Research Proposal on "Finance and Financial Management"

Research Proposal 12 pages (3280 words) Sources: 10 Style: Harvard

[EXCERPT] . . . .

Finance

a) the projects net present value is a loss of £2,180,988. The IRR is -7%. The project does not pay back, since the viable lifespan of the project is six years. Therefore, the project as presently constituted is not viable. The initial setup cost for the facility of £12 million represents such a significant upfront cost that the project simply cannot generate sufficient revenue to render it viable.

The first assumption is that the £2 million already spent on product development is not taken into consideration. When examining a capital budgeting project, sunk costs should not be incorporated into the calculation. This is because that money has already been spent, and the decision that management is faced with concerns money that has not yet already been spent. Capital budgeting has a strong future orientation.

The second assumption is with regards to the plant space. The £80,000 of rent that the company would forgo is included in the calculation. An opportunity cost such as this should be included in the calculation. My calculations of the taxes from the project also included the opportunity cost, because that income would have been taxable. In other words, the £80,000 in revenue would have been subject to £24,000 had it been earned. Opportunity cost calculations must be on a net basis, not gross. The other opportunity cost that was included was the potential resale of the equipment. If the project goes ahead, that equipment will not be sold, but will be disposed of later for no value. Therefore that opportunity cost must also be included.

There were also a few items that did not represen

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t cash flows. These items include the depreciation on the £12 million investment and the £50,000 in rent that head office attributed to the project. The rent charged is not a cash flow for the project, since the opportunity cost of not renting that space has already been included in the calculation. That rent, however, affects the after-tax cash flow because it increases expenses, lowering the project's tax burden. Depreciation expense will also lower the project's tax burden.

Not included in the calculation was the variable cost of £1.80 per unit. This is the portion of head office costs that has been attributed to the project. This is not counted as a project cash flow, because these costs are not project-specific. They would be paid by the company regardless of whether or not the project proceeded. This also means that they do not represent a project-specific tax benefit, either. The capital budgeting process should ideally incorporate cash flows that are attributable to the project itself.

It was assumed for this project that the 20% of completed goods inventory is attributed to the year in which the goods were produced, rather than sold. For example, year 1 production would be the 300,000 sold in year 1, plus the additional finished goods inventory required for year 2 of 80,000. The year 6 production would therefore be the 400,000 units sold less the 80,000 in the finished goods inventory at the beginning of the year.

The 10% materials that need to be purchased in advance of the coming year were not included in the project's calculations. It was assumed that materials will be purchased on credit, and that the increases in liabilities will be offset by an increase in accounts receivable.

A b) the purpose of a sensitivity analysis is to test the effects on the budget calculations of changes to key variables. Sensitivity analyses are a crucial component of capital budgeting for a couple of reasons. One is that the figures used in the budgeting process are estimates, and thus subject to change. Management needs to know what the impacts of some key changes might be. A project could have a high net present value as calculated, but a minor shift in one variable may render the project unprofitable. The other reason why sensitivity analysis is important is to help management identify ways to improve a project's profitability. For a project such as this one, management can evaluate different price points, or identify that the major impediment to profitability is the £12 million initial cost and realize that if they can cut that figure they can improve the project's outlook dramatically.

For this project I performed a sensitivity analysis on the £12 million initial cost, the discount rate, the price, the sales estimates and the variable costs. The initial cost is a significant impediment to profitability. In order to achieve the company's desired rate of return on this project, that initial cost would need to be reduced to £7.25 million. That represents a reduction of 39.5%. Given that this cost is in the very near-term, the £12 million figure is likely fairly accurate. What this says about the project is that since the company is unlikely to change the initial cost enough to bring the project to the desired rate of return, profitability must be found elsewhere.

A test of the sales estimates reveals that if an extra 100,000 units are produced each year, the project's IRR increases to the 14% hurdle rate. It is unknown if the sales estimates are reasonable at this time, but these increases amount to 33% and 25%, which again points to a lack of viability for this project.

Adjusting the price shows us that an increase to £23 will put the value of the project past the hurdle rate. This represents a 28% increase over the estimated price of the product. This may be something that the market can bear, depending on the product and market conditions. This can be a starting point for further discussion as to how this product can be made profitable. For example, suppose modifications are made that would allow the product to be priced at a premium level. The materials cost may increase to £7 but the selling price goes up to £25. Such a scenario would effectively increase the contribution margin of the product, thereby bringing it into profitability.

The sensitivity analysis can also be used to identify variables that have very little bearing on the project. Reductions in the cost of capital, for example, are not sufficient to bring the project to profitability. This is in large part due to the fact that the initial capital outlay is not discounted, and represents a significant portion of the total cost.

Sensitivity analysis can also be used to measure combinations of variables. It may be feasible, for example, to cut the initial cost by £1 million, and raise the price slightly. From that analysis, even adding in a reduction in the tax rate, we see that the project does not clear the hurdle rate based on minor changes. From performing all of these different sensitivity analyses, we can identify improving the contribution margin as the best way to bring the project to profitability. However, if it requires a series of variables to fall into their best-case scenarios for this project to be viable, then it should not be considered a viable project.

2. a) a price earnings (P/E) ratio measures the value of a company's stock vs. The amount of money that the company is actually earning. In theory, the value of a company is the net present value of its future earnings. Future earnings are calculated based on present earnings and the expected growth rate. The growth rate is applied to the earnings, and then discounted back to present value. The P/E ratio is therefore an indicator of the company's future growth prospects, as determined by the market. The result is that if you have two companies both with earnings of fifty cents per share, the one with the higher growth prospects will have the higher stock price.

One valuation model is the dividend growth model. This is a variation of the P/E model, in that only the dividends are measured to determine stock price. This is recognition of the fact that a share of stock represents an investment, and the value of that investment is the value of the cash flows emanating from it. The underlying theory is that it is the dividends, not the earnings, that comprise the value of the investment. The earnings are related to the value of the company as a whole, and only if their capital structure is 100% equity. Therefore, the dividend discount model is a more realistic measure of the value of the stock, as an investment rather than the value of the company as a whole. The components of the dividend discount model are today's dividend, the payout ratio, the expected dividend growth rate, and the discount rate. The P/E can be used to derive the expected growth rate, since P/E is an indicator of the expected future earnings. With these earning and the payout ratio, the future earnings growth can be extrapolated and used to calculate the NPV.

A b) the four companies I have chosen to analyze are FedEx, Yahoo, Nike and Boeing. The respective P/E ratios are 19.25… READ MORE

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Quoted Instructions for "Finance and Financial Management" Assignment:

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Inorder to work on this assignment the ***** must use below info to access the website.www.intranet@gsb.strath.ac.uk

Login to the SBS intranet using nkb06122 password shar959D. Go to course information/click Finance and Financial Management then Assignment. Click international to use the Assignment Return Datasheet and the FFM Portfolio calculations

The question below is estimated to an answer carrying 3000 words

Master of Business Administration

International

MANAGING FINANCIAL RESOURCES

(Finance & Financial Management)

ASSIGNMENT

October 2008 *****“ September 2009

The questions in this assignment require some quantitative work and some interpretation. When answering the discursive questions make full use of the relevant theoretical propositions and concepts.

Question 1: Capital Expenditure Decisions and Investment Criteria

Ammanford Plc

As the finance director of Ammanford Plc you have been asked to evaluate an investment proposal relating to the manufacture of a new product. The company*****s Research and Development Department has been working on this product for quite some time and has already spent Â£2.00m on its development and it will be necessary to spend a further Â£500,000 to complete the work. Management is confident that it will be able to launch the product successfully quite quickly without spending more than the planned amount.

The selling price for the product is expected to be set at Â£18.00 per unit and it is anticipated that sales in the first year will be about 300,000 units, rising to 400,000 in year two, and sales are expected to remain at this level for the following four years. It is anticipated that the product will no longer be competitive after six years and it will be withdrawn from the market.

To manufacture the product an investment of Â£12 million will be necessary in new production facilities. This expenditure can be written off (capital allowances) for tax purposes on a straight-line basis over the product*****s six year life. The re-sale value of the equipment has been estimated to be about Â£0.80 million at the end of the six years. Use will also be made of some equipment the company already owns. This equipment is fully depreciated for tax purposes but could be sold today for Â£0.45 million. If used in the manufacture of the product it is not expected to have any value at the end of the six year period. The production facility will be located in one of the company*****s factories that is not being fully utilised. The company has no alternative uses available for this space, but it could be rented out to another manufacturer who is short of space for Â£80,000 per annum. The product will be charged Â£50,000 per annum for the space it utilises through the company*****s management accounting system. The fixed costs associated with the production are expected to be Â£750,000 per annum. Each product sold by the company is also allocated by the company*****s accountant an overhead charge of 10 per cent of the revenues it generates to cover head office expenses. The direct manufacturing costs are expected to be Â£6 per unit. The company will need to hold stocks of the finished product at the start of each year equivalent in value to 20 per cent of the sales expected in the next year. It is also planned to hold 10 per cent of the materials required for production in the following year. The increase in debtors as a result of introducing the product will be offset by the increase in creditors. The company requires a rate of return of 14 per cent on investments of this nature, and the tax rate is 30 per cent.

a) Determine the investment*****s net present value, the internal rate of return and payback period and carefully interpret your results. All key assumptions should be specified and explained.

(15 marks)

b) Explain what is meant by sensitivity analysis, use sensitivity analysis to identify the critical determinants of the NPV of the proposed investment, and interpret your results.

(10 marks)

(TOTAL 25 MARKS)

Question 2: Price-Earnings Ratios

a) Explain what is meant by a price earnings ratio and utilise a valuation model to identify the theoretical determinants of these ratios.

(10 marks)

b) Take a sample of four companies quoted on a stock exchange and obtain estimates of their price earnings ratios for a particular day. Discuss the factors that might account for the differences in the reported price earnings ratios of the companies you have chosen.

(10 marks)

(TOTAL 20 MARKS)

Question 3: Rights Issues

The Royal Bank of Scotland (RBS), the second bank in the UK at the time, announced a rights issue to raise Â£12 billion on April 22nd. There was considerable coverage of the issue, the largest UK equity issue, in the financial press.

The following contains extracts from the report on the issue released on the internet by the BBC.

*****Royal Bank of Scotland (RBS), the UK's second-biggest banking group, is asking shareholders for an extra Â£12bn to shore up its finances.

The rights issue was announced as part of a trading update and is one of the largest seen in UK corporate history.

The firm also announced a write-down of Â£5.9bn before tax, following its exposure to the credit markets.

BBC business editor Robert Peston said other banks may well follow suit, to reinforce their financial foundations. Mr Peston also said RBS would "retain more capital in its balance sheet to meet the risks of default by borrowers than it had been doing".

Market conditions

RBS, which played a leading role in last year's takeover of the Dutch bank ABN Amro, said it needed to increase its cash base and a rights issue was the best option. In its latest update, which covered the period from 31 December to 22 April 2008, RBS said global banking and markets had been "acutely affected by credit market conditions" especially in March.

RBS said it may sell assets to raise funds, which could net it around Â£4bn. It is reviewing its insurance arm, which includes Churchill and Direct Line among others.

The bank said it had seen a "severe and increasing deterioration in credit market conditions, the worsening economic outlook and the increased likelihood that credit markets would remain difficult for some time".

"The rights issue deals with concerns over the balance sheet," said ***** Cumming, head of UK equities at Standard Life Investments, which holds a 3.5% stake in RBS. The rights issue enables the bank to add to its reserves - which were hit following the ABN Amro deal, with some analysts now arguing it paid too high a price for the Dutch bank.

When the deal was sealed at the end of 2007, many banks hoped market conditions would improve in 2008. Since then, however, the impact of problems in the US housing sector has worsened not improved. And what were viewed as problems of a particular sector - the housing market and specifically risky borrowers known as sub-prime customers - have had a wider economic impact.

Under the terms of the rights issue, 11 new shares will be issued for every existing 18 shares at 200 pence each.

The rights issue value is 46% less than Monday's closing share price of 372.5p. RBS shares ended Tuesday down 3.89% at 358p.

The reaction in the press to the issue were mixed. The following extract from a financial times article reported the views of stockbrokers on the issue

RBS rights issue is a 'no-brainer', By Matthew Vincent

Published: April 26 2008 03:00 | Last updated: April 26 2008 03:00

Under the terms of the fundraising, shareholders will be offered 11 new shares for every 18 held, at an issue price of 200p - a 43 per cent discount to yesterday's closing price. Analysts suggest this represents good value on fundamental grounds.

Alex Potter of Collins Stewart says: "I certainly think people should take up the rights. They get the benefit of the discount, avoid dilution and, post-disposal and rights issue, the stock is not looking that expensive." Taking his 2009 earnings per share forecast of 37p, the shares currently trade on a forward multiple of 9. But Potter argues: "If you're buying shares at 200p, it's incredibly cheap."

Richard Hunter of Hargreaves Lansdown says that for anyone who was considering investing in RBS anyway, the rights issue is "a no-brainer", although the firm takes a neutral view of the stock. He suggests that investors should adopt a "tail swallowing" approach - selling some of the rights in the market to cover the cost of taking up rights on the rest.

Various aspects of the RBS rights issue were discussed in the press: among these was the level of the underwriting fees for the issue. The prospectus indicated that the cost of the issue to RBS was about Â£246 million, of which Â£210 million stemmed from underwriting and sub-underwriting fees.

The Under-writing of the RBS Rights Issue

In an article in the Financial Times on May 29 ***** Burgess, *****Banks slated over rights issue bonuses*****, discussed the under-writing fees associated with the RBS rights issue.

Leading UK investors have lashed out at investment banks for earning big bonuses from advising on rights issues at the expense of shareholders.

Keith Skeoch, chairman of the Association of British Insurers' investment committee and chief executive of Standard Life Investments, has warned today that investors will take a very dim view of boards allowing their investment bank advisers to bump up the costs of rights issues, and to earn big bonuses for doing so.

"In future . . . boards should expect institutional investors to focus increasingly on the marginal costs of rights issues so as to ensure that the marginal rewards accrue to the long-term risk-takers that facilitate systemic repair rather than to the bonus pots of investment bankers who helped to create the problem in the first place," he says.

UK shareholders point out that most banks leading a rights issue pass on much of the risk that an issue will be unsuccessful to investment institutions which act as sub-under*****s. Investors' concerns about rights issue fees have mounted after seven rights issues from European and UK banks since the start of the year, with many more expected.

Investment bankers counter that underwriting fees attached to the recent rights issues are lower than they have been in the past. At the same time, volatile markets mean the risk of being left with unwanted stock has risen, even when issues have been priced at a deep discount to the company's share price prior to the launch of a fundraising. Share prices of several of the banks that have recently launched deeply discounted issues are edging closer to the rights issue price. And while in the UK some of this risk is passed on to sub-under*****s, lead banks usually keep the majority, bankers say.

These concerns emerged recently when Royal Bank of Scotland announced Europe's biggest ever rights issue. RBS agreed with its lead banks that fees would be 1.75 per cent maximum. However, shareholders objected when the investment banks leading the issue then offered them 0.8 per cent of this fee for sub-underwriting - about half the amount shareholders might have expected in the past. The banks subsequently agreed to raise this sub-underwriting fee to 1 per cent after investors complained to RBS.

During the subscription period the price of RBS*****s shares fell quite significantly along with the shares of other financial institutions, but it remained above the exercise price and was deemed to be a successful issue.

The Outcome of the RBS rights issue

*****Royal Bank of Scotland completed its historic Â£12bn rights issue on Monday despite a fall in the bank*****s shares last week.

The bank confirmed at the open on Monday that 95.11 per cent of the shares offered had been taken up by investors leaving a *****rump***** of nearly 300m shares with the under*****s *****“ Goldman Sachs, Merrill Lynch and UBS. Later in the session the remaining 299.4m shares were placed with investors on Monday at a price of 230p a share, raising an additional Â£688.6m.

The success of the issue *****“ the largest seen in European markets *****“ followed an upturn in the bank*****s share price last week, which at the start of the week had fallen to 220p, dangerously close to the 200p price for the shares, offered to investors on an 11 for 18 basis. By Thursday night, though, the shares had recovered to 259p, ahead of the rights deadline on Friday. On Monday the shares fell 5 per cent to 231Â½p.*****

Maggie Urry *****RBS completes Â£12bn rights issue.***** Financial Times June 9 2008

a) Determine the expected ex-rights price and the value of a right of the RBS issue at the time of announcement.

(7 marks)

b) Demonstrate that in principle a shareholder owning 900 shares will be equally well off from investing in the rights and selling the rights.

(7 marks)

c) Discuss the rationale for having the issue underwritten and comment on the costs of the underwriting.

(8 marks)

d) Critically evaluate the views of Alex Potter of Collins Stewart

"I certainly think people should take up the rights. They get the benefit of the discount, avoid dilution and, post-disposal and rights issue, the stock is not looking that expensive." Taking his 2009 earnings per share forecast of 37p, the shares currently trade on a forward multiple of 9. But Potter argues: "If you're buying shares at 200p, it's incredibly cheap.

(8 marks)

(TOTAL 30 MARKS)

Question 4

The file FFM Ass Oct 08 Ass Returns.xls will be found on the class website, it gives 50 months returns for 40 securities drawn from the FT ALL share index for the period. Choose any five securities at random and form an equally weighted portfolio of these securities

a) Determine the returns for the portfolio for each month in the period. On this basis determine the average monthly return for the portfolio and its standard deviation.

(5 marks)

b) Determine the average returns over the same period for each of the securities and their respective standard deviations. Using Excel derive the co-variances or correlation coefficient for each pair of securities. On the basis of this information and using portfolio equations, based on the average covariance and average variances calculate the standard deviation of the portfolio. Compare your results to those obtained in (a).

(5 marks)

(TOTAL 10 MARKS)

Question 5

Options Traded on Marks & Spencer Shares

Share Price Exercise Price Calls Puts

Sep Oct Nov Sep Oct Nov

210 205 12.0 24.0 27.0 6.0 17.5 19.5

210 9.5 21.5 24.5 8.5 20.0 22.0

a) Explain carefully why the November calls are trading at higher prices than the September calls.

(5 marks)

b) Draw a diagram illustrating a straddle, using calls and puts expiring in November and an exercise price of 210. Explain the circumstances in which an investor might consider it worthwhile to invest in a straddle.

(5 marks)

c) Comment on the contention that options are a zero sum game for the ***** and investor in options.

(5 marks)

(TOTAL 15 MARKS)

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