I would also like to discuss some points that consist of irrelevant information (that is considered relevant by the Accountant). These points are:
- Depreciation is irrelevant to this decision as it is non-cash flow item. It doesn’t meet the definition of cash flow i.e. neither it is incremental nor cash based.
- Fixed Overheads are irrelevant to the decision as these are apportioned not specified.
- Admin Overheads are also irrelevant.
- Consultancy fee paid to the consultant is also irrelevant as it is a sunk cost.
- Interest on loans is although relevant but these are not considered as it is indulge in cost of capital.
Comparison of the currently used methods (Payback period and rate of return) with Discounted Cash Flow techniques:
Engineering Products PLC is currently using payback period and rate of return method to assess the capital budgeting, however I would suggest that company should use discounted cash flow techniques to assess the project, I would explain it later in this report. Before going further I would first like to define current methods employed by the company and my suggested DCF techniques.
Payback Period:
In this technique, we consider cash inflows for each period rather than just considering profits. In this method, we are actually searching for that point which you can say as breakeven point where our initial investment for the project is being covered. Such time in which all those cash inflows equate the initial investment is called Payback period.
Payback period is the time period during which, initial investment (that is being incurred for the project) is being recovered i.e. the point at which we have no profit, no loss. As evident from the calculations, initial investment made for the project is 280,000 pounds (240,000 for machine and 40,000 for marketing expenses)
Now, we have to find out the time period that is being required to cover this investment of 280,000.
So, Inflows for the first year are 56,500 pounds.
Inflows for the second year are 130,375 pounds.
These two totaled 186,875 pounds so we require another 93,125 pounds to find payback period so we divide 93,125 by 245,300 to find out the remaining time period i.e. 0.38 portion of the year, so payback period for the investment is 2.38 years.
Rate of return method:
In this technique, profits for the years are considered with initial investment and therefore respective rate calculated is called Rate of Return.
This measure represents the ratio of average annual profits after taxes to the investment in the project.
But this method is rejected due to its principal shortcoming that it is based on accounting income rather than on cash flows and that it fails to take account of the timing of cash inflows and outflows. Time value of the money is ignored.
Annual cash flows are the net cash flows obtained before tax shield.
So Rate of return is 57.67/280*100=20.6%
(57.67 is the average for the four year profits)
Net Present Value (NPV) method:
In this technique, cash outflows and inflows throughout the life of the project are being considered carefully. It is basically the difference between an investment’s market value and its cost. NPV also measures, how much value is made or added by undertaking a particular investment. NPV with positive result should only be accepted.
NPV= -C0 + (sum of) [OCF/ (1+R(r)) ^t] + [TCF/ (1+R(r)) ^n]
Where
C0= initial investment made for the project
OFC= operating cash flows (that include both inflows and outflows) for certain period of Time.
t= year (time period)
n= life span (in years) that the project undertakes
R(r) = rate of return that is being required
TCF = total cash flows
Comparison of Traditional methods and discounted cash flow method
Now coming towards comparison of these methods, if the company wishes to adopt payback period method, all subsequently incurred cash flows are to be ignored.
Also all predominant cash flows are an equal footing, regardless of whether an investment has faster return or not. Rate of return method also include those non cash flow items that are irrelevant to the decision like depreciation, fixed overheads. So if we employ these two methods (that are currently being employed by the company) to assess the project, they will not correctly assess the profitability.
Thus the most appropriate method to assess capital budgeting is by using discounted cash flow techniques i.e. Net Present Value (NPV) method. It expresses the capital value in monitory terms; it considers only the cash flows which are core relevant. NPV method interprets the results very simply. We can adjust the discount rate for different periods using cost of capital which in this case is 10%.
So after this comparison, let me discuss some merits of DSF techniques so that you would properly get to know how much this technique is important to assess the capital projects.
Merits of Discounted Cash Flow Techniques:
- This method considers entire economic life of the project whether there are profits or losses.
- Time value of money is given due importance in this technique.
- This method provides us with the measure through which we can compare different projects in a sense, which project is to be undertaken.
- The profitability is being calculated in a sense that all cash flows (including inflows & outflows) are being measured at a present value.
- It is the best method as compared to other methods as it employs discount factor to measure the present value.
- This method is an authentic method for evaluating investment projects where the cash flows are not even. As compared to other methods where such cash flows are get averaged, this method directly measured them.
Calculation of NPV:
As I have suggested using the NPV instead of Payback period or rate of return method, here I have calculated the NPV of our project so that we can analyze whether this project is profitable for us or not.
Net present Value (NPV) = 470.28 – 260
= 210.28
As this NPV is positive so this project should be accepted.
**Tax Shield:
Here depreciation is calculated on the basis of 25% rate with written down value. Although initial investment is 240,000 pounds for the machinery but it also has scrap value of 20,000 pounds so we have to deduct this scrap value(240K-20K) before applying depreciation rates. Tax shield is being calculated by applying 30% rate on relative values of depreciation.
So total tax shield would be= 65.475.
Which project is to be considered due to shortage of Finance?
Our company “Engineering Products PLC” is currently in a phase of shortage of finance so we have to consider this project in depth whether to undertake this new project or continue the already taken projects. In this case, if we undertake this new project then we have to defer some other projects, so here the concept of mutually exclusive projects arises.
First of all, which project is to be considered and which project is to be deferred depends upon time period required for completion, its strategic importance etc. Normally we consider that project that is profitable for our business. Here, in our case, the chief Engineer considers this project strategically important. According to his view only they have to get grip over the new technology, it should deliver improved product quality and greater flexibility. As our organization is already in a profitable business so this new investment would result in much greater benefits in future.
Strategic factors Assessment:
Traditional financial appraisal techniques might have been very adequate for appraising sophisticated new technology projects. If our company would not make an investment at a time when it is needed, it may have very serious long term consequence and that innovation & change are part of our everyday business life. Now a day’s competition has grown much rapidly in industries, only those companies are successful which maintain their competitive advantage. Companies that would not focus on demands & opportunities presented by technological improvement are actually making their company towards an end as there are less chances of improvement. Today’s many challenges now faced by industries indicate that technology management is a critical strategic issue.
A Financial executive made the following interesting observation (Bierman, 1986): “The real challenge is creativity & invention, not analysis. Timely execution of projects by entrepreneurial managers is also more critical than sophistication of analytical budgeting techniques.”
Many investors basically focus to evaluate different methods to get short-term financing. But there are some problems regarding short term financing as it is not very helpful for gauging expectations. Investors usually made their own standards rather than benchmarked. Without knowing where expectations are today, it is hard to know where they are likely to go tomorrow.
Company’s management is facing problems in a way that they not only have to invest in new technology but also on the other hand they also need to justify, using different appraisal techniques, all those capital expenditure. The financial evaluation methods are well established, well documented, while the methodologies for evaluation of the strategic, intangible benefits are low formalized and low understood.
Recommendations:
Some of the recommendations from my point of view are:
- Company must have to use discounted cash flow techniques rather than payback period or rate of return method.
- Only relevant items are to be considered in calculations, irrelevant items must be ignored.
- Company has to consider this project as it would result in positive NPV so it should be accepted.
References:
Brealey, R., Myers, S. and Allen, F. (2011) Principles of Corporate
Finance, 10th Edition, McGraw-Hill Inc. International Edition
Charles, H., Gary, S. and William, S. (2007) Introduction to management Accounting, 14th Edition, Prentice Hall.
James, V. () Financial Management and Policy, 12th Edition, Prentice Hall
