GlaxoSmithKline is one of the world largest companies operating in pharmaceutical product industry. The UK based GlaxoSmithKline is the third largest GlaxoSmithKline with a large variety of pharmacy and health care products and their lines. The GlaxoSmithKline is a London stock exchange listed GlaxoSmithKline having thousands of employees working in different branches around the world.
The significant objectives of this report are to identify, evaluate, analyze and interpret results of GlaxoSmithKline's financial data. This report will include the presentation of financial theoretical background along with the analysis of financial statements comparing with industrial norms. It also includes preparation of budgets such as sales budget, production budget, etc. finally it also include evaluation of financial proposal using the NPV and IRR methods with different rate of cost of capital.
Learning outcome - I
FINANCIAL DATA SOURCES
The financial data can be obtained from the internal financial sources such as balance sheet, which represents the financial position at the end of the accounting period, the income statement, which presents the operating result of the firm for the reporting period, the cash flow statement, which presents the cash flows for the period and reconciles cash flow with the net profit reported in the income statement, a statement showing changes in equity and other explanatory notes of the GlaxoSmithKline.
Similarly the financial data can also be obtained from the external financial sources such as stock exchange reports, which represents the financial position at the shareholders view point, the returns on investments, which presents the operating result of the firm for the reporting period, the banker's statement, which presents the cash flows for the period and reconciles cash flow with the bank book reported in the GlaxoSmithKline books, articles and journal in equity and other research notes of the GlaxoSmithKline.
Factors influencing internal and external source of data:
Content of the data: the GlaxoSmithKline should pay due attention to the content of the external data.
Credibility: the dependability of the data is also a matter of concern in case of external source of data.
Validity: the validity refer o he dependability of the data. The data collected should be valid and acceptable.
Accuracy: as the data collected from various source may be trustworthy but no be accurate, therefore care should be taken as to evaluate the accuracy of the data, it can be evaluated for dependency and accuracy by comparing it with the similar data available from the other organization.
ROLE OF IFRS AND FASB AND CONTENTS OF FINANCIAL REPORTS:
Usually accounting standards stipulate accounting principles and methods regarding recognition, measurement, and presentation of various items recognized in the balance sheet and income statement. However, there are certain accounting standards that specifically deal with disclosure.
External audit report: External audit report is an important source to check the validity of financial data. External auditors evaluate the truth and fairness of financial statements and about the quality of financial statements. Comments and qualifications in audit report provide important information and independent opinion on financial statements. Usually, board of directors, in its report, comment on audit qualifications. Analysts often adjust numbers in financial adjustments before financial analysis to give effect to audit qualifications.
Board of director's report: Board of director's report provides information that is important to understand past performance and future business prospect. For example, an act which stipulates that a report by the board of directors be attached to every balance sheet laid before GlaxoSmithKline in a general meeting require that the report, at the minimum, should provide the state of the GlaxoSmithKline's affairs, the amounts, if any, which it proposes to, carry to any reserves in such balance sheet, the amounts, if any, which it recommends should be paid by way of dividend, material changes and commitments, if any, affecting the financial position of the GlaxoSmithKline which have occurred between the end of the financial year of the GlaxoSmithKline to which the balance sheet relates and the date of the report and the conservation of energy, technology absorption, foreign exchange earnings and outgo, in such manner as may be prescribed.
Management's discussion and analysis: In the USA, European countries, and many other parts of the globe, management's analysis of the business form an important part of the narrative section of the annual report of publicly traded companies. It is usually referred to as 'Management Discussion and Analysis' (MD&A).
A position paper issued by the European Accounting Study group in May 2000 describes the function of management's analysis as follows:
"The financial statements and management's analysis of the business should complement one another in presenting fairly the economic effects on the enterprise of developments in the period and of the state of affairs at the end".
Corporate Governance Report: In reality, the code of Corporate Governance requires listed companies to include a separate section of 'corporate governance' in their annual reports. This section should include a detailed compliance report on corporate governance.
Voluntary Disclosures: Voluntary disclosure describes financial and non-financial disclosure primarily outside the financial statements, which are not explicitly required by governing statutes. Managers improve the credibility of their financial reporting through voluntary disclosure. Voluntary disclosure articulates firm's long-term strategy and specification of non-financial leading indicators which are useful in evaluating the effectiveness of strategy implementation. Voluntary disclosure is also used for managing capital market expectations. Managers have the incentive to disclose information when they believe the market's expectations are sufficiently different from their own. It is said that the voluntary disclosure reduces the probability of being sued by investors.
VALIDITY OF FINANCIAL DATA:
The most important information for any stakeholder of GlaxoSmithKline is the financial data. The financial data has its importance due to its required by the GlaxoSmithKline's stakeholders who have invested their money or money worth in the GlaxoSmithKline. The financial data shows the present status of the GlaxoSmithKline in respect of their financial condition. This helps the stake holders to compare the performance of the GlaxoSmithKline taking into accounts the previous financial data. They can also be used to compare GlaxoSmithKline's performance with the other companies in the market producing same product or providing same services. So it is very important that the financial data of the GlaxoSmithKline should show the correct picture of the GlaxoSmithKline, it should not be modified in any way which shows a modified picture of the GlaxoSmithKline either good or bad than the actual position. If the financial data presented by the different statements of the GlaxoSmithKline then all the analysis done would show a different result than the actual one which is not true and the decisions taken by the managers would also be wrong and it can go against the GlaxoSmithKline as it is illegal to manipulate financial and other important information of GlaxoSmithKline.
DIFFERENT TYPES OF ANALYTICAL TOOLS- RATIO ANALYSIS AND VARIANCE ANALYSIS:
Ratio analysis: ration analysis is an important tool for financial analysis. Although, accounting measures have many limitations, they are extensively used by analysts and managers in a number of metrics that measure the performance of a firm. For a meaningful analysis financial ratios should be used in conjunction with non-financial ratios or other non-financial measures of performance in different activities of the firm.
Meaningful analysis of financial statements requires adjustments of accounting figures to overcome these limitations; however care should be taken to ensure that such adjustments do not make computations so complex that the interpretations of results become difficult.
Uses of Ratios for internal management:
Financial statements present amounts of asset, liabilities, incomes and expenses, in aggregate, appropriately classified in different groups. Aggregates cannot be managed. Therefore, financial ratios cannot lead to appropriate managerial actions for maintaining or improving the performance of a firm. Financial ratios, at best, can guide one to the 'right questions'. Therefore, managers usually use financial ratios only to understand economic consequences of their decisions. The board of directors uses financial ratios to evaluate the performance of the firm as a whole and the performance of different segments of the firm.
Types of ratios:
Liquidity ratios:
Liquidity ratios are used as indicators of a firm's ability to meet its short term obligations. These obligations include any current liabilities, including currently maturing long term debt. Current assets move through a normal cash cycle of inventories, sales, accounts receivable, cash. The firm then uses cash to pay off or reduce its current liabilities. The best known liquidity ratio is the current ratio: current assets divided by current liabilities. For the present GlaxoSmithKline the current ratio is calculated as follows:
Current ratio = Current Assets
Current Liabilities
Most analysts suggest a current ratio is 2 to 3. A large current ratio is not necessarily a good sign; it may mean that an organization is not making the most efficient use of its assets. The optimum current ratio will vary from industry to industry, with the more volatile industries requiring higher ratios.
Acid test ratio:
Since slow moving or obsolescent inventories could overstate a firm's ability to meet short-term demands, the acid test ratio is sometimes preferred to assess a firm's liquidity. The acid test ratio is current assets minus inventories, divided by current liabilities; the acid test ratio for the GlaxoSmithKline is calculated as follows:
Acid test ratio = Current Assets - Inventories
Current Liabilities
An acid test ratio of approximately 1 would be typical for American industries. Although there is less variability in the acid test ratio than in the current ratio, stable industries would be able to operate safely with a lower ratio.
Leverage ratios:
Leverage ratios identify the source of a firm's capital owners or outside creditors. The term leverage refers to the fact that using capital with a fixed interest charge will "amplify" either profits or losses in relation to the equality of holders of common stock. The most commonly used ratio is total debt divided by total assets. Total debt includes current liabilities and long term liabilities. This ratio is a measure of the percentage of total funds provided by debt. A total debt total assets ratio higher than 0.5 is usually considered safe only for firms in stable industries.
Total debt
Total assets
The ratio of long term debt to equity is a measure of the extent to which sources of long term financing are provided by creditors. It is computed by dividing long term debt by the stockholders' equity.
Long term debt
Equity
Activity Ratios:
Activity ratios indicate how effectively a firm is using its resources. By comparing revenues with the resources used to generate them, it is possible to establish an efficiency of operation. The asset turnover ratio indicates how efficiently management is employing total assets. Asset turnover is calculated by dividing sales by total assets. For the GlaxoSmithKline, asset turnover is calculated as follows:
Assets turnover = Sales
Total assets
The ratio of sales to fixed assets is a measure of the turnover on plant and equipment. It is calculated by dividing sales by net fixed assets.
Fixed asset turnover = Sales
Net fixed assets
Industry figures for asset turnover will vary with capital intensive industries, and those requiring large inventories will have much smaller ratios.
Another activity ratio is inventory turnover, estimated by dividing sales by average inventory. The norm for U.S. industries is 9, but whether the ratio for a particular firm is higher or lower normally depends on the product sold. Small, inexpensive items usually turn over at a much higher rate than larger, expensive ones. Since inventories normally are carried at cost, it would be more accurate to use the cost of goods sold in place of sales in the numerator of this ratio. Established compliers of industry ratios, such as Dun & Bradstreet, however, use the ratio of sales to inventory.
Inventory turnover = Sales
Inventory
The accounts receivable turnover is a measure of the average collection period on sales. If the average number of days varies widely from the industry norm, it may be an indication of poor management. A too low ratio could indicate the loss of sales because of a too restrictive credit policy. If ht ratio is too high, too much capital is being tied up in accounts receivable, and management may be increasing the chance of bad debts. Because of varying industry credit policies, a comparison for the firm over time or within an industry is the only useful analysis. Because information on credit sales for other firms generally is unavailable, total sales must be used. Since not all firms have the same percentages of credit sales, there is only approximate comparability among firms.
Accounts receivable turnover = Sales
Accounts receivable
Profitability ratios:
Profitability includes a large number of the company's policies and decisions made by the management of an organization. The profitability ratios shows how successful were the management of the organization in managing the firm. Its profit margin is calculated by dividing its net earnings by sales, profitability ratios are often called return on sales. The average profitability ratio for U.S. firms is approximately 5 %.
Net Earnings
Sales
Another ratio that is useful for evaluating profitability is the return on investment or ROL as it is frequently found when dividing net earnings with the total assets. The GlaxoSmithKline's ROI calculation is as follows.
Net earnings
Total Assets
(The ratio of net earnings to net worth is a measure of the rate of return or profitability of the stock holders' investment. It is calculated by dividing net earnings by net worth, the common stock equity and retained earnings account. The present GlaxoSmithKline's return on net worth, also called ROE, and it is calculated as follows:)
Net earnings
Net worth
COMPARATIVE FINANCIAL DATA ANALYSIS OF THE GLAXOSMITHKLINE:
Liquidity Ratios
Formula
interpretation
GlaxoSmithKline
Industry Norms
Current ratio
Current Assets
Current Liabilities
240 ÷ 120
2 times
2 times
Acid test ratio
Quick assets
Current liabilities
120 ÷ 120
1 time
1 time
Interpretation of analysis: the above table shows that both current and acid test ratio are equal to industry norms, it means the management is maintaining proper current assets in meeting current liabilities.
Profitability Ratios
Formula
interpretation
GlaxoSmithKline
Industry Norms
Return on capital employed
Profit before interest and taxes ÷ capital employed
100 ÷ 670
14.93%
26%
Gross profit margin
Gross profit ÷ sales
200 ÷ 400
50.00%
47%
Net profit margin
Net profit ÷ sales
100 ÷ 400
25.00%
25%
Expense to revenue
Expenses for the year ÷ sales revenue
100 ÷ 400
25.00%
27%
Interpretation of the analysis: the above table gives the conclusion that except for the return on capital employed all the other ratios are good, the management should continue the same. The higher the profitability ratio shows higher efficient of management.
Efficiency Ratios
Formula
interpretation
GlaxoSmithKline
Industry Norms
Trade receivable Collection period
360 days ÷ Average receivable turnover ratio
360 ÷ 5
72 days
60 days
Trade payable collection period
360 ÷ Average payable turnover ratio
360 ÷ 2
180 days
130 days
Fixed assets-turnover
sales turnover ÷ total assets
400 ÷ 550
0.73 times
1.20 times
Inventory-turnover
cost of goods sold ÷ average inventory
200 ÷ 120
1.67 times
2.40 times
Interpretation of analysis: this table shows that the management availing good credit days, but the required level of inventory is not maintained.
Investment Ratios
Formula
interpretation
GlaxoSmithKline
Industry Norms
Earning per share
Profit after tax and preference dividend ÷ Equity share capital
61÷150
£0.41(41p)
16.67p
Profit earning ratio
Market price of equity share ÷ Earnings per share
4 ÷ 0.41
9.76
16.82
Dividend cover
Total amount for dividend ÷ Dividend available for equity share holders
61 ÷ 21
2.9 times
5.1 times
Dividend yield
dividend on equity share capital ÷ number of equity shares
21 ÷ 150
14p
4.1p
Comparative analysis: in this the above table shows that the company is earning good profits but its major part it is retained, hence there is a drop in earning according to company's norms.
Gearing Ratios
GlaxoSmithKline
Industry Norms
Debt-Equity
Debt ÷ equity
140 ÷ 530
26.42%
26.8% or 50%
Interest coverage
EBIT ÷ interest charges
115 ÷ 0.15
766.67
9.2 times
Interpretation of analysis: the above table shows, that the company is maintaining a proper debt-equity and a coverage ratio too, that means that it can be managed more appropriately.
CONCLUSIONS AND SUGGESTIONS:
The firm is at liquid state, the liquid ratio shows that there efficiency in its performance, and can earn more profits and has efficient assets at the time of solvency. .
it reveals any long term liquidity if present, and helps the firm to face the challenges and risk that is involved in business.
The advice to GlaxoSmithKline is to maintain this same consistency in performance.
MAJOR STAKEHOLDERS OF GLAXOSMITHKLINE
Shareholder: as any other company, even the capital of GlaxoSmithKline is divided into small parts, sharing the entire capital with different people. These people are called shareholders of GlaxoSmithKline, They hold ownership and so they always want to check the financial data on regular basis.
Customers: customer are the essential par for the running of any business, they are composite groups that consists producers, wholesalers and retailers at every level of processing, the retailer is the ultimate consumer
Employees: The employees are people that work for the firm on salary basis, bonus and pension etc, but all this ultimately depends on the GlaxoSmithKline's earnings. The employees have a lot of benefits by the business, and so to get those advantages the employees are always interested in the stability of the business.
Researchers: researches are the people who do they interpret of the accounting statements and gives its report in a systematic data on which the companies working successfully is depended.
Management: They are elected by the owners or the shareholders to manage the everyday affairs of a firm, the management bears the responsibility of the company's performance. Hence they periodically compile, interpret and presents the required financial statements.
Learning outcome - II
Budgeting:
Budget is "A financial report prepared and accepted to define a policy that is meant to be pursued during that period, it includes the income and the expenditures that is needed and also the capital that is employed --definition given by CIMA of England and Wales.
In other words, budget or budgetary control is a tool to control the costs with minimum costs the hands of management to control the cost with minimum costs. The budget controller has to be careful while preparing a budget he has to keep within limits of certain budgetary activities, it may posses one or more limiting features which can effect the total activity, in spite of huge demands certain features can restrict it, for instance; realization of targets, lawful requirements and accounting conventions. These features are known as limiting features. To gain a effective budgetary control these features should be found out, traced and then estimated
Advantages and disadvantages:
It is beneficial to a management as it helps in the planning, in its control, decision making and even in fixing its prices
It reduces preparation of reports on pricing, and even control and quotation purpose and initiate cost reduction.
It also supports the matching schedule production with machine capacity and preparing reports on business logs in terms of time.
It determining profitability of specific profit line and checking selling prices etc. systematic and easy.
When deviation and variance are more than tolerance it is taken to task.
Helps in preparing budge for ever budge centre.
Disadvantages:
It is confirmed to organization whose process or jobs are repetitive.
Inadequate budget education brings about unsuccessful budget proposal.
Execution of budgetary control does not occur automatically.
Its budgetary can lead to restrict the resources.
SALES BUDGET OF MIRACURE
Month
October
Units
2400
Selling price
£4.4
Sales revenue
£10560
Month
November
Units
2600
Selling price
£4.84
Sales revenue
£12584
Month
December
Units
2800
Selling price
£5.324
Sales revenue
£14907.2
Month
January
Units
3100
Selling price
£5.86
Sales revenue
£18155
Month
February
Units
3000
Selling price
£6.44
Sales revenue
£19326
Month
March
Units
3150
Selling price
£7.09
Sales revenue
£22322
BUDGETED SALES OF MIRACURE
£97854
SALES BUDGET OF ROTARIX
Month
October
Units
2300
Selling price
£7.20
Sales revenue
£16560
Month
November
Units
2560
Selling price
£8.64
Sales revenue
£22118
Month
December
Units
2750
Selling price
£10.368
Sales revenue
£28512
Month
January
Units
3200
Selling price
£12.4416
Sales revenue
£39813
Month
February
Units
3200
Selling price
£14.9299
Sales revenue
£47776
Month
March
Units
3250
Selling price
£17.9159
Sales revenue
£58227
BUDGETED SALES OF ROTARIX
£149305
Hence the total budget sales for Japan project = £97853.8 + £149305 = £247158.9
Labour cost budget for a month for Japan Project
Labour cost per month for Miracure
skilled labour
unskilled labour
Total Labour cost per month for Miracure
Labour Hours
400
400
Labour Rate
£30
£15
Total - M
£12000
£6000
£18000
Labour cost per month for Rotarix
skilled labour
unskilled labour
Total Labour cost per month for Rotarix
Labour Hours
450
450
Labour Rate
£30
£15
Total - R
£13500
£6750
£20250
Total labour cost for one month (M + R) = £18000 + £20250 = £38250
For 6 months i.e. from October to March = £38250 * 6 months = £229500
TRADE RECEIVABLES BUDGET
Month
Opening balance from September
credit sale
Total
Received
Balance Carried forward to November
October
£2800
£1600
£4400
£1100
£3300
Month
Opening balance from October
credit sale
Total
Received
Balance Carried forward to December
November
£3300
£1760
£5060
£1700
£3360
Month
Opening balance from November
credit sale
Total
Received
Balance Carried forward to January
December
£3360
£1936
£5296
£1600
£3696
Month
Opening balance from December
credit sale
Total
Received
Balance Carried forward to February
January
£3696
£2129.60
£5825.6
£1760
£4065.6
Month
Opening balance from January
credit sale
Total
Received
Balance Carried Forward To March
February
£4065.6
£2342.56
£6408.16
£1936
£4472.16
Month
Opening balance from February
credit sale
Total
Received
Balance Carried forward to April
March
£4472.16
£2576.82
£7048.98
£2129.6
£4919.38
TRADE PAYABLES BUDGET
Month
Opening balance from September
credit purchase
Total
Paid
Balance Carried forward to November
October
£4900
£2400
£7300
£1000
£6300
Month
Opening balance from October
credit purchase
Total
Paid
Balance Carried forward to December
November
£6300
£2900
£9200
£1800
£7400
Month
Opening balance from November
credit purchase
Total
Paid
Balance Carried forward to January
December
£7400
£3400
£10800
£2100
£8700
Month
Opening balance from December
credit purchase
Total
Paid
Balance Carried forward to February
January
£8700
£2992.
£11692
£2400
£9292
Month
Opening balance from January
credit purchase
Total
Paid
Balance Carried Forward To March
February
£9292
£2992
£12284
£2900
£9384
Month
Opening balance from February
credit purchase
Total
Paid
Balance Carried forward to April
March
£9384
£2992
£12376
£3400
£8976
MONTHLY PRODUCTION BUDGET FOR PRODUCT MIRACURE
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Miracure
October
2400
£4.4
£10560
£4225
£1200
£13585
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Miracure
November
2600
£4.84
£12584
£5034
£1200
£16418
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Miracure
December
2800
£5.324
£14907
£5963
£1200
£19670
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Miracure
January
3100
£5.8564
£18155
£7262
£1200
£24217
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Miracure
February
3000
£6.44204
£19326
£7730
£1200
£25856
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Miracure
March
3150
£7.086244
£22321.6686
£8929
£1200
£330051
BUDGETED PRODUCTION OF MIRACURE (6 MONTHS)
MIRACURE
Gross sales units
Selling price
Gross Sales Value
(6 months)
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production (6 months)
TOTAL COST OF PRODUCTION
17050
£97853.8286
£39141.53144
£31412.8
£105582.496
PRODUCTION BUDGET FOR PRODUCT ROTARIX
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Rotarix
October
2300
£7.20
£16560
£6624
£1100
£22084
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Rotarix
November
2560
£8.64
£2218
£8847
£1100
£29865
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Rotarix
December
2750
£10.368
£28512
£11405
£1100
£38817
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Rotarix
January
3200
£12.4416
£39813
£15923
£1100
£54636
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Rotarix
February
3200
£14.9299
£47776
£19110
£1100
£65786
Month of production
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Rotarix
March
3250
£17.9159
£58227
£23291
£1100
£80418
Budgeted production of Rotarix (6 months)
ROTARIX
sales units
Selling price
Sales Value
Add: closing stock (40% of sales)
Less: opening stock
Budgeted production for Rotarix
Total Cost Of Production
17260
£213006
£85200
£6600
£291606
Hence, total production cost for Japan project is:
= Budgeted production cost of Miracure + Budgeted production cost of Rotarix
= £129796 + £291606
= £421402
BUDGET FOR NEW PRODUCT AND ITS VARIANCES
particulars
Sales units
Sales revenue
Variable costs:
Total
V.C
Sales - variable cost
Fixed cost
Income from operations
Materials costs
Labor costs
Other variable o/h
Standard
7000
£120000
£40000
£30000
£21000
£91000
£29000
£23000
£6000
Standard budget for actual sales
7600
£130285.7
£43428.6
£32571.4
£22800
£98800
£31485.7
£23000
£8485.7
Actual
7600
£132000
£45500
£34200
£26000
£105700
£26300
£25150
£1150
Variance
1714.3
£2071.4
£1628.6
£3200
£6900
£-5185.7
£2150
£-7335.7
Favorable
or Adverse
Favorable
Adverse
Adverse
Adverse
Adverse
Adverse
Adverse
Adverse
Causes for variances:
The variances occur because of the changes in basic price or rate of material or labor, excess transport charges, this happens mainly during inflation. Variances occurs if there is inappropriate mix of material usage and inappropriate purchases of quantity of materials, a sudden increament in production due to demand forces an uneconomical quantity of high rate labor.
Advise to the management:
The management has the responsibility to take care of all the materials that are handled by workers and other production personnel; he has to make sure they make proper machine adjustments. Improvements must be done in production process and it is the manager's duty to see that extra care is taken by the workers in carrying out their jobs.
Learning outcome - III
Financial proposals:
Every financial proposal is based on points; like the return from investment, the level of risk that is involved, its NPV (net present value) and the payback period of that proposal.
NET PRESENT VALUE:
The first discounted cash flow or present value technique is the NPV. NPV it can be described as the summation of the present values of cash proceeds (CFAT) in every year minus the summation of present values from the net cash outflows.
This means that the net present value is simply found by subtracting a projects initial investments from its present value, its cash inflows is discounted at the firm's cost capital.
There are some selected measures used to judge certain project. They are:
Average rate; any product that has a return above the average rate is accepted an should be more than the required ARR.
Proposal that have lower payback period is accepted rather that the one with longer payback period.
Proposal that have highest positive NPV is accepted rather than to the proposal with lower NPV.
A proposal with negative NPV is rejected.
The proposals with 0 NPV may or may not be accepted, it depends on the management's decision.
NET PRESENT VALUE FOR PROJECT SELECTION:
Calculation of net present value of Japan project
CASH OUTLAYS:
Purchase of Cosmo + working capital: £4100000 + £499950 = £4599950
Whereas working capital = £550000*0.909 = £4599950
Year
Cash inflows
Present value factor@ 10%
Present value of cash inflows
1
£690000
0.909
£627210
2
£1126500
0.826
£930489
3
£662515
0.751
£497548.765
4
£699834.25
0.683
£477986.622
5
£733500.6
0.621
£455504.121
6
£2818458
0.564
£1589610.312
Total PVCF
£4578349
Initial outlay
£4599950
NPV
£-21601.18
Suggestion: Net present value must be positive for selecting a project, but in the above case it is negative, thus project must be rejected.
Year
Cash inflow
PV Factor at 8%
Present value cash inflows
£
1
£690000
0.926
£638940
2
£1126500
0.857
£965410.5
3
£662515
0.794
£526036.91
4
£699834
0.735
£514377.99
5
£733501
0.681
£499514.181
6
£2818458
0.63
£1775628.54
Total PVCF@8%
£4919908.121
Initial outlay
£4599950
NPV
£319958.121
Suggestion: Net present value must be positive for selecting a project, and in the above case it is positive, thus project must be accepted.
Difference in cost of capital: The main reasons for difference in cost of capital could probably be because of excess expectations of the investors regarding the Japan project, the net present value is getting negative, if the company takes the 10% rate of cost of capital. The other reason could easily be because of the financial down fall or excess of money flow in the market. This could be the reason for bringing down the returns.
Calculation of internal rate of return:
Calculation of average cash inflows
Average cash inflows = Total cash inflows = £6730808 = £1121801
Number of years 6
Calculation of Payback period = Cash Outlays = £4599950 = 4.10
Average cash inflows £ 1121801
year
cash inflow
PV Factor at 9%
PVCF@9%
PV Factor at 10%
PVCF@10%
1
£690000
0.917
£632730
0.909
£627210
2
£1126500
0.842
£948513
0.826
£930489
3
£662515
0.772
£511461.58
0.751
£497548.765
4
£699834
0.708
£495482.472
0.683
£477986.622
5
£733501
0.65
£476775.65
0.621
£455504.121
6
£2818458
0.596
£1679800.968
0.564
£1589610.312
Total PVCFAT
£4744764
£4578349
less: Initial investment
£4599950
£4599950
NPV
£144813.67
£-21601.18
IRR = Lower rate + [(Total PVCF@9% - Initial outlay)/(Total PVCF@9% - Total PVCF@10%)] Ã- (Higher rate - Lower rate)
IRR = 9 + (£4744764 - £4599950) Ã- (10-9)
£4744764 - £4578349
IRR = 9 + (£144814) Ã- (10-9)
£166415
IRR = 9 + 0.87
Therefore, IRR = 9.87
Internal rate of return is supposed to arrive at 9.87; hence the project must be accepted for investment at 8% rate of cost of capital investment.
