Capital Investment Decision Making - Essay Example

Importance of Capital Investment Decisions The alternate name in financial terms used for capital investment decision is capital budgeting. The capital investment decisions are made in order to apportion and allocate the investment funds which are maintained by the firm in order to capitalize any upcoming investment opportunity so that the firm can ensure the best returns out of several available projects (Baker and Martin, 2011). The assessment of the capital investment decision along with the allotment of the appropriate capital funds to the project mainly depends upon the requirement of the project and its related aspects. There is no specific criterion for the selection of the most adequate and perfect capital investment decision as it is highly dependent upon the strategic objectives of the firm (Brigham and Ehrhardt, 2008). The prime objective of any capital investment decision is the increase and maximization in the value of shareholders’ funds. This prime objective is preceded by many other objectives which vary firm to firm (Fields, Lys and Vincent, 2001). Some firms believe in the accumulation of the quick returns from the investment projects so they are more interested towards picking up those projects which ensure brisk cash inflows (Jaffe and Ross, 2004). On the contrary, some firms believe in the long-term growth of the firm and they are less bothered in the event of obtaining small returns or negative returns in the initial period of the project as the project will likely to generate solid returns after some time. The ability of the financial manager or the owner of the business to undertake an in-depth study as well as taking the capital investment decision allow him/her to allocate the scarce resources of the business specifically in those investment opportunities which can best earn him/her the yield so that those returns can match the strategic objectives of the business in the most adequate manner (Shim and Siegel, 2008). As a result of this, at times the capital investment decisions are also referred as strategic capital investment decisions. Some examples of capital investment decisions include construction of a new factory site, launching a new marketing and advertising campaign, development of a new product, opening up a new branch for the business, introduction of new technology for the business processes etc. (Leuz and Verrecchia, 2000). As mentioned above, the prime objective of any capital investment decision is the maximization in the wealth of shareholders and this can be achieved by accepting those projects which can generate positive net cash flows (Eckbo, 2008). The firm needs to select the best possible investment opportunity among various investment projects such that the one intended to be chosen, should best achieve the strategic objectives of the firm. In case when the firm has more than one projects available and the firm is obliged to undertake only one project out of them, priority based ranking in the major approach that can help firm in selecting the most appropriate project (Asbaugh and Pincus, 2001). The priority based ranking approach identifies the investment opportunities which are prioritized on the basis of specific criteria e.g. highest positive net cash flows, highest internal rate of return, lowest payback period etc. (Kvaal and Nobes, 2010). These are also referred as evaluation techniques of capital investment appraisal. Alternative Investment Appraisal Techniques Capital Investment decisions are mainly dependent upon the results of various investment appraisal techniques. These techniques help financial managers in taking appropriate decisions regarding the financial viability of any project given the specific variables which vary from project to project basis. Following are some of the alternative investment appraisal techniques which have their own pros and cons in comparison with each other. Investment appraisal process for any capital project can be undertaken by utilizing two types of techniques which are known as cash flow based techniques and non-cash flow based techniques. The following discussion covers aforementioned techniques in more detail. Cash Flow Based Investment Appraisal Techniques Cash flow based approach is that that approach in which all the estimations regarding receipts and payments pertaining to the project are based on cash inflows and cash outflows. Financial managers carry out deep evaluations and estimation of the relevant cash inflows that are expected to be received from a given a project as well as the relevant cash outflows that are expected to be paid in the form of expenses. Cash flow techniques are preferred by the financial managers because it is actually the cash position of the company which allows it to consider the project initiatives etc. One of the most important considerations regarding the cash flow based investment appraisal techniques is the concept of discounting. Since all the associated cash inflows and outflows are expected to arise in the later years of the project, therefore, it will not be appropriate to estimate the future cash flows on the existing prices. The real value of the future cash flows today should be less than their value in future time. Because of this, the concept of time of value of money provides us the guidelines to discount the expected future cash flows in order to equate the future cash flows with their current prices. This is done by discounting the expected future cash flows with the appropriate discount factor which is also known as cost of capital or required rate of return. NPV and IRR techniques work on the basis of discounted cash flows. However, for payback both discounted and non-discounted cash flow are in wide practice of the financial managers. Internal Rate of Return Internal rate of return is referred to as the rate which can generate zero net present value of any project under its technical sense (Berk and DeMarzo, 2010). This is actually the rate of return which a project can bring in case if the project is accepted. Investors generally compare the internal rate of return generated by the project with the cost of capital incurred on the project. In case, if the internal rate of return exceeds the cost of capital, the excess amount is considered as the net return or benefit which the project can offer to the investors. Conversely, in case of opposite situation, the investors will not accept the project as it will incur more cost as compared to the associated returns. This technique fundamentally works on the principles of discounted cash flows. There are mainly two ways in which internal rate of return can be computed i.e. 1) through interpolation and 2) through trial and error method (Siegel and Shim, 2008). Payback and Discounted Payback Payback is slightly a different investment appraisal technique such that it incorporates all the cash flows in such a manner that it brings about the estimated tenure of time in which the initial investment of the project is recovered. This technique also works on the principle of cash flows rather than accounting profits (Sheeba, 2011). In order to incorporate the concept of time value of money, the modified form of payback is discounted payback which works on the basis of discounted cash flows. This technique is quite simple and easy to both calculate and understand as it approximately figures out as to when would the project start providing benefits to the investors. Profitability Index Profitability index is that technique in which the projects can be ranked based on its results. In case of having several projects, the firm can rank all the projects on the basis of profitability index and can accept those projects with the highest ranking (Babu, 2012). This technique mainly works on the principle of net present value such that it can be computed by dividing the net present value by initial investment and adding 1 to the final answer (Khan, 2004). In case if the project earns a profitability index of greater than 1, it indicates that the project should be accepted. On the contrary, in case of having profitability index lower than 1, it shows that the project should be avoided (Vishwanath, 2007). Non-Cash Flow Based Investment Appraisal Techniques Accounting Rate of Return Accounting rate of return is that return in which the return generated is obtained through accounting profits. This technique works on the principle of accounting cash flows rather than cash flows like internal rate of return (Bierman, 2003). Accounting rate of return is, however, easier to compute as well as understand, yet its significance is slightly hampered as it ignores the cash flows and includes the non-cash items in its calculation. Accounting rate of return is computed by dividing the average profits associated with the project by average investment of the project. Recommendation for a Robust Decision Making Process Financial decision making is not something which is only dependent upon the financial indicators. Decision making process itself is a comprehensive procedure based upon technicalities, uncertainties, and above all the skills and expertise of the financial manager. There are a number of risks and rewards which are associated with every financial project. It is the responsibility of financial manager to conduct an in-depth study on both the risk factors associated with a certain project. Various considerations that a financial manager needs to account for are the nature of business of the company, the philosophy of the company and its leadership, the past history of the company especially in respect of its exposure to risk, the risk appetite of the company etc. Based upon these factors, a financial manager can provide a detailed and comprehensive strategy on dealing with risks for a particular project. Risk appetite in one of the key factors which play a key role in a decision making process. A business can be risk taker, which likes to absorb more risk. Conversely, a business may be risk averse i.e. the one which likes to avoid risk. Third form is of a business which is risk neutral. Risk taker business is considered as the one having optimistic mind set such which only considers the best out of best. Such a business adopts the strategy of accepting most optimistic solutions while neglecting risk elements which is known as maximax. Conversely, risk-averse businesses tend to follow a different strategy and become pessimistic. These businesses accept the best category out of the worst opportunities by considering risk elements. This strategy is known as maximin. For risk neutral business, minimax regret is there which states that a decision maker would try to minimize the maximum loss as much as possible. In order to assess the implications of a project in respect of costs and benefits associated with that project, there are a number of tools available to the financial manager. Expected value is one of the criteria, which is based upon the probability of certain costs and benefits. Decision tree is also another tool for providing better guidance towards reaching at a particular decision after taking into consideration various factors. Risk assessment procedure comprises of different techniques such as sensitivity analysis, scenario planning, and simulation etc. Sensitivity analysis is the one in which one variable at a time is modified in the calculation and its resulting consequences are then analysed. Under scenario planning, various different scenarios with different estimates are prepared and then their results are compared and analysed. Simulation is process which highly involves the use of probability and develops comprehensive changes into the main projected calculations to provide the most accurate results. Other financial factors which can affect the results of profitability index include cost of capital used by the company, the nature of cash flows i.e. conventional or irregular cash flows etc. Non-financial factors include the legal aspects of pursuing the project, the social costs which the firm might have to pay, the impact of accepting the project on employee motivation etc. (Stoltz, 2007).  b) Calculations based on Original Variables Years 0 1 2 3 4 Initial Investment (1,200,000)   Annual Lease Payments (100,000) (100,000) (100,000) (100,000) Residual Value 200,000 Working Capital (140,000) 140,000 Administrative Cost (150,000) (425,000) (700,000) (975,000)     Sales Units 30,000 50,000 80,000 40,000 Selling Price 110 110 110 110 Total Sales 3,300,000 5,500,000 8,800,000 4,400,000 Variable Costs per unit   Plastic - 0.8kg @ £10 per kilo 8 8 8 8 Bought-in sub-assembly (1 per product) - £22 each 22 22 22 22 Other materials - £4 4 4 4 4 Assembly labour - 2 hours @ £20 per hour 40 40 40 40 Other variable production costs - £20 20 20 20 20 Variable Costs per unit 94 94 94 94 Total Variable Cost 2,820,000 4,700,000 7,520,000 3,760,000 Contribution Margin 480,000 800,000 1,280,000 640,000     Net Cash Flows (1,340,000) 230,000 275,000 480,000 (95,000) Discount Factor (10%) 1.0000 0.9091 0.8264 0.7513 0.6830 Discounted Cash Flows (1,340,000) 209,091 227,273 360,631 (64,886) Cumulative Cash Flows (1,340,000) (1,130,909) (903,636) (543,005) (607,892) Net Present Value (607,892)         Internal rate of return -17.72%   Discounted Payback Nil   Profitability Index 0.49         By using the information given in the scenario, the above calculations have been performed. From these calculations, four major investment appraisal techniques have been deployed such as net present value, internal rate of return, discounted payback and profitability index. By incorporating all the variables into the calculations, the project is estimated to generate negative net present value of around £607,892. On the other hand, the IRR computed is found to be -17.7%. The discounted payback is also nil as the company could not manage to recover the initial investment of the project. Profitability index of this project is also less than 1. All of these indicators show that the project is highly undesirable and the company should avoid it as it can create losses for the investors if accepted. Change in the Variable “Administrative Cost” Years 0 1 2 3 4 Initial Investment (1,200,000)   Annual Lease Payments (100,000) (100,000) (100,000) (100,000) Residual Value 200,000 Working Capital (140,000) 140,000 Administrative Cost (150,000) (200,000) (250,000) (300,000)     Sales Units 30,000 50,000 80,000 40,000 Selling Price 110 110 110 110 Total Sales 3,300,000 5,500,000 8,800,000 4,400,000 Variable Costs per unit   Plastic - 0.8kg @ £10 per kilo 8 8 8 8 Bought-in sub-assembly (1 per product) - £22 each 22 22 22 22 Other materials - £4 4 4 4 4 Assembly labour - 2 hours @ £20 per hour 40 40 40 40 Other variable production costs - £20 20 20 20 20 Variable Costs per unit 94 94 94 94 Total Variable Cost 2,820,000 4,700,000 7,520,000 3,760,000 Contribution Margin 480,000 800,000 1,280,000 640,000     Net Cash Flows (1,340,000) 230,000 500,000 930,000 580,000 Discount Factor (10%) 1.0000 0.9091 0.8264 0.7513 0.6830 Discounted Cash Flows (1,340,000) 209,091 413,223 698,723 396,148 Cumulative Cash Flows (1,340,000) (1,130,909) (717,686) (18,963) 377,185 Net Present Value 377,185         Internal rate of return 20.56%   Discounted Payback 3.05 years   Profitability Index 1.31         The above calculations have been performed in order to change the variable of administrative cost. Originally, the administrative cost is supposed to increase by £275,000 every year. However, if the company can manage to limit its administrative cost such that it increases by £50,000. As a result of this change, the results of this project can become fruitful for the company. The net present value of this project can turn out to be positive £377,185. Similarly, internal rate of return is changed to 20.56%. Since positive cash flows have been increased, therefore there is likelihood that the initial investment can be recovered in 3.05 years. The profitability index of the company has also improved and jumped to 1.31. All these results are indicative of the fact that the project has become highly viable and the company should accept this project as it may enhance the wealth of investors. Change in the Variable “Selling Price” Years 0 1 2 3 4 Initial Investment (1,200,000)   Annual Lease Payments (100,000) (100,000) (100,000) (100,000) Residual Value 200,000 Working Capital (140,000) 140,000 Administrative Cost (150,000) (425,000) (700,000) (975,000)   Sales Units 30,000 50,000 80,000 40,000 Selling Price 110 115 120 125 Total Sales 3,300,000 5,750,000 9,600,000 5,000,000 Variable Costs per unit   Plastic - 0.8kg @ £10 per kilo 8 8 8 8 Bought-in sub-assembly (1 per product) - £22 each 22 22 22 22 Other materials - £4 4 4 4 4 Assembly labour - 2 hours @ £20 per hour 40 40 40 40 Other variable production costs - £20 20 20 20 20 Variable Costs per unit 94 94 94 94 Total Variable Cost 2,820,000 4,700,000 7,520,000 3,760,000 Contribution Margin 480,000 1,050,000 2,080,000 1,240,000     Net Cash Flows (1,340,000) 230,000 525,000 1,280,000 505,000 Discount Factor (10%) 1.0000 0.9091 0.8264 0.7513 0.6830 Discounted Cash Flows (1,340,000) 209,091 433,884 961,683 344,922 Cumulative Cash Flows (1,340,000) (1,130,909) (697,025) 264,658 609,580 Net Present Value 609,580         Internal rate of return 26.48%   Discounted Payback 2.23 years   Profitability Index 1.51         In case of all other variables remaining constant except the selling price of the product, there can be significant changes in the overall calculations and results of this project. It is assumed that the company increases £5 every year in the selling price of the project. In such case, the cash inflows of the project can increase substantially leading towards more convincing results such that net present value of the project may increase up to £609,589. Moreover, the internal rate of return may increase to a very healthy rate of 26.48%. Further, the discounted payback may also reduce to 2.23 years which shows the time in which initial investment may likely to recover. The profitability index of this project may increase to 1.51 which is a very sound indicator of the better results. In the light of all these paramount indicators which have undergone a tremendous change as a result of merely increasing the selling price, the project has become a better investment opportunity for the company and the company is advised to accept it with the proposed changes in the key variables. Works Cited Ashbaugh, H. and Pincus, M., 2001. 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