Capital Budgeting and Investment Appraisal: The Alpha plc - Assignment Example

Capital Budgeting and Investment Appraisal: The Alpha plc. 1. Introduction This paper seeks to help Alpha to decide whether it should acquire an open-cast coal mine in South Wales at a cost of £2.75 million. This paper consists of two parts. The first part will make recommendations to the company as to whether the project should go ahead with explanation as to the choice of the investment appraisal method as the most appropriate for evaluating investment projects. The second part will discuss the issues in investment appraisal, cost of capital, and risk in relation to investment appraisal made in the first part. 2. Analysis and Discussion 2.1. a.) Prepare calculation and make recommendation whether the project should go ahead as an external consultant to Alpha using the most appropriate investment appraisal method. State any assumptions made. The company should proceed with the acquisition because of the positive NPV of the proposal as generated using the cost of capital of 12% as discount rate. Calculations are summarized in Appendix A and some of the highlights that must be pointed here is the fact the depreciation must be added back to the net profit or loss in the computation of the net cash flows per year. The depreciation as presented in the case was apparently understated, as the breakdown does not add up to £13.75 million. This was corrected by doubling the amount of depreciation in Year 4 since the project will only last for four years. The depreciation amount then per year was added back for each applicable year since depreciation does represent cash inflow. Since there is also clearing cost to be used in at Year 5, the discounting included Year 5 in the Schedule. The salvage value £ 2.75 million is also included as part of cash inflow at end of Year 4. See Appendix A. The assumptions made for the use of NPV include those the time value of money and the reliability of the discount rate used in discounting the estimated cash flows. The use of cost of capital in net present value analysis assumes cash flow values to be discounted using the weighted average of cost of capital (WACC) as discount rate. The cash flow could either be cash inflows or cash outflows arising from the expected benefits of a certain proposal and costs and other cash outlays that are needed to have the either of the proposal. The concepts of cash flows and discounting the same are very much related to the concept of time value of money, which assumes that a £100 today has more value or is preferable than £100 in the future. To make therefore the values of cash from the inflow or outflow of cash resources comparable could be achieved towards bringing their present values by discounting the same using WACC as discount factor (Arnold 2004; Brigham and Houston, 2002). Discounting the free cash flows for Alpha as estimated by forecasting into the future using the cost of capital to bring the values into net present values would then indicate whether the option delivers that net advantage over the other. It could however happen that it is not acceptable because if it produces negative NPV which would imply giving a headache in terms of wasted resources to the decision maker. As it turned out however, the NPV was positive thus the project should be accepted. See Appendix A. 2.1.b. ) Explain why you consider the investment appraisal method selected in a) above to be the most appropriate for evaluating investment projects. The use of NPV as the most appropriate appraisal method to be used for evaluating investment projects because of the advantages of the method over other methods. The tools that could be used are the capital budgeting techniques including the net present value (NPV) method and internal rate of return (IRR), payback method (PB) and the accounting rate of return (ARR) method. The four methods could actually be divided into discounted cash flow (DCF) methods and non-DCF methods. NPV and IRR belong to the DCF while PB and ARR belong to non-DCF. Between DCF and non-DCF, this researcher prefers the first because it is more scientific and logical than the first. What makes it so is the use of the time value of money concept. The time value of money concept assumes that a hundred British pounds received today is different from that received in the future. Thus, the concept assumes that to compare those two values, the money in the future should be computed to bring the same to its present value. This therefore assumes as well a discount rate, which is normally assumed the cost of capital. Capital investment decisions argue for what will maximize wealth for the organization. Between acquiring and not acquiring, the proposed coal mine creates a choice on which one would maximize wealth for the company. Since not deciding to acquire presupposes alternative use of the resources, the competing option should be able to provide an advantage. Thus normally among competing options, the one with the highest NPV should be chosen, but since this case just ask whether the proposal should be accepted, the decision should be to accept if the resulting NPV after discounting the cash flow would generate a positive amount discounted at given cost of capital of 12%. 2.2 Making reference to appropriate theory, discuss the following areas in relation to your appraisal: (a) Issues in investment appraisal, (b) Cost of capital (c) Risk. 2.2.(a) Issues in investment appraisal The issues in investment appraisal include the political factors that may be involved in making the investment decision as well the possibility that other methods may have been used by the company in the past which may influenced the decision at present. The impact of non-financial factors and the political processes in decision making cannot be discounted. It is asserted quantitative appraisal of a project for many organization is just part of an organizational process that in many organizations political factors may be prevalent and thus would mean that decision makers are not necessarily governed by rational factors in decision making (Open University Course Team, n.d.). There are political decisions that must be considered including the reality the CEO may have some pet projects that must done. There are also some strategic considerations that will get into the process (Pearce, J. and Robinson, Jr. R. ,2004; Porter, 1980). Any of this would possibly reduce therefore the rationality of the decision process. Thus, the allocation of resources based on qualitative factors must be accepted as reality as when there is need to do a project because of mandatory or legal considerations. Another factor is the involvement of senior managers in the approval who expects that projects brought to them have positive NPVs or to other convincing arguments, otherwise, they would reject a project despite having positive NPV (Open University Course Team, n.d.). 2.2.(b) Cost of capital This issue is very important because its possible understatement or understatement will definitely change everything that was computed earlier. The cost of capital is normally determined using different models like the CAPM model and yet there are still authors who may point out to the limitation of the model in determining the cost of capital. The cost of capital varies for each company as each company sources its capital requirements from different sources and by using different ways of financing. Since cost of capital is weighted – that is the share of long—term debt and equity, a decision to minimize the same is apparently a decision to be made. Generally it is argued that cost of equity is higher than cost of debt (Van Horne, 19920. This is based on premised that payments for interest expenses for debts are tax deductible and while payment for dividends are not (Higgins, 2007; Bodie, Kane and Marcus, 2007)). This would encourage therefore companies to borrow from creditors as a way to finance their capital as this would cause the company to minimize their cost of capital or maximize their wealth maximization objective at a certain point. There is maximum point to borrow however, as the higher the debt, the higher financial leverage would be created and this makes company or a risky to invest with. A typical situation happens when there is sudden slowdown in demand and targeted revenues are not realized. This would create a situation where the company would not be able to pay its debts and this would cause creditors to ask to payments earlier than expected due to acceleration clauses in some of the debt agreements. If nothing can be done to prevent further deterioration from a crisis, the company could go bankrupt and the business may closes leaving other stakeholders with lost values of their investments. Cost of capital is also influenced therefore by macroeconomic variables (Samuelson and Nordhaus; Slavin, 1996). If the inflation gets higher, the government through central monetary boards increase interest rate and this would increase the cost of doing business for many organizations. This would therefore cause companies to react and adjust their discount rates in the decision that they would make. The more uncertain the future, the higher could the cost of capital for companies. 2.2.(c) Risk In finance, risk goes with return. Thus, it is said that there is trade-off between risk and return. So that the higher the risk, the higher would be the return of a proposed investment. An investor cannot accept an investment that is too risky because that would be putting his or her money at a very dangerous situation that loss becomes more probable. An investor or a decision maker in a capital investment project would try to minimize the risk in investment and that is the point where the most realistic rate of return is maximized. That point in therefore mathematically represented by the cost of capital that is used in discounting the cash flows of a project. The CAPM model assumes that that there is such a thing as risk-free rate and this could be approximated by treasury bonds where the government is the creditor (Brigham and Houston, 2002). However, investors desire to have returns than the risk-free rate so choose investment options like capital investment project where they could maximize their return while being able to accept the higher risk as represented by the volatility of the market. Risk, in capital investment projects, can relate to volatility of the return as the life of project extends to the future and a result of uncertainties in the macroeconomic variables. As Alpha in this case views that future cash flows may be worthless by way of inflation than the current cash that the investment project may for some reason, fail to meet payment expectations including the changes in the interest rates as a barometer to measure the general cost of the borrowing funds to invest, it has decided to use 12% cost of capital to discount the cash flows. Companies source their funds for investment from long-term debt and equity thus the cost of capital is normally based on weighted cost of capital 3. Conclusion It appears from the NPV analysis of proposed acquisition that it is justified by generating positive NPV for the projects. NPV method is most logical and scientific among other methods. It partly resolved some the issues in investment appraisals and applies time value of money for being the most rational but decision-makers do not necessarily decide based on rationality alone. However there other factors that must be considered in effecting the acquisition decision including the political factors and how will senior managers approved the proposal. This it is in the light of the reality that the company may have been using other methods, which it may deem convenient still for this project proposal. The use of NPV was also found to be the most scientifically acceptable to the company in terms of meeting its objectives of maximizing the wealth of shareholders as compared with other capital budgeting techniques. The use discounted rate of return using the cost of capital of 12% is assumed correct cost for Alpha in making the investment. The same cost of capital should balance the risks the company expects to have when it will accept the proposal as recommended in this paper. Appendix A – NPV Computation of the Proposal as computed using MS Excel. References: Arnold, Glen (2004). The Financial Times Guide To Investing: The Definitive Companion to Investment and the Financial Markets. London: FT Prentice Hall Bodie, Kane and Marcus (2007). Essentials of Investments, Sixth Edition, The McGraw−Hill Companies Brigham, E. and Houston, J. (2002). Fundamentals of Financial Management, London: Thomson South-Western Case Study - Capital Budgeting and Investment Appraisal: The Alpha plc. Case Higgins (2007). Analysis for Financial Management, Eighth Edition. The McGraw−Hill Companies Open University Course Team (n.d.). Decision making. Open University Worldwide Ltd Pearce, J. and Robinson, Jr. R. (2004). Strategic Management. Ninth Edition. New York: McGraw-Hill Porter (1980). Competitive Strategy. London: Free Press Samuelson, P. and Nordhaus, W. (1992). Economics, London: McGraw-Hill, Inc Slavin, S. (1996). Economics. Fourth Edition. London: IRWIN Van Horne, J.C. (1992). Financial Management Policy. London: Prentice-Hall, Inc Read More