One of the major indicators and measurements of enterprise growth is an expansion of its business operations. Expansion can be undertaken either through acquisition, launching of a new product line or establishment of capital projects related to the operations of the entity. For the present case study of LEGO Plc., the expansion plan which the company is considering undertaking is being analyzed and evaluated. LEGO Plc. is considering investing in a capital project of software as the presented software of LEGO Plc has become obsolete and outdated. Two of the projects are assessed and a project is chosen for the organization. LEGO Plc. is also considering the acquisition of an existing company. For the purpose of the same, two companies for potential investors are being scanned and looked over for selecting the better option for investment.
Sources of funds for LEGO Plc and their advantages and disadvantages
The sources of funds can be internal and external:
Share capital LEGO Plc. can raise funds through the issue of share capital. The shares can be equity and preference shares. The equity shares are issued to owners of the company (Detzer and et.al., 2017). Preference shareholders have a fixed percentage of dividend irrespective of the earnings of a business.
- Helps business in raising long term capital
- The funds are committed to the business and are the equity of owners.
- The owners will no longer have control over operational activities of LEGO Plc.
- The legal regulation is very lengthy and cumbersome when raising for raising capital.
LEGO plc can also use retained earnings as they have direct impact on the number of dividends. This is the profit which is invested as retained earnings otherwise would have been distributed as dividends.
- Readily available source with business
- No legal and procedural requirements are needed to be fulfilled
- Funds are related to shareholders and so, business shall restrict self-financing.
- No over generous dividend and salaries to shareholder and directors respectively.
Debentures are form of loan stock and this is a debt incurred by LEGO Plc. containing a provision for payment of interest at a certain rate and repayment of capital.
- No participation in the voting in business issues.
- A fixed percentage of return is guaranteed.
- A cost stamp duty and cost is incurred for raising capital.
- Changes in earning can become fatal for the business.
The borrowings can be short term as-overdrafts, medium-term as loans for a period of 3-10 years, and long-term in form of loans for a period of over 10 years (Advantages & Disadvantages of Different Sources of Finance, 2018). LEGO plc can borrow funds according to the time duration of projects.
- Petty funds can be raised in short time without many formalities.
- One's loan is repaid no obligation on business and does not include any possession of ownerships.
- For overdraft the interest rate is variable which can lead to more payment of interest.
- With no substantial record of earlier repayment of its difficult to obtain loans.
LEGO plc is considering to undertake a capital project and acquisition of a business unit as well. For the capital project, it can use the retained earnings of the business and it can also borrow a short-term loan for the capital project. For the purpose of acquisition, LEGO plc can raise funds from issuing equity shares as it do not-involve a fix payment of dividend. The business can also raise long term loan (Anzoategui and et.al., 2016). It is recommended to LEGO Plc to use retained earnings for capital project and issue equity share capital for acquisition as loan will require a payment of interest to bank.
Analysis of investment proposal
The given project have a life of 5 years and an initial investment of 15900 worth a working capital availability of 900. so the initial fund require for investment is 15000. the discounting rate for these project is 15%. After all the adjustments in working capital, overheads, components, salary of two technology officers, depreciation, capital allowance and taxation the total cash flow from the project comes out to be 11112.26 which is less than the initial fund requirement of 15900, hence gives a negative NPV of 4787.74. The IRR for the project is .9%, which is very low then the actual rate of discounting.
This project also have a life span of 5 years with an initial fund requirement of 8500. the working capital available with the firm for this project is 2100, which reduced the capital requirement for project to 6400. The discounting rate for this project is given 18%. With all given adjustment in working capital, overheads and components, and considering the salary of one technology officer the total present value of cash flow at discounted rate is 8777.89. and with the initial investment of 8500 the NVP of this project comes out to be 277.89. the projects give a positive NPV because only one technology officer is appointed on the project which reduced the expense related to the project. The IRR of LEGO Platform is 19.73%, which is higher than the discounted rate of cash flow.
The criteria for project selection under NPV method of capital budgeting is a positive NPV. The project LEGO platform is giving a Positive NPV of 277.89 as compared to LEGO super which gives a negative NPV of 4787.74. One of the major reason for this difference is the initial cost of the projects. The different between the initial cost of LEGO super and LEGO Platform is 7400 which is a huge gap. Another reason is availability of the working capital with the firm at for the year in which the project needs investment (Freeman, 2016). The gap at the 0 year in the working capital available with the business is 1200. For the project LEGO Super two technology officers are being appointed whereas for LEGO Platform only one officer is appointed the salary difference of one officers have an impact on the expenses related to the project and reduces the expense liability of LEGO Platform. All these factor together leads to giving a positive NPV to LEGO Platform. Hence, it is recommended to LEGO Plc to select the project LEGO Platform which is a profitable project.
Other technique LEGO can use and its limitations:
Another technique used for this evaluation is IRR, this is a technique that estimates the profitability of a potential investment. LEGO Super gives a IRR of .9% and LEGO platform gives a IRR of 19.73%. On the basis of this technique also LEGO platform shall be selected.
- It can give conflicting answer for mutually exclusive projects.
- It can contradict with results given by NPV method.
Management tools – Break even analysis and Budgets
Break even analysis: this is an analysis which is carried out for the determination of the point, where the revenues and the expenses incurred for generating such gains become equal. LEGO Plc shall determine the point where income and expense are equal and this is the point where the firm makes its first step towards profitability (McGee, 2015). This analysis is important for project evaluation. The project with a lower break-even point shall be selected as that would yield profits at an earlier time and stage.
Budgets: The future income and expense are forecasted in budgets for a particular time frame. The budges are compared with actual performances and the degree of deviation is seen for taking corrective and controlling measures. The capital budgets are prepared to make a blue print of investment in capital projects. These budgets determine the profitability and long-term investment related to the projects.
Evaluation of target Companies
Pauteaux digital France-
The sales revenue of the business has increased from 10406 to 12516 which is 2110. With an increment in sales, the gross and net profit of business have also increased. The increment in administrative cost is not proportionate to sales revenue which indicates the cost control by Pauteaux digital. The increment in net profit is 737. The liquidity position of Pauteaux digital can be affected as there is a fall in non-current assets of the business from 8658 to 6450 (Internal rate of return, 2018). The amount due to creditors has reduced from 2184 to 1693 which indicates that company is going towards a less credit policy. Company owns a share capital of 500 with a share premium and retained earnings of 7400 and 10 respectively.
Melia portfolio Research, Spain-
There is a huge increment in the sales revenue of the business of 6981. This will lead the business towards higher profits but the operational cost of the business is more than its sales revenue which haven't reduced yet. Still, there is a proportioned reduction in the administration cost as compared to sales revenues. The loss amount of firm have also reduced but it haven't reached in profitability situation. The non-current assets have increased by 2897 over past three years. The current assets have seen a growth from 5724 to 7252 from 2016 to 2018. The amount of creditors of the organisation have also increased by 7583 which is not a good sing in long term situation. This indicated that purchases are made on credit and company is facing a situation of lack of cash and liquid funds. With no share premium and retained earnings the share capital of the Melia is 450.
The sales revenue of Melia have shown more growth in comparison with Pauteaux, the sales revenue of Pauteaux have increased by 2110 while the increase in sales of Melia was 6981. With an increase in sales, Melia is still not able to operate at profits. The creditor in Melia have increased while for Pauteaux there is a decrease. When compared between both the companies, Melia only have a paid up share capital of 450 while Pauteaux have a share premium of 7400 and retained earnings of 10. It is recommended to LEGO Plc that it shall acquire Pauteaux, as this company is operating at profit which indicates that it has achieved break-even point. It can also use the retained earnings for investment in capital project. With the acquisition of Pauteaux it generate more profits which will enhanced its sales revenue. Therefore, LEGO Plc shall acquire Pauteaux for long term benefits and profitability.
Investment appraisal analysis and budgets:
As per Detzer and et.al., (2017), with the investment appraisal planning tool a business can determine that whether the long term investment of the business are worth funding through the capital structure of the company. The long term investment of a business are related to acquisition or replacement new plant or machinery or product/ s. The objective of a business is to enhance the business value for its stakeholder which is done through capital budgeting investment. However, Freeman, (2016) says that, investment appraisal allows changes in assumption used in forecast which makes it a sensitive analysis. With a change in the assumption the degree of risk involved also gets changes which sometime can be good or may get worse.
Anzoategui and et.al., (2016), stated that in a business the revenues and expenses are forecasted through the budgets. The budgets tell the prospective incomes a business must earn and expected cost and expenses irt shall incur to generate such profits. The budgets are prepared to guide the business towards better profitability. The budgets basically sets targets for a business unit each it shall achieve. As fas as Chittenden, and Derregia, (2015), is concerned, erstwhile budgets can be present unrealistic figure which can not be linked with the reality. They are sometimes based on pure assumptions. The facts and information used to prepare budgets can also change with changes in national economy and market conditions.
Break even analysis:
According to (de Andrés, de Fuente and San Martín, (2015), break even tool assist a business to determine the point where the cost incurred on business operation is equal to revenues generated by it. This is a point where profit and loss both are Zero. A condition of no profits and no loss for the business. A brake even analysis fir an organisation is carried out to exactly determine the income which a firm must earn in order to meet its essential business expenses. But McGee, (2015), pointed out that break even analysis does not evaluate the impact of different price level on the demand. The sales prices of the Product is assumed to be constant at all level of output which is not a realistic approach.
Andor, G., Mohanty, and Toth, (2015), stated that, this tool describes the relationship of fixed and variable cost with returns. This helps a business to anticipate the impact of sales price changes. The mangers can also foresee effects of cost and efficiency alteration on the profitability of business. As per Calabrò, F., (2017), break even analysis can sometimes lead to mislead the managers at it take many assumptions to reach the break even point, the assumption are related to sales quantum and price of product or services. With all the assumptions the implication of this analysis in actual scenario have lesser possibilities and managers can not rely on this assumption based analysis.
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Issues to be considered by LEGO on the two projects
- Effects of leverages: The discounted rate and cash flows must match up with the group of investors. With the discounted rate as cost of equity the cash flow shall be of equity investors and with discounted rate as cost of capital the cash flows shall be of firm.
- Effects of taxation: The investment shall be analysed in after tax terms. Tax shield must be credited to a project when the losses are set off against the profits of project.
- Inflation: Cash flows and discounted rates used shall either be in real terms or nominal terms. In relation to expected or adjusted inflation. A strategy shall also be prepared by the managers of LEGO plc to deal with hyperinflation and after stock price inflation.
- Cash flows must be incremental: Incremental cash flows shall be considered as they include direct or indirect consequences on the project. Sunk cost shall not be charged as they are not recoverable. Opportunity cost is considered as it is the cost of resources used in project that are already owned by the LEGO Plc.
The management of LEGO Plc shall consider all the above-mentioned point while considering a project as this will assist the management to reach a real and factual analysis of both the project. the project selected after considering all the above points by LEGO Plc is LEGO Platform.
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In the above report LEGO plc advises to raise the funds either through the issue of equity share capital or raise a capital loan for the acquisition and use the retained earnings available with it for investment in capital project. The company must invest in the project LEGO Platform. It is recommended to LEGO Plc to acquire Pauteaux with higher returns and stable liquidity and having retained earnings as this can be beneficial for the business. The managers are also presented with the issues that it shall take into consideration while analyzing the projects and for a better selection decision.