Importance of Long-Term Planning and Investing - Essay Example

Accountancy & Finance and Economics Word Count Part A 1. Introduction The company follows internal rate of return method for its investments. The first part of the assignment deals with the evaluation of the investment of the company. As the company has decided to invest by taking a package of instructions from different methods, the internal rate of return and net present value methods are to be evaluated as they are discussed in the directors’ meeting. The earnings per share also need to be included in the evaluation along with the share price. The company is contemplating that investment criteria should be in line with consistent share price to have a substantial value of assets. However, net present value of investment worth is suitable for this criterion the company wants to take the rate of return aspect into consideration as well. This compels the company to use the prospects of internal rate of return method that is followed in the company for the years passed. According to the meeting of the directors though they are contemplating of package of points from different methods, the most points should be from net present value method. The aspects from internal rate of return also need to be taken to maintain the consistency of the returns from each share. It is as much important as net present value method for the company as the rate of return depends on the profitability of the company. So, by following net present value method with internal rate of return the value of the capital can be maintained along with the consistency in the rate of return in the form of profitability and earnings per share. 2. Internal Rate of Return The internal rate of return is the discount rate often used in capital budgeting. Company is using it to make the net present value of all cash flows from a particular project equal to zero. In this manner, the company is using internal rate of return method to rank several prospective projects it is undertaking. The consideration of internal rate of return when all the other factors are equal is crucial to rank the project. The project of the highest internal rate of return can be undertaken first, provided the remaining factors are same. As the company is following the internal rate of return from last thirty years, it helped in the growth of the company as it portrays the growth generated by a project before the initialisation. The company’s policy until date is to start a project based on the higher internal rate of return to have a better chance of strong growth. The company has often contemplated about investing in financial markets when none of the projects are projecting reasonable rate of return.1 Though it is easy to figure the internal rate of return in the investments like bank accounts, it is not possible in all the projects of a company. The rate of return estimated in any project is not a guarantee. The guarantee of the rate return depends on number of process including the executing methods. The company has followed income streams method to make the rate of return method a method that lists years or months that the amount of money is flowing and this made the monitoring of returns on a periodical basis possible. These types of methods try to estimate the probable earnings in the form of income stream. This process is capable of capitalising the income stream and helps in determining the NPV. In this case, NPV is determined by adjusting revenue and expense item on income statement. A reasonable discount rate helps in capitalising the income stream when applied to income stream. The discount rate depends on the inherent risks of the project. The operating profit must be a sum of interest that can be obtained by the investment in a bank account, the profit on the project and the value of the machinery. To apply net present value at the end of the period considered for machinery, the operating profit at the end of the period should be included with the value of the machinery as it will be made zero after the period considered. So the company must think of including the value of the machinery in the operating profit at the end of the period. That is, the strategy should divide the value of the machinery into number of parts equal to number of years or number of months, the machinery can be used before reaching zero value. The operating profit of each fraction of the period need to include the fraction of the value of the machinery divided earlier. As the operating profit includes the value of the machinery in the profit to be incurred, the depreciation of the machinery can be compensated. The company should deal this additional aspect if internal rate of return is to be combined with net present value method.2 The internal rate of return again can be evaluated in two types. If it is just purchase and sale, the operating profit can exclude the value of the initial investment. If the investment involves production, the investment devaluation should be considered and the company by adopting the aspects of net present value can do that devaluation of the investment at the end of the considered period for the investment. In case of production, the discount rate is to be considered for the investment and the period at which the net present value for the investment will be zero is calculated. The part of the value of the machinery that is calculated in the operating profit should be divided into that much number of parts equal to number of years or months of the period considered. Consider the following table 1 that calculated returns on the investment. According to it, the profit doubles the investment after 7 or 8 years. Therefore, the investment can be divided into 8 equal parts Investment Return Year 0 $70,000 --- Year 1 $12,000 Year 2 $15,000 Year 3 $18,000 Year 4 $21,000 Year 5 $26,000 ------------------------- NPV (Year 0) $70,000 $68,755.45 Table 1 The above table is adopted from http://ces.iisc.ernet.in/hpg/envis/ratdoc95.html In addition, can be included into operating profit of the each year. 3 By using internal rate of return the company is using the system of implementing projects that have the profit crosses the investment substantially in a reasonable time. When the interim cash flows are absent, the company is using internal rate of return to have an indication of annual return on the investment. While sticking to internal rate of return, the company needs to maximize the net present value by having a reasonable rate of returns on the projects implemented. 4 In an examination of the investment policy of the company, it can be understood that it is using the hurdle rate to avoid the cost of capital exceeding the rate of return. It can be calculated by using the following formula. The above formula is adopted from http://www.visitask.com/internal-rate-of-return.asp CF is the cash flow generated in a particular period and the last unit of the period being ‘n’. In case of net present value, the NPV is obtained by the discounted value of a stream of cash flows that are generated from the investment. By using internal rate of return with net present value, company is contemplating to calculate the break-even rate of return that shows the discount rate that can result in a positive net present value for the investment. 5 3. Net Present Value As in the above chapter the preference given to internal rate of return by the company and is evaluated, not it is the net present value that helps to decide a positive operating profit in internal rate of return. Net present value will be sensitive to the reliability of future cash flows that investment on a project can generate. It can be calculated by the following formula. In the above formula, Ct is the cash flow at the end of time period t and C0 is the cash flow at the beginning. R is the rate of return or discount. However, the company is considering the disadvantage of NPV regarding not accounting for flexibility and the presence of uncertainty.6 As the company concentrates on the long-term projects and follows internal rate of return, the net present value can help in financial appraisal. The future cash flows that are based on rate of discount will take into consideration the devaluation of the capital or the firm has weighted average cost of the capital. In this case, the real options can capture the value of managerial flexibility by adapting decisions in response to unexpected market developments. The shareholder value can also be created by the identification of real options associated with investment portfolio. The process of adopting a package of policies from different methods of estimations, help the company adapting to real options. One of the real options that can be suggested in this context is treating strategic investments as financial options. This results in valuations involving the future flexibility.  The management need to take into consideration the point that the higher discount rate calculated than the real terms will give wrong estimates indicating even viable projects terming them risky. 7 Part B 1. Introduction In this, section of the paper the planning and investment decisions according to the package of methods are discussed. According to the director’s meeting of Clontarf, it is clear that they are using a package of decisions from different methods but using majority aspects of internal rate of return and net present value methods. There will be certain uncertainties intrinsic in long term investing and planning. Along with that, the extent the company can use transaction cost theory in make-or-buy decisions can be discussed in this part of the paper. The discussion will be in the sense of getting useful guidance from the method thus reducing long-term uncertainties. 2. Long term Planning and Investing 2.1 Importance of Long Term planning and investing: In case of long term, planning and investing the assessment of investment outcomes and their resulting behaviours are important. In this context the hypothetical latest decline in the value of the portfolio of the company, need to be taken into consideration. In long term investments, the investments in technology that are financially viable are most important and help in achieving accuracy in estimating returns in the future. This helps in successful closing of a transaction regarding any long-term investment. If the company is not consistent on the objectives that guide the decision of period, the results may not be encouraging. 8 2.2 One of the most important decisions that affect the results is making or buying decisions about a product required by the company. This is done by comparing the costs and benefits of manufacturing a product or a component instead of purchasing it. In general, the make, decision is taken when the need is in large scale and if the need is lesser, the management may prefer buy decision. In some exclusive cases, the make decision may be cost effective even it is needed in lesser quantity. One more aspect that is needed to be considered is about the skills and equipment that the management have to make a product needed. Though it is viable to make product in lesser quantity, the alternative sources, design flexibility and access to technological innovations can be considered to buy it. 9 2.3 Role of Supplier in Make or Buy Decision: The relationship with a particular supplier and future benefits from him also need to be considered while making a buy decision. This needs contracting and organisational design. These designs use transaction cost approach to take right decisions that involve viability of the project and importance of supplier. For this, current controversies about data and method need to be removed with accurate calculations about sample selection and related issues. The evidence on procurement of components and integrating them into marketing and distribution also is necessary. When the company is not able to integrate the make decision need to be thought twice. 10 3. Transaction Cost Approach: 3.1 Cost of Providing Product or Service: The Transaction Cost Approach involves the cost of providing service or offering product through the market or within the firm. A term known as social cost is involved according to Ronald Coase. In case of market transactions, the wish of the person to deal with should be taken into consideration. The transaction costs include search and information costs, bargaining and decision costs and policing and enforcement costs. The transaction costs depend on the nature of the firm and depend on the market prices that govern relationships between firms but within firm decisions. These need entrepreneurial coordination. The conscious power in the ocean of unconscious co-operation is needed. This helps to understand the variety of arrangements in producing goods or offering services. The labour force is temporary and permanent based on the type of industry. The costs of labour force also differ accordingly. The short-term contract may not be suitable due to costs of negotiating contracts and the big companies like Clontarf need long term contracts to meet the needs of the firm. The inconvenience in the market transactions will be minimised, the transaction costs minimise in the long-term contracts, and this makes the management think about making product neglecting a supplier. While making a decision about make or buy, the costs involving the organising additional transactions regarding organisation and market play a crucial role. Coase proposes that in the absence of transaction cost, the standard of the production in any company depending on externalities is legally liable for the expenditure incurred due to externalities on the other activities. This responsibility may increase the inherent risks if not considered or estimated practically. 11 In case of thinking about the outsourcing or producing goods, the market prices only is not the sole factor. The other transaction costs as search costs and costs involved in contracting need to be considered along with coordination. These costs gain significance due to the frequency they occur. These play a crucial role in making or declining the buy decision. 12 The choice of in sourcing and out-sourcing the decisions are taken into consideration. Lacity and Willcock have taken important 40 decisions about outsourcing and decided 35 decisions as anomalies. The decisions differ from discipline to discipline; Clontarf need to make decision considering its discipline. Blindly following the sourcing decisions of another company cannot serve the purpose as practical implications differ from theoretical considerations. The theoretical considerations need to be used to minimise the practical problems. For example, the outsourcing is considered as a viable decision in case of Information Technology discipline and it may not be so in another discipline. The readymade decisions made in the papers regarding transaction costs may not give practical positive outcomes and might be problematical for some disciplines. The asset specificity is taken into consideration to minimise the practical problems posed in application of transaction cost approach. 13 As the company is following internal rate of return and net present value method, the processes and transaction costs should be seen from that point of view. While out sourcing the services along with the minimisation of transaction costs, the efficiency of the aspect of the service is taken into consideration. This is due to link between the two processes and gives an explanation about the need to understand the transaction cost approach as a comprehensive process. As a result, the transaction cost approach need to be connected to the concept of scripts of the company and the service blue print for the service offering companies. 14 While considering the non-performing loans it exists not only in banking sector but also in other sectors. In case of production sector, the failure of the company to recover the credit given for the customer may result in non-productive assets. The increase of share value above the actual value also may result in the same thing if there is no need to sell them and use it as a capital. Employing the integrative approach about make or buy decision is involved in transaction cost economics. The transaction between the company and the manager of the customer firm may involve the characters of transaction cost economics. Investing in real estate and making them productive is also a key in making viable transaction decisions if the company is in no mood to sell them at a larger margin. The specificity of the investment of the workout manager will emerge as crucial in deciding about integrating or disintegrating the workout of the credits. This depends on the status of the credit commitment between the company and the customer.15 3.2 Reducing the Costs: The intersection between supply chain management and information technology depends on developing a transaction cost analysis. This should involve the reducing the cost on IT. The impact of IT on supply chain management need to be assessed and the costs to be reduced accordingly or the productivity should be increased as per the costs incurred due to maintenance of information technology I the company. This type of assessment is needed on every infrastructure facility of the company. This involves the supply chain management and transactions committed in it. The infrastructure development must be taken up in such a way to reduce the costs incurred in supply chain management and this involves asset management along with transaction cost economics. The classification of different forms of collaboration is necessary for this type of assessment that involves the reducing of costs due to development of infrastructure or contracts. The high cost of transactions in supply chain management generally prompt many firms to develop a system to make the essentials on a large scale. The claim of reduction of transaction costs is generally objected in its general form as initial development of infrastructure involves high costs and the assessment need to be done on the activities those can be done after the completion of infrastructure development. The infrastructure development needs to minimise the transaction costs in contractual agreements by enabling the company by making the products needed. 16 References 1. Investopedia, 2008, Internal Rate of Return, Investopedia.com, Volume information not available, Retrieved on 22nd February 2008 from http://www.investopedia.com/terms/i/irr.asp 2. Samuel L. Baker , 2006, The Internal Rate of Return, HSPM, Volume 9, Retrieved on 22nd February 2008 from http://hspm.sph.sc.edu/COURSES/ECON/irr/irr.html 3. CES, 2007, Internal Rate of Return, CES, Volume information not available, Retrieved on 22nd February 2008 from http://ces.iisc.ernet.in/hpg/envis/ratdoc95.html 4. Value Based Management, 2008, Internal Rate of Return, Methods, Value Based Management, Volume Information not Available, Retrieved on 22nd February 2008 from http://www.valuebasedmanagement.net/methods_irr.html 5. Visitask, 2007, Internal Rate of Return, Visitask, Volume information not Available, Retrieved on 22nd February 2008 from http://www.visitask.com/internal-rate-of-return.asp 6. Investopedia, 2008, NPV, Investopedia.com, Volume information not available, Retrieved on 22nd February 2008 from http://www.investopedia.com/terms/n/npv.asp 7. Media Wiki, 2008, Net Present Value, Wikipedia, Volume information not available, Retrieved on 22nd February 2008, http://en.wikipedia.org/wiki/Net_present_value 8. Media Wiki, 2008, What NPV Means, Wikipedia, Volume information not available, Retrieved on 22nd February 2008 from http://en.wikipedia.org/wiki/Net_present_value#What_NPV_Means 9. Ena Garmaisem 2006, Long–Run Planning, Short-Term Decisions: Taking the Measure of the Investor's Evaluation Period, FPA, Volume Information not Available, Retrieved on 22nd February, 2008 from http://www.fpanet.org/journal/articles/2006_Issues/jfp0706-art8.cfm 10. Answers.com, 2008, Make or Buy Outsourcing Decision, Answers.com, Volume Information not Available, Retrieved on 22nd February 2008 from http://www.answers.com/topic/make-or-buy-outsource-decision?cat=biz-fin 11. PETER G. KLEIN , The Make-or-Buy Decision: Lessons from Empirical Studies , Social Science Research network, volume information not available, Retrieved on 22nd February 2008 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=529962 12. Thayer Watkins, 2007, The Transaction Cost Approach to the Theory of the Firm , SAN JOSÉ STATE UNIVERSITY, Volume information not available, Retrieved on 22nd February 2008 from http://www.sjsu.edu/faculty/watkins/coase.htm 13. Sourcingmag.com, 2005, Transaction Cost Theory, Sourcingmag.com, volume information not available, Retrieved on 22nd February 2008 from http://www.sourcingmag.com/dictionary/Transaction_cost_theory-203.htm 14. Benoit A. Aubert, 2001, TRANSACTION COST THEORY, THE RESOURCE-BASED VIEW, AND INFORMATION TECHNOLOGY SOURCING DECISIONS: A RE-EXAMINATION OF LACITY ET AL.’S FINDINGS, École des Hautes Études Commerciales de Montréal., Volume information not available, retrieved on 22nd February 2008 from http://www.hec.ca/gresi/documents/cahier0108.pdf 15. Janine Frauendorf, 2007, Customer Processes in Business-to-Business Service Transactions, Springer Link, Volume information not available, Retrieved on 22nd February 2008 from http://www.springerlink.com/content/wm1464x3432gl274/ 16. Nico B. Rottke, Julia Gentgen , 2008, Workout management of non-performing loans: A formal model based on transaction cost economics, Emerald Group Publishing Limited , Volume 26, Retrieved on 22nd February 2008 from http://www.emeraldinsight.com/Insight/viewContentItem.do;jsessionid=106489D7D56B7EC10A47FB3A26A370E0?contentType=Article&hdAction=lnkhtml&contentId=1662924&history=true 17. Martin Müller, Stefan Seuring, 2007, Reducing information technology-based transaction costs in supply chains , Emerald Group Publishing Limited , Volume 107, Retrieved on 22nd February 2008, http://www.emeraldinsight.com/Insight/viewContentItem.do;jsessionid=6BCFB47B27BDA2179BF988F40A84E930?contentType=Article&hdAction=lnkhtml&contentId=1602614 Read More