternative to Bradford. Financing the investment by issuing securities is often considered as a less costly alternative for any business organisation especially if it chose to issue common stocks instead of preferred stocks. It should be noted that as opposed to preferred stocks which pays dividends at regular intervals at preset rates, Bradford owns the discretion to announce and pay dividend for common stocks. The main advantage of issuing stock is that the company does not incur any responsibility to pay a certain amount for the fund. However, there are also a lot of challenges for business organizations should they choose to utilise this means of raising money. In issuing additional stocks, Bradford is diluting the ownership of its stockholders. The company needs to handle the reaction of the current stockholders. The salability of the company's stocks is directly correlated with its financial position and prospects. Investors will be hesitant to buy ownership for a business entity which is not profitable. Bradford needs to prove to its prospective investors that its stocks will yield their expected returns. Investors will surely scrutinize the financial position of the company through its published accounts. Bradford also needs to update its investors on the development of its operations in preset intervals. The company should also see to it that it remains profitable in the future in order for the stockholders to keep its stock. Question 3. Most companies and other organisations need to borrow money, either long or short term. Continued availability of finance is critical for an organisation's viability. Running out of money has drastic consequences for any company." Cash is one of the most important assets of a business organization. In a typical business organisation, cash is generated through the sale of products and services. On the other hand, cash is utilized to pay the company's suppliers, wages, rent, interest and other operation expenses. When companies fall short of cash to finance its various investments, they resort to external funding often extended by creditors or stockholders. Thus, it is a challenge for firms to efficiently manage their cash flows in order to have the right amount of cash at the right time at the right cost. The importance of cash management in a business entity is captured by Entrepreneurs.com (2003) in its articles which states that "Cash is king when it comes to the financial management of a growing company." In the heart of cash management is stated above-having the right amount of cash at the right time at the right cost. This will be further discussed in the following section. Having the right amount of cash at the right time is imperative. In the operation of a typical manufacturer, there are often lags on the time the company pays its suppliers and the time it collects from its customers. It should be noted that the typical scenario shows that in order to manufacture a product, materials should be procured from and paid to suppliers. It is only after the product is manufactured that companies expect to generate revenue and collect from their clients. This lag often represents huge dilemma for companies. Just imagine if a company needs to pay its suppliers and employees in a month's time while revenues are collected within a span of three months. This lag can create a cash crisis for firms especially if they cannot source cash for working capital. Therefore, it is important that a company maintains a balance on the timing of cash flow and inflow. The company should be able to generate an ample amount of cash to pay the expenses as they come due. Failure to do so will be detrimental as it presents disputes between the company, its creditors, suppliers, and employees. The rule of the thumb in cash flow management is "delaying outlays of cash as long as possible while encouraging anyone who owes you money to pay it as rapidly as possible" (How to Better Manage Your Cash Flow 2003). This will lessen the risk of running out of money when the company needs it. Borrowing funds from financial intermediaries is an inevitable predicament for firms. Huge amounts are often sourced to fund the firm's investment in plants, machineries, and other long-term assets. However, it is irrefutable that businesses also borrow in order to maintain their liquidity and working capital purposes. The source and the cost of financing is an n important decision for a financial manager. He should see to it that the company chooses the proper way of financing. For example, long-term investments whose returns will be realized in the span of five years should not be financed by short-term loans but should be funded by long-term liability. Also, financial manager should look at the implications of the different types of financing from different financial intermediaries. The key is being able to match the needs of the business organisation to the available source. Another decision that the financial manager should take into account is the cost of financing. Logically, a company will not borrow if the cost of borrowing is more than the returns of the investment. In financial decisions, it is imperative that a company sets a cost of capital which takes into account all important factors like interest rates. The company should also be aware of the different techniques used to assess the profitability of investments. Lastly, each investment should be evaluated using the time value of money. If a company is not able to thoroughly evaluate the cost of borrowing, it will incur liabilities, which is greater than the profit that the funded investment is going to generate. It is also important to note that the cost of borrowing is not only reflective on quantitative aspects but also on other factors like the disclosure of business information. Lastly it should be highlighted that holding excessive cash is also detrimental for a company. Too much cash implies that the company might not be taking advantage of profitable investments. The amount of cash that the company must hold at a certain point in time should be large enough to pay its obligations but small enough that it doesn't forego profitable investments. Question 4. "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." The presence of financial intermediary in the economic system is justified by their role of channeling excess or surplus funds to entities which needed financing. Business organisations' need for funding is often aided by stock exchanges like the London Stock Exchange (LSE). LSE traces its roots way back 1801 and is currently one of the largest stock exchanges in the world. The effectiveness of LSE in performing its role as a financial intermediary can be assessed by looking at its operational performance. Since its opening to facilitate s tock trading between companies and investors, it can be seen that LSE was able to generate funds for various business organizations. It boasts of being the "most international" among stock markets with its listing of 350 companies operating in 50 different countries. LSE ( 2006) is also "the premier source of equity market liquidity, benchmark prices and market data in the European time zone." Because of its commitment to serve the international market by lowering the cost of capital and international barriers, LSE has linked partnerships to international exchanges in Asia and Africa. It can be seen that London Stock Exchange has adopted advance technology in order to facilitate transactions. The stock exchange has partnered with Hewlett Packard creating LSE's Infotech data delivery application. This new technology makes LSE the fastest international exchange: "With a data latency of only two milliseconds, the exchange's system broadcasts 20 million messages a day to more than 100,000 terminals in more than 100 countries" (London Stock Exchange Becomes 2006). LSE has been a successful exchange based on the number of companies utilizing its services. However, the evolution of hypercompetitive global village puts pressure on the stock exchange. It can be recalled that 18% of LSE's shares has been acquired by NASDAQ. The acquisition of LSE by companies like NYSE and Macquarie Bank is also indicative of the challenges it faces. References How to Better Manage Your Cash Flow (2003). Entrepreneurs.com. Retrieved 28 August 2006, from http://www.entrepreneur.com/article/0,4621,312291,00.html Net Present Value (2006) Wikipedia: The Free Encyclopedia. Retrieved 28 August 2006, from http://en.wikipedia.org/wiki/Net_present_value London Stock Exchange (2006). Wikipedia: The Free Encyclopedia. Retrieved 28 August 2006, from http://en.wikipedia.org/wiki/London_Stock_Exchange London Stock Exchange Becomes World's Fastest with HP and Microsoft Technology (2006). Retrieved 28 August 2006, from http://www.hp.com/hpinfo/newsroom/press/2006/060712xa.html Read More