Evaluating The Investment Opportunities And Alternative Methods Finance Essay - Free Essay Example

Firstly, compare the Base case NPV and Opportunity 1 NPV, according to the results of NPV calculations, we can obtained the results is Opportunity 1 NPV is positive and greater than Base case, under NPV rule, accept all project with positive NPV, under this rule, Opportunity 1 should be accept. On the other hand, even Opportunity 1 should be accept, there have some uncertainty factors should be consider, such as foreign currency risk. Since the Opportunity 1 is build new factory aboard, that will occur foreign currency risk. The foreign currency risk usually occur when the money must be converted to another currency, thus changes in the currency exchange rate will cause the cost material or sales the product amount decrease or increase when the money converted back into original currency. Secondly, compare the Base case NPV and Opportunity 2 NPV, according to the results of NPV calculations, we can obtained the results is Opportunity 2 NPV is positive but it is less than Base case, under NPV rule, Opportunity 2 should be accept, even the NPV is less than Base case. If Penta Ltd accept Opportunity 2, they should be consider the uncertainty factors is the retail business is not their expertise, if will affected the retail business cant run efficiency, they may need to hire outside management and salesperson to run their new business, it will increased their operation and other relevant cost. 2. Evaluate the investment opportunities and alternative methods Net present value (NPV) is different than the present value, the present value is no considered the initial investment of the project, present value is compute the expected cash flow by the discounting them at the required rate of return. NPV is including the initial investment of the project, which means is the total amount of the initial investment minus present value. Advantages of NPV: NPV have considered the time value of money which can make the forecast cash flow discount back to today cash value, it can allows management to decide which project should be invest through the positive NPV or negative NPV. NPV is uses cash flow, not accounting profit, cash flow is more reliably, because cash flow is not affected by judgment of the accounting policies and cash flow is more difficult to manipulate. Accounting profit may adjusted by the management due to few reasons (creative account) and accounting profit would affected by judgment on accounting policies. NPV can take account of conventional and non-conventional cash flows, as well as changes in discount rate during project and gives absolute measure of project value. Disadvantages of NPV: Since the NPV is uses the cash flow, project cash flows is very difficult to estimate, in the real practice, the project cash flow is determined based on managements preference not actual cash flow. NPV allows the management to accept all projects with positive NPV, if two project simultaneous positive NPV, the management should choose the project with higher NPV. In addition to NPV method used to evaluate the investment opportunities, there are other ways can evaluate the investment opportunities, such as internal rate of return (IRR), Payback period and Profitability index. Internal rate of return (IRR): IRR is discount rate which gives zero NPV for project which the decision rule is allows the management to accept all projects with an IRR greater than the companys cost of capita or the companys target rate of return. Advantage of Internal rate of return (IRR) IRR can indicator for the choosing investment, if the result show that IRR is higher than the companys cost of capital or higher than the companys target rate than the project should be invest if there is no multiple IRR, compare between the IRR and NPV, when the project is mutually exclusives, NPV should be select advice. Disadvantage of Internal rate of return (IRR) IRR have no consider the time value of money, IRR method assumes that the opportunity cost of capital is the same for all cash flow. NPV have considered the changes in discount rate during project, but IRR ignores the changes in discount rate during project. If the projects with non-conventional cash flows and applying IRR method and that may occur multiple IRR, in this situation, if compare with the NPV, NPV should be select advice. Normally, NPV gives more correct selection advice to the management about mutually exclusive projects. Payable period: The payback period is a simple method to calculate how manage time can recover the capital spent on an initial investment. Advantage of payable period: Payback period can give simple concept to the companys management to understand how much time the cash will flow back to the company. Payback period is easy to understand than other method to the management. Payback period is easier to calculate than other method, such as NPV and IRR and the payback period is uses cash, not accounting profit. Cash flow is more reliably, because cash flow is not affected by judgment of the accounting policies and cash flow is more difficult to manipulate. Accounting profit may adjusted by the management due to few reasons (creative account) and accounting profit would affected by judgment on accounting policies. Disadvantage of payable period: Payback period only considers the cash flows within the payback period; it is no nothing about the project. Payback period have no consider the size of cash flows, timing of cash flows and the time value of money which can not discount back the forecast cash flow to today value and payback period does not consider the risk of the project, risk is very important element for the consider whether the project should be invest. If ignores that will affected the management decision making. Profitability index: Profitability index is that the present value ration of a projects cash flow to initial investment. When the result of profitability index is 1 indicates that the project should be accept, and this is consistent with net present value greater than 0. Advantage of Profitability index: Profitability index and tells the management whether the investment of project increases the firms value, it is easily to understand for the management decision making, profitability have considers all cash flow of the project and considers the time value of money, through the cost of capital, profitability considers the risk of future cash flows. Disadvantages of Profitability index: Profitability index is based on the cost of capital to calculate the result, but the cost of capital is very difficult to estimate accurately. When to use the profitability index to compare mutually exclusive projects which may not give the correct decision to the management, if compare mutually exclusive projects, NPV gives more correct selection advice to the management about mutually exclusive projects. 3. Implications of undertaking Option 2 If Penta Ltd undertaking Option 2, enter into the retail business, based on the acquisition the option 2 NPV which result is positive, therefore, the project should be invest. In this selection of Penta Ltd, it will seen as a vertical acquisition, vertical acquisition is the company in the same industry at different stages of production merge, vertical acquisition have backwards acquisition and forwards acquisition, Penta Ltd is seen as a forward acquisition, it is because that Penta Ltd is to acquire a small chain of shops in UK and enter into the retailing business under its own brand, it is same business but in differ stage. Vertical acquisition can secures vital outlets for finished products. It can secure Penta Ltd can quickly and directly to sell their product. Normally, the company makes acquisition decision that objective is that they want through acquisition to gain synergy effect and economies of scale effect. Synergy effect is arise when the acquire complementary activities lead to increasing profit or output, synergy effect normally reflected by the company operating, financial and managerial, but the problem is the synergy effect is very difficult to quantify before the companies combine and also difficult to realise once combination occurred. Economies of scale can make the acquirer have a larger scale of operations or through the acquisition can more efficient to use the assets through this activity leads to decrease in average unit cost. Economies of scale normally reflected by the company production, distribution and marketing. In this situation, Penta Ltd better able to experience the economies, it is because that Penta Ltd is making a vertical acquisition, it can help Penta Ltd to entry to the new market and extend their business to retail business, from manufacturing products to sell is also a train. Penta Ltd can through the acquisition to secures their the can more efficient to sell their product. Even Penta Ltd able to experience the economies, due to Penta Ltd is entry to new market, retail is not their expertise. If Penta Ltd transfer their managerial skills to the new business, due to the retail business is not their expertise, that will cause the management of Penta Ltd can not efficient to run the new business, it may cause Penta Ltd need to recruit new management and sales persons with a good customer services and good retail experience and skills to manage the new business. It will be increased the cost of capital. And the other problem is the culture problem, culture problem is more important, it is because that when two company is merge together, often occur the culture problem. Penta Ltd can through the acquisition to quickly to entry to the new market for existing product, it is faster than organic growth and through the acquisition, and Penta Ltd can savint the carry costs such as research and development cost. Penta Ltd through the acquisition can quickly to growth their market share and increased market power or market size. 4.1 Penta Ltd has access to unlimited funds If Penta Ltd access to unlimited funds, since the both option 1 and 2 is a positive NPV, under the NPV rules, if the project result is positive, the project should be accept. For Investment Option 1(Build new factory abord), the investment cost of the factory is 8 million. For Investment Option 2(Enter into the retail business), the investment cost of entering into the retail business is 5 million. The total investment cost of both investment opportunities is 13 million. The company have sufficient funds to undertake both investment under unlimited funds, even option 1 NPV is higher than option 2 NPV, separate to discuss the implication of option 1 and option 2. Option 1 is to build new factory abroad, Option 1 NPV is higher than base case and option 2, option 1 can generate more revenue to Penta Ltd, Option 1 can increase Penta Ltd market share in their business and increase their production capacity which may increase their output and profit, through build new factory abroad, Penta can increase their production efficiency, improve their internal operation. On the other hand, to build new factory will increase their operation cost. Option 2 is to enter into the retail busines, this option through the acquisition can help Penta quickly to entry new market and extend their business from manufacturer to the retail business which can secures Penta Ltd vital outlets for finished products. Through the acquisition they can extend their market size and market share. On the other hand, retail business is not their expertise, it may can not run efficiency, they may need to hire new management with good sales and customer experience to manage the new business, it will increase their cost. Based on above information, Penta Ltd should undertake option 1, it is because that option 1 is their expertise, option 2 is not their expertise, and option 1 is higher than option 2. Therefore, Penta Ltd should undertake option 1. 4.2 Penta Ltd is only able to raise capital up to  ¿Ãƒâ€šÃ‚ ¡10million Since Penta Ltd is only able to raise capital up to 10million, therefore, it should be undertake the highest NPV option, the highest of the two options is option 1 which NPV is higher than option 2 and base case. Penta Ltd should undertake option 1 not option 2, even the both NPV is positive. To build new factory an increase Penta Ltd market share in their business and increase their production capacity which may increase their output and profit, through build new factory abroad, Penta can increase their production efficiency, improve their internal operation and reduce the average cost of production. On the other hand, to build new factory will increase their operation cost such as labour cost, they should be hire person to run their new factory. If build new factory aboard, Penta Ltd should considering the foreign currency risk. The foreign currency risk usually affects Penta Ltd when their make export and/or import activity, when the money must be converted to another currency, thus changes in the currency exchange rate will cause the cost material or sales the product amount decrease or increase when the money converted back into original currency. It will affected their profit of whole business.