Cost-Effectiveness Analysis - Case Study Example

Financial Management and Analysis Introduction Biz System Consultant Ltd is a new consultancy firm who are discovering growing demand for the retail businesses thereby changing and upgrading from the manual systems to the computerized systems. The company has three projects in hand to explore in the City of London. As it is a new company so it requires financing from different sources. Financing is required to initiate a business and raise it up to productivity and success. There are numerous sources of financing available for a startup business. The financial requirement if a company varies according to the size and type of business such as processing companies are capital intensive therefore requiring great amount of funds whereas retail business requires less amount of funds (Iastate, 2013). As Biz System Consultant Ltd is exploring demand for retail business so it will need less capital. The initial investment required by the project is £1,700,000 which can be borrowed from the bank at the rate of 5% per annum. The various sources of financing which the company would require are debt financing, equity financing, and lease. The aim of this report is to evaluate the techniques that can be used in choosing the best option among the three sources of financing (Icrc, 2012. Sources of Finance The company has three projects in hand which needs an initial investment of £1,700,000 which can be financed through debt financing by way of bank credit, equity financing, and lease. Debt Financing Debt financing includes borrowing finance from the creditors along with the provision of reimbursing the borrowed amount plus the interest at a specific future time. It may be unsecured and secured. The secured debt includes collateral and the unsecured does not include collateral and therefore puts the lender in the less secure state in relation to repayment in default case. Debt financing may be long term or short term in terms of their repayment plans. The debt of short term is used towards financing the present activities like operations and the debt of long term is used towards financing the assets for example equipment and buildings. The most accepted source of project financing in the business is bank credit (Iastate, 2013). Bank Credit The short term needs of the business are financed by the commercial banks by means of the commercial loans which are the main basis of debt financing (Unescap., 2008). They grant finance in various ways which are mentioned below: Loans: When the advances are made by bank in terms of heavy amount, the entire amount is withdrawn into cash instantly by the borrower, and he undertakes to settle it in single installment. It is required that the borrower should pay interest on the entire amount (Business, n.d.). Cash Credit: It is considered as the most accepted means of financing through commercial banks. When the borrower borrowed up to a certain limit besides the security of guarantees or tangible assets, it is recognized as a secure credit, however if the currency/cash credits are not supported by any security then it is called as a ‘clean cash credit’. In such a case, the borrower provides the promissory notes which are duly signed by means of two or more than two sureties. The borrower needs to pay the interest on the sum that is actually utilized (Business, n.d.). Overdrafts: Under the overdraft facilities commercial banks permits it users to overdraw their current account in order to show the debit balance in their account. The interest is charged to the customer on that account which is actually overdrawn and therefore not upon the limit which is sanctioned (Business, n.d.). Discounting of bills: Those businesses are financed by the Commercial banks which is concern through discounting their credit mechanisms like promissory notes, hundies, and bills of exchange. These instruments are discounted through banks at a lower price than their face value (Business, n.d.). Bank credit would be good source of finance for Biz System Consultant Ltd and the advantage of is that set reimbursements are generally spread over the time period which is excellent for the budgeting. The disadvantages are that it could be expensive because of the interest payments; as well as bank may need security on loan. Equity Financing Equity financing refers to exchanging a part of business ownership for the purpose of financial investment in business. The stake of ownership which comes from the equity investment permits the investor to have a share in the profits of the company. Equity engrosses permanent investment in the business and it is not reimbursed by the business afterwards. The advantages of the equity financing are that: it is less risky in comparison to a debt because the company don’t have to repay it and is also a good alternative if the company cannot manage to pay for a debt; investors generally take a view of long term and most of them don’t look ahead to get a return immediately; the company would not have to distribute profits into the loan repayments; the company can have additional cash on hand in order to develop the business; and most important is that there is no need to pay back the investment if the business fails (Icrs., 2012). However, there are also some disadvantages of equity financing which are: returns may be required that could be greater than the rate paid by the company for the bank loan; investors may need some rights of the company and also a profit percentage and such kind of control the company don’t like to give; they may also have to discuss with the financier before making the big decision and it may happen that the company don’t agree with the investors; in case of opposing disagreements with the investors, the company may require to permit the investors to run the business without the owner; and it also takes effort and time to find the true investor for the company (Icrs., 2012). Investment appraisal Investment appraisal is also known as process of capital budgeting and is defined as planning or decision making process regarding long term investment by a firm. Investment appraisal is generally undertaken when the project requires intensive capital investment, is long term in nature and return is accrued over a period of time that is more than one year. Projects that are evaluated using investment appraisal technique involve heavy investment in land, machineries, research and develop or new product development (Brealey, 2012). This technique helps in assessing overall contribution of the project or investment towards firm’s strategic objectives. Investment appraisal reviews costs and benefits (advantages and weaknesses) associated with a project. There are several qualitative and quantitative methods of investment appraisal that can be considered with respect to the proposed project of Biz Systems Consultants Ltd (Tirole, 2010). With respect to this project, critical assessment is very necessary as the required investment is very high and three mutually exclusive projects have been proposed. One primary disadvantage associated with mutually exclusive projects is that at most only one project can be accepted from the set (Tirole, 2010). In this regard, discounting techniques like net present value, payback period and internal rate of return (IRR) will prove to be useful. Other investment appraisal techniques such as cost benefit analysis, sensitivity analysis, multi-criteria analysis and scenario analysis can be vital (Scottish Government, 2013). These techniques have been discussed in an elaborate manner in the following sections. Net present Value (NPV) NPV is a very important discounted capital budgeting techniques which is invariably an important part of any kind of investment appraisal. In this technique, the revenue is considered as inflow while the costs are considered as outflow of fund. The net inflow of fund is discounted using a specific discount rate and then compared with the initial investment. Projects with positive NPV are accepted while those with negative values are rejected. However, another factor that should be taken in consideration especially for mutually exclusive projects is that project that has highest NPV should be given highest preference. Projects with negative NPV are rejected because inflows from such projects are not sufficient for covering total cost of the project (Bierman Jr and Smidt, 2012; Central Expenditure Evaluation Unit, 2014). NPV is generally the most preferred discounting method and in often referred over other methods such as IRR and payback period. Discounting methods are generally preferred for investment appraisal because they take in account time value of money. The factors that play an important role in NPV calculation are accurate estimation of inflow and outflow of cash, discounting factor and appraisal horizon. The discounting factor is a vital component in this respect and is calculated based on opportunity cost of the project and weighted average cost of capital (Central Expenditure Evaluation Unit, 2014; Prentice Hall, 2001). NPV, however, is not devoid of drawbacks and one of its chief drawback is excessive emphasise on time factor. It evaluates projects for a specific time period and does not take in account inflows afterwards. Therefore, a project with initial high inflow will be considered more preferable. Furthermore, NPV is focussed on maximisation of firm’s net worth instead of that of shareholders. Another flaw in the NPV method is manual determination of discount rate. The discount rate is calculated taking in account factors such interest rates, investment risk and other factors. Minor changes thereof can affect the NPV significantly (Central Expenditure Evaluation Unit, 2014). Internal rate of return (IRR) “IRR can be defined as the discount rate at which net cash inflow from a project for a certain time period is equal to firm’s initial investment in the project. In other words, IRR is the rate of return at which NPV of a project is zero” (Tirole, 2010, p.10). The primary reason behind this specific criterion is that when internal return is equivalent to discounting factor, the project breakevens. When more than two projects are evaluated, IRR is also taken in consideration along with NPV because it helps in minimising the underlying issues in NPV. The primary benefit associated with IRR method is that it helps in maximising return of shareholders. However, there are some significant drawbacks in the IRR technique. IRR is not suitable for mutually exclusive projects and under specific circumstances, may produce contradictory results (Central Expenditure Evaluation Unit, 2014). Payback period (non-discounted and discounted) Payback period determination is another vital capital budgeting method. Under this appraising method, the time span within which the project can recover the initial cost is calculated. However, non-discounted payback period is often considered inconsistent due to certain specific flaws. The payback period does not account for time value of money and neglects the inflows which follow after the payback period. Consequently, this method is considered inappropriate for project ranking (Brealey, 2012; Bierman Jr and Smidt, 2012). The non-discounted payback period technique is generally used for evaluating small budget projects; however, projects with large initial outlay are evaluated using discounted payback period. The discounted payback period method is a variation of the actual technique but it considers time value of money while determining the payback period. Payback period is generally referred along with other appraising techniques and not as a sole appraiser. The evaluation criterion, in this regard, is that a project is accepted over other choices if it has relatively less payback period (Bierman Jr and Smidt, 2012). Benefit Cost ratio The benefit cost ratio is determined by establishing quantitative relationship between the initial investment and discounted value of net inflows from the project. Any project that has cost benefit ratio higher than 1, should be accepted. For more than one project, the project with highest cost benefit ratio should be selected. Cost benefit ratio approach is generally favored by appraisers owing to its simplicity and ease of understanding. However, when benefit cost ratio is used in combination with other evaluation techniques, results can be conflicting. For instance, project A can have high cost benefit ratio and low NPV while project B has high NPV and low cost benefit ratio; at such situation the choice is very difficult, as one project maximises the benefits while the other enhance overall value of the firm (Bierman Jr and Smidt, 2012). Multi criteria analysis Under multi criteria analysis, preference among various project choices depends significantly on certain set of criteria and objectives. These objectives are primarily project oriented such as value addition, social cost, environmental impact and others. Multi criteria analysis is frequently used as an alternative to traditional appraisal techniques because it is a comprehensive approach that focuses on every aspect beside the monetary factor. The process often evaluates various criteria on the basis of its weighting with respect to the primary objective so as to establish its relative importance (Central Expenditure Evaluation Unit, 2014). Cost benefit analysis (CBA) The key objective of cost benefit analysis (CBA) to assess and to ensure that social and various economic benefits of a project are relatively greater that the existing cost thereof. As a result, the CBA establishes a project as desirable if its benefits outnumber the social and economic cost. It was however determined that high economic and social benefits does not result in project approval as there can be more projects with better NPV and prospect vying for the particular investment. Additionally, positive NPV may not necessarily imply that the project is worth undertaking as well. In CBA, sevaral relevant direct and indirect costs and benefits are evaluated critically. Net worth of the project based on market price or shadow price is considered with respect to the particular time when the assessment has been under taken. Since methods such as NPV and IRR are highly analytical in nature, it is ensured that CBA is relatively objective and determine attractiveness of the project from economic and social perspective (Central Expenditure Evaluation Unit, 2014). Sensitivity analysis A comprehensive cost benefit analysis significantly emphasises on sensitivity analysis as assessment technique of investment risk. This technique enables cost benefit analysis users to question the robustness of various assumptions associated with investment decision making such as discount rate, estimation of costs and benefits and time spread. Sensitive analysis is very detailed in nature and ensures that various parameters in an investment process are identified and sensitiveness of the primary outcome to one or more of these is highlighted. Consequently, it allows users to be specific about parameters that require further examination and clarification (Savvides, 1994). Sensitivity analysis recognises and establishes those outcomes of cost benefit analysis that are sensitive to certain specific assumptions that have deployed in the analysis. Sensitive analysis is considered as an integral part of investment appraisal process because it helps in delivering a comprehensive analysis of the project and its returns. Sensitivity analysis indicates impact of different variable on one another. If it is established through the analysis that selection of a choice results in significant variation in a variable, then the particular choice regarding the project is not taken in consideration. Additionally, if benefits associated with a particular choice are affected by assumed value of one or more variables then these variables and their values will be examined critically to enhance their credibility (Savvides, 1994). Scenario analysis A strong connection can be observed between sensitivity analysis and scenario analysis. Sensitive analysis is primarily related to determination of sensitiveness of various variables while scenario analysis is focussed on establishing interrelationship between various costs and benefits associated with a project. Scenario based approach implies that modification in variables should be supported by changes in the remainder as well. Holding one of them constant to gain specific outcome is unrealistic and impossible. Instead, each modification should be treated as a scenario and a series of scenarios should be evaluated through constant reviewing and adjustments within a specific framework (Savvides, 1994). Generally, more than one scenario is always developed such as best case, worst case and neutral case so that various issues are evaluated from every aspect. The analysis helps in assigning various values to every variable of cost-benefit analysis. These values reflect the level uncertainty associated with the variable or the final outcome. Post reviewing these values, it is essential that NPV is recalculated for the investment choice. However, scenario analysis produces certain fixed outcomes. The primary drawback of scenario analysis is that estimated probabilities and values indicate towards extremes of positive and negative outlook. It rarely takes in consideration the low probability values and consequently neglects certain outcomes (Savvides, 1994). Cost effectiveness analysis (CEA) Cost effectiveness analysis is undertaken to find out the degree of value addition that is caused by a particular venture to the society as in general it is not feasable to determine the impact or benefits specifically. The CEA determines cost of various alternative investment choices in monetary terms and compares them with respect to their contribution towards the society. However, it should be noted that CEA is not meant for determining whether to take-up a particular project. Instead, it is focused on determination of relative costs of each of the investment choices that are available to an organisation for achieving specific purpose. CEA assists in determining minimum cost at which objective of the capital project is achieved. Thereby, provides scope for better decision making (Central Expenditure Evaluation Unit, 2014). In CEA, evaluation of various investment choices is done most appropriately by using principles of NPV technique on various costs or cash outflows. In this regard, recurring cost associated with consumption of various facilities as well as the respective capital cost of developing the facilities should be considered, especially when these costs are different for different alternatives. Unlike NPV, where projects are selected on basis of highest value of NPV, CEA helps in selecting projects that has least net present cost (Central Expenditure Evaluation Unit, 2014). Conclusion It is observed that there are some drawbacks of equity financing but it may also considered as a good source of project financing for Biz System Consultant Ltd because of the various benefits offered by it; of which the most important is that it is less risky in comparison to a debt and there is no need to repay the investment in case the business fails. Additionally, for evaluation of the project net present value techniques, sensitivity analysis and payback period method is recommended to Biz System Consultant Ltd. Reference List Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. London: Routledge. Brealey, R. A., 2012. Principles of corporate finance. India: Tata McGraw-Hill Education. Business., n.d. Sources of Finance. [online] Available at: [accessed 02 December 2014]. Central Expenditure Evaluation Unit, 2014. The Public Spending Code: D. 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