Capital Budgeting of Pevensey PLC - Essay Example

?Running Head: Report on Capital Budgeting Report on Capital Budgeting Moule Table of Contents: INTRODUCTION……………………………………………………………………..2 PRESENT SCENARIO………………………………………………………………..2 ASSESMENT METHODS…………………………………………………………….3 RESULTS………………………………………………………………………………5 REFERENCES…………………………………………………………………………8 APPENDIX…………………………………………………………………………….9 INTRODUCTION: Capital Budgeting is an important process for any organization. No organization can make good use of their money, unless they plan, decide and assess the best use of money. Good investment decisions maximize the earning potential of an organization and help boost the firm’s overall financial position and financial health. Good financial decisions are not intuitive. They require a lot of effort and financial planning. Many firms employ people with excellent financial knowledge and skills just to enhance the use of money. These people often lie at an important level of organizational hierarchy and given a title of CFO or Chief Financial Officers. Many firms, over the years, have realized the importance having people with good financial skills and have given these people more power and authority than the CEOs. As a result, these people are consulted every time a need arises for an organization to make a good financial decision. This good financial decision regarding the best machine is going to improve the asset earning potential for the firm and it is also going to improve the asset turnover and return on assets ratios. PRESENT SCENARIO: Pevensey PLC is a growing company. It needs to decide on the best option of a machine purchase. Currently, the company has four different options to ponder upon. It is good for the company to use financial tools of capital budgeting to appraise each of the four options before making the purchase. This will reduce the chances of a bad decision, and will put the company in a win-win direction. Hence, the company has done the right thing by consulting someone with the financial knowledge to look at the available options and deciding the best option for the purchase (Brigham & Ehrhardt 2010). This would ensure that the best purchase is made in the given budget. The best purchase will not only be the cheapest method, but the best purchase is also going to improve the overall financial position of the organization in the long-run. ASSESMENT METHODS: Capital budgeting is considered to be a specialist field. The methods used that are used to determine the best option to purchase are net cash flow method, discounted cash flow method, Payback period, NPV and IRR. No one method can alone be a good guide for the company for the best decisions. All of these methods have to be studied and used in congregation for giving the best answer to the company. This would ensure the best purchase is made in terms of returns, time value of money and cost of capital. The company can raise capital at a rate of 8 percent. This means that any of the option chosen must provide a return of at least 8 percent for the company to break-even. If this is not the case, the company will be losing money in real terms. It might be making money in nominal terms. Nominal and real returns are different. Nominal returns do not take into account the inflation rate and the cost of the capital to the company. Real returns take into account the cost of the capital that the company has to pay for obtaining the finance needed to make a purchase. The methods used in the report would help us calculate both the nominal returns and real returns to decide the best Machine to purchase that would maximize not only the firm’s cash flow, but will also the allow the firm to earn decent rates of return. The first method used to calculate the effectiveness of the options is Net Cash Flow Method (Please refer to appendix). The method is simple and is popular among the non-accounting and finance people. This method simply calculates the effectiveness of the machines in terms of its earning potential. However, it is a nominal calculation method. It does not take into account the cost of capital for the organization. It also does not take into account the rate of inflation. Although non-accounting people might choose to appraise their projects using this method, but in financial terms this method is of little value. The second method used in the report is Discounted Cash Flow (Refer to Appendix). The method is similar to Net Cash Flow Method, but it does take into account the Time Value of Money, inflation and cost of capital. This is a hybrid tool for capital appraisal it adds finance flavor to a method that does not recognize any financial implications. It can be difficult for non-accounting and finance professional to calculate, but provides a more concrete picture then the previous method. This method is widely accepted by financial analysts in appraising the capital projects. The third method used in the report is Payback Period Approach. This method calculates the time taken to cover the cost of investment. Again this method ignores the cost of capital, but it is a good measure of calculating the feasibility of different projects. Needless to say, the sooner the project covers the cost of investment the better it is. Many organizations try to cover their investments as fast as possible, and this method can be used by those organizations to decide on the best alternative available to them. This method again does not recognize the cost of capital and other important financial concepts, but it is widely used by growing organizations. The next method used in the report is Net Present Value. It is more commonly known as NPV method. This method is backbone of capital appraisal. It does not only recognize the Time Value of Inflation and Cost of Capital, but it also tells the financial i the rate that the project is earning. The higher the rate or figure, the better it is. The next approach used in the report is IRR. This method is more commonly known as internal rate of return. It gives the accurate measure to finance professionals and organizations the break-even rate that should be yielded by the project, for the investment to be at par with the cost of capital and inflation rates. If the rate is in minus, then the investment is junk investment. Similarly, if the rate is less than the cost of capital than such projects leads to organization losing money in real terms. On the face of it, any project with the positive cash flows might look feasible, but comparing with the cost of capital and other measures, we come to know of the real earning potential of the project. RESULTS: This part of the report is going to discuss the results that were obtained using each of the methods of capital appraisals discussed in the previous section. First of all company four machines using Net Cash Flow Method tell us that option “D” is the best purchase for the organization. The Net Cash Flow provided by Option “D” is 90. This is higher than Net Cash Flows provided by any other method. Hence, the firm should go with this option. However, it must be noted that this method is simple and does not make use of any financial concepts. This brings us to the other method. The method that was used next is Discounted Cash Flow Method. This method takes into account the project’s earning potential and uses important financial concepts such as cost of capital and time value of money. This is a better indicator than Net Cash Flow Method because it takes into account the rate at which the firm is raising its finance. According to this method, Option “D” is not a wise investment. In real terms, Option “D” is yielding the negative cash flow. In other words, the organization is actually losing money in Option “D” if the purchasing power of money is taken into account. The best option according to this method is Option “A”. This option is yielding the highest discounted Cash Flows and the firm is actually earning money making money more money than any other option. Hence, the right path for the company is to purchase Machine “A”. Going deeper into the analysis, it can be seen that it is Option “B” that is covering the company’s investment in the shortest period of time. But this method is clearly not the best in terms of its earning potential as it does not provide the highest Net Cash Flows or Discounted Cash Flows. Hence, it should not be chosen and search for the best option should be continued using other appraisal techniques that the firm can use. (Van Horne & John 2008) NPV or “Net Present Value” is probably the best option when deciding the best capital project. The best NPV is provided by Option B. However, Option A and Option D are pretty close also. Option C again fails to make its mark. Hence, we can say that option C is out of the question. The company should quickly decide against using Option C, since it is far below any of the other options. This leaves us with three options and the company can use Internal Rate of Return for deciding the best project. (Graham & John 2005) Internal Rate of Return specifies the real rate of return of an investment. It takes into account all the financial concepts such as inflation, time value of money and cost of capital. This method can be used by the companies that are unsure or facing a dilemma in choosing the best possible investment. Pevensey PLC can also make use of this technique to decide the best possible investment and which Machine the company should buy. In terms of IRR, Machine B beats the other available option with Machine C again being the substandard investment option for the company. The decision that the company should make is pretty much clear and will be discussed in the next part of the report. (Froot & Stein 2010) Decision: The company should invest in Machine B. It is the best alternative available to the company in terms of its earning potential, investment coverage and real rate of return. This option is clearly defeating all the other options available to the company. The company can earn high amount of returns if they choose to invest in Machine B. Not only will the company be covering their investment in a little more than 2 Years, but they will be earning a higher return than their cost of capital. Hence, the company should quickly invest in Machine B given that all the techniques of capital appraisal are pointing towards this option. The second choice for the company is option A. Option A is second best in IRR and is depicting a decent rate of return in other techniques of capital appraisal. The company’s third choice should be Machine D. However, the company should not invest in Machine C. If the company invested in this machine, it would be actually losing its money in the real terms, than making money. (Mills 1995) Conclusion: The capital appraisal techniques have clearly highlighted that the best option available to the company is Option B. That option would not only maximize the firm’s return, but it would also lead to quickest coverage of the original investment amount. It would only take a little over two years to cover the investment would be yielding more than 8% in return that is higher than the firm’s cost of capital. This will ensure that the company is actually making money in both real and nominal terms. Works Cited Brigham, E & Ehrhardt, M 2010, Corporate Finance, 5th edn, South-Western College, Chicage. Froot, K & Stein, J 2010, HBS, viewed 4 March 2012, < HYPERLINK "http://www.people.hbs.edu/kfroot/oldwebsite/cvpaperlinks/new_approach.pdf" http://www.people.hbs.edu/kfroot/oldwebsite/cvpaperlinks/new_approach.pdf >. Graham & John, HC 2005, How do CFOs make capital Budgeting Decisions, viewed 4 March 2012, < HYPERLINK "http://faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf" http://faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf >. Mills, GT 1995, 'Impact of Inflation on Capital Budget and Working Capital', Journal Of Financial And Strategic Decisions, vol 9, no. 1, pp. 11-43. Van Horne, J & John, W 2008, Fundamental of Business Finance, 13th edn, Prentice Hall, New York. Appendix: Cash Flow Method: Cash Flow Method = Acquisition Cost – Sum of Net Cash Flow for 5 Years Discounted Cash Flow Method: Payback Period = (Acquisition Cost/Net Cash flow) NPV, PAYBACK PERIOD AND IRR: IRR = Read More