Coventry University M004LON Finance Coursework 2 Sample

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1. Introduction Madison plc, a UK based firm, plans to expand its presence in Europe through the acquisition. Both Puteaux digital France and Melia Portfolio Research Spain are its target firms but Madison can acquire one of them. Thus, Madison has to assess these two firms through ratio analysis and sources of funding, and then makes the final decision. Another challenge faced by Madison is that the company needs to invest in a new software product since the current one is outdated. Two options are available for Madison: Madison Super and Madison Platform. This report uses the net present value (NPV) approach to determine whether Madison Super and Madison should be undertaken. The rest of the report is structured as follows: section 2 critically discusses the sources of funding; section 3 explains the significance of working capital management; section 4 analyzes the two software proposals through NPV method; section 5 uses break-even analysis to determine which software should be produced; section 6 discusses the factors that may affect the investment decisions; section 7 performs the ratio analysis to select the target company; section 8 summarizes the main findings of the report.

2. Sources of Funding Madison has been operating in the UK for the past 10 years and plans to expand its presence in Europe. Either its acquisition plan or software production needs funds.

On the one hand, Madison can use internal financing (e.g. retained earnings) to support the acquisition and investment projects. The most significant advantage of internal financing is that the company can control its operation without the interference from the external and that the company does not need to carry on the burden of interests (Goergen and Renneboog, 2001).However, the use of internal funds reduces the capability of firms to face the emergent need of cash flows and worsens the financial health of firms. More importantly, even the most profitable firms cannot only rely on their retained earnings to finance their growth or investment projects (Blazenko and Pavlov, 2009). Madison will not be an exception.

On the other hand, as a publicly traded firm, two most common sources of external funding are available for Madison: debt financing and equity financing.

According to Hui (2003), debt financing refers to the obligations to the lenders plus the

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fixed payments. Within the category, there are three options of debt financing: bank loan, corporate bond, and leasing (either operating or financial). There are some advantages associated with debt financing. First of all, companies remain the control of their business and facilitate the effectiveness of the resources utilization. This is because companies have to effectively use their resources to ensure their ability to pay back the interests and the debt to the lenders. In addition, the interest payments are tax deductible. The employment of debt allows firms to explain their repayment schedule (Brigham and Ehrhardt, 2013). The disadvantages of debt financing consist of two aspects: the requirement of credit rating and the need of collateral. Furthermore, companies need to notice that the carry-on of extensive debt is considered as a signal of high risk business. For Madison, if it determined to use debt financing, it would ensure that the benefits of debt financing surpass the costs.

With the regard to equity financing, it refers to the selling of shares (both common stocks and preferred stocks) to investors (Zhengfei and Kangtao, 2004). The first advantage of equity financing is that companies do not need the repayment of principle and interests. In other words, it enhances the value of firms. Moreover, equity financing leads to the introduction of expertise into the management or the board of directors of firms. In addition, companies can benefit from the knowledge and network of equity contributors (Gompers and Lerner, 2010). However, the use of equity financing leads to the sharing of the profits between shareholders and companies. The control of companies is diluted due to the issuing of new shares. In addition, the conflicts of shareholders with different interests may interrupt the operation of companies (Wu, Chua and Chrisman, 2007). It is necessary for Madison to evaluate the capital need for its acquisition plan. If the capital need is high, the company may use of a mix of debt financing and equity financing.

3. Work Capital Management Working capital refers to the difference between current assets and current liabilities (Gill, Biger and Mathur, 2010). The importance of effective working capital management is reflected by its role in the cash conversion cycle of firms. In other words, working capital management addresses the liquidity elements of current assets and liabilities of firms (Brigham and Ehrhardt, 2013). The effective working capital

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management can reduce the capital tied in the current assets of firms and hence improve the cash flow position of firms. If companies want their working capital management to be effective, they have to concentrate on the control of trading receivables and the collection period as well as the management of inventory levels. In doing so, firms can improve their cash flow positions.

4. Results of Two Investment Proposals NPV method has been the most common way for companies to determine whether they should undertake or reject an investment proposals. It is on the basis of discounted cash flow techniques and the difference between the present value of cash inflows and cash outflows (Awomenwe and Ogundele, 2008). The summative outputs for the two proposals are presented in Table 1 and Table 2 and the detailed calculation process is illustrated in the Appendix. It is clear that the NPV of Madison Super is 3,691,430 and that of Madison Platform is 3,288,041. On the basis of the rule of thumb, an investment project with a positive NPV should be accepted. On the contrary, an investment project with a negative NPV should be rejected (Drury, 2004). The two options for Madison are mutually exclusive. Thus, the company should accept the project with higher NPV. It is evident that the NPV of Madison Super project is higher than that of Madison Platform. In addition, Madison has £5.5 million of funds available for the new investment. Thus, based on the evaluation of NPV and the capital constraints, the company should accept Madison Super software project.

Table 1 NPV for Madison Super Year (In Thousands) New Software Cost Sales Revenue Less: Component A Component B Overheads Cost of Senior Technology

1

2

3

4

5

5665

6695

7931

9012.5

10094

696.8 1112.8 283.25

832 1560 334.75

988 1872 396.55

1144 2184 451.14

1404 1872 504.7

Officer 1

294

299.644 8

Officer 2

170

305.398 173.005 2 4196.04 7

311.261 6 174.527 6 4747.57 1

Taxable Cash Flow

0 5500

3108.15

171.496 3497.10 9

317.2378 176.0635 5819.999

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Less: Tax Liabilities Add: Tax Benefit Less: Working Capital (Incremental)

1025.69 453.75 400

166.5

154.5

1

2941.65 0.87719 3 2580.39 5

1863.17 0.76946 8 1433.64 9

After-tax cash flows Discount rate at 14% Present Value NPV

-5900 3691.43

1154.04 6 340.312 5

1384.69 5 255.234 4

154.5 2547.18 8 0.67497 2

154.5 2953.14 1

1719.28

0.59208 1748.49 7

1566.698 191.4258

4061.875 0.519369 2109.61

Table 2 NPV for Madison Platform Year New Software Cost

0 8500

1

2

3

4

5

6386

7790.92

9271.03

10846.9 3

12366.18

354.64 1372.8 191.58

550.16 1950 233.81

842.4 2340 278.1

1095.12 2831.92 325.48

1498.64 3062.8 370.8

Officer 1

294

299.644 8

Officer 2

170

305.398 173.005 2 5332.12 7 1513.31 7 525.937 5

311.261 6 174.527 6 6108.62 1 1759.60 2 394.453 1

Sales Revenue Less: Component A Component B Overheads Cost of Senior Technology

Taxable Cash Flow

4002.98

Less: Tax Liabilities Add: Tax Benefit Less: Working Capital (Incremental)

701.25 500

172.59

1

3830.39 0.88495 6 3389.72 6

After-tax cash flows Discount rate at 13% Present Value NPV

171.496 4585.80 9 1320.98 3

-9000 3288.04 1

157.59 2405.98 6 0.78314 7 1884.24

157.59 3135.28 2 0.69305 2172.90 8

157.59 3796.97 6 0.61331 9 2328.75 6

317.2378 176.0635 6940.639 2015.845 295.8398

4628.954 0.54276 2512.411

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The NPV is considered as the best technique to assess the investment projects (Bhandari, 2009). Under the NPV method, the risk, time value of money and cash flows are justified in order to maximize the shareholders’ wealth. More specifically, if companies accept an investment project with positive NPV, the shareholders’ wealth would increase accordingly. There are other methods to assess investment projects: payback period and internal rate of return (IRR). According to Ehrhardt and Brigham (2013), payback period is the number of years that companies need to cover its initial investment. The shorter payback period is more attractive. However, the drawbacks of payback period technique include the ignoring of time value of money, cash flows after payback period and inability to relate shareholders’ wealth with payback period. With the regard to the IRR, an investment project with higher IRR is more acceptable for companies. The assumption behind the IRR is that the cash flows of firms can be reinvested at the IRR (Awomenwe and Ogundele, 2008). In other words, the unrealistic return is realized by firms. But this report also calculate the IRR of two investment projects. The output is presented in Table 3. In Table 3, the IRR of Madison Super is 19% while that of Madison Platform is 12%. It is clear that, on the basis of the IRR, the company should accept Madison Super project since the IRR of Madison Super is higher than that of the benchmark (10%).

Table 3 The IRR of Madison Super and Madison Platform IRR

Madison Super Madison Platform 19% 12%

5. Break-even Analysis Break- even analysis can also be used as a tool to help the decision making of firms. Breakeven is a point in which the revenue of products are equal to the costs of production (Alhabeeb, 2012). In the case of Madison, break even analysis can help the firm to determine which one of these two new software to be produced. Since the fixed costs of two products are the same, the influential factors are selling price and variable costs of these two software. If the production is equal to zero, the variable cost is equal to zero. But variable costs increase as the production level increases. This report uses a simple example to illustrate how Madison can use breakeven analysis to determine which software should be produced.

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Table 4 Projected Breakeven Analysis Selling Price per unit Variable Cost per unit Fixed Cost Quantity for Break -Even Point

750 250 100000 200

Figure 1 Breakeven Analysis Revenue

Breakeven Point

Number of unit sold More specifically, Madison can use the breakeven point to determine which software should be produced. The software with lower breakeven point should be selected. This is because the decline in the breakeven point leads to the increase in the contribution margin. Accordingly, producing software with higher contribution margin, Madison can quickly cover its fixed costs or take less sales to cover its fixed costs, compared to the software with lower contribution margin. Especially for Madison, the fixed costs are same to the two software. Therefore, the case company should choose the software with lower breakeven point.

6. Other Factors Affecting Investment Decision Making Although this report uses the NPV method to make the investment decision, there are other factors that can influence the decision making process as well. The existing literature documents the factors that have the impact on investment decision making. On the one hand, the investment decision of firms is exposed to the influence of the external environmental, including the economic risks, political and social conditions as well as the regulatory frameworks (Enoma and Mustapha 2010). If companies believe that the current economy is expected to face a downside pressure, they would be more cautious and conservative in investing. In addition, the study of Karim and Azman-Saini (2013) highlights the influence of macroeconomic prospects and fiscal policy on the investment decisions. The decline in gross domestic product

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growth and the increase in interest rate could impede the investment decisions of firms.

In addition, the informational transparency and market trustworthiness or uncertainty are the important factors that affect the investment decisions (Kahraman 2011).

Moreover, within the company, some internal factors may also influence their investment decision as well. For instance, Kahraman (2011) suggest that the liquidity position and the serving of debt of firms can affect their investment decisions. This is because, if firms are ineffective and inefficient in the collection of their receivables, they are less likely to take new investment projects into consideration due to its insufficient capital available. In addition, the behaviors of government could significantly affect the investment decisions of firms as well. Beyond the fiscal policy, the tax policy has also played an important role in the investment decision of firms, since the corporate tax rate directly influence the return of investment projects (Overesch and Wamser 2010).

Furthermore, Qureshi and Hunjra (2012) document that the corporate governance of firms can affect their investment decisions since firms with the risk adverse corporate governance are likely to reduce the investment in new projects.

7. Ratio Analysis of Two Target Firms The case company plans to expand its presence in Europe through the acquisition. Both Puteaux digital France and Melia Portfolio Research Spain are its target firms but Madison can only acquire one of them. In order to assess which one is a better decision for the case company, this report employs ratio analysis to evaluate their overall performance during the period from 2011 to 2013. The output of ratio analysis is presented in Table 5. First of all, this report examines two profitability ratios (operating profit margin and net income margin) of these two target firms, respectively. It is clear in Table 5 that the operating profit margin of Puteaux France is much higher than that of Melia Spain which is negative. In addition, there is an upward trend in the operating profit margin of Puteaux France. The similar result is identified through the interpretation of net profit margin. The upward trend of net profit margin is also found in Puteaux France. However, the net profit margin of Melia Spain is negative, suggesting that Melia Spain experienced the losses in the period of 2011-2013.

Table 5 Ratio Analysis of Madison plc Puteaux France

Melia Spain

ProEssay 专业代写 WeChat：pro1essay Ratio Profitability Ratio Operating Profit Margin Net Profit Margin Liquidity Ratio Current Ratio

2011

2012

2013

2011

2012

2013

25.45% 17.63%

29.31% 20.32%

29.65% 20.79%

-9.00% -8.93%

-9.00% -8.94%

-9.00% -8.93%

1.78

2.99

4.92

0.58

0.48

1.69

With the regard to liquidity ratio, this report focuses on the current ratio, which measures the capability of firms to cover its short-term obligations through the liquidation of their current assets. According to the rule of thumb, the current ratio of Puteaux France in three years is much higher than 1, implying that the company has a very strong liquidity position. On the contrary, Melia Spain had the current ratio that was lower than 1 in 2011 and 2012 although its current ratio increased to 1.69 in 2013.

Compared to Puteaux France, Melia Spain has a much worse liquidity position, which indicates that the company may have difficulties to meet the requirement of its shortterm obligations. Based on the analysis of profitability and liquidity, Puteaux France is a better choice for Madison to acquire for its expansion plan. But it is better to know the reasons of Melia Spain’s negative operating profit. If its negative operating profit is attributable to the macroeconomic conditions, the further analysis is required. In addition, the corporate culture is another factor that should be considered by Madison as well. If corporate culture between Puteaux France and Madison is totally different, the acquisition may not be executed.

8. Conclusion This report mainly assessed two investment proposals of software and the two potential target firms for the expansion plan of Madison. This report found that the NPV of Madison Super project is higher than that of Madison Platform. In addition, Madison has £5.5 million of funds available for the new investment. Thus, based on the evaluation of NPV and the capital constraints, the company should accept Madison Super software project. With the regard to its target firms of acquisition, Puteaux France has higher profitability and stronger liquidity position than those of Melia Spain. Based on the analysis of profitability and liquidity, Puteaux France is a better choice for Madison to acquire for its expansion plan.

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Appendix

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