Net Present Value and Capital Expenditures - Essay Example

Task I a) Calculation of Net Present Value French Machine Revenue and other costs have been adjusted with specific inflation rate. Net Present Value German Machine Net Present Value NPV of French machine is $ 38857 and that of German machine is $67026. Accordingly Clarke Plc. should go in for the German Machine. It is important to note that while making calculations for projected cash flows inflationary aspect of the project has been taken account. Instead of applying general rate of inflation, specific provided rates for inflation have been applied. Though the present value provides solution in terms of present worth of the project, its cash flow measurements are based on a number of assumptions and estimations. Also NPV has a optimistic bias as initial investment is under estimated and operating cash inflows are exaggerated. b) Average Accounting Rate of Return French machine German Machine The higher the accounting rate, the better is the project. The rate of return of French machine is 22.92%, and that of German machine it is 28.95%. Accordingly choice goes in favor of German machine. This is also because the company has a target of 25% and German machine surpasses the target. But this decision is based is subject to following factors: Net margins are treated as profits after taxes in absence information about rates of taxes. Profits (Margins) have been calculated after taking inflationary factors into account. C) The Clarke Plc. Accountant is correct as the method of evaluation of capital projects has under noted advantages as compared to Net Present Value method of evaluation: The accountant has stated rightly that accounting rate of return is easy to calculate; mainly because accounting information is readily available and familiar to business community. The accounting rate of return considers benefits over the entire life of the capital project, and it can be used even with limited data. The discounted cash flow method requires estimation of costs and revenue over the life of the capital project. This is difficult exercise. Some time it is very difficult to predict the future of the project. Changes in cost and revenues cannot be predicted. At best prediction can be accurately estimated only for earlier two three years of the project. But there are certain weaknesses of the accounting rate of return that are described as under: Accounting rate of return is based on accounting profits and not on cash flows. As such this method does not take into account the time value of money. The method of calculation is internally inconsistent. While the numerator of this method represents profits belonging to equity and pref. stockholders, its denominator represents fixed investment outlay which is rarely equal to contributions of equity and preference stockholders. Task 2 Capital expenditures represent the growing edge of the business. Such expenditures have three very important features that greatly influence decision making with regard to capital expenditures. These features are: Capital expenditures have long term consequences over the success of the business. Substantial planning and capital outlays are often involved with regard to capital expenditures decision making. Capital expenditures decisions may be difficult and often expensive to reverse. Uncertainties or flexibilities are associated with capital projects. But traditional methods of evaluating capital projects handle cash flow forecasts as passive factors in decision making. It is very important that methods of evaluation of capital expenditures should take into account all shades of the character of capital expenditure that affect its future performances. Traditional available methods work on certain assumptions. As Richard A Brealey and other in their book ‘Principles of Corporate Finance’ have stated that “Discounted- cash- flow analysis commonly assumes that company holds assets passively and ignores the opportunities to expand the project if it is successful or bail out if it is not.” Finance managers and planners have to consider all flexibilities of capital expenditures into account while deciding about capital projects. They need to envisage all sorts of economic and technical possibilities attached with flexible character of capital projects. Role of flexibility in capital expenditures decision making Economical, technical and other flexibilities in the nature of capital expenditure are the results of capital expenditures’ sensivities with regard to following matters: Long term financial strategies of the firm. Objectivity of improved productivity demands regular assessment and revisions of the capital project. Capital outlays must meet market uncertainties effectively. Maximum and superior returns are required to be achieved on invested capital. Capitalizing on growth opportunities should be the character of the project. Expanding the clientele base demands flexibilities in the character of capital project Cash generation need reinvestment in order to sustain and for the growth of the business, and this feature affects capital expenditures under restrictive resources. All these sensitivities demand that capital project decision should be capable of modifications as per available future opportunities. Simply speaking finance managers should have power to exploit opportunities and such power and right is called ‘real option’. Real Option Analysis “Real option theory has attracted significant interest in the field of strategic management in recent years. Advocates of real options approach emphasis that importing concepts from financial economics on options holds out the potential of yielding new insights on strategic decision making under uncertainty as well a boundary of the firm issues that are focus of competitive and corporate strategy, respectively.”(Jeffery J. Reuer and Tony W. Tong, 2007) Basically traditional tools of capital expenditure assessment are net present value (NPV), payback method, simple interest rate, and internal rate of return. Out of these methods of capital expenditure assessment only two namely, NPV and IRR are considered to be the methods that evaluate capital expenditures on time value basis. Other methods are preferred by the users only for simplicity of those methods. There are also certain limitations in the NPV method as it does not any consider or react to changing volatilities of underlying variables including revenue. Compared to all these traditional methods, the ‘real option analysis’ duly considers the flexibilities of capital investments or expenditures and also the changing risk environments. “As the name implies, a real option is the right or privilege to take action with a financial consequence having to do with real assets or property.” (Glen Kautt CFP, February 2003). While defining Real options Lawrence J. Gitman has stated in his book that “Real options are opportunities that are embedded in capital projects and that allow managers to alter their cash flow and risk in a way that affects acceptability (NPV). By explicitly recognizing real options, the financial manager can find a project’s strategic NPV. Some of the common types of real options are abandonment, flexibility, growth, and timing options. The strategic NPV improves the quality of capital budgeting decisions.” The above definitions states that there are four type of real options, namely , Abandonment option, Flexibility option, Growth option, and timing Options. Let us examine the effects of using those options on acceptability (NPV). Abandonment Option: As the term suggests this option provides the management a right to abandon the capital project even before its envisaged period of operation. This option helps the management to minimize or save the expected losses that may be caused by flexilibilities in capital projects. The management should exercise this option only under circumstances when it is imperative that continuation with the project is bound to bring or add up to the losses. Technically speaking, “Abandonment options, which are the right to sell the cash flows over the remainder of project’s life for salvage value, are like American put options. When the present values of remaining cash flows fall below the liquidation value, the assets may be sold. Abandonment is effectively the exercising the put option. These options are particularly important for large capital intensive projects such as nuclear plants, airlines, and railroads. They are also important for projects involving new products where their acceptance in the market is uncertain.” (Campbell R. Harvey, 1999). Flexibility Option This is an option which promotes innovations, adherence to popular demands, and opportunity to encash a popular trend and like that. It involves an extra or excess-capacity in capital projects, so that effect of use of flexibility options does not hamper the existing growth. Net present value will be enhanced by exercising flexibility options. The actual work environment is effected by forces like uncertainty and competitive interactions. These forces have an impact on cash flows. Whenever there are technical innovations or some progressive information at the disposal of management, the management has a flexible option to exercise. “Management’s flexibility to adopt its future actions in response to altered future market conditions expands an investment opportunity’s value by improving its upside potential while limiting its downside losses relative to management’s initial expectations under passive management. The resulting asymmetry caused by managerial adoptability calls for an “expanded NPV” rule reflecting both value components: traditional (static or passive) NPV of direct cash flows, and the option value of operating and strategic adoptability. This does not mean that traditional NPV be scrapped, but rather should be seen as a crucial and necessary input to an option based, expanded NPV analysis, i.e, Expanded (Strategic) NPV = static (passive) NPV of expected cash flows + value of options from active management.” (Trigeorgis, Lenos, 1993). Growth Option Growth is a necessary process in any and every aspect of development. Projects, cushioned with adoptability factor, are bound to develop in response to growth attributes. Growth option is “the ability of a project to provide long term growth despite negative values. For example, a new research program appears negative, but it might lead to new product innovations and market growth.” (Matt H. Evans). When a project has capabilities of adopting growth opportunities, then cash flows arising from such growth opportunities need to be recognized while taking a capital expenditure decision about this project. Timing Options This is the most important option that management can exercise keeping in view the flexibility nature of the capital expenditure responding to future uncertainties of circumstances. The projects, that shows adoptability to changing circumstances or allow the management to say delay or accelerate the execution of certain aspects of the projects, if need be, are bound to have effects on its cash flows. These factors needed to given due weightage keeping in view their importance while taking capital expenditure decisions. References Campbell R. Harvey, Identifying Real options, Abandonment or Termination Options, December 30, 1999, http://faculty.fuqua.duke.edu/~charvey/Teaching/BA456_2002/Identifying_real_options.htm Glenn Kautt CFP, Real Option Analysis: The Profession Next Cutting- Edge Tool, Financial Planning Journal, February 2003 issue, http://www.fpanet.org/journal/articles/2003_Issues/jfp0203-art9.cfm Jeffery J. Reuer and Tony W. Tong, Real Options in strategic Management, Advance in Strategic Management Volume 24(2007), http://www.rotman.utoronto.ca/~baum/v24_toc.html Lawrence J. Gitman, Principles of Managerial Finance, 11th edition 2006, Chapter 10, Risk and refinements in capital budgeting, page 476 Matt H. Evans, Excellence in Financial Management, Capital Budgeting Analysis, viewed on February 19, 2008, http://www.exinfm.com/training/pdfiles/course03.pdf Richard A Brealey and other, Principles of Corporate Finance, 8th Editions, Chapter 10, A project is not a black box, page no.247 Trigeorgis, Lenos, Real Options and interactions with financial flexibility (Topics in Real Options and Applications), Financial Management magazine, September, 1993, http://www.encyclopedia.com/doc/1G1-14793735.html Read More