Optimal investment choices: Report prepared to the board of director

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Report prepared to the board of director

 

By the President of Kingdom Gearge

Gerald, XXXX

April 2012

 

 

Table of contents of this report

Table of contents of this report………………………………………………………………………… 11

1.     Introduction……………………………………………………………………………………………. 12

1.1      Preface………………………………………………………………………………………….. 12

1.2      Background of the report………………………………………………………………… 12

1.3      Basic terms adopted in this project…………………………………………………… 12

1.3.1     Time value of money & Net present value (NPV)……………………… 12

1.3.2     Profitability & Profitability Index (PI)…………………………………….. 13

1.3.3     Tax shield…………………………………………………………………………….. 13

1.4      Available project investments…………………………………………………………… 14

1.5      Our capital budget and source of capital……………………………………………. 14

2.     Analysis………………………………………………………………………………………………….. 14

2.1      Evaluation of the major measuring methods………………………………………. 14

2.1.1     Evaluation of the use of Net Present Value (NPV)……………………. 14

2.1.2     Evaluation of the use of Profitability Index (PI)……………………….. 15

2.2      Calculations in some major indicators……………………………………………….. 15

2.2.1     Calculations based on Net Present Value (NPV)……………………….. 15

2.2.2     Calculations based on Profitability Index (PI)………………………….. 16

2.3      Analysis based on the calculations……………………………………………………. 16

2.4      Optimal choices……………………………………………………………………………… 17

2.4.1     Choice statement…………………………………………………………………… 17

2.4.2     Justifications………………………………………………………………………… 18

2.5      Key issues……………………………………………………………………………………… 18

2.5.1     Other cash inflow………………………………………………………………….. 18

3.     Conclusions…………………………………………………………………………………………….. 19

List of references…………………………………………………………………………………………… 20

Appendix 1.0 Calculations – Net present value (NPV)………………………………………… 22

Appendix 2.0 Calculations – Profitability Index (PI)………………………………………….. 25

1.      Introduction

 

1.1     Preface

 

It would be a piece of good news to share with you all that our company, Kingdom Gearge, a company with more than 200 years’ history in the real estate industry is going to harvest one of the best years in the history as the 2011 financial year approaches to its end. This will also means that the new 2012 financial years is coming and we are under more pressures with higher expectations from our investors based on the good performance last year, and it is time to make a planning for the future.

 

1.2     Background of the report

 

In the new financial years, our focus of the business is still in the real estate investment that we have been doing for the past two hundred years since the establishment of the company by our founder, Karl McDonald, this project will state some of the key projects that our talented investment analysis managed to identified base on our researches and market analysis, and also another focus point is to introduce with you several key measurements to better understand the available projects in term of which one is better for our business development. Below we will first introduce some basic terms for those who do not have a financial background to better understand this report.

 

1.3     Basic terms adopted in this project

 

1.3.1  Time value of money & Net present value (NPV)

 

The term time value refers to the belief that a dollar in hand today is worth more than a dollar promised at some future time (Magoon & Vasishth 2007). And because of the time value, people believe that at the future money need to be discounted according to how far it is expected. Based on this concept, we can better under another concept in making decisions about which project should be adopted, the net present value (NPV). The Net Present Value (NPV) could be defined as the present value of a project’s cash inflows minus the present value of its cost, which measures the contribution of the project to the shareholder wealth (Brigham & Ehrhardt 2009, p. 383).

 

1.3.2  Profitability & Profitability Index (PI)

 

Profitability refers to a situation where output exceeds input, that is, the value created by the use of resources is more than the total of the input resources (Khan & Jain 2006, p. 113). And apparently, the maximization of the profitability is one of the key principles while we are making decisions regarding what projects and product we should be focusing. A related term is the profitability index (PI) which is a ratio of a project’s net cash inflow to the project’s net investment. It is calculated using the below formula (Kinney & Raiborn 2009, p. 558):

 

Profitability index (PI) = PV of future cash flow / Initial investment

 

By referring to the present value of the future cash inflow and also the current investment that the company needs to pay at the beginning, it is said that profitability index (PI) helps measure the efficiency of the capital investment.

 

1.3.3  Tax shield

 

A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income (Kantor 2008, p. 210).

 

1.4     Available project investments

 

JobToday (cost)

 

Expected Sale Price in Year 5Annual cash inflowDiscount rate
KCC Pearl$3,000,000$18,000,000015%
Sea View15,000,00075,500,000015%
Mountain View9,000,00050,000,000015%
Hill Top3,000,00035,500,00008%
Bridgetown6,000,00010,000,00008%
Northern Giant9,000,00046,500,00008%

Table 1 Available project investments

 

1.5     Our capital budget and source of capital

 

There are three major kind of source of capital: current account balance, bank loan and issue of new stocks. And currently, our company has a cash of about $12,000,000 and at the same time we are considering the options of either applying for an additional bank loan or issue additional public stocks.

 

2.          Analysis

 

2.1     Evaluation of the major measuring methods

 

2.1.1  Evaluation of the use of Net Present Value (NPV)

 

According to Derek H. Allen (2006, p. 31), a project’s profit generation could be considered as a series of cash flow throughout the project’s whole lifetime. And because today’s money will be more valuable than the future money because at least one can deposit the money at the bank, and also different project due to the different risk level and other factors tend to have different discount ratio which does make sense because of the principle that higher risks comes with higher returns. The NPV lets us plug in target yield for the investments and then reveals whether or not the future cash flow benefits generated by that income property will be enough to achieve that yield based on the capital required to make that investment. But there are also some disadvantage about the using the NPV to evaluate the candidate projects like adjustment for risk by adding a premium to the discount rate thus making cost higher. But still, NPV can still act as a major measurement and evaluation tool for the long term investment.

 

2.1.2  Evaluation of the use of Profitability Index (PI)

 

As said above, maximization of the profitability is one of the key principles while we are making decisions regarding what projects and product we should be focusing on, there are two major advantages in using the Profitability Index (PI) as a measurement for selecting the better investment alternatives: first of all, the profitability index tells about an investment increasing or decreasing the firm’s value by taking into consideration of all the inflow and outflow of cash as well as the cost of investment, when the Profitability Index of a project is more than 1, than it suggests that the project is acceptable or else not acceptable; and secondly, by calculating the Profitability Index (PI), we can easily rank the candidate projects in term of profitability. But there are also a major disadvantage of using the Profitability Index (PI) as a ranking principle is that it may provide the best ranking of investment especially when the projects are mutually exclusive (readyratios.com 2009).

 

2.2     Calculations in some major indicators

 

2.2.1  Calculations based on Net Present Value (NPV)

OptionsNPVInitial investment
KCC Pearl5,832,190.60$3,000,000
Sea View22,046,132.7815,000,000
Mountain View15,533,862.769,000,000
Hill Top12,438,806.893,000,000
Bridgetown2,194,030.116,000,000
Northern Giant15,152,240.019,000,000

Table 2 Calculations based on Net Present Value (NPV) (detail calculation sees appendix 1.0)

 

2.2.2  Calculations based on Profitability Index (PI)

 

PV of future cash flowInitial investmentProfitability index
KCC Pearl8,832,1913,000,0002.94
Sea View37,046,13315,000,0002.47
Mountain View24,533,8639,000,0002.73
Hill Top18,438,8076,000,0003.07
Bridgetown5,194,0303,000,0001.73
Northern Giant24,152,2409,000,0002.68

Table 3 Calculations based on Profitability Index (PI)

 

2.3     Analysis based on the calculations

 

Therefore we rank the six optional investments by these two measures:

 

OptionsNPVProfitability indexInitial investmentTotal score (NPV ranking + PI ranking)
KCC Pearl25$3,000,0007
Sea View6215,000,0008
Mountain View549,000,0009
Hill Top363,000,0009
Bridgetown116,000,0002
Northern Giant439,000,0007

Table 4 Ranking of the optional investments based on NPV and PI

 

Firstly, we select the top three ranking investment: Sea View, Mountain View and Hill Top because they are ranked at the top by the total ranking scores (NPV ranking + PI ranking); secondly, within the remaining three options, here we see an interesting rankings: Sea View has been ranked the top option of NPV while it as a very low Profitability index, in contrast, Hill Top has a lower NPV but highest Profitability index. And when these two ranking are in conflicts, here we prefer the choice according to NPR suggesting that Sea View should be the optimal choices, reasons are given in the following part.

 

2.4     Optimal choices

 

2.4.1  Choice statement

 

Based on the above analysis, we will choose Sea View property to invest with the initial cost of $15,000,000 and an expected selling price at $75,500,000 in the end of the five year term. And the discount rate if 15% and the profitability index score is 2.47 and NPV is $22,046,132.78.

 

 

 

2.4.2  Justifications

 

Firstly, NPV is a more favorable rule of ranking, according to William G. Droms and Jay O. Wright (2010, p. 199), the ranking based on the NPV should be preferred if a conflict arises with that by profitability index, and when projects vary very much in term of cost, project with the highest NPV value may suffer the lowest profitability index, and in this case the NPV method should be more favorable. This is exactly what we have found out in choosing the six optional projects.

 

Secondly, because the optional projects are mutually exclusive, therefore, another reason that we recommend the investment in the Sea View option is that this option would require an investment of $15,000,000 which will make a full use of our current capital.

 

Thirdly, because we still have to source additional capital to buy this property, full usage of the current cash and also the possible borrowing will in the coming few years create tax shield to us which is because of the reduction in income taxes that results from taking an allowable deduction from taxable income.

 

2.5     Key issues

 

One problem that we have not taken into consideration is the inflation rate, because we do not know the inflation in the future, if significant inflation is expected, then changes could happen and influence the ranking of the alternatives.

 

2.5.1  Other cash inflow

 

Another point that we have not considered is the possible cash inflow such as lease or other kind of income generated by the property, which may not be clear so far.

 

3.          Conclusions

 

Based on the above discussion and review of the relative concepts, we have come to a preliminary conclusion that Sea View option is more favorable because of the high NPV of the option and also the NPV method should be favorable in the said conditions when costs of investments are much differentiated.

 

Word count: 2136

List of references

 

Allen, D. H. 2006, Economic evaluation of projects. 3rd edition, Warwickshire: Institution of Chemical Engineers. p. 31

 

Brigham, E. F. & Ehrhardt, M. C. 2009, Financial Management Theory and Practice. Natrop Boulevard Mason: South-Western Cengage Learning. p. 383

 

Bygrave, W. D. & Zacharakis, A. 2004, The portable MBA in entrepreneurship. New Jersey: John Wiley & Sons. p. 458

Droms, W. G. & Wright, J. O. 2010, Finance and Accounting for Nonfinancial Managers: All the Basics You Need to know. New York: Basic Books. p. 199

 

Kantor, M. 2008, Valuation for arbitration: compensation standards, valuation methods and expert evidence. The Netherlands: Kluwer Law International. p. 210

 

Khan, M. Y. & Jain, P. K. 2006, Cost Acc & Fin Mgmt Ca Pe Ii, 2E. New Delhi: Tata McGraw-Hill Publishing Company Limited. p. 113
Khan, M. Y. 2004, Financial Management: Text, Problems And Cases. New Delhi: Tata McGraw-Hill Publishing Company Limited. p. 10

Kinney, M. R. & Raiborn, C. A. 2009, Cost Accounting: Foundations and Evolutions. Natrop Boulevard: Thomson South-Western. p. 558
Magoon, L. M. & Vasishth, P. 2007. 50 Plus One Tips to Building a Retirement Nest Egg, West Glenlake, Chicago: Encouragement Press, LLC.

 

Readyratios.com 2009. Profitability Index. Viewed on 4 Apr 2012 [online] http://www.readyratios.com/reference/profitability/profitability_index.html

Appendix 1.0 Calculations – Net present value (NPV)

 

KCC Pearl

YearCash inflow15%NPV
0-30000001.0000-3,000,000.00
10.86960.00
20.25000.00
30.15300.00
40.40960.00
5180000000.49078,832,190.60
Total5,832,190.60

 

Sea View

YearCash inflow15%NPV
0-150000001.0000-15,000,000.00
10.86960.00
20.25000.00
30.15300.00
40.40960.00
5755000000.490737,046,132.78
Total22,046,132.78

 

 

 

 

 

 

 

 

Mountain View

YearCash inflow15%NPV
0-90000001.0000-9,000,000.00
10.86960.00
20.25000.00
30.15300.00
40.40960.00
5500000000.490724,533,862.76
Total15,533,862.76

 

Hill Top

YearCash inflow8%NPV
0-60000001.0000-6,000,000.00
10.92590.00
20.25000.00
30.14000.00
40.40960.00
5355000000.519418,438,806.89
Total12,438,806.89

 

 

 

 

 

 

 

 

 

 

Bridgetown

Bridgetown
YearCash inflow8%NPV
0-30000001.0000-3,000,000.00
10.92590.00
20.25000.00
30.14000.00
40.40960.00
5100000000.51945,194,030.11

 

Northern Giant

YearCash inflow8%NPV
0-90000001.0000-9,000,000.00
10.92590.00
20.25000.00
30.14000.00
40.40960.00
5465000000.519424,152,240.01
Total15,152,240.01

 

Appendix 2.0 Calculations – Profitability Index (PI)

 

PV of future cash flowInitial investmentProfitability index
KCC Pearl8,832,190.6030000002.94
Sea View37,046,132.78150000002.47
Mountain View24,533,862.7690000002.73
Hill Top18,438,806.8960000003.07
Bridgetown5,194,030.1130000001.73
Northern Giant24,152,240.0190000002.68