Calculations on Finance Growth - Essay Example

Finance Growth Calculation of Net Present Value Fijisawa Inc. The NPV for the project is calculated as below: Year 0 2 3 4 5 6 Total Outflow -10950000 -10950000 Inflow 4500000 4500000 4500000 4500000 4500000 4500000 NPV Factor @ 9 % 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 NPV 4128300 3787650 3474900 3187800 2924550 2683350 20186550 Net Inflow 9236550 The project yields a positive NPV and hence is acceptable. Calculation of Internal Rate of Return Year 0 1 2 3 4 5 6 Total Outflow -10950000 -10950000 Inflow 4500000 4500000 4500000 4500000 4500000 4500000 NPV @ 28% 0.7813 0.6104 0.4768 0.3725 0.291 0.2274 NPV 3515850 2746800 2145600 1676250 1309500 1023300 12417300 Net Inflow 1467300 NPV @ 32% 0.7576 0.5739 0.4348 0.3294 0.2495 0.189 NPV 3409200 2582550 1956600 1482300 1122750 850500 11403900 Net Inflow 453900 NPV @ 34% 0.74645 0.5573 0.4162 0.3109 0.2322 0.1735 NPV 3359025 2507850 1872675 1398825 1044900 780750 10964025 Net Inflow 14025 NPV @ 36% 0.7353 0.5407 0.3975 0.2923 0.2149 0.158 NPV 3308850 2433150 1788750 1315350 967050 711000 10524150 Net Inflow -425850 Since the Net Present Value (NPV) when discounted at 34% more or less equals the cash outflow on the project the internal rate of return for the project can be taken to be 34 percent. The project is acceptable because it yield positive NPV at the required rate of return of 9 percent. Moreover the Internal Rate of Return (IRR) on the project is 34 percent as calculated above which is a very good return the company can expect from the project. Importance of Capital Budgeting Decisions Capital budgeting decisions of firms are considered to be of strategic importance not only for the growth of the company but for the economy as a whole. The capital budgeting decisions commit the economy's productive resources to its production systems and also for the firms as they strengthen and renew the resources. Such decisions consist of allocation of the resources of the firms with carefully laid out plans to recoup the initial investment as well as adequate returns in the form of cash flows or other benefits that are expected to be generated during the economic life of the asset or investment. It is hard to reverse such capital budgeting decisions without severely disturbing an organization economically or in any other manner. Therefore it becomes critically important for any firm to make its capital budgeting decisions after a systematic and careful analysis of all associated risks and issues. But it must be noted that the capital budgeting decisions are many sided analysis. The process of this analysis involves estimation and forecasting of the current and future cash flows and the economic evaluation of alternative projects on hand. "Since in reality the cash flow estimations take place in a non-deterministic environment, full of complex interplay of conflicting forces, an exact description about cash flows is virtually impossible"(Chandra Prakash Gupta). Therefore it becomes important that the firm attempts to develop procedures and techniques that help the firm to make a meaningful analysis and evaluation of all the alternatives available in its hands before any decision is taken to invest money in any of the projects. This also makes the decisions of capital budgeting risky and difficult to retrieve. Capital budgeting is primarily concerned with fairly large investments in long-term assets. The assets may be tangible like property, plan, and equipment or intangible like new technology, patents, or trademarks. Irrespective of the nature of the assets, the capital expenditures have two characters; one is that they are meant to be a long term investment and secondly their benefits or cash flows are expected to be spread over many years. These characteristic features make the capital expenditure decisions very important for a firm. The capital expenditure decisions since have a considerable impact on the organization's future cash flows there is a considerable risk associated with the capital expenditures. Moreover the firm usually commits large amounts of funds in capital expenditure projects. Hence they are considered very important and if any error is made in the capital budgeting decisions, it will affect the performance of the firm by directly affecting the profitability of the company (Capital Budgeting). Similarly the capital budgeting decisions will also influence the stock valuation in the sense that there will be changes in the market value of the stock. Moreover depending on the financing plan for the capital expenditure for the expansion the internal valuation of shares will also get vitiated. Depending on the leverage, the book value of the shares is likely to be impacted. If the company is contemplating to issue new equity for financing the expansion programs the holdings will get diluted to the extent the new common stock is issued for subscription. The increase in the number of shares will affect the free cash flow to the equity which in turn will affect the valuation of shares. Payback Method The payback period is the amount of time needed to recover the initial cost of an investment in a project. The period is usually measured in terms of years. Under the payback method the initial investment costs and the resultant cash flow in the ensuing years are considered. The payback method does not take into account the savings that may accrue from the project after the initial investment is paid off from the earnings from the project. Nevertheless this method is considered useful for a 'first cut' analysis of the project - that is this method is adopted by the companies as a screen for making the myriad of minor investment decisions the companies continually face. This method is often adopted for its simplicity. Criticisms against Payback Method The following are some of the criticisms leveled against the payback method: The cash flows beyond the payback period are not taken into account which sometimes may affect the capital budgeting decisions There is no recognition of the time value of money as in the case of net present value method When a number of capital projects are being considered it may become difficult to differentiate between projects of different size. This becomes more difficult when the initial investment amounts differ too much The payback method focuses more on the short run profitability of the projects without giving importance to the long term viability of the projects (Capital Budgeting1) Advantages of Payback Method The payback method is simple and easy to use and hence can be understood easily. The capital projects that return large cash flows in the early period after investment are favored by this technique. Even though the method does not focus on the risks associated with a project directly, it enables a finance manager to analyze the risks by making him to find out the period required for recouping the initial investment. The payback method is capable of addressing the capital rationing issues more easily. Since the payback period method is easy to use and interpret it helps in decentralizing the capital budgeting decisions. By this the management needs to evaluate only those projects which are worth considering. Despite the disadvantages the method is being used by the companies as a method for making the initial screening of the projects with respect to their viability on the basis of expected cash in flows. The companies prefer to use this method because of its simplicity. This method is always useful for making minor investment decisions (Ross, Westerfield and Jaffe). Expropriation of Foreign Investments Expropriation is a kind of risk in the overall political risk. "It means the seizure, with or without payment of compensation, of the physical project within the host country. This seizure can be an action of the host country government, or a host country unofficial government installed by a coup d'tat" (Chapter 16).Expropriation can be identified as one of the potential risks involved with foreign direct investment. It takes the form of confiscation of foreign assets in return for a meager sum of money. Some times such payments may represent a mere formality with no relationship to the assets confiscated as in such cases the owner of the business becomes a forced seller and the transaction is undertaken without the consent of the business owner. In addition in such transactions the competition from any other buyer is totally excluded. The expropriation refrains the owner from expecting any reliable returns from the business which otherwise might have proved successful. Similarly acts of expropriation may be resulting from reasons peculiar to the local government entity. Hence the company proposing to make any investment in a foreign country should make a political risk analysis of the country assessing the longevity of the governments and changes in the policy decisions of the government relating to commerce and trade within the country. Based on such an analysis the company should arrive at the decision for making the investment in the company. For mitigating this risk the companies investing in the foreign countries may raise the necessary working capital and funds required for its activities, by local currency loans in the country of investment. Thus by providing substantial cost of the foreign projects financed through the debt, an additional protection can be created against the expropriation by the foreign countries. One more kind of expropriation that can happen is through a gradual increase in taxes. This risk of gradual increase in taxation can be mitigated by entering into tax exemption agreements with the governments of the countries in which the investments are proposed to be made. Mergers and Acquisitions Recently mergers and acquisitions have become a prominent and permanent part of the strategic moves of the corporations and these can be regarded as high-stake games. In these strategic moves, the companies often bet a very large proportion of their market capitalization with a view to gain more competitive advantages. The mergers and acquisitions are expected to change the strategic and financial characteristics of the players overnight. A number of reasons have been attributed for and benefits identified with the activities of mergers, acquisitions, and joint ventures. These activities are entered into by different firms as a strategic measure to gain access to expanded markets, and newer technological developments. Such activities are expected to provide economies of scale and provide easier ways to fill the critical gaps in the product lines. The other values that are expected to be added by the mergers and acquisitions are the additional infusion of capital and expansion in the available pool of managerial and technical talent. But in most of the cases of mergers and acquisitions the managements usually forget to take into account the odds that are pitted against the entities involved, in the pressure to conclude the bold and strategic move initiated by way of mergers and acquisitions. Studies have proved that somewhere between 50 and 85 percent of all mergers and acquisitions fail to deliver the intended value out of such strategic moves. In worst cases the failed attempts of merger and acquisition of two companies in fact results in the complete erosion of the underlying value of the core business. The accepted theory behind entering into the strategic deals of mergers and acquisitions postulates that the combined effect of the organizations under these deals must result in an enhanced value for firm. Thus the goal of combining two organizations under merger and acquisition schemes is to combine their resources in such a way that the combined management of the entities creates greater value for the new entity. This new value is expected to be much greater than the value of the firms had they continued under their original management and control. This can be explained that the objective of the mergers and acquisitions is to make one plus one three with respect the value of the firm which in practice does not happen due to the following reasons: Bad Strategy The first and foremost reason for the failure of the mergers and acquisition schemes to deliver the expected value is the improper strategies adopted in arriving at the capabilities of the company to produce joint values for the combined new entity. Poor Implementation Another reason that may result in the failure of the combination of firms to produce the desired result is that the process of implementation of the merger and acquisition scheme might not have been attempted to properly integrate the activities and resources of both the companies leaving loose ends which hinder the delivery of the desired combined values. The above two reasons will magnify the risk of combining the two organizations in the following areas: Maintenance of performance of both the organizations and customer focus in the context of a number of fundamental organizational changes envisaged by the merger or acquisition Merging the different cultures and operating styles of both the organizations to result in new organizational culture to be directed towards providing more values There are the leadership and succession issues that need to be tackled in respect of both the organizations involved There should be efforts directed towards combining the resources taken in such a way that the organizations are not linked either too tightly or too loosely The risks and issues associated with the motivation of the employees to identify themselves with the new organization There are circumstances which offer incomplete information and put the decision makers under severe time constraints that needs to be taken into account and the risk here is to take best possible decisions on these incomplete information and time constraints In short, a consideration of all the above factors should lead to the creation of more value than destroying the existing values. Approaches to Strategic Combinations Most of the mergers and acquisitions fail to provide the desired results due to the fact that the leaders of the organizations involved focus only on the financial aspects of the deal value. In the process they miss the key strategic and organizational issues that are instrumental to derive the expected values out of the merger or acquisition arrangement. It is necessary that the following principles are incorporated in to the merger and acquisition schemes to make them successful strategic moves: An Integrated Perspective But for few better schemes, most of the mergers and acquisitions are exclusively based on finance motives. It is necessary that the human side of these deals also is taken into account, as there will be some cultural clashes and leadership struggles that may come in the way. A successful integration of the firms should consider the issues in all these perspectives to derive the expected values. This can be achieved through a comprehensive focus on the basic strategic considerations, organizational architecture, and the broad principles of change management that need to be applied to the new entity. Design of Integration It is also important that there should be definite boundaries laid down for the integrative process. Therefore it becomes necessary that the ways of combining the activities should precede the reasons for making such combinations. It must be understood that successful combinations normally do not happen automatically. There is lot of planning and deliberations that would go into the execution of the merger and acquisition schemes. Leadership Roles It is another important issue that the leadership roles are defined clearly in the early stages of the merger and acquisition process. It is so critical that the leadership roles are clearly thought of and specifically assigned among the leaders to inform everyone concerned as to who is responsible for what as the integration process pass through. Organizational Due Diligence Just in the same way the financial and legal due diligence is undertaken, there need to be an organizational due diligence undertaken before the process of merger and acquisition is undertaken. At the initial stage of the process, it is vitally important that the 'organizational health' is identified. The identification of organizational health involves the observations on the effectiveness of the management process, the strength of the organizational infrastructure, the depth, and excellence of talents and the loyalty of the key people (Oliver Wyman.com). These observations are necessary to gauge the compatibility of the cultures of both the organizations. Even in these issues, there may be some which need to be considered only on their face values to assess their impact on the combined values. There are other issues, which need some serious calculations about the resources they possess, the time needed by them to act and react, talents possessed by them and the amount of funds that may be required to fix the problems if any in these issues. Conclusion In order to effectively create greater firm values out of merger and acquisition activities it is imperative that the above mentioned factors are given due considerations in the process of combining two organizations. The integration process should be made as comprehensive as possible so that all of the above elements are considered. In the absence of a comprehensive integration process, critical decisions are driven by expedience, not strategy-usually with tragic results. References Capital Budgeting 'Capital Budgeting: an Overview' Cambridge University Press Capital Budgeting1 'Capital Budgeting; an Applied Point-of-view' Chandra Prakash Gupta 'Capital Budgeting Decisions under Fuzzy Environment' Chapter 16 'Multinational Corporations and International Project Appraisal: Answer to Review Questions' Oliver Wyman.com 'Mergers and Acquisitions' Ross A. Stephen, Westerfield W. Randolph, and Jaffe Jeffrey 'Corporate Finance' Edition VII Tata McGraw Hills Publishing Company Limited New Delhi Read More