Impact of Financial Ratios and Financing Constraints on Firms
Importance of financial ratios and financing constraints on modern business. The target audiences of this paper are investors looking for financial investment options and small business firms seeking growth. Therefore, the article and information might be contained in a financial magazine such as wall street journal. The goal of this paper is to inform audiences on the important financial ratios, and how they are important in determining whether a company is worth investing in or not. Any business owner will want to find out the performance of his or her company in order to make informed management decisions.
In addition, an investor will want to have accurate financial position of any business firm for investment decision processes. In this regard, business organizations and financial analysts use a variety of analytical tools that are aimed at comparing the existing relative strengths and weaknesses of their businesses. These basic tools and techniques have enabled the investors as well as the analysts to develop fundamental analysis systems (Butzen & Fuss, 2003). Therefore, ratio analysis was developed as a tool that established the functions of quantitative analysis in the financial statement numbers. These ratios link the financial statements and determine figures that are comparable between sectors, companies, and across industries. Therefore, financial ratios have a significant financial analysis technique that is used for comparative analysis.
Financial Ratios and Business Growth
Small and growing business firms use financial ratios to determine how their businesses perform. A significant financial ratio is the activity ration that is used in measuring how companies are efficient in utilizing their assets (World Bank, 2005). Therefore a negative ratio will force a company or an organization to either increase or decrease their assets or liabilities. These ratios are widely used by investors who can easily check out the overall operation of a prospective company for investment decisions (Harrison et al, 2002). If the overall performance of a company is determined to be poor, a company may lose investor confidence and as a result, lose business.
In addition, activity ratios are deemed to be turnover ratios that are associated with a balance sheet line item and an income statement line item. Generally, income statements are used for measuring the performance of any company, but for a specified period of time. However, the balance sheet provides data for a specific point in time. The advantage of using activity ratios is that they are able to give an average figure between the two financial statements. This means that companies or organizations are able to determine the rate of turning over their liabilities or assets. This helps the companies to control their receivables or inventories per year (Harrison et al, 2002).
Moreover, there are inventory turnovers that are used in the management effectiveness of any business organization (Butzen & Fuss, 2003). This ratio is determined when the cost of goods sold is divided by the average inventory. In this regard, a company is able to know whether its inventory is sold at a higher rate, when the turnover is recorded to be high.
This ratio is then significant in giving companies signals for inventory management effectiveness. In addition, this kind of inventory ratio communicates that there are less resources which are tied up in the company’s inventory (Butzen & Fuss, 2003). However, it is also important to understand that an unusually high turnover means that the company’s inventories are too lean. Consequently, the management discovers that the company may be ineffective in keeping up with the demand that is increasing (Harrison et al, 2003). Therefore the management is forced to act swiftly in adjusting the company’s operations to fit a favorable inventory ratio. Investors are keen in checking out companies with high inventory turnovers since it means that that specific industry gets stale quickly, thus an attractive investment option.
Another significant financial ratio is the receivables turnover ratio, that enables a business organization determines how fast it collects the bills that are outstanding (Harrison et al, 2002). This specific ratio determines the effectiveness of any company credit policy towards its customers. In this regard, negative receivables will force a company to have stringent credit policies that are aimed at ensuring that bills are collected as easily and fast as possible (Butzen & Fuss, 2003). This particular ratio is achieved by dividing the all the net revenues with the average receivables. In this case a company is able to know how many times per financial period, it is able to collect all its outstanding bills and have the cash used in the operations of the business.
However, it is important for a prospective investor to understand that a high turnover does not only indicate that the company is operating in the best interests of its customers. A high turn over may also indicate that the business company policies are too stringent and thus the company is missing out on sales opportunities to its competitors (Harrison, et al, 2002). Alternatively, a low turnover or which is seen declining means that the company’s customers are struggling with the credit policy that is set out by the company and thus are having trouble paying their bills. In this regard, this turnover ratio is very significant when any company is developing its credit policy.
Creditors are able to measure how effective companies are in paying off their financial obligations, when determining whether to extend their credit facilities to them. The financial ratio that is used in this case is the liquidity ratio, that helps establish any company’s ability in meeting its financial obligations usually short term financial obligations (Harrison et al, 2003). However, it is important to understand that the level of liquidity is not standard and thus varies from different existing industries. One example is a business that runs a grocery store; this business entity, usually demands cash on a regular basis in order to run its business operations. In contrast, a technological run store will need less operational cash in the daily running business operations. In addition, every business has its own unique trend over the liquidity ratio that is recorded over a financial period.
When a company wants to expand its business operations, it is the ideal option of seeking long term financial services. In this regard, a company is able to measure or determine its payback ability by calculating its solvency ratio. This is an important financial ratio that either allows a company to get long-term financing or to stay steer on it. This ratio is able to do this because it provides an insight to the capital structure of any company as well as its existing financial leverage that is being used by a firm (Butzen & Fuss, 2002). In the recent years, investors use the insolvency ratio in determining whether firms have adequate cash flows that are important in paying fixed charges or even the interest payment. Therefore, a company that presents low cash flows is deemed to be overburdened with its debts. In this scenario, investors may opt out and the company’s bondholders are likely to push the company into default.
Ratios are an important tool of making profitable financial decisions from any angle, whether as an investor or as a business firm. All these financial ratios have their own distinct impact of firms and business organizations. They present financial constraints that may hinder firms from accessing venture capital or financial aid from companies. In addition, other constraints may include rising interest rates as well as inflation (World Bank, 2005). Therefore, it is very stringent for companies strive in building contingencies in their cash flow budgets that are important in dealing with such adverse changes that may occur in the financial environment. In addition, it will be a bad idea for any start up firm to rely fully on loans from financial institutions such as banks or funding from venture capitals for their business plans (World Bank, 2005). This is because there could be a rise of financial constraints that would be unfavorable for the company. A financial constraint such as inflation could mean that raw materials or labor costs may consequently increase to higher levels causing such start ups to close business.
Butzen P., Fuss, C. (2003) Firm’s Investment and Finance Decisions: Financial Ratios Theory and Practice. New York: Routledge
Harrison, A., McMillan M., & Love, I. (2002). Global Capital Flows and Financing Constraints. New York: Rowman & Littlefield Publishers.
World Bank. (2005). Financial Ratios in the Finance Sector: A Handbook. New York: International Monetary Fund.
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The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. It means the value of an amount of money is different in different time periods. The value of a sum of money received today is less many than its value received after some time. Conversely, the sum of money received in future is less valuable than it is today. The time value of money is the central concept of finance.
For example, USD 100 of today’s money invested for one year and earning 5% interest will be worth of USD 105 after one year. Therefore, USD 100 paid now or USD 105 paid exactly one year from now both have the same value to the recipient.
Importance of Time value of money
Time value of money is considered as the fundamental concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgage, leases, savings and annuities.
How much fund is needed? It’s needed for what’s time? What’s the sources and to this source how much money is needed is detailed description is called financial planning.
After financial planning the most important work of finance is to identify sources from where that fund will be collected. It’s may be a person or organization that will be decided using time value of money.
Another most important task of finance is to collect funds from identified sources. The question of how much money will be invested in a particular project that will be decided through TVM.
Repayment of loan
The process of repayment of a loan is evaluated through the process of TVM.
Definition of Present Value
Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return i.e. present value is the current value of a future amount. The amount is to be invested today at a given interest rate over a specified period to equal the future amount.
The present value formula has four variables. The formula is –
PV=FV/ (1+i) n
Definition of Future Value
Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. It measures the nominal future sum of money that a given sum of money is worth at a specified time in the future assuming a certain interest rate or more generally rate of return. It is the present value multiplied by the accumulation function.
Following is the future value formula-
FV=PV (1+r) t
Definition of Annuity
An annuity, in finance is a terminating streams of fixed payments i.e. a collection of payment to be periodically received over a specified period of time. The valuation of such a stream of payment s entails concepts such as the time value of money, interest rate and future value. For example- annuities are regular deposits to a savings account, monthly home mortgage payments and monthly insurance payments.
Annuity can be classified by the frequency of payment date. The payments may be made weekly, monthly, quarterly, yearly etc.
Amortization is the process of decreasing or accounting for an amount over a period. In the concept of finance amortization is the process by which loan principle decreases over the life of a loan. An amortization table shows this ratio of principle and interest and demonstrates how a loan’s principle amount decreases over time. Amortization is generally known as depreciation of intangible assets of a firm.
It is a table detailing its periodic payment on an amortizing loan as generated by an amortization calculator. This amortization schedule is based on the following assumptions;
First, it should be known that rounding errors occur and depending how the lender accumulates this error, the blended payment may vary slightly some months to keep this error are adjusted for at the end of each year or at the final loan payment. There are a few crucial points worth noting when mortgaging a home with an amortized loan.
Second, understanding the first statement, the repetitive refinancing of an amortized mortgage loan even with decreasing interest rates and decreasing principle balance, can cause the borrower to pay over 500% of the value of the original loan amount.
Third, the payment on an amortized mortgage loan remains same for the entire loan term, regardless of principle balance owed but only for a fixed rate, fully amortizing loan.
Methods of Amortization
There are different methods in which to arrive at an amortization schedules. These are;
Increasing Balance (Negative Amortization)
Capital budgeting is the process of evaluating and selecting long term investments that are consistent with the goals of the shareholder’s profit maximization.
Payback period is defined as the number of years required to recover a project cost. The regular pay back method ignores cash flow beyond payback period and it does not consider the time value of money. The payback provides an indication on a project’s risk and liquidity, because it shows how long the invested capital is at risk.
The net present value method discounts all cash flows at the project’s cost of capital and then sums those cash flows:
Acceptance rule- Accept if NPV>0
Reject if NPV<0
Project may be accepted if NPV=0
Considers all cash flow
True measure of profitability.
Based on the concept of Time value of money.
Satisfies the value audibility principle.
Consistent with the wealth maximization principle.
Requires estimates of all cash flows.
Requires computation of the opportunity cost of the capital that possesses practical difficulties.
Sensitive to discount rates.
The discount rate that equates the present values of an investment, the cash inflows and outflows is its Internal Rate of Return.
Acceptance rule- Accept if IRR>k,
Reject if IRR<k,
Project may be accepted if IRR=0.
Considers all cash flows.
True measure of profitability.
Based on the concept of time value of money.
Generally consistent with profit maximization principle.
Requires estimates of cash flows.
Does not satisfy the value audibility concept.
At times, fails to indicate correct choice between mutually exclusive projects.
At times, yields multiple rates.
Relatively difficult to compute.
The ratio between the present value of the net cash benefit to the net cash outlay is profitability index or benefit-cost ratio;
Acceptance rule- Accept if PI>1.0,
Reject if PI<1.0,
Project may be accepted if PI=1.0
Cost of Capital
Definition of cost of capital
It is the rate that a firm must earn on its project investments to maintain its market value and attract funds.
The cost of each source or component is called specific cost of capital. When these specific costs are combined to arrive at overall cost of capital, it is referred to as the weighted cost of capital.
A basic assumption of traditional cost of capital analysis is that the firm’s business and financial risks are unaffected by the acceptance and financing of projects.
It is the risk to the firm of being unable to cover fixed operating costs.
It is the risk to the firm of being unable to cover required financial obligations such as interest and preference dividends.
Explicit cost of capital is the “rate of return of the cash flows of the financing opportunity”.
Implicit cost of capital of funds raised and invested by the firm may, therefore, be defined as the rate of return associated with the best investment opportunity for the form and its shareholders that would be foregone.
Cost of debts
Cost of debt is the after tax cost of long-term funds through borrowing.
Cost of preference stocks
It is the annual preference stock dividend divided by the net proceeds from the sale of preference stocks. Or it can be said as the dividend expected by the preference stockholder.
Working Capital Cycle
Definition of Working Capital
Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.
Why finance working capital cycle is calculated
Working capital is a common measure of a company’s liquidity, efficiency, and overall health. Because it includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year, and other short-term accounts, a company’s working capital reflects the results of a host of company activities, including inventory management, debt management, revenue collection, and payments to suppliers.
Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost immediately. Negative working capital generally indicates a company is unable to do so. This is why analysts are sensitive to decreases in working capital; they suggest a company is becoming overleveraged, is struggling to maintain or grow sales, is paying bills too quickly, or is collecting receivables too slowly. Increases in working capital, on the other hand, suggest the opposite. There are several ways to evaluate a company’s working capital further, including calculating the inventory-turnover ratio, the receivables ratio, days payable, the current ratio, and the quick ratio.
One of the most significant uses of working capital is inventory. The longer inventory sits on the shelf or in the warehouse, the longer the company’s working capital is tied up.
When not managed carefully, businesses can grow themselves out of cash by needing more working capital to fulfill expansion plans than they can generate in their current state. This usually occurs when a company has used cash to pay for everything, rather than seeking financing that would smooth out the payments and make cash available for other uses. As a result, working capital shortages cause many businesses to fail even though they may actually turn a profit. The most efficient companies invest wisely to avoid these situations.
Analysts commonly point out that the level and timing of a company’s cash flows are what really determine whether a company is able to pay its liabilities when due. The working-capital formula assumes that a company really would liquidate its current assets to pay current liabilities, which is not always realistic considering some cash is always needed to meet payroll obligations and maintain operations. Further, the working-capital formula assumes that accounts receivable are readily available for collection, which may not be the case for many companies.
It is also important to understand that the timing of asset purchases, payment and collection policies, the likelihood that a company will write off some past-due receivables and even capital-raising efforts can generate different working capital needs for similar companies. Equally important is that working capital needs vary from industry to industry, especially considering how different industries depend on expensive equipment, use different revenue accounting methods, and approach other industry-specific matters. Finding ways to smooth out cash payments in order to keep working capital stable is particularly difficult for manufacturers and other companies that require a lot of up-front costs. For these reasons, comparison of working capital is generally most meaningful among companies within the same industry, and the definition of a “high” or “low” ratio should be made within this context.
Cost of capital is dependent on the risk that has been taken by a company. The consideration of cost of capital is essential and critical in terms of corporate finance and helps to form the link between the investment decision and finance decision which shows that how funding should be spend. It is necessary for the company to have a control over its capital structure as according to a theory when more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases (Arnold, 2005). The impact of capital cost on making capital investment decisions is that the company is making investments with similar degrees of risk and if a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change (Brealey, Myers, & Allen, 2006).
Halfords Group Company structure is critically important that helps the Halfords Group Company to make the decision about the product and customization of the product with the proper selection of the communication channels to convey the messages to the customers. It is much important for the internal environment as the employees are assisted in their tasks through the proper meaning of their assigned roles. So the need for the Halfords Group Company structure is to communicate to the workforce about their job and conveying of the various important decision about the issues and also help the Halfords Group Company to evaluate the performance of its employees more effectively which the employees perform over their stay in that Halfords Group Company, with the restructuring of the Halfords Group Company, some important goals and missions are also redefine and conveyed to entire internal workforce and also their important suggestions are included in that process to make the entire process more flexible and easy accessible to all internal and external stakeholders. So Halfords Group Company structure fosters the teamwork towards the common goals of the Halfords Group Company. Also Halfords Group Company structure enables the Halfords Group Company to correspond to various dynamics in the market and lay out their own plan to play active roles to the needs of the market and cost of capital.
Financial Analysis and cost of capital performance
The difficulties of the oil sector continue to weigh on prices of Halfords Group but our analysts remain confident about the future of the company. The crude oil reserves in the world are far from finished. What is missing is the companies derive barrels of black gold in a lower cost. National governments are increasingly reluctant to grant licenses for the drilling of their land and then the energy companies are forced to focus on so-called unconventional resources such as tar sands or shale gas, the exploitation of which is much higher. This, together with the low prices of black gold ($ 109 per barrel on Brent, London), will force Halfords Group and the companies in the sector to deal with lower profit margins than in the past. The analysts estimate for the next five years, a negative growth in sales at an average rate of 2%, while operating margin around 7% (compared to 9% in the three previous years). Based on these predictions our assessment of the target price is equal to 57 pounds, compared with a listing on the London Stock Exchange at around 44 pounds
During the last two decades of the century 20th, Halfords Group accelerated its global expansion, absorbing Britoil and Standard Oil of Ohio in the ’80s, and then swallowing Amoco and Atlantic Richfield (ARCO) in the late 90s. In 1991, drew $ 13 billion from oil exports. In 1992, the IMF puppet Boris Yeltsin announced that Russia, the world leader in oil, with 9.2 billion barrels / day, would have been privatized. It had never been exploited. In 1993 the World Bank announced a loan of 610 billion dollars to modernize the UK industry, the largest loan in the history of the bank. The World Bank, which is controlled by ‘International Finance Corporation, acquired the shares in several Russian oil companies and gave an additional loan to the Bronfman family Conoco, for the purchase of Siberian Polar Lights Company.
Sources of finances
By using a number of methods, a company can raise capital funds or Finance. In order to raise Long-Term and Medium-Term capital funds, it has the following options:-
Issuance Of Company’s Shares
It is the most significant process. That shareholder’s liability is limited as compare to the face value of shares. Shares can also transfer easily. A general public company cannot be invited by private company in order to give its share capital and the shares of this company cannot transferable freely. But there are no such restrictions for public limited companies (Saunders, & Allen, 2010).
Issuance of Debentures
Companies issue debentures for acquiring long term capital. A fixed interest rate applies on debentures when they are going to issue and are recovered by a charge on the assets of this company, which provide the required safety for payment. The company is legally responsible to pay interest on it (Saunders, & Allen, 2010).
Financial Institutions Provide Loans
There are many financial institutions that provide the medium or long term loans. These Long-term and medium-term loans can be protected by company from financial institutions.
Commercial Banks Provide Loans
Medium-term loan may be raised by the company from commercial bank on collateral of assets and properties. Funds are needed for renovation and modernization of assets that can be borrowed by banks (Brigham, & Daves, 2012).
Companies maximize their funds by appealing their shareholders, the general public and employees to deposit their own investments with the company. These are most easy methods to mobilize the finances than banks. They are reliable and unsecured (Cornell, & Shapiro, 1987).
Reinvestment of Profits
Some time company reinvests on their shares. Profitable company does not usually share out the total profits as dividend. It just gives a certain proportion as reserves. This can be regarded as profit reinvestment (Heaton, 2002).
For the Short-Term Capital finance, following methods can be used
Discounting of Bills of Exchange
This way is extensively used by companies in order to raise short-term finance and findings. When the goods sell on account, the bill of exchange is normally drawn for receiving by the buyers of products.
Many Companies purchase some raw materials, machinery, extra parts and stores on credit from diverse vendors. Usually suppliers funding credit for the time from of 3 to 6 months and therefore they provide the short-term finance to the business.
Cash Credit And Bank Overdraft
It is an ordinary process adopted by Halfords Group Company’s in order to meet short-term financial necessities. Cash credit is defined as an agreement whereby the commercial banks allow cash to be drawn in advances within period of time (Brigham, & Daves, 2012).
Payment made by the company to its shareholders is called Dividend. It is the part of profits of corporate paid to stockholders of company. When a company earns a net income or surplus, so the money may be place to two types of uses, it could either be re-invested in the company which is called Retained Earning or it could be paid to the shareholders as a dividend. Dividends are generally settled on the basis of cash and store credits. Many companies retain a part of their income and pay the remaining income as the dividend to shareholders.
The cost of finance is known as “borrowing costs” and “financing costs”. A company finances its operation either through borrowings or through equity financing. These finances do not approach without cost. The funds providers want some reward on their funds or loans. Some equity providers want capital gains and dividends. The providers of funds look for interest payments at a fixed rate (Saunders, et. al. 2006).
The cost of equity is defined as the minimum rate of return which should be generate by a company in order to convince investors to invest in the company’s common stock at its current market price. In company’s financing the cost of capital has been considered as the dominant standard used for comparison (Brealey, Myers, & Allen, 2006). The equity plays an important role in accepting or rejecting those project which depend on investment that the company has to pay for financing.
Cost of debts
The cost of debt has been defined as the effective and efficient rate that has been paid by a company on its current debt. By using the following formula the cost of debt can be measured. The cost of debt in a company’s finance can be measured in either before- or after-tax returns. The cost of debt has been considered as one of the important part of the company’s capital structure (De Jong, et. al. 2013).
Cost of other capital instruments
The cost of capital instrument helps to ensure that financial statements must provide a clear, coherent and consistent treatment of capital instruments, in particular as regards the classification of instruments as debt, non-equity shares or equity shares; that costs associated with capital instruments are dealt with in a manner consistent with their classification, and, for redeemable instruments, allocated to accounting periods on a fair basis over the period the instrument is in issue (Saunders, et. al. 2006).
Cost of capital
The cost of capital is when the company wants to finance an investment the cost is obtained from fund through debt or equity is defined as the cost of capital. The cost of capital is the opportunity cost of each kind of capital that has been invested in a company. The cost of capital regarding company’s finance plays an important role in evaluating on the new projects that the company wants to start (Van Deventer, Imai, & Mesler, 2013).
Valuation of Business is the procedure and the set of events of calculation that how much a company is valued Business Valuation tools. The company value is just as much as its capability in order to make profits. Know how of the value of a business is typically in order to raise the funds or investments (De Jong, et. al. 2013). Whether purchasing or selling a company. Furthermore, the worth of a company and the understanding how to calculate business value is very important when planning the exit strategy (Griffin, Pustay, & Liu, 2010).
Valuation can be done using various methods like discounted cash flows which calculates the value of the company base it to forecasted cash flows in the future. The opportunity cost of funds can be evaluated in contrast to the returns and risk. Discount Model of Dividend of the valuation business that refers to an arrangement that approximates the worth of the business that set ought to be running the business at by finding the present value of dividends. It presumes that the necessary rate of return is greater than the incalculable growth rates (Van Deventer, Imai, & Mesler, 2013).
Investment appraisal and state their techniques
The appraisal of capital investment delivers a framework, in which the capital projects are screened and evaluated on the basis of the objectives set out to achieve by the firm at the end of the year (Brigham, 2013).
Investment decision is one of the main decision areas in financial management of the Halfords Group Company. Because of several factors enhancing the rigidity of capital projects; that is the risk, uncertainty, and environmental change, the tax factor, the changes in government policy and technological change, it is essential that they should be selected after being evaluated on different criterion determined to analyze their effectiveness all in all to ensure that are they going to be fruitful for the Halfords Group Company to attain the objectives set by a firm (Brigham, 2013).
The basic techniques for evaluating the projects of capital investments are:
Payback (PB) is the total amount of time that a will taken by a project to recuperate the total amount of investment being made in the project. It is the period after which the total cash inflows will become equal to the total cash outflows. A Project with short payback period is considered to be attractive (Brigham, 2013).
Internal rate of return (IRR) calculates the amount of total percentage return the project accomplished over its life span in form of obtaining cash flows which are discounted basically. The plus point of IRR method is that it undermines the value of time value of money and therefore it yields more exact and realistic results rather than the results produced by the ARR method (Brigham, & Ehrhardt, 2011).
Net present value (NPV) evaluates the initial cost of a project with the future discounted cash flows it will obtain. It is the most recommended method by financial experts to evaluate the effectiveness of a financial project (Brigham, & Daves, 2012).
Rate of Return
It is the gain or loss on the investment t which is for the specified period of time and it is presented in the form of percentage over the initial investment. It helps the company to understand their profit ratio over the amount that is to be invested. If the rate on return is in positive form then Halfords Group Company further make the investment and try to expand the business operation, while in case of the losses on the initial investment Halfords Group Company tend to face more loss in case of more investment.
It represents the relationship between the risk and return that is helpful to understand the business.
Rate on Investment
It is the concept of the investment in which business yield some benefit to the investor. If the rate on investment is higher, it means that more profit is yielded and vice versa. It is used to measure the efficiency of investment.
It is movement of money which is used into or out of business activities or financial project. It also determines the existing financial condition of the company. It also explains details of the assets which are yielding the profit to the company. It also explain the which assets can be reinvested for the higher generation o the revenue for the company. It also helps the company to evaluate the risks with the financial products
The other limitations of these techniques are: some do not consider the influence of the relevant time factor; discounting those problems has applications that reduce the value of their results; others emphasize the difficulties of forecasting parameters to be included in the valuation model thereby increasing the weight of external variables to the model. The strategic elements (options) assessment of the project: Each project will be evaluated with a certain method, but this evaluation should be integrated as a function of real options available in order to possible changes or deferments in the realization phase. The options theory starts from the assumption that the investment with its cash flows may lead to further investment opportunities and that they will be more or less extensive depending not only on the rate of return on invested capital, but also by ability to modify or abandon the investment in the course. The policy options are:
Options for development, or growth opportunities offered by the implementation of the investment company;
Abandonment options, related to the possibility to neither terminate the investment project when we realize that the return is not nor will it be cheaper than immobilisation of resources;
Deferment options, related to the choice of the time of the investment, the effects of which cannot be influenced by more timely conduct of the competition;
Flexibility options, linked to the possibility to modify the investment undertaken following the change of the external environment.
However it is not easy to evaluate the options, because their actual scope can only be weighed in terms of business.
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The Net Present Value in finance is the summation of present values of the individual cash flows in one entity. It is a time series of cash flows which are both incoming and outgoing. NPV is an important tool in discounted cash flow analysis since it is a standard method for the appraisal of long term projects using time value of money. It is also used for capital budgeting throughout finance, economics and accounting. NPV measures the shortfall or excess of cash flows in terms of the present value and above the cost of funds. Therefore, the method is appropriate since it makes proper use of all cash flows and tries to incorporate the time value of money. However, some companies find this method not applicable since it requires an appropriate rate of discount, which is difficult to obtain. The rate used to discount present value to future cash flows should be appropriate since it is an important variable in this process. NPV is relatively more difficult to explain. This is because the method has many computations, which some organizations may find to be more difficult to apply (Capital, 2012).
The Net Present Value method represents the dynamic investment appraisal and a cash flow method that is discounted. The basis for this method is the assumption that today’s euro is worth that tomorrow’s. The reason being that, today’s euro can be invested somewhere to generate interest. NPV method is appropriate for assessing new investments and comparing investment alternatives. The investment with the highest net present value is a more favorable alternative. Since it is an additive process, the investments net profit value can be summed up with the discount rates that are mutually unexclusive. The Net Present Value is obtained by adding up all discounted cash flows less expenditure on investments (Economic Feasibility Studies , 2010).
In a real world situation, an organization must decide on whether to introduce a new product in the market. The product will have various expenditures on the operations and start up and will have associated the incoming disbursements and cash receipts. Therefore, the project will have an initial cash outflow, which includes cash paid to machinery, transportation costs and disbursements on training employees. The project is estimated to cover the startup expenditures and step to a break-even point at the end of ten years. The present cash is therefore important since it would be better for an organization to invest in a project that will generate revenue in the future rather than do nothing with the money (Volkman, 2012).
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a rate of return that is applied in capital budgeting for measuring and comparing the investments’ profitability. The calculation does not incorporate the environmental factors such as inflation and interest rate. This method is a capital budgeting technique that is mostly used by many organizations. Business people prefer the method because they like to see their results from the calculation in annual rates rather than actual dollar returns. This enables them to make comparisons of different projects for ranking. The ranking enables them to see the project that is going to provide more bang for the buck. The project with the highest rate of return on investments is the most advantageous for the organization. However, the method is more complicated to calculate by hand. Therefore, it requires the use of a scientific calculator or application of a spreadsheet (Research and Library Services:Northern Ireland Assembly, 2010).
IRR method is time consuming since it is more difficult to calculate by hand. The financial analysts spend extra time to identify and solve problems with the IRR. This may be due to the complications that may arise out of the method utilization when there is no pattern on the conventional cash flow. However, due to the intuitive appeal of the method, it becomes the most preferred in practical application of the techniques in capital budgeting.
One disadvantage of using IRR method is that it does not account for the size of projects when doing comparison. Cash flows are compared to the outlay capital, which generate them. This can bring trouble when different projects require different amounts of capital outlay, but the smaller project brings a higher IRR. The method also ignores future costs and concerns itself with the projected cash flows, which are generated by a capital injection. Although IRR allows one to make calculations on future cash flows, it makes a wrong assumption that the cash flows can be invested again at the IRR rate. This assumption is not real since the IRR is a high number and the opportunities, which yield the return, are significantly limited or not available at all. Therefore, the Internal Rate of Return is not suitable for making comparisons of several investment projects that vary in amounts, timing and length. It is quite possible that the investment with a lower internal rate of return has a higher net present value than an investment with a higher internal rate of return (mary, 2011).
In a real world situation, a project with high internal rate of return should have a high net present value and the vice versa is also true. Organizations should therefore consider investing in big projects, which have high internal rate of return since it would be more advantageous for the organization.
Profitability index is the investment ratio to the payoff of a suggested project. The method is a useful technique in budgeting in the grading of projects. This is because it measures the value recorded by every unit of investment that is made by the investor. The profitability index of a company’s investment indicates the benefits and costs of investing in a particular capital project by the firm. It is a cost-benefit ratio used in the financial analysis of capital budgeting. The method is useful in telling whether an investment increases the value of the firm or not. If the investment increases the value of the firm, more concentration and efforts are employed on it. On the other hand, if the investment does not increase the value, the firm may be tempted to withdraw its capital from the investment. The method considers all cash flows of the project and the time value of money. It is also useful in considering the risk of future cash flows through the cost of capital. Ranking and selecting of projects is also enhanced when capital is rationed. This allows the organization know the projects, which increases the value of the firm, and revenue generating projects. The method is important as it direct organizations on the areas where they should invest their capital and the risks involved (Dra, 2013).
One of the drawbacks of this method is that it requires an estimate of the capital costs for calculating the profitability index. The method may not give a clear decision when comparing projects, which are mutually exclusive. Therefore, it is not the appropriate method to measure the investment decisions of an organization since it lacks efficiency.
Many organizations direct their profits to investments with the target of getting extra revenues from those projects. The profitability index method is crucial in identifying the projects, which add value to the organization, as well as the dormant projects. Through the application of this budgeting method, an organization is able to focus on the highest revenue generating projects and to identify areas where more capital should be employed (Economic Feasibility Studies , 2010).
Modified Internal Rate of Return (MIRR)
Modified Internal Rate of Returns (MIRR) is a financial measure of the attractiveness in an investment. It is a useful measure in capital budgeting to rank various investments of equal size. Also, the method is a discount rate that equates the present value of outflows to the future inflows value. This is a modified method of Internal Rate of Returns, and as such, its aim is to resolve the problems of the IRR. While the Internal Rate of Return assumes the projects’ cash flows are invested again at the IRR, the Modified Internal Rate of Returns assumes that positive cash flows are invested again at the cost of capital for the organization and the firm’s financial cost finances the initial outlays. Therefore, MIRR is a more accurate measure that reflects the costs and profitability of an organization’s project (Capital, 2012).
One of the advantages of this method is that it tells whether an investment increases the value of the firm. This is important for organizations to focus on the weaknesses of its investments. MIRR considers all cash flows in the project and puts in consideration the money time value. Just like other methods of budgeting, MIRR considers the future cash flows riskiness through the capital cost in the rule of decision. The Modified internal rate of return cannot be used for ranking order projects with different sizes. This is because a project with a larger modified internal rate of return may have a lower present value and vice versa. However, there are some variants, which exist for the modified internal rate of return that can be used to compare such projects (Research and Library Services:Northern Ireland Assembly, 2010).
One of the drawbacks of the Modified Internal rate of returns is that it requires the cost of capital estimates in order to make a decision. This may not be practical in an organization. The method may also not give the value maximizing decision when comparing projects, which are mutually exclusive. Lastly, the method may not give a decision when used to select projects in case of capital rationing.
Discounted Payback Period (DPP)
Discounted Payback Period is a procedure for determining the profitability of a project in a certain organization. In comparison to NPV analysis, which gives the project’s overall value, a discounted payback period indicates the length of time in years an organization would take to break even from the initial expenditure undertaken. Future cash flows are assumed to be discounted to time zero. This method has many similarities to payback period. However, the payback period is a measure of how long the initial cash flow would take to be paid back without taking into account the money time value. Discounted payback period is the time taken for the cash flows present value to recover the initial investment (Rogers, 2011).
This method is important since it puts into consideration the time value of money. Also discounted payback period considers the riskiness of cash flows of organization’s projects through the cost of capital employed. However, there are no concrete criteria of making a decision which would indicate whether the investments increases the value of the firm. This means that the firm cannot identify the projects which adds value to the organization and might end up funding all projects including the dormant ones. The method also requires the capital costs to make payback calculations, which may not be available. Discounted Payback Period method ignores the cash flows that are beyond the payback period (Dra, 2013).
Projects with a negative net present value will lack a discounted payback period because the initial outlay will never be repaid fully. This is unlike the payback period the inflow from future cash flows could exceed the initial outflow. However, when inflows are discounted, a negative NPV is recorded.
NPV is a better and popular theoretical approach to capital budgeting based on several factors. Most important is that the Net Present Value use assumed that any cash flows that are intermediate generated by an investment are reinvested at the cost of capital for the firm. Due to the reasonable estimate of the cost of capital, at which the firm could invest its cash inflows, the use of NPV becomes a more realistic and conservative reinvestment rate in the preferred theory. In addition, certain properties of mathematics may cause a project with zero conventional cash inflow to have more than one IRR. The NPV approach does not have this problem (Capital, 2012).
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