The Use of Sufficient Method of Project - Assignment Example

Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: Q1. Reason for Sole Reliance on NPV George used NPV in appraising the projects for the company in both cases because of the merits attached to it compared to other methods. The use of sufficient method of project appraisal result in the sound decision made the management. The decision made should be aimed at maximizing company profits which in turn increasing shareholder wealth. This is a sole objective for every company management team. Therefore, George used NPV solely to improve the quality of the information to be used in making a major decision on investment. The NPV considers various aspects of the project that provides a viable conclusion on the feasibility of the project. According NPV, the opportunity cost of the investment is considered. This ensures that investors compare the value of the money if they consume now with future consumption. The method shows the value added on the shareholder wealth by choosing to undertake the project. This is essential since it echoes the role of management in increasing shareholder wealth. The extensive use of NPV method and not other methods of appraisal such as internal rate of return, payback, and profitability index can be best explained by comparing demerits of these other methods with NPV. First, NPV will be compared with payback method to rule out why George did not use payback in appraising the project. Payback method shows the number of years the project will return the capital invested compared to the project life. The project should payback before the end of project economic life of the project to be considered feasible. This method has several weaknesses that George did consider. This includes lack of consideration of changes in time value of money due to inflation and deflation in the economy. NPV considers the time value of money by discounting the cash flow in respect of the year earned to come up with a present value of future cash flow. The use of discounted payback method overcomes this weakness since it allows time value of money, unlike traditional payback method. Also, NPV considers the cash flow after the project has paid back. This is not considered by the two payback methods since they only use the cash flows until the project has paid back, and remaining cash flow is ignored. The failure to consider cash flow for the whole period makes it difficult to understand the value added by the project on shareholder current shareholder wealth. This makes NPV the best method since it shows an overall increase in the shareholder wealth that is important in making an investment decision. Secondly, George preferred NPV in place of internal rate of return in appraising the project because of the weakness of IRR. The IRR shows the rate of return of the project without considering the required rate of return which will be used as a benchmark. This weakness includes lack of consideration of the value of the money and economies of scale. This is because IRR cannot be used to appraise two projects but a vast difference on the value of the project. On the other hand, NPV uses absolute terms that eliminate this weakness, thus increasing the credibility of the information in decision making. Also, NPV uses the market interest rate in discounting the cash flow making information more relevant. The IRR uses assumed value of discounting rate that is the rate that gives the positive present value of cash flow and discounting rate that gives the negative present value of project’s cash flow. NPV overcomes this weakness making it the best method for George compared to IRR. Lastly, Gorge did not use profitability index for the two instances because of the merits that are tied to NPV compared to this method. Profitability index shows the times in which the project paid back the initial capital. This signifies that the measure was automatically inappropriate in appraising first project. This is because PI is preferred when comparing more than two projects to choose the most profitable project. The use of PI on a project with equal index might not make sense on which project to invest in (relativity). Also, it has a huge difference in connection to the value of money between two projects. This weakness can be overcome by using NPV since it shows the value added to the company by choosing a given project. In conclusion, we can find out that NPV overcomes various weaknesses that are experienced in using other methods in appraising the projects. The merits and ease of using NPV to evaluate the feasibility of the project forced George to use it solely to give out reliable and credible information in decision making. This ensures that the chance of loss of shareholders wealth is minimized as much as possible. Q2.Factors need to be considered The use of NPV shows that it can be relied upon in making a major investment decision in a company. Though, shareholders should not rely on this method more since it has weaknesses. This weakness arises from factors that the method assumes in arriving at the end value. The discounting factor considers the change of value of money because of inflation. Also, the cash flows are deemed to be affected by a small range of factors. This factor includes depreciation, tax, working capital, and initial capital which is not true in the real world since the perfect market doesn’t exist. The factor not considered in calculation of NPV includes; First, the use of NPV does not consider the management efficiency and effectiveness. The management plays a great role in ensuring that the project is implemented well to realize the forecasted results. The great concern of management is on the motivation of the employee in the organization. The management with low motivation will lead to reluctance in implementation, review and monitoring of the project. This will result in failure or underperformance of the project thus failing to meet the set threshold set in the calculation of NPV. The company should improve management motivation both top and low management level. This can be improved by improving remuneration structure, ensuring that demand and supply of labour are balanced. Also, involving employees in decision making, establishment of a clear channel of communication and implementation of feedback system in all levels of management helps greatly. This will increase the performance of the employee in implementing the project since they feel part of the company. This is because increased company performance is reflected in the improved standard of living and pride for working in the company. Secondly, the method assumes that government legislation is constant and cannot change within the five years of the project. The government legislation affects the project directly and indirectly. The direct effects arise if the government increases or reduces corporate tax rates, customs duty, and value added tax. This impact on the company profitability due to increased liability and reduced demand for the company product because of increased prices of the product. Also, the government might impose trade barriers to the countries which the company exports its products and imports raw material. This affects the profitability of the company thus faulting on the previous analysis of the project. These factors greatly affect the performance of the project compared to the previous evaluation. The method did not consider changes in the cost of raw materials and prices of final goods that arises from an increase in Competition. When there is no regulation concerning entry and exit in the market, the number of producers will increase due to huge profits made by existing businesses in the market. The new entry will increase the level of competition in securing raw material and other factors of production. The increase in the number of competitors will also reduce the size of the market thus making it difficult to make the profits forecasted in the analysis. This factor is not considered in the calculation of NPV since the cash flows kept increasing, but it directly affects the project. Climatic changes affect the supply of dates to the factory and in the market. The climate change has become unpredictable thus making it hard to predict the supply of the raw material that depends on climate variation. The cycle can delay or underperform which results to low production that increases operation cost due to the cost of idle resources. This has not been considered in the estimation of cash flows for the five-year period. Q3.Practical significance of comments made The comment by Bob Smith that “The decision that maximizes stockholder wealth shouldn't depend on the discount rate we use or the cost of capital” is inappropriate. The project performance evaluation depends on analysis of cash flows and source of finances to fund the project. Therefore, Bob Smith comment does not make sense regarding project appraisal using NPV. The cash flows of the project will be received in a period of five years. The future value of cash flow will be affected by inflation. Therefore, discounting the future cash flow to obtain the present value of cash flow is crucial in determining the return in future compared to the present consumption. When the NPV is negative, the project is going to reduce shareholder wealth but positive NPV increases the shareholder wealth. Without discount rate, we cannot obtain a certain value of the project at the end of five years thus resulting in wrong information and poor decision making. Also, failure to consider the cost of capital not appropriate since the investment will lead to changes in the capital structure. This is because the company might choose to use equity or debt or mix the two in financing the project. This will change the cost of capital structure which can be efficient/optimal, or inefficient. The inefficient capital structure will result in increased cost of capital which might reduce the cash flow expected from the project (Lumby, 1994). The evaluation of the optimal capital structure during the introduction of a new project is crucial to ensure that best mix between equity and debt is achieved in funding the project. For instance, use of debt provides tax shield while equity doesn’t. The equity comes up with its weakness such as high underwriting cost. The equity has benefits since the company doesn't have fixed obligation in case the project don’t pay off as expected. There is a trade-off between the use of the two sources thus company need to ensure that it makes its decision at the point where cost it is at a minimum. Therefore, it is not possible to make a decision on investment without the cost of capital coming into the subject due to its crucial role in investment evaluation. Despite the disregard in Bob Smith comment, he might be true to consider not only the cost of capital and discount rate but also other factors such as efficiency of machines. This comment could have been appropriate, but complete disregard of these elements in the calculation of NPV is inappropriate. Q4.Project selection The scenario where we have more than two projects that company has a dilemma in choosing the best project to implement. This is caused by lack of enough resources to implement both projects or precautionary measure to ensure that the current project is running well before implementing the other project. The best way to rank this project is the use of profitability index (Lumby, 1994). As mentioned earlier, this method measures the number of times the project pays back the invested capital. The project with the high profitability index is considered to be the best to choose from compared to other investment. The method is appropriate when the present value and initial investment of projects are different. Therefore, the best method is to determine the time in which the present value of cash flow pays back the initial capital invested. The formula is as follows; PI = Therefore, evaluation of project A and B is as follows; Project A; PI= = 1.14 Project B; PI= = 1.19 According to the analysis we are able to realize that project B can pay slightly many times compared to project A. The project B performs 0.05 times better than Project A thus concluding project B to be the best to adopt. The fact that Project B has high profitability index than A does not guarantee to be the best option. The other factors affecting the present value of investment need to be considered before deciding on the project. These factors include the likelihood of market entry, government legislation and changes in consumer preference. This affects expected future cash flow which can impact both projects positively or negatively. Therefore, a recommendation to adopt project B is subject to other factors that might directly or indirectly affect the performance of the project. Q5.Effect of project B on share price upon release of investment information According to Lumby (1994), Investors are rational in making their decision thus making them aware of activities that are going on in the financial market. The information dissemination by the management has signaling effect in the market about the company. The signaling effect is brought by company steps in implementing strategic plans, payment of dividends and overall company performance. The dissemination of positive information company performance increases the demand for the share that in turn increases the price of the share. On the other hand, negative information such as profit warning will lead to a decrease in the price of the share due to a decrease in demand and increase in supply simultaneously. The dissemination of information to the public is mandatory to the public company since regulatory bodies ensure that investors have enough information before making any given investment. According to the case study, adoption of Project B will greatly improve the profitability of the company thus increase in capital gain and dividend payout. This will attract investors to purchase company shares. The availability of sufficient information about the strategies adopted by investment increases shareholders trust and they can pay a higher cost (opportunity cost) in obtaining the shares since they are confident on returns (Lumby, 1994). The demand for shares will exceed the supply making the share rise steadily to the point that the shareholders will consider investing in the company unprofitable or riskier. The rise in the share price will increase the company market capitalization. The company should consider tracking the trend of company performance in the last five years and informing prospective shareholders of major changes in the performance. This is crucial since most investors carry out analysis of company financial statements for past five years or more before making an investment decision. The management should examine their effectiveness since it impacts on the share price changes. The consideration of these variables will ensure that the company share price respond well with the information realized to the public. Reference: Lumby, S. (1994). Investment appraisal and financial decisions. London: Chapman & Hall. Read More