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

€’000

1

€’000

2

€’000

3

€’000

4

€’000

5

€’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 – €349,720

PLAN Y

Details

€’000

1

€’000

2

€’000

3

€’000

4

€’000

5

€’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 – €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

 

16%

17%

16%

17%

(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

 

18%

19%

18%

19%

(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 €79,250 [€428,970 – €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

€’000

1

€’000

2

€’000

3

€’000

4

€’000

5

€’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 – €261,111

PLAN Y

Details

€’000

1

€’000

2

€’000

3

€’000

4

€’000

5

€’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 – €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 €35,694 (€261,111 – €225,417).

1.3 Analysis of real option data for plans

1.3.1 Net Present Value Method

PLAN X

Details

€’000

1

€’000

2

€’000

3

€’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: -€1,147,949 + (€100,000 x 25%) = -€1,122,949

PLAN Y

Details

€’000

1

€’000

2

€’000

3

€’000

4

€’000

5

€’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: €225,417 + (€500,000 x 20%) = €325,417

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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 €64,306 higher [€325,417 – €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 €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.

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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.

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