Investment Opportunity of Penta Limited - Essay Example

Business Appraisals Background Penta Limited is a textile company supplying garments to a large number of retailers in Europe. The company has enjoyed robust growth and is at the maturity stage. Like any other mature company, growth is not impressive. Therefore, Penta Limited is seeking to invest outside the company. The company management board have identified two investment opportunities of which one will be undertaken. The company seeks to invest either in building a new factory in another country or venture into the retail market. Question 1 Table 1- Building a new factory abroad Year 2011 2012 2013 2014 2015 2016 Incremental revenues £ 0.00 £ 2,424,000 £ 5,575,000 £ 9,672,000 £9,849,000 £ 10,029,000 Incremental cost of sales £ 0.00 £ 1,164,000 £ 1,857,000 £ 2,867,000 £ 2,218,000 £ 1,554,000 Administration and selling costs £ 0.00 £ 211,000 £ 443,000 £ 671,000 £ 671,000 £671,000 Interest paid (8%) £ 0.00 £ 320,000 £ 320,000 £ 320,000 £ 320,000 £ 320,000 Net profit before tax £0.00 £ 729,000 £ 2,955,000 £ 5,814,000 £ 6,641,000 £ 7,484,000 Tax (30%) £ 0.00 £ 219,000 £ 887,000 £1,744,000 £ 1,992,000 £ 2, 245,000 Net profit after tax £ 0.00 £ 511,000 £ 2,069,000 £ 4,070,000 £ 4,649,000 £ 5,238,000 Cash flow £ 0.00 £ 511,000 £ 2,069,000 £ 4,070,000 £ 4.064,000 £ 5,238,000               Initial investment £ 6.040 £2,000,000 £ 0.00  £ 0.00  £ 0.00  £ 0.00  Incremental working capital £ 0.000 £ 152,000 £348,000 £604,000 £594,000 £594,000 Table 2- Computation of the Net Present Value for building a new factory abroad Year Cash Inflows Cash Outflows Rt (1+ r + i ) (1+ r + i )t NPV = Rt ÷ ((1+ r + i )t) -6.040 1.106 1 (2012) £ 511,000 £ 2,152,000 -1.641 1.106 1.222 £ -1,343,000 2 (2013) £ 2,069,000 £ 348,000 1.721 1.106 1.351 £ 1,274,000 3 (2014) £ 4,070,000 £ 604,000 3.466 1.106 1.494 £ 2,320,000 4 (2015) £ 4,649,000 £ 594,000 4.055 1.106 1.652 £ 2,455,000 5(2016) £ 5,238,000 £ 594,000 4.644 1.106 1.827 £ 2,542,000 Net Present Value £ 1,207,000 Where, NPV= Rt/(1+ r+ i) t r= cost of capital (8.56%) i = inflation rate (2%) t = the time of the cash flow Rt = Net cash flow If the company chooses to invest in building a new factory, shareholder value will increase by £ 1,207,000 at the end of 2016. Table 3- The retail business Year 2011 2012 2013 2014 2015 2015 Incremental revenues £ 0.000 £1,810,000 £4,045,000 £ 6,773,000 £ 10,115,000 £ 10,115,000 Incremental material costs £ 0.000 £ 436,000 £ 971,000 £ 1,626,000 £ 2,428,000 £ 2,428,000 Incremental labour costs £ 0.000 £ 970,000 £ 970,000 £ 970,000 £ 970,000 £ 970,000 Administration and selling costs £ 0.000 £ 42,000 £ 85,000 £ 129,000 £ 174,000 £ 220,000 Interest paid (8%) £ 0.000 £ 200,000 £ 200,000 £ 200,000 £ 200,000 £ 200,000 Net profit before tax £ 0.000 £170,000 £ 1,819,000 £ 3,848,000 £ 6,343,000 £ 6,298,000 Tax (30%) £ 0.000 £ 51,000 £ 546,000 £1,154,000 £1,903,000 £ 1,889,000 Net profit after tax £ 0.000 £ 119,000 £1,273,000 £ 2,694,000 £ 4,440,000 £ 4,409,000 Cash flow £ 0.000 £ 119,000 £ 1,273,000 £ 2,694,000 £ 4,440,000 £ 4,409,000               Initial investment £5,000,000           Incremental working capital £0.00 £ 114,000 £ 253,000 £ 423,000 £ 632,000 £ 621,000 Table 4- Computation of the Net Present Value for the retail business Year Cash Inflows Cash Outflows Rt (1+ r + i ) (1+ r + i )t NPV = Rt ÷ ((1+ r + i )t) 0 (2011) £ 0.000 £ 5,000,000 -£ 5,000,000 1.106 1.000 £ -5,000,000 1 (2012) £ 119,000 £ 114,000 £ 5,000 1.106 1.222 £ 4,000 2 (2013) £ 1,274,000 £ 253,000 £ 1,021,000 1.106 1.351 £ 756,000 3 (2014) £ 2,694,000 £ 423,000 £ 2,271,000 1.106 1.494 £ 1,520,000 4 (2015) £ 4,441,000 £ 632,000 £ 3,809,000 1.106 1.652 £ 2,306,000 5 (2015) £ 4,409,000 £ 621,000 £ 3,788,000 1.106 1.827 £ 2,073,000 Total net present value £ 1,659,000 Where, NPV= Rt/(1+ r+ i) t r= cost of capital (8.56%) i = inflation rate (2%) t = the time of the cash flow Rt = Net cash flow If the company chooses to invest in retail business, shareholder value will increase by £ 1,659,000 at the end of 2016. Decision The two projects have positive net present values. This means they can both be implemented because they add value to the shareholders wealth. However, if only one investment opportunity was to be carried out in a limited period of six years, Penta Ltd should consider investing in retail business because it has a higher net present value of £ 1,659,000 as compared with that of building a new factory, which has net present value of £ 1,207,000. Question 2 The methods used to appraise investment opportunities use either non-discounted values or discounted values. The most appropriate investment appraisal technique for the two investment opportunities anticipated by Penta Ltd is the Discounted Net Present Value method. Discounted Net Present Value method is defined as the summation of all discounted net cash flows that accrue to an investment opportunity in a defined period of time (Brigham and Houston 2009 p. 338). The method considers time value of money received and spent in a given project in a specified period of time. If the net present value is greater than zero (NPV>0), the investment opportunity will be implemented because it adds value to the company. If the net present value is zero (NPV= 0), the investment may or may not be undertaken. Other factors such as competition, socio-cultural and political issues may be considered to enable the manager or project director to invest or not. However, when the net present value is less than zero (NPV Read More