An Investment Proposal for a Business - Assignment Example

Investment Proposal Investment Proposal Executive Summary Real e is one of the investments that are experiencing exponential growth due to the return it promises to the investors. Thus, a rational investor in the current economic dynamic should consider investing in the real estate to gain from the prospective returns of the investment opportunity. The investment has low potential of incurring losses in future due to the growing demand of houses by households. Accordingly, the investor has undertaken an investment decision to invest in the real estate. The funds that will be solicited in actualizing the investment will be utilized in acquiring land, consultancy, acquiring building materials and hiring contracts to complete the construction tasks. Owing to the huge amount of the financial resources that will be required to implement the investment successfully, the funds will be sourced from commercial banks due to their ability in lending huge loans. The financial amounts that will be required to undertake a real estate investment has the potential of running into millions due to the cost of the essential requirements that will be needed. However, an investment analysis has been undertaken to evaluate the feasibility of the proposed investment. The business proposal evaluation has been undertaken using financial tools to measure the economic value of undertaking the investment. In addition, the investment proposal investigates the optimal financing approach that should be adopted by the investor based on the cost of financing an investment will incur to actualize the operations. Undertaking the financial plan of the investment is essential since it helps in validating the feasibility of the project to the financiers in supporting it implementation. Consequently, the investment proposal evaluation has played a critical role in establishing the significance of the investment and the optimal investment direction that should be adopted. Sources of Finance In order to undertake the investment, the investor will need financial resources for operation of the investment activities. The amount of financial resource that is estimated to be required in undertaking the investment is £100,000. Consequently, the financial resources will need to be solicited from the available sources. Sources of finance could be long-term, medium term or short-term depending on the favorable source for the investor. The long-term sources of finance are sources that exceed one year of reimbursement. The components of long-term debts are made up of equity and long-term debts (Ingram & Albright, 2009). Medium sources of finance are sources that have a one year of investment. The medium sources of finance are leasing arrangement and hire purchase agreement that runs for one year. Short-term sources of finance on the other hand are made up sources that run less than one year. Examples of short-term sources of finance are commercial paper, overdraft, bill of exchange and trade credit. Similarly, an investment proposal can be financed by personal savings. This is contribution by a sole proprietor or partners in partnership and company to start the business idea. An investor should consider the source of finance to finance the investment depending on the cash flow nature of the business. This is because the reimbursement of the finance needs to fit within the cash flow ability of the proposed investment. Furthermore, the amount of financial capital that will be needed to actualize the project will determine the type source of finance that should be employed (Peterson & Fabozzi, 2012). Owing to the nature of the real estate in realizing initial cash inflows after a period exceeding one year, the source of finance that should be employed is the long-term source of finance. In addition, the capital that will be needed is very huge for the partners to contribute in successfully financing the project. The investment will require acquisition of land, premises and machineries that are fixed assets. These are highly expensive fixed assets that will require huge capital investment. Furthermore, the time the assets will take to repay back exceeds one year of investment. Consequently, long-term debt and equity type of financing have been selected in financing the investment proposal. Long-term sources of finance for the investment is preferable since it will allow for huge amount of finance to be solicited at a favorable terms. Furthermore, the source of finance will allow the investment to accumulate cash inflows in future to start repaying the borrowed funds. Long-term source of finance is solicited through long-term debt financing and equity financing. Owing to the diverse financial risks of the two types of financing the investment proposal, the cost of financing the investment has been determined through the weighted average cost of capital cost (WACC). The WACC factors the weight and cost of each type of financing that will be employed in undertaking the project. The WACC is computed using the formula illustrated below. WACC = WeRe + WdRd(1-TC); where We is the proportion of the equity finance, Re is the cost of equity, Wd is the proportion of debt finance, Rd is the cost of debt and TC is the corporate tax rate (Gibson, 2012). Consequently, the capital finance, cost of equity, cost of debt, tax rate and proportion of each type of finance will need to be given to determine the cost of the proposed investment finance. The investment is estimated to have an initial outflow of £100,000 to start the acquisition of fixed assets and contract with the contractors to undertake the project. In addition, the cost of the debt in the market is currently at an average of 5%. The management of the company has decided to raise capital at a ratio of 30% and 70% for debt and equity financing respectively. Thus, debt will contribute £30,000 while the equity financing will contribute £70,000 of the capital finance. The cost of the equity has been determined through the return of equity from the previous financial year statement. According to the income statement of the income of the organization, the earnings before interest and profit (EBIT) was £12,400 while the balance sheet statement indicates that the shareholders’ equity amounted to £250,000. Thus, the expected return that the investors of the firm expect that is the cost of the equity finance is as computed in the formula below. ROE = EBIT/ shareholders’ equity ROE = 12400/ 250,000 * 100 = 4.96% Accordingly the cost of the capital through the WACC computation is as illustrated in the computation below. WACC = WeRe + WdRd (1-TC) (Brigham & Houston, 2009) WACC = 70% * 4.96% + 30% * 5% = 0.035 + 0.015 = 5% The WACC value is the discounting rate that has been employed in determining the net present value of the investment project. This is because it is the rate at which the firm will pay for the capital finance it has utilized to actualize the project. Return on Investment The investment proposal has been put under test to evaluate it economic feasibility in meeting its financial obligations and maximizing wealth to the investors. Thus, an investment appraisal has been undertaken using capital budgeting approach to determine the profitability of the investment. The capital budgeting approach has employed the payback period, net present value (NPV), and internal rate of return (IRR) in determining the feasibility of the proposed investment. In order to undertake the capital budgeting tasks, cash inflows in the subsequent years have been forecasted. The cash inflows in the next ten years are expected to be £10,000, £12,000, £14,000, £16,000, £18,000, £20,000, £22,000, £24,000, £26,000, £28,000. Thus, the payback period, NPV and IRR of the proposed investment are as illustrated in the computations below. These are the projected annual incomes the proposed investment is expected to generate in the next ten years of the project life-span. The real estate will be sold to the buyers in the market in the next ten years to generate the expected incomes for the investor. Payback period is the period it will take to repay the capital finance of undertaking the proposed investment. Capital investment = £100,000 Payback period => £100,000 - £10,000 = £90,000 - £12,000 = £78,000 - £14,000 = £64,000 - £16,000 = £58,000 - £18,000 = £40,000 - £20,000 = £20,000 - £22,000 = -£2,000 Thus, the period the proposed will take to recover the capital expense will be 7 years (Gibson, 2012). This, illustrates that the firm will be able to repay the finance it used in undertaking the project before it expires. Thus, the financial credit providers and shareholders should accept to contribute towards the implementation of the project since the project will be able to raise adequate finance to repay equity finance and debt finance it has utilized in undertaking the project in it lifespan. NPV analysis Year Cash flow PV factor (discount rate = 5%) NPV 0 -£100,000 1 -£100,000 1 £10,000 0.9524 £9524 2 £12,000 0.9070 £10,884 3 £14,000 0 0.8638 £12,093.2 4 £16,000 0.8227 £13,163.2 5 £18,000 0.7835 £14,103 6 £20,000 0.7462 £14,924 7 £22,000 0.7107 £15,635.4 8 £24,000 0.6768 £16,243.2 9 £26,000 0.6446 £17,565.6 10 £28,000 0.6756 £18,916.8 NPV £43,052 The NPV value above illustrates that the firm will achieve a positive NPV from the proposed investment during the lifespan of the project. This means that the potential of the investment proposed becoming profitable in future are very high. Thus, the project should be accepted for implementation since it promises to be profitable in future (Sinha, 2009). The investors and credit providers will be able to recover their expected return and debt obligation respectively from the investment been undertaken by the firm. Consequently, the shareholders and financial creditors in the market should accept contributing towards the capital finance the firm intends to raise to implement the project. The IRR for the proposed investment by the firm has been determined using the excel software as illustrated below. Internal rate of return (IRR) is the interest rate that has the potential of turning the net present value to zero value. Thus, the interest rate that has the capacity of turning the NPV to zero through a trial and error method is 11.39% as illustrated in the computation below. The formula that has been employed in computing the IRR for the proposed investment is as shown below.   CF1  +  CF2  +  CF3  + ...    − Initial Investment = 0 ( 1 + r )1 ( 1 + r )2 ( 1 + r )3 0 = -100,000 + £10,000/ (1 + 11.39%)1 + £12,000/ (1 + 11.39%)2 + £14,000/ (1 + 11.39%)3 + £16,000/ (1 + 11.39%)4 + £18,000/ ((1 + 11.39%)5 + £20,000/ (1 + 11.39%)6 + £22,000/ (1 + 11.39%)7 + £24,000/ (1 + 11.39%)8 + £26,000/ (1 + 11.39%)9 + £28,000/ (1 + 11.39%)10 The IRR computed above for the proposed investment reflects that IRR rate is above the hurdle rate that is 5%. Financial theories hold that an investment proposal should be considered if the IRR is higher than the hurdle rate (Moyer & McGuigan, 2012). This is because a higher IRR to hurdle rate means that the investment proposed has the capacity to service the financial obligation that was utilized in implementing the project in future. Thus, the proposed investment should be accepted since the interest rate of return is above the hurdle rate. Consequently, investment proposal should be undertaken by the firm due to its ability to give positive return in future (Baker & English, 2011). The three methods of appraising an investment proposed above reflects that the project has the ability has the ability of meeting it financial obligation in maximizing the profitability of the shareholders. Financial Analysis Financial analysis is critical in establishing the financial position of the firm undertaking the investment under proposal to service its financial obligations once they fall due (Seidner, Zietlow, & Hankin, 2013). In addition, the financial analysis is critical in demonstrating how the project will maximize the wealth of the shareholders (Gibson, 2012). In undertaking the financial analysis of the investment proposal, financial ratios have been utilized. The components that have been used in undertaking the financial analysis are derived from the financial position and performance the proposed is forecasted to experience in the future financial periods. The life span of the proposed investment is expected to run for 10 years after the initial year of raising the capital finance. Gearing ratio and return of capital employed have been utilized in undertaking the financial analysis of the investment. The gearing ratio measures the ability of the proposed investment in servicing financial obligations once it is implemented (Bagad, 2010). On the other hand, the return of capital employed has been utilized to measure the ability of the investment in enhancing the value of shareholders’ capital investment. Consequently, the following figures have been used in undertaking the financial analysis for the investment proposed. Over the ten years of the proposed investment, the proposed investment is expected to have a debt of £70,000 while the shareholders’ equity will be £30,000. Thus, the total of shareholders’ equity and long-term debt will be £100,000. Consequently, the capital gearing ratio of the investment will be as computed below. Capital gearing ratio = total debts/ shareholders’ equity + total debt £70,000/ £100,000 = 0.7 Equity gearing ratio = shareholders’ equity/ shareholders’ equity + total debt £30,000/ £100,000 = 0.3 The gearing ratios reflected above indicates that the investment will highly be financed by debts compared to equity financing. This implies that risk of the investment in defaulting to service it financial obligation are very high if the forecasted financial returns fail. Thus, the creditor firms in the market are likely to charge a high capital due to the high default risk of the investment in repaying the financial obligation (Ingram & Albright, 2009). Similarly, the return of capital employed of the organization has been computed using the forecasted financial income the firm is expected to generate in the next ten years. The average profit before interest and tax for the investment lifespan has been applied in computing the net profit margin. Return of capital employed is used to measure the ability of the investment to expand the wealth of the shareholders in financing the project (Sinha, 2009). The net incomes for the next ten years of the project are £10,000, £12,000, £14,000, £16,000, £18,000, £20,000, £22,000, £24,000, £26,000 and £28,000. Thus, the average net income for the project is £19,000. Thus, the return on capital employed for the proposed investment is as computed below. Return of capital employed = net income/ capital employed £19,000/ £100,000 * 100 = 19% Thus, the investment is expected to make an investment return of 19% during lifespan of the investment. This implies that the proposed investment is profitable in enhancing the wealth of the shareholders (Brigham & Houston, 2009). Thus, the project should be undertaken due to its potential of maximizing the wealth of the shareholders. Potential Success of the Investment Owing to the financial feasibility test that has been undertaken in accepting the implementation of the proposed investment, the investment has high potential of been successful for the investor. This is because the financial analysis reflects that the investment has the potential of generating positive return on investment (ROI). A positive ROI indicates that investment will generate profit for the investors due to the ability of the investment in generating cash inflows in future. Similarly, the financial plan the investment has employed illustrates that the business investment has the potential of been positive in future. This is because the financial plan will ensure that the resources are sourced and utilized in the optimal way possible. Thus, the investment has the potential of ensuring the resources are utilized optimally to successfully improve the wealth of the investors. In order to succeed in the industry, the pricing strategy that will be employed is the penetration pricing. Penetration pricing strategy is pricing the product at a lower price compared to that of the competitors. This will help in attracting the clients that will allow the price of the houses to keep on shifting upward as market awareness is created over the lifespan of the investment. Thus, the markup price of the houses will be determined by adding a10% of the cost of coming up with one unit of house. This approach is essential in enabling the investment to be successful since it will enhance demand of the houses that is critical in generating cash flows in future. Similarly, budgeting for the project is another aspect that has the potential of making the business successful. This is because it will allow the management to undertake cost controls to eliminate wastages of resources that causes the cost of the project to increase. In addition, it will ensure all activities are financially focused in increasing the profitability of the project for the investors. This is critical since it ensures any activity undertaken by the line managers in implementing the project add value. Financial Documentation Projected Income Statement 1st year 2nd year 3rd year 4th year 5th year 6th year 7th year 8th year 9th year 10th year sales £80,000 £100,000 £120,000 £140,000 £140,000 £150,000 £160,000 £180,000 £200,000 £220,000 Cost of inventory sold £50,000 £60,000 £80,000 £90,000 £90,000 £95,000 £100,000 £110,000 £125,000 £140,00 Gross profit £30,000 £40,000 £40,000 £50,000 £50,000 £55,000 £60,000 £70,000 £75,000 £80,000 Admin expenses £3,000 £6,500 £6,500 £7,000 £7,000 £7,500 £8,000 £12,000 £12,000 £12,000 Advertisement expenses £3,000 £4,450 £1,400 £2,850 £800 £2,250 £3,700 £6,650 £7,650 £7,550 Land rates £1,000 £1,000 £1,000 £1,000 £1,000 £1,000 £1,000 £1,000 £1,000 £1,000 Salary and wages £12,000 £16,000 £16,000 £20,000 £22,000 £23,000 £24,000 £25,000 £27,000 £30,000 Interest £750 £750 £750 £750 £750 £750 £750 £750 £750 £750 Tax expense £250 £300 £350 £400 £450 £500 £550 £600 £650 £700 Net income £10,000 £12,000 £14,000 £16,000 £18,000 £20,000 £22,000 £24,000 £26,000 £28,000 Projected Balance Sheet 1st year 2nd year 3rd year 4th year 5th year 6th year 7th year 8th year 9th year 10th year Assets Cash £10,000 £22,000 £26,000 £42,000 £60,000 £80,000 £102,000 £126,000 £152,000 £180,000 Inventory (house units) £95,000 £89,000 £81,000 £72,000 £63,000 £54,000 £44,000 £33,000 £21,000 £7,000 Land £40,000 £40,000 £40,000 £40,000 £40,000 £40,000 £40,000 £40,000 £40,000 £40,000 Total assets £145,000 £151,000 £147,000 £154,000 £163,000 £174,000 £186,000 £199,000 £213,000 £227,000 Liabilities Long-term debts £70,000 £70,000 £70,000 £70,000 £70,000 £70,000 £70,000 £70,000 £70,000 £70,000 Payables £35,000 £39,000 £33,000 £36,000 £45,000 £54,000 £64,000 £75,000 £87,000 £99,000 Equity capital £30,000 £30,000 £30,000 £30,000 £30,000 £30,000 £30,000 £30,000 £30,000 £30,000 Retained income £10,000 £12,000 £14,000 £16,000 £18,000 £20,000 £22,000 £24,000 £26,000 £28,000 Total liabilities and shareholders’ equity £145,000 £151,000 £147,000 £154,000 £163,000 £174,000 £186,000 £199,000 £213,000 £227,000 Reference Bagad, V. 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Sinha, G. (2009). Financial statement analysis. New Delhi: PHI Learning Pvt Ltd. Read More