Capital Budgeting and Investment Appraisal: The Alpha Plc - Coursework Example

Capital Budgeting and Investment Appraisal: The Alpha plc. Case Part a) Data: Initial Net Investment (Cash Outflow) Alpha plc. Will be purchasing an open cast-coal mine in South Wales at a cost of £2.75 million from the British Government. The company will be acquiring vehicles and equipment which will cost £13.75 million The project will require investment in Working Capital of £0.55 million. Cash Outflows   Cost of Equipment (13.75) Changes in Working Capital (0.55) Cost of Coal Mine (2.75) Total Cash Outflow (17.05) Cash flows for each period: Cash flow forecasts have been prepared using the information provided in the case. To compute the cash flows we will be using a direct method to exclude all the non cash expenditures from our calculations. The project will require an investment of £0.55 million of working capital from the beginning of the project until the end of the useful life of the mine. The project will recover the working capital at the end of the fourth year. One-third of the head office expenses consist of amounts directly incurred in managing the new project The company’s surveyors have spent the last three months examining the potential of the mine and have incurred costs to date of £0.22 million. Since these costs are of no more benefit to the project stakeholders therefore they will also be classified as sunk costs and we will deduct them from the survey costs of year 1. These assets can be sold for £2.75 million in the fourth year which is the salvage value. After the mine has been exhausted, the company will be required to clean up the site and to make good the damage to the environment resulting from its mining operations. The company will incur costs of £0.44 million in Year 5 in order to do this. The cost of Capital is 12%   1 2 3 4 5 Sales 10.34 10.78 9.35 6.93   Wages and Salaries -2.53 -2.75 -2.86 -1.98   Selling and distribution costs -1.43 -1.32 -1.65 -0.66   Materials and consumables -0.33 -0.44 -0.44 -0.22   Head Office Expenses -0.22 -0.22 -0.22 -0.22   Survey Costs -0.22         Salvage Value       2.75   Environmental Costs         -0.44 Net change in working capital 0.55     0.55   Total Cash Inflows 6.16 6.05 4.18 7.15 -0.44 b) Investment Appraisal: NPV Method: NPV = -17.05 + 6.16/1.12 + 6.05/(1.12)2+4.18/(1.12)3+7.15/(1.12)4-0.44(1.12)5 NPV = -17.05 + 5.50 +4.82 + 2.98 + 4.54 - .25 NPV = 0.54 million Using the NPV Method, we conclude that the project should be accepted since it has a positive worth of 0.54 million. b) I have preferred net present value as the most appropriate investment appraisal tool since it gives me an idea of how much wealth would be added to my net share holder’s equity after taking into account my cost of capital. It will increase my value of the share. There are other appraisal methods which could have given me the same result such as internal rate of return but it does not provide an absolute value addition. Internal rate of return is the return on the project which has a net present value of zero. It is a method which requires relative comparison; comparing the internal rate of return with cost of capital. The project is only accepted if the internal rate of return is greater than the cost of capital. Part 2) Issues in Investment Appraisal: Investment appraisal is a strategic decision making process for identifying which capital project should the firm opt for using its limited capital resources. The ultimate objective of an investment appraisal is to increase the market value of the firm while taking into account all the costs and constraints. A firm conducts an investment appraisal whenever it authorizes a capital project or expenditure. A capital expenditure is generally regarded as expenditure in fixed assets such as plant, equipment, land etc. which will provide long term benefits as the benefits from the project extend beyond the current year. There are several reasons for conducting a capital expenditure and generally firms are motivated by the following reasons to conduct a capital expenditure. To enhance the competitive position of the firm capital projects are undertaken. To expand the operating capacity, additional facilities will be required to meet increase in demand. Renewing, revamping or overhauling the buildings and equipment might be necessary for the firm to increase efficiency, improve quality or comply with any regulations imposed by a government authority. Replacement of the old machinery or equipment due to the advancement of the technology. The main issues of concern mainly in these appraisal techniques are to consider the relevant cash inflows and outflows of the project. The emphasis is not on the accounting profits rather it is on the cash which is required to pay the shareholders. The incremental after tax cash inflows should be of concern to the management. To obtain incremental tax cash flows the management needs to make a comparison between the costs incurred and benefits gained with and without the project. In addition to that, the management also needs to take into consideration any sunk cost and opportunity cost of the relevant activities. There are several techniques available to appraise investment but at the same time there are grave issues of concern associated with each of the method. These are only the decision making tools that will help management, but management still needs to incorporate their own judgment and experience while making any decision. We will be discussing the major financial techniques available for investment appraisal and issues associated with them. The most common methods are; Payback method, Net present Value and Internal rate of return. Payback method is the most popular technique and is used by majority of the large corporations for investment appraisal (Sangster, 1993). This tool provides us information about how long it does take a project to recover its investment. Usually, management sets a maximum payback period and if the criterion is not fulfilled than the project is rejected. Payback is an intuitively appealing concept since is easy to use and understand especially for non-financial managers. In addition to that it is a very useful concept and can serve as a risk screening device (McMenamin, 1999). It is helpful in cases where a company is facing a liquidity crisis and therefore aims that it quickly recovers cash thus reducing the risk of insolvency. Despite its widespread popularity, the payback method has serious limitations. First of all, it does not consider the time value of money although this can be overcome by using discounted cash flows. Secondly, it does not incorporate cash flows after the payback period since there are many projects which have substantial cash flows after the payback period (Cook, 2002). Finally, it does not provide us any information on the profitability of the project which is the core objective of any investor or decision maker. Net present value is determined by finding the present value of the future cash inflows and then deducting the initial investment which is discounted at the present value of the firms cost of capital. A project with a positive NPV implies that the project will recover the initial investment and provide all the interest payments to all the creditors who are financing for the project and it will also provide a return to the shareholders either in the form of dividends or capital gains. Net Present Value is often criticized for using an inappropriate discount rate to discount the cash flows as a result of which management can arrive at an erroneous conclusion (Rupert, 1999). An implicit assumption taken about NPV method is that cash flows during the life of the project can be reinvested at the discount rate which is an irrational thought. Similar to the concept of NPV is the internal rate of return which is obtained by setting the net present value of the firm to zero. It is compared with the cost of capital to reach a decision. If internal rate of return is greater than cost of capital than the project is accepted otherwise it is rejected. As the other methods have their drawbacks, IRR is also associated with several problems. First of all projects have different cash flow profiles, one project can have large cash inflows early in its economic life while others can have large cash inflows at the end of the project. For projects with higher cash inflows during the earlier period will have a greater IRR which exaggerates the profitability of the project. Secondly, IRR is also criticized because it sometimes produces conflicting results from NPV. A project with higher investment or scale can have a higher NPV and lower IRR while a project with lower investment can have a greater IRR but a lower NPV. IRR only provides a relative comparison but it does not provide how much absolute advantage could be gained by investing in the project. Cost of Capital: Cost of capital is basically the return demanded by the creditors and shareholders. Creditors finance a company and demand a fixed or floating interest rate which is called as the cost of debt. We always take into account the after tax cost of debt since interest expense provides us a benefit on the balance sheet in the form of tax benefit. The second aspect of the capital relates with the shareholders equity which is the return demanded by the shareholders. Since shareholders are always paid after the debtors are paid in full therefore these shareholders incur a risk of suffering from a loss, if the company does not perform well. As we know that the fundamental rule of finance is that an increase in risk is compensated by an increase in return therefore shareholders demand a higher rate of return from the debt holders since they are taking a higher level of risk. The literature emphasizes that a weighted average cost of capital should be used to compute the cost of capital and it can be calculated by the formula (Ross, Westerfield & Jaffe, 2002) Cost of Capital = (D/D+E) Cd + (E/D+E) Ce Here D = Amount of Debt E = Amount of Shareholders equity Cd = After-tax cost of debt Ce = Cost of equity Risk Risk can be considered as how much one is uncertain about the project meeting its expectations. Shareholders compensate themselves for the risk that they bear by increasing the cost of capital. However, the management also needs to conduct an extensive research about similar projects happening in the past and their probability of success. This can provide them a judgment about how much risk they are undertaking since the nature of different projects to a great extent. Management should further adjust the cost of capital into incorporate the project specific risk but it should not be exaggerated. References Cook, M. 2002, Approaches to investment appraisal: Teaching Business & Economics, 6(1), p.16 McMenamin, J. 1999, Financial Management: An Introduction: New York: Routledge Ross, S. A., Westerfield, R. W., & Jaffe, J., 2002. Corporate Finance. 6th ed. New York: McGraw−Hill Primis Rupert, B. 1999, Avoiding pitfalls in Investment Appraisal. Management Accounting: Magazine for Chartered Management Accountants, 77(10), p.22-23 Sangster, A. 1993, Capital Investment Appraisal Techniques: A Survey of Current Usage. Journal of Business Finance & Accounting, 20(3), p.307-332 › Visit Amazons Stephen A. Ross Page Find all the books, read about the author, and more. See search results for this author Are you an author? Learn about Author Central Read More