Plastipipes Ltd is a manufacturer of plastic pipes and fittings for plumbing. Considering the expansion of the European Community, the company is planning to increase it operations so as to meet increasing demand for plastic pipes in the European Single Market. The company is considering three expansion options including: setting up a new production facility in the UK or in another EU country or acquiring a new facility. The objective of this paper is to provide an analysis of the financial position of Plastipipes Ltd along with an evaluation of the alternative courses of action so as to determine the best option to consider and provide recommendations to the management. Having discussed the paper’s objectives, the paper will now continue with an analysis of Platipipes current financial position in section 2 below; section 3 follows with an evaluation of the alternative courses of action; and section 4 follows with some conclusions and recommendations.
- Analysis of the Financial Position of Plastipipes Ltd.
To analyse the financial performance of Plastipipes Ltd, this paper employs financial ratio analysis as the appropriate tool of analysis. The analysis is done by calculating profitability, liquidity and long-term solvency ratios and comparing them across time since it is a single company. Comparisons are also done by making reference to industry averages. Before moving on with the analysis of Plastipipes Ltd, it is necessary to provide a brief analysis of what ratio analysis is all about.
Table 1: Financial Ratios for Plastipipes Ltd.
|2007 Audited||2008 Audited||Budget 2009||To 30/9/08 Unaudited|
|Operating Profit Margin||9.96%||7.70%||11.97%||11.20%|
|Net Profit Margin||7.03%||5.61%||9.20%||11.07%|
|Return on Assets/Investment||12.27%||9.54%||15.15%||10.48%|
|Long-term Solvency Ratios|
|Fixed Charge Cover.||25.5||32||91||88|
The ratios are calculated based on the financial statements of Plastipipes Ltd. Looking at the profitability ratios, it can be observed that the company is in a good profitability position. One can observe a decline in actual performance in the profitability ratios over the period 2007 to 2008. For example, the profit margin declined from 9.96% in 2007 to 7.70%; net profit margin fell from 7.03% in 2007 to 5.61% in 2008, while the return on equity dropped from 12.27% to 9.54% over the same period. The profitability ratios calculated based on the unaudited accounts as at 30/09/08 show a higher profitability. The profitability ratios based on the budgeted accounts also show mark improvements. However, these are based on forward looking financial statements and should be considered with care. They are contingent upon the company meeting a lot of anticipated events which may not be met practice. The liquidity ratios also show that the company is doing well especially as far as the current ratio is concerned. Again the liquidity ratios based on the budgeted accounts indicate that the company is expecting to improve it liquidity in 2009. The quick ratio however, is below 1 for the actual results for 2007 and 2008. This shows that if the company fails to liquidate its stock it may find itself in a difficult position as far as meeting short-term financial obligations are concerned. The long-term solvency ratios show that the company is a high gearing company. That is, the company uses more debt in financing its long-term financial obligations than it uses equity. However, the budgeted accounts show that the company plans to reduce its gearing. This is evident from the lower total debt-to-equity ratio, as well as the lower long-term debt-to-equity ratio for the budgeted financial statements. Based on the analysis of Plastipipes Ltd, one can say that the company has a good profitability but it needs to improve on its liquidity and solvency.
- Evaluation of Alternative Courses of Action.
3.1 Analysis of the Investment in Ball Park
Table 2: Calculation of Expected Cash Inflows from Ball Park.
|Probability||Expected Value (£’000)||Expected Dividends (£’000)|
Table 2 above shows the expected cash inflows from investing in the ball Park project. The expected values for the profits are calculated by taking a probability weighted value for the low and high figures. The expected dividends are based on the fact that subsidiaries pay a dividend of 90% to parent companies. Therefore the expected inflows each year from the project as shown in column 7 in table 2 above. To determine whether investing in Ball Park is profitable, we will apply three analytical techniques including the Net Present Value (NPV), the Accounting Rate of Return (ARR) and the Payback period methods of evaluating investments.
- Net Present Value
The NPV of a project is calculated using the following formula (Ross et al., 1999; Myers and Brealey, 2002; Arnold, 2005):
C0represents initial investment;
C1, …, Cn represents the net cash flows at time t = 1, …, t = n; and
r is the discount rate or cost of capital.
Table 3: Calculation of Net Present Value of Ball Park
|Initial Fixed Asset investment||450|
|Working capital investment||250|
|Recovery of Working capital||250|
|Total Cash Flows||-700||153||206.1||241.2||316.8||423||790|
|Discount Factor @ 20%||1.000||0.833||0.694||0.579||0.482||0.402||0.335|
|Net Present Value (NPV)||298|
Table 3 above shows the calculation of the NPV of Ball Park. Note that all cash flows are in thousands of pounds. The calculation is done by discounting the expected dividends to be received from the project at the firm’s discount rate which is 20%. The initial investment is subtracted from the total figure to arrive at the net present value. The initial investment constitutes of fixed assets of £450,000 and working capital investment of £250,000. It should be noted that working capital invested at the beginning of the project is recovered or liquidated at the end of the project. Thus we add the working capital investment to the cash flow at the end of the project to get the total cash inflow for that year, which is 2013 in this case. We can observe that the NPV is positive. The decision rule for NPV is to accept all projects with a positive NPV. The NPV in this case is £298,000. Since the NPV is positive the project should be accepted on the basis of the NPV approach.
- Accounting Rate of Return
The Accounting rate of return (ARR) is calculated as the average annual profit divided by the initial investment. That is,
The company incurs no other cost in the course of the investment apart from the initial investment. Thus we can consider the dividends as the annual profits from the investment. Taking this into consideration, we can calculate the average annual profit as follows:
Average Annual Profit = = £355,000
Therefore, the ARR is given by:
ARR = = 50.7%.
The ARR is 50.7%, which is greater than the 14% required by the company. The higher the ARR the better for the company. Thus, the investment should be accepted based on the ARR investment appraisal technique.
- Payback Period
The payback period is defined as the time a project will take to pay back the money spent on it. The payback period is based on expected cash flows and serves as a measure of liquidity. When cash flows are constant, the payback period is relatively easy and straightforward to calculated. This is given by the following formula (ACCA, 2009; Ross et al., 1999; Myers and Brealey, 2002):
Payback period = (3)
The case at hand has uneven cash flows. Thus we use interpolation to calculate the cash flow. Going back to table 2 above, one can observe that the total cash inflows of £600,300 (153,000 + 206,100 + 241,200) are expected to be recovered in the first three years. This means that at the start of year 4 the unrecovered cost will equal the initial investment less the cost recovered during the first three years. This gives £99,700 (700,000 – 600,300). The cash flow during year 4 equals £316,800.
We calculate the payback period using the following formula
Payback period = 3 + Unrecovered cost at start of year of recovery
Cash flow during year
Therefore payback period = = 3.3 years.
Therefore the payback period is 3.3 years, which is less than the 4 years payback period required by the company. The shorter the payback period the higher is the liquidity of the investment. Therefore, since the payback period is only 3.3 years whereas the company requires a payback period of 4 years, the investment is highly liquid and therefore should be accepted based on the small payback period.
3.2 Analysis of the Investment in Plasextrude Gmbh
The investment in Plasextrude Gmbh is analysed by conducting a valuation of the company’s shares prior to the acquisition.
We employ the price-to-earnings ratio to value the company. The company had issued share capital amounting to €100,000 valued at €1 per share. Therefore, the number of shares outstanding stood at 100,000 shares. The company’s operating profit in 2008 amounted to €1,267,459. If we assume that depreciation of 2008 is charged at 25% of €76,000, earnings is given by €1,267,459 – €19,000 = €1,248,459. The earnings per share is given by
EPS = €1,248.459/100,000 = €12.5
The shareholders have indicated that they need a price of €8.50 per share. This means that the price to earnings ratio is expected to be
P/E ratio = Price/EPS = €8.50/12.5 = 0.68 times.
The price to earnings ratio is very low, indicating that investors are only willing to pay 0.68 euros per euro of current earnings. This means that the company is not expected to achieve superior growth. According to Penman (2007) the price-to-earnings ratios measures the amount that investors are willing to pay for future earnings of the company. A higher price-to-earnings ratio indicates that investors are willing to pay more per unit of future earnings and vice versa. Therefore the option to invest in Plasextrude is not likely going to be profitable.
- Conclusions and Recommendations.
Based on the foregoing analysis, one can conclude that Plastipipes Ltd is performing well as far as profitability is concerned. However, its liquidity and solvency are not very good. He company needs to adopt strategies to reduce its debt financing so as to avoid the possibility of facing financial and business risk. business risk comes as a result of increasing levels of fixed costs. When the company has too much short-term debt outstanding, its interest expense, and thus fixed cost is very high. This increases the risk that it may not meet these payments and thus reduces its liquidity. (Ross et al., 1999). Financial risk on the other hand comes as a result of too much long-term debt. when too much long-term debt is used, it increases the possibility that the company may not meet interest and principal repayments, especially in circumstances where the company does not make enough earnings. (Myers and Brealey, 2002). Therefore, Plastipipes Ltd should reconsider its solvency and liquidity position.
As far as the expansion options are concerned, the first option to invest in Ball Park is profitable. This is based on analysis using the NPV, the ARR and the Payback period. these analyses all suggest that the investment is going to be profitable as shown in section 2.1 above. Therefore, this paper recommends the investment in Ball Park. On the other hand, based on the low price-to-earnings ratio of the Plasextrude Gmbh, the investment in the company is not likely going to be profitable. Therefore Plastipipes Ltd should discard this option. The only option to consider should be the investment in Ball Park.
Arnold, G. (2005). Corporate Financial Management. 3rd Edition. Prentice Hall, Financial Times.
Myers, S. C. Brealey, R. A. (2002). Principles of Corporate Finance. 7th Edition McGraw-Hill.
Penman S. (2007) Financial Statement Analysis and Securities Valuation. 3rd Edition, McGraw-Hill.
Ross, S.A., Westerfield, R.W., Jaffe, J. (1999). Corporate Finance. 5th Edition. McGraw-Hill International Edition Finance Series.
British Computer Colleges (2009). “Payback period”. Available online at: http://www.britishcomputercolleges.com/numb3rs/payback_period.html