Types of Investment Appraisal Techniques - Essay Example

Financial Management Table of Contents Introduction 3 Optimal Capital Structure 4 Understanding Capital Structure 4 Illustration and analysis 5 Limitations 7 Investment appraisal 9 Types of Investment appraisal techniques 9 Discounted cash flow 9 Internal rate of return 10 Critical evaluation of the two techniques 10 Illustration and analysis 11 Conclusion 12 References 14 Introduction Capital structure signifies the mix of a company’s debt and equity. Capital structure and capital budgeting are different in their approaches, but they are interdependent. Capital budgeting refers to the viability of investment projects of a company, whereas capital structure determines the source of financing its projects. It considers the ways to finance its future projects. There are two ways in which a company can procure its capital i.e. debt and equity. The sources of capital comprise debt which includes short term debt and long term debt and equity includes common and preferred equity. Either of the ways has certain benefits and costs associated with it. Companies carefully consider whether to use deft financing or equity financing as the cost benefit trade off can significantly affect the future earning potential. Equity financing costs are lower than debt. It does not create any binding on the company to pay its investors except for preference shareholders. Debt financing creates a cost where a company has to bear a finance charge which also helps to lower its tax liability. Capital structure influences the financing decision of companies. If the cost of capital is high despite the high profitability of the project a company might not consider in investing in the project as the resultant income level would be reduced. Capital budgeting or investment appraisal is the way to evaluate the profitability of the investment after considering the cost of capital. It considers the current value of the investment after adjusting the expected returns with the capital cost to find the net value of the investment. This is one of the methods for investment appraisal; the other methods like IRR and NPV are also used to evaluate investments which are discussed later (Cox and Fardon, 2008). Optimal Capital Structure Optimal capital structure refers to the ideal debt to equity mix of company whereby the value of the firm is increased with minimum cost. Firms should try and minimise the cost of capital so as to increase the incremental value of its financed operations and projects. An optimal capital structure not only aims at maximising its incremental value but also maximising the wealth of its investors. Prospective investors consider the capital structure before investing in a company. Though cost of debt is comparatively lower than cost of equity owing to its tax deductibility, it still has high potential risk exposure as increasing debt indicates the burden of the company (Chorafas, 2002). Understanding Capital Structure Capital structure as discussed earlier is significant of the capital distribution of a firm. It shows how much of the capital comprises debt and how much of equity. Companies with high borrowing either short term or long term are called highly leveraged as their main source of fund is debt. On the contrary firms with high equity capital have low leverage. The debt capital includes a firm’s long term and short term obligations. Long term debt sources mainly comprise bond, debentures, notes issues, bank loans, etc and short term debt sources include cash credit, bank overdrafts, working capital loans, etc. Equity sources include common stock and firms retained earnings. Financing operations and projects using retained earnings benefits a firm from zero cost but at the same time reduces the reserves for future expansion as it will have to borrow or issue shares to fund its operations. Capital structure is a key indicator of the debt burden of a firm that influences the decision of investors and potential investors of a firm. Highly leveraged firms enjoy high tax deductibility but are exposed to high risk as investment projects might fail which will lead to payment default leading to bankruptcy. Low leveraged companies have high equity capital (Brigham and Houston, 2011). Over the years capital structure planning has gained importance owing to the changing market conditions and risk exposure. It is critical for a company to decide how much of its own fund and eternal sources will it employs in financing its operations and investment projects. Firms in order to attract fresh investments for its expansion need to structure its capital in a way that influences investor decisions. Capital structure affects the balance sheet of firms which indicates its financial health. Capital structure planning is incumbent on the type of business i.e. start up or running company. Start up companies usually have low rate of return and a highly leveraged capital structure will reduce its return as debt involves payment of a fixed charge i.e. interest. It is thus better for new firms to have a low leveraged capital structure. In case of a running business it is better to have high leverage as this would reduce its tax availability owing to its high positive returns (Periasamy, 2009). Illustration and analysis Balance Sheet of X Plc for the year ended 31st December, 2015 Assets ( in 1000s) £ £ Current assets 9609 Long term investments 1460 Property, plant and investment 9716 Intangible assets 1222 Other assets 62 Total Assets 22069 Liabilities Current liabilities 3464 Long term liabilities 5474 Total liabilities 8938 Networth Equity capital 9439 Retained earnings 3698 Total equity 13137 Balance Sheet total 22075 Table 1: Balance sheet of X Plc The above table shows the balance sheet of company X Plc which is used to calculate the capital structure as shown below. The balance sheet is divided in three sections i.e. Assets, liabilities and networth. Assets include short term and long term assets. Long term assets include property and equipments, intangible assets and other assets. Assets also include long term investments. Liabilities comprise short term and long term liabilities. Networth includes equity capital and retained earnings (Pandey, 2009). Calculating capital structure (I) of X plc Equity and debt £ Ratio Long term debt 5474 Total equity 13137 Debt to equity 42% Calculating capital structure (II) of X plc Equity and debt £ Ratio Current liabilities 3464 Long term debt 5474 Total equity 13137 Debt to equity 68% The above table shows the capital structure of X Plc. The first table shows the capital structure by considering the long term debt and the total equity whereas the second table considers the short term liability in calculating the total debt. Debt equity mix is calculated by dividing the total debt by total equity. In the above tables the capital structure ratio is expressed in percentage. In the first case the debt equity mix is 42% compared to the second case where it is 68%. The second case shows a comprehensive capital structure which includes the short term liability of the firm X Plc. Usually in determining the capital structure of a firm long term debt is considered, but including the short term liability reflects the overall debt of the company. Calculating the debt equity mix by including only long term debt would understate the debt obligation of the company as observed in the first case i.e. 42%. The actual debt shows the true and fair value of the firm’s external obligation status i.e. 68%. Thus, if X Plc would only consider case 1, it would have resulted in underestimation of its debt value by 26% (Chandra, 2011). Limitations The capital structure mainly deals with the combination of debt and equity. Apart from the advantages or the benefits of the capital structure there are certain limitations or disadvantages of capital structure which mainly includes the combination of debt and equity. Increase in the debt ratio may increase the extent or the degree of the risk which will result in the increase in the interest rate for compensating the additional risk (Kaplan and Stromberg, 2009). The most important limitation on the application of the capital structure is that it is subjected to two main types of risk which includes the financial risk and the business risk. The factors that influences or affects the business risk mainly includes the variability in the sales price, demand, input cost and also exposure of the foreign exchange. The financial risk that is encountered by the companies on the adoption of the capital structure technique by the companies are in case of the financial risk which is an additional or the extra amount of risk that is being transferred to the stockholders for financing with debt. The disadvantages or the limitation of the capital structure can be better explained with the help of the Modigliani and Miller approach which explains that the increase in the return of the stock holders through the use of leverage will increase the risk and therefore no benefit can be provided out of it. The firms are not provided with the opportunity in changing the total value of the securities by dividing the cash flows into different streams. Capital structure also leads to the bankruptcy risk. It increases the debt obligations in the payment of the principal and the interest which imposes more pressure on the company. The failure of the management in ensuring the policies related to the sound cash management may result in the situation in which the company fails to meet its obligations. High dependence on the debt structure by the firms or the companies cannot be said or preferred to a strategic decision. Many firms or the companies generally make investment decision with the help and support from the banking institutions and therefore the capital structure of the firms either government or non government are more related to debt financing as compared to equity financing. Therefore the firms are subjected to risk as it prefers or is related to debt financing (Cumming, 2009). The other disadvantages in the debt financing of the capital structure is that the new companies often face the shortages in the generation of cash flow which tends to make the regular payment difficult and the availability of the debt financing is also limited and restricted to certain companies or businesses and the problem with equity financing is that it makes the process of initial public offering very complex and it creates problem for the entrepreneur. Investment appraisal Investment appraisal also known as capital budgeting is used by firms to evaluate the economic viability of a firm’s investment in expansion projects and future operations. Since resources are not unlimited with the given capital firms should try and maximise the value of its investment. It should accept projects that are aimed at generating higher profits that will help to maximise shareholders return. Capital budgeting considers the time value of money i.e. which signifies how a firm expects its money to grow and provide it with positive returns. Capital investment in projects bears certain costs which is a critical determinant in accepting projects. Firms which have high cost of capital and where the return from the project is less than the cost of capital, should not accept the project and vice versa. Capital budgeting help firms to take strategic financial decisions. There might be cases where firms undertake certain projects aimed at increasing their goodwill, thus in such cases evaluating project viability would not make much sense, as firms do not expect any return from such investments. It helps to strategise and forecast future cash flows. It assists mangers in effectively control future expenditures. Long term goals of a firm can be set using investment appraisal techniques. It ensures long term sustainability of a firms business (Arnold, 2008). Types of Investment appraisal techniques In evaluating the prospects of an investment, firms usually consider one of the techniques i.e. Net present values, internal rate of return and payback. Discounted cash flow Net present value or the discounted cash flow method is a decision making tool for evaluating investment projects. Under this method the future cash flows or expected cash flows are adjusted or discounted with a factor to arrive at the present value. It considers the discounted rate owing to future market risk and uncertainty of business. The future value of cash flow will not be the same as the present value. There will be some variations. Firms standing at present time when wants to evaluate the effectiveness of the future business projects. Any project will have an initial outlay or cost that is adjusted with the discounted cash flows to calculate the net present value of the project. NPV can either be negative or positive. Any value of NPV which is greater than 0 add to a firm’s value and can be accepted. In case of independent project where NPV is positive it is accepted and rejected when it is negative. When there are two projects that are to be appraised the one in which NPV is high is accepted and the other is rejected (Fight, 2005). Internal rate of return It refers to the adjustment rate or the discount rate that is used to evaluate the returns from a project. It is observed that in a project where the net present value is zero, the discounting rate is the internal rate of return. In other words it is the rate of return of the cash flows. It considers the cost of capital or cost of financing in evaluating project feasibility. Any project where the internal rate of return is higher than the cost of capital should be accepted. The positive difference in the cost of capital and the IRR contributes to the firm’s value if the project is accepted (Higgins, 2008). Critical evaluation of the two techniques Though the above two methods are unique in its own way and is highly effective, it still has certain limitations. IRR and NPV results can be contradicting at times when there are two projects i.e. when firms have to decide on either of the projects. The timing of cash flows and the investment size are always not same that gives differentiated results. There might be situations where one project has a high IRR and low NPV and vice versa. Firms have to be critical in deciding on which method to use in such cases. IRRs can also give negative values. Projects in which the cash flows are negative it gives negative IRR as the firm has to contribute more capital towards the project which has potential losses (Helferty, 2001). Illustration and analysis X Plc considers buying a machine for its business. This machine is expected to increase its output efficiency by reducing waste and power consumption. There is also another machine that is equally functional compared to the other machine. Let the two machines be A and B. The initial outlay and the projected cash flows along with discounted cash flows are provided in the table below. Using the given data IRR and NPV are calculated. X Plcs project investment Appraisal ( in GBP) Year 0 1 2 Cash flow of machine A -5000 3000 3000 Discounted cash flow -5000 2768 2553 Net Present Value 321 Internal Rate of Return 13.1% Cash flow of machine B -10000 5800 6000 Discounted cash flow -10000 5350 5106 Net Present Value 456 Internal Rate of Return 11.7% Table 2: X Plcs investment appraisal The above table shows X plc’s cash flow and initial cash outlay for considering the purchase of either machine A or B. The future cash flows are discounted with the cost of capital for either of the machines. Cost of capital here refers to the cost of financing. The initial outlay for either machine is £5000 and £10000. From the above table it is observed that how IRR and NPV differ for two independent projects when the initial outflow is different for both the machines. Moreover the timing of cash flow is another reason for difference in the value of the two methods. If the firm wants to consider NPV method, then machine B will give more positive returns than A and if it considers IRR then machine A is more profitable. IRR for machine A is greater than machine B. Conclusion Capital structure is considered as the complex and expensive approach to be adopted by the small businesses or the firms. Capital structure is very critical; it requires various factors to be considered. Since capital structure is the composition of both debt and equity financing therefore too much dependence on either equity or debt financing may be dangerous or difficult. Therefore the company or the firms are required to balance between debt and equity financing for increasing the profitability and growth of the company in the long run. Capital budgeting has increasingly gained importance owing to the various investment decisions of a firm. It evaluates the effectiveness of a firm’s investment. Though there are certain limitations in either of the methods as discussed above, still there are positive implications of the methods. Capital budgeting techniques are useful tool to make sound financial decisions. Managers should use the appropriate method to evaluate the effectiveness of the investment projects. It involves two important decisions that are financial decisions and investment decisions. If a company accepts a project it should ensure that it gives positive returns with the given risk outlay. The projected cash flow of the business can be reduced owing to various risks like project delays, government restrictions, systematic risk, etc. Managers should carefully consider investment decisions after taking into consideration the risks mentioned above. They should also take extra precaution in taking financing decisions i.e. how to raise money for the investment project, whether to use own funds or borrowed funds (Debt or equity). Firms should also measure the effectiveness of its investment appraisal techniques. The actual measure of the cash flows should be matched with the forecasted figures to evaluate the effectiveness of different tools of capital budgeting. If the degree of difference is high firms should carefully consider the various investment parameters for its future projects. References Arnold, G., 2008. Corporate Financial Management. Essex: Prentice Hall. Brigham, E. and Houston, J., 2011. Fundamentals of Financial Management. Ohio: Cengage Learning. Chandra, P., 2011. Financial Management. Delhi: McGraw-Hill. Chorafas, N. D., 2002. Liabilities, Liquidity, and Cash Management: Balancing Financial Risks. New Jersey: John Wiley & Sons. Cox, D. and Fardon, M., 2008. Management of finance. Worchester: Osborne Books. Cumming, D., 2009. Private equity: fund types, risks and returns, and regulation. Canada: John Wiley and Sons. Fight, A., 2005. Cash Flow Forecasting. MA: Butterworth-Heinemann. Helferty, A., 2001. Financial Analysis: tools and techniques. New York: McGraw Hill. Higgins, R., 2008. Analysis for financial management. New Jersey: McGraw Hill. Kaplan, S. N., and Stromberg, P., 2009. Leveraged buyouts and private equity. Journal of Economic Perspectives. 23(1), pp. 121-146. Pandey, M. I., 2009. Financial Management. Noida: Vikas Publishing House Pvt Ltd. Periasamy., 2009. Financial Management. New Delhi: Tata McGraw-Hill Education. Read More