Strategic Financial Management - Essay Example

Running Head: STRATEGIC FINANCIAL MANAGEMENT Strategic Financial Management In Harvard Style By Why is the investment appraisal process so important The investment appraisal process is very important as it supports the main goal of a business organization's goal of shareholder wealth maximization (Higgins, 2005). It should be noted that investment appraisal helps a company to come up with a decision which can enhance or erode profitability. In this consideration, it should always be able to undertake an investment appraisal method which will enable it to come up with good decisions. If the company fails to evaluate its prospective ventures through the use of a credible method, it is most likely to fail. A thorough analysis of what a business venture or investment will impart the company is one of the most important steps in sustaining profitability, maximizing company's resources, and accepting or rejecting prospective projects (Brealey et al, 2005). 2. What are the criticisms of the payback period The payback period is regarded and widely used because of its relative simplicity. Managers prefer to use it because it is generally easy to memorize and to use (Peterson and Fabozzi, 2002). However, this technique disregards the additional cash flow which can be recouped from the project as it only focuses on the time when the whole investment will be recovered (Higgins 2005). Since the concern of the payback period is when, it does not really tell a business organization whether an investment is worth pursuing or not. Also, because of the relative view of managers on when the amount of investment should be recovered, there is no definite conclusion if project should be accepted or not. 3. Determine the NPV for each project-should they be accepted Explain why. The following tables show the computation of the Net Present Value (NPVs) of the two projects under consideration. Using the expect annual cash flow, the computed NPV for project 1 is $31,740 while it is $34,200 for project 2. If NPV is only the man consideration of the business organization in capital budgeting decision, it is apparent that both of the projects should be accepted. It should be noted that using the NPV method, any project which does not yield zero NPV should be considered and pursued by the business organization. Thus, in the case of the evaluated projects above, both should be considered as they both yield positive values of NPV. 4. Explain the logic behind the NPV approach. Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows (Keown, et al, 2005). The Net Present Value (NPV) analysis is very much different from other capital budgeting techniques like payback period because it takes into account the time value of money. In the computation for total cash flow, it also takes into account the total cash flow from the investment including the depreciation and the tax shield resulting from it. Starting from the expected annual cash flows from the prospective project, managers should assign a specific required rate of return, that is, the rate of return that the companies want to generate from the investment. This is often indicated as an interest rate. For example, if the company's rate of return is 12%, the company will only accept investments which will yield 12% or higher. This method recognizes that the value of dollar today is greater than its expected value tomorrow. Thus, all the cash flows are discounted according to the required rate of return. After generating the present value of all the expected future cash flows, it then takes the sum of these present values. Logically, if the sum is positive, it means that the project exceeds the required rate of return. In contrast, if the NPV is negative then the project fails to generate the set return. This technique is favored by more economists and managers because it is more realistic. 5. What would happen to NPV if the required rate of return increased The required rate of return decreased As discussed above, the required rate of return is the interest rate which can induce companies to invest in a specific project. Lower required rate of return means that the business organization is only expecting a low investment return and vice versa. In the computation of NPV, the present value of future cash flows is affected on how high or how low the required rate of return is set. Logically, if the required rate of return is higher, then the present value factor or the expected value of a $1 is lesser compared to a lower required rate of return. Thus, if the required rate of return is increased, NPV will decrease in order to reflect the more stringent hurdle in being accepted. In contrast, a lower required rate of return will increase NPV. 6. Determine the IRR for each project. Should they be accepted The internal rate of return is the cost of capital which equates the NPV to zero (Keown, et al, 2005). The following table shows the computed IRR of the two projects as generated from Microsoft Excel. Project 1's IRR 21% Project 2's IRR 24% Consistent with the NPV findings, both of the projects should be accepted. It can be recalled that when using IRR, the project is accepted if the computed IRR is greater than the required rate of return. In this case both projects yield IRR's which are higher than the company's required rate of return. 7. How does a change in the required rate of return affect the projects' IRR method As the main function of IRR is to find out which rate of return will yield zero NPV to the project, a change in the required rate of return will not affect IRR in any way. Required rate of return is exogenous and is not included in the computation of IRR. The rate of return is only needed when the company is making a decision whether to accept the project or not serving as a hurdle which the IRR must surpass. It should be noted that in IRR computation only the annual cash flows are used. Because of this, IRR does not change regardless of what the required rate of return. It is only the company's decision which can change as a result of a higher or lower required rate of return. 8. Why is the NPV approach often regarded to be superior than the IRR method The NPV approach is regarded as superior to the IRR method because of its relatively less tedious manner of computation. When computing manually, NPV involved just finding out the value for a specific required rate of return. For IRR however, one needs to adjust and solve the NPV for a number of required rate of return until coming up with one where the answer is zero (Brealey et al, 2005). The NPV approach is also more preferred academically because it can be used to decide on mutually exclusive projects. IRR on the other hand, is only efficient in deciding whether one project should be accepted or not (Higgins 2002). Another criticism of IRR is its ability only to state the rate of the gain but not the exact size of the gain which NPV does. Also, IRR ignores the company's capacity to reinvest and there are also cases where IRR is not unique (Keown et al, 2005). References Brealey, R. A., Myers, S.C., and Allen, F., 2005, Principles of Corporate Finance, Irwin-McGraw Hill. Higgins, R., 2005, Analysis for Financial Management, Irwin-McGraw Hill, 8th edition. Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, 2005, Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition. Peterson, P. P. and Fabozzi F. J. 2002, Capital Budgeting: Theory and Practice, John and Wiley Sons, Inc. Read More