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INTERNATIONAL UNIVERSITY COLLEGE Sofia
Financial Management ( U21075/S21075)
Coursework in Financial management
Statement of originality I, the undersigned, declare that this coursework is my own original work.
Student registration No:
678836
Program: Lecturer:
Business Administration, Level 3 Veneta Andreeva1
ContentsContents................................................................................................................................. 2 Introduction............................................................................................................................ 3 Payback period....................................................................................................................... 4 Discounted payback period.................................................................................................... 4 Accounting Rate of Return......................................................................................................5 Net present value...................................................................................................................5 Internal Rate of Return........................................................................................................... 5 Critical evaluation of Investment Appraisal methods.............................................................6 LLOYDS BANKING GROUP PLC................................................................................................7 Conclusion for LLOYDS BANKING PLC.....................................................................................7 Appendix A (Payback method calculations)............................................................................8 Appendix B (Discounted payback method calculations).........................................................8 Appendix C (Accounting Rate of Return calculations).............................................................9 Appendix D (Net Present Value calculations)..........................................................................9 Appendix E (Internal Rate of Return calculations)..................................................................9 Appendix F............................................................................................................................ 10 References:........................................................................................................................... 12
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IntroductionIn this coursework a company called Oakland plc is considering a major investment project. In this project the initial outlay of 900,000 will, in subsequent years, be followed by positive cash flows, as shown below: Year 1 2 3 4 5 Cash flow() +50,000 +120,000 +350,000 +80,000 +800,000
It is also said that after the end of the fifth year this business activity will cease and no more cash flows will be produced. Another important thing is that the initial investment of 900,000 is to be depreciated over the five-year life of the project using the straight-line method. These assets will have no value after year 5. As Karris (2004, p. 8-3) said, the straight-line method is considered to be the most common method for depreciating assets. To calculate the annual depreciation using the straight-line method requires two things: The initial cost of the asset less its salvage value Its estimated useful life The formula is: Annual depreciation = Cost- Salvage Value Estimated useful life In our case this will be: 900,000/ 5 years = 180,000 per annum What is more the appropriate discount rate to use for the firms project is 10 per cent per annum. We are supposed to assess this project using a number of different methods and to advise the board on the advantages and disadvantages of each. We are supposed to calculate: a) The payback period b) The Accounting Rate of Return c) The Net Present Value d) The Internal Rate of Return
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Payback periodA good manager always estimates the cash flow that an investment will generate. Their goal is to determine the minimum time it will take to recover this investment. No matter how many methods are used, we should choose the one that pays back its initial cost in a shorter time. That period of time is known as payback period and the method of evaluation payback method. (Crosson & Needles, 2010, p. 449) It is calculated as follows: Payback Period= Cost of Investment Annual Net Cash Inflows
YEAR 0 1 2 3 4 5
NET CASH FLOW (ANNUAL RETURN) -900,000 50,000 120,000 350,000 80,000 800,000
CUMULATIVE CASH FLOW (CASH IN FLOW) -900,000 -850,000 -730,000 -380,000 -300,000 500,000
In our case the operating cash flows occur evenly throughout each year, thats why we should use an operational formula for calculating the payback period by adding up the future cash flows. (Baker & Powell, 2009, p.247) The formula and calculations can be seen in Appendix A.
Discounted payback periodAccording to ( Ehrhardt & Brigham, 2010,p.412) the discounted payback is similar to the regular payback except that it discounts cash flows at the projects cost of capital and also considers the time value of money, but unfortunately still ignores cash flows beyond the payback period. The formula is: Discounted cash flows= Actual cash flow (1+) where i is the discount rate and is the period. It is written that the appropriate discount rate is 10 per cent per annum. See calculations in Appendix B.4
Accounting Rate of ReturnAccounting rate of return or the return on investment is a method, which differs from the other in that profits rather than cash flows are used. (Drury, 2007, p.307) To calculate our ARR on total investment basis, we will need the following formula (Arnold, 2008, p.133): ARR = Average annual profit x 100 Initial capital invested See calculations in Appendix C.
Net present valueAccording to (Brigham & Houston, 2009, p.338), net present value tells us how much a project contributes to shareholder wealth. The larger the NPV, the more value the project adds, thus an added value means a higher stock price. Like (Drury, 2005, p.233) said, the net present value can be expressed as: NPV= FV + FV + FV ++ FVn - 1 1+K (1+K) 2 (1+K) 3 (1+K) n Where 1 is the investment outlay and FV represent the future values received in years 1 to n, and K is the rate of return. See calculations in Appendix D.
Internal Rate of ReturnThis method is the compounded annual rate of return the project is expected to generate and is related to the NPV of the project. The IRR is the discount rate at which the NPV of the project is zero. Meaning that IRR is the discount rate where the cash benefits and costs exactly cancel. (Bidgoli, 2003, p.216) According to (Gallagher & Andrew, 2007, p.272), the formula for the IRR is: NPV= 0 = CF + CF + + FVn (1+K) 1 (1+K) 2 (1+K) n
In order to calculate the IRR, where it equals 0, we should take the following actions: The discounted rate is 10 % The NPV is 58,9665
IRR should be greater than 10%
See calculations in Appendix E.
Critical evaluation of Investment Appraisal methodsThe payback method has several advantages and disadvantages. The main advantages are that it is easy to use and calculate. What is more it is more relevant to businesses with cash flow problems. Therefore, when analysts need a quick measure of risk, they may use the payback period to see if the invested capital will be paid back in a reasonable period of time. The cons of the method are that it ignores money received after payback. Also it doesnt count the cash inflows produced after the initial investment has been recovered. (Groppelli & Nikbakht, 2006, p.158) On the other hand the ARR also ignores the time value of money and it is harder and more time consuming. Likewise the method is unreliable if estimated annual net incomes differ from year to year. As an advantage it shows the profitability of a project. (Crosson, Needles, Powers, 2010, p.1167) The positive sites of the NPV are that it considers all the cash flows and it reveals the true profit potential of any investment. As a negative site are that it is expressed in terms of cash, not in percentage and also is more difficult to understand. As ARR is time consuming. (Sheeba, 2011, p.390) The IRR method makes an appropriate adjustment for the time value of money. What is more all cash flows are equally important. It is the method where there is a maximum profitability of Shareholder. Like any other method, there are some problems. The first one is the difficulties in interpreting the numbers that one obtains from solving an IRR equation. The other problem is that IRR is not helpful for comparing two projects. (Smart & Megginson, 2008, p.271) To sum up I would like to say that according to (Pogue, 2010, p.39), the payback method continuous to be widely used by the majority of companies, as well as the IRR, followed by the NPV method. Thats why in our coursework I think that the project should be accepted, according to all of the presented methods.
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LLOYDS BANKING GROUP PLCA company listed as FTSE100 on the London Stock Exchange The bank is also a Public Limited Company and provides wide range of banking services in the United Kingdom and in some certain locations abroad. The bank activities are organized in three segments: insurance and investments, retail banking and wholesale and international banking. From the attached companys balance sheet for years 2011 and 2010. (See in Appendix F), we can see that: a) Total Equity We can see that the total equity is 46,594,000, with an ordinary share capital of 6,881,000. Whats more the retained profits are 8,680,000. b) Total Liabilities The total liabilities are 932,952,000 c) Debt to Equity Ratio According to (Albrecht & Stice,2010,p.472) the Debt-to-Equity Ratio formula is : Debt-to-Equity ratio= Total Liabilities Total Stockholders Equity In our case this will be: For Year 2011: Debt-to- Equity ratio= 932,952 20, 02 46,594 For Year 2012: Debt-to-Equity ratio = 944,672 20, 14 46,902 Overall the Debt to Equity ratio is a very useful indicator of the current situation of particular financial organization. It can be used by investors globally with managing of its investment portfolios, but it must be considered the fact that this is only a numerical method which describes past financial data.
Conclusion for LLOYDS BANKING PLCFrom highly leveraged Lloyds PLC seems to follow the largest banks example but in slow motions. Overall the bank looks stable in terms of indebtedness and currently has very good performance to invest
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in. Because the bank is the smallest by market capitalization, we must consider the fact that it is hard to a bank with this size to rearrange its source of finance with the speed of the largest banks in the world.
Appendix A (Payback method calculations)Payback period= Year before full recovery+ Unrecovered cost at start of the year Cash flow during the year Payback period= Year 4+ 300,000 = 4 + 0.375= 4.375 4 years 800,000 0.375 * 12 months= 4.5 5 months
Appendix B (Discounted payback method calculations)Year 0 1 2 3 4 5 Net cash flow -900,000 50,000 120,000 350,000 80,000 800,000 Discounted Cash flows -900,000 45,454 99,173 262,960 54,641 496,737 Cumulative net cash flow -900,000 -854,546 -755,373 -492,413 -437,772 58,965
Discounted cash flows during the years: Year 1- 50,000/1+0,11 = 45, 454 Year 2- 120,000/ 1+0.12= 99,173 Year 3- 350,000/1+0.13= 262,960 Year 4- 80,000/1+0.14= 54,641 Year 5- 800,000/1+0.15= 496,737 Again we should use the payback formula, but including the discounted cash flows: Payback period= 4+ 437,772 = 4+ 0.881 = 4.881 4 years 496,737 0.881 *12 months= 10.57 10 months and a half
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Appendix C (Accounting Rate of Return calculations)ARR= (-130 000+ (-60 000) +170 000+ (-100 000) +620 000)/5 900 000 x 100 =11.11% average profit per annum
Appendix D (Net Present Value calculations)Therefore the NPV in our case will be: NPV= 50,000 + 120,000 + 350,000 + 80,000 + 800,000 900,000 58,966 (1+0.1)1 (1+0.1)2 (1+0.1)3 (1+0.1)4 (1+0.1)5
Appendix E (Internal Rate of Return calculations)If the IRR is 10%, the NPV will be as follows- 58,966; using the NPV formula. If the IRR is 13%: NPV= 50,000 + 120,000 + 350,000 + 80,000 + 800,000 900,000 35,926 (1.13)1 (1.13)2 (1.13)3 (1.13)4 (1.13)5 In order the IRR to be equal to zero, the discount rate should be: 10% + 58,966 * (13% - 10%) 11.81 (58,966+35,926)
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Appendix F
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References: Arnold, G. (2008). Corporate Financial Management, 4th ed., England: Pearson Education Albert, W. & Stice, E. & Stice, J. (2010). Financial Accounting, 11th ed., Cengage Learning
Baker, A. & Powell, G. (2009). Understanding Financial Management: A practical Guide, John Wiley & Sons. Inc Bidgoli, H. (2003). The Internet Encyclopedia, volume 3, John Wiley & Sons. Inc Brigham, E. & Houston, J. (2009). Fundamentals of Financial Management, 12th ed. Cengage Learning Crosson, S. & Needles, B. (2010). Managerial Accounting, 9th ed., Cengage Learning Drury, C. (2005). Management Accounting for Business, 3rd ed., Cengage Learning Drury, C. (2007). Management and Cost Account, 7th ed., Cengage Learning Ehrhardt, M. & Brigham, E. (2010). Corporate Finance: A focused Approach, 4th ed., Cengage Learning Gallagher, T. & Andrew, J. (2007). Financial Management: Principles & Practice, 4th ed., Freeload Press Groppelli, A. & Nikbakht. (2006). Finance. Barons Business Review Series, 5th ed., Barons Educational Series Karris, S. (2004). Mathematics for Business, Science and Technology; With MATLAB and Spreadsheet Applications, 2nd ed., Orchard Publications London Stock Exchange (2012). Lloyds Banking Group Plc. Retrieved December 12,2012, from Stock Prices, Financial Markets News, FTSE100 Index: http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/companysummary.html?fourWayKey=GB0008706128GBGBXSET0 Lloyds Plc website, Retrieved December 12,2012, Consolidated Balance sheet: http://2011.lloydsbankinggroupannualreport.com/media/96161/FinancialStatements_LBG_AR_2011.pdf Pogue, M. (2010). Corporate Investment Decision: Principles & Practice, Business Expert Press Sheeba, K. (2011). Financial Management, Pearson Education Smart, S. & Megginson, W. (2008). Corporate Finance, Cengage Learning
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