please discuss the IPO process in the USA. Then, identify and discuss the critical events, points-in-time, for an IPO.

please discuss the IPO process in the USA. Then, identify and discuss the critical events, points-in-time, for an IPO.

 

Through an Initial Public Offering, or IPO, a company raises capital by issuing shares of stock, or equity in a public market (Fuhrmann, 2013).There are few reasons for a private company to go public –

  1. Raise cash for expansion or debt reduction
  2. Some initial investors ( angel investor or venture funds) might want to exit
  3. Becoming public can generate buzz and might mean awareness of the brand or the company
  4. The shareholders like CEO or the founder members can see value unlocking of their holdings

Before a private company can go public it has to hire investment banks with experience in same business sector, so that they (Underwriter of the bank) can value the business. Here important point to note that businesses are usually valued based on valuation multiples of the sector, potential future earning etc,. And Investment banks usually find initial investors too.

Before a company goes public, it has to come up with a prospectus with all the company related information for Security and Exchange Commission or SEC and investors. And the company has to file S-1 with SEC. S-1 provides detailed information about the business, financial statements, potential risks and plan for the cash raised from public offering (Hall, 2015).

S-1 files can be found in SEC website https://www.sec.gov/cgi-bin/browse-edgar?company=&CIK=&type=s-1&owner=include&count=40&action=getcurrent

According to PWC, a company intending to go public (file IPO) can expect to pay 5 – 7% to underwriters. And there will be costs related to legal, accounting distribution, mailing etc. But, underwriters work on coming up with the price to make maximum profit, share allotment and finding a stock exchange to list. In US every company will try to be listed on NYSE or NASDAQ, since these markets are so liquid (Fuhrmann, 2013).

Next the CEO , CFO, investor relations individuals start roadshows essentially to convey the vision, mission and future prospect of the company to the potential investors.

After going public, each public company files 10 Q every quarter with all those information and every year these public companies file 10-K. All these information filed with SEC are for public to access, who can be investment firms or individual investors.

Any public company has to spend $1.5 million to comply with financial, legal and regulatory burdens ( Fuhrmann, 2013).

So, we can see going public is not an easy task for a company, but per The Economist IPO process is the locomotive of capitalism (Fuhrmann, 2013).

 

 

 

 

https://www.fool.com/investing/general/2015/06/22/sec-form-s-1-what-is-it-why-is-it-important.aspx

 

Major Methods of Company Valuation

Abstract

This paper will discuss valuing a company or business based on market capitalization method, book value method, expected future earning method and valuing company based on multiples, such as price/earnings method. After that, we will compare all these methods.

Keywords: market cap, book value, price to earning

 

 

 

 

 

 

 

 

 

 

 

 

Market Capitalization method is one of the easiest ways to value businesses/companies listed in the stock market. In this method, we need to multiply the number of outstanding stocks with the market price of each share to find out the market capitalization of the business/company (Investopedia, n.d.).

For example – a fictitious company ABC Inc. is listed in NYSE, it has 1 billion outstanding shares, and on NYSE each share is priced at $10, in this case, the market capitalization of AB Inc. is $10 billion.

 

Book value is very different than market capitalization. Book value is calculated based on the assets and liabilities a company has. So, it is more of an accountant’s job than the market price (Investopedia, n.d.).

Book Value = Total assets – Total liabilities

Book value per share = book value/number of shares outstanding

Note – here a company can have more current and long-term liabilities than its current and long-term assets, so book value can be negative.

 

On the other hand, an old company can have a lot of assets in land, real estate, equipment, unsold inventories and that would make the book value higher for the company, but the assets might not be income producing. But in certain businesses book value might help determine the size of the business, and real estate would be a good example of that, in such cases book value of a stock can impact the share price in the stock market.

Expected Future Earning is another method and most widely used method to value a company based on future earning potential by that company. Here we use NPV method, PV of all future earning and using a discount rate that will factor is the cost of capital, inflation etc.(Investopedia, N.d.).

But this is highly speculative too, analysts often take their best guess to estimate future earnings growth. But we need to remember the cost of capital can increase due to interest rate increase or due to inflation. And input cost can increase for the same reasons bringing down the cash flow.

For example, for a company XYZ Inc. the analysts forecast cash flow of $100000 in year 1, $150000 in year 2, $200000 in year 3, $250000 in year 4 and they do not have much information to calculate much further in time with much accuracy, so 5th year cash flow they will consider as Terminal value, $500000

If we use the discount rate of 10% then the estimated value of the company would be $846,353. But, in case the discount rate goes up to 12% then the company value would change to $793,813.

 

Valuing Company based on multiples is another quick way to value any business. And we can use price to earning to quickly value a business. P/E ratio is price one share / earning per share or

Market capitalization / Earning of one year.

The same way a company can be valued based on price/sales or price/asset too. These are all quick way to determine or get an idea of the price of a business.

Compare different valuation methodologies –

 

Market capitalization method Book value method Expected future earnings method Valuation based on multiples
This is a simple method to value public companies, price or 1 share multiplied with a number of outstanding shares would give market capitalization This can be applied to both privately held and public businesses. This valuation is also can be used for both public and private companies This can be used for public companies or for those companies those have outstanding shares.
In an open market when the shares are being traded, market capitalization can change in moments and news or speculation can affect the price Book value usually won’t change if there is no change in asset or liability, so this method is comparatively stable This is done based on estimation and based on discounted cash flow valuation can be way off too, things in economy might change very fast , very soon Valuation based on multiples are stable, although it might go up or down based on share price as they are traded in open equity market,
Valuation based on market cap often shows how market looks at a company’s future based on it’s earning potential Book value by itself can tell us if a company has enough asset to cover its liabilities, but that does not always tell us earning potentials Estimating future earning growth might go wrong, so this is not exact science, but usually people impose expectation based on the outlook of economy and for the company This is more of a comparative method, in the same sector the ratios can be compared to understand if a company is undervalued or overvalued, but after that future investigation is required
A Company can be overvalued due to over-optimism in traders A high book value might represent lot of unsold inventory and unproductive assets, which might justify ow price in stock During estimation in future earnings, the earnings growth can be overestimated, or economic slowdown can cause lower cash flow, that can throw off valuation The multiple can also vary based on high share price or low earning etc.

 

 

 

 

 

 

 

 

References:

 

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/terms/m/marketcapitalization.asp

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/articles/investing/110613/market-value-versus-book-value.asp

Retrieved on 5/14/2018. Retrieved from https://www.investopedia.com/terms/d/discounted-future-earnings.asp

 

Please describe market capitalization as a valuation method, what are strengths and weaknesses? Then, please discuss book value as a valuation method. Compare it to market capitalization.

Please describe market capitalization as a valuation method, what are strengths and weaknesses? Then, please discuss book value as a valuation method. Compare it to market capitalization.

A Company’s market capitalization is calculated by multiplying the number of outstanding stocks and the current market price of one share. This one way to calculate the value of the business by investors (Investopedia, n.d.).

For example “Xyz Company” has 10 million outstanding shares and in a major stock exchange, one share is being sold at $50. In that case, the market capitalization of this company is only $500 million and investors might call it a small cap company at current context. Apple, Google, Exxon they are big cap companies, but the formula to calculate market cap is same all across for all companies.

It is a fairly easy way to calculate the value of a company and an investor might decide to invest solely based on the market cap, although that won’t be a good investing strategy. One simple fact is, an investor with $50 million to invest can buy every single share ( but the current shareowners should be willing to sell) and own 100% of the business.

Market capitalization definitely tells us how the market values the company, risk, the future of the business and capabilities of generating cask. But then it is all from market’s perspective, might not necessarily be accurate.

So the weaknesses are, for example during great depression or more recently during financial crisis many great companies share price fell and market capitalization also fell dramatically, but the underlying business model was not impacted due to the fall of the share price. So, greatest weakness is, the market cap is not the greatest tool to measure the strength of the underlying business.

 

Book Value – is the value of the business based on the balance sheet.

Book value = total assets – total liabilities

In other words, it is the difference between the total assets and total liabilities (Investopedia, n.d.).  If we go back to “Xyz company”, say its total asset is (i.e.: current assets+ long-term assets) worth 1 billion and total liabilities (i.e.: current liabilities + long-term liabilities) worth 1 billion to. In that case, the book value of the business will be worth 0 dollars.

Now you can ask, then why the market capitalization is 500 million. The market values the customer base the company has the employee, the knowledge and other intangible assets the company might have, more importantly, the market values the earning potential of the company in future. Hence book value and market capitalization are very different valuation methods.

 

Now for certain companies such as real estate or banks, book value might be important. Especially for a real estate company that sells properties. We can figure how much property or inventory they have to sell, same goes for banks, we can understand if the bank has more assets to back all the liabilities. But market capitalization would vary based on the earning potential or expectation, and it might not work based on book value all the time. Another instance might be, sometimes the older the company gets the better the book value of the company gets. One example would be unsold inventory, equipment, even the old equipment those are not being used anymore help to boost the book value. But all those assets do not help the company earn more, so the market capitalization might not get much help from a big book value.

Book value can be calculated per share too. book Value per share = Total book value/number of outstanding shares.

 

References:

 

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/terms/m/marketcapitalization.asp

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/articles/investing/110613/market-value-versus-book-value.asp

 

Quantitative Analysis of Portfolio

Abstract

In this paper we are going to review the portfolio position, calculate the estimated yields for each stock and overall dividend income. After that we are going to determine the weighted average factor and weighted average.

We will explain how all these are being calculated, explain the difference between yield that is based on cost and yield on current market price and finally I will make some observations and recommendations.

 

Keywords: weighted average, yield

 

 

 

 

 

 

 

 

 

First let us quickly find out total portfolio value we know the number of stocks and price of each stock, we can multiple number of stocks with price of each stock and then sum up –

Type of Investment Company Name Stock Symbol Portfolio Position (# of shares) Current Market Price Current Market Value
Common stock Altria MO 119 50.20 5,973.80
Common stock AT&T T 173 32.65 5,648.45
Common stock Chevron CVX 26 104.98 2,729.48
Common stock Coca Cola KO 59 40.55 2,392.45
Common stock Duke Energy DUK 65 76.78 4,990.70
Common stock Johnson & Johnson JNJ 31 100.60 3,118.60
Common stock McDonalds MCD 52 97.44 5,066.88
Common stock Pepsi Cola PEP 17 95.62 1,625.54
Common stock Philip Morris Intl PM 70 75.33 5,273.10
Common stock Proctor & Gamble PG 52 81.94 4,260.88
           
        Total Portfolio Market Value 41,079.88

 

First we need to multiply number of stocks with portfolio position or number of stocks. Then I added current market value of each company name to get total portfolio value.

 

Calculate individual yields

 

Now we know Current market value of each company in the portfolio and we know estimated dividend income from each company. So for example dividend yield for Altria would be –

Estimated Dividend / Current Market Value = 247/5973.80*100 = 4.13%

And I applied the same method to calculate estimated current yield for each company we have in the portfolio.

Company Name Stock Symbol Portfolio Position (# of shares) Current Market Price Current Market Value Estimated Dividend/Interest Estimated Current Yield
Altria MO 119 50.20 5,973.80 $247.00 4.13%
AT&T T 173 32.65 5,648.45 $325.00 5.75%
Chevron CVX 26 104.98 2,729.48 $111.00 4.07%
Coca Cola KO 59 40.55 2,392.45 $77.00 3.22%
Duke Energy DUK 65 76.78 4,990.70 $206.00 4.13%
Johnson & Johnson JNJ 31 100.60 3,118.60 $86.00 2.76%
McDonalds MCD 52 97.44 5,066.88 $176.00 3.47%
Pepsi Cola PEP 17 95.62 1,625.54 $44.00 2.71%
Philip Morris Intl PM 70 75.33 5,273.10 $280.00 5.31%
Proctor & Gamble PG 52 81.94 4,260.88 $133.00 3.12%

Weighted average factor and the weighted average yields

 

We determine weighted average factor for each stock by dividing the current market value with total market portfolio value. For example, for Altria or stock symbol MO Current Market Value / Total Market Portfolio Value = 5973.80/41079.88 = .15 and did the same exact thing for each stock to find out the weight then have in portfolio(Weighted Average, n.d.).

Stock Symbol Portfolio Position (# of shares) Current Market Price Current Market Value Estimated Dividend/Interest Estimated Current Yield Weighted Average Factor Weighted Average Yield
MO 119 50.20 5,973.80 $247.00 4.13% 0.15 0.60%
T 173 32.65 5,648.45 $325.00 5.75% 0.14 0.79%
CVX 26 104.98 2,729.48 $111.00 4.07% 0.07 0.27%
KO 59 40.55 2,392.45 $77.00 3.22% 0.06 0.19%
DUK 65 76.78 4,990.70 $206.00 4.13% 0.12 0.50%
JNJ 31 100.60 3,118.60 $86.00 2.76% 0.08 0.21%
MCD  

52

97.44 5,066.88 $176.00 3.47% 0.12 0.43%
PEP 17 95.62 1,625.54 $44.00 2.71% 0.04 0.11%
PM 70 75.33 5,273.10 $280.00 5.31% 0.13 0.68%
PG 52 81.94 4,260.88 $133.00 3.12% 0.10 0.32%
            1.00  
    Total Portfolio Market Value 41,079.88        
            Weighte Averatge Yield: 4.10%

 

To calculate weighted average yield, we just have to calculate weighted average yield for each stock. We already have calculated weighted average factor for each stock, and we have current yield for each stock. I have multiplied estimated current yield with weighted average factor to get weighted average yield for that stock.

The market value of each stock is different in the portfolio and that is why we have to determine the average weight of each stock in the portfolio. And we have estimated yield for each stock, so we just multiply the estimated yield with the average weight factor to get weighted average yield.

Price of stock goes up and down. And yield can vary every day. For example say you purchase just 1 stock of ABC Company for $100. This company pays yearly dividend worth $2, so the dividend yield of the stock would be 2%. This yield is based at cost.

After purchasing the stock, say after 1 month the stock price increased to $120, but that dividend is still $2, so based on current market price the dividend yield would be 1.67%.

Next month the stock price drops to $80, at current market price the yield would be 2.5%. Yield at cost remains same until the stock is sold, because right now the purchase cost is still $100 and the yield is still $2, although the market value is changing and based on changing market value the yield is also changing.

 

 

My observation is my friend has common stocks in portfolio, these are not bonds or preferred stocks, so the dividend payments are not promised, on positive side those can go up but those might go down too, and even stop based on the financial results of company. So my friend should not consider the dividend income from the portfolio as fixed income for life. This income can go up or down in future, while common stocks bear greater risk than bonds or preferred stocks (Common Stock, n.d.). Based on all these observations, my recommendation would be based on my friends age and investment horizon, if he is young, has a regular full time job with minimum to no dependency on this dividend income , then he can stay invested, but if he wants to cash out sooner or have a regular source of income, maybe he should sell some shares, book profit and switch to bonds with regular coupon payouts.

References:

Retrieved on 5/9/2018. Retrieve from http://www.financeformulas.net/Weighted_Average.html

Retrieved on 5/9/2018. Retrieved from https://www.investopedia.com/terms/c/commonstock.asp

 

Corporate bond interest in terms of cost of capital

Please discuss corporate bond interest in terms of cost of capital versus investor yields. Also, discuss municipal bond interest in terms of investor yields.

 

Corporate bond interest in terms of cost of capital

A company can raise capital for a project or to cover other expenses, issuing bond in the market. Depending on the credit rating and other risk factors the company will have to offer coupon rate on the bond.

A corporate can issue bond at a fixed bond rate, say 5%, par value of $1000, the corporate will have to pay the bondholder $50 as coupon payment. Bonds come with a maturity date too. It is usually few years. The coupon rate in most of the cases are fixed, but could be floating too. In case of a floating coupon rate the bond rate usually changes with US treasury or some other benchmark rate. The coupon rate the corporate offers is usually the cost of capital (Investopedia, n.d.).

Corporate bonds usually yield higher than inflation and make good return on investment for investors. But the income from bonds are usually taxable. But from the corporate’s perspective the cost of capital will depend on the coupon rate it offers. The coupon rate is determined based on the credit risk, market risk and other associated risk factors. These risk factors are measured by credit rating companies like Moody’s, Fitch or S&P.

Now, interest on these bonds or investor yield depends on the price an investor pays for the bond and on the remaining future cash flow. Bonds price changes based on interest rate ( that is risk free rate), when interest rate goes up, bond prices fall, and when interest rate drops , bond prices goes up.

For example, say a Company ABC Inc., issued bonds of par value $1000 with coupon rate 5% on 1/1/2018, and bonds are due to mature in 3 years. Now you can quickly project a future cash flow –

The bondholder will receive $150 in coupon payment over 3 years, so $50 each year. In this case yield to investor is 5% pretax, if the investor has to pay 30% tax, then his or her income from the bond would be $35 every year, yielding 3.5%.

No that calculation was done based on par value $1000, is the investor purchases the bond from secondary market for $1050, in that case $50 in coupon payment would result in only 4.76% pre-tax , and 3.37% post tax yield.

Now one might wonder why the bond prices go up or down based on risk free rate. Say, you can buy risk free government bond at 3% interest rate, and the corporate bond offers 5%, many investors pay premium to on the par value of the corporate bond to earn the extra interest, that increases the bond value. Likewise, when risk free rate goes up and the difference between risk free rate and corporate coupon rate comes down, investors switch from risky corporate bonds to safer government bonds, hence bringing down the bond price.

 

Municipal bond interest in terms of investor yields

Municipal bonds or muni bonds work on same concept of corporate bonds with some basic differences. Municipal bonds are issues by municipalities or local governments to fund their local infrastructure projects or fund other expenses. There are 3 types of muni bonds

  1. GO or General Obligation bonds, where municipality has to repay the full obligation after bond matures, these type of bond yield lowest because these are most secure muni bond instrument.
  2. Revenue bonds which come with a promise of repayment from a specified stream of income.
  3. Assessment bonds – these are linked to property tax assessment in the municipal area.

Of course muni bonds are also rated by same credit rating agencies. But, major difference from corporate bond is that income from muni bonds are tax exempt (Pat s, n.d.), so you do not pay any federal or state tax on muni bond. But, muni bonds are vulnerable to interest rate hikes as corporate bonds are.

For an example, if any corporate issues bonds of par value $1000 with coupon rate 5%, and a municipality bond is available at par value $1000 with coupon rate 3.75%, an investor might find muni bond attractive, because the corporate bond would yield him 3.5% post tax, but since there is no tax on muni bond, it would yield him extra 25 basis point or 3.75%.

 

 

References:

Retrieved on 5/6/2018. Retrieved from https://www.investopedia.com/ask/answers/020415/what-difference-between-cost-capital-and-required-return.asp

Pat s(n.d.). What Are Municipal Bonds – Pros & Cons of Investing. Retrieved from https://www.moneycrashers.com/municipal-bonds-investing/

 

 

Capital Budgeting for WePROMOTE

Abstract

In this paper, I am going to perform NPV calculations for both plans and explain, how I did them. Then I will try to justify if we should pursue this idea and then will present my logic and arguments behind the conclusion.

NPV is used to determine if a proposed project would be profitable. NPV is calculated by finding out the difference between cash outflow and aggregated future cash inflows (Investopedia, n.d.).

IRR or Internal rate of return is used to estimate the profitability of proposed project/investment. It is a discount rate that makes the NPV of future cash flows to zero (Investopedia, n.d.).

Keywords: NPV, IRR

 

 

 

 

 

 

 

Before we start the NPV calculation, here are the facts we are going to use –

  • The cost to install the required equipment will be $105,000, this is the outflow on year 0, this is a tangible long term asset, and we are going to depreciate it over 5 years in straight line, so it will depreciate at the rate of $21000 every year until the book value becomes 0
  • The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 and 3. Year 4 will be $28,000 and year 5 (the last year of the project) will be $23,000·
  • The estimated cash outflows are $13000 on year 1, $12000 on year 2 to 4 and on 5th year $10000
  • In 5 years, the equipment will stop working and can be sold for its parts for about $5,000.
  • The capital borrowing cost is 3%
  • Discount rate we will use to calculate NPV 7%

With these data we can calculate the net income from the project considering all cash inflows and cash outflows –

Year 0 1 2 3 4 5 5
Project Discount Rate 0.07            
Equipment purchase price ($105,000)            
Cash inflow from new equipment   $25,000 $27,000 $27,000 $28,000 $23,000  
Salvage value             $5,000
Depreciation   ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) $0
Interest Payment on Loan   ($3,150) ($3,150) ($3,150) ($3,150) ($3,150)  
Outflow   ($13,000) ($12,000) ($12,000) ($12,000) ($10,000)  
Earning Before Tax   ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $5,000
30% Income Tax             $1,500
Net Income ($105,000) ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $3,500

 

In the table above we have considered the gross revenue (estimated) to the estimated cash inflows and the salvage value of the equipment to be cash inflow too.

Depreciation is considered as a deduction from revenue before tax (Investopedia, n.d.)

The $105000 was borrowed and we will have to make an interest payment at interest rate 3%, that is considered as cash outflow.

And we have to factor in the project cash outflows over 5 years period.

So, we can see in the above table the Income before tax is in negative, so the income tax won’t be applicable on those, apart from the cash the business generates for the salvage value of the equipment.

We can calculate the Operating Cash flow, just by adding the depreciated value back to net income

Year 0 1 2 3 4 5 5
Project Discount Rate 0.07            
Equipment purchase price ($105,000)            
Cash inflow from new equipment   $25,000 $27,000 $27,000 $28,000 $23,000  
Salvage value             $5,000
Depreciation   ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) $0
Interest Payment on Loan   ($3,150) ($3,150) ($3,150) ($3,150) ($3,150)  
Outflow   ($13,000) ($12,000) ($12,000) ($12,000) ($10,000)  
Earning Before Tax   ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $5,000
30% Income Tax             $1,500
Net Income   ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $3,500
OCF   $8,850 $11,850 $11,850 $12,850 $9,850 $3,500

 

Taxes are included while calculating operating cash flow, but depreciation is added first to the revenue and then tax is subtracted (Investopedia, 2018). But in this case the company is not making any profit before taxes. Since the company is making loss there won’t be any tax on losses.

Now that we have Cash Flow, we can estimate the Present Value and Net Present Value –

Year 0 1 2 3 4 5 5 NPV
Project Discount Rate 0.07              
Equipment purchase price -105000.00              
Cash inflow from new equipment   25000.00 27000.00 27000.00 28000.00 23000.00    
Salvage value             5000.00  
Depreciation   -21000.00 -21000.00 -21000.00 -21000.00 -21000.00 0.00  
Interest Payment on Loan   -3150.00 -3150.00 -3150.00 -3150.00 -3150.00    
Outflow   -13000.00 -12000.00 -12000.00 -12000.00 -10000.00    
Earning Before Tax   -12150.00 -9150.00 -9150.00 -8150.00 -11150.00 5000.00  
30% Income Tax             1500.00  
Net Income   -12150.00 -9150.00 -9150.00 -8150.00 -11150.00 3500.00  
OCF   8850.00 11850.00 11850.00 12850.00 9850.00 3500.00  
Present Value of Future Cash Flow -105000.00 8271.03 10350.25 9673.13 9803.20 7022.91 2495.45  
NPV               -61854.88

 

Hence the NPV the negative, so this project is not financially profitable.

Conclusion – based on the NPV which is negative this project should not be pursued.

 

 

References:

Retrieved on 4/29/2018. Retrieve from https://www.investopedia.com/terms/n/npv.asp

Retrieved on 4/29/2018. Retrieved from https://www.investopedia.com/terms/i/irr.asp

Retrieved on 4/29/2018. Retrieved from https://www.investopedia.com/ask/answers/012615/are-taxes-calculated-operating-cash-flow.asp

 

Capital Budget Problem:

Please set-up solution model for the following capital budget problem. Explain the approach you plan to take and why. Then, please perform the calculations of your model and draw conclusions.

Capital Budget Problem:

This case continues following the new project of the WePPROMOTE Company, that you and your partner own. WePROMOTE is in the promotional materials business. The project being considered is to manufacture a very unique case for smart phones. The case is very durable, attractive and fits virtually all models of smart phone. It will also have the logo of your client, a prominent, local company and is planned to be given away at public relations events by your client.

More details have emerged and your estimates are becoming more precise.

The following are the new values to the data that you have been estimating up to this point:

  • You can borrow funds from your bank at 3%.
  • The cost to install the needed equipment will be $105,000 and this cost is incurred prior to any cash is received by the project.
  • The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 – 4. Year 5 will be $23,000.
  • The expected annual cash outflows (current project costs) are estimated at being $13,000 for the first year, then $12,000 for years 2, 3, and 4. The final year costs will be $10,000.
  • After 5 years the equipment will stop working and will be worthless.
  • The discount rate you are assuming continues to be 6%.

 

 

 

 

 

 

 

 

 

 

 

We are going calculate the NPV with the data we have. Before we start –

  1. On year 0 of the project we are going to spend $105000 for the equipment and it is capital out flow that would cause increase in long term liability and increase in long term assets, we can use a liner depreciation too which will be $21000 starting year 1, in the project

Depreciation is an accounting trick which allows a business to write off the value of an long term asset over a period of time, but this is considered as a non-cash transaction (Investopedia, n.d.).

  1. Revenue on year 1 = $25000, years 2 – 4 = $27000 and on 5th year $23000
  2. Cash outflow for the project on year 1 =$13000 , years 2 – 4 = $12000 and on 5th year $10000
  3. There is no salvage value for the equipment after 5 years
  4. And the discount rate we will use is 6%, considering that the 3% bank borrowing rate is included with any inflation or other factors.

Considering all the points we can now quickly calculate the projected Operating cash for each year:

Project Timeline
  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
 
Equipment Cost -105000          
 
Gross Revenue   25000 27000 27000 27000 23000
 
Current project Costs   -13000 -12000 -12000 -12000 -10000
 
Depreciation   -21000 -21000 -21000 -21000 -21000
 
Net Income   -9000 -6000 -6000 -6000 -8000
 
Operative Cash Flow -105000 12000 15000 15000 15000 13000

 

The negative numbers show cash outflow and the positive numbers are cash in flow

We have the projected future cash flow from this project, but these are future money (and of course not accurate amount, just projected amount) and we can determine what that means in present amount. But we need to calculate NPV. We can find out if we are going to profit (considering the projected cash flow) or make a loss in this project in terms of present dollars.

Now, to obtain the present value of the future cash flow we need to discount the future cash flow with 6% discount rate.

Net Present Value is the difference between the present value of all cash inflows and cash outflows over a period of time, in our case the time period for this project and NPV is used to do capital budgeting (Investopedia, n.d.).

So let us find out the NPV = (105000) + 12000 / (1+0.06) ^1 + 15000 / (1+0.06) ^2 + 15000 / (1+0.06) ^3 + 15000 / (1+0.06) ^4 + 13000 / (1+0.06) ^5 = ($43,527.59) or – $43,527.59

 

We can see it is a negative return, so we should not continue this project and it will not be financially beneficial.

 

Reference:

Retrieved on 4/28/2018. Retrieved from https://www.investopedia.com/terms/d/depreciation.asp

Retrieved on 4/28/2018. Retrieved from https://www.investopedia.com/terms/n/npv.asp

Case Study of WePROMOTE

Abstract

In this paper, I am going to perform NPV calculations for both plans and explain, how I did them. Then I will try to justify if we should pursue this idea and then will present my logic and arguments behind the conclusion.

NPV is used to determine if a proposed project would be profitable. NPV is calculated by finding out the difference between cash outflow and aggregated future cash inflows (Investopedia, n.d.).

IRR or Internal rate of return is used to estimate the profitability of proposed project/investment. It is a discount rate that makes the NPV of future cash flows to zero (Investopedia, n.d.).

Keywords: NPV, IRR

 

 

 

 

 

 

 

Before we start the NPV calculation, here are the facts we are going to use –

  • The cost to install the required equipment will be $75,000, this is the outflow on year 0
  • Per my business partner, the firm will receive $15,000 annually for 7 years.
  • I think cash inflows will be of $14,000 in years 1-2, then inflows of $15,000 from years 3-4, and then inflows of$17,000 for years 5-7.
  • In 7 years, the equipment will stop working and can be sold for its parts for about $5,000.
  • The Capital cost or Discount rate: 6%
     Rate 6%    
  Approach 1 ( Partner’s Plan)   Approach 2
Year Cash Flow NPV Cash Flow NPV
0 ($75,000) -$75,000.00 -$75,000.00 -$75,000.00
1 $15,000 $14,150.94 $14,000.00 $13,207.55
2 $15,000 $13,349.95 $14,000.00 $12,459.95
3 $15,000 $12,594.29 $15,000.00 $12,594.29
4 $15,000 $11,881.40 $15,000.00 $11,881.40
5 $15,000 $11,208.87 $17,000.00 $12,703.39
6 $15,000 $10,574.41 $17,000.00 $11,984.33
7 $15,000 $9,975.86 $17,000.00 $11,305.97
    $8,735.72   $11,136.88
   
  IRR: 9%   IRR 10%

 

This NPV calculation is not complete without including the $5000 that would be generated from the equipment sale

On year 0 or right away we will invest $75000 that is the cash outflow

We will have to calculate the PV of future cash flow, keeping in mind we will pay 6% on capital

So the we calculate PV of cash flow = Cash flow / (1 + Discount Rate) ^ year

So in approach 1, cash flow in 5th year would be calculated: 15000 / (1+6%) ^5 = 11208.87

And we have applied the formula for each year, and cash flow is same each year in this instance

But for approach 2, the cash flows differ, but we can use the same formula, apply same discount factor, since the cost of capital does not change, neither does the timeline, in both cases the equipment lasts 7 years. And at the end of 7 years, the equipment can be sold for the same amount which is $5000.

Let us do the NPV calculation including the cash that would be generated from the sale of equipment.

In approach 1, or cash flow projection by my friend, the 7th year cash flow will be $20000 ($15000 + $5000)

In approach 2, or cash flow projection by myself, the 7th year cash flow will be $22000 ($17000 + $5000)

 

Year Cash Flow NPV Cash Flow NPV
0 ($75,000) -$75,000.00 -$75,000.00 -$75,000.00
1 $15,000 $14,150.94 $14,000.00 $13,207.55
2 $15,000 $13,349.95 $14,000.00 $12,459.95
3 $15,000 $12,594.29 $15,000.00 $12,594.29
4 $15,000 $11,881.40 $15,000.00 $11,881.40
5 $15,000 $11,208.87 $17,000.00 $12,703.39
6 $15,000 $10,574.41 $17,000.00 $11,984.33
7 $20,000 $13,301.14 $22,000.00 $14,631.26
    $12,061.01   $14,462.17
   
  IRR: 10%   IRR 11%

 

Now including $5000 with the cash flow projected on the 7th year, our NPV and IRR changes.

We use the discount factor because the projected cash flow is in future and Present value of the future cash flow can be determined only if we use the discount factor that is derived from the interest rate and time.

A positive net present value tells us that the projected earnings generated in present value by the project exceed the anticipated costs in present value (Investopedia, n.d.).

            This project is definitely worth considering, since the NPV in both approaches (my partners or mine) greater than 0 that means, this project will yield in positive cash flow and yield better return, in a nutshell, this would be a profitable project.

In approach 1, where cash flow for 7 years would be $15000 and then the equipment can also be sold for $5000, the NPV would be $8,735.72 excluding the cash that would be generated from equipment sell. Including the $5000 from the sale of the equipment the NPV would be $12,061

In approach 2, the cash flow for 1 and 2 years would be $14000, over years 3 – 4 it would be $15000 and over years 5-7 it would be $17000, we have applied the same discounting factor to calculate the PV of those future cash flows and added them up to get the NPV.  The NPV would be $11,136.88, excluding the $5000 that would be generated from the sale of the equipment after 7 years. Including the $5000 from the sale of the equipment the NPV would be $14,462.17

Logical Summary and Conclusion:

The NPVs are positive in both approach, so this is a profitable project, and the company should pursue it. Moreover, if we calculate IRR, we get 10% IRR with approach 1, that my friends approach or cash flow projection and we get 11% IRR with approach 2 or with my cash flow projection. Our cost of capital is 6%, so we get a good return on this project either way.

Now that our NPV and IRR calculation shows that the project will generate profit, we need to keep in mind that my business partner thinks that this project will generate more leads in future, so we should definitely go ahead with this project.

 

 

 

 

 

 

 

References:

Retrieved on 4/21/2018. Retrieve from https://www.investopedia.com/terms/n/npv.asp

Retrieved on 4/21/2018. Retrieved from https://www.investopedia.com/terms/i/irr.asp

 

Impact of depreciation expense has on the cash flow analysis of a capital project

Discuss the impact of depreciation expense has on the cash flow analysis of a capital project.  Also discuss the implications of a leasing arrangement has on depreciation expense.

 

Impact of depreciation expense has on the cash flow analysis of a capital project

Depreciation is a non-cash accounting charge that does not impact direct impact on cash flow, although if a business produces sufficient taxable income, depreciation would reduce it as a tax-deductible expense and that would have a positive impact on cash flow by reducing tax(Investopedia, n.d.).

When a business purchases a long-term asset such as a car, furniture, real estate, computer, equipment etc. it can depreciate the value of it in future years, over the lifespan of the purchased asset.

An important point to remember, land can be part of a long-term asset, but it cannot be depreciated. The long-term asset is usually used to generate income in the long-term that is more than 12 months.

All fixed assets (except land) has a useful life, and business can depreciate the value over the useful life. Business can use “Straight line” method, Declining Balance or units of production approach to depreciating the value of the asset.

Before we go to depreciation, let us quickly see what happens when the business purchases the fixed asset –

The fixed asset can be purchased with the cash in hand, financed by bank or shareholders can loan the money to the business. So after purchasing the fixed asset, it will appear in the balance sheet as a fixed asset, and there might be a drop in cash in the balance sheet(if purchased with the cash in hand/ current asset) or there will be an increase in long-term liability.

Now coming back to how depreciation impacts cash flow –

Depreciation is not a cash outflow so it is added back to net income for each year until the value of the asset depreciates to 0.

For example, say I am a business owner and business needs a laptop. I loan my own money to the business, the laptop costs $1500. We can expect the laptop to be useful for 3 years. We expect the laptop to depreciate in a straight line, so $500 each year and it should generate enough income to cover for its cash. But when I say, depreciation is cash inflow, it is not 100% accurate. It is inflow over the useful life of the asset but there was outflow, the moment the business purchased the asset for $1500. So the inflow in form of depreciation just offsets the initial outflow. And usually the financing term is also for over the useful life term of the asset, so the business has to return the $1500 I gave it over 3 years. I am excluding any interests, since it is my own business, I did not charge any, but in case the business borrows money from a bank, it will pay bank principle + interest over next 3 years.

Just to recap, in year 0, there is a cash outflow of $1500, on year 1 – 3, there will be cash inflow of $500 as depreciation. And the business will pay back the loan it took over 3 years. After the end of year 3, the book value of the laptop becomes 0. Now if the business can sale the laptop, the cash inflow from the sale will be added back to income. But, it the business decides to sell the laptop after the 2nd year when it’s book value is $500 ( after depreciating $1000) and its sales for $700, it will be added to income too. But it will have to pay back the lender first and then anything that is leftover can be considered as profit.

 

Implications of a leasing arrangement have on depreciation expense.

 

            Under certain circumstances a business can show a leased item as an asset on balance sheet that means the business can depreciate the asset (leased item here) and also the interest expense would be recognized on cash flow statement(Investopedia, n.d.).

Here are the situations when a business can recognize a leased item as an asset on balance sheet –

o   The business gains ownership of the leased item after the end of the lease term

o   If the business can buy out the leased item after the lease term is over

o   If the lease term is at least 75% or longer than the useful lifespan of the leased item

o   The lease payment is 90% or higher than the fair market value of the leased item.

 

In this case, the lease obligation is recognized as the cash outflow and over the lifespan of the leased item, the business can recognize depreciation and book value of the leased item or the asset would decline. And the other calculations remain same as what we did for the depreciation of a long-term asset.

 

References:

Retrieved on 4/22/2018. Retrieved from https://www.investopedia.com/terms/c/capitalleasemethod.asp

Retrieved on 4/22/2018. Retrieved from https://www.investopedia.com/ask/answers/080216/how-does-depreciation-affect-cash-flow.asp

 

Case Study of Great Service Cleaning and Maintenance Company

Abstract

This paper will provide a financial ratio analysis of the company using:  Gross profit margin, Current ratio, and Debt ratio, Quick ratio and Interest Coverage ratio. We will look into the significant line items in ‘Balance sheet’ and ‘Income statement’ and we will try to analyze the numbers and trends too.

 

Keywords: gross profit margin, current ratio, debt ratio

 

 

 

 

 

 

 

 

 

 

 

 

We have balance sheet and income statement of Great Service Cleaning and Maintenance Company and we need to find out

  1. Gross Profit Margin
  2. Current Ratio
  3. Debt Ratio

And we will look into the “Quick Ratio” and “Interest Coverage Ratio” too.

Gross Profit Margin

Gross profit margin gives us idea about the money company made from the revenue after covering its cost of goods sold (Investopedia, n.d.).  We have data for year 2013 and 2014, so let us first find out the ‘Gross Profit Margin’ for the year 2013 –

Gross profit margin = gross margin / net sales

In the year 2013 the Company made profit of = $1337600 and the Service contract Revenues was $6295400

Hence the gross profit margin for year 2013 = 6295400 / 1337600 = 4.71 or 47.1%

In the year 2014, the ‘Gross Profit’ was $2196900 and Service Contract Revenues was $9700000

Hench the Gross profit margin for the year 2014 was = 9700000 / 2196900 =4.42 or 44.2%

 

Current Ratio

Current ratio is expressed by = Current Assets / Current Liabilities

Current assets are most liquid assets, such as cash or cash equivalents, payment receivables or inventories. Any asset that can be converted to cash quickly is current asset (Investopedia, n.d.).

Current liabilities are payments to vendors and creditors or any such liabilities, those have to be paid back within a year.

From the Balance sheet we get for the year 2013, the company had current asset worth $ 3726900. And current liability was $ 3092850

Hence, current ratio for the year 2013:  3726900 / 3092850 = 1.2

For the year 2014, total current asset was worth $ 4602200 and total current liability was worth

$3125950

Current ratio for year 2014: 4602200/3125950 = 1.47

Debt Ratio

The debt ratio helps us understand how much of company’s assets are financed by debt (Investopedia, n.d.).

In the year 2013, the company’s total debt was = $5025400 and total assets was $3667900

So for year 2013, the debt ratio was = 5025400 / 3667900 = 1.37 or 13.7%

In year 2014, total assets was $5957800 and total debt was $3770300

So. The debt ratio of 2014 was = 5957800 / 3770300 = 1.58 or 15.8%

 

Quick Ratio:

Quick ratio is another way or most prominent way to find out if the company has enough liquid assets excluding inventory to meet its short term obligation (Investopedia, n.d.).

Quick Ratio = (Current Assets – Inventory) / Current Liability

The quick ratio for 2013 was: (3726900 – 100200) / 3092850 = 1.17 or 11.7%

The quick ratio for the year 2014 was: (4602200 – 89800)/ 3125950 = 1.44 or 14.4%

Interest Coverage Ratio:

This is used to determine how easily company can pay the interest on the debts it has (Investopedia, n.d.).

Interest coverage ratio = Earnings before interest and taxes / Interest expenses

Interest Coverage ratio for 2013: (581600+7700) / 70800 = 8.32

Interest Coverage ratio for 2014: (1300900+59900) / 69500 = 19.58

 

 

 

 

Significant line items from Balance Sheet –

Cash reserve has increase by 105% year on year. Which is good, especially when inventory has gone down by 10% that means, the sales are going up. And total current assets have gone up by 23% while inventory has gone down, that means, company is selling their service well.

Total assets have gone up by 18% but long term liability has gone up by 12%.The business is investing, but the increase is mostly concentrated in long term notes.

The retained earnings have gone up too and so did stockholders equity by 61%. The company is profitable and had good cash flow.

Total liability is up by 2.79%, that is not very significant, but it means, the company is not trying to pay down the debts.

From Income Statement the significant lines are –

The Revenue has increased by 54%, which is okay, not that great, but the gross profit margin has gone down from 2013 to 2014.

Gross profit has also increased in 2014 by 64%.  Net income has a good increase by 437%. One major chunk is coming from their equipment sell.

 

 

 

Conclusion –

The increase in cash (by 105.26%) and drop in inventory (10%) shows us, the sale is great, and we can see the same in revenue increase and gross profit increase (by 64%). We can see the Gross profit margin changing from 47.1% to 44.2%.

The company’s total assets have gone up by almost 18.55%. Which is good, cash has doubled, which is great. Although the company has sold some of its equipment, hence we see a drop is long term asset in equipment by 4.2%, but it has a significant increase in note receivables by 35.59%.  May be the company is trying to get rid of its old equipment that it does not use anymore, and trying raise cash selling  those. The company sold equipment in 2013 and 2014, we should find out if they have the equipment they would need or if they are planning to rent in future instead of owning.

I would like to know the reason behind the increase in long term asset -“Note receivable” while there is an increase in long term liability by 31.46%, we need to understand why the company had this increase, and why dint they pay down some debts? Especially when the Debt Ratio has increased from – 13.7% to 15.8%.  The retained earnings is up, the cash holding is up, but why they did not pay off some off their long term debts? And they are selling their equipment and investing in long term notes, are they making more in interest than what they are paying for the liabilities they have?

The company is doing well in terms of sales, but it could do better in paying off debts, and reducing costs, as we can see service contract costs have increased by 51.33%. Their Gross profit margin is dropping, which needs attention too, how can they reduce cost, options should be explored.

References

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/d/debtratio.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/g/gross_profit_margin.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/q/quickratio.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/i/interestcoverageratio.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/g/gross_profit_margin.asp