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MANU 1398 International Engineering Management-Internal Sources of Fin

Following advice from an agent in Vietnam TNA have an opportunity to purchase a majority interest in a small local firm that manufactures equipment for the food processing and packaging industry.  This firm has a factory in a convenient location close to the ports and transport routes and a loyal and hardworking workforce.  Unfortunately the factory has outdated equipment and a relatively high cost structure and the firm is increasingly falling behind its competitors.  However the Agent’s advice may provide an opportunity for TNA to establish a production facility in the heart of Asia without the problems and lead time involved in developing a Greenfield facility.

Following further enquiries TNA management determine that they could complete the takeover of the Vietnamese company that owns the factory for an investment of $A 15 million, $A 10 million of which would be to purchase 100% of the Vietnamese company and $A 5 million in the form of capital equipment to replace some of the aging factory infrastructure.

If TNA proceed with the takeover they estimate that they can be operational by beginning 2018.  They further consider that the existing contracts from the Vietnamese company will provide underpinning revenue equivalent to A$ 200,000 per month at current exchange rates.  They are also confident of rapidly gaining additional food processing and packaging business because of the superiority of their new equipment.  Their estimates of the value of sales growth per annum in the Vietnamese market are shown in the following table.

YEAR

Year 1

Year 2

Year 3

Year 4

Year 5

10%

15%

20%

20%

10%

Total costs are assumed to 60% of revenue in the first year and 50% of revenue for subsequent years.  The exchange rate at May 22th 2017 is 22690 Vietnamese Dong per Australian dollars and it is assumed that the inflation rate will be 4% higher in Vietnam than Australia.

Based on the information provided and further research answer the following questions:

Q.The management of TNA are undecided about their best option for sourcing the $A10 000 000 required for the transaction.  Discuss their options for sourcing these funds.

Carry out a capital budget evaluation of the proposed takeover assuming a 5 year timeframe and an estimated residual value of A$ 200,000 for the capital equipment at the end of the 5 years.  Assume that TNA use a weighted average cost of capital of 10% in their financial evaluations.  Does the takeover represent a good investment for TNA based on your evaluation What would be the situation if the investment required was only A$ 5 000 000. 

Discuss what will be benefit, comparing to the situation, that whole production is operating in Australia.

Answer:

Globalization has opened new ways to source the business expansions but capital structure decision is still very sensitive. In olden days, raising funds was the primary objective of finance department but now it is changed to raise funds with minimum cost. Success and growth in business highly depend on source of financing (Beck, Levine & Loayza, 2000).Cost of source of finance is very important to consider while finalizing the option. There are two categories of financing which are internal and external financing.

Internal sources of finance come within organization while funds raised from external bodies are called external sources of finance (Carpenter & Petersen, 2002). Internal sources of finance include excess cash, retained earnings, debt collection and sell of fixed assets (Guariglia, Liu &Song, 2011). As declared that TNA has insufficient cash to execute the project worth $10,000,000 so TNA needs to explore other sources. Debt collection and sell of fixed assets are best sources of finance because internal sources of finance are ready to use and does not incur any cost. As amount is very big therefore raising funds through internal sources of finance will not be sufficient. TNA management should look for external sources of finance to fund the project in Vietnam.

To fund very large expansion projects, firm can raise financing from equity or debt financing. Public companies issue new shares to individual investors or venture capitalist to finance projects (Carpenter & Petersen, 2002). To fund the business expansion project, TNA can issue shares in secondary market at current or discounted price. Issuing new stock needs approval from board of directors and top level management. There are few advantages and disadvantages


of issuing new stock in secondary market. Issuing new stock is very costly process because it involves intermediary financial institutions and in urgency firms issue stock at discounted price. Holder or owner of common stock have right to vote for any material decision and issue of new common stock will increase the number of voters. This situation can create the situation of management overtake and dilution of control. Dilution of firm’s control is the primary risk of issuing new stock in secondary market.

Another alternative for TNA is to issue debt instruments to finance the Vietnam expansion project. To give a clear idea of debt financing, major advantages and disadvantages of debt financing needs to be discussed. Although cost of debt financing is lower than equity financing but it increases the changes of bankruptcy (Dahiya et.al, 2003). Debt financing needs payment of interest amount every year and failure to do so will leads to bankruptcy. Debt financing saves the tax payment therefore debt financing is also called tax shield. Interest expense is tax deductible and saves taxes payable. Holders of debt instruments do not posses right to vote and issue of new debt will not dilute the firm’s control.

Preferred stock is also an option to raise funds and this instrument is mixture of debt and ordinary stock. Preferred share holders are paid dividends every year but common stock holders not necessary receive dividends (Baker &Wurgler, 2004). In some cases, management can delay dividends of preferred stock holders but next year cumulative dividends are paid to preferred stock holders. Preferred stock do not give right to vote in management decisions. Capital structure decisions are very critical for the success of the project. TNA management should use the mixture of debt, preferred stock and common stock to reduce cost of capital. Reduction in weighted average cost of capital increase the chances of success of project. TNA management should use mixture of three sources to generate $10,000,000 because this can reduce cost of financing. It is suggested to TNA management that following capital structure should be used to minimize the cost of financing.

Sources

Portion of Total

% of total

Equity

6,000,000

60%

Preferred

2,000,000

20%

Debt

2,000,000

20%

Total

10,000,000

100%

Capital budgeting techniques are used to evaluate the attractiveness of expansion projects (Kahraman, 2001). Although there are many techniques used to evaluate the financial projects but this project is evaluated using Net Present Value (NPV), payback period and profitability index. Given below is the financial data of the project and calculation is given in table format. This project international project therefore exchange rate fluctuation is incorporate in evaluation of project. Inflation is rate is 4% higher in Vietnam than Australia therefore exchange rate is adjusted for inflation differential. After adjusting for inflation rate, new exchange between Australian dollar and Vietnam dong became VND 23597.6 per AU$. We adjusted the exchange rate for inflation to receive money operating cash flows which can be directly used to evaluate through capital budgeting techniques.      

Data:

Initial Investment 10000000

Expected Revenue 200000

Revenue Growth

Year 1 10%

Year 2 15%

Year 3 20%

Year 4 20%

Year 5 10%

Cost (Percentage of Revenue)

Year 1 60%

Year 2 to Year 5 50%

Current Exchange rate 22690 Dong / AUD

Inflation in Vietnam in Excess to Australia 4%

AU$  

23597.6

23597.6

23597.6

23597.6

23597.6

Dong

0.0000424

0.0000424

0.0000424

0.0000424

0.0000424

Revenue AU$

$220,000

$253,000

$303,600

$364,320

$400,752

Revenue Dong

   5,191,472,000  

  5,970,192,800  

   7,164,231,360  

    8,597,077,632  

   9,456,785,395  

AU$

 $132,000

 $126,500

 $151,800

 $182,160

 $200,376

Dong

  3,114,883,200  

  2,985,096,400  

   3,582,115,680  

  4,298,538,816  

   4,728,392,697  

OCF AU$

 $88,000

 $126,500

$151,800  

$182,160

$200,376

OCF Dong

2,076,588,800  

   2,985,096,400  

  3,582,115,680  

  4,298,538,816  

   4,728,392,697  

  (PVF)
 

1/(1.10)1

1/(1.10)2

1/(1.10%)3

1/(1.10)4

1/(1.10)5

Present Value Factor

0.91

0.83

0.75

0.68

0.62

Present value AU$

$80,080  

                $104,995

$113,850

$123,868

$248,23

Present value Dong

 1,889,695,808

2,477,630,012

2,686,586,760

2,923,006,394

5,857,705,872

NPV of this project is $(9,328,973) or VND (220,141,375,152) which means this project should be rejected. Major reason of rejection of this project is heavy investment and very low revenue. The cost is 60% in first year and 50% in next four years which is also reason of rejection of this project. Internal Rate of return of this project is negative which means IRR decision also rejects this project.

Payback Period

Payback period is very famous project evaluation technique that considers the time in which firm recover initial investment (Chowdhury, Bertling & Custer, 2006). Under this investment appraisal technique, a project is accepted if it recovers full investment amount in the life of project. Payback period of this project is also beyond the life of this project. Therefore, under the decision criteria of payback period, it is suggested to TNA management to reject this project.  

Year

Cash Flow

 Cumulative Cash flow

0

($10,000,000)

($10,000,000)

1

$220,000.00

-9,780,000

2

$253,000.00

-9,527,000

3

$303,600.00

-9,223,400

4

$364,320.00

-8,859,080

5

$600,752.00

-8,258,328

 Profitability Index:

Profitability index is investment appraisal technique that compares sum of present value of inflows with investment required. Under this technique, a project with profitability index greater than 1 is accepted (Jang, 2002). Profitability index of this project is 0.0671 which is well below 1therefore, under decision criteria of Profitability index, project should be declined.  

Profitability Index =Present Values of Cash Inflows / Initial Investment

= $547,026.92 / $10,000,000.00

= 0.0671

Initial Investment decreases to $5,000,000:

Management of TNA is interested to know suggestion of investment appraisal techniques in case of decrease in initial investment. Project with initial investment of $5,000,000 is evaluated using Net Present Value, Payback period and profitability index.

 

 Year 1

 Year 2

 Year 3

 Year 4

 Year 5

Exchange rate change due to inflation

AU$1:Dong + 4%

AU$1:Dong + 4%

AU$1:Dong + 4%

AU$1:Dong + 4%

AU$1:Dong + 4%

AU$

23597.6

23597.6

23597.6

23597.6

23597.6

Dong

0.0000424

0.0000424

0.0000424

0.0000424

0.0000424

Revenue AU$

$220,000

$253,000

$303,600

$364,320

$400,752

Revenue Dong

   5,191,472,000

   5,970,192,800

    7,164,231,360

  8,597,077,632

  9,456,785,395

AU$

$132,000  

$126,500  

$151,800  

$182,160  

$200,376  

Dong

   3,114,883,200

   2,985,096,400  

   3,582,115,680  

   4,298,538,816  

   4,728,392,697  

Operating Cash Flow AU$

  $88,000

$126,500

$151,800

$182,160

200,376

Operating Cash Flow Dong

   2,076,588,800  

2,985,096,400

3,582,115,680

  4,298,538,816  

   4,728,392,697  

  
1/(1 + WACC)t   

1/(1.10)1

1/(1.10)2

1/(1.10)3

1/(1.10)4

1/(1.10)5

Present Value (PV)
Cash Flow x Present Value Factor

PVF x Cash Flow Year 1

PVF x Cash Flow Year 2

PVF x Cash Flow Year 3

PVF x Cash Flow Year 4

PVF x Cash Flow Year 5

Present Value Factor

0.91

0.83

0.75

0.68

0.62

Present value AU$

$ 80,080

$ 104,995

$ 113,850

    $123,868

$248,23

Present value Dong

  1,889,695,808  

   2,477,630,012  

  2,686,586,760  

   2,923,006,394

5,857,705,872

Net present value (NPV) of this project with initial investment of $5Million is $ (4,328,973.08). Decision criteria of NPV suggest that this project should be rejected because of negative NPV. Other data such as WACC, revenue and cost remained same over the life of project.  

Payback Period

Year

Cash Flow

 Cumulative Cash flow

0

($5,000,000)

($5,000,000)

1

$220,000.00

-4,780,000

2

$253,000.00

-4,527,000

3

$303,600.00

-4,223,400

4

$364,320.00

-3,859,080

5

$600,752.00

-3,258,328

Payback period of Vietnam project by TNA suggest that project should be declined due to higher payback period.

 Profitability Index:

Profitability index of this project is 0.1342 therefore, this project should be rejected. TNA management should straightforward reject this project under the suggestion of PI.

Profitability Index =Present Values of Cash Inflows / Initial Investment

= $ 671,026.92 / $5,000,000.00

= 0.1342

Based on detailed and critical investment appraisal techniques NPV, Payback Period and Profitability index, it is suggested to management of TNA to reject this project because this takeover does not represent good investment. Even 50% decrease in initial investment, does not represent good investment. Summary of decision under both investments of $10 M and $5 Million is given in table below.

Investment appraisal technique

acceptance criteria

Project result

Decision

NPV

NPV > 0

NPV < 0

Reject

Payback period (PP)

PP < life of project

PP > Life of Project

Reject

Profitability Index

PI > 1

PI < 1

Reject

Investment appraisal technique

acceptance criteria

Project result

Decision

NPV

NPV > 0

NPV < 0

Reject

Payback period (PP)

PP < life of project

PP > Life of Project

Reject

Profitability Index

PI > 1

PI < 1

Reject

Globalization has increased the doors for international market but still there many issues in international market. If whole production is operating in Australia then there will be benefits of inflation, exchange rate, tax, revenue, cost and other macro economic factors. If TNA invest in an Australian firm then there will be benefit of low inflation. Inflation is higher in Vietnam by 4% that significantly impacts on the free cash flows. Inflation may significantly change over life of project that may decrease expected cash flows in future.

If whole production will operate in Australia then there will be stability in cash flows. Another benefit of production in Australia is difference in exchange rate risk. Exchange rate risk rapidly changes over the small span of time and global investment can decrease significantly (Obstfeld & Rogoff, 2005). If AU$ decrease in comparison to VND then value of cash inflows will significantly decrease. Tax also significantly differs from country to country which also add benefits to operating cash flows if production takes place in Australia. If production takes place in Australia there will be more revenue as compared to Vietnam. Increase in revenue will increase operating cash flows and net present value.

Due to inflation, cost of revenue is also higher in Vietnam. Macro economic factors significantly impact on global investment. If TNA produces products in Australia instead of Vietnam it will benefits from local macroeconomic factors. Changes in political situation in foreign countries also impact on revenue and cash flows. In other words, if production is planned in Australia then there will more benefits and cash flows as compared to Vietnam.   

References 

Baker, M. and Wurgler, J., 2004. Appearing and disappearing dividends: The link to catering incentives. Journal of Financial Economics, 73(2), pp.271-288. Data retrieved from https://archive.nyu.edu/jspui/bitstream/2451/27221/2/wpa03023.pdf

Beck, T., Levine, R. and Loayza, N., 2000. Finance and the Sources of Growth. Journal of financial economics, 58(1), pp.261-300. Data retrieved from  https://www.researchgate.net/profile/Ross_Levine/publication/46432835_Finance_and_The_Sources_of_Growth/links/53f345d20cf2da8797445dd7/Finance-and-The-Sources-of-Growth.pdf

Carpenter, R. E., & Petersen, B. C. (2002). Capital market imperfections, high?tech investment, and new equity financing. The Economic Journal, 112(477), F54-F72. Data retrieved from https://ecoxs02.eco.unipmn.it/eventi/innovarepercompetere/carpenter-petersen-cm.pdf

 Carpenter, R.E. and Petersen, B.C., 2002. Is the growth of small firms constrained by internal finance?. Review of Economics and statistics, 84(2), pp.298-309. Data retrieved from https://ecoxs02.eco.unipmn.it/eventi/innovarepercompetere/carpenter-petersen-gsmf.pdf

Chowdhury, A.A., Bertling, L. and Custer, D.E., 2006, June. Determining distribution substation transformer optimal loadings using a reliability cost-benefit approach. In Probabilistic Methods Applied to Power Systems, 2006. PMAPS 2006. International Conference on (pp. 1-9). IEEE. Data retrieved from https://scholarsmine.mst.edu/cgi/viewcontent.cgi?article=1703&context=ele_comeng_facwork

Dahiya, S., John, K., Puri, M. and Ram??rez, G., 2003. Debtor-in-possession financing and bankruptcy

resolution: Empirical evidence. Journal of Financial Economics, 69(1), pp.259-280. Data retrieved from https://www.researchgate.net/profile/Gabriel_Ramirez9/publication/4978660_Debtor-in-Possession_Financing_and_Bankruptcy_Resolution_Empirical_Evidence/links/02e7e519e08a8f371c000000.pdf

Guariglia, A., Liu, X. and Song, L., 2011. Internal finance and growth: microeconometric evidence on Chinese firms. Journal of Development Economics, 96(1), pp.79-94. Data retrieved from https://www.econstor.eu/bitstream/10419/35627/1/584698879.pdf  

Jang, S.C., Morrison, A.M. and T O’Leary, J., 2002. Benefit segmentation of Japanese pleasure travelers to the USA and Canada: selecting target markets based on the profitability and risk of individual market segments. Tourism Management, 23(4), pp.367-378. Data retrieved from https://s3.amazonaws.com/academia.edu.documents/36968040/benefit.pdf?AWSAccessKeyId=AKIAIWOWYYGZ2Y53UL3A&Expires=1495876733&Signature=i1rx0RfxNyGup539%2BnkBENF4b54%3D&response-content-disposition=inline%3B%20filename%3DBenefit_segmentation_of_Japanese_pleasur.pdf

Kahraman, C., 2001. Capital budgeting techniques using discounted fuzzy cash flows. Soft Computing for Risk Evaluation and Management, pp.375-396. Data retrieved from https://www.researchgate.net/profile/Cengiz_Kahraman/publication/289655369_Capital_Budgeting_Techniques_Using_Discounted_Fuzzy_Cash_Flows/links/569495ee08ae3ad8e33b79cc/Capital-Budgeting-Techniques-Using-Discounted-Fuzzy-Cash-Flows.pdf

Obstfeld, M. and Rogoff, K.S., 2005. Global current account imbalances and exchange rate adjustments. Brookings papers on economic activity, 2005(1), pp.67-146. Data retrieved from https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.601.1324&rep=rep1&type=pdf

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