the method of investment appraisal which may be applied to evaluated and rank potential investment opportunities and their relative merits and limitations

Table content Introduction………………………………………………………………………………2 I-Analysis of the reasons behind takeovers and the methods by which such takeovers may have take place together with the potential effects of a takeover……………………… 3 II- The method of investment appraisal which may be applied to evaluated and rank potential investment opportunities and their relative merits and limitations…………… 7 1-Payback period………………………………………………………………………….7 2-Accounting rate of return……………………………………………………………….8 3-Net present value……………………………………………………………………… 9 4- Internal rate of return………………………………………………………………….10 III- The nature of gearing and the potential effects of high gearing on perceived risk and cost of capital…………………………………………………………………………….12 IV- Conclusion………………………………………………………………………… 13 Appendix…………………………………………………………………………………14 Reference……………………………………………………………………………… 17 Word account: 3,625 1 Introdcution: Jebb Plc wants to takeover a rival company in which they believe will be successful in increasing the wealth of shareholders. Due to understanding of limited fund, managers of Jebb PLC are going to raise money through increasing debts in order to acquire target’ firm. As a senior financial manager in Jebb PLC, I have to prepare a report to analysis reasons behind takeovers and the methods by which such takeovers may take places together with the potential effects of a takeover. Then, I will give four method of investment appraisal to evaluated and rank potential investment opportunities and their merits and limitation. Moreover, the nature of gearing and potential effected of high gearing on perceived risk and cost of capital. 2 I-Analysis of the reasons behind takeovers and the methods by which such takeovers may have take place together with the potential effects of a takeover. ‘Takeover’ is referring to transfer of control of a firm from one group of shareholders to another group of shareholders. It is a change in the controlling interest of corporation, either through a friendly acquisition or unfriendly, hostile, bid. A hostile takeover with the aim of replacing current existing management is usually attempted through a public tender offer. (asia.advfn.com) Next following below I will give reasons for takeover company. • Defensive. Some acquisitions take place because the buyer is itself the target of another company, and simply wants to make itself less attractive through acquisition. • Intellectual property includes patents, trademarks, production processes, and databases. This is defensible knowledge base that gives a company a competitive advantage, and is one of the best reasons to acquire a company. • International alternative. A company may have an extremely difficult time creating new products. And so looks elsewhere to find replacement products. This issue is especially likely to trigger an acquisition of a company has just decided to cancel an in-house development project, and needs a replacement immediately. • Market growth. Buyer can not grow revenues quickly in a slow-growth market, because there have few sales to be made. In contrast, a target company may be suitable in a market that is growing faster than the buyer itself. Hence, the buyer can see rapid growth when acquire target Company. • Market share. In general, companies all look toward a high market share, because it allows them to have advantage in price competitive. The acquisition of a large competitor is a reasonable way to quickly attain significant market share. • Production capacity. The buyer may have excess production capacity available, from which it can readily manufacture the target’s products. Moreover, the target company may have an excellent product that the buyer can use to fill a hold in its own product line. This is an especially important reason when the market is expanding rapidly, and the buyer does not have time to develop its product before others compete and take over the market. 3 • Sales channels. A target company may have an effective sales channel that buyer think can use to distribute its products. Besides, the target sales staff might be effective so that it may be the prime reason for an acquisition offer. • Vertical integration. This is use in security term. The buyer may want to secure its supply lines by acquiring selected suppliers. It is important when supplier has to control over a large proportion of demands. In addition to backward integration, company can engage in forward integration by acquiring a distributor or customer. This most commonly occurs with distributors, especially when they have good relationship with customers (Accountingtool) Thirdly, I will give some method to takeover the target’s company. There are 4 methods to takeover a company: cash offers, share-for-share offers, mixed bids and security package. • Cash offers. Public offering of security issue to every interested investor, with or without involving an underwriter. In contrast, a right issue is offered only to the current stockholders. General cash offer is the most common method of selling debt (bond) and equity (stock) issues. According to the SEC Rule 415 (1982), a large firm can file a single new issue registration statement that is valid for two years. Within this period the firm can make general cash offer as and when it wants. (investorword.com) Cash-offer attracts a target company shareholder because it provides shareholders with significant, immediate and certain value for the buyer’s existing assets, as well as its future growth potential. Besides, cash-offer adjusts company’s portfolios, its operation and development capabilities and strong balance sheet. (transalta.com) Advantage of using cash-offer is that company can determine the outcome. However, its disadvantage that cash offer to acquire target’s company may insufficient and in case company borrows money from bank, the interest rate changes must be considered. • Share-for-share offers. Takeover bid in which the acquiring firm offers its shares for an equal number of shares in the target firm. It accepted. Shareholders of the both pre-merger firms become owners of the resulting firm (Businessdictionary.com) A shareholder must take an offer when its shareholding, including that of parties acting reaches 30% of the target. Information relating to the bid must not be released except by 4 announcements regulated by the Code. The bidder must make an announcement if rumor speculation has affected a company’s share price. If shares are bought during the offer period at a price higher than the offer price, the offer must be increased to that price. (Business&Financemarket.) • Mixed bids are where share for share offer is supported by a cash alternative. This method is being acceptable to company’s targeted shareholder. • Security packages. Projects involve risks for all parties. The ability of the parties to agree on how risks will be shared is often the key to initiating a successful project. In order to reduce the risk particularly for all parties, a security package is established through the various agreements, contractors, undertaking and the guarantees. Buyer looks to the security package agreement in order to provide security for money the investment and target’s company assets. There preparation of the key agreement must be coordinated in order to avoid conflicts and provision of interlocking among these agreements should be made.(assessmylibrary.com) Fourthly, I will analysis and explain impacts that effect when Jebb PLC takeover rivals. When a company wants to takeover a target firm, there are some influences affect management, employees, financial, stockholder and economy of scale. • Management. When a change in company control takeover often the corporation who becomes in charge often prefers to bring in their own staff members to assimilate and become the decision makers of their newly acquired business. As a result of the acquisition the original management may be dismissed or given notice. In case, the current management is allowed to stay there is a good possibility things may not continue per the norm and managers may find themselves having to adjust to new policies, practices and an overall different way of doing things; the transition that occurs with a change of control can be difficult.(helium.com) • Employees. They are people who also go through a lot when takeover occurs. With a shift of control/ownership comes lots of organizational change, sometimes new bosses, loss of job and an over attitude of ‘out with the old. In with the new’. Sometimes the change entails letting easy on everyone. Other times the new corporation maintains some employees for good or to train their own people. 5 Whatever the decision on employees, this can have a serious impact on employee morale. (helium.com) • Financial. Ansof (1971) found that after an acquisition, low sales growth companies showed significantly higher rates of growth, whereas, high sales growth companies showed lower rates of growth. However, even though low sales growth companies showed higher rates of growth after acquisitions, they actually suffered decreases in their mean P/E ratios, mean EPS and mean dividend payouts. The similar pattern of inconsistency found in the high sales growth companies whereby their performance levels for EPS, PE ratio, earning and dividend payouts were greater. Low sales growth companies financed their acquisitions through decreased dividend payouts and the use of new debts. In contrast, high sales growth companies with other strategies tended to decrease debts but increase dividend payouts. (international business and management) • Stockholders have such a vested financial stake in the corporations they own stock in that a takeover affection. The company may falter or thrive and either way this affects the bottom line of their investment. • Economy of scale. According to Ansof (1971), acquisitions were in general unprofitable, as they did not contribute to increase in all of the variables of companies’ growth. However, follow Ajit Singh, after a two-year period of takeover, there was deterioration in relative profitability record. He added that as in relation to EPS, the biggest potential losers are shareholders in biding companies who were sacrificing profits for future growth. Those acquiring firms could have maintained their profitability records if they were not involved in takeovers and large companies tended to engage in higher gearing and this led to higher retention ratio and eventually higher growth is attained. (international business and management) 6 II- The method of investment appraisal which may be applied to evaluated and rank potential investment opportunities and their relative merits and limitations. In this report, I will give 4 methods to evaluate and rank potential investment opportunities. They are: payback period, ARR, NPV, and IRR 1-Payback period (PP) The payback method focuses on the payback period. The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is sometimes referred to as ‘the time that it takes for an investment to pay for itself’. The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period. (accountingformanagement.com) *Formula: Payback period = Cash outlay (investment)/ annual cash inflow • Merit It is very easy to calculate and allow managers and stakeholders an easy understanding when the initial investment will be recouped. This allows information to decision making based on simple cutoff date rules. It recommends to quick return of the invested fund so that may be put to use in other places or in meeting other needs. Besides, it is easy to apply. (nettle@Africa) • Limitation When PP’ merit is easy to calculate but its limitation is also can lead to wrong decision. Discounted cash flow should be the preferred way to evaluate payback since it does recognize the time value of money. This is cash in the future is not worth as much as cash today. PP also ignores all cash flow that occurs after the payback period is reached or in other word, PP does not consider post-payback cash flows and time value of money. In addition, it does not explicitly consider risk. (nettle@Africa) Evaluation the PP. it is not a true measure of the profitability of an investment. Rather, it simply tells the manager how many years will be required to recover the original 7 investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than other. 2- Accounting rate of return (ARR) ‘The rate of return on an investment that is calculated by taking the total cash inflow over the life of the investment and dividing it by the number of years in the life of the investment. The ARR does not guarantee that the cash inflows are the same in a given year. It simply guarantees that the return averages out to the average of return’. (thefreedictionary.com) ARR uses the data from the income statement. This is a non-discounting cash flow project appraisal model. This is computed by using the following formulas: ARR = Average net profit / Average Annual Investment Or ARR = − (Increase in expected average operating income/ Initial increase in investment) ARR is related with conventional accounting models of calculating income and required investment. It shows the effect of an investment on project’s financial statement. • Merits: It is simple to calculate using accounting data. ARR formula is easy to apply and familiar concept to managers which they refer to as ‘returns on investment’ or ‘return on capital employed’. ARR helps manager to calculate earning of each year which includes the profitability of the project. • Limitations: It is no account of time value of money like PP, i.e. company expected future dollars are erroneously regarded as equal to present dollars. ARR is inconsistency with wealth maximization as the objective of the firm. It uses the accounting data it includes the amount of accruals in accounting the earnings ‘net profit’. Moreover, it can be manipulated by changing accounting method like depreciation rates and methods which have nothing to do with the underlying investment. 3- Net present value (NPV) Definition: it is the method of evaluating project that recognizes that the dollar received immediately is preferable to a dollar received at some future date. It discounts the cash flow to take into the account the time value of money. 8 This approach finds the present value (PV) of expected net cash flows of an investment, discount at cost of capital and subtract from it the initial cash outlay of the project. In case the PV is positive, the project will be accepted. If it is negative, it should be rejected. When the projects under consideration are mutually exclusive, the one with the highest NPV should be chosen. The next following I will show the NPV formula. (source:netel@africa) • Merits: NPV’s method measure directly the dollar contribution to the stockholders. It recognizes the risk associated with future cash flow. NPV consistent with shareholder wealth maximization: added NPV generated by investments are represented in higher stock prices. Besides, NPV consider both magnitude and timing of cash flows. Moreover, it indicates whether a proposed project wills yield the investor’s required rate of return. 9 • Limitation: Many people find it difficult to work with a dollar return rather than a percentage return 4- Internal rate of return: (IRR) Definition: IRR is the investor’s required rate of return which equates the Initial Costt outlay with the present value of series of expected cash flows. • Merits It considers both the magnitude and the timing of cash flows. • Limitations It does not distinguish between a lending (investing) or borrowing (borrow and invest) situation, whereas the NPV clearly points out the negative aspects of the borrowing strategy. IRR can affect the scale (size) of business. There has conflict between NPV and IRR method (possible decision conflicts). An accept/reject ‘conflict’ occurs when NPV says ‘accept’ and IRR says ‘reject’ or NPV says ‘ reject’ and IRR says ‘accept’. When projects are independent, there is no accept or reject conflict arise. A raking conflict occurs when one project has a higher NPV than another while the lower NPV project has a higher IRR. Ranking conflict is usual but can occur. These conflicts are relevant only when there are multiple acceptable mutually exclusive projects. The ranking conflicts arise because of: timing differences in incremental cash flows and magnitude differences in incremental cash flow. When a conflict arise among mutually exclusive project, it would be better to pick the one with the highest NPV. Company A Company B Company C PP 4.38 years 3 years 2.96 years ARR 6% 12% 18% NPV -$20,950 @ 10% $57,500. @ 10% $103,250 @ 10% IRR 12.05% 18.46% 21.86% The table above shows the result of PP, ARR, NPV and IRR. The 4 method has it own strength and weakness. Looking at the PP’s result, the shortest time for the company to payback its investment is C which PP is lowest in the three-project. ARR of company A is lowest of 6% compare to project B, 12% and project C, 18%. The NPV of company A also is the lowest with - $ 20,950 at 10%. The highest NPV is company C is $103,250 10 [...]... exactly offset each other This leaves one net advantages: the tax relief on debt interest Behind the use of WACC (the average of the costs of these sources of financing) as the NPV discount rate is the assumption of an unchanging capital structure In using the WACC, the net advantage of debt capital is taken into account by using the after-tax cost of debt capital Gearing ratio measures the percentage of. .. above, we know how to calculate the four -method Hence, the most suitable method is NPV, then the second one is IRR, third one is PP and ARR is the last one It seems that most suitable method which is the more accurate measure of telling which project is a good investment and which one is better is NPV method There are 3 main reasons: • NPV measures project value more directly than IRR because NPV actually... capital) to borrowed funds, Gearing is a measure of financial leverages, demonstrating the degree to which a firm’s activities are fund by owner’s funds versus creditor’s funds (accoutingformanagement.com) There are three effects arising directly from an increase in corporate gearing Two of these, the advantage of debt being ‘cheaper’ than equity and the disadvantage of the cost of equity rising because of. .. agreement • Friends and relatives A good relationship help company can lend money from friends or relative It may be viable option and you will still have to pay interest rate on the loan amount However, it may not be wise to mix business with personal life Hence, be careful and make sure terms are clear and documented before proceeding with borrowing from friends and relatives • Bonds and debentures Bonds... for the project is not reliable NPV must be used for this type of project III- The nature of gearing and the potential effects of high gearing on perceived risk and cost of capital 11 There are some ways to increase company fund: • Bank Company can raise funds by taking out a loan from bank Some banks are more flexible in their loan requirements than other Generally, banks prefer property to inventory... calculates the project’s value In this case it has more than one project lined up, then manager can simply add the values together to get a total • NPV assumes that project cash flows are reinvested at the company’s required rate of return, IRR assumes that they are reinvested at the IRR Since IRR is higher than the required rate of return, in order for the IRR to be accurate, the company would have to keep... financed by debt and long-term finance The higher level of gearing leads the higher lever of financial risk due to increase volatility of profit Capital gearing ratio is important to the company and the prospective investors, it must be carefully planned as it affects the company’s capacity to maintain a uniform dividend policy during difficult trading periods It reveals the suitability of company’s capitalization... security which is issued by the authorized issuer to the masses They generally have a fix term of maturity, which is more than 10 years The company has authority to give limited powers to the bond holders with respect voting rights, information related to company,etc Debenture are long term debt instrument used by large companies and governments to raise finance from the generate people Debentures... acquiring a stock market listing for the first time • Rights issues: Loan stock; Retained earnings, etc Jebb plc understands that to carry out any of the proposed projects will require them to raise a substantial amount of money through increased debt and this will increase the gearing of Jebb plc to a high level Gearing ratio is a term describe a financial ratio that compare some form of owner’s equity... generate people Debentures are different from bonds because of securitization conditions They are usually unsecured debt instruments If the company gets liquidated, the debenture holders would be considered at par with general creditors Debenture can be pledged against the amount received, only if state in the terms and 12 conditions of the issue Debentures are freely transferable instruments (firewordzone.com) . 3 II- The method of investment appraisal which may be applied to evaluated and rank potential investment opportunities and their relative merits and limitations …………. management) 6 II- The method of investment appraisal which may be applied to evaluated and rank potential investment opportunities and their relative merits and limitations. 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