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Preference Of Npv Over Other Investment Appraisal Methods Finance Essay

The different investment appraisal methods has their own pros and cons. But Net Present Value is by far the most preferable of all methods. There are valid reasons which make this preference.

The first one is Payback Period which is widely used as a measure of time to get the money back. But as it doesn’t consider the time value of money so NPV is superior. To overcome this problem an adjusted payback period is calculated to incorporate the time value of money into it.

One investment appraisal method that can be compared with NPV is the Internal Rate of Return(IRR). It also considers the time value of money and it is easier to understand even for non finance people. IRR should give the same accept or reject decisions as NPV unless there are mutually exclusive projects or we have limited capital to invest. So when a company has projects to invest which are mutually exclusive then NPV is preferred as it is in monetary terms and IRR is in percentage terms. For example if there are two projects named Project A and Project B and Project A has an NPV of £100,000 and an IRR of 12% and Project B has an NPV of £10,000 but an IRR of 25%. On the basis of IRR we should select Project B but on the basis of NPV we will select Project A as it will add more to the wealth of shareholders.

IRR has also some other problems in calculations for example when there are more than one cash outflow or cash out flow occurs during the project life rather than in the start of the project we can get more than one IRR. So we prefer NPV which is more realistic and meaningful approach for investment appraisal.

Question 2

Part (a)

Sources of finance for a Listed Company

A listed company has generally access to more sources of finance as compared to a non listed or a private company. For example it is easier for a listed company to issue the shares as compared to a non listed public company.

As we are going to discuss the sources of finance that needs to finance the long term projects we will only consider the long term sources of finance either equity or debt.

Following are the types of finance that a listed company can have to finance a long term project.

Issue of new shares (to new and existing shareholders)

Rights issue to (existing shareholders)

Preference Shares

Debenture

Retained Earnings

Long Term Bank Borrowings

New Shares Issue

A company can issue Ordinary shares to finance a long term project because it doesn’t have a responsibility to return that money. But it does not mean that it will be a free money. Money always have a cost as the issue of new shares have. The new share issue benefit of no obligation to return money comes at a cost which is almost always higher than the cost of debentures or other types of loan.

Ordinary shares have a nominal value or ‘face’ value. The market value of a listed company's shares has no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares.

Rights issues

A rights issue provides a way of raising new share capital by offering to existing shareholders, inviting them to subscribe for new shares in proportion to their existing share holdings and this is also a source of finance which can be used for long term projects.

A company planning a rights issue should set a price which is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share. So this balance of price is very important to get the funds required and also maintain the value of company.

Preference shares

Preference shares can also be issued to fund a long term project as it has very similar properties as ordinary shareholders. A company who issues preference shares promises to preference shareholders that it will pay a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shareholders, a preference shareholder can only get dividend if sufficient distributable profits are available. One benefit of the issue of preference shares is that it does not restrict the company's borrowing power, as preference share capital is not secured against any assets of the company.

On the other hand, dividend on preference shares is not tax deductible in the way that interest payments on loan are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks.

Retained earnings

A company can also use it retained earnings to finance its long term projects but one important thing to remember is to remember is that if the company has enough cash in hand to use its retained earnings. Profit which is re-invested as retained earnings is the profit that could have been paid to its shareholders as dividend.

The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.

One other factor that is important to consider is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, shareholders would rather prefer make a capital gain (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.

A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends.

Debentures

Debenture is a type of long-term debt raised by a company for which interest is paid, usually half yearly and at a fixed rate but it can be quarterly or yearly also. Debenture holders are therefore long-term creditors of the company so these funds can be used for investment in the long term projects.

Like ordinary shares, debentures also have a nominal value, which is the debt owed by the company, and interest is paid at a stated rate called "coupon yield" on this amount. For example, if a company issues 7% debentures the coupon yield will be 7% of the nominal value of the stock, so that £100 of debentures will receive £7 interest each year.

Debentures are usually redeemable but it can be irredeemable as well. As far as companies are concerned, debt capital is a potentially attractive source of finance because interest charges reduce the profits chargeable to tax. Debentures are generally secured on the assets of the company. 

Bank lending

Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term and long term lending is quite common these days. So we will only discuss here the long term lending.

Lending to companies is normally at a margin above the Bank of England base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate which is not a long term borrowing. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans are mostly available only for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors including the company’s creditworthiness.

Q.2

Part (b)

Explain why is it essential to that discounted cash flows should be calculated when making long term investment decisions

Discounted Cash Flow (DCF) analysis is the technique used to derive economic and financial performance criteria for investment projects. First we will discuss what is a cash flow analysis and then we discuss what a discounted cash flow analysis is and how it is essential to long term projects.

Cash flow analysis is simply the process of identifying and categorizing of cash flows associated with a project or proposed course of action, and making estimates of their values. For example, when considering investing in a waste disposal plant of a company, this would involve identifying and making estimates of the cash outflows associated with the new project (e.g. the cost of buying or leasing the land on which plant will be installed, purchasing the necessary machinery and installation costs if any), maintaining the plant (such as cost of regular maintenance and labour etc.) and in the disposal cost of plant when its life ends. Also, it would be necessary to estimate the cash inflows from the savings of outsourcing waste disposals that company was doing before.

Discounted cash flow analysis is an extension of simple cash flow analysis and takes into account the time value of money and the risks of investing in a project. The discounted cash flow techniques involve time value of money for example net present value, internal rate of return, cost- benefit ratios. and adjusted pay back period. The main reason for using discounted cash flows is to consider the time value of money when making investment decisions. As we know that the value of £1 today is not equal to £1 after a year or any future time period. The same applies to our investment decisions specially when they are long term. As long term decision involves considerable amount of time in that they needs to be discounted for that value of money that time generates or loses.

For example if we invest in a project which will use our initial outlay of £1 million pounds and generates £1.5 million in one payment after 5 years. Apparently looking at the figures we can see that the profit generated from the project is £0.5 million. But as the amount of money we receive will take 5 years we have to consider that what our funds cost us to invest in that project for 5 years. If our cost of investment is less than the return on investment (calculated by IRR) we should invest in the project otherwise not.

The different discounted cash flow techniques have their pros and cons but the most recommended one is the net present value as it is the only one which considers the time value as well as the money in amount not in percentages or time periods, although many companies use IRR as their preferred technique in practice possibly because of its simplicity to understand.

Question 3

To: Board of Directors of Davinbrough

From: Managing Director Davinbrough

Date: December 26, 2010

Calculation of Financial Ratios and Analysis

Question 3 Part (a)

All amounts are in $’000’

Return on Capital Employed

We assume capital employed here as shareholder’s equity and long term loans which is 335 +300 =635 and net income Is after interest expense but before tax.

Net Income

= ______________

Capital Employed

186

= ____ = 29.29%

635

Revenue / Capital Employed

Revenue

= ______________

Capital Employed

2,425

= _____ = 3.81 times

635

Gross Profit Margin

Gross Profit

= ______________

Sales Revenue

555

= ______ = 22.9%

2,425

Net Profit (Before tax) Margin

Net Profit (before tax)

= _____________________

Sales Revenue

186

= ______ = 7.67%

2,425

Current Ratio

Current Assets

= ______________

Current Liabilities

595

= _____ = 1.19 : 1

500

Quick Ratio

Current Assets - Stock

= ______________

Current Liabilities

595 - 245

= ______________ = 0.7 : 1

500

Inventory Holding Period

Inventory

= ______________ x 365

Cost of Sales

245

= _______ x 365 = 48 Days

1,870

Accounts Payable Collection Period

Accounts Payable

= ____________________ x 365

Cost of Sales

350

= _______ x 365 = 68 Days

1,870

Accounts Receivable Collection Period

Accounts Receivable

= ____________________ x 365

Sales

320

= _______ x 365 = 48 Days

2,425

Debt to Equity

Total Debt

= _________________

Total Owner’s Equity

300

= _______ = 47.24%

635

Ratio Analysis

Now we will discuss what these ratios are and how these effect our company as compare to the industry.

Gross Profit Margin

The gross profit margin ratio tells us the profit a business makes on its cost of sales. It is a very simple idea and it tells us how much gross profit per £100 of turnover business is earning.

Gross profit is the profit that we earn before we deduct any admin, selling and other costs. So we should have a much higher gross profit margin than net profit margin. The industry average is 30% and our company has 22.9% which is lower than the industry. We should investigate why we are paying more for the production of goods and which part of cost of goods sold is making this ratio lower than the industry average.

Net Profit Margin

The net profit margin ratio tells us the amount of net profit per £100 of turnover a business has earned. That is, after taking account of the cost of sales, admin, selling and distributions costs and all other costs, the net profit is the profit that is left, out of which company will pay interest, tax, dividends and so on.

Our company have net profit margin of 7.67% and industry average is 12.5% which is again lower than industry average. It means we are again paying more for the administration and selling costs than the industry. It should also needs investigation and further analysis.

Return on Capital Employed

In accounting, there can be different definitions of capital employed. It can, for example, include bank loans and overdrafts since these are funds employed by the firm. There are different interpretations of what Return on capital employed can mean, we used the most common term but others may interpret this definition in a different way.

We have return on capital employed 29.3% which is well above the industry average of 22.1%. We are doing well on this and should try to maintain this in the future.

Revenue / Capital Employed

Revenue per capital employed means that how much revenue is generated per £1 of capital which is employed by the company. This indicates that how well we are using the available finance of the company.

The industry average for revenue over capital employed is 1.8 times but our company has this 3.81 times which is much better than the industry average. This is a good thing as it is about double he industry average but as our profit margins are lower than industry average it may mean that we are concentrating more on sales rather than getting much margin. It may be because we paying more in selling commissions or any costs which is more than the industry averages.

Current Ratio

The current ratio is also known as the working capital ratio and is one of the most important ratios in a ratio analysis. This ratio tells us how liquid is our company and how much current assets we got to pay off our current liabilities.

The industry average for current ratio is 1.6:1 and our company has 1.19:1 and it is again less than the industry. It means we have less current assets to pay off current liabilities than the industry. It may be because we have less stock in hand because we have more sales.

Quick Ratio

Quick ratio is same as current ratio but it deducts inventory from current assets as inventory is not as liquid as other currents assets e.g. accounts receivables and cash.

Industry has quick ratio of 0.9:1 but we have 0.7:1 which is again less than the industry average. The reason may be the same as for current ratio.

Accounts Receivable Days

Account Receivable Ratio, or Days Sales Outstanding Ratio, is a financial ratio that illustrates how well a company's  accounts receivables are being managed. This is very important working capital ratio as it tell us how long our debtors take to pay our money back and it means how much working capital we need when we have our sales growth which this company has as compared to industry average.

Ideally these days should be as less as possible but a very low ratio can also mean that company is not selling on credit which in most industries enhance the sales expect very few ones e.g. supermarkets and restaurants.

The industry average is 45 days and we have 48 days which is almost the same so we are not behind the average to collect money from our debtors than the industry which is a good sign that we are managing well our debtors.

Accounts Payable Days

Account Payable Days or Days payable outstanding is an efficiency ratio that measures the average number of days a company takes to pay to its suppliers. From working capital managing perspective it should be as much as possible because it is a source of finance that company can use to fund either trade receivables or stock or any current assets. But care should be taken as not paying to trade payable for long may make them to decide that company is not very good in meeting it credit obligation and it can make the company to obtain future credit difficult.

The industry average is 55 days and we are paying to our trade payable on average 68 days which is a good thing as we are paying to our creditors more than 13 days than the industry. But again care should be taken as we company is a growing company and it needs credit in the future. Sometimes it may cost us more to get more days as we pay more on our purchases to get paid later than the normal credit terms and this should also be carefully calculated to determine the benefit analysis.

Inventory Holding Period

The inventory holding period is also an efficiency ratio which measures the average number of days we hold inventory before it is actually sold. The longer the period the less efficient we are. Japanese invented the term Just in Time (JIT) which means virtually no inventory. But in most businesses there is almost always some inventory which means we will never have zero inventory days.

But we should try to have as less as possible after accounting for the demand of products because if we have very less inventory then it may mean we may be turning down customers which is also as fatal for the business as having excessive inventory with no current use.

The industry average holding period days are 46 days and we have 48 days which is about the same as the industry. It means we are holding the inventory about the same number of days as the industry.

Debt to Equity Ratio

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets.  This ratio is also known Gearing Ratio. The debt and equity part of the formula are often taken from the company’s balance sheet or statement of financial position means the book values , but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded. This is a very important ratio and indicates that how much a company has debt as compared to equity.

The more a company has debt the more it can benefit from the tax shield the interest expense provides but more debt also makes a company risky in terms of meeting its short term and long terms debt obligations .

Our company has a debt equity ratio of 47.24%. but the industry average is 40% so we are a little more prone to debt on one hand it is beneficial as a tax shield but on the other hand It makes company a riskier one as it has more debt obligations to meet.


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