Capital Budgeting and Investment Appraisal: The Alpha plc - Coursework Example

Capital Budgeting and Investment Appraisal: The Alpha plc. Case Part a) Sources of Initial Cash Outflow: Purchasing open cast-coal mine in South Wales at a cost of £2.75 million The company will require vehicles and equipment costing £13.75 million Working Capital of £0.55 Million is required. Cash Outflow   Cost of Equipment -13.75 Changes in Working Capital -0.55 Cost of Coal Mine -2.75 Total Cash Outflow -17.05 Cash flows for each period: We have used these data for preparing the cash flow forecasts for the economic life of the project. The project will make an investment in working capital of £0.55 million during the lifetime of the project. This working capital can be recoverred by the end of the fourth year. Two-thirds of Head office expenses represent an apportionment of other head office expenses which are not relevant to the project and are classified as sunk costs. We will add back an amount (2/3 of £0.66) equal to £0.44 to estimate the true cash flows relevant to the project. The company’s surveyors have conducted a feasiblity study and they have incurred costs to date of £0.22 million. These costs will be classified as sunk costs which are not incorporated in calculating the cash flows. After four years the company can sell the assets for £2.75 million. At the end of the project (in the fifthe year), the company needs to clean up the site and it will incurr cost amounting to £0.44 million.   1 2 3 4 5 Net Income 0.88 1.54 -0.33 -0.66   Add: Depreciation 2.75 2.75 2.75 2.75   Add: Interest Charges 1.32 1.32 1.32 1.32   Add: Sunk Costs related to Head Office Charges 0.44 0.44 0.44 0.44   Add: Incremental Survey Costs 0.22         Add: Salvage Value       2.75   Add: Change in Working Capital  0.55     0.55   Environmental Costs         -0.44 Total Cash Inflows or Outflows 6.16 6.05 4.18 7.15 -0.44 The cost of Capital is 12% Investment Appraisal: Payback Method: It will take approximately 3.04 years to recover the investment that Alpha plc is planning to make in open-cast coal mine. NPV Method: Using the NPV Method, we conclude that the project should be accepted since it will add to shareholder value after adjusting for the cost of capital. IRR Method: The internal rate of return is also greater than our cost of capital which implies that the project should be accepted. b) I have used three investment appraisal methods to evaluate the project and all of the three methods are leading to the same conclusion. However, I will prefer net present value method since it takes into account the cash flows, cost of capital, economic life and the value (wealth) that will be added to the shareholder’s equity. The other methods simply give you a holistic view of the scenario while NPV method is much precise and has fewer shortcomings. Part 2 Issues in Investment Appraisal: First of all, it is necessary for investment appraisal also to take in account the after-tax cash inflows and any opportunity cost which is forgone during the life of the project. In the above appraisal we ignored the cost of taxes which is an issue of practical concern. In addition to that, it is imperative to take incremental cost or benefits that will arise from the project when evaluating two projects. Discounted cash flow methods have been given considerable attention in the contemporary world; especially the NPV and IRR method have been extensively used by corporations to evaluate their capital projects. These methods are more time consuming and costly that the other principle techniques such as payback period and accounting rate of return. In United Kingdom, Payback method has been the preferred method for evaluating projects rather than the DCF methods because of its ease of use; a finding which is consistent with the “costly truth” hypothesis (Sangster, 1993). A study conducted about the usage of quantitative evaluation methods in the Scottish Large Companies revealed that they preferred payback method over all other methods Appraisal Method Percentage IRR 58 2 NPV 48 3 Payback 78 1 ARR 31 4 DCF 73 There are several issues of concern in investment appraisal and each of the appraisal method has its own pitfalls. Net Present Value is often criticized for using an inappropriate discount rate to discount the cash flows which often leads to faulty conclusions. Furthermore, an implicit assumption about NPV method is that cash flows are reinvested at the discount rate which is not a valid assumption. In other words, it implies that the management is assuming that for the economic life of the project, the cash flows can be invested at a rate of return equal to the discount rate. Because in the practical environment, market dynamics are always changing and reinvestment opportunities cannot be precisely measured therefore it is considered as a drawback of NPV Method. IRR is favored by majorities since it’s conceptually simple to understand and it does not require a discount rate since IRR itself is a discount rate which gives you a net present value equal to zero. However, it has some drawbacks as well, since some time multiple IRR can occur for a single project due to uneven pattern of cash flows (Longbottom, 1977). In addition to this, different scales (size) of the project can provide contradictory results between NPV and IRR method. An alternate discount rate measure was provided by (Baldwin, 1959) where he proposed that since during the economic life of the project the funds cannot be invested at a rate similar to discount rate, but at an average rate at which general corporate funds can be invested. The company’s management needs to find the average rate of return that will be gained on funds drawn from the melting pot of the company’s treasury. Some of the financial engineers argue that the value of the money must be a subjective judgment delivered by the management because it is the management who can gain insight to the projection of future. Company’s actual performance over the recent periods (last four to five years) can serve as a threshold for future period’s performance. The return on assets can provide a realistic guideline on the value of the money or the discount rate. However, if the management sincerely expects to increase the level of performance in the upcoming periods than the future’s expected rate of return can be used as a discount rate to evaluate any projects. Cost of Capital and Risk: Capital mainly comprises of two things; debt and equity. The first cost of capital measure is a interest rate accrued on the debt. It can easily be computed by comparing the risk free rate on any treasury bond equal to the economic life of the project. Since the capitals invested in the project have an opportunity cost therefore they should be taken into account by discounting the cash flows with the cost of capital. An important point to note is that debt provides a tax free benefit to the corporation therefore after tax cost of debt should be used as a measure rather than simply using the cost of debt (Elliott, 1980). The second component of capital is equity and is very difficult to estimate its cost. As per the definition, the cost of equity is the rate of return demanded by the shareholders for their invested equity. CAPM model has been proved to be a reliable measure for calculating the cost of equity. CAPM Model can be demonstrated by the equation Cost of equity model can be explained in simple terms; since equity holders are accepting risk therefore they demand that they should be compensated for the risk that they bear. The additional compensation is measured in the model by risk premium and betas of the stock. Beta represents the volatility of the stock with respect to the market. The more volatile a stock with respect to the market, the higher will be its beta and the higher premium above the risk free rate the equity holders will demand in the market. Another issue pertains to the calculation of beta since it does not come out of thin air. It is determined from the characteristic of the firm. Generally, the beta of a stock depends upon three factors; the cyclical nature of revenues, operating leverage, and financial leverage. Revenues of some firms are quite cyclical in nature as they depend upon the condition of the economy. There is empirical evidence that the high-tech firms, retailers, and automotive firms fluctuate with the business cycle (Ross, Westerfield, & Jaffe, 2002). Therefore if the stock is highly cyclical, its beta will be high. Operating leverage arises from the fixed costs an organization incurs for its operations. The higher the fixed costs, a small change in demand will cause a larger decline in profitability. Finally, financial leverage derives from the fixed costs an organization incurs to pay its debt holders. The more a firm is leveraged, higher will be its beta. Cost of Capital is currently the most emphasized topic and it is heavily disputed in the financial literature. As per the literature the cost of capital is used generally in two ways: As a tool for financial decision making where the optimal mix of financing sources is defined as a mix which minimizes the cost of capital. Secondly it is considered as a standard for investment appraisal decision where the minimum acceptable rate of return on new projects is defined as the cost of capital. A study conducted in Australia reported that the majority of the respondents who were surveyed used a cost of capital for their investment appraisal purposes. However, the cost of capital was subject to regular review by the management, more often within an annual year. Most of the respondents of the survey said that they calculated the cost of capital themselves, but few of them used both their own estimates and estimates from external sources as well. External sources of estimates emanated from financial institutions and analysts. The rising popularity of CAPM was exhibited in the fact that 72% of the respondent companies were using the model. Among the second most popular method was the cost of debt plus some premium for equity which was used by 47% of the firms (Truong, Partington, & Pear, 2008). Even the fact that, CAPM model is heavily criticized for its assumptions it is yet interesting to see that majority of the firms are using it and it did not have any significant impact on corporate practice. In a same industry, many of the firms will have different risk structures. Even within a single firm, opting for different projects will face different level of risks for each project. Some of the projects are quite risky while others are not. Therefore, it is necessary for a firm to make necessary changes to its beta, if the beta of the firm differs from its project. A slight adjustment is always needed to compensate for the level of risk faced by the project. References Baldwin, R. H., 1959. How to Assess Investment Proposals Harvard Business Review, 37(3), p- 98 Elliott, J. W., 1980. The Cost of Capital and U.S. Capital Investment: A Test of Alternative Concepts. Journal of Finance, 35(4), p.981-999 Longbottom, D. A., 1977, Capital Appraisal and the Case for Average Rate of Return. Journal of Business Finance & Accounting, 4(4), p.419-426, Ross, S. A., Westerfield, R. W., & Jaffe, J., 2002. Corporate Finance. 6th ed. New York: McGraw−Hill Primis Sangster, A. 1993, Capital Investment Appraisal Techniques: A Survey of Current Usage. Journal of Business Finance & Accounting, 20(3), p.307-332 Truong, G., Partington, G. & Pear, M. 2008, Cost-of-Capital Estimation and Capital-Budgeting Practice in Australia, Australian Journal of Management, 33(1) › Visit Amazons Stephen A. Ross Page Find all the books, read about the author, and more. See search results for this author Are you an author? Learn about Author Central Read More