Main Advantages and Disadvantages of Payback and Net Present Value - Essay Example

Financial Management Analysis Contents Introduction 3 Main Advantages and Disadvantages of Payback and Net Present Value 3 Usage of Weighted Average Cost of Capital as a Discount Rate in Investment Appraisal 6 Distinguish Between three main sources of Long Term finance for a Large PLC 7 Advantages and Disadvantages from the Point of View of the Large PLC 8 Conclusion 9 References 10 Introduction Financial management analysis is the process of evaluation of business activities, budget of finance, estimation regarding projects and other financial transactions. It is also helped to take decision regarding proper and suitable investments from where business can earn more money. Financial management analysis describes any entity’s stability, liquidity, solvency and profitable position. Depending on this analysis a person or a company can trust on that entity and invest money for more amount of return. Analysis of financial statement is also more important to understand the growth and loopholes of the business. These financial statements include income statement, balance sheet, cash flow statement, fund flow statement etc. which are able to show the actual condition of the company and also focus the areas where corrective steps have to be taken for further growth of the business. These key areas which show the past performance of the company will help also to make future plans and also provide estimated future condition of that particular organization. Shareholders can get this information about the stability and growth of the company and take decision for further investment in this company or bring back their amount of capital. It is also useful for the work of comparison among other rival companies in the same industry. Main Advantages and Disadvantages of Payback and Net Present Value Payback period method is a process through which a company can estimate about the total cost to launch a new project or to start a new work. It also indicates the amount of money the company can get from the newly launched project after a certain period of time. It focuses on the time phrase when the company will meet its break even line and start to earn profit. For example this can be said that ABC Company wants to start a new production plant in China. This is a toy manufacturing company and headquarters of this company is located in India. China already has so many toys manufacturing company and they are doing very stable business in their domestic as well as international market. So for this reason ABC Company will face some challenges and tough competition if it will going to start its manufacturing procedure in China. In such case financial analyst of that company can use payback period method to analyse the situation in details that how much scopes are there and if scopes exist in that market then in how many days the company can start to earn revenue and meet the break- even point after starting its operational activities. There is a certain formula to calculate the payback period which is mentioned below. Payback period = Total requited investment for a specific project / Net annual cash inflows By the above mentioned formula a company can estimate the time within which it can quickly recover its initial investment and will start to earn profit (Higgins, 2011). In the above graph it is clear that at which level the business will start to earn its revenue after meeting all its costs and liabilities. It is also observed that There are so many advantages and disadvantages in case of payback period method. Advantages are as follows – It is a very simple method which can be widely used and easy to understand by everyone. The computation or calculations are also very easy. The investor or the management of company can get information about the time period of recovery the invested money and on the basis of this information they can make plan or take decision for further investment of that amount of capital in any other project. The chances of losses will be reduced also in case of short term payback period and according to it management can invest the capital in any particular project. In short term period economic condition will not changed in drastically way. So the business will be more benefitted and there will be very less chances of other unavoidable reasons which can generate risk factor for the business. Company’s liquidity position also will be increased in case of short term payback period. So by using this method management can anticipate the flow of liquidity and the amount of working capital within the business. Management can also prepare a proper and effective capital budgeting plan as they can get information about the cash inflows by using the mentioned method. Disadvantages of payback period method – This method cannot consider the time value of money. This method is unable to provide information about the cash inflows after the payback period. It is also not considered the asset’s useful life. It mainly focuses on the liquidity part of the business but ignore the profitability part of the company from that particular project (Graham and Smart, 2011). Net present value can be defined as the difference of discounted value or present value of cash inflows and cash outflows. It is majorly used in case of capital budgeting in any particular company and it helps to analyze the profitability from any certain project or investment. Calculation of Net Present Value (NPV) is as follows. Net Present Value = ∑ {Ct / (1 + r) t} – C0 Here, Ct = Net cash inflow during a particular period C0 = Initial investment t = Number of time period and r = Discount rate. Advantages of Net Present Value are - Net present value always considers the time value of money in case of investment. Here before cash flows and after cash flows over the total life span of any project are considered which helps to give a clear view about the liquidity system of that particular project. It helps in maximizing the value of the company and it gives high priority on the risk factors which are related to business activities and the profitability of the project. Disadvantages of Net Present Value are – It is very difficult method used by everyone. More expertise is required to apply this method in any company or project. Calculation of the appropriate discount rate is very complex and tough. If the projects have unequal lives then it is not the right method to use as because it cannot provide any kind of right decisions or information in such cases. If invested amount of capital in mutually exclusive projects are not similar then apply of this process will not bring success to reach at the accurate decision level by the end of the management. Usage of Weighted Average Cost of Capital as a Discount Rate in Investment Appraisal Weighted average cost of capital is a certain method of calculation which is used to calculate the cost of capital of any company and it is weighted proportionately each category of capital. All category of capital sources are long term debt, preferred stock, bonds, common stock etc. These all re included in the weighted average cost of capital (WACC). The increase of weighted average cost of capital will decrease the valuation and chances of higher risk and it also direct the increase of rate of return and beta on equity in any business activities. The equation of weighted average cost of capital is mentioned below. Weighted average cost of capital = {(E / V) * Re} + {(D / V) * Rd * (1 – Tc)} Here, Re = Cost of equity; Rd = Cost of debt; D = Market value of firm’s debt; E = Market value of firm’s equity; V = E + D [Market value of firm’s equity + Market value of firm’s debt]; Tc = Corporate tax rate; E / V = % of financing in equity; D / V = % of financing in debt. This equation shows that components of cost of capital multiplied by its proportional weight and then sum with each other. It is a complex and difficult practise in the development market. There are three types of discount rates which can be found in case of WACC. 1st type of discount rate is used in case of corporate weighted average cost of capital. Every multi- national company is maintained a portfolio of multiple investment. So every investment is considered as the same cost of capital. Now this will provide a reflection on the total aggregated risks in the portfolio of any company. The 2nd type of discount is explained that value of each investment project will be calculated according to the local weighted average cost of capital and risks of the projects are reflected on the basis of local countries. 3rd types of discount highlight the additional risk factors which are related to certain investments within a particular country. It also indicates the sovereign risks which mean country risk and credit risk associated with any investment in a country (Fabozzi and Peterson, 2003). Distinguish Between three main sources of Long Term finance for a Large PLC There are so many sources of long term finance which can be used for a large PLC. Among those sources 3 major sources are ordinary share and preference share, Debenture & convertible debenture and Bank loan. Ordinary shares are famously known as common share or equity share or voting shares. Ordinary shares provide the right to the shareholders for taking share of profits as dividend. It gives the voting right to the shareholders for selecting board of directors in the annual general meeting of any company. On the other hand preference share holders can get fixed amount of dividend. Debenture & convertible debentures are one kind of loan but in this case collateral securities are not required. This has to be repaying after a certain period of time. A fixed level of interest has to pay for borrowing such amount as a long term source of finance. This interest has to pay between the maturity date and the date of issuing the debenture to the debenture holders. If company will not face profit then also interest and repayment of debenture have to be done by the management of the company. The lender of the debenture is considered as general creditor of the company in case of liquidation of business. So this can be said that it is primarily unsecured. Convertible debenture is such kind of debenture where repayments can be done through cash or stock. Bank loans are another long term source for financing capital in the business. There is certain interest rate which has to pay instead of taking loan from banks and this interest rate depends on the tenure of the loan. This tenure can be 5 years, 10 years, 15 years and maximum up to 25 years. This source is very much stable than the source of overdraft. Loan will be granted by the respective banks after verifying the nature of project and purpose of taking loan. Suppose a manufacturing company want to purchase expensive machinery for the purpose of production and for the purpose of purchase this machinery they ask certain amount as loan from any existing bank in the country. In that case at first bank will investigate that is the business is going concern or not. They will seek information about the reputation of this business activity in the present market. After that they will analyze the requirement of purchasing the machinery and the quantum amount the company will pay to purchase that particular machinery. Then bank will grant the loan amount if they will get all the positive signs related to business (Brigham and Ehrhardt, 2011). Advantages and Disadvantages from the Point of View of the Large PLC Advantages of ordinary shares & preference shares – Ordinary share gives the right to the owner of the share for taking active participation in the amount of profit the company can earn in a financial year. These share holders have the right to vote for selecting board of directors and can take part in case taking major decision for the further growth of the business. It provides long term source of finance in case of growth of the PLC. Preference share is redeemable which gives a big advantage for PLC. Disadvantages of ordinary shares & preference shares – In PLC profit can be varied widely. So payment of dividend to ordinary share holders also can be varied. If PLC does not make any profit then it will not pay any kind of dividend to ordinary share holders. They are also obliged to bear operational risks of the company. Company has always the legal obligation for paying dividend to the preference share holders in case of losses also. Advantages of Debenture & convertible debenture – PLC pay fixed level of interest in such case. Convertible debenture provides lower interest rate which is very much helpful for PLC activities. It is comparatively lower risky way to raise capital for business. Disadvantages of Debenture & convertible debenture – If business will be failure then repayment has to be done before paying the share holders by selling the assets of the company. Advantages of Bank Loan – It is a quickly secured source of long term finance. Disadvantages of Bank Loan – Bank can interrupt in case of operational activities in the business. It is a more expensive source. Interest rates can be high and vary time to time. Guarantees are required for taking this loan (Higgins, 2012). Conclusion At the part of conclusion this can be said that financial management analysis is such kind of process where so many equations are used to analyze the financial health of a business entity. It is playing an important role in case of management activities in the daily operation in a business. Management can concentrate on reducing the cost factors and increase the amount of revenue which can be generated from the activities of business. Management can set some goals and objectives on the basis of financial analysis and estimate future projects and further initiative from the end of the company. References Brigham, E. and Ehrhardt, M. 2011. Financial Management: Theory and Practice. Boston: Cengage Learning. Fabozzi, F. and Peterson, P. 2003. Financial Management and Analysis. New Jersey: John Wiley & Sons. Graham, J. and Smart, S. 2011. Introduction to Corporate Finance: What Companies Do. Boston: Cengage Learning. Higgins, R. 2011. Analysis for Financial Management. New York: McGraw-Hill Education. Higgins, R. 2012. Analysis for Financial Management. New York: McGraw-Hill Irwin. Read More