Corporate Finance
Introduction
Assessing the viability of the genetically engineered soya seeds will involve comparing various projects. Consequently, it is crucial to consider various methods of capital budgeting among the projects. This is a process, which decision makers in a company use in deciding various budgeting options in projects. For example, the replacement of equipments as it involves ways of assessing and deciding whether to continue using the existing machinery or replacing with new ones. This is among the simpler techniques of capital budgeting, which go a long way in helping organizations maximize on the equipments they have. Thus, repairing, retaining or purchasing new ones when those in use begin to depreciate in value and productivity are viable options
Environmental and Safety Assessment
Capital budgeting assists in deciding projects in some organizations like insurance companies and governments where there is forecasting of the prevailing conditions to the forward movement of the organization. These may sometimes not bring revenue but it is of importance to analyze because the costs may be prohibitive.
New business opportunities; the decision makers assess the viability of new product lines and new services, which are more uncertain than replacement.
Expansion and growth; decision makers decide whether to increase the capacity of their organization they are more uncertain than replacement decisions (Sullivan & Steven, 2005).
Capital budgeting uses various assumptions. Decisions are based on cash flows and not revenue. The current worth of money is more than in the future. Thus, timing of cash flow is of importance.
Cash flows on opportunity cost; cash flows that arise with an investment venture compared to what they would have been without the asset. Cash flows are analyzed on an after tax basis. Financing costs are not considered because they are incorporated in weighted average cost of capital, and thus counting them would be double counting (Sullivan & Steven, 2005).
Capital Budgeting Concepts
Sunk costs are costs already incurred, such as marketing and research. Opportunity costs are the cost for next best use or foregone. Incremental cash flows refer to cash amounts that are realized with the project. This translates to the cash flow with a decision, minus the cash flow without the decision. Externality, they are the effects of the decision on other things that can be both advantageous and disadvantageous. For example, when a new product line or service takes customers and sales from the existing lines, it would be considered in analysis as incremental cash flows as they would not happen for the project (Sullivan & Steven, 2005).
Mutually Exclusive versus Independent Projects:
Mutually exclusive investments are the projects that compete with each other directly, that is, when a company owns an equipment needing replacement. Two suppliers provide quotations of installation and purchase for deliberation. In some instances, there are more than two investment decisions and one should be selected. Independent investments are those that are not dependent of each other. A company may invest in both without going beyond the projects. All projects that are being evaluated have a likelihood of being chosen so long as their forecasted cash flows will give a positive net present value or an internal rate of return higher than the firm’s set hurdle (Sullivan & Steven, 2005).
Capital Rationing versus Unlimited Funds.
Capital rationing is used when a company has limited amounts to invest and the budget is caped. This is when the company investment needs are higher than the capital it must allocate among the projects. Unlimited fund criterion is used when a company can afford funds for all projects available.
Project Sequencing
The other important criterion relates to project sequencing. For example, many projects can be assessed and evaluated through time. This translates to an investment in one project producing the option to empower in more projects in the future. Thus, a company can decide to invest in marketing and distribution of products, and then continue to manufacture the product rather than relying on marketing and distribution.
Investment Decision
The decision to invest in a proposal can be termed as simple. However, it is vital to consider the following factors. First, does the decision criterion adjust for the time value of money? Consequently, does the decision criterion adjust for risk? More so, does the decision criterion provide information on whether we are creating or depleting value for the firm? In analyzing the proposal for the marketing and distribution of genetically engineered soya seeds, which have been developed by a biotechnology firm to sell under license, the company will follow the following procedure.
Initial investment cost
£ ‘000’
Marketing cost 127
Vehicles cost 650
Investment of working capital 1500
Total 2277
Annual Cashflows for ProGen Plc on Undertaking the Project £’000’
| Year | 1 | 2 | 3 | 4 | 5 |
| Sales
|
5480 | 6190 | 6890 | 9455 | 9900 |
| Add Increase in revenue | 47 | 47 | 47 | 47 | 47 |
| 5527 | 6287 | 6937 | 9502 | 9947 | |
| Less variable cost | |||||
| Raw materials | 2320 | 3200 | 3410 | 3500 | 3500 |
| Direct wages | 630 | 630 | 630 | 630 | 630 |
| Variable transport cost | 625 | 625 | 625 | 625 | 625 |
| 1952 | 1832 | 2272 | 4747 | 5192 | |
| Less fixed cost | |||||
| License | 1000 | 1000 | 1000 | 1000 | 1000
|
| Overhead(750-50) | 700 | 700 | 700 | 700 | 7000 |
| Annual cashflows | 252 | 132 | 572 | 3047 | 4642
|
Rent is an irrelevant cost in analysis of ProGen Plc since the company has spare capacity already and can undertake the project without further incurring more rent costs.
Using Net Present Value
The Net Present Value (NPV) is the present value of future after-tax cash flows deducts initial outlay. It shows the difference between the market value of the project and its cost.
Computation Criterion
Estimate the expected future cash flows. Consequently, estimate the required return for projects of this risk level. Lastly, find the present value of the cash flows and deduct the initial investment. ProGen Plc will undertake the project of marketing and distribution of genetically engineered soya seeds if it has a positive net present value, and reject if it has a negative net present value.
Year Cashflows pvif@11% Present Value
1 252 0.9009 227
2 132 0.8116 107
3 572 0.7312 418
4 3047 0.6587 2007
5 4642 0.5935 2755
Present value of annual cash flows 5514
Add present value of terminal cashflows 0.5935*1620 961
Total present value 6475
Less initial cost (2277)
Net present value 4198
The company should accept the project since it has a positive net present value
- Using the Payback Period Method.
Year cashflows cumulative cash flows
1 252 252
2 132 384
3 572 956 2277
4 3047 4003
Pay back period = 3+ (2277-956)/3047=3.4 years
The management should establish the minimum acceptable payback period and if the pay pack period is less than the management set the project should be accepted, otherwise if the payback period is higher the company should not adopt the project.
3 Using Internal Rate of Return
Internal Rate of Return (IRR) is the discount rate at which the net present value of the project is zero (0). It is the most common alternative to Net Present Value (NPV) as it is used in practice frequently. It is intuitively appealing as the trial and error is mainly applied. It is entirely based on estimated cash flows. More so, it is independent of interest rates found elsewhere.
Computation Criteria
Estimate the expected future cash flows.
Estimate using trial and error the discount rate that makes NPV = 0
IRR=A%+(B%-A%) m/(m+n)
Where; A% is the rate that gives positive net present value.
B% is the rate that gives negative net present value.
m is positive net present value.
n is negative net present value
Re-discount the cashflows using a higher rate to get a negative net present value for example 50% Year
Year cashflows pvif@50% present value
1 252 0.6667 168
2 132 0.4444 58
3 572 0.2963 169
4 3047 0.1975 602
5 4642 0.1317 611
Present value of annual cash flows 1608
Add present value of terminal cashflows 0.1317*1620 213
Total present value 1821
Less initial investment cost (2277)
Net present value 456
Therefore the Internal Rate of Return =11%+(50%-11%)4198/(4198+458)
=46%
Acceptance Rule
The criterion for acceptance is accept projects with an Internal Rate of Return higher than the cost of capital hence the project that is marketing and distribution of genetically engineered soya seeds should be accepted since its Internal Rate of Return is greater than the cost of capital (Sullivan & Steven, 2005).
Advantages and Disadvantages of Internal Rate of Return (IRR) and Net Present Value (NPV) Methods
In order to evaluate the potential capital investments among small business and projects, the Internal Rate of Return (IRR) ought to be utilized as a valuable tool. It should be used to assess the projects IRR measures worth pursuing. The assessments ought to include thee rate of return of projected cash flows mainly acquired from the capital investment. The Internal Rate of Return (IRR) among the projects being considered as a potential form of business ought to be compared. Consequently, the comparison results should be applied during the decision-making procedure. Internal rate of return (IRR) is measured based on calculations of the interest rate. The interest rate determines the present value of future cash flows. They should be equal to the required capital investment. Thus, the advantage of using Internal Rate of Return (IRR) is based on the fact that the timing of cash flows in future accounting periods are considered. As a result, each cash flow is awarded equal accounting measure by applying the time value of money (Varshney & Maheshwari, 2010).
The second advantage of using Internal Rate of Return (IRR) is due to its simplicity. The Internal Rate of Return (IRR) is an easy measure applied to calculate and provide simple accounting measures applied to compare financial worth among projects being considered. The Internal Rate of Return (IRR) awards major small business entrepreneurs with quick, accurate, and reliable ideas on what capital projects can provide with regards to potential cash flows. Internal Rate of Return (IRR) can also be applied during budgeting in order to provide quick accounting solutions. The solutions should have the potential of increasing asset or project value. However, savings of purchasing new equipment as opposed to repairing old equipment can also be relied for budgeting purposes (Varshney & Maheshwari, 2010).
Capital budgeting analysis does not require the hurdle rate. The hurdle rate also known as cost of capital refers to the required rate of return investors agree in order to fund a project. The hurdle rate can be a subjective amount although it is mainly acquired through use of rough accounting estimates. Thus, the Internal Rate of Return (IRR) method does not require the hurdle rate. This is because failure to use the hurdle rate reduces the accounting risks of determining either unreliable or wrong rates. Thus, when the Internal Rate of Return (IRR) is calculated, potential business ventures and projects can be selected. The selection is mainly made when Internal Rate of Return (IRR) exceeds estimated cost of capital (Varshney & Maheshwari, 2010).
With regards to disadvantages while using the Internal Rate of Return (IRR) method, it does not account for size especially when comparing potential business ventures and projects. Thus, cash flows are simply compared to the amount of capital likely to be generated. This can result to accounting errors as well as financial conflicts especially when two potential business ventures or projects require a significantly different amount of capital outlay. The accounting conflicts can expand if the smaller business ventures or projects records higher returns through the Internal Rate of Return (IRR) method. Thus, the Internal Rate of Return (IRR) method ignores size of potential projects or business ventures.
This is because using the Internal Rate of Return (IRR) method can make a smaller project appear more profitable and attractive. However, the method assumes and ignores facts affirming larger projects can generate higher cash flows recording larger profits (Varshney & Maheshwari, 2010).
The Internal Rate of Return (IRR) method also ignores future costs. This is because the method focuses on projected cash flows generated by a capital injected in a project. Consequently, it ignores potential future costs likely to affect profit margins. More so, it either assumes or ignores reinvestment rates. The Internal Rate of Return (IRR) method permits business owners to calculate the value of future cash flows. However, it also makes an implicit assumption that the cash flows can be reinvested at the same rate as the Internal Rate of Return (IRR). This assumption is neither reliable nor practical as the Internal Rate of Return (IRR) can have higher number of opportunities likely to yield an equal return. However, the returns can either be unavailable or limited (Varshney & Maheshwari, 2010).
With regards to the Net Present Value (NPV) method, the following advantages can be recorded. Foremost, Net Present Value refers to the direct measure of cash flows injected or contributed to the stockholders. Thus, the first advantage of applying the Net Present Value (NPV) is based on the fact that it shows the return on the original cash flows invested. However, Net Present Value (NPV) method also records the following disadvantage. It does not measure the size of the project size. As a result, it can provide conflicting answers when accounting estimates among mutually exclusive projects. Net Present Value (NPV) and Internal Rate of Return (IRR) methods are therefore capable of producing conflicting rankings. This can be attributed to use of diverse accounting basis. For example, an independent project involves making the decision to invest in the venture independently regardless of any other projects. Both Net Present Value (NPV) and Internal Rate of Return (IRR) methods can give similar results. They can either reject or accept the project. However, when using metrics to analyze mutually exclusive projects, both Net Present Value (NPV) and Internal Rate of Return (IRR) methods can provide metrics affirming the project is profitable. Thus, they can provide similar results ensuring the decision-making procedure is clear. This is because they apply similar timing of cash flows for each project. More so, conflicting results can occur because of differing project sizes (Varshney & Maheshwari, 2010).
The post-audit process during capital-budgeting process is vital. During the post-audit process, analysts examine companys’ capital-budgeting decisions. This is aimed at ensuring the company can evaluate and assess if the actual results from the projects compare to the results estimated by the company. Thus, the post-audit process provides a potential business venture among small and large projects with a sense of how they are likely to perform. More so, it provides results on how project inputs are likely to be injected. For example, if a project records actual results differing in a negative direction, the post-audit process should be applied to assist the company assess the inputs. Consequently, it can learn where wrong inputs were applied in order to avoid making a similar mistake in the future in analyzing future projects (Varshney & Maheshwari, 2010).
Question b
Internal rate of return and net present value are methods or criteria used to determine the viability of projects. They are used to determine whether a project should be undertaken or not, they are also used to select which projects should be undertaken between two or more mutually exclusive projects i.e. those projects that cannot be under taken together due to cost constraints. If the results of internal rate of return differ with those of net present value, they will be dominated by the net present value result (Sullivan & Steven, 2005).
For example , if you want to select which project should be undertaken between projects A and B, and using Internal rate of return you should undertake project A ,while using net present value project B should be undertaken the overall decision is that project B should be should be undertaken.
There are some situations that net present value and Internal rate of return results may differ which may include; Projects with different lives for example if a project will last for ten years while project B lives for 4 years the net present value and internal rate of return differ. Projects with different patterns of cash flows for example if project a generates most of its cash flows in its earlier years and projects B generate of its cash flows in its later years the net present value and internal rate of return will differ. Projects with significantly different initial cash flows for example project A 100 pounds while project B costs 5 pounds the results will differ (Sullivan & Steven, 2005).
For non conventional cash flows projects where;
Conventional cash flows have costs followed by revenue -++++++
Non-conventional cash flows have irregular flow of revenue and costs within the project life where after initial cost, there are other investment costs -+-+-+ or– + + + -, or – – – + + -. For non conventional cash flows, Internal rate of return gives multiple and at times negative Internal rates of return, which makes it difficult to apply the rule of Internal rate of return that states decision makers should accept only projects whose Internal rate of return is greater than the company’s cost of capital. In conclusion, the internal rate of return criterion is disadvantageous because of its unrealistic assumption of reinvestment at internal rate of return, to net present value method which assumes reinvestment at weighted average cost of capital. This is a practical and realistic hypothesis. Internal rate of return is also redundant for comparing two mutually exclusive investments (Sullivan & Steven, 2005).
References
Sullivan, A., & Steven, M. S. (2005). Economics: Principles in Action, Upper Saddle River, New Jersey, Pearson Prentice Hall.
Varshney, R. L. & Maheshwari, K. L. (2010). Manegerial Economics, 23 Daryaganj, New Delhi, Sultan Chand & Sons.