The report presents a situation analysis of Madison PLC; different sources of funding; working capital management and related management of the capital; investment appraisal methods, including NPR and IRR and their limitations; evaluation of these investment methods; other factors to consider in investment decision-making; break-even analysis as a tool for investment appraisal; and ratio analysis, their limitations and recommendations for investment. Finally, the report presents a summary of the case of Madison with regard to the NVP computation and investment decisions made.
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Background Information and Situation Analysis of Madison PLC
Madison plc. is a company with shares quoted on the Alternative Investment Market in London. For the past ten years, the company has operated in the UK. It offers the intellectual property to firms across various industries, including oil and gas, HR consultants, marketing firms, tourist firms, and investment property companies. The company is generally profitable and now seeks to expand operations across Europe. The finance director of the company is interested in sourcing for funds for expansion. The company must choose software for its operations and expansion, as well as acquire a new company for expansion.
Effective investment decisions will be based on a financial analysis of the presented data.
Different Sources of Funding, their Advantages, and Drawback, and Effective Management for Expansion
Madison plc. may raise funds using both internal and external sources.
Owners’ investment: Madison will receive a capital loan from the parent entity. Alternatively, the company can exploit other funding opportunities. While the fund is from the parent company, it is considered as a capital loan and, therefore, Madison must repay it perhaps with no interest. However, the loan capital may be inadequate to finance the entire acquisition.
Retained profits: Madison is currently a profitable company. Hence, it can plow back its profit into the business to fund expansion. It will act as a source of medium-term or long-term finance with no interest payable. Moreover, the company will not have to pay it back. However, retained earnings may not finance the entire acquisition and expansion.
Sale of stock: Madison can also sell off unsold stock, but it will only be a short-term source of funds. It will allow the company to raise finance fast and reduce related costs of holding such stock. However, selling off stock will automatically lead to a decline in the price of the company’s stock.
Term loan: Madison may also opt for a term loan scheduled between five and ten years of repayment. A term loan is a better alternative for the company because the repayment period will be spread for several years, which is imperative for budgeting. A term loan, however, will be expensive for Madison-based on terms and conditions. Moreover, a bank may insist on the company’s assets as security.
Rights issues: Madison should also consider a rights issue to raise the required capital from its existing shareholders. Shareholders will have to subscribe to funds for new shares based on a given fraction of their existing shareholdings. They do not attract any interest. Hence, rights issues could be the most affordable means of raising finance for expansion. Nevertheless, Madison must set relatively low prices to gain acceptance of shareholders.
This approach will generate extra funds from shareholders. The price must however not be too low to inhibit possible dilution of investors’ earnings per share. The company will spend most profits paying out to investors as dividends while the company’s ownership will significantly change.
For effective management of these funds, the company must choose the most suitable source of finance. The funds must be invested to fund the intended purpose, which is the acquisition of a new company for expansion across Europe and buying new software. Madison must also review periods for financing. That is, it must determine how long it will require resources to finance the entire acquisition. The company must also clearly state the amount required for expansion, as well as ownership and size of the firm.
Working Capital Management and Related Management of the Capital
Working capital management involves the management of short-term investment and financing of operations. Madison will have to manage inventory, cash and cash equivalents, accounts payable, accounts receivables, short-term, and others. The primary goal of working capital management is to ensure sufficient cash flow for operations and the most productive use of resources.
It is observed that too much cash could result in Madison putting excess investment in low and nonearning assets (Atrill & Hurley 2012). The company will have to assess both internal and external factors that influence working capital requirements. Madison will assess its size and growth rate, structure, techniques applied in working capital management, and borrowing and investing activities. External factors, such as interest rates, banking services, new technologies to be acquired, the EU economy, and regional competition, will significantly influence working capital management. For effective management of working capital, the following recommendations are appropriate for Madison.
The company should assess its liquidity position using liquidity ratios. These ratios will show whether Madison can meet its current cash needs with the available assets. In this regard, it must concentrate on cash and cash equivalent, short-term funds, and cash flow management. In addition, the company should assess its debt contracts and renegotiate them, and sell assets (if necessary).
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It will also be imperative to evaluate operating and cash conversion cycles. The operating cycle shows the length of the period it would take Madison’s investment in inventory to be collected as cash from clients. The company will have to analyze operating cycles and compare it against its peers to determine the effectiveness of working capital management. For a longer operating cycle, Madison would have an increased need for liquidity.
Madison will also manage its cash position to ensure that it has a positive cash balance while forecasting short-term cash flows. In most instances, it is prudent to maintain a low balance of cash to guard against negative cash balance. Madison should consider cash investment in excess of daily requirements and assess effectiveness of short-term sources of funds, including borrowing. Management of capital expenditures, the intended acquisition, and asset acquisition will be imperative for working capital management.
Madison may consider short-term investments to generate some funds. It could opt for repurchase agreements, Eurodollar time deposits, and treasury bills among others, but the company must assess liquidity position, maturity, yield, collateral needed, and related risks.
Madison will continuously review inventory, accounts receivable, and accounts payable and compare them against peers to determine working capital management effectiveness.
For any short-term financing to ensure that Madison has adequate funds, the company will assess both costs and risk that are appropriate.
Investment Appraisal Methods – NPR and IRR, and their Limitations
Both the NPV and IRR appraisal methods are applied for assessing whether an investor should accept or reject an investment decision. The NPV method will allow the company to approximate revenues and costs of the project, discount them, and assess against the initial investment. The highest positive NPV is the most preferred option. Conversely, the company should reject a project with negative NPV because the current value for generating benefits cannot sufficiently cover the cost of the project (Peterson-Drake n.d).
On major drawback of the NPV is that it largely relies on an estimate of the cost of capital to compute the net present value.
The IRR reflects the discount rate used to gauge net revenues of a project to give the same result as the initial investment. Better IRR outcomes should have large values. The IRR also shows the discount rate of breaking even.
The IRR is based on the cost of capital estimation, it may not reflect value-maximizing decisions, and it might not be suitable for a project with cash flow challenges. These challenges normally affect cost of capital and discount rate. The hurdle rate usually depicts an opportunity cost of the deployed capital.
It is recommended to use NPV when two projects have a similar IRR, but varied NPV related to costs and benefits (Atrill & Hurley 2012). Moreover, NPV is the most appropriate for assessing finance value over time.
NPR and IRR Evaluation
NPR Madison Super
|Net Cash Flows|
|Net Cash Flows|
|84.36% = IRR|
From the analysis of Madison Super and Madison Platform, Madison Platform should be accepted because it has high NPV relative to Madison Super. While Madison Super has higher IRR, it is always recommended to consider NPV (Brealey, Stewart, & Allen 2007).
Other Factors to Consider in Investment Decision-making and Consideration of Capital Rationing
The company should also consider other factors, such as inflation, taxation, finance, and overheads.
While the above analyses have been conducted without considering inflation, taxation, financing, and overhead costs, these factors generally have significant impact on investment appraisal processes. High tax rates, inflation, overhead costs, and costs of finance can lead to poor outcomes for the preferred project. For Madison Super and Madison Platform, for instance, overheads and working capital are expected to rise by 3% per year from year 1 while inflation is estimated to rise by 4%. The corporate tax is 33%.
Tax and financing liabilities, as well as inflation are critical factors that influence investment decision-making and, therefore, companies should not ignore them. Therefore, a general financial analysis of investment cannot lead to better investment decision-making.
Madison will therefore proceed and account for working capital requirements, tax, inflation, and overhead costs to provide specific financial analysis and management.
Both Madison Super and Platform have positive net present value, but Madison cannot implement all of them because of capital shortage. Hence, Madison Platform offers optimal profits, and it should therefore be considered (Chen & Deng 2011). Capital rationing will assist Madison to avoid costs associated with acquiring new capital, control project implementation issues, and manage negative impacts of unreliable forecasts, specifically cash flows (Kira, Rakita, & Kusy 2000).
Break-even Analysis as a Tool for Investment Appraisal
Break-even analysis is an important investment appraisal tool that will help Madison to identify the connection among variable costs, fixed costs, and returns (Gutierrez & Dalsted 2012). The company will use this tool to identify when it can start generating positive returns by considering production volumes and price required to cover all costs. Madison will use break-even analysis to understand how variations in the three variables will impact profits and the break-even point (Gutierrez & Dalsted 2012). It will support capital budgeting to show the lowest levels of operations required to avert losses.
Ratio Analysis, their Limitations, and Recommendation for Investment.
|Ratios 2013||Puteaux France||Melia Spain|
|Profit Margins (net profit/turnover)||0.208||– 0.089|
|Current Ratio||1.255||– 0.695|
|Operating margin||0.296||– 0.0899|
|Return on Equity||0.192||– 1.2368|
These ratios show that Puteaux France is performing relatively well. On the other hand, Melia Spain is financially unhealthy and, therefore, it is not suitable for acquisition.
While these ratios are useful, they have inherent limitations. First, they are derived from historic figures that do not reflect current performance (Ryu & Jang 2004). Second, it could be misleading to compare firms based on ratios because they have different practices, including accounting principles, investments, capitalization, and others.
Summary – the NPV computation and decisions made
Madison plc. should accept Madison Platform because it has high NPV relative to Madison Super. In addition, the company should also consider Puteaux France because it appears more financially healthy relative to Melia Spain. Meanwhile, all factors influencing investment decisions and ratio limitations should be considered.
Atrill, P & Hurley, P 2012, Financial Management for Decision Makers, Second Canadian Edition, Pearson Canada Inc, Canada.
Brealey, RA, Myers, SC & Allen, F 2007, Principles of Corporate Finance 9th edn, McGraw-Hill / Irwin, New York, NY.
Chen, Y-J & Deng, M 2011, ‘Capital Rationing and Managerial Retention: The Role of External Capital‘, Journal of Management Accounting Research, vol. 23, no. 1, pp. 285-304. Web.
Gutierrez, P & Dalsted, N 2012, Break-Even Method of Investment Analysis. Web.
Kira, D., Rakita, I. & Kusy, M., 2000. The Effect of Project Risk on Capital Rationing under Uncertainty. The Engineering Economist, vol. 45, no. 1, pp. 37-55. Web.
Peterson-Drake, P., n.d. Advantage and disadvantages of the different capital budgeting techniques. Web.
Ryu, K & Jang, S 2004, ‘Performance Measurement through Cash Flow Ratios and Traditional Ratios: A Comparison of Commercial and Casino Hotel Companies’, Journal of Hospitality Financial Management, vol. 12, no. 1, pp. 15-25.