Advantages and Disadvantages of Payback Period - Coursework Example

Coursework Course Code and Name Professor’s Name University Name City, State Date of Submission Years Cash flows(£) 0 (900,000) 1 50,000 2 120,000 3 350,000 4 80,000 5 800,000 a) Payback period Formula=Year before full recovery of initial investment + unrecovered amount at the beginning of the next year ÷Total cash inflow during that year. Payback period=4 years+300,000÷800,000=4.375 years Advantages of payback period 1. It is simple to understand, compute and use. It is ideal under high risk investment as it identifies which projects can recover the initial capital outlay in the shortest time period possible. 2. Payback period does not entail any cost on the part of the company therefore it is cheaper to use to gauge the venture viability. 3. Payback period will be realistic for those companies which wish to invest intermediary returns as it will choose those ventures that generate big returns faster. 4. PBP also shows how money will be tied up in a project. 5. For companies operating in high risky areas, it is a powerful tool as it will choose the venture that pays back earliest, which minimizes the risk associated with returns. Disadvantages of payback period 1. It ignores all the returns generated after the payback period as this are not part of the payback .Thus this technique is more lenders oriented than investor oriented. 2. The viability of a project is not measured rather than the time period a project takes to recoup the initial capital outlay. 3. PBP ignores the time value of money. Money loses value with time. A shilling now will have lesser value than a shilling received 5 years from now. 4. It may pose problems of setting a yardstick as to which should be the standard payback period. This problem is more severe if finance is generated on the retained earnings which have no maturity periods. The PBP set by management of a business may be a relative decision. 5. It is not in line with the share holder’s goal of wealth creation. The value of shares does not rely on the payback period but on the total cash flows. (b) Accounting rate of return It is also known as returns on investments. This method does not use cash flows but the accounting profits found in the financial statements of a company. ARR = Average income-Average depreciation ÷ Average investment of project×100 Depreciation = initial amount - residual value ÷ number of useful economic life of the asset. Depreciation=£900,000-0÷5=£180,000 Average income=cash flows for each year less the depreciation÷ number of periods. Year 1=£50,000-£180,000=£-130,000 Year 2=£120,000-£180,000=£-60,000 Year 3=£350,000-£180,000=£170,000 Year 4=£80,000-£180,000=£-100,000 Year 5=£800,000-£180,000=£620,000 (620,000+170,000-290,000)÷5=£100,000 Average income=£100,000 Average investment=Initial investment+ salvage value÷2 Average investment= (£900,000+0) ÷2=£450,000 ARR=£100,000÷£450,000×100=22.2% ADVANTAGES OF ARR 1. It is simple to comprehend and utilize in the gauging of the viability of an investment. 2. The financial statements of the company contain information of accounting nature that is readily employed. 3 The project’s profitability is determined by all cash flows generated in its entire lifetime. DISADVANTAGES OF ARR 1. It ignores the time value of money. 2. It uses accounting profits instead of cash flows which could have been arbitrarily determined. 3. It does not allow for the fact that profits can be reinvested. NET PRESENT VALUE YEAR CASH FLOWS PVIF (10%) PV(Present values) 1 £50,000 0.909 45,450 2 £120,000 0.826 99,120 3 £350,000 0.751 262,850 4 £80,000 0.683 54,640 5 £800,000 0.621 496,800 TOTALS 958,860 NPV= PV (INFLOWS) - PV (OUTFLOWS) (INITIAL CAPITAL OUTLAY) NPV=£958,860-£900,000=£58,860 The NPV is positive and greater than zero hence the project should be accepted since it is a viable investment. The firm will earn a return greater than its cost of capital thereby enhancing the market value of the firm and the shareholders wealth. ADVANTAGES OF NET PRESENT VALUE 1. It is a central tool in discounted cash flow analysis and is used to appraise long term projects. 2. It measures the excess or shortfall of cash flows. 3. It shows how much worth an investment or project puts into the firm. 4. It considers the time value of money. 5. It considers all the cash flows. 6. It increases the wealth of the shareholders as it gives them money. 7. It considers the risk of future cash flows through the cost of capital. DISADVANTAGES OF THE NET PRESENT VALUE 1. Compounding of Risk Premium results in very low NPV. 2. The cost is higher if the risk adjustment by adding a premium to the discount rate is done. 3. The cost of capital needs to be projected in order to calculate the net present value. 4. It is expressed in terms of dollars and not as a percentage. b) INTERNAL RATE OF RETURN This is the discounting rate that equates the net present value to zero. Formula=lower rate interest+ lower rate NPV÷ lower rate NPV-Higher rate NPV× differences in interest rates. At 10% the NPV is £58,860 At 15% the NPV is £-92,120 Using the formula, IRR=10%+£58,860÷£58,860+£92,120×5%= IRR=0.1+£58,860÷£150,980×0.05= 0.1+0.3988=0.4898×0.05=0.02449 IRR=0.02449×100=2.449% IRR=2.449% ADVANTAGES OF IRR 1. It recognizes the time value of money. 2. It considers cash flows occurring under the entire life of the project. 3. It calculates an alternative cost of capital including an appropriate risk premium. 4. The method is used to calculate Break Even. 5. It considers the risk of future cash flows through the cost of capital in the decision rule. 6. It tells whether an investment increases the firm’s value or not. DISADVANTAGES OF IRR 1. It is not easy to work out as it entails tedious calculations. 2. It is not consistent with the value creation principle in that it does not consider value to the shareholder. 3. This method cannot be used to rate mutually exclusive projects. 4. A projection of the capital cost is necessary in order to make a decision. 5. It may not generate utmost value decision where there is capital rationing in the project chosen. 6. It cannot be used in situations whereby cash flow signs change in the whole life of the project. 2. EVALUATION OF THE INVESTMENT APPRAISAL METHODS Payback period It refers to the number of periods a project takes to recover its initial capital outlay. This method deals with cash flows only unlike ARR which deals with the accounting profits (Shim & Siegel 1998). The project with the lowest payback period should be selected as it recovers the initial amount faster. The project in this case has a long payback period and therefore recovers the full amount in almost the final year. Accounting rate of return Return on investments is another name for ARR. The project with a higher should be considered and in this case the decision arrived ought to be based on the minimum acceptable ARR since it is the preferred rate of the company. The project in this case has a high ARR and therefore should be accepted by the firm (Arnold 2008). Net present value Present value of inflows and the present value of outflows difference give the net present value. In this case the NPV is positive at £58,860 and greater than zero hence the project should be accepted as it will earn a return greater than the cost of capital thereby enhancing the value of the firm and maximizing on the shareholders wealth. Projects with a negative or less than zero should be rejected as they will earn less than the cost of capital. Internal rate of return IRR is the discount rate that equates the NPV to zero. In the case above the IRR is at 2.449% and hence the project should be rejected based on this criterion since this figure is less than the required rate of return of 10%. This shows that the project based on the IRR is not viable and is not worth investing (Woodhall & Stuttard 1999). (3) The FTSE 100 Company I chose is STANDARD CHARTERED PLC which is an investment company dealing in the banking business while offering financial services. It has two segments namely, Wholesale banking and Consumer banking. Wholesale banking provides corporate and institutional clients with services in the management of cash, asset finance, foreign exchange rate business, and corporate finance and debt capital markets. a) The bank is highly liquid and primarily deposit funded with an advances to deposit ratio of 77.6%. The profile of the balance sheet remains stable, with 70% of the financial assets held at amortized cost and 57% of the total assets have a residual maturity of less than one year. Balance sheet footings grew by 4% during this period. The expansion in balance sheet was accelerated by bank and customer lending on the back of growth in client deposits and excess liquidity held by the central bank. The company is primarily financed by ordinary share capital and customer deposits and less by borrowed funds or equity as seen in the balance sheet. Share holders’ funds play fundamental roles in company expansion since they seek their wealth maximization objective through the increased returns that the company is able to generate. b) Equity financing is the preferred source of finance for this bank since it is a permanent source of finance, it is unsecured and returns are paid to the shareholders when they are available in form of dividends and in case of company losses no returns are made to the owner’s of capital. This method of financing reduces the leverage ratio hence company debt obligation is met with ease. The shareholders acquire voting rights which enable them to influence the decision making process of the firm in the annual general meetings and appoint directors of their choice to run the company on their behalf. The shareholders also have a residual claim on the company assets and profits. This enables them to make the necessary decisions regarding the firm. Since it is the owner’s money, the company is under no legal obligation to pay back the share capital in cases of insolvency or liquidation. References List Peterson, P. P., Fabozzi, F. J., & Habegger, W. D. (2004). Financial management and analysis workbook step-by-step exercises and tests to help you master financial management and analysis. New York: Wiley. Financial management (3rd ed.). (2011). London: BPP Learning Media Arnold G. (2008) corporate financial management, 4th edition. Financial Times Pitman publishers ltd, England. Shim, J. K., & Siegel, J. G. (1998). Schaum's outline of financial management (2nd ed.). New York: McGraw-Hill. Woodhall, G., & Stuttard, A. (1999). Financial management. Houndmills, Basingstoke, Hampshire: Macmillan. Read More