Nov 26, 2020 in Business

Project Valuation 1

Project Valuation 6

PROJECT VALUATION By Student's name Code+ course name Professsor's name University name City, State Date

Memo 03

Operating and Financial Lease

Operating leverage is the ability of the firm to magnify the effects of sales on its earnings before interest and tax (EBIT) using fixed cost (Zhang, 2005). Fixed cost includes depreciation, taxes, advertising expenses, administrative cost, equipment and technology (Sagi & Seasholes, 2007; Zhang, 2005). A firm can significantly increase its profits by using fixed production costs. If a company has a large percentage of its fixed cost, it means that this company has a high degree of operating leverage. On the other hand, financial leverage is the financing of a firms assets using, debt or preferred stock. Both types of leverages may boost a firms return but they increase risks as well (Kogan, 2004).

Operating Lease

A firm with a higher contribution margin or words excess of sales over variable cost has a potential of creating larger profits than a company with a lower contribution margin or contribution leverage (Novy-Marx, 2007). The high contribution margin means the break-even point is lower; hence if more units are sold above the break-even point, the profit gets higher. Moreover, the contribution that the sales make to profit is greater than when the costs are variable. However, the problem with this type of leverage is that if the company has very high fixed costs, the firm might have difficulty in selling enough units to break-even resulting to losses (Novy-Marx, 2007).

Financial Leverage

A company financed by debt makes profits, increasing the shareholders earnings. In addition, the additional earned profits can be reinvested to increase production without the need to dilute the earnings of shareholders, hence, increase the profit per share (Davis et al., 2000). However, if the firm is over leveraged and sales fall, there can be a cash flow problem that results in defaulting on the debt. Companies with significant amount of debts earnings are more unpredictable than those with manageable debts. From the shareholders perspective, financial leverage runs the highest risk because interest is paid before any dividends are issued. Both of these two types of leverages have their fair share of merits and demerits; their use in the firm may depend on several other things, for example, the nature of capital formation, the availability of technology for cost effective production and the state of the economy. It should be recalled that the operating leverage is concerned with the relations between sales and profit while financial leverage is concerned with the relation between sales and earnings per share (Carlson et al., 2004). The comparison of both leverages has been conducted below.

Firms

Operation leverage

Financial leverage

Earnings

3,400,000

3,400,000

Interest on loan/internal rate of return 10%

(340,000)

(340000)

Tax 41%

(1,394,000)

(1254600)

Tax shield

0

131200

Earnings after tax

1666000

1805400

Earnings per share(5000 shares)

333.2

361.08

In the table, the internal rate of return is charged against EBIT in the operation leverage, while interest is charged EBIT on financial leverage. There is a tax savings shield of $131200, which is then given to share holders as earnings. Moreover, using a debt as leverage has proven to be a successful tool during inflationary period.

Memo 01

Project Valuation

Valuation analysis is the evaluation of the potential merits of projects or value of assets or business (Kogan, 2004). In this assignment, the projects are valued to find the one that realizes the best return on capital invested. Valuation gives the answer to the question whether it is worth the investment. This analysis is based on the projections of the future financial outflow. In the assignment, the investor is advised on which investment project is worth investing in. The table below shows the analysis on the project.

Year end

Project1

Project 2

Project3

Project4

Project5

01

-830000

-200000

-850000

-5000000

-350000

02

100000

350000

800000

284067

03

100000

500000

800000

255922

04

100000

700000

800000

208830

05

800000

-2650000

06-30

1000000

800000

187126

B/C ratio

119%

10%

18%

27%

First 113%,2nd 4.9%

PBP

7 years

2 years

3 years

26 years

First 1 year, second 24years

IRR11%

11%

6.7%

12%

9%

10.5%

NPV11%

7634388

20166

151124

1355882

111048

Valuation using the NPV

Net present value is the difference between the present value of the cash inflow and the present value of the cash outflow (Davis, et al., 2000). In this valuation, the net present value was used to get the project that had the best net inflow. Project one has the highest net present value, followed by project 4,3,2,5 in that order. Project five had two parts; the first part had a very positive NPV while the last part performed very weak.

Valuation using the payback time

The payback time is the time required for the amount invested to be recouped by the cash outflow generated by the asset (Davis, et al., 2000). In a way, it is one of the methods used to calculate risk associated with the project. When calculating the payback period, the initial cash outlay is divided by the cash generated by the project per year. It is assumed that the cash outflow is uniform every year. Payback time method picked number two as the project with the shortest payback time among all projects. It was closely followed by project three, one, four and five respectively.

Using the Internal Rate of Return

The internal rate of return is the amount a given project is expected to generate (Davis, et al., 2000). Mostly, the internal rate of return is used to rank several prospective investments a firm is considering. If all other economic factors are constant, the project with the highest internal rate of return will be considered. In this assignment, the project with the highest rate of return is project three with 12 per cent, followed by project one with 11 per cent, projects four, two and five followed in that order. The internal rate of return was calculated by looking at all aspects of every project. It is not very accurate because the market variables were not given. The benefit cost ratio on the other hand measured the amount used in the project versus the money gained from the project. Using this method the project that fetched a lot of money is project one followed by project four, three, two and five respectively. It is advisable for any organization to evaluate their projects before they commit the resources into it to avoid investing a lot of resources in a project that cannot fetch much.

Order now

Related essays