Finance Calculating Investment Values When a Firm Essay

Excerpt from Essay :

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…

Sources Used in Document:

If it is assumed that the profit level remains the same, the use of the dividend discount model can be used to assess the firms' value

. If it is assumed that the profit level remains the same, and does not decrease, and an alternate investment over a long period of time will yield 11%, this will give the firm a value of $509,090, this is above the asking price. Therefore, while the firm has a low level of assets, it is generating income. The issue that would hold back a purchase would be the current decline in profit and concern for the reason this is declining and Gino's reason for sale. If there are no other negative factors then $200,000 may be a fair price.

Dividend discount model calculator can be found at http://www.moneychimp.com/articles/valuation/dcf.htm

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