Discuss about the Fundamentals of Financial Management.
Investment decisions are the decisions to invest in the capital assets of the company such as land, building, plant, machinery, equipment, shares or other long term assets. These decisions have long term strategic implications which means the revenues generated from such decisions must be able to cover the costs of past (Biermanand Smidt, 2012). Long term investment decisions are of acute significance for two main reasons. Firstly, these decisions involve a huge amount of money and resources (Banerjee, 2017). And secondly, these decisions are irreversible decisions and once the projects have begun, it’s nearly impossible to cease them. The investment appraisal decisions are also important as these enable to en cash the various economic opportunities of the following types, such as
The step wise step procedure for making an investment decision is as follows (Tulvinschi, 2014).
The five chief techniques of evaluating feasibility of investment proposals are Net Present Value (NPV), Profitability Index, Internal Rate of Return, Accounting Rate of Return and Payback Period. Each of the techniques is described in the following segment.
This method uses one of the most important concepts of time value of money and discounted cash flows arising out of operations of the projects. This technique involves using an appropriate discount rate to discount the future financial cash inflows and outflows, and then comparing them with the initially invested amount of capital. For determining the net present value we use the following formula (Baker and English, 2011).
NPV=
= + + + …. +
where:
CFi = net cash flow from year i,
CF0 = initial investment,
k = discount rate, and
n = number of years.
In case of a single project, positive NPV leads to selection of the project and negative NPV leads to rejection of the project (Gray, Larson and Desai, 2011). In case of two or more mutually projects out of which one has to be selected, the project with the highest NPV would be preferred (Brigham and Houston, 2012). The technique can be described using the following example.
Suppose the management of a company is considering to purchase a machinery part. The part will cost LKR 8,000 and will result in opeartional efficiency leading to increse in the annual cash inflow by LKR 3,000. The useful life of the part is 6 years, with no salvage value at the end. The management’s required rate of return is assumed to be 20 %. The NPV would be calculated as follows:
|
Year (s) |
Particulars |
Amount in LKR |
Present Value Factor @ 20 % |
Present Values |
|
0 |
Initial Cost |
(8000) |
1.000 |
(8000) |
|
1-6 |
Annual cash inflows |
3000 |
3.326 |
9978 |
|
– |
NPV |
– |
– |
1978 |
Since the NPV is positive, the proposal to buy the machine part would be selected.
Few of the advantages of this method of investment appraisal are that, firstly it considers the important concept of the time value of money (Gallo, 2014). Secondly, both pre and post theproject cash flows are taken into account for the calculation of NPV. Thirdly profits and risks associated with the proposals are also taken into consideration. There exist some weaknesses as well such as, the method is compliacted and requires an expert to operate. Moreover it is difficult to compute an appropraite discount rate, the failure of which might lead the calculations and decisions to be misleading.NPV may not be usweful in case of comparison of two projects having unequal lives.
Profitability Index (PI):
This technique is in close line with the NPV method. While the NPV measures the difference between a project’s cash flows and the initial investments, the profitability index meausres the ratio between the two. Thus the formula for PI can be deduced as follows-
Profitability Index = 1 + or
Profitability Index =
When the NPV of a proposal is 0, profitability index is 1. If the PI is more than one, the project is accepted and if the PI is less than one, the project is rejected (Moran, 2015). In this technique, investsments are ranked in order of their PI value. The operation of technique can be explained with the help of the following example.
Suppose a company is considering a project for a cost of $40 million. And the said project is expected to realise cash flows in future, the present value of which is $55 million. The profitability index would be calculated as follows
Therefore profitability index of the project = $55 million / $40 million = 1.375 ≈ 1.4
Since the P I is more than 1, the project would be accepted.
The appraisal method particularly is an aid when the capital investment is of limited amount (R?hrich, 2014). Moreover it makes the investments having different capital outlay comparable. Thus projects having higher NPV and high costs at the same time can be compared and ranked to other projects in light of available capital investment (Berman, Knight and Case, 2013). The advantages of this method are similar to that of the NPV method, i.e. consideration of the time value of money and pre and post project cash flows. The disadvantages are that it fails to secure an appropriate capital rationing when the projects are indivisible. Inspite of the existence of few weaknesses, NPV and IRR are the most preferred investment appraisal methods, followed by the payback period method (Nurullah and Kengatharan, 2015).
The IRR model is also in close line with the net present value model. The internal rate of return or the economic rate of return is a representation of interest earned on the capital invested at different points of time by the project concerned (G?tze, Northcott and Schuster, 2015). In the context of loans, IRR is also referred to as the effective interest rate. In relation to any investment proposal, it is the annualized effective compounded rate of all the cash flows (costs and the benefits) i.e. the discounting rate at which the net present value of all the cash outflows over the years become equal to the net present value of the cash inflows of the project.Which implies at IRR, NPV is zero (Arjunan, 2017). IRR can be computed by solving the following equation:
IRR= ????l + ,
Where dl = lower discount rate and
dh = higher discount rate.
When comparing a number of projects, having different IRRs, the higher the IRR, the more viable a project is. And therefore, the project with the highest IRR is chosen. The IRR technique is explained in the next segment, through a example.
Let us assume there is a company which is considering purchase of a vehicle for $30,000. The useful life of vehicle is 3 years, and it is estimated that it would generate $12,000 of incrmental cash flows in 3 years. The salvage value is estimated to be $10,000. IRR of the company would be determined as follows-
NPV at 10% = 7342
NPV at 25% = (1456)
Therefore IRR would be around 21 %
Like NPV, IRR also recognises the time value of money, which is a key benefit. Few of the major weaknesses of the method is that it assumes that the reinvestment of intermediate cash flows is made at a rate equal to the same IRR (Goyat and Nain, 2016). Another weakness is that a project can have multiple IRRs. In case of multiple IRRs, decision based on the IRR can be misleading.
The technique’s focus is on the expected net operating profits. As in other methods, cash flows are not considered to evaluate the viability of an investment proposal. The computation of accounting rate of return is done by dividing the net operating profits of the entity by the initial investsment. The results are then compared with the management’s pre decided rate of return in order to accept or reject the proposal. If the resulting rate of return is more than the decided rate of return, the proposal is accepted. And if not, the propsal is rejected (Corporate Finance Institute, 2018).
Thus the formula for accounting rate of return is stated below
Accounting rate of return =
The net operating profit in the above formula is derived by deducting incrememtal expenses out of the incremental incomes. Following example provides a better understanding of the technique. Suppose an entity is willing to replace an old asset, with a new asset. The new asset would result an increase in the existing annual revenues by $ 185,000. The additional annual operating expenses would be $ 75,000. The company can buy this new asset for $ 300,000 and estimated useful life is 12 years with zero salvage value. If the required rate of return as decided by the top management is 15%, the evaluation of the project on the basis of the accounting rate of return would be done as follows.
Accounting rate of return =
Net Operating Profits = Incremental Revenues – Incremental Expenses
Therefore, net operating profits = ($ 185,000 – $ 75,000) = $ 110,000
ARR = $ 110,000 / $ 300,000 = 36.67 %
Since the ARR is more than the required rate of return, the proposal can be accepted.
The benefit of this method is that it takes into consideration the accounting profits and is relatively a simple technique to operate. The method also suffers from few weaknesses such as firstly, it ignores the time value of money (Scott, 2012). Secondly, ARR is describes the ratio rather than the actual profits earned by the proposal and hence two projects can have the same ARR, while having different sets of cash inflows. The project with the highest ARR may not always have the highest cash inflows. And hence, it can be concluded that a projects selcetion sholud not be based merely on the ARR, other factors should also be taken into consideration.
Pay Back Period: The Pay back period is indicative of the time taken to recoup the expenses incurred on any proposal. Therefore the time in which the revenues of any project become equal to the investment of the project, wouled be the pay back period. The cash flows here refer to the profits after tax but before depreciation. It is calculated as follows:
Pay back period = Cost of the project/ Annual cash inflows
When the comparison is made between two or more projects, the project with the lowest pay back period is considered over the others (Prakken, 2012). Example of pay back period computation is as follows
Suppose an organisation is considering the purchase of one asset, out of the two proposals. The cost of the first asset is $ 90,000 and it will generate net cash flows of $ 15,000 per year. The payback period for this asset would come out to be 6 years ( $90,000/ $15000). The price of the second asset is $75,000, which will reduce the operating costs by $7,500 per year. The payback period for this asset would be 10 years ($75,000/ $7500). In case of these mutually exclusive proposals, the one with the shorter payback period would be selected i.e. the first asset.
The advantages of this technique is that it is simple and easy to understand and perform. Another strength is that the liquidity is given due weightage. The major weakness of this appraisal technique is that it doesn not considers the time value of money. The other weakness of this technique is that cash inflows after the cut off date are not taken into account (Lane and Rosewall, 2015). In spite of the weaknesses, payback period method is in use as investment appraisal method in the corporate sector of America, in the Fortune 500 companies (Yatiwelle Koralalage and Rathnayaka, 2014).
The techniques that use the discounted cash flows require an appropriate discounting rate of return, in order to compute the present equivalent of the future cash flows to be aroused out of the projects. The computation of the applicable rate of return is a matter of strategic importance. The two methods to be used for calculating the discounting rates are Weighted Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM). The critical analysis of WACC has been undertaken in the following segment.
Weighted Average Cost of Capital is the overall average cost of different sources of capital i.e. debt, equity shares, preference shares (Ross, et. al, 2014). This rate is often used as the rate of return in the investment appraisal evaluations. Since while computing the weighted average cost of capital, exact information of the market value of the assets and the required rate of returns is not available accurately, the current market returns and the market related information may be used as the required rate of returns (Pogue, 2010). In order to estimate the weighted average cost of capital, effective rate of return of each category of investors is determined. These effective returns are then proportioned in the ratio of the proportion of either the book weights or the market capitalization of each investor type. And therefore, formula for WACC in case of say market weights comes out to be
K = ( / + ) + ( / + )
Where,
K = WACC
= Cost of equity
= After tax cost of debt
= Market value of equity
= Market value of debt
The formula to compute the cost of equity is = + – ,
Where
– = Premium on market risk
Co efficient of unsystematic risk
The formula to compute the cost of debt is = K (1-t),
Where K = Current Rate of Interest in the market
t = Tax rate
The computation of WACC can be understood by the following formula. Suppose, an entity’s financial data consists of the following figures:
Therefore WACC would be calculated using the above formula as
WACC = [(10000*0.15)/15000] + [(5000 * 0.042)/15000]
Or, WACC = (0.10 + 0.014) = 11.4 %
The weighted average cost of capital is best suited to analyse the new projects that have the same risk structure as that of the existing structure of the organisation (Baum and Crosby, 2014). The disadvantage that exists with weighted average cost of capital is the appropriate assignment of the weights, i.e. whether to assign the book value weights or the market value weights. The problem with the market weights is that the determination of the market values is a complicated computation, especially when the concerned entity is not even listed on the stock exchange. Moreover, the market values are not always constant. Market values are required to be calculated period after period. Also the market returns are required to be adjusted as per the industry specific beta values so as to take into consideration the risk factors, in order to arrive at the desirable returns. In spite of this, the market value weights are preferred over the book values, because the desired rate of return of an investor would be in line with the existing market returns. Another weakness of WACC is that due to change in the various economic conditions such as the inflation rates, WACC changes from one period to another. Yet another limitation of WACC is that the computation of cost of equity and the cost of debt is based on a number of assumptions, such as the capital structure will remain constant throughout the life of the project, which is not true. And therefore, if the gearing levels change drastically, different method for discounting rate calculation would be appropriate. In spite of the limitations, it was found in a study that majority of the firms make use of weighted average cost of capital method as the measure of computation of the cost of capital for the purpose of investment appraisal decisions (Ranaweera, et. al, 2015).
Conclusion
Thus, as per the discussion in the previous parts it can be concluded that investment appraisal decisions are an important part of functioning of the organisations. These are one of the most critical decisions to be undertaken by the management because the amount of the money and other resources involved. There have been enumerated various techniques so as to analyse the viability of the investment proposals. Techniques like net present value method and the internal rate of return method are complicated to operate, but consideration of the time value of money and the cash flows after the project makes them useful in present scenario. Another important concept in the investment appraisal process is the computation of the appropriate rate of return to be used as the entity’s cost of capital. One of the widely used methods to compute the appropriate discounting rate of return is weighted average cost of capital. Weighted average cost of capital is further divided into two approaches on the lines of the types of weights that must be assigned to debt, equity and preference shares i.e. book value weights or the market value weights. Both the book value and the market value weights come with few weaknesses. While book weights are not the real reflection of the required returns by the investors as these are based on the historical cost and would dramatically reduce the value of an entity, market value weights are difficult to compute and assign. Moreover the market value weights do not remain in equilibrium, as to changing business conditions. In spite of the weaknesses, market value weights are preferred so as to match the desired return of the investors with that of the market returns. Thus it can be said that the weighted average cost of capital method of determination of the discounting rate of return holds appropriate only in the circumstances where the underlying assumptions are fulfilled. Though few limitations are there in the weighted average cost of capital method, still it is one of the most widely used method for the determination of the discounting rate of return because of its simplicity to operate.
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