Evaluation Of Investment Alternatives Essay

Introduction – Capital budgeting A critical role of a financial manager is the evaluation of capital projects.   This is a very important task because the money involved in such activities is significant and the benefit or loss derived from will highly influence the financial performance of the whole organisation (Brockington R. B. 1996, p 102).   Indeed, Nobel laureates Modigliani and Miller suggested in their theory of capital structure that the value of a company is not affected by its gearing, but the primary factor that influences such value is the investment in wealth creating projects (Pike R. et al.   1999. p 557 and 577). 1.1   Evaluation of plans if their risk equals that of the firm 1.1.1 Net Present Value Method PLAN X Details 0 â‚ ¬Ã¢â‚¬â„¢000 1 â‚ ¬Ã¢â‚¬â„¢000 2 â‚ ¬Ã¢â‚¬â„¢000 3 â‚ ¬Ã¢â‚¬â„¢000 4 â‚ ¬Ã¢â‚¬â„¢000 5 â‚ ¬Ã¢â‚¬â„¢000 Initial Investment (2,700)                Cash Flows    470 610 950 970 1,500 Net Cash Inflow/(Outflow) (2,700) 470 610 950 970 1,500 12% Discount Rate 1.0000 0.89286 0.79719 0.71178 0.63552 0.56743 Present Value (2,700) 419.64 486.29 676.19 616.45 851.15 Net Present Value – â‚ ¬349,720 PLAN Y Details 0 â‚ ¬Ã¢â‚¬â„¢000 1 â‚ ¬Ã¢â‚¬â„¢000 2 â‚ ¬Ã¢â‚¬â„¢000 3 â‚ ¬Ã¢â‚¬â„¢000 4 â‚ ¬Ã¢â‚¬â„¢000 5 â‚ ¬Ã¢â‚¬â„¢000 Initial Investment (2,100)                Cash Flows    380 700 800 600 1,200 Net Cash Inflow/(Outflow) (2,100) 380 700 800 600 1,200 12% Discount Rate 1.0000 0.89286 0.79719 0.71178 0.63552 0.56743 Present Value (2,100) 339.29 558.03 569.42 381.31 680.92 Net Present Value – â‚ ¬428,970 Source:   Drury C. 1996, p 389. 1.1.2 Internal Rate of Return Method PLAN X Year Net Cash Inflow/(Outflow) Discount Factor* Present Value    â‚ ¬ 16% 17% 16% 17% 0 (2,700,000) 1.0000 1.0000 (2,700,000) (2,700,000) 1 470,000 0.86207 0.85470 405,172.90 401,709.00 2 610,000 0.74316 0.73051 453,327.60 445,611.10 3 950,000 0.64066 0.62437 608,627.00 593,151.50 4 970,000 0.55229 0.53365 535,721.30 517,640.50 5 1,500,000 0.47611 0.45611 714,165.00 684,165.00 Net Present Value 17,014 (57,723) PLAN Y Year Net Cash Inflow/(Outflow) Discount Factor* Present Value    â‚ ¬ 18% 19% 18% 19% 0 (2,100,000) 1.0000 1.0000 (2,100,000) (2,100,000) 1 380,000 0.84746 0.84034 322,034.80 319,329.20 2 700,000 0.71818 0.70616 502,726.00 494,312.00 3 800,000 0.60863 0.59342 486,904.00 474,736.00 4 600,000 0.51579 0.49867 309,474.00 299,202.00 5 1,200,000 0.43711 0.41905 524,532.00 502,860.00 Net Present Value 45,670.80 (9,560.80) Source: Horngren T. C. et al. 1997, p 785 – 787. 1.1.3 Evaluation of projects Plan Y is more financially feasible under both methods.   The net present value of Plan Y is â‚ ¬79,250 [â‚ ¬428,970 – â‚ ¬349,720] higher than Plan X.   The internal rate of return of Plan Y is also 2.61% higher than the other plan, indicating a higher margin of safety on losses in case the expected cash flows are not achieved (Randall H. 1996, p 446). 1.2 Examination of plans at different risk profiles 1.2.1 Net Present Value Method PLAN X Details 0 â‚ ¬Ã¢â‚¬â„¢000 1 â‚ ¬Ã¢â‚¬â„¢000 2 â‚ ¬Ã¢â‚¬â„¢000 3 â‚ ¬Ã¢â‚¬â„¢000 4 â‚ ¬Ã¢â‚¬â„¢000 5 â‚ ¬Ã¢â‚¬â„¢000 Initial Investment (2,700)                Cash Flows    470 610 950 970 1,500 Net Cash Inflow/(Outflow) (2,700) 470 610 950 970 1,500 13% Discount Rate 1.0000 0.88496 0.78315 0.69305 0.61332 0.54276 Present Value (2,700) 415.931 477.722 658.398 594.920 814.140 Net Present Value – â‚ ¬261,111 PLAN Y Details 0 â‚ ¬Ã¢â‚¬â„¢000 1 â‚ ¬Ã¢â‚¬â„¢000 2 â‚ ¬Ã¢â‚¬â„¢000 3 â‚ ¬Ã¢â‚¬â„¢000 4 â‚ ¬Ã¢â‚¬â„¢000 5 â‚ ¬Ã¢â‚¬â„¢000 Initial Investment (2,100)                Cash Flows    380 700 800 600 1,200 Net Cash Inflow/(Outflow) (2,100) 380 700 800 600 1,200 15% Discount Rate 1.0000 0.86957 0.75614 0.65752 0.57175 0.49718 Present Value (2,100) 330.437 529.298 526.016 343.050 596.616 Net Present Value – â‚ ¬225,417 Source:   Hirschey M. et al. 1995, p 799. 1.2.2 Comparison of decisions at different risk rates When the discount rate of the project is considered instead of the overall rate of the company, the financial viability of Plan Y diminishes because this plan is a riskier project than the other one and hence, a higher discount rate is chosen.   The process of discounting arises from the time-value of money principle, and the higher the discount rate the lower the present value from the cash flows generated from the project (Pike R. et al. 1999, p 66 & 67).   In such a stance, Plan Y is no longer the most optimal project because Plan X net present value exceeds that of Plan Y by â‚ ¬35,694 (â‚ ¬261,111 – â‚ ¬225,417). 1.3 Analysis of real option data for plans 1.3.1 Net Present Value Method PLAN X Details 0 â‚ ¬Ã¢â‚¬â„¢000 1 â‚ ¬Ã¢â‚¬â„¢000 2 â‚ ¬Ã¢â‚¬â„¢000 3 â‚ ¬Ã¢â‚¬â„¢000 Initial Investment (2,700)          Cash Flows    470 610 950 Net Cash Inflow/(Outflow) (2,700) 470 610 950 13% Discount Rate 1.0000 0.88496 0.78315 0.69305 Present Value (2,700) 415.931 477.722 658.398 Net Present Value: -â‚ ¬1,147,949 + (â‚ ¬100,000 x 25%) = -â‚ ¬1,122,949 PLAN Y Details 0 â‚ ¬Ã¢â‚¬â„¢000 1 â‚ ¬Ã¢â‚¬â„¢000 2 â‚ ¬Ã¢â‚¬â„¢000 3 â‚ ¬Ã¢â‚¬â„¢000 4 â‚ ¬Ã¢â‚¬â„¢000 5 â‚ ¬Ã¢â‚¬â„¢000 Initial Investment (2,100)                Cash Flows    380 700 800 600 1,200 Net Cash Inflow/(Outflow) (2,100) 380 700 800 600 1,200 15% Discount Rate 1.0000 0.86957 0.75614 0.65752 0.57175 0.49718 Present Value (2,100) 330.437 529.298 526.016 343.050 596.616 Net Present Value: â‚ ¬225,417 + (â‚ ¬500,000 x 20%) = â‚ ¬325,417 Source:   Lucey T. 2003, p 416. 1.3.2 Comparison of real option plans with original plans If we consider and apply the real options available, Project Y becomes the best project, on the contrary of the conclusion noted in sub-section 1.2.2.   It is also worth nothing that the application of the real option for Plan X is not financially viable because we will end up with a negative net present value.   If we compare the net present value of Plan Y under the real options scheme with the net present value of Plan X we can deduce that Plan Y real options project is more feasible than the other plan since the net present value is â‚ ¬64,306 higher [â‚ ¬325,417 – â‚ ¬261,111]. 1.4 Effect of Capital Rationing Capital rationing is an absolute restriction on the amount of finance available for a project irrelevant of cost.   This should not be confused with scarcity of economic resources.   Capital rationing on projects is sometimes applied even though the organization posses or can attain available finance.   For example, a capital rationing may be imposed on the amounts of debts an organisation can take in order to limit the gearing of the firm (Brockington R. B. 1996, p 151). When conditions of capital rationing are imposed, there is the possibility that the most optimum project is not selected.   Therefore yes capital rationing may effect the selection of Plan X or Plan Y.   For example if a capital rationing is adopted by the firm which states that the initial investment cannot exceed â‚ ¬2,000,000 due to its effect on gearing. Under such conditions no Plan would be selected by the firm.   Another example of capital rationing that will affect the project choice is if management decided to restrict expansion of the factory, because they fear that control on employees may be lost affecting negatively their relationship and control on staff.   In this case Plan X would be excluded, even though it is the most optimal project as denoted in sub-section 1.2.2., and the available choice would be Plan Y. 1.5 Financial instruments available for private companies The alternative financial instruments that the firm can use, apart from shares are: Corporate Bonds & Debentures; Overdraft facility by the bank; Bank loan; Venture capital; and Leasing 1.5.1 Advantages and disadvantages of corporate bonds/debentures The advantages related to corporate bonds are (E*Trade Financial website): Corporate bonds are usually lent at a longer period of time (Veale R. S. 2000, p 155). Interest payments for bonds are tax deductible. Interest rates of corporate bonds are frequently lower than those of banks. Percentage ownership of shareholders is not weaken by the issue of corporate bonds or debentures (Veale R. S. 2000, p 156) The disadvantages encountered with corporate bonds are: Obligation of interest on the firm’s cash flow, thus increasing the risk of bankruptcy during periods of financial problems. Upon maturity, the company has to pay back all the amount of the bond. 1.5.2 Advantages and disadvantages of bank overdraft facility A bank overdraft facility can provide the following benefits (tutur2u website): Allows flexibility of finance.   The company can increase the overdraft facility within acceptable limits. Interest is only charged on the amount used and is tax deductible. Percentage ownership of shareholders is not diluted by taking an overdraft facility. The disadvantages imposed by an overdraft facility are (tutur2u website): Rates of interest are higher than those of bank loans. Money due is repayable on demand. The facility limit can be changed by the bank according to its discretion. Usually used for short-term borrowing. 1.5.3 Advantages and disadvantages of bank loans These are the advantages derived from bank loans (tutur2u website): Loan is repaid back in regular payments thus allowing better cash management. Lower interest charged than bank overdraft. Percentage ownership of shareholders is not diluted by taking an overdraft facility. Large amounts can be borrowed for long term finance. Limitations of this type of finance are (tutur2u website): Interest has to be paid within a specified date. Less flexible than an overdraft facility. 1.5.4 Advantages and disadvantages of venture capital The advantages of venture capital are (Business Link website): Obtain proficient management expertise, if they get involved in the firm’s operations. Large sums of finance can be obtained from venture capital. The disadvantages incurred by using such medium of finance are (Business Link website): Require detailed financial reporting like business plans and financial estimates. Legal and accountancy fees are incurred in the negotiation process. Firm require a proven track record to take such finance. High returns are frequently expected from venture capitalists.       15.5 Advantages and disadvantages of leasing The advantages obtained from leasing are (Enterprise. Financial Solutions website): Provides 100% financing of asset. There is no need of credit lines with banks and other depositary associations, which are hard to obtain. Minimal paperwork required to acquire lease. Acts as hedging against inflation. Flexible payments are allowed in leasing. Interest on leasing is not subject to increases like bank overdrafts. The disadvantages encountered through leasing finance are (Auto Leasing Software Lease Tips website): The organisation is committed to the entire validity period of the lease. High amounts of insurance coverage are frequently demanded in leases. No ownership of the asset the firm is using in the project’s operations. References: Auto Leasing Software Lease Tips.   Disadvantages of leasing (on line).   Available from:   http://www.autoleasingsoftware.com/LeaseTips/Disadvantages.htm (Accessed 13th March 2007). Brockington R. B. (1996).   Financial Management.   Sixth Edition.   London:   DB Publications. Business Link.   Equity Finance (on line).   Available from:   http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1075081582 (Accessed 13th March 2007). Drury C. (1996).   Management and Cost Accounting.   Fourth Edition.   London:   Thomson Business Press. Enterprise.Financial Solutions.   Advantages of leasing (on line).   Available from:   http://www.efsolutionsinc.com/Advantages_of_leasing.htm (Accessed 13th March 2007). E*Trade Financial.   Corporate Bonds Overview (on line).   Available from:   https://us.etrade.com/e/t/kc/KnowArticle?topicId=13200&groupId=8722&articleId=8723 (Accessed 13th March 2007). Hirschey M; Pappas L. J. (1995).   Fundamental of Managerial Economics.   Fifth Edition.   Orlando:   The Dryden Press Horngren T. C.; Foster G.; Srikant M. D. (1997).   Cost Accounting – A Managerial Emphasis.   Ninth Edition.   London:   Prentice-Hall International (UK) Limited. Lucey T. (2003).   Management Accounting.   Fifth Edition.   Great Britain:   Biddles Ltd. Pike R.; Neale B. (1999).   Corporate Finance and Investment.   Third Edition.   London:   Prentice-Hall International (UK) Limited. Randall H. (1999).   A Level Accounting.   Third Edition.   Great Britain:   Ashford Colour Press Ltd. Tutur2u.   Bank Loans and Overdrafts (on line).   Available from:   http://www.tutor2u.net/business/gcse/finance_bank_loans_overdrafts.htm (Accessed 13th March 2007). Veale R. S. (2000).   Stocks, Bonds, Options and Futures.   Second Edition.   United States of America:   New York Institute of Finance.