Finance Analysis of Gosling and Hopkins PLC - Essay Example

Finance Report of Gosling & Hopkins (G&H) PLC Introduction Finance is the most integral part of any business, because in order to undertake any kindof activity, major or minor, source of funds has a significant role. The finance manager or his associates is responsible for the proper utilization and allocation of funds. Gosling and Hopkins (G&H) PLC, the producer of food products in UK market, have now decided to expand its business operations. For this, the company requires adequate source of funds, the quantum of which should be relevantly decided by the Finance Department of the company in detail. 1. Evaluation of R&D Projects with Capital Budgeting Techniques By capital budgeting of an entity we mean a detailed planning of capital assets. The decision about capital budgeting helps in determining whether or not the money should be invested in long term projects. When we consider the Research and Development projects of G&H PLC for the purpose of better decision making, we find that the fundamental project evaluation techniques like Pay back period, ARR (Accounting or Average Rate of Return), NPV (Net Present Value), or IRR (Internal Rate of Return) are applicable. The initial outlay or initial investment of the project of G&H Plc is 4m, i.e. 4000000. Pay Back Period= Initial Investment/Total Cash inflow. Here, cash inflow means profit after tax, but before depreciation. Calculation of Cash inflow under Two Options- (Assume Calculation only for the first year) Particulars Option A (' 000) Option B('000) Profit Before Tax. Less:Tax@30% PAT (Profit after tax) Add: Depreciation Written off. Total Cash inflow. 440 132 150 45 308 160 105 200 468 305 Pay Back Period= 4000000, i.e. ( '000s), Option A= 4000/468= 8.547 years approximately, and for option B= 4000/305= 13.114years approximately. If both options are considered in fact option A has 8.5years and B has more than 13years, but option B has a much higher return than option A, so it should be preferred. ARR= Total Profit after tax and depreciation*100/Net Investment in the project*number of Years of Profits. Calculation of Profit after Tax and Depreciation under Two options (assume only for one year) Particulars Option A (' 000) Option B('000) PAT (Profit after tax) Less: Depreciation. Profit after tax and Depreciation. 308 160 105 200 148 _95 Option A- 148*100/4000*5Years= 18.5%. Option B- _95*100/4000*5Years= _11.875%. Assume that net income for the first year is taken for both options, and there is no scrap taking place. Both these options are not equal since the profit in Option B starts accruing at a much higher level as compared to the profits of Option A. So, ARR fails to give stress for the concept of Time Value of Money. NPV= Total Present value of future cash inflows_ Total Cash outflows. For calculating the total Present value of future cash inflows, assume the discount factor @10% for both options. Calculation of Present Value of Option A YEAR CASH INFLOWS (' 000) DISCOUNT FACTOR @10% PRESENT VALUE(' 000) 1 600 0.909 545.4 2 400 0.826 330.4 3 300 0.751 225.3 4 200 0.683 136.6 5 200 0.621 124.2 TOTAL 1700 875.8 Calculation of Present Value of Option B YEAR CASH INFLOWS (' 000) DISCOUNT FACTOR @10% PRESENT VALUE(' 000) 1 350 0.909 318.15 2 400 0.826 330.4 3 500 0.751 375.5 4 650 0.683 443.95 5 700 0.621 434.7 TOTAL 2600 1902.7 NPV= Cash inflow_ Cash outflow, Out flow for A&B are 800 and 1000 respectively. OPTION A= 875.8_800=75.8; OPTION B=1902.7_1000=902.7 Option B is more profitable than A, because the present value of the cash flow of Option B is more than Option A. 1RR= It means, the sum total of cash inflows after discounting equals to the discounted cash outflows. Under IRR, the discount rate makes the NPV of the project equal to zero. Assume that, here, in both options the discounted value is in between 10% and 12%. Take inflow of 10% given in the table above and 12% factor for Option A assumes 750.9 and Option B assumes 1750.3 approximately. IRR= r+ PVCFAT_ PVCO/PV*r Here, PVCO= present Value of cash outlay. PVCFAT=Present value of cash inflows. r = Interest rates. r = Difference in interest rates. PV= Difference in present values of inflows. Option A- IRR= 10%+ 875.8__800/875.8_750.9*2= 11.21% Option B- 1RR= 10%+=1902.7_1000/1902.7_1750.3*2= 21.846% Therefore, it is better to select Option A for making investment Under IRR. Highlights of Four Methods METHOD OPTION A OPTION B PREFERABLE FOR INVESTMENT PAY BACK 8.547 YEARS 13.114 YEARS OPTION B ARR 18.5% _11.875% OPTION B NPV 75.8 902.7 OPTION B 1RR 11.21% 21.846% OPTION A Accordingly, we can conclude that it is essential to undertake expansion of G&H PLC through Option A by using Natural Products for further development. 2. Use of CAPM (Capital Asset Pricing Model) "A model that describes the relationship between risk and expected returnandthat is used in the pricing of risky securities. ." (Capital Asset Pricing Model. 2007). CAPM stresses two concepts and they are time value of money and risk factor. Here, G&H Plc employs CAPM as an appropriate method for its investment evaluation concept. CAPM specifies the relationship between expected return and risk for all securities and all portfolios. CAPM is based on Security Market Line (SML), which is a straight line joining risk free asset, which has a beta coefficient of zero, and the market portfolio, which has a beta coefficient of one. Here, Beta of Equity 1.7, the risk-free rate of return is 4% and the market risk premium is estimated to be 5.94%. So, CAPM= 4%+1.7*(5.94%_4%) = i.e. 1.74*0.0194= 0.033756. 3. Appropriateness of CAPM The major observations about the use of CAPM are as follows- Capital Asset Pricing Model is really extension of the portfolio theory. It is mainly based on the assumptions about the investor's preference. Under this method, there should be a proper relation between the risk and return factors. CAPM can be used for evaluating the price of various securities. Even though CAPM is a suitable investment appraisal technique, it has also certain problems as this method is not relevant for an average investor. 4. Recommendations On the Research and development Projects G&H Plc undertook a R&D Project for evaluating the best suitable investment appraisal for the further expansion of the company. This is because, for undertaking the expansion programme, a business should evaluate a number of investment and project appraisals, and among them the most suitable method should be selected. Capital budgeting and investment decisions are highly related with the working of G&H Plc. Major investment appraisal projects based on the capital budget techniques are being implemented by G&H PLC are Pay back period, ARR, NPV, IRR. Pay back period- is the period within which the total cash inflows from the project equal the cost of the project. Major advantages of this method are the following- The pay back period can be compared to a Break-even point, the point at which the costs are fully recovered but profits are yet to originate. The risk related to the project arises due to uncertainty associated with the cash inflows. This method is suitable in case of projects which generate cash inflows in earlier years. Major disadvantages of the method are explained below- This method gives more emphasis on capital recovery rather than profitability. If cash inflows are uneven, this method is not adequate to evaluate two projects. ARR means the average annual yield on the project. The major advantage of ARR is that it includes income from the project through out its life. Similarly, ARR has limitations too. It is because the ARR ignores the effect of fluctuations in profits from year to year. Another difficulty is that it ignores the time value of money, which is crucial for taking capital budgeting decision. NPV is considered to be the best method to evaluate an investment proposal. The major merits of NPV are: Consideration given for time value of money. The entire stream of cash flow is considered. NPV should express cash flows in terms of discounted figures. Limitations of NPV include Complicated method to calculate the present value. It requires the forecasting of cash flows and discount rate. Selection of the suitable projects should be based on the discount rate. IRR- It is interpreted in two ways 1. Rate of return on the unrecovered investment balance in the project. 2. IRR is the rate of return earned on the initial investment made in the project. Merits of IRR are It gives emphasis on time value of money. Consideration should be given for all the cash inflows in the project. IRR techniques help to achieve the objective of minimization of shareholders wealth. Limitations While comparing two projects with different inflow or outflow patterns, it creates an abnormal situation. In case of multiple IRRs, the interpretation becomes quiet difficult in nature. When we consider the present situation of G&H Plc among all the abovementioned techniques, NPV is the best method for evaluating the investment proposal. If NPV is positive, a project can be accepted, and the project may be rejected if it is negative. If NPV is zero, the project generates cash flows at a rate just equal to the opportunity cost of capital. 5. Analysis of Share Price Movement Share price movement of G&H Plc is quiet remarkable during the eight week period. Moreover, the company should occupy an outstanding position in its share market. The G&H Plc has a share price at present has been in the region of 750p per share. Due to the expansion programme, company decided to undertake export of 20% within two years. Table Showing the Share price impact of G&H PLC during Eight Week Period Week Stock Price 1 2 3 4 5 6 7 8 G&H PLC 100p G&H PLC 100p G&H PLC 100p G&H PLC 100p G&H PLC 100p G&H PLC 100p G&H PLC 100p G&H PLC 100p 650p 624p 734p 790p 784p 784p 834p 790p When the Stock summary of G&H PLC is evaluated, it will be clear that there is a fluctuation in the price movement from week period to week period. FTSE index is a share index of capitalized companies which are listed on the Stock Exchange of London. "The Food & Drink Service is designed to enable industry professionals, manufacturers and suppliers, company analysts, consultants, industry and regulatory organizations to evaluate and better manage the risks and exploit business opportunities in global food, drink & retail markets." (Food & Drink Service. 2006). 6. Evaluation of financing options There are mainly three financing options that are available to G&H Plc, such as- 1. 100% equity financing. 2. A Proportion of equity & debt financing. 3. 100% debt financing. Similarly, the present market price for the shares and debentures of G&H PLC are- 1 Ordinary shares 3.50 ex div, 0.50p, 6% Preference shares 0.55 ex div, and 7% Debentures 2010 104 ex interest. Calculation of Earnings per Share for Three Alternatives to finance the Project of G&H Plc. [Calculation Based on 2007 Figures, and Total Required sum is 1000000] PARTICULARS To raise 100% Equity[ 1000000] Proportion of Equity and Debt[ 50%basis proportion] 100% Debt Financing.[Debt fully and remaining Equity] Amount in '000s Amount in '000s Amount in '000s Earnings before interest and tax. Less: Interest on Debt. Earnings Before tax Less: Tax@30% Earnings after Tax. Number of Shares. EPS= Earnings after Tax/ Number of Shares 1456 Nil 1456 436.8 1019.2 1333 0.764 1456 53 1403 420.9 982.1 666 1.474 1456 53 1403 420.9 982.1 333 2.949 Workings Alternative 1 Alternative 2 Alternative 3 Equity Financing Market Price Per share Number of Equity shares. 1000000 750p per share 1000000/ 750p per share 1333 shares 5000000 750p per share 5000000/ 750p per share 666 shares 250000 750p per share 250000/ 750p per share 333 shares Assume that under alternative 2, 50%Equity & 59% debt is taken; and under option 3, 100% debt i.e. 750000debt and the remaining 250000equity is taken. Now, Earning per Share under Alternative 3 is higher, i.e. 100% debt and remaining equity financing is preferable by G&H PLC to finance its project. The present shareholders of the company enjoy its financial implications in a stable and satisfying. Out of the total share holdings, presently 30% of shares is held by the management and remaining 70% by investors. 7. Financing Option When the aforesaid financial impact of G&H Plc is considered, it is clear that in order to undertake its expansion of business operations profitably, it is necessary to choose the most suitable financing option for the company which is under the responsibility of Finance manager of G&H PLC. From the point of view of capital budgeting technique, company should adapt Net Present Value method. Also, when the capital structure and cost of capital decision are evaluated, company can opt for EPS and it is Debt financing which is crucial to maximize the overall profitability. So, it is necessary stress the project and technical feasibility, and financial viability of G&H PLC in appropriately to accomplish its targeted expansion programme. Bibliography Capital Asset Pricing Model. (2007). [online]. Investopedia. Last accessed 28 November 2007 at: http://www.investopedia.com/terms/c/capm.asp Food & Drink Service. (2006). [online]. Business Monitor. Last accessed 28 November 2007 at: http://www.businessmonitor.com/bmo/food/gclid=CNyx7uDo_I8CFQMkegodCAmLw Read More