The Time Value Of Money

Published Date: 02 Nov 2017

FINAL ASSIGNMENT

SUBMITTED BY- QURESHI LUKMAAN

UNIVERSITY REGISTRATION NO – 12905980

SUBMITTED TO – UIVERSITY OF SUNDERLAND, LONDON CAMPUS

DATE OF SUBMISSION – 2nd

NO OF WORDS –

NO OF WORDS INCLUDING BIBLIOGRAPHY –

PART A

(a)

Year Revenue Cost Depreciation EBT TAX(30%) EAT CFAT

1 80000 15000 40000 25000 7500 17500 57500

2 80000 15000 40000 25000 7500 17500 57500

3 80000 15000 40000 25000 7500 17500 57500

4 80000 15000 40000 25000 7500 17500 57500

Pay Back investment 200000 3.47826087

Constant annual cash flow 57500

Year CFAT k(10%) Cash inflow

1 57500 0.909 52267.5

2 57500 0.826 47495

3 57500 0.751 43182.5

4 57500 0.683 39272.5

5 40000 Salvage 0.683 27320

Total 209537.5

Discounted Pay Back 3+ 57055 3.856

66592.5

Year Cashinflow

1 52267.5

2 4749.5

3 43182.5

4 39272.5

4 27320

209537.5

Less outflow 200000

NPV 9537.5

Profitability index p/v of cash inflow 209537.5 1.0476875

p/v of cash outflow 20000

if we follow IRR it comes to 13.17 (between 13% &14%)

Tax is assume to be 30%

An evaluation technique should consider all the following elements of capital project

All the future incremental cash flows from the project,

The time value of money; and The uncertainty associated with future cashflows.NPV provides us with what we really need (peter atrill &Eddie mclaney 2001 p.275)

NPV Merits. It recognises the time value of money.The net present value method is able to distinguish among investments whose cash flows have different risk .Secondly ,it also fulfils the second condition of a sound method of appraisel in a way that it considers the total benefits arising out of the proposal over its lifetime.Thirdly, a changing discount rate can be built into the NPV calculations by altering the denominater. This feature becomes important as this rate normally changes because the longer the time span, the lower is the value of money and the higher is the discount rate. This method is instrumental in achieving the objective of financial management which is the maximisation of the shareholder wealth.The discount rate that is used to convert benefit into present values is the minimum rate at which the present values of cash inflows is equal to the initial outlay or when the NPV=0There would ,therefore be no change in the market price of shares.When the present values exceeds the outlay or the NPV>0, the return would be higher than expected by the investors.It would ,therefore ,lead to an increase in share prices.A problem related with the present value method ,is that it involves the calculation of the required rate of return to discount the cash flows. The discount rate is very important because different discount rates will give different present values.

(b)The internal rate of return is the discount rate that, when applied to the future cash flows of the project, will produce an NPV precisely zero. peter atrill &Eddie mclaney 2001 p.284) IRR Merits: It does not use the concept of the required rate of return/the cost of capital itself provides a rate of return which is indicative of the profitability of the proposal.IRR lso gives the condition of maximising shareholders wealth. The required rate of return is, defined as minimum rate which investors expect on their investment.

If IRR of a project is equal to the rate expected by the investor ,the share price will remain unchanged .

If IRR>required share price rise

The IRR consider all cash flows

The IRR does consider the timing of cash flows .

Limitation

It involves complicated calculation and it results into rates.

Under IRR it is assumes that all cash flows are reinvested at IRR.

Profitability index

The PI includes all cash flows .

PI considers the time value of money.

PI does not consider the riskness of the investments cash flows

In cash of single project it is consistent with the objective of maximising owners wealth.

Payback period is the lenth of time it takes for the initial investment to be repaid out of the net cash inflows from the project( peter atrill &Eddie mclaney 2001 p.272) PAYBACK MERITS: Easy calculation.

DEMERITS :it is more concerned with recovery rather than future cash flow.

It does not consider entire life of the project during which cah flows are generated.

Discounted payback

Discounted payback period is able to distinguish investment with different timing of cash flows.

Risk is reflected through the discount rate ,risk is explicitly incorporated .

Demerits: Discounted payback does not give information about how profitable an investment is, as it ignores everything after the breakeven point. Hence it is not consistent with maximisation of owners wealth.

PARTB

(d) Assumptions of breakeven analysis

This analysis presumes that cost can be divided into fixed and variable category.

This is very difficult practice.

This analysis presumes an ability to predict cost at different activity volumes in practice a lot of experience may be required to develop this ability.

A series of breakeven charts may be necessary where alternative pricing policies are under consideration. Therefore differential price policy makes breakeven analysis a difficult exercise.

It assumes that variable cost fluctuates with volume proportionally, while in practical life the situation may be different.

This analysis presumes that efficiency and productivity remain unchanged in other words this analysis present a static picture of a dynamic situation.

This breakeven analysis either covers a single product or presumes that product mix will not change. A change in njix will significantly change the result.

This analysis disregards that selling price are not constant at all levels of sales. A high level of sales may only be obtained by offering substantial discounts on the competition in the market.

Stocks changes effects income. The breakeven depicts that volume of production of sales and thus ignores the effect of changes in stock volume .

As a matter of fact, it is assumed that stock changes will not affect the income.

PART C

"Profitability ratios provide the insight to degree of success in achieving profit. They express the profit made in relation to other key figures in the financial statement or to business resources" (Atrill, 2008).

Profitability analysis: GP ratio shows a declining trend. This decline may be because of factors like high cost of production on account of acquisition of raw materials on unfavourable terms, inefficient utilization of assets, low selling price resulting from completion or lack of demand.

Whereas operating shows a good trend. It indicates operational efficiency.

A decrease trend in ROCE indicates that long term funds of owners and lenders are not used efficiently. Profitability ratio and turnover ratio has a direct bearing on ROI. Because of fall in turnover rate and rise in cost of production ROI Is adversely affected. If profit margin cannot be improved then the co must try to increase the ratio of capital/assets turnover by improving productivity.

Operation profit also shows a decline Although any standard is not given still it can be conclude that there is low efficiency in managing purchases sales and inventory as well as low productivity because less funds are available to meet other expenses.

"Liquidity ratios are concerned with the ability of the business to meet the short term financial obligations". Atrill (2008)

Liquidity analysis: The liquidity position of company does not appear to be commendable during all the years under reference in fact its current ratio was less than one implying negative working capital (2011&12)and acid test ratio was at an alarming low level of 0.8 though the current ratio range of 2.00-1.65 (during 2010-12) is an indicative of satisfactory liquidity position, the acid- test ratio appear to be on the lower side the range being 0.90-0.80. One of the major reason for the sharp difference in these two liquidity ratios may be ascribed to a significant proportion of inventory (in current assets).

To conclude the liquidity position of the co. does not appear to be satisfactory. It is suggested that co. should a fair share of short term bank borrowing by long term loans. Such a step would help to improve its liquidity ratios.

Investor analysis

An investor is primarily concerned with four things earning per share , dividend per share ,intrinsic value per share and prospects of growth in the market value of the share. The analysis of the financial date of varied products LTD indicates an downward trend in the respect. The EPS has gone down from 1.3 in year 2010 to 1.00 in year 2011 to 0.8 in year 2012 because of if it dividend cover will be affected and for the same reason co cannot expect good intrinsic value.

In such circumstances investor cannot expect any bonus share in near future. From the point of view of granting short term credit to the company the firms position is not very satisfactory as its current ratio is below the standard of 2.

PART D

The sources from which a business meets its financial requirements can be classified as

According to period

(a) Long-term sources, viz, shares, debentures, long-term loans etc.

(b)Short- term ,viz,advances from commercial banks, public deposits,advances from customers and trade creditors, etc.

According to owner ship

(a)Own capital, viz, share capital, retained earnings and surpluses.

(b)Borrowed capital viz, debentures, public deposits and loans.

According to source of generation

(a)Internal sources viz, retained earning and depreciation funds.

(b)External sources viz securities such as shares and debentures loans.

However for the sake of convenience the different sources of funds can be classified into 3 categories

Security financing This includes financing through shares including both equity and preference shares and debenture

Internal financing This includes financing through depreciation funds and retained earnings

Loan financing This includes both short term and long term loans.

Merits of preference shares