Capital Investment Decision Making Processes in an Organisation - Term Paper Example

Submit a critical appraisal based on your own investigation of capital investment decision making processes in an organisation. Table of Contents Literature Review 3 Structure of financial statements in Project Finance 4 Project appraisal techniques 5 Pay-back method- 5 Accounting Rate of Return (ARR)- 6 Net Present Value (NPV)- 6 Internal rate of return (IRR)- 7 Profitability Index (PI)- 8 Techniques adopted by the managers 8 Project appraisal of McCain Foods 9 Recommendation 10 Reference 12 Introduction Project Finance refers to the financing of long term based projects like infrastructure depending on the project’s anticipated cash flows. The finance for the project is extended by financial institutions and equity investors. These loans are backed by the assets of the project and the cash flows generated from the project is used to pay the project loan. The project financing is secured by the project assets and revenue-generating contracts and not by general assets of the business or the project sponsor’s creditworthiness. This type of financing is more complicated as compared to the other financing methods and is common in transportation, public utility, and mining industries. Literature Review There has been a significant change in the concept of investment appraisal over the past 250 years. Previously the investment making decisions were based on the intuition and knowledge of the business owners. Currently the decisions relating to the investments are focused on the financial tools which consider the risk inherent in the project, time value of money, project duration, simulations and weighted average cost of capital. At present the prospective investors and the external stakeholders have an access to the accounting data of the company and estimate the economic rate of return of the firm on the basis of these accounting figures. Danielson & Press (2003) highlight that there exists a relation between the economic and the accounting rate of return. According to Parker (1968) the risk analysis methods and time value concept were incorporated in the cash flows of the insurance companies even in the nineteenth century. However it took some time for the discounted cash flow technique (DCF) to gain acceptance among the general businesses (Chapman, et al., 2007). The managers of the publicly traded companies in US rely more on the DCF technique today as compared to the past. This situation is similar for the other countries like South Africa, Britain, Sweden and other European countries. A survey of the Industrial Sector listed companies of Johannesburg Stock Exchange (2000) has shown that two-third of the surveyed South African companies use DCF technique to make investment decisions. Of these nearly 32.3 percent of the companies consider IRR as the best tool for project evaluation whereas 13.9 percent view NPV as the preferred tool and 16.9 percent apply the discounted payback period. There is a link between the size of the firm and techniques of investment decision. A survey of the small sized South African firms highlights that nearly 14 percent apply NPV or IRR as the investment appraisal tool. But this figure is 75 percent for the large sized firms. Studies have highlighted that large sized firms are more likely to use NPV technique. Structure of financial statements in Project Finance A project requires investment in equipments, procurement of necessary materials, hiring the labour force and the administrative staff etc. The fund needed for the project expenditures can be raised externally by the issue of equity or in the form of bank loans. Acquisition cost incurred by the company in the initial phase of the project is known as the Initial Flow. The proceeds from the project represent a source of inflow. Such inflows occur every year. Besides the project inflows the business has to expend an amount very year in the form of salaries, depreciation, cost of material, finance charges etc. These represent the project outflows. Based on the anticipated project outflows and inflows the Operating cash flow of the project is calculated. As the depreciation on machinery is not an actual outflow, it is not deducted in the calculation of the net cash flow of the project. The proceeds realized from the sale of equipments at the end of the estimated life of the project is known as scrap value. This is considered as Terminal Flow of the project. An adjustment of the initial, operating and terminal flows gives the net cash flow of the project. As these cash flows are of a future date these are then discounted to the date of inception of the project to assess the viability of the project investment. An analysis of the projected financial reports or statements helps in the project evaluation technique. Project appraisal techniques Project management refers to the way of managing or controlling the resources of the company on a specified activity within a permissible time, fund availability and technology constraints (Hopwood, et al., 2008, pp.1208). The planning, structuring and the ultimate execution of a project form a natural sequence which is called the project cycle. This cycle starts from the identification of the project, appraisal, carrying out of the project, supervision and evaluation of the project performance. Of the various stages of the project cycle the most important is the project appraisal as this helps in assessing the financial aspect of the project (Buljevich, et al., 1999). The project appraisal techniques include the pay-back methods and discounted cash flow method that are used in the organizations belonging to the private sector. Pay-back method- The pay-back method considers that the allocation of funds to a project is based on two factors. This includes the opportunity cost of investing the funds in other avenues with a similar duration and also the risk inherent in undertaking the project. Therefore the time period of the project and the willingness of the management to commit funds to the project for its estimated duration till the initial investment in the project is realized play a key role in the project selection (Palmer, et al., 2001, P 184). The pay-back period refers to the time taken for recovering the initial investment in the project. This method is very simple and easy to calculate. Suppose it is the policy of the business to invest in the projects of up to three years duration. In this situation if the payback period of the project is less than the acceptable time period then only the project is accepted otherwise it is rejected. However this is not reliable as it does not consider the cash flows for the entire project duration i.e. it ignores the cash flows relating to the post-payback period. The timings of the cash flows is taken into consideration. Accounting Rate of Return (ARR)- This is a non-discounting method of appraising the cash flows of the project. As this is calculated using the accounting data from the income statement it is easier to calculate. This is expressed as Average net profit/ Average Annual Investment. The annual earnings of the project is used for calculating the project profitability. As the accrued amounts are also considered in calculating the accounting data it does not give a true picture of the profitability. Besides, this method also ignores the timing of the cash flows. As a result the future cash flows are erroneously taken as the present cash flows distorting the project profits. Even though this method is fairly simple but the inherent weaknesses in the method make it unsuitable for investment appraisal (Washington State University, n.d.). Net Present Value (NPV)- The NPV method of project evaluation solves the limitations of the payback period and accounting rate of return. Unlike the accounting rate of return which considers the net earnings, the net present value method considers the project cash flows. The NPV method considers the time value of money aspect into consideration in the determination of the net cash flows. NPV is given as the difference between the initial cash outlay and the present value of the cash inflows of the investment. This basically measures the value added or created from a new investment. Only the projects that can generate a positive net present value is considered for investment. The NPV method is a straightforward way of selecting between the projects of varying levels of risk. Higher rates can be used for discounting the cash flows of risky investments. The NPV method considers the cash flows of the entire project cycle making it more reliable as compared to the Pay back period method. This method is employed by the corporations with the combination of other tools of capital budgeting. The NPV technique is most ideal while selecting between two mutually exclusive projects. Internal rate of return (IRR)- The internal rate of return of an investment is similar to the yield-to-maturity (YTM) of the bond. Just like YTM refers to the discount rate equating the present value of the future cash flows of the bond with the prevailing market price, the IRR of a project is the rate of return earned on it. After the calculation of the IRR it is then compared with the pre-set hurdle rate which represents the minimum return that can be accepted by the firm on a project. Therefore a project is taken up only if its IRR is greater than this hurdle rate. This hurdle rate is set on the basis of market returns on similar investments. Like NPV method, the decision in IRR criteria is based on the market whereas pay-back method and ARR approaches are arbitrary thresholds of investment appraisal. Even though this method is a significant improvement over the other methods of appraisal there are some problems associated with it. This happens when the IRR of various projects exceeds the hurdle rate but considering the funds constraint the company cannot take up all the projects. This creates problems in the prioritization of the project or when the company has to choose between two mutually exclusive projects. Profitability Index (PI)- Like IRR, the profitability index comes very close to the NPV technique. This is calculated as present value of cash inflows/ Initial investment. If the PI of the project is greater than 1.00 this means that the NPV of the project is positive and if it is less than 1 then the project is not capable of generating any positive returns. Therefore a PI of 1.60 indicates that for each unit of money invested in the business there will be a gain of 0.60 (Mount Holyoke, n.d.). Techniques adopted by the managers A survey of the chief financial officers (CFOs) conducted by Graham and Harvey highlighted the important capital budgeting tools adopted by the companies in making investment decisions. Nearly 75 percent of the respondents used the NPV and IRR techniques for appraising a project. A previous study conducted by Gitman and Forrester (1977) revealed that nearly 9.8 percent of the large sized firms use the NPV as a primary technique. This shows that the popularity of this tool has increased with time. The selection of the NPV approach is also based on the size of the firm. For instance this technique is most commonly used in the large sized firms. Pay-back approach is the next alternative that is frequently used in the capital budgeting decisions. This method is particularly common in the small firms. Majority of the respondents reported limited reliance on ARR, or the profitability index. A study by Sandahl and Sjogren (2003) revealed that 64.8 percent of 128 surveyed companies Swedish companies adopt either NPV or IRR or use both the techniques together. Lumby (1991) reported that a positive relationship exists between the size of the firm and the tendency to apply the discounted cash flow technique. Brounen et al (2004) showed that the majority of the European companies use IRR and NPV comes a close second. (Lucey, et al., 2008). Project appraisal of McCain Foods Mc Cain Foods is the market leader in the frozen potatoes market with a market share of nearly 45 percent in the UK market. To bring about an innovation in its operations the company installed wastewater treatment system and wind turbines at its Whittlesey plant. These two projects jointly cost the company approximately £15 million. The company evaluated the financial benefits of the project. The cash outflows of the project include the initial investment at the inception and maintenance costs incurred for a period of five years and the cash inflows of the project is the amount that the company will be able to save in its energy bills. It is expected that the cash outflow on the wind turbines will be £10 million at the beginning followed by £0.1 million for the following three years and £0.2 million for the next two years. Similarly the initial investment on wastewater treatment is anticipated to be £5 million followed by the £0.5 million for the following two years and £0.10 million for the remaining three years of the project. The cash inflows from the wind turbine project is anticipated to be £2.6 million, £2.8 million, £3.0 million, £3.2 million and £3.4 million for the five year period; the same for wastewater treatment is anticipated to be £1.37 million, £1.39 million, £1.60 million, £1.80 million and £1.90 million. The net cash flows of the wind turbine project are anticipated to be £2.5 million for year1, £2.7 million for year 2, £2.9 million for year 3, £3.0 million for year 4 and £3.2 million for year 5. Similarly the anticipated net cash flows of the wastewater treatment project is anticipated to be £1.32 million for year1, £1.34 million for year 2, £1.50 million for year 3, £1.70 million for year 4 and £1.80 million for year 5. On the amount invested the company anticipates to earn a negative cumulative cash flow of £1.9 million in the third year of the wind turbine project and the same for the wastewater treatment project is anticipated to be £0.14 million in the fourth year. From thereon the company expects to earn positive cash flows on the wind turbine project of £1.1 million and £4.3 million in the year 4 and year 5 respectively; and £1.66 million on the wastewater treatment project in year 5. The payback period of the wind turbine project is expected to be 3 years and 8 months and for the wastewater treatment project is estimated to be 4 years and 9 months. The NPV of both the projects is profitable. Net present value of the wind turbine project is £0.17 million. Taking a discount rate of 12 percent, the NPV of the wind turbine project is close to positive indicating that its IRR is a little more than 12 percent. All these calculations suggest that the projects are worth investing. The only risk in the project is that if the project costs increase then there will be lesser amount of savings than expected (The Times 100, n.d.). Recommendation The investment appraisal technique involves analysing, reviewing and implementing the investment proposals that are in line with the goals of the business. The managers must ideally use the technique that considers the time value aspect in the cash flows and recognizes the risk inherent in a project by using the appropriate discounting rate. Even though a simple approach is desirable, but it may not always yield correct results. This is the main reason for the popularity of the NPV and IRR technique among the large sized corporations. Reference Buljevich, C.E. Park, S.Y. 1999. Project financing and the international financial markets. Kluwer Academic Publishers. Palmer, P. Randall, A. 2001. Financial management in the voluntary sector: new challenges. Routledge. Washington State University. No Date. Non Discounted Cash Flow Methods. Session 2: Project Evaluation and Selection Analysis Techniques. Available at: http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm [Accessed on February 12, 2010]. Lucey, M.B. Megginson, L.W. Smart, S. Cengage Learning EMEA. Chapman, S.C. Hopwood, G.A. Shields, D.M. 2007. Handbook of management accounting research. Elsevier. The Times 100. No Date. Edition 14 Study. Available at: http://www.thetimes100.co.uk/case-study--sustainability-through-investment--101-333-2.php [Accessed on February 12, 2010]. Mount Holyoke. No date. How Do I Value a Project?. Corporate Finance Basics. Available at: http://www.mtholyoke.edu/~aahirsch/howvalueproject.html#npv Hopwood, G.A. Chapman, S.C. Shields, D.M. 2008. Handbook of Management Accounting Research. Elsevier. Bibliography Drury, C. 2008. Management and Cost Accounting. Cengage Learning. Hoque, Z. 2005. Handbook of Cost and Management Accounting. Spiramus Press Ltd. Chadwick, L. 1998. Management accounting. Thomson. Read More