This paper is a report to Mr. Kelvin explaining different problems that are faced by the organization, and their solution. The success and survival of any company depend on its different decisions including various investment decisions. The investment decision has to be taken after a deep analysis of different factors like internal rate of return, net present value, payback period…etc. The paper analyses the proposed decision of the company to buy a tour vehicle costing £20,000. The cost and benefits of the proposed decision are analyzed. Also, issues related to the new plan of tying up with the local agent are discussed.
Herewego Travel is a tourism company in Britain which was established in 2003 by Mr. Kelvin. The company is engaged in tour activities, which is mainly a seasonal business. The company’s main assets are its three vehicles which have helped the company to reach to present position. The human resource in the company includes three tour guide drivers and an administrative person. The tour package is as follows: The Company, along with the clients, decides the route, accommodation, etc of the tour. The bill is according to the nature of service and the average price is £400 per tour per day. The driver’s payment is £150 per day and the number of working days differs in each month. In case of surplus booking, the company uses the service of a local travel business with which the company has an association. In such cases, the company has to pay all the income to the local service.
A report on Investment decision To Mr. Kelvin.
The investment decision is an important task in any organization which influences the growth, profitability, and risk of a firm in the future. Investment decisions are influenced by different factors like sales forecasting, profitability forecasting, cost of capital, time series analysis, net present value, internal rate of return and payback period…etc Forecasting of Sales and Profitability:
Sales and profitability forecasting are very important tools for management. These tools play a very important role in the decision-making of an organization. Sales forecasting refers to predicting or foreseeing future sales. Sales forecasting is one of the challenging and difficult tasks of management. Some specialized skills are required for sales forecasts. Sales forecasting helps in taking various decisions related to the marketing mix. With the help of sales forecasting future profitability can also be forecasted. There are two types of sales forecasting. They are macro forecasting and micro forecasting. Total forecasting of the market is called macro forecasting and unit-wise forecasting is called micro forecasting.
Advantages of forecasting
Sales forecasting can offer lots of advantages to the organization. Some of the advantages are, it helps to find out the sales trend and helps in finding out the value of the business.
Improvement in the cash flow: Sales forecasting helps in improving the cash flow of the company. The reason is that based on the forecasted data of sales, the cash flow can be profitably planned.
Helps in the purchase decision: Forecasting helps in making purchase decisions in such a way that, the future purchase requirement can be identifies based on looking at the forecasted sales data.
Helps to understand customers well: The trend and interest of the customers can be easily understood from the forecasted sales data.
Assist in planning future operations: The future operations of the organization can be planned according to the forecasted sales. The company can plan various investment decisions to be taken.
Tool for finding out the future value of a business: Sales forecasting acts as a tool for finding out the value of the business as future sales form the main part of the total value of the business. (How do I: forecast sales and profitability n.d.).
Time series is a set of statistical observations arranged in chronological order. Mathematically a time series is defined by values y1, y2, y3, etc of a variable y at time t1, t2, t3, etc. Thus, y is a function of t. Symbolically it can be written as follows: y = f (t)
Time series is usually used with reference to economic data and economists are largely responsible for the development of the time series model. The effects of various forces in time series are given in four broadheads or data under time series has the following components:
- secular trend;
- seasonal trend;
- cyclical trend;
- irregular trend.
The secular trend can be a general long-term pattern due to the general tendency of data. Seasonality shows the cyclical variations on either a regular or predictable basis due to the change in climate, festival, etc which is of fixed frequency. A cycle is the same as seasonality but without a fixed frequency. Booms and depressions are examples of the cycle. Irregular or random refers to the variations that cannot be predicted like flood, earthquake, etc.
Advantages of time series analysis
Time series helps in understanding the fast behavior of data.
It helps in planning the future operations of the business.
Evaluation of the current data can be done which also can be used for comparison.
Time series analysis; an effective tool for sales forecasting:
There are different methods for forecasting sales. An organization has different options for doing sales forecasts. Some of them are the time series model, buyer intention, judgment, salesforce opinion, and experts. Among these different options, time series analysis is the commonly used and most reliable option.
Models of economic time series
Forecasting of a basic economic time series can be done in two ways: multiplicative model and additive model.
The data at time t may be represented as the product of the four components in the multiplicative model. The equation is as follows: Yt = Tt Ct St Rt
In the additive model, the data at time t is represented as the sum of four components. The equation is as follows: Yt = Tt + Ct + St + Rt. (Polhemus 2005).
Forecasting and decision making
Forecasting has a very important role in making various decisions like purchase decisions, additional capital raising decisions…etc. While making such decisions different factors like cost of capital, internal rate of return (IRR), profitability index and payback period…etc should be considered.
Cost of capital: Cost of capital is defined as “the opportunity cost of the funds employed as the result of an investment decision; the rate of return that a business could earn if it chose another investment with equivalent risk.” (Noun: cost of capital n.d.).
While making an investment decision the cost of capital is analyzed and is compared with the expected return. Here, in this case, the company is making the decision whether the company should buy the new vehicle or hire it. The cost of capital is 10% and it should be compared with the internal rate of return and payback period.
Internal rate of return (IRR):
IRR is also known as the Yield method, Trial and Error Method, Marginal efficiency of capital, etc. IRR is a modern technique of capital budgeting that takes into account the magnitude and timing of cash flows. IRR means that the rate of interest which equates the present value of future expected cash inflows, to the present value of cash outflows or cost of investment.
Net present Value (NPV)
This is generally considered to be the best method for evaluating the capital investment proposal. Under this method, cash inflows and cash outflows associated with each project are worked out. The present value of cash inflows and outflows is then calculated at the rate of return acceptable to the management. The rate of return is considered the cut-rate and is generally determined on the basis of the cost of capital. NPV is calculated as the sum of the present value cash inflow minus the sum of the present value of cash outflows. The steps involved in the calculation of NPV are as follows.
- Determination of an appropriate rate of interest to discount the forecasted cash flows.
- Computation of the present value of cash flows by using the discount factor selected.
- Calculation of NPV by subtracting initial capital outlay and commitments at various points of time from the present value of cash inflows.
- Net present value is the difference between the total present value of future cash inflow and the total present value of cash outflows.
It is the number of years required to get back the initial investment. A lower payback period is good with regard to an investment. Therefore, when comparing the payback period of two or more projects, a project with a lesser payback period is considered and in most of the cases, they are selected.
Profitability Index (PI)
It is another important method used to evaluate two or more projects. It is the relative profitability. Here the present value of cash is compared with the initial cost of an investment. Generally, the project which has the highest profitability index is selected.
As the company expects an increase in booking in 2009 and the coming years, the company decides to purchase a tour vehicle costing £20,000. Comparing the cost and benefit, the company has to decide whether to purchase the new vehicle or not. The main issues in the case can be summarized as follows
- Analyze the present situation and decide whether to expand business or not, based on the forecasted sales and profitability in the coming years.
- The company has to make a decision whether to purchase a new vehicle or rent the local service, based on internal rate of return, profitability index, and payback method.
- Another issue is regarding the booking through the local travel agents where the local tour agent charges according to the local rate of the currency.
It is assumed that the inflation rate is 7% as in most of the countries average inflation rate is 7% in almost the countries.
Forward contract and reduction of FX risk
A forward contract can reduce the risk of fluctuations in the currency. A forward contract can be defined as 7155(Forward contract 2009).
In other words, in future contact, the price of the commodity is determined at the time of the contact, but the actual delivery of the commodity is made on a future date. The benefit is that both the seller and buyer of the commodity can reduce the risk of a hike or reduction in the currency rate. “Hedging Foreign Exchange Risk To control for the risk of exchange rate fluctuation, a forward contract for currency can be purchased.”
(Foreign currency transactions- presentation transcript 2009). Hedging helps to reduce the risk of currency variations.
Question1: Forecasted Sales and profitability for 2009, 2010 and 2011
For calculating the sales, the linear trend is used because of the following reasons:
It is simple to calculate.
Actual sales Variances could be identified easily from the forecasted sales
Calculation of linear trend during 2009 using the following equation
Y = a + bx
Where a = Σy/n and b=Σxy/Σxx, n=number of months
Table showing the calculation of seasonal linear trend
- Insert Graph 1.
In the graph, series 1 shows the trend line during 2009. Series 2 shows the actual trend. From the graph, it is seen that the actual trend has a great variation from the trend line. During the tour season, the actual business is above the trend line i.e. from March to the centre of September. The business during January to March and October to December is below the trend line.
a) Forecasted sales trend for 2009, 2010 and 2011
For this, the number of workdays for each worker is added to get the sales from 2005 to 2008. The actual days and booked days of 2009 is added and is considered as the sales for 2009.
- Insert Graph 2
From analyzing the previous business, it is seen that the actual sales and trend line go in hand. Only minor fluctuations can be seen in the seasonal trend of business. In addition, we can see that in 2008, the actual sales have crossed the trend line and the sales from 2009 onwards can be considered as increasing.
b) Profitability estimate during 2009, 2010, and 2011:
Let, the tour days of 2009, 2010, 2011 be taken as 672, 817, and 962 respectively, which are calculated from the linear trend equation. The estimated costs given are as follows:
Charges per day to client – £400
Cost of driver per day – £150
Cost of Fuel per day per vehicle – £ 40
Driver’s expenses per day – £ 35
Average miles travelled per day 250 and the vehicle maintenance cost is £200 per 10,000 miles.
Based on the following assumptions, profitability of the company is calculated:
The number of vehicle is taken as three in the three years.
Let depreciation amount be £20000 on straight line basis Corporation Taxation on Profits over £10,000 is 20% and is not considered.
Other cost during 2009, 2010 and 2011 is taken as £37000, £40500 and £45000.
From the forecasted sales and profitability, we can see that even though there is an increase in sales, we cannot see corresponding increase in profit. It may be noted that the 50% increase in all cost due to the expansion of business, has led to the decrease in profit. Therefore, it is suggested that the company can expand its business by reducing the cost and increasing the charge per client. There should be a control in the cost of driver and marketing cost during the expansion of business.
Question 2: Whether Herewego should purchase an additional vehicle, or consider renting at a cost of £500 per week?
The cost of capital is taken as 10% and inflation rate is taken as 7%
Calculation of Internal Rate of Return
Factor of internal rate of return = Investment required / Net annual cash inflow
Net Present value of the investment.
Calculation of net present value
We may calculate under the following assumption that, the project cost is £20000. If the number of client increases, then the incoming cash flows for three years can be considered as £15000, £10000 and £5000. Then net present value can be calculated using the following equation:
Where Co is the initial investment and Ct is the cash inflows for a time period of t. NPV = (14010*.909 + 8730*.826 + 4080*.751) – 20000
= 23009 – 20000
When considering the net cash inflow over the three years and net cash outflow, we can see that present value of cash inflow of £23009 is higher than the initial cash outflow which is £20000.
Profitability index of Investment
Profitability index = Present Value of cash inflows/Initial cash outlay
Profitability Index = £23009/£20000
Profitability Index = 1.15
Payback period if the company invests in new vehicle
Calculation of payback:
Payback period = Investment required / Net annual cash inflow
The cash inflow for three years can be £14010, 8730, 4080. Then payback period will be 1.6 years if the company purchases new vehicle. The company can recover its investment within 1.6 years.
Renting the service of a local travel business with a cost of £500 per week
Considering the tour days of 2009, 2010, 2011 as 672, 817, and 962 respectively, then the cost of renting the service for 96, 117 and 137 weeks during 2009, 2010 and 2011 will be as follows:
In 2009 the cost will be 96 * 500 = £48,000
In 2010, the cost will be 117*500 = £58,500
In 2011, the cost will be 137*500 = £68,500
Comparing the investment decision of purchasing a vehicle with an initial investment of £20,000 and cost of capital as 10%, and inflation rate at 7% then
The internal rate of return = 20%,
Profitability index = 1.15%
Payback period = 1.6 years
Net Present Value = £3009.
The company has two options: one is to purchase a new vehicle costing £20000 and another is to rent the local service costing £500 per week. The cost of renting the service of a local travel business is increasing year by year. By analysing the two options we can see that all the three investment criteria show that investment in new vehicle is profitable to the company rather than renting the local tour service. In case of IRR, the same is higher than the cost of capital. Therefore, it is recommended that the company can invest in its new project.
Question 3: How Herewego can handle its potential foreign currency exposure?
The pound sterling has been devalued during the summer. In the case of clients in US, they prefer tour booking with local travel agents in US in which they pay the cost to them. From this, the local travel agents take their commission and the rest is paid to the company at the spot rate of local currency. The company then has to convert the local currency into the currency of the home country. The travel agents charge about £500 from the clients in US dollars. There arises a foreign exchange risk. Foreign exchange risk can be defined as “the risk of an investment’s value changing due to changes in currency exchange rates.” (Foreign – exchange risk 2009).
To reduce this transaction exposure risk, the company can enter into a forward contract with the local agency at a forward rate.
“One of the challenges in any business is to make investments that consistently yield rate of return to shareholders in excess of the cost of financing those projects and better than the competition.” (Pike & Neale 2006, p.4). The investment decision of an organisation is influenced by different factors like net present value, internal rate of return, pay back period…etc. If an organisation makes proper analysis of investment opportunities using these tools it can ensure a good and adequate return on the investment. A company which has transactions in foreign currencies should be well aware of the exchange differences, so that it can avoid loss that may arise due to currency fluctuations.
- Foreign – exchange risk: what does foreign exchange risk mean 2009. Investopedia: a Forbes Digital Company. Web.
- How do I: forecast sales and profitability n.d., Scot Land of Food & Drink.
- Noun: cost of capital n.d., Word Net Search -3.0, 2009.
- Polhemus, NW 2005, How to: forecast seasonal time series data using statgraphics centurion, 2009.
- Pike, PR & Neale, B 2006, Corporate finance and investment: Decision & strategies: introduction, 5th edition, Amazon. Web.
- Foreign currency transactions- presentation transcript. 2009. Slideshare. Web.
- Forward contract. 2009. Investopedia: A Forbes digital Company. Web.