Capital Investment - Essay Example

?Strategic Financial Management Table of Contents Introduction 3 Capital investment and Project Appraisal 4 Time Value of Money and Discounted Cash Flow 5 Capital Budgeting 7 Return on Capital Employed 9 Conclusion 10 Reference 11 Introduction Modern trade and business has become more complex with increasing volume of business activities and competition in the market. Requirement of capital and necessary investments are inevitable part of finance for any profit making or any non-profit making organisation. Finance plays very crucial role in economic development of any organisation. Emmanuel has explained that finance deals with money and credit employed in business and return on capital and investments. Hence, finance can be interpreted as lifeblood of business (Emmanuel, 2010, p.32). Finance also helps the management in the process of controlling, planning, decision making, evaluation and performance appraisal etc. Therefore, management must control and plan its financial activities to develop a growth oriented organisational (Collier, 2003, p.42). In order to execute operational activities, companies needs to investment for various purposes like capital investments and operational investments, and in this process it is very necessary to evaluate performance of investments. There are some financial techniques which are very helpful in evaluating the performance of investments like capital budgeting and ratio analysis (Williamson, Cooke and Jenkins, 2003, p123). This paper will attempt to present various techniques of capital investments and project appraisal for a business organisation. At first, importance and understanding of capital appraisal techniques will be explained. The next section will present brief descriptions of various project and capital investment techniques. Finally, the conclusion will sum up the entire discussion and analysis. Capital investment and Project Appraisal Since last two decades, there have been significant changes in the field of finance and its various techniques. The modern organisations are using multiple financial theories, models, and tools for enhancing the financial activities. The main reason behind this development is the increasing academic concern. Constant innovation in financial management techniques has facilitated the financial related activities. Besides, managers have to take decisions for allocation of resources in capital investments (Chadwick, 1993, p.143). Hence, the quantitative performance appraisal techniques have also been modified and these techniques have become more accurate and efficient to measure the effectiveness of capital investments. Management or the decision makers have to understand the important of decision theories to realize the necessity of decision making theories. According to Rapoport (1989), “decision theory deals with situations in which one or more actors must make choices among given alternatives” (Serfas, 2010, p.16). Before explaining various techniques for capital investment appraisal, it is very necessary to understand the importance of capital investment appraisal for a business organisation. The decision making process for investment is very necessary as it help management to determine the future profitability of any project or capital investments. Michael Pogue defined investment decision as “involving the company making cash outlay with the aim of receiving future cash inflows” (Pogue, 2010, p.10). Therefore, the process of investment decision making should go through a proper stages for enhancing its effectiveness. The Institute of Charted Accountants has defined four vital stages in this process. These are “origination of proposals”, “project screening”, “and analysis and acceptance” and “monitoring and review" (Institute of Charted Accountants, 2008, p.278). While making an investment decision of project appraisal, it is necessary to consider various aspects of finance to generate relevant and accurate decisions. There are certain macro and micro economic factors that must be considered in this process like inflation, default risk, liquidity, maturity interest rate, term of the project, associated risks, hidden cost, demand and supply etc (Schaltegger and Burritt, 2000, p.139). Therefore while making capital investment appraisal, it is decision makers should follow proper risk analysis process. In this respect, the following model to analyse risk in project and capital investment appraisal. Figure 1: Risk analysis process (Source: Savvides, 1994) Time Value of Money and Discounted Cash Flow The primary aim of making investment is to gain a decent return after a specific period of time. The rate of return on investment is known as discounting rate of required rate of return. While analysing the investment decisions, management must evaluate the time and value factors of total future cash flows. A company is expected to experience a chain of cash inflow and cash outflow in project life cycle, and these cash flows must be adjusted as per the time value of money. The time value of money is a technique to determine the value of cash at specific period of time. Time and money is interrelated with each other as time tends to influence the value of money. In this respect, Rohrich has stated that “an amount of money which has to be paid or is earned ‘today’ does not have the same value as amount of money which has to be paid or is earned ‘tomorrow’” (Rohrich, 2007 p.56). According to Needles et al, time value of money “refers to the cost of benefit derived from holding or not holding money over time and “interest is the cost of using money for specific period” (Needles, Powers and Crosson, 2007, p.428). In case of project appraisal, the discounted cash flow techniques are considered to be the most important and effective. There are certain key principles that must be taken into accounts in this method and these principals are given below. There must be a specific rate for cost of capital or discounting rate. Decision makers should determine various factors to determine the relevant cost of capital for gaining accuracy (Kambil, Henderson and Mohsenzadeh, 1991). The estimation of cash flows must be at incremental basis. All the hidden cost and past expenditures should be included in appraisal system. The systematic risks, market risk premium, default risk premium and liquidity risk premium must be taken into consideration. All the assumptions should be backed by relevant judgments and logical sequences. The project efficiency in terms of finance must be reviewed and audited after the completion of project (International Federation of Accountants, 2008). The above key principals are very important for appraising a project investment taking time value of money factors into consideration. Capital Budgeting Capital budgeting is very popular method for appraising a project or making decisions for capital investment. This technique is helpful in planning, controlling and decision making for long term investment and for determining the profitability of a long term projects which last more than one year (Finkler and McHugh, 2008, p.245). Periasamy defined the capital budgeting as “the evaluation of several alternatives capital projects for the purpose of assessing those which have the highest rate of return on investment” (Periasamy, 2009, p.5.2). Capital budgeting can be used for project appraisal in two ways i.e. considering time value of money and without considering time value of money. The previous section has explained the validity and relevancies of time value of money while making decisions for project and capital investment appraisal. Hence, at present, capital budgeting techniques are implemented taking the time and value factors into account. There are four major techniques in capital budgeting for project appraisal which includes payback period, profitability index, net present value (NPV) and internal rate of return (IRR) (Albrecht et al, 2007, p.1125). These techniques can be used by using discounted or non-discounted cash flows method. However, each technique is explained below in respect of discounted cash flow method. Profitability Index (PI): PI is a ratio that relates total present value of future cash inflow and cash outflow. It is the simplest way for making decisions in selecting or rejecting a project. In order to calculate PI, total cash inflows and total inflows must be compared as given below. If PI of any project is more than 1, then it can be considered as profitable project and vice versa (Shapiro, 2008, p.47). Payback Period: Payback period deals with the realization of total cash inflows in term of time period. It is an effective technique to judge time span required to cover the total investments made in project. However, it is not effective for the project that includes cash outflows frequently or every year. This technique alone is inadequate to appraise a project as it neglects the cash inflows after the realization of total investment (Lasher, 2007, p.424). Peterson and Fabozzi have stated that payback period is inefficient and inconsistent in maximising shareholders’ value. They commented that “discounted payback cannot provide us any information about how profitable an investment is – because it ignores everything after the “break even” point!” (Peterson and Fabozzi, 2002, p.69). Net Present Value (NPV): In capital budgeting method, it is one of the most widely used techniques in project appraisal and capital investment decision making process. NPV technique considers all the necessary aspect of time value of money and it produces results in absolute terms. This “technique is broadly adopted in practice, managers are comfortable with it, and it is reasonable to consider the fuzzy alternative to take account of more general forms of uncertainty” (Sergieva, Hunter and Kalganova, 2008, p.214). Internal Rate of Return (IRR): This is another technique for project appraisal. IRR technique helps to determine rate of discounted rate return for a project and it represent the point where the NPV becomes zero (Perez, 2007). The following graph shows the relationship between IRR and NPV. Figure 2: IRR and NPV (Source: James, 2005) IRR is an effective method in capital investments appraisal. However, it also has some limitations like it does not consider the size of a capital investments and it is difficult to use IRR method for “non-conventional cash flows” (Walker, 2008. p.334). Return on Capital Employed Return on capital employed (ROCE) is a ratio and it is very powerful technique to review the effectiveness of the total capital employed to generate profit (Palmer and Randall, 2001, p182). Generally, this ratio is effective in post-completion of project and it uses historical financial statements like income statement and balance sheet. This ratio is very crucial in determining an organisation’s profitability and efficiency in utilizing total capital investment made by company (Lumby, 1988, p.30). ROCE is calculated by comparing earnings before interest and tax, and total assets less total current liabilities. The flowing calculation shows ROCE calculation. Conclusion The quantitative capital investments and project investment appraisal is a crucial activities for management in decision making process. There are a number of project appraisal methods and techniques available for this purpose. However, time value of money theory is the most important factor for project appraisal, and it must be implemented while selecting projects and for making capital investments decisions. Capital budgeting is the most popular method for project appraisal. There are four major techniques in capital budgeting that includes PI, IRR, NPV and payback period. Among these, NPV and IRR are the most widely used capital budgeting techniques. ROCE is helpful in determining a company’s efficiency in utilizing the capital investment in generating revenue. Reference Albrecht, W. S., Stice, J. D., Stice, E. 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