Capital Budgeting- the Payback Paradigm, Risk for Overseas Investment - Case Study Example

Capital Budgeting Submitted by…………………………………………… Table of Content Table of Content 2 Corporate decisions that govern the use and structure of capital within a firm are critical in that they define the ability of the investment to make a profit. Executives or decision makers are faced with a task of making decisions that best limit the amount of risk to the company and result in the highest amount of profit. When faced with alternative investment options, the ability of the decision maker to select an alternative will depend on many factors. Key among the factors is the level of return that the possible venture could generate in a period. The time factor and the investment options are, therefore, critical to the managers in making decisions at the time of budgeting. A look at the most common method of increasing productivity or performance of capital shows that decision makers in the business have numerous options that can be explored to reduce the impact of the future uncertainties. The methods used in this case target to limit the financial failures or uncertainties unforeseen. This paper looks at these methodologies. It takes into account the available literature that has been developed to look at the same. At a more specific level, this paper examines the possibility of a similarity and if need be the difference of literature while addressing the subject of avoiding financial risks. It also examines and present the various ways each of the financial risk evaluation techniques are given by each literature. The general finding of this paper is that there is no specific difference of presentation that the literature referred to in the text give. In fact, there is only a slight difference in the presentation of the literature regarding the concept of financial risk management at budgeting. Introduction Corporate decisions that govern the use and structure of capital are critical determinants to the success of a business organization (Peterson & Fabozzi 2002). The notion on criticality is driven by the fact that the use and system employed by the executives in the business model of the corporate will determine the outcome measure which is profitability or loss. An adept capital budgeting procedure looks into the possible measure of success in the field of investment and gives a manager the best possible alternative to generate the highest possible return on capital. Apart from targeting the profitability of a venture and the selection of investment, the capital budgeting procedure aims at reducing the level of risk associated with an investment option. Several factors influence the level of risk that is involved in a business that is taken. the factors include the political atmosphere, the geographical and climatic factors, the economic impact and importance of the project and the prevalent and future standards required. All these can lead to a considerable loss of capital and time taken in an investment. Within the process of capital budgeting, the main considerations are to reduce the level of risks that would lead to abject failure of the business venture and capital growth to produce returns. This paper examines the possible ways of dealing with the risk of failure of performance of capital. Specifically it looks at the ways of evading risks that can result in the low performance of options in investment in the budgeting and the expected uncertainties. The approach taken here is an observation and evaluation of the available literature on the possible ways of mitigating the risks involved at the time of capital budgeting. The main method of dealing with the financial risks and failures at the time of capital budgeting are diverse and specific to each economic situation. Some of the process used to reduce the level of frequency of financial failure in the capital budgeting include measures that are to deal with the discounted cash flow techniques. The other methods do not explicitly rely on the discounting, but the time of return on the capital. The methods that will be discussed here include accounting rate return, the profitability index, the internal rate return method. It also looks at the payback period method, the net present value, the equivalent annual cost, and the real options value (Dayananda 2002). The net present value This method of risk reduction in a business capital budgeting looks in to the future of the capital performance in terms of cash flows (Megginson, Smart & Lucey 2008) and discounts it back to its current value (Jackson, Sawyers & Jenkins 2009). It is important in determining the fact that a venture would be highly profitable or not in the long run. This implies that despite a difference in the level of revenue obtained at that time, there is a possibility of the same investment making a loss even at higher amounts of sales generated in future. The most common factor that could lead to the possibility of this situation is the levels of inflations (Goldschmidt, Shashua, & Hillman, 1986; Hassett 1999). The simplicity of this method is the main purpose for its overall adoption in the budgeting of capital (Trivedi 2002). It takes into consideration of the overall value of the capital at present of the investment and makes a comparison of the same, after all, the investment period is covered. The problem is the discounting rate of the same method. To many accounting formulas, the most common figure used is the average weighted cost of capital. In some publications, this unit is referred to as the average cost of capital Internal rate of return (IRR) It is a discounted method f determining the risk of loss associated with an investment at the time of capital budgeting (Greer & Kolbe 2003). Some studies refer to the method as the use of the critical rate of discounting. At the critical rate of return, the relationship between the forgone alternative and the alternative being considered are at equal returns on the investment. The ability to make a judgment on the choice to take is therefore on exuding returns or the other significant advantages that can be realized on the same investment to be chosen. Warren, Reeve & Duchac (2012), believe that there is a similarity between IRR and the net present value. The similarity is because both measures of avoiding risky investments are based on the fact that an investment decision is made on the consideration of the projected cash flows of a business. Weale (1993) looks at the use of this method of reducing risks associated with education and finds out that there is a possibility of limiting the loss of capital by comparing options. Its major concern is the evaluation of the capital on the basis of the opportunity costs of the same. The findings of this research echo the possibility of linearity between the rates of discounts, and the value of the investment. At the point of integration, the level of return on the investment is considered as similar to both options of investment. The payback paradigm: The opportunity cost associated with the variety of investment options can also be looked at in terms of the payback period (Keown 2004). In this case, the payback period becomes the central determinant of the need to take on an investment or not. Ordinarily in the case of investments, the investor looks at the amount of time that they require to recover their investment (Hunt and Andrews 1968). The value of money against the investment to reach the level of return and produce the initial capital is not taken into account. The length of the payback period is an essential factor in this case, and there is no discounting of the value of money at the time of the investment (Groppelli & Nikbakht 2006). In internationalization of a company, the level of risk in this kind of strategy to reduce the level of financial risk is still mitigated by time. The shorter the payback period, the lower the risks that are associated with international investments and this is the basis of making such investments. An investment that does not pay anything at the first two initial years of work would be disputed and not taken. This is majorly derived from the fact that the investment task a longer time in delivering its expected outcomes in the payback rule (Grossman & Livingstone 2009). In most cases, the payback period remains faulted for many factors that include the calculations about the value of money and the possibility of the fact that other small scale or unforeseen factors. These factors could either be geographical or the economic changes that cause a low value on the initiated projects. The factors could be unforeseen at the time of the inception of the business project and would impose a level of uncertainty. However, these factors have an important contribution at the international level. For instance, the inability of the foreign business personnel to articulate the language of the Nationals could set it behind and lower its performance and the cash flow respectively. The average rate of return This normally does not take into consideration the value of money in regards to its time value (Sarawathi & Reddy 2007). In this case, the investment option taken is based on the prerequisite rate of return that would offset the cost of capital, and the budget of capital that is consumed by the investment. Furthermore, it is not based on any type of a discounting capital. Schniederjans & ‎Schniederjans (2005) add a twist to this notion because the all the book assets, in this case, have to be depreciating in the process of business operation. The depreciation means that there is a small difference between this methodology and the other methods that use discounting in the capital budgeting process. The principal reason, in this case, is that both the methods apply a form of backtracking and redress for the lost value of assets in capital budgeting (Drury 2006). In this perspective, it is implied that the depreciation of assets is as a factor of the value of capital at that point in time. Risk for overseas investment After assessing the most viable project or investment, using the various project appraisal tools discussed earlier, to undertake in foreign market, investors must know they are likely to face four major kind of risks. Such risk are: i. Transaction Costs The biggest obstacles to investing in global markets are embedded in the transaction costs. Though we are in a comparatively connected and globalized world, transactions costs may still vary significantly depending on the foreign market an investor is investing in. it is evident that brokerage commissions are nearly always higher in global markets as opposed to domestic rates. Moreover, aside from augmented brokerage commissions, additional charges, specific to domestic market, frequently occur. This charges may include levies, taxes, stamp duties, exchange fees and clearing fees. ii. Currency Risk Currency volatility is another area of potential risk to overseas investors. If investors invest directly in the overseas market, they have to exchange their domestic currency into foreign currency so as to buy the foreign capital goods. This conversion is normally done at the current rate of exchange. As such, holding foreign stock for some time and sell it may be detrimental because of the uncertainty of the future rate of exchange. The best solution to alleviating this currency risk will be the investors to just hedge their currency exposure. iii. Liquidity Risks Risk of liquidity also pose as a threat to overseas investors. This is the risk investors will face by not being capable of sell their stock speedily enough as soon as the sell order is reached. It is very hard to evade this risk and so investors should just pay attention to overseas investments which are, or may get, illiquid whenever they desire to close their shares. iv. Expropriation risk The last major risk in the expropriation risk, which occurs when a regime deprives shareholders of their ownership of their properties. Typically, it entails the outright seizure of the investors` asset or the company itself by the government. Moreover, the host government can raise taxes and royalties to an extent that the shareholders are effectively and considerably deprived of their accrued benefits form that investment. Sensitivity Analysis In spite of the prevalence of such risks, sensitivity analysis grants investors a way out. Sensitivity analysis offer investors a way of knowing how the project will be affected by changing one risk variable. It tells how responsive the outcome would be if we were to change specific variables. The effects of policies or strategic plans may be hard to predict or measure, and the value associated with those impacts might be difficult to monetize. As such, sensitivity analysis provides a way of examining the level of uncertainty and how the risk affects the project`s results. We will give a summary of sensitivity analysis as well as describes three ways of conducting it. This part will assume a theoretical viable project was selected among the available projects. We will analyze the risk of currency volatility using partial sensitivity analysis. Table 1: Summary of sensitivity Analysis outcome for a Theoretical Project year one Year two Year three Year four Year five Total Aggregate sales £5,000,000 £5,120,340 £5,259,800 £5,384,050 £5,395,445 £21,244,455 Cost of products sold £3,600,000 £3,741,100 £3,964,395 £4,259,934 £4,395,290 £14,943,050 Operating Expenses Depreciation cost £350,000 £350,000 £350,000 £350,000 £350,000 £350,000 Initial cost of equipment £1,700,000 - - - - £1,700,000 Working capital requirement £400,000 - - - - £400,000 Total cost £17,372,000 Profit before Tax rate Total sales, £21,244,455– Total cost, £17,372,000 £ 3,872,455 Net profit (After 30% tax) £ 3,872,455–1,161,736.5 (30/100 * £ 3,872,455) £ 2,674,350 Change in foreign exchange rate by 5% Net profit = £ 2,003,317 Change in foreign exchange rate by 10% Net profit = £ 1,284,295 Note that we assumed that: From year two to year five the unit price upsurge by 1.5% and number of units sold also upsurge by 0.5%. Variable cost for each unit upsurge by 5.5% each year Partial sensitivity analysis Under this analysis, we can select one variable (foreign exchange rate), change its value by 5% and 10% while keeping the other variables constant. As such, we note how much the net profit increase or decrease after such a change. Table 1 demonstrates the outcomes of the partial sensitivity analysis which scrutinized the effect of changing foreign exchange rate on the net profit of a theoretical viable project. A 5% reduction in exchange rate would cause a net profit of £ 2,003,317 while a 10% reduction would occasion a net profit of £ 1,284,295. Conclusion All these techniques given in the preceding decision aim at making managerial decisions that will lower the risks of loss in the performance of capital at the budgeting stage. However, decisions can also be influenced by the economic value added (Smith & Tan 2013). The decision affected by the economic value added in investment aim at creating value to the firm at the present moment. In the event of the increase of firms market value, the benefits is that there will be in increase of returns which is ideal for the investors (Grant 2003). The decisions taken by the managers, in this case, are purely to align their managerial objectives to the requirements of the investor by increasing profit margins (Reckers 2003). The measurement of value in decisions does not eliminate any risk of failure in the budgeting decisions. The inability to limit the financial risks is because the decision is purely on the profit levels at the time of operation. It does not take into consideration the longevity risk on assets of the projects initiated in this way. Bibliography DAMODARAN, A. (2011). Applied corporate finance. Hoboken, NJ, John Wiley & Sons. DAYANANDA, D. (2002). Capital budgeting: financial appraisal of investment projects. Cambridge [u.a.], Cambridge Univ. Press. DRURY, C. (2006). Management accounting for business. London, Thomson Learning. GOLDSCHMIDT, Y., SHASHUA, L., & HILLMAN, J. S. (1986). The impact of inflation on financial activity in business, with applications to the U.S. farming sector. Totowa, N.J., Rowman & Littlefield. GRANT, J. L. (2003). Foundations of economic value-added. Hoboken, NJ [u.a.], Wiley GREER, G. E., & KOLBE, P. T. (2003). Investment analysis for real estate decisions. Chicago, IL, Dearborn Real Estate Education. GROPPELLI, A. A., & NIKBAKHT, E. (2006). Finance. Hauppauge, N.Y., Barrons. GROSSMAN, T. AND LIVINGSTONE, J. L. (2009). The portable MBA in finance and accounting. New York, John Wiley and sons. HASSETT, K. A. (1999). Tax policy and investment. Washington, DC, AEI Press. HUNT, & ANDREWS. (1968). Financial management. JACKSON, S., SAWYERS, R., & JENKINS, J. G. (2009). Managerial accounting: a focus on ethical decision making. Mason, OH, South-Western. KEOWN, A. J. (2004). Foundations of Finance: The Logic and Practice of Financial management. Beijing, Qinghua University Press. KNOPF, F. C. (2012). Modeling, analysis, and optimization of process and energy systems. Hoboken, N.J., Wiley. MEGGINSON, W. L., SMART, S. B., & LUCEY, B. M. (2008). Introduction to Corporate finance. London, Cengage Learning EMEA. PETERSON, P. P., & FABOZZI, F. J. (2002). Capital Budgeting Theory and Practice. Hoboken, John Wiley & Sons. RECKERS, P. (2003). Advances in Accounting, Volume 20. Burlington, Elsevier. RÖHRICH, M. (2007). Fundamentals of investment appraisal: an illustration based on a case study. München [u.a.], Oldenbourg. SARAWATHI, S. & REDDY, K. M (2007) Managerial Economics and Financial Accounting SCHNIEDERJANS, M. J SCHNIEDERJANS ‎, A. & ‎SCHNIEDERJANS , D. G. (2005) Outsourcing and Insourcing in an International Context, New York. M.E. Sharpe SMITH, J. M., & TAN, B. (2013). Handbook of stochastic models and analysis of manufacturing system operations. New York, NY, Springer SALTELLI, A., TARANTOLA, S., & CAMPOLONGO, F. (2004). Sensitivity Analysis in Practice a Guide to Assessing Scientific Models. Chichester, John Wiley & Sons. TRIVEDI, M. L. (2002). Managerial economics: theory and applications. New Delhi, McGraw- Hill. MACHINA, M., & VISCUSI, W. K. (2013). Handbook of the Economics of Risk and Uncertainty. Burlington, Elsevier Science. WARREN, C. S., REEVE, J. M., & DUCHAC, J. E. (2012). Accounting. Mason, OH, South- Western Cengage Learning. WEALE, M. (1993). A critical evaluation of rate of return analysis. The Economic Journal, 729- 737. Read More