Understanding Return on Investment - Essay Example

Financial Management Registration Number Module Number and of Assignment Question 1a The quantitative results can be found in the Appendices section of this report. Based on the results using the Payback Period, Net Present Value and Internal Rate of Return, Paddle Your Own Canoe Plc should not consider undertaking the project. With the Payback Period method, the number of years to recover the initial costs of the project resulted beyond the life of the plant and machinery, which is only five years. With the Net Present Value method, using a discount factor of 14%, resulted in a negative figure, i.e. -GBP 3,833M. This means that the project will generate a negative cash flow. Considering the large investment capital needed to undertake the project, it is not feasible to go ahead with it based on the poor returns. The company does not seem to be cash-rich as it currently has an overdraft facility. Although the company has been operating successfully, taking on the project will put the company in an unfavourable cash flow position. The Internal Rate of Return in which the Net Present Value is zero is undefined as there is no discount rate that is small enough to make the Net Present Value zero. The company has already incurred a considerable sum of GBP 750,000 on research and development of this new range. Perhaps, the company can consider alternative ways of manufacturing this product, such as outsourcing or negotiating for better material costs without compromising on its quality. Question 1b The initial research cost of the project has already been incurred by the company and is considered as sunk cost. This is because whether Paddle Your Own Canoe Plc takes up the project, or not, the initial research cost will still be considered as being spent. In analysing the cash flow that will be generated from the project, sunk costs must be ignored. As such, the treatment of the initial research cost is to exclude from the cash flow calculation. Likewise, depreciation of the plant and machinery is not included in the calculation of the cash flow because this is a non cash flow item, while the investment appraisal focuses on cash flows. Depreciation is an accounting method of recognising the reduction of the company's fixed assets in its income statement over time and does not affect cash at all. Thus, this item has also been excluded. The additional working capital that the company needs to invest in is meant for other purposes at the end of the project. In fact, this will only be released for use at the end of the project. Although the company has to commit to this much earlier, the item has also been excluded in the calculations. This is because the working capital is not related to the project and will not affect the investment at all. However, in the event that the working capital is sought for the purpose of the project, then this will have to be considered in determining the feasibility of the project. Question 1c The payback period calculation looks at the shortest number of years to recover the cost of the project. Although the calculation is easy to understand and simple, it still has its limitations. It ignores the benefits that occur after the payback period and more importantly, the method ignores the time value of money. The Net Present Value is an indicator of how much value an investment or project adds to the company. The Net Present Value is a more reliable method of calculating the returns expected from investments as the method considers the time value of money. The Net Present Value compares the value of a dollar today to the value of that same dollar in the future, taking both inflation and returns into account. A positive Net Present Value generated from a prospective project is a good sign and should be accepted On the contrary, a negative Net Present Value resulting from projects should be rejected because the cash flows will also be negative. The Internal Rate of Return is the discount rate that delivers a Net Present Value of zero for a series of future cash flows. As with the Net Present Value, this technique uses the discounted cash flow approach and is as widely used as the Net Present Value method. The Internal Rate of Return represents the interest yield expected from an investment and is expressed as a percentage. Moreover, the Internal Rate of Return can be found without having to estimate the cost of capital. Question 2a The use of Discounted Payback Period in investment analysis is more reliable than the use of Payback Period method. This is because the former considers the time value of money by discounting the estimated cash flow at the end of each year before determining the number of years that the initial cost of the project will be recovered. Like the Net Present Value, it considers the time value of money and as such, the outcome of using this method is more realistic and appropriate. On the other hand, the risk adjusted discount factor produces the expected rate of return for the project, given its risk. The rate considers both the risk premium and the risk-free rate in order to determine the present value of the project. As such, the rate is lower for less risky investments and vice versa. This rate is useful in that it reflects the degree of risk of any investments whereas risks can be anything from the business to the economy and even to Government policies. Indeed, the latter has become increasingly popular in assessing investment projects as it considers many risks that can be associated with an investment. It is good that the company is aware of the risk factors that can be associated with the project before undertaking it. This is to better prepare the management of possible uncertainties. High-risk investments generally offer higher and better returns but the company must know its position in terms of taking risks, as there are shareholders that may be risk-adverse. In larger firms, risk consideration using the second method would be preferable because the stakeholders are equally bigger. The management of larger firms has higher accountability and as such, it is important to determine the risks. However, the risk levels of managements in smaller firms are usually lower and as such, risk considerations are not as popular. Nevertheless, determining the risks is equally important. The Discounted Payback Period method is a useful and more reliable tool in appraising investments because not only does the method consider the time value of money, it is also very easy to use and understand. Question 2b Issuing shares to raise capital to finance the investment project is a good way of obtaining capital needed by Paddle Your Own Canoe Plc. The company must be aware that with shares come voting rights and investors are typically attracted to a company's shares due to the dividend payouts, be it small or large. With more investors, the value of the shares will rise. This form of equity to raise capital is beneficial for the company, as the company will be spared having to settle large amount of interest payments, which can be a burden if it is for long-term. However, the company must note that any one person who manages to buy large amount of shares may give that person the power to control the company. On the other hand, borrowing to raise capital will have its own advantages as well. This is because interests incurred on borrowings are tax deductible and this means that the company will be able to leverage on this savings. However, for smaller firms, it may not be as easy to obtain loans from banks, especially in times like this where banks are tightening their controls in order to avoid running bad debts. Another way of obtaining capital is to seek government grants that are usually available for research and developments or at a certain percentage of the investments. However, the company is required to draw up an exhaustive report, including its plans for submission to government agencies so that they can evaluate the eligibility of the company. It is best that the company have a balance mix of equity and debt in its capital structure. Not having any debts does not mean that the capital structure of the company is strong because debts have its own financial advantages to the company as well. For Paddle Your Own Canoe Plc, going public for the first time by way of initial public offering would also require substantial amount of expenses. Question 3a There have been many mergers and acquisitions that occurred in the last two decades. Many companies take over and merge with others in the hope of creating value through synergy. Of course, before a takeover occurs, the financial gains on such deals would have already been assessed to be very favourable. However, this is precisely the root cause of problems in failed mergers: the concentration on financial gains before takeovers. For instance, mergers between so and so have failed or have not lived up to the initial expectations of growth, such as the merger of Hewlett Packard and Compaq. There is no doubt that mergers can create value through synergy but only if the merged companies have strong management teams that can make this synergy possible. Indeed, attractive companies that are up for takeovers have favourable financial position and paying a premium for what such companies are worth are expected. Mergers are able to combine the operations of two companies, and keeping one that has a stronger position, or both in order to become a bigger player in the market. Either way, the combined efforts will result in lower costs and provide better products and services to consumers at a more competitive price. In addition to having economies of scale due to merger, there is also a competitive advantage with it due to its size, available resources and wider contacts. Having said that, the values that can be created by merged companies not only depend on its operations, products or services offered but also by its people. This is because merged companies are also creating double managements with different organisational goals and cultures. These differences often result in conflicts and if not managed timely and effectively, may cause failure in mergers. As such, the ability of mergers to create shareholder value by means of synergy for a long term is possible, but difficult. For synergy to happen, there must be cooperation between the merged companies with a single or combined objectives so that the management and employees are aware of the direction that the merged companies is going and so that there is goal congruence. Without good management and people to run the operations of merged companies is as good as not merging at all because then the objectives and goals will not be met. It is important that these factors are considered and dealt with before takeovers take place in order to avoid conflicts. In addition, the takeover of companies with strong management teams is more likely to create value through synergy. Question 3b Non-financial factors are equally important in contributing to the success of a merger because a merger also involves stakeholders. These include, employees, vendors, the government and auditors. On the other hand, many mergers fail to consider the aftermath of joining two companies together. Having said that, the merger of two companies mean there are now duplicate management teams and roles. These two managements belong to two different companies that are operating on separate organisational values, goals and cultures. The management styles are also different. On the lower level, employees may be confused on the reporting level that they now have to make or may dislike the cultural values of the other. These differences create conflict within the organisation and it is important that such issues are addressed in the shortest time possible so as not to affect the operations of the merged business. The human factor is normally left out when mergers take place and in most cases, this is a contributing factor to many failed mergers. Although, many a times, clear paths or goals are established before takeovers, merged companies are at a loss of the next steps to take in reaching such goals. More often than not, it is harder to put in place such visions and goals because the establishment of these do not include the human factor. With conflicts in place, it is difficult to create the very initial values that are expected of mergers because, in the first place, there is no synergy between the two merged companies. Question 4 There is a cycle in every economy that shows the bust and boom periods. The boom period shows growth and expansion of businesses, increase in personal income and higher spending power. With this, there is a relative increase in the Growth Domestic Product, which is the measure of the total value of all goods and services that are produced in a country over a specific period. The economy would be experiencing growth nationally and globally. There is increase in demand as oppose to the supply, resulting in higher prices of goods. The rapid economic expansion then becomes unsustainable and leads to economic decline and recession. The bust period shows decline in all the above-mentioned factors. In addition, inflation in prices, contraction of businesses, recession in the economy and at its worse, depression can be experienced. There is increase supply and low demand as consumers become more wary about their spending habits, buying only what they consider as necessities and foregoing luxury items. This boom and bust cycle shows an unbalanced economy. Indeed, governments play a part in stabilising economies by adopting measures to curb current economic problems. The theory of efficient markets states that complete information is available in determining current market prices and changes just as rapidly when new information, good or bad, is known. However, the belief that such prices are not supposed to deviate greatly from fundamental values do not sit well with what the current economy has seen and experienced. The credit crunch in the U.S. that spilled even to the U.K. resulted in the decline of economy all over the world, with market prices falling sharply and with many businesses collapsing over night. Even financial giants such as the American Insurance Group needed government support. Many big companies experienced tremendous drop in their market value, for instance, Citibank as they struggle to survive in this economic downturn. The boom and bust cycles in the Asian region have surfaced more frequently with the Hong Kong crises in the 1980s, followed by the Financial Crises in the lates 1990s and then this current economic downturn. Having said that, countries like Malaysia managed to overcome the Financial Crises as the government took immediate actions to minimise the crises' effect on its economy by spending less and putting major constructions on hold and lowering the interest rates. Indeed, the Malaysian economy saw benefits from these as they remain very stable during that period. Just like the U.K., Singapore housing properties saw a boom about 1 - 2 years ago, inflating prices not just on private properties but also on government housing, which matches its pricing on the current market regardless. The property saw an increase in demand and shortage in supply as home seekers rush to join in the property craze. The recent hike in oil prices, and other commodities such as gold, globally present evidence of unbalanced economies. However, it is worthy to note that the increase in oil prices do not signify the boom position of an economy but rather the cost push factor. Currently, oil prices have stabilised. The current economic conditions clearly support the boom and bust cycle. However, the theory of efficient markets do not. This is because prices do deviate greatly from fundamental values, as seen in many big companies. On the other hand, the theory that markets are efficiently informed can be marked as true in many cases. Although alarming, this is not necessarily a bad thing if companies can take preventive measures in crises like this so that companies are able to emerge stronger and better when the economy picks up. In fact, companies should be prepared for times like this by ensuring that its management regularly monitors the company's financial position. Most importantly, it is necessary to have a healthy cash flow position as company's operations will bound to fail without sufficient cash flow to sustain its running expenses. *** The End *** APPENDICES Question 1a Payback Period Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 GBP'000 Initial Outlay -4,250 0 0 0 0 0 Additional Costs 0 -1,150 -1,150 -1,150 -1,150 -1,150 Material Costs 0 -3,000 -3,300 -3,600 -2,700 -2,400 Direct Labour 0 -2,500 -2,750 -3,000 -2,250 -2,000 Overheads 0 -1,250 -1,375 -1,500 -1,125 -1,000 Cash Inflow 0 8,000 8,800 9,600 7,200 6,000 Scrap Value 0 0 0 0 0 425 Cumulative CF -4,250 -4,150 -3,925 -3,575 -3,600 -3,725 Payback Period 5 + (125 / 3,725) > 5 Years Net Present Value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 GBP'000 Initial Outlay -4,250 0 0 0 0 0 Additional Costs 0 -1,150 -1,150 -1,150 -1,150 -1,150 Material Costs 0 -3,000 -3,300 -3,600 -2,700 -2,400 Direct Labour 0 -2,500 -2,750 -3,000 -2,250 -2,000 Overheads 0 -1,250 -1,375 -1,500 -1,125 -1,000 Cash Inflow 0 8,000 8,800 9,600 7,200 6,000 Scrap Value 0 0 0 0 0 425 Total Cash Flow -4,250 100 225 350 -25 -125 14% Disc Factor 1.000 0.8772 0.7695 0.6750 0.5921 0.5194 Disc Cash Flow -4,250 87 173 236 -14 -65 Net Present Value -3,833 Internal Rate of Return NPV = -4,250 + 100 + 225 + 350 + -25 + -125 = 0 (1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)5 r = undefined* *IRR is undefined as there is no discount rate that is small enough that will result in NPV = 0. 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