Risk-Adjusted Discount Rate - Essay Example

Running Head: Risk adjusted discunt rate Risk adjusted discunt rate f the f the institutin] Risk adjusted discunt rate In reference to the meeting held on the 6th of November 2006, I have provided you with information below on the investment appraisal techniques and sources of finance that are available for the proposed investment on the new digital photographic printer. To clarify briefly on the information I received, it shows that the photographic printer inconsideration is intended to be unique, adaptable to any model of digital camera and also if accepted will be retailed at an affordable price. It has also been forecasted by the sales manager that product sales will exceed the capacity of the existing factory, therefore additional production facilities and support staff will be needed to meet the required demand. In addition the company may also need additional finance for the project. Nature of Investment When considering a business investment of large sums of money within a long term project, it is an important objective to ensure that the money received over the life of the project is higher that the initial cost of investment. In deciding on the investment to undertake time is the most essential factor, followed by the amount of cash going in and out of the business. In some cases, an investment is made not to generate more cash but to make a saving on present cost. (Tony D. and Brian P. 2002, pg 458).The lay out of investments usually involve the injection of large sums of money and returns on the investment are received in a series of small amounts over an extended period of time. In addition, because large sums of money are usually involved it can be very expensive and catastrophic to pull out. Considering the loss of production and investment that can be lost from a failed investment, it is essential that investment proposals are properly screened and examined to ensure that the business uses the appropriate appraisal method. Sources of Finance Businesses need finance or funds, both in the short-term and long-term to expand, operate their business or just survive. The business is involved in a continuous in and out flow of money by way of income and expenditure. Expenditure can either be capital expenditure, which is the payment made to acquire additional fixed assets and these fixed assets can in turn be loans made by the business or shares in another business bought by the company, as well as buildings and machinery which are usually long term. On the other hand, income can be revenue expenditures which relates to the purchase of goods and services are in use or have already been used in daily running of the business. In financing an investment a company can either use internal or external source of finance, related to the period repayment. Internal sources of finance as a long term approach are retaining profits from previous investment rather than issuing out new shares and re-investing the profit. The short term source of finance can be to increase level of creditors and reducing the stock and debtor levels. External sources of finance in the short-tem funding are short-term debts which are elements of overdrafts, loans, leases that are payable within one year and invoice discounting. Other sources of external finance are long-term which include ordinary shares or equity shares, preference shares, debentures and leases. INVESTMENT APPRAISAL ANALYSIS Capital investment appraisal methods are divided into two: firstly, those which do not take into account the time value of money and lastly, those which take into account the time value of money. METHODS WHICH DO NOT TAKE INTO ACCOUNT THE TIME VALUE OF MONEY Accounting Rate of Return (ARR) ARR is concerned with either the profit before interest and tax, and average capital employed or average annual profit and the initial investment to earn profit. They both result in the same outcome. However, profit is written as profit before interest and tax and average capital employed which means the money tied up in the business, can be calculated fixed asset + current asset + current liabilities. ARR is expressed in percentage of the average capital employed Profit before Interest and Tax X 100 Average Capital Employed Or Average Annual Profit X 100 Average Investment to earn that profit In deciding whether the percentage return is acceptable after calculation, it will have to be compared against the minimum percentage target on rate of return set by the business. ARR and the Return on Capital Employed ratio use similar approach of performance measurement but differ in the sense that ROCE asses the performance of the business after the period has passed but ARR, however assess the opportunity for investment before it commences. ARR is simple and easy to use and is concerned with the measurement of profitability of the investment. It also takes into account the entire life of the project. However, it can be said to ignore the time value of money and is dependent on the depreciation policy adopted by the business. In addition, the timing of cash movement is completely ignored and it takes no account of incidents of profit. Averages can also be misleading. Payback Period(PP) The payback period calculates simply the amount of time it will take the business to recover its initial cost of investment. It is calculated by cumulative cash flow. For example, if the capital cost of investment is £30,000 and the annual net cash flows from the investment is £5000, the payback period will be 6years. Atrill et al 2005 opines that "PP is an improvement of the ARR in terms of the timing of cash flows but however not the whole answer". Being aware of the PP can be said to adequate because the longer the time, the more uncertainties may arise. Inflation may ease or get worse, interest rates may rise, new techniques may be developed that might render the investment obsolete especially with fast pace of technology. However, with all these uncertainties that may occur with the life of the investment, managers may sometimes prefer projects that have a shorter payback period say 2years compared to 10years, even though one with a longer PP has a higher net present value and internal rate of return. In addition, the decision to choose an investment with a longer PP will ultimately depend on the business attitude to risk and returns. The advantage of the PP is its simplistic nature and the ease in understanding the data. Louderback et al 1988 suggests that being aware of company PP is important for liquidity purposes. In addition, it can be used to screen investment proposals in cases where investments will longer PP, because that will mean a low rate of return. It can also be used to measure risk because the longer it takes a business to recover its money, the riskier it becomes and the possibility of loosing the money increases. The disadvantage of the PP is that the project to be appraised is considered solely from the point of view of the cash flow and neglects the life of the project after the cost of capital has been received. In addition it ignores the timing of the expected cash flow (i.e. the time value of money) beyond the payback period, therefore avoids forecasting the cash flow over a long period of time. METHODS THAT TAKE INTO ACCOUNT THE TIME VALUE OF MONEY Net Present Value(NPV) Hussey et al (1994) pg 61 suggests that NPV converts the future net cash flows into present day values. This invariably means the way we compare money today with the value of money in the future. Example £1 today is worth more than £1 in a years time, because inflation erodes the buying power of money in the future, while today's money can be invested which can lead to profit. There are three main reasons why a pound today is worth more than a pound in the future as described in Atrill et al 2001 pg 276 (Interest lost, Risk and Inflation). Interest forgone Inflation Discount rate Risk premium However, the company should logically asses the investment project in terms of the effect it might have on the wealth of the business and shareholders. The NPV is calculated by determining the discount rate or the estimated rate of return for the project. t = end of project NPV = Initial + Cash flows at Yr t Investment (1+r) t Managing Finance Lecture Note, 2006 If the NPV gives a positive value, which is greater than zero, it means the project is viable and can be accepted because the project will yield a return greater than initial cost of investment. However, if the NPV is negative or equals to zero, the former is likely to be less than the initial cost of investment and the later is said to equal to the cost of investment which is known as the break even point i.e. where the company neither makes a profit or a loss. The advantages of NPV are that it makes use of relevant cash flow, takes into consideration the time value of money. It is an absolute measure of shareholder wealth and it is additive in the sense that if the cash flow is doubled then the NPV is doubled too. However, Michael Pogue 2004, 19 Issue 4 disqualifies NPV for its "complex nature and error in application and underlying assumption of shareholder value maximisation and its relevance on pragmatic grounds." In addition its application of discounted cash flows on a yearly basis and also its sensitivity towards the flow of cash inwards and outwards over the life of the project. However, the NPV allows for changes in the discount rate during the life of the project, which means that the cash flow generated over the course of the project dose not always have to be positive, thereby taking into account "convention and unconventional cash flows" (http://dev.i10.org.uk/learning elements /21/media /Invest_Appr_draftsourcefile/o20_v3.pdf) Internal Rate of Return (IRR) IRR tries to find a single rate of return that summarises the merits of the project. It also has to be an 'internal rate' which depends on the cash flow of the particular investment proposed. IRR is also known as the time adjusted rate of return. Simply put IRR is the discount rate at which NPV is equals to zero. I.e. the cash flow discounted - the initial cost of the project, machine and equipment = Zero. It considers the cost as the same or equivalent to the revenue. As explained by Hussey et al 1994 pg 62, "it uses the same principal as NPV, but aims to find the discounted rate at which NPV is 0 for the project." It however posses a question "What return are we earning if we invest £70000 now and receive £24000, yearly for 7years" In deciding what rate of return will be on the proposed investment, it will be measured with the company set target say 10% and based on the rule of IRR "an investment is acceptable if the IRR exceeds the required return", but if otherwise is the case it should be rejected Ross A. et al 2006; pg. 274. The formula for calculating IRR is IRR = A + [(a/a - b x B)-A] Where Big A = First discount rate Small a = First NPV Big B= Second discount rate Small b = Second NPV However, if the discount rate is not known, it can be found by asking how high the discount rate would be before the project is rejected. As explained above in the NPV, that the company will be indifferent between accepting and rejecting the investment if the NPV is zero which means it is a break even point and value will neither be created nor destroyed. Therefore, in determining the point at which discount rate (IRR) equates NPV to zero, we would need to solve for R (Which is the unknown discount rate). The advantages of IRR is that it takes into account time value of money and it is easier to understand and communicate because it is based on the point at which there will be a percentage of return on the investment. It is also closely related to NPV and can usually lead to the similar decisions. In addition, it is easier to calculate because it doesn't require the cost of capital. Sensitivity Analysis This is the method of assessing how change in one or two variables in the assumption on which a capital investment project would be affected by the outcome. For example change in wage settlement, cost of running machines, taxation. This helps management be aware and examine the sensitivity of different variables in the cash flow that may change and thereby allocate more time and resources to them. Marshall E. H suggests that "sensitivity analysis reveals how profitable or unprofitable the project might be if input values in the analysis change from what has already assumed in the approach to measuring the project worth". http://www.fire.nist.gov/bfrlpubs/buikl99/pdf/b99012.pdf The advantages are that it shows how a change in variable might make the business profitable or worthless; it also helps decision makers decide on crucial areas to allocate additional resources in the case of uncertainty, risk and inflation thereby preparing for questions like "what if". However, the disadvantages are that although it makes aware the possibility of risk, it dose not give a particular measurement of the likelihood of risk occurring. It gives no suggestion about what to do in the event that risk or uncertainty arises. In addition it uses break even analysis to determine the margin of safety (i.e. where value is neither created not lost) for each variable. Bibliography Arnold, Glen (2002), Corporate Financial Management, 2nd Edition, Pearson Education. Atrill, Peter & McLaney, Eddie, (2005), Accounting: An Introduction, 3rd Edition, England, and Pearson Education. Atrill, Peter. & McLaney, Eddie, (2001), Accounting and Finance for Non-specialists, 3rd Edition Pearson Education. Boczco, Tony. & Davies, Tony (2006), Principles of Accounting and Finance, Berkshire, Mc Graw Hill. Dominiak, F. Geraldine & Louderback III, G. Joseph (1988), Managerial Accounting. 5th Edition PWS-KENT Publishing Company, Boston. Pogue, Michael, (2004), 'Investment Appraisal: A new Approach', Managerial Auditing Journal, 19, no.4: 565-569. Stephen A. Ross, Randolph W. Westerfield & Bradford D. Jordan, (2006), Corporate Finance Fundamentals, 7th Edition. McGraw-Hill Irwin, publication. Jill & Roger Hussey, (1994), Elements of Management Accounting: A modular series. Published by South Birmingham College Mustafa M. K (2006), Real Options as a Tool for Making Strategy Investment Decisions, Journal of American Academy of Business, Cambridge; 8, 1; ABI/IFORM Global, pp.282-284 http://dev.i10.org.uk/learningelements/21/media/Invest_Appr_draftsourcefile%20_V3.pdf Accessed 9/12/06 http://www.examstutor.com/business/resources/studyroom/accounting_and_finance/sourcesoffinance/4-longtermfinance.phpstyle Accessed 9/12/06 http://www.fire.nist.gov Read More