Finance Calculating Investment Values When a Firm

Finance

Calculating Investment Values

When a firm has a number of investment options but can only undertake one, the firm is likely to undertake some assessments in order to determine which is likely to provide the optimal return. In the first scenario there are three potential factory expansion choices, with the need to determine which will create the greatest value for the firm. The investment levels and the expected net profit per annum have been supplied. This may be used as the basis for a comparison.

The assessment method used is a straightforward approach which looks at the return on the capital to be invested. It is assumed that the firm want to gain the greatest potential return and that there will be other investment opportunities for any capital that is not used to fund the factory expansion.

To calculate the expected return the expected net profit is divided by the capital to be invested and expressed as a percentage. This is shown in table 1.

Table 1; Return on investment

A

B

C

Investment

88,000

36,500

8,000

Expected net profit

13,200

8,000

1,400

Return on investment

15.00%

21.92%

17.50%

This shows that the optimal return will be achieved if the firm chooses option B, as this will provided an expected return of 21.92%. The worst option is option A where there is a return of only 15%.

However, the decision may not be this easy; consideration may also need to be given to the alternatives which may be used with the remaining funds. While it is important to maximize returns, the actual numerical amount realized is important. If the remaining projects that may receive the money have much lower rates, then the amount created by option A may become attractive. Issues such as the term of the investment and the period over which the increased profits may be realized may also have an impact, if different periods of time are associated with the expansion options then tools such as net present value and internal rate of return may be used to make a comparison.

Question 2

Gino wants to sell his business for $200,000, the question is to assess whether or not it is worth that amount. There are different ways in which a firm may be valued. A basic approach is the book value; the assets of a firm. The current assets are declared as being worth $40,000, so the book value is well below the price that is being asked by Gino.

An area of concern would be that the current profit (including wages) rate has declined in 2012 compared to 2011. If the current level of profits is maintained then a simple calculation indicates that that there would be a payback period of 3.57 years or 3 years 7 months, not a bad payback period, especially if the investors feels they can improve the businesses performance.

Anther approach is to look at the business as an investment and assess the firms' value in that context. When buying an investment it is the future profits that are the subject of the investment; the investor is buying the business to gain those profits. The future revenue streams can only be estimated, and it is known that money received in the future is not worth the same amount received today. To value a business as an investment the potential profits are taken and then discounted into today's terms.