Recommendations on Competing Investment Opportunities - Assignment Example

Analyze and make recommendations on competing investment opportunities. Make effective oral and written communications Introduction: The capital investment decision making process is tightly coupled with the company’s strategic planning. Strategy would shape the choice of investment projects and in turn the choice of projects would dictate the company’s future strategic decisions. While important in themselves even the most rigorous financial analysis tools cannot capture the strategic dimensions that are inherent in any given capital investment project. Keeping this inherent fact in mind one could arrive three basic processes that could be used for an analysis of the financial viability of a given project at a given point in time. Capitral Investment: DCF, Payback and ARR Capital investment or capital expenditure means spending money now in the hope of getting it back later through future cash flows (Ahadiat and Brueggemann, 1990). Most investment appraisals consider decisions such as whether or not to invest; whether to invest in one project or one piece of equipment rather than another and whether to invest now or at a later time. There are three main methods of evaluating investments: Accounting rate of returns, payback and discounted cash flow (DCF). For a given project, investment appraisal requires estimation o future incremental cash flows, that is, the additional cash flow or the net income less expenditures that would result from the investment, as well as the cash outflow for the initial investment (Allen, 1961). Depreciation is of course an expense in arriving at profit which does not involve any cash flow. Cash flow is usually considered to be more important than accounting profit in investment appraisal given the fact that it is cash flow that drives shareholder value. DCF capital Investment appraisal method: Despite the apparent lack of sophistication of techniques like DCF capital investment decisions are often made subjectively and then justified after the event by the application of financial techniques (Hartley, 1990). Shank (1996) used a case study to show how the conventional net present value (NPV) approach was limited in high technology situations as it did not capture the richness of the investment evaluation problem. He saw NPV more as a constraint than a decision tool given the fact that it was driven by how the investment proposal was framed. He also argued that a strategic cost management approach could apply value chain analysis, cost driver analysis and competitive advantage analysis to achieve a better fit between investment decisions and business strategy implementation. The first method that is to be used in the calculation of investment validity is the discount cash flow method wherein stress is laid on the timing of the cash and not the profit for arriving at the capital investment appraisal. The idea in essence is that cash outflows are outflows of money that is given by the investor to the business, and on which a return on investment is required while the money is still in the process of it remaining invested. The idea therefore is that the faster the cash is recovered the more would be its equivalence to the given present value of the money invested and therefore it would have the better return on the investment made. The method is inclusive of the implementation of the principles of application discount arithmetic to the estimated future cash flows from a capital investment project, in order to decide whether the project is expected to earn a satisfactory rate of return. The idea would therefore be to make use of the NPV method of DCF, the cost of capital which is representative of the smallest acceptable rate of return on investment as it is utilized by the discount rate so that one is able to tabulate the NPV of the cash inflows and outflows. The method gives the tabulator method provides an absolute measure of the cash surplus or deficit in present value terms (as opposed to the internal rate of return (IRR) method – not covered in this article – which provides a relative measure of project worth).The profitability of a capital investment project using NPV is determined by the relationship between the total present value of the net cash inflows and the present value of the cash invested in the project, ie whether the NPV is positive or negative. The decision rule, using the NPV method of appraisal, is to invest if NPV > 0 (ie positive). For the purpose of this particular appraisal one would make use of the DCF capital investment appraisal method and the payback method in order to justify the investments in both the cases thereby coming at a conclusion on the investment that would be the more profitable business of the two. In accordance with the DCF method investment at the start of the project would be £15 million over an above the cost of maintaining the hotel that would come to about 5 million at the end of the five years (Appendix 1). The investment sum, assuming nil disposal value after five years, would be written off using the straight-line method. The depreciation has been included in the profit estimates above, which should be assumed to arise at each year end. Accounting rate of return (ARR) Accounting rate of return or ARR is a financial ratio used in capital budgeting.  The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable (Hawawini and Viallet, 2002). If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Paybacks The simplest method of investment appraisal and measures how quickly the returns from the investment cover the cost of the investment (Hayes and Abernathy, 2007). A firm will calculate the payback period of a project. If it is acceptable then the project will be undertaken. If there is more than one possible project, then the one with the shortest payback period will be selected. The method works given the fact that It is extremely simple and is useful in cases where technology changes rapidly cost of machinery is recovered before new model comes out. It also helps in the prevention of cash flow problems since money will be recovered as quickly as possible. The payback method could be used as guide to investment decision making in tow basic ways. When faced with a straight accept-or-reject decisions it could provide a rile where projects are only accepted if they payback the initial investment outlay within a certain predetermined time. In addition the method could provide a rule when a comparison is required of the relative desirability of several mutually excusive investments (Lumby, 1988). In such cases projects could be ranked in terms of speed of payback with the fasted paying back project being the most favored and the slowest paying back project the least favored. Thus the project which paid back quicker would be chosen for investment. Two of the better known and available techniques that could be used to beat the problems associated with foreign currency trading with respect to capital investment are the forwards trading and the futures trading. A forward trading contract is a particularly simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price. It could be contrasted with a spot contract, which is an agreement to buy or sell and asset today. A forward contract is traded in the over the counter market-usually between a financial institution and its clients.   Forward and Futures Trading One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party then assumes a short position and agrees to sell the asset on the same date for the same price. At the time the contract is entered into, the delivery price is chosen so that the value of the forward contract to both sides is zero. This means that it costs nothing to take either a long or a short position.   Trading forward and futures contact with the objective of reducing risk sis called hedging. Forward contracts are used for hedging foreign currency risk. There are several commonly used instruments that can hedge forward interest rate exposure. The most direct is to lend the exact same amount of money that has been borrowed, at the exact same interest rate. This way, the interest expense earned will offset the interest expense paid. Forward contracts can be used to swap the floating interest expense with fixed future interest expense cash flows, thereby locking in a set rate in the present. Manage the credit risk. The hedge will serve no purpose if the counterparty involved goes bankrupt and cannot pay its side of the deal. Look at the credit rating of the counterparty, and consider using a credit default swap to add protection against default. Such a swap would pay in the event of a default by the counterparty, but as in the case of all insurance, there will be a cost to entering the protective contract.     Like a forward contract, a futures contract a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, future contracts are normally traded on an exchange. To make selling possible, the exchange specifies certain standardized features of the contract. As the two parties to the contract do not necessarily know each other, the exchange would also be an opportunity to provide a mechanism that gives the two parties a guarantee that the contract would be honored. The largest exchanges on which the futures contract are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). On these and other exchanges, a very wide range of commodities and financial assets from the underlying assets in the various contracts. One significant manner in which a futures contract is different from a forward contract is that an exact date of delivery is not. The contract is referred to by its delivery month and the exchange specifies the period during the month when delivery must be made. Usually contracts with several different delivery months are traded at any one time. The exca he specifies the amount of the asset to be delivered for one contract and how the futures price is to be quoted. In the case of a commodity, the exchange also specifies the amount of the asset ti be delivered for one contract and how the futures price is to be quoted. Futures prices are regularly reported in the financial press. Through the aegis of a futures contract, the holder of the contract is endowed with the obligation and the added responsibility of ensuring that the delivery is made under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The duty of the one selling is to ensure that the commodity is delivered ti the one making the purchase or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. When one has to come out of the commitment before it has been fulfilled the duty of the one rescinding to ensure that before the date of settlement, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations. ARR method: Project one: Average Investment=15+12/2=13.5 Project two: Average investment=20+15/2=17.5 Project one ARR=15/13.3=10 per cent Project two ARR-20/17.5=12.5 per cent This would therefore mean in essence that going by the ARR method; the Spa project is a lot more profitable than the hotel project. Assuming the firm could not raise output prices above the general rate of inflation, the firm would have to accept lower NPV and hence lower profitability as measured by NPV. At the margin, the firm would have to forego investment projects unless output prices could be raised at a rate greater than the general expected rate of inflation. The exact amount which prices would have to be raised is dependent upon the degree of net working capital required relative to the overall level of investment. A firm does have a number of ways in which it can respond to the problems created by inflation. There are three major areas that could be addressed in an attempt to offset the negative impact of rising price levels. One action would be to raise output prices above the level of inflation, but the ability of the firm to do so will be limited to the extent that the market will withstand the higher prices. Market structure will play an important role here, with the more oligopolistic firms enjoying greater success than the more competitive firms. However, in the long run, this will lead to high inflation and thus may be self-defeating. Unless other adjustments are made, the investment sector of the economy could under allocate resources to new investment projects. Appendix one: Project one: Operating costs-hotel- £14, 600 a year, £73, 000 over 5 years, which means a total operating cost of $43, 450 over five years for one room which would again mean an operating cost of $26, 070, 000 over 5 years over and above the $3 million in fixed operating costs in that time. This would then peg the total expenditure of the hotel at a little over 5 million in five years. Also given the fact that inflation in UK is pegged at 1.5 per cent, this would mean that the total value of investment would diminish at a rate lower than the second project where the rate of inflation is 2.8 per cent. References: Ahadiat, N. and R. I. Brueggemann. 1990. Evaluating an investment proposal. Journal of Accounting Education 8(2): 299-310. Allen, C. B. 1961. Evaluation of capital projects - An application of the investor's method. N.A.A. Bulletin (January): 45-54. (The cash rate of return or investor's method of calculating the return on investment). Hartley, R. V. 1990. Teaching capital budgeting with variable reinvestment rates. Issues In Accounting Education (Fall): 268-280. Hawawini, G. and C. Viallet. 2002. Finance for Executives: Managing for Value Creation, 2e. South-Western Educational Publishing. Hayes, R. H. and W. J. Abernathy. 2007. Managing our way to economic decline. Harvard Business Review (July-August): 138-149. (This is a reprint of their 1980 article with a retrospect by Hayes on page 141) Bangs, David H., Jr., with Robert Gruber. Finance: Mastering Your Small Business. Upstart, 1996. Chen, Richard C. "A Discounted Cash Flow Analysis for Financing Alternatives." National Public Accountant. July 1998. John A. Carlson, “Short Term Interest Rates as Predictors of Inflation: A Comment,” American Economic Review, June, 1977, pp. 469-475. Phillip L. Cooley, Rodney L. Roenfeldt, and It-Keong Chew, “Capital Budgeting Procedures Under Inflation,” Financial Management, Winter 1975, pp. 12-17 Read More