Capital Budgeting: The Alpha Plc - Coursework Example

Capital Budgeting: The Alpha Plc. The net profit (loss) that has been calculated ignores the time value of money. This amount also includes depreciation on equipment. But the depreciation is not an actual cash outflow for the business therefore for estimating the project viability the amount of depreciation has been added back to the net profit. The working capital mainly caters to the short term obligations of the company like salary, wages administration expenses, etc. As these items have already been adjusted while estimating the project profitability no adjustments have been made with respect to the working capital. One-third of the head-office expenses are directly attributable to the project and the remaining two-third comprises other office expenses that cannot be directly attributed to the project. There are some general expenses like rent that cannot be identified with any particular project. It is important to allocate this kind of expense to all the projects on an equitable basis. For this reason no adjustments have been made to this two-third of Head-office expenses in the determination of the net present value. The survey costs have been deducted as these costs are incurred before the initiation of a project. This includes costs for determining project viability. In short these costs are unavoidable or have to be incurred even if the project is rejected later on. As the survey costs are incurred at the beginning of the project these costs have not been discounted with the cost of capital. Interest charges represent a cash outflow and have been rightfully deducted in the estimation of the project profit. In the determination of the project profit the costs relating to environmental damage have not been shown. As these costs are incurred in Year 5 it has been assumed that these costs are incurred at the beginning of Year 5 i.e. at the end of Year 4. For this reason this cost has been discounted for a period of 4 years. The residual value of the equipment has been shown as an inflow at the end of Year 4. The cost of purchasing of mine and equipment costs have been treated as Initial Costs. From the initial costs the present value of the net cash inflows has been subtracted to calculate the Net Present Value (NPV) of the project. The NPV of the project is found to be negative at £5.32 million. This indicates that the present value of the cash inflows is less than the cash outflows thus the project is not suitable. b) For the purpose of evaluating the investment the NPV method has been selected. This represents the excess of present value of cash inflows over project outflows. The projects with a positive NPV are selected for investing by the management. Other than NPV there are various other methods like Payback, IRR, etc. But each has its own set of limitations. Unlike Payback method NPV considers the time value aspect in the determination of project profitability. This is an important aspect as the value of £1000 today is not the same as the value of £1000 after five years. By taking this factor into consideration the NPV gives a correct estimate of the project profitability. Moreover the NPV method considers the project cash flows for the entire project duration as it is possible that some projects have higher inflows towards the end of the project tenure. However this is ignored in methods like Payback which does not consider the project cash flows towards the end of the project duration. For this reason NPV is superior to Payback method. NPV method also provides information whether the project has been able to create value for the company (Girvin, n.d.). Another method that is very popular among the executives is Internal Rate of Return (IRR). This method is simple to understand but NPV is given preference over IRR in the case of mutually exclusive projects. NPV estimates the value of the project more accurately as compared to IRR. The reason for this is that the NPV method finds out the true value of the project to the business (Mount Holyoke College, n.d.). While estimating NPV necessary adjustments can be made with regard to the risk of the project. Like for a project with a higher risk the company can use a higher discounting rate and for the project with a lower risk the company can use a lower discounting rate. This is not possible in the case of other methods. For all these reasons the NPV method has been considered for the purpose of evaluating the project. Part 2- Issues in investment appraisal While appraisal of a project the management should take into account all the vital issues that directly or indirectly affect the project. Many a time negligence of any minor issue results in major hurdle in the project. Such negligence can ever make the whole project unfeasible and it has to be stopped in mid way. Therefore, while analysing a project, the management should take into account all the factors that directly or indirectly affect the project. Among these issues, the time scale of the project is of great importance. Many a time the project losses its utility when it suffers with time overrun. It has commonly seen that with increase in time, different cost associated with the project increases and hence the profitability of the company gets hampered (Smith & Merna, 1999, p.21). Therefore, the management should be cautious that the project is progressing as per the predetermined schedule. Inflation and cost of capital are of vital importance because with changes taking place in the market condition there is a high possibility of fluctuation in them. Due to hike in inflation rate the cost of input that is cost of raw material, cost of labour and other indirect expenses may increase. Similarly, if the cost of capital increases, company has to pay more to avail required capital for the project. High cost of capital also affects the net present value of the project. As a result the expenses may go high and the make the project unfeasible. Apart from these above mentioned issues, the management should also pay equal attention to issues such as government policies and taxation structure. A project that seems profitable may not remain same after the government introduces some changes in its tax structure (Röhrich, 2007, p.150). The management should also pay attention towards availability of resources and accordingly the purchase strategy should be decided. It will be more beneficial if the company conduct inventory analysis while analysing the project. ABC analysis, VED analysis and FSN analysis are some of commonly used inventory analysis took that help in formulating effective stock management policies. Therefore, the above mentioned factors should be taken care while analysing the project. Cost of capital Cost of capital can be defined as “the rate of return that the market requires to attract funds to a particular investment” (Pratt, 2003, p.101). In economic term, cost of capital can be considered as the opportunity cost for the investors. While analysing a project, the management has to determine what should be the minimum cost of capital for the project so that the project appears attractive in long run. This cost of capital is directly influenced by the market situation; for example when the market is at a boom state, the company will prefer to have a high cost of capital similarly when the market is in recession phase, the company will accept the project even at low cost of capital. In general terms, the cost of capital is used to discount the net cash flow of a project while deciding that whether it should be accepted or not. The concept of cost of capital is quite import in the analytical techniques like net present value or internal rate of return. Therefore, the management should be cautious enough while determining the value of cost of capital. The management should understand that cost of capital is quite sensitive to the economical factors such as inflation and investment opportunities available in the market. If the inflation is high, the investor will demand a high cost of capital and similarly if the investors have several investment opportunity then he/she will prefer to invest in the project that offers highest cost of capital. After conisation the above mentioned factors it can be said that company not just take into account the cost of capital (cost of long term capital and cost of short term capital) while finalising the cost of capital for the project; factors such as market condition, inflation rate and investment opportunities should also be used. If the management fails to determine the accurate cost of capital, then there is a high possibility that whole process of appraisal goes wrong and the management ends up selecting an unfeasible project. Risk While making investment in a project, the management should be careful about all possible risk associated with the project. It is a common saying that risk and return are directly proportional to each others. That means if an investor takes high risk then he or she will demand for high return. However, in real life situations this may not be true always. Therefore, it is quite essential that the management should identify all the possible risk associated with the project. Management prefers to take calculated amount of risk so that it can take proactive action to manage the risk. There are several type of risk associated with a project. Among them the most common type of risk is financial risk. There is always a possibility that the assumption regarding demand and supply may not be fully correct and due to poor demand, the project fails to generate predetermined cash flow. The other factors like unavailability of the resources may also result to high risk for the project. A project is highly sensitive to the external factors and among them economic factor is quite vital. Any adverse economic condition can have a negative impact on the project cash flows. It is important that the sensitivity of the project to the economic uncertainties is taken into consideration at the time of assessing the risk of the project. Apart from the above mentioned risks, a project is also vulnerable to sudden changes in government policies relating to tax rate. Like a sudden rise in tax rate can reduce the net cash inflow of the project. Similarly, increase in inflation rate may lower the real value of the cash flows thereby impacting the estimated project profits. Thus, the management should conduct a sensitivity analysis to understand the riskiness of the project. This will be helpful in making appropriate decision. Reference Girvin, M. No date. Advantages of NPV Rule. Net Present Value And Other Investment Criteria. Available at: http://people.highline.edu/mgirvin/YouTubeExcelIsFun/ch8.ppt [Accessed on November 13, 2010]. Mount Holyoke College. No date. How Do I Value a Project?. Corporate Finance Basics. Available at: http://www.mtholyoke.edu/~aahirsch/howvalueproject.html [Accessed on November 13, 2010]. Pratt, S. P. 2003. Business valuation body of knowledge: exam review and professional reference. John Wiley and Sons. Röhrich, M. 2007. Fundamentals of Investment Appraisal: An Illustration Based on a Case Study. Oldenbourg Wissenschaftsverlag. Smith, N. J. & Merna, T. 1999. Managing risk in construction projects. Wiley-Blackwell. Read More