Financial Mangement: The Viability of the Project Using Net Present Value - Essay Example

Financial Management Question One (A) Determining the Viability of the Project Using Net Present Value Calculation of Depreciation per annum '000' Dep. p.a = Cost - salvage value = 4250 - 250 No. of years 5 = 800 (2) Cash flow schedule Year 2007 2008 2009 2010 2011 Sales Units @ 200 220 240 180 160 Sales price/ Unit @ 35 35 35 35 30 Sales Revenue c=a x b 7000 7700 8400 6300 4800 Variable cost = 25a (5000) (5500) (6000) (4500) (4000) Contribution 2000 2200 2400 1800 800 Fixed costs Earnings before interest 1500 1700 1900 1300 300 Dep. And tax Less Dep. p.a (800) (800) (800) (800) (800) EBT 700 900 1100 500 500 Less Tax NIL NIL NIL NIL NIL Earnings after tax (Accounting profits) 700 900 1100 500 (500) Add back dep. p.a 800 800 800 800 800 Net operating cashflows1500 1700 1900 1300 300 Add Terminal cashflows (250 + 1000 + 5000) Total net cash flow s 1500 1700 1900 1300 6550 (a) (b) 1 (c) a x b (1 + 0.11) n YEAR CASH FLOWS P.V.I.F 11%np PRESENT VALUE 2007 1500 0.901 1352 2008 1700 0.812 1380 2009 1900 0.731 1389 2010 1300 0.659 857 2011 6550 0.593 3884 8,862 Less Initial cash outlet (5000 + 500) (5,500) Not present value 3,362 Since the Net value of the project is positive Barnsley Limited should undertake it. USING INTERNAL RATE OF RETURN This is the rate of return which relates to a particular project independent of all other projects. It is the rate of return which equates N. P. V to zero. STEP 1: Compute the Net present value using the given discounting rate. Sdn: - From the above calculation, the N.P.V is 3362 STEP 2: Since the N. P.V is positive, discount, the cash flows using a higher trial discounting rate which should give a negative NPV say 14%. YEAR CASHFLOWS P.V.I.f 14%np PRESENT VALUE 2007 1500 0.877 1316 2008 1700 0.769 1307 2009 1900 0.675 1283 2010 1300 0.592 770 2011 6550 0.519 3399 8075 Less Initial cash outlay (5500) 2575 The NPV is still positive. Try a higher discounting rates say 30%. YEAR CASHFLOWS P.V.I.f30%np PRESENT VALUE 2007 1500 0.769 1154 2008 1700 0.592 1006 2009 1900 0.455 865 2010 1300 0.350 455 2011 6550 0.269 1762 5242 Less initial cash outlay 5500 258 STEP 3 After now getting a negative NPV from step 2 above interpolate the results I. R. R = lower discounting + [N. P.V at lower discounting rate - NPV at I.R.R] HDR rate NPV at LDR - NPV at H.D.R LDR Where HDR = Higher Discounting Rate = 30% LDR = Lower Discounting Rate = 11% IRR = Internal Rate of Return & NPV at I.R.R = 0 I. R.R = 11% + [3362 - 0] (30% - 11%) 3362 - - 258 = 11% + 17.65% = 28.65% Since the internal rate of return is greater than cost of capital the project should be accepted. B The initial research costs of 500 will have to be capitalized and form past of the initial cash outlay (investment). This is because the cost can be directly attributable to the cost of the project. It is not a period cost and hence cannot be treated as a normal expense. Working capital will comprise of the salvage value of the plant and machinery and the additional capital of 1,000,000 & 5,000,000 invested on 31st Dec 2006 & 31st Dec 2007 respectively, working capital are the financial resources which shall be availed at the end of the project life. These can be invested. They are assumed to be past and pared of the economic benefits flowing onto the enterprise. But should be captured at the end of the fifth year. Depreciation is a non- cash item. Depreciation is not taxed. Instead the entrepreneurs are given a wear and tear allowance. It is excluded from taxation and their added back to arrive at the Net operating cash flows. The following factors highly affect the earlier decision of accepting the project. a) The sales are first an estimated and do not reflect the actual sales that would actually be realized. Lower sales than anticipated might mean a negative Net present value of the project. b) The value costs are also an estimated. There could've been an underestimate of variable costs during forecasting. This would change the earlier decision. QUESTION 2 The chairman of the Board is in favour of issuing more shares whilst the finance Director has settled on a medium term loan. Impact of issuing more shares on the gearing and capital structures of Barnsley Ltd Raising finance through issuing of more shares will lower the gearing level of the firm. Gearing refers to the extent to which the assets of the firm have been financed using borrowed capital. The raising of more shares will make the ordinary share capital and other equity instruments in totality to outweigh the fixed charge capital in the capital structure gearing, being a ratio of fixed charge capital vs. equity will then be lower. What would happen is that the current shareholders would be diluted by an additional issue of shares. Impact of going for a loan A medium term loan is form of fixed charge capital. A fixed charge is a borrowing characterized by an obligation to pay a pre -determined interest normally fixed at a given percentage. Going for such a medium term loan will adversely affect the gearing position of Barnsley. This firm has already and overdraft of 40,000 which has not been financed. Any additional borrowing would increase its financial risk. This might ultimately lead to insolvency of Barnsley. It would mean that the firm will be highly geared because shall have been increased by virtue of going for the loan. In addition the loan is short -term in nature. The providers of the loan would therefore require that it be surfaced within a short time period. This may in return affect Barnsley's working capital. Owing to the above factors, Barnsley Ltd would rather go with the chairman of the Board and raise finance through a share issue rather than negotiate a loan. QUESTION 3 Shareholders are the owners of the firm. The maximization of their wealth means the maximization of the value of the firm. This is achieved by ensuring that the market price per share is as high as possible. This price can be increased by undertaking investments which yield positive benefits called Net present value (NPV) Not all projects that yield positive Net present value can be undertaken by the firm Some projects are initiated to benefit managers and directors in the short term of their tenure. These projects normally generate steady flow of benefits in the first years & none in future years. This is risky for the firm if such a project must have consumed a significant amount of resources. Benefits from projects are mere estimates. The figures arrived at are therefore subjective hence unreliable. This risk however can be balanced by attaching probabilities to the projected cashflows. Alternatively a certainty equivalent can be used to calculate the real cashflows. To achieve the shareholders' wealth maximization goal a higher dividend payout policy is adopted. It leaves the firm with inadequate retained profits. This has the following effects Retarded investment: Little or no investments will be done when the firm pays out most of its earnings as dividends. Insolvency: The firm may be liquidated since there's no cash to pay off its financial obligations as and when they fall due for payment. The firm should therefore adopt a dividend policy that strikes a balance between wealth and risk. Managers require certain skills in order to carry out their work more effectively and efficiently. Conceptual skills: - These skills enable managers to think in the abstract. Managers must be able to do things that others will not do. This skill can be essential in balancing return and risk in the following ways: - (1) Proper budgeting of resources: The limited financial resources available for investment purposes require prioritization by the management. This will enable the firm to undertake only the most profitable projects. (2) Proper estimation of future benefits: Future benefits / cashflows from a project are difficult to estimate because investment decisions extend far into the future which is uncertain. Poor benefit estimation may lead to undertaking of unviable projects hence high risk. It requires a financial manager with conceptual skills to curb this problem. Inter personal skills: - These skills enable a financial manager to relate well with his juniors and other stakeholders. A manager's good inter -personal skills will motivate the employees who will in turn work harder. Thus the firm will realize more returns and the wealth of the shareholders shall have been maximized. Inter - personal skills reduce conflicts in the firm. The firm will therefore earn respect. This attracts one of the factors that will attract potential investors. This high demands of the company's shares will push share prices upward hence maximized benefits. Technical skills: These skill are required by financial managers to handle technical tasks. For instance most of the business transactions are carried out using computers. Some tasks require use of complicated software in order to be executed & decisions to be made thereafter. For a financial manager to carry out his work successfully he ought to possess these technical skills. Otherwise there will be a risk of losing profits because vital information for decision making will not have been made. The alternative investments market has greatly succeeded and is now ahead of the more traditional markets. Through the AIM many small firms can now publicly trade their shares without much difficult. The success of AIM is attributed to a number of factors. Among these are (1) Understandability: - The rules that govern the operations of this market are easy to interpreted and understand. They are written in simple English as opposed to the traditional markets characterized with complex legal language. (2) Accessibility It is easier to access AIM for small companies whose interests might not be well catered for in the other markets AIM does not have a requirement that a particular company achieve a given market share for it to trade its shares under it. AIM gives no restrictions as to the size of the company. And this is why it enjoys popularity amongst smaller firms. It is mainly designed to cater for these small firms. The Alternative Investment Market offers no ceilings as to what level of performance a company needs to achieve in order for it to be allowed trade its shares in the market. Under AIM a company can easily transfer its shares. References Barrow, P. and Branson, R. (2001): The Bottom Line: Business Finance: Your Questions Answered, 3rd Edn, London, Virgin Business Guides Dixon, H (2002): Finance Just in Time: Understanding the Key to Business and Investment Before It's Too Late, 1st Edn, Sydney, Texere Eiteman, D.K., Stonehill, A. I, and Moffett, M.H (2006): Multinational Business Finance, 11th Edn, London, Addison Wesley Klein, W.A, John, C. and Coffee, Jr. (2004): Business Organization and Finance: Legal and Economic Principles, 9th Edn, London, Foundation Press Siegel, J.G., Shim, J.K. and Hartman, S.W. (1997): Schaum's Quick Guide to Business Formulas: 201 Decision-Making Tools for Business, Finance, and Accounting Students, 1st Edn, New York, McGraw-Hill Read More