Financial Management and Investment markets and principles
In business finance ,evaluation of a project net worth is always a daunting task because there exist many ways of measuring the value attached to the future cash flows .This is due to the fact that the value of money earned today wouldn’t not have the same worth as money earned in future. Thus Business finance analyst must incorporate time value of money to get the net present worth of the project proposal. The company`s cost of capital or the discounting rate is the major variable in the net present value formulae. Different companies have a their own ways of indentifying and calculating the discounting rate, however the most common one is using the returns which are expected from other investment decisions from other similar projects which carry the same risk.
Hence in definition we can define that the Net Present Value as the difference between the incoming cash flows and the outgoing cash flows over a certain period of time .In other words the incoming cash flows are regarded as benefits while the outgoing cash flows are regarded as costs .The time value of money is the surrounding phenomenon behind the computations .Thus the Net Present Value of Investment is usually determined by taking into consideration calculation of the present values of the total inflows and outflows which is derived by method of discounting the future value of individual cash flows. If the results are positive then the NPV is Profitable, If the results are negative then the NPV amount to a loss. Thus this method is used the surplus or else the deficit of the cash flows, in the value of present terms which should be above the cost related to funds .In an empirical or theoretical manner a company which carries out capital budgeting always approves the projects which yield positive NPV .On the other hand the ,every company is faced with Financial constraints’ thus they may hinder or slowdown the company progress on investment to the projects with the maximum and desirable NPV, whose the cash flow cost don’t exceed the capital of the company .In addition to that, business finance analyst use NPV as the core and the fundamental tool in the discounted cash flow analysis and also as the paradigm technique for the usage of the time value of money. This can be used to weigh up projects which are long term. Economist, accountants’ and financial analysts use this technique widely to value the projects which would yield maximum returns.Net Present Value method can also be defined as the amount in difference between the arithmetic summation of cash inflows and cash outflows which are discounted .Inflation and returns are taken into consideration in when comparing the sums of discounted cash outflows and the cash inflows .Formulae used above
There may be many variables in the formulae but the rate used for discounting is a key factor in this .Most of the companies use the weighted average cost of capital which is computed after taxes their main rate of discounting .Some other financial analyst believe that its necessary to use a rate above that to accommodate other macroeconomic variables such as inflation and other financial analyst believe that its necessary to use a rate above that to accommodate other macroeconomic variables such as inflation and unemployment and the opportunity cost. It goes without mention that the yield curve premium for a debt which has withstood for long can be evaluated by changeable discounting rate which occur along a time path. However there exist other measures that are used to calculate discounting rate. Such as the discounting rate can be chosen by decide the rate the investment will return if the same amount is invested in a similar venture. For example for our both proposal ,project 1 and project 2 ,the discounting rate for the NPV calculation will be able to permit comparison to be made on both proposal 1 and proposal 2.There exists a close relation between the discounting rate and the firms reinvestment rate. In definition the Firm reinvestment rate represents the rate of return for the investment of the firm on averaging terms. The capital market is always constrained, thus it may prove to be impossible to use the weighted cost of capital as the discounting rate thus use the firms reinvestment rate. The rate is used to represent the opportunity cost involved in carrying out the investment instead of lowering the cost of capital. If the variable reduction rates are used to calculate NPV ,the analysis provide a better reflection of the of the financial profitability at the situation .On the contrary if the NPV are calculated using the discounting rates that are constant for the entire duration of period, the results may not reflect the true nature of the project profitability.
Some investors, who are very professional in capital budgeting, commit their investment funds to an objective or a target .In such situations, when calculating the NPV the rate of return should represent the discounting rate. In this method the can be a direct assessment between the desired rate of return and the profitability of the venture.
Before computing the NPV, many of the business fund managers already set a target return that will be used as a bench mark to discount the net cash inflows from the proposed project. The net cash flows during the investment period will be subtracted from the expenses which are directly related to generating the inflows in cash .The NPV indicator is a measure of how much worth does the investment add to the company real asset value. The rules of decision state that the project is only accepted if the NPV is zero or else it’s positive. The project is rejected if the project is having a negative NPV .In the case one is comparing two mutually exclusive projects ,both having positive NPVs, the project with a higher NPV is the one which is accepted ,the other with a lower NPV is rejected.
SECTION A: SELF ASSESSMENT (TO BE COMPLETED BY THE STUDENT)
In relation to each of the set assessment criteria, please identify the areas in which you feel you have strengths and those in which you need to improve. Provide evidence to support your self-assessment with reference to the content of your assignment.
STRENGTHS AREAS FOR IMPROVEMENT
I certify that this assignment is a result of my own work and that all sources have been acknowledged:
SECTION B: TUTOR FEEDBACK
(based on assignment criteria, key skills and where appropriate, reference to professional standards)
1. STRENGTHS AREAS FOR IMPROVEMENT AND TARGETS FOR FUTURE ASSIGNMENTS
MARK/GRADE AWARDED DATE: SIGNED
It is anticipated that marked coursework with feedback will be available to candidates three weeks
(21 days) after submission. Notice of availability will be posted on blackboard.
Assignment/coursework general submission requirements
• Your student identification number must be clearly stated at the top of each page of your work.
• Each page must be numbered.
• Where appropriate, a contents page, a list of tables/figures and a list of abbreviations should precede your work.
• All referencing must adhere to School/Institutional requirements.
• A word count must be stated at the end of your work.
• Your course, year of study and the relevant module must be included as a “footer” on each page.
• Appendices should be kept to the minimum and be of direct relevance to the content of your work.
• All tables and figures must be correctly numbered and labelled.
• If there is calculation involved you are required to provide workings. Otherwise, no credit will be awarded.
Module: BAC5006 Financial Management Level 2 – Coursework
Case study – Mercia plc.
Mercia plc. owns two acres of derelict land near to the centre of a major UK city. The firm has received an invoice for £50,000 from consultants who were given the task of analysis, investigation and design of some project proposals for using the land. The consultants outline the two best proposals at a meeting of the Board of Mercia.
Proposal 1 is to spend £150,000 levelling the site and then constructing a six-level car park at an additional cost of £1,600,000. The earthmoving firm will be paid £150,000 on the start date and the construction firm will be paid £1.4m on the start date, with the balance payable 24 months later.
It is expected that the car park will be fully operational as from the completion date (365 days after the earthmovers first begin).
The annual income from ticket sales will be £600,000 to an infinite horizon. Operational costs (attendants, security, power, etc.) will be £100,000 per annum. The consultants have also apportioned £60,000 of Mercia’s central overhead costs (relating to the London-based head office and the executive jet) to this project.
The consultants present their analysis in terms of a commonly used measure of project viability, that of payback.
This investment idea is not original; Mercia investigated a similar project two years ago and believe that there are some costs which have been ignored by the consultants. First, the local council will require a payment of £100,000 one year after the completion of the construction for its inspection services and a trading and environmental impact licence. Second, senior management will have to leave aside work on other projects, resulting in delays and reduced income from these projects amounting to £50,000 per year once the car park is operational. Also, the proposal is subject to depreciation of one-fiftieth (1/50) of the earthmoving and construction costs each year.
Proposal 2 is for a health club. An experienced company will, for a total cost of £9m payable at the start of the project, design and construct the buildings and supply all the equipment. It will be ready for Mercia’s use one year after construction begins. Revenue from customers will be £5m per annum and operating costs will be £4m per annum. The consultants allocate £70,000 of central general head office overhead costs for each year from the start. After two years of operating the health club Mercia will sell it for a total of £11m.
Information not considered by the consultants for Proposal 2
The £9m investment includes £5m in buildings not subject to depreciation. It also includes £4m in equipment, 10 per cent of which has to be replaced each year. This has not been included in the operating costs.
A new executive will be needed to oversee the project from the start of the project costing £100,000 per annum.
The consultants recommend that the Board of Mercia accept the second proposal and reject the first.
– If the site were sold with no further work carried out it would fetch £100,000.
– No inflation or tax.
– The cost of capital for Mercia is 10 per cent.
– It can be assumed, for simplicity of analysis that all cash flows occur at year ends except those occurring at the start of the project.
(a) Calculate the net present value of each proposal and comment on its financial acceptability.
(b) Calculate the internal rate of return and the payback for each proposed project.
(c) Critically evaluate the use of NPV approach in proposed investments.
(d) Discuss what further information might be obtained to assist a fuller analysis.
(Total 100 marks)
Standard assessment regulations apply. You must reference your work as required by.
Note: Word limit is 3,000 words. Only printed copy is to be submitted through I-ZONE by due day.
This is assessment One and contributes 50% of the overall module assessment.
Learning Outcomes. On successful completion of this assessment, the student will:
• Demonstrate an awareness of the financial context in which business operate.
• Understand and explain key concepts and models, in this case discounted cash flows.
• Evaluate capital projects/investments using a range of recognized techniques.
• Recognize and evaluate the effect of economic environment for business.
F Failure to meet learning outcomes
E Failure to meet PASS criteria. Few competencies achieved. Little integration or evaluation of learning exercise. Small amount of remedial work required, may be compensatable subject to mark in second assessment.
D A basic attempt to answer the question, with little attention to structure. Figures and tabulations substantially correct, though there may be some errors and omissions. Little evidence of research.
C Satisfactory structure and flow, with minimal errors in composition. Figures and presentation substantially correct. Little evidence of independent research but satisfactory discussion of main issues.
B As for ‘C’ plus answer displays familiarity and comprehension of the issues, but without a great deal of independent or critical comment. Majority of figures correct and presented in an appropriate fashion. Evidence of research of current sources of information and correct referencing.
A As for ‘B’ plus answer displays evidence of independent criticism and analysis. Free from errors and all relevant points discussed. Research includes investigation of current issues. Research correctly referenced.
Graduate Skills assessed: 1a, 1b, 1d, 2a, 2b, 2c, 3c, 4a, 4b, 6a, 6b, 6c, 6d, 7b & 7c.
Skill Category Skill Elements to be developed
1. Communications a. Written
b. Presentation: verbal and written
c. Listening and interpretation
d. Reading and interpretation
2. Numeracy a. Calculation/estimation
b. Understanding conventional numerical data.
c. Handling and interpreting date.
3. Technology a. Use/application of ICT
b. Electronic communications
c. Information retrieval and manipulation
4. Learning and Study a. Personal time management
c. Learning technology
5. Interactive Group a. Team working
b. Taking initiative
c. Leadership/managing others
6. Problem Solving a. Identifying key issues
c. Managing tasks
d. Creativity and originality
7. Professionalism a. Ethical evaluation
d. Self reflection evaluation
e. Career/career development awareness.