Keflavik Paper Company - Case Study Example

? Project Management-Case study of Keflavik Paper Company al Affiliation) Introduction Capital budgeting is an essential aspect of projects’ portfolio management of any given company. It is used to describe every action relating to the planning and financing capital investments. These capital outlays may include a purchase of new machines, modernization of equipments or even introduction of a new product. The capital budgeting process involves commitment of funds by a company in order to receive cash inflows in the future (Baker, 2011). Since funds available for these purposes are limited and the investment opportunities are many, screening and thorough evaluation is the best way to establish whether a proposed project outlay meets a number of set standards for acceptance. Screening entails the process of grouping projects into categories of acceptable and those that are not acceptable. Then from the alternatives, a preference decision is made by selecting the best courses of actions. This procedure also ranks them in order of desirability (Baker, 2011). If this planning is ignored, and the company goes ahead to endorse investment projects without analyzing them, problems are bound to occur. a) Problems Related with Excessive Reliance on a Single Screening Technique. Keflavik Paper will rely on a number of screening and evaluation techniques in order to determine which project to add to their projects portfolio. There are various criteria, which they can employ to determine whether a particular project meets the requirement to invest funds to implement it. Most of these projects will include expansion and diversification investment decisions or even replacement and modernization decisions (Allen, 2010). These projects are aimed at increasing production and also improve operating efficiency and reduce cost. This is reflected in increased profits and where firm replaces obsolete assets with those that operate more economically. The capital budgeting decisions are quite important since their effects continue for many years and entails large amounts of money investments into projects. These resources invested are committed for a long period and it may become hard to mitigate the effects of poor decisions. Thus, the success or failure of the company may rely on a single or relatively few investment decisions (Allen, 2010). Erroneous forecast of requirements of the assets can have grave consequences. If Keflavik Paper Company invests too much into these projects, it may end up incurring unnecessarily high depreciation and expenses. As a result the company may end being less competitive and eventually lose market. Like any other company, Keflavik Paper has scarce capital resources and thus timing is of essence. The various investment decision rules or investment criteria are divided into two distinct categories. First, there are the discounted cash flow techniques, which include net present value, profitability index and internal rate of return. Secondly, there are non-discounted cash flow methods, which comprise criteria such as payback period (Clear, 2011). Non-discounted cash flow techniques can be used to identify the ideal project to include into the company project portfolio. However, these methods of project appraisal do not take into account the project time value of money. Over reliance on these criteria to selecting and screening of projects could cause problems to the company. Payback period criteria attempts to measure the time that a certain project will take into the future to recoup the cost invested into the project. To approve a project the company would have a maximum allowable payback period within its policies, within which investments projects are compared (Allen, 2010). Excessive reliance on pay-back-period as a screening and evaluation technique would result to development of a pool of projects that no longer benefit the company after some years of operation. This is because the criteria do not consider projects’ cash flows after the payback period. This means that, a project might recover its investment cost but shortly thereafter become obsolete. Thus relying on this criterion will lead management to accept many projects merely because they repay the cost of investment (Clear, 2011). Nevertheless, this project might end up a burden to the company after some time. Secondly, the fact that Pay-back-period put more emphasis on recouping the cost of investment is not enough to accept a project as ideal. This is because paying back investment cost is not a measure of profitability. Profitability will tend to determine the overall cash inflows. The problem here is that most projects undertaken by Keflavik Paper may end up a burden to the company due to continued loss making even after paying the investment cost. A portfolio of loss making investments might cause the company to collapse (Clear, 2011). Non-discounted cash flow techniques also require estimation of the cost of invested capital in order to determine their viability. These estimations are not the correct figures of the projects and might result to excessive expenses on these projects. Some costs might be difficult to predict such as inflation costs and these might make completion of the projects difficult. Another problem is that this criterion is inconsistent with the company shareholders value and interest. This technique is not consistent with maximizing objective of the market value of the shares (Clear, 2011). This might lead to unsatisfied shareholders who might even resolve to disinvest from the company. This might cause the company to experience financial difficulties. In addition, The Company might not determine the acceptable maximum payback period effectively. The period might be too long that the project may hold most of the Company’s funds for long that it becomes difficult to reinvest into other viable projects. The Company will have a slow investing culture that will eventually slow down the pace of its growth and profitability altogether. The company might encounter hard times since payback period also consider projects whose cash flows are irregular. During such periods, the projects could be making losses at the expense of the owners. The cash flow pattern changes with time and thus might cause further losses to the shareholders value. The fact that the company may end up with a list of completed project but unprofitable projects might threaten the long-term profitability of the company (Clear, 2011). Payback period might be considering short-term projects, which will end up useless after some time. The ideal approach to establish the most effective project portfolio for the company is to ensure that the Keflavik Paper Management officials adopts a mixture of discounted and non-discounted cash flows criteria for project selection and screening (Clear, 2011). b) Investment Evaluation Criteria As an attempt to maintaining an effective and profitable Keflavik’s Projects Portfolio, it is crucial to identifying a number of useful criteria to evaluate all new projects suggested to the company for investment before they are accepted to be added to the portfolio (Lam, 2007). It is important to realize the objective to this criterion is to identifying the ideal project to invest in terms of profitability and long run growth of the company. Investment Evaluation Process The investment evaluation process entails a number of steps that ensure the criterion used is most effective. Firstly, this should ensure that the total cash flows of the project are estimated as accurately as possible. Any project that the company wishes to invest in should be able to earn future income to the company. This is the essence of investing into any particular project. The company should be assured of the inflows to accept it as a viable investment option. Cash inflows add to company’s profitability (Lam, 2007). Secondly, it should be able to identify the required rate of return for every investment capable of earning cash inflows. This stands for the rate at which the company wishes to recover the money invested, from the projects income realized. This is usually found in the company polices and should be agreed upon by the top management of the Keflavik Paper Company. This rate should be capable of ensuring the investment cost is recovered efficiently and within what period. The last step of evaluation of an investment includes the application of the decision rule for making a choice. For every project, the management of the company should be in a position to make a decision after looking into the information made available. Policies should be formulated which would dictate the decision made on whether to accept to drop a project depending on the details availed (Lam, 2007). The investment decisions rules adopted by the company would be regarded as investment criteria or capital budgeting techniques. Investment Decision Rule Every appraisal technique adopted by Keflavik Paper should have the capacity to measure the economic value and worth of any investment project available. The most essential feature of a sound investment technique is that it should be able to maximize the wealth of the shareholders. According to Pierre-Jean & Daniel (2007), a number of issues should be considered while selecting the evaluation criterion: 1) It should consider the total cash flows to be able to determine the correct profitability of the project. 2) The criteria should provide for unambiguous and an objective way to separate good projects from bad ones. 3) In addition, the criterion should help rank projects according to their profitability. 4) It should also recognize the fact that early cash flows are highly preferable to later ones and bigger cash inflows are preferable to smaller ones. 5) It should help in choosing among mutually exclusive projects, the investment project that sufficiently maximizes the shareholders wealth. 6) Lastly, it should be applicable to every conceivable investment project, which is independent of others (Pierre-Jean & Daniel, 2007). Investment Appraisal Criteria There is quite a number of project appraisal criteria used in a company. As mentioned earlier, these budgeting techniques divided into Discounted and not-discounted cash flow techniques. Non-discounted Cash Flow Methods I. Simple Pay Back Period It refers to the time required to recover the first cost or initial investment. This criterion prefers projects with shorter payback period (Pierre-Jean & Daniel, 2007). Advantages of Payback period It is a widely used investment criterion and is relatively simple to apply because it does not use difficult and tedious calculations. It also favors projects that are more profitable during the first years than those that bring cash inflows in later years. II. Return on Investment This criterion takes into account the cash flows over the project life and the discount rate by converting the total present value of ongoing cash flows to an equivalent annual amount over the life of any project, which can then be compared to the capital cost (Allen, 2010). ROI does not need similar project life or capital cost for comparison. This is one of the non-discounted cash flow criteria, which tend to express the return from projects as percentage of the cost of capital. It usually considers all the cash flows over the life of the project and the discount rate from conversion of the present value of cash flows to an equivalent amount over project life, which is then compared to cost of their capital. The greater the ROI the greater the project's earnings. However, it does not take time value of money into consideration and the variable nature of cash flows (Pierre-Jean & Daniel, 2007). Discounted Cash Flow Techniques Time Value of Money Project’s feasibility is test is assessed by equating the present and the future cash flows. However, there is usually a problem equating these cash flows, occurring at different times since the value of money will change with time (Pierre-Jean & Daniel, 2007). This concept of equating a number of different cash flows is called present value concept or discounting process. I. Net Present Value This equates the sum of the total present values of the cash flows associated with the project. This measure represents the net benefit after compensation for risk and time. Hence, the decision rule in this criterion is to accept any project if its NPV is positive and on the other hand, to reject any project if the NPV is negative. This technique takes the cash flows time value of money into consideration and the total cash flow stream over its project life (Pierre-Jean & Daniel, 2007). However, the criterion requires an extensive estimate of capital cost in an attempt to determine the project’s net present value. In addition, it is difficult to understand since it is not expressed into percentage. II. Internal Rate of Return This technique calculates investment’s rate of return expected to be yield. The method calculates the rate of return of each alternative of an investment. The expected rate of return refers to the interest rate when the total discounted benefits equals to total discounted costs. Here the selection criterion among alternatives is choosing an investment, which offers the highest rate of return. The internal rate of return is normally determined by a rather trial and error method, by computing the net amount of cash flow for a number of discount rates till its value reduces to zero. It also takes time value of money into consideration and the entire cash flow stream (Pierre-Jean & Daniel, 2007). It is useful since it shows whether a project invested in has potential to increase the value of the firm. It is also consider all the cash flow of the projects, their time value, and the risk of the future inflow of cash as well. On the other hand, the procedure is not useful in mutually exclusive project or even in capital rationing projects. To maintain the Keflavik’s projects portfolio, I would recommend extensive use of most of discounted cash flow techniques due to the many benefits they have. c) Effect of poor project-screening technique on Keflavik’s ability to manage suggested projects effectively Keflavik Paper Case Study demonstrates a number of issues that result due to ineffective projects screening and evaluation processes. This seems to be source of numerous problems in the management of portfolio within an organization. It is said that the Keflavik Company is experiencing problems in project development project. This means that the company does not have viable projects in operation that are essential for every company growth and long-term profitability (Dayananda, 2002). The new product opportunities that the company wished to support is said to be lagging behind, five years after its endorsement. The poor management of the projects has had a negative impact on the completion of most of the projects. There are many investment projects that are behind schedule and it looks the company has run out of ideas on how to complete them. This may be attributed to the fact the company has been undertaking so many projects of which the company has not done a thorough job to determine the time and resources need for the successful completion of the projects (Dayananda, 2002). The budget of most of these projects has been overrun once too many times. This means that the funds set aside to complete the projects turns out to be insufficient for the job. This necessitates additional of more funds to complete the investment something that put the company on a dangerous liquidity spot. These additional funds to halted projects steal away money from other viable investments. This will ultimately slow down the growth of the company its profitability as well (Dayananda, 2002). Although there are records of projects earning quite a good amount of returns to the company, a number of them are said to have lost a lot of money. These project ends up obsolete and unable to generate income even after huge investment of funds to make them operational (Dayananda, 2002). At the end of the day, it is loss of funds to the company and this reduces the company’s future ability to investing other projects. A continuous occurrence of such trend can cause the company to collapse due to lose of the capital. The poor management of company project portfolio has forced the management of the company to hire a consultant to try analyzing the situation and provide ideas on how to improve. This necessary action is essential in bringing the company back on track. However, this will have an effect on the on the financial status of the company since these consultations come with a price. The company hires an expert to offer these services will need to be paid fees. This would have been avoided could the management of the projects been appropriate. The case of Keflavik Paper outlines the importance of proper project screening on the success of the overall project portfolio. This also results to the general long-term growth and profitability of the organization. It has also re-emphasized all through the case that application of only one capital budgeting technique in evaluating the acceptability of projects is not valid (Dayananda, 2002). However, discounted cash flow methods should be used along the not-discounted cash flow techniques in screening the projects. References Allen, D. (2010, 8 27). Huffington Post. Retrieved from The Project Management Problem: http://www.huffingtonpost.com/david-allen/the-project-management-pr_b_95172.html Archibus. (2011, 08 25). Capital Budgeting. Retrieved from ARCHIBUS: http://www.archibus.com/index.cfm/pages.content_application/template_id/820/section/Capital%20Budgeting/path/1.3.29.90/menuid/90 Baker, H. K. (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. New York: John Wiley and Sons. Clear, J. (2011, 02 04). 7 Common Project Management Problems (And How to Solve Them). Retrieved from Six revisions: http://sixrevisions.com/project-management/7-common-project-management-problems-and-how-to-solve-them/ Dayananda, D. (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press. Hann, P. (2011, 04 01). Explaining Acceptability in the Capital Budget Process. Retrieved from Bright Hub: http://www.brighthub.com/office/finance/articles/112797.aspx International Association for Impact Assessment. (2002). Impact assessment and project appraisal. Journal of the International Association for Impact Assessment, Volume 20, 22-40 pages. Retrieved from http://freemba.in/articlesread.php?artcode=341&substcode=21&stcode=10&PHPSESSID=6dfe945de33ce2522fb02517ed1b76bc Lam, M. (2007). The capital budgeting evaluation practices (2004) of building contractors in Hong Kong. International Journal of Project Management, Pages 824–834. Lutchman, C. (2010). Project Execution: A Practical Approach to Industrial and Commercial Project Management. Boca Raton: CRC Press. Pierre-Jean Charrel, D. G. (2007). Project Management and Risk Management in Complex Projects: Studies in Organizational Semiotics. New York: Springer. Read More