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The duty of the company manager is to make their company more profitable and valuable so manager must take a right decision to identify, evaluate and implement as well as estimate the benefits of potential projects that meet or exceed investor expectations. It also estimates that how changes in capital structure, dividend policy and working capital policy will influence shareholder value. How ever the value creation is impossible unless company do appropriate forecasting for the future.
Financial planning process is a crucial part so there are following forecasting techniques which help manager in decision making
One of the most appropriate forecasting method in capital budgeting is estimating future cash flow for a project that enable cost and revenue forecasting for an organisation as well.
Capital budgeting tools evaluate expected future cash flows in relation to cash put out today.
Cash flow forecasts
It is very important task for forecasting cost and revenue for an organisation that the final result we obtain are really only as good as the accuracy of our estimate. Because cash, not income is central to all decisions of the firm.Â We express what every benefits we expect from a project in term of cash flows rather than income. The firm invests cash now in the hope of receiving returns in a greater amount in the future. Only cash receipts can be re invested in the firm or paid to stock holders in the form of dividends. In capital budgeting good guys may get credit, but effecting managers get cash. In setting up cash flows for analysis a computer spread sheet program is invaluable, It allow one to change assumptions and quickly produce a new cash stream.
Incremental cash flows
For each investment proposal we need to provide information on expected future cash flows on and after text bases. In addition information must be provided on an incremental bases so that we analyze only the difference between the cash flow the firm with and without the project for example if a firm contemplates a new product that is likely too compete with existing product it is not appropriate to express cash flow in term of the estimated sales of the new product. We must take into account some probable cannibalization.
The sales forecasting normally starts with a review of sales during the past five to ten years. Through these past five years historic sales firm can predict its future growth. Once sales have been forecasted, company must forecast future balance sheets and income statements.
Analyze the Historical Ratios
The objective of historic data is to forecast the future or pro forma financial statement. The percent of sale method assume that costs in a given year will be some specified percentage of that year's sales. Thus company begin their analysis by calculating the ratio of costs to sales for several past years.
Income Statement forecast
For making any decision to invest in any project company forecasts the income statement for the coming year. Income statement forecast is needed to estimate both income and the addition to retained earnings.
Balance Sheet forecast
The asset shown in the balance sheet must increase if sales are to increase. So on the basis of assets, sales, inventory and receivables ratio analysis company manager make decision for future projects.
- Financial forecastingÂ generally starts with a forecast of the company sales in terms of both units and dollars (Ref: Eugene F. Brigham, Michael C. Ehrhardt - 2008 - Business & Economics - 1071 page, Accessed on 15th May 2010)
- Either the projected or pro forma, financial statement method can be used to forecast financial requirements. The financial statement method is more reliable and it's also provides ratios that can be used to evaluate alternatives business plans.
- A firm can determine the additional fund needed by estimating the amount of new asset necessary to support the forecasted level of sales and then subtracting from that amount the spontaneous funds that will be generated from operation. The firm can then plan how to raise the additional funds needed most efficiently.
- Adjustment must be made if economies of scale exist in the use of assets, if excess capacity exists or asset must be added in lumpy increments.
- Linear regression and excess capacity adjustment can be used to forecast asset requirements in situation where assets are not expected to grow at the same rate as sales.
Different sources of Funds available to a WAPDA to Raise the Mangla Dam for more water storage
Businesses, individuals and government often need to raise capital to invest in specific projects. For example, suppose WAPDA(Pakistan Water and power Development Authority) Need to Raise the Mangla Dam to increase its capacity of water storage. As the main purpose of Mangla Dam was to supply the water to Pakistan & Azad jummu Kashmir IrrigatedÂ areas. The WAPDA forcast the big increase in the demand of the water as More land need the water for growing different season's crops with the increase in the population. But WAPDA was not having the enough money to pay for this project.WAPDA will have to raise this capital in the financial market. Although equity, debt and preferred stock are the major sources of funds for the company to raised a capital.
Ability to borrow
A liquid position is not only way to provide for flexibility and thereby protect against uncertainty. If the WAPDA has the ability to borrow on comparatively short notice, it may relatively flexible. This ability to borrow can be in the form of a line of credit or a revolving credit from a bank or financial institution.
Bond is another option for the WAPDAto raise a capital for the investment in new project. In financial term a bond is a debt security in which the authorized issuer owes the holders a debt and, it's depend upon the terms of the bond, some bonds obliged to pay a certain amount of interest until the time of its maturity. A bond is a kind of formal contract to payback borrowed money with interest at fixed intervals. So issuing bond can be the one of source for the company to raise capital.
Leasing as an alternative to outright purchase, minimize cash outgoing and maximize the tax advantages. The lease can include such charges as maintenance, which enables the company to know, in advance, the total costs for the year. At the end of the lease period the company can return the asset, exercise its option to buy or negotiate a new lease on new equipment. Leasing mean that company can always have the most up-to-date equipment. The company may never own the good outright. However, if it wants to keep the equipment, it must take out a new lease or buy.
Alternatively organization can sell an asset to a financial institution and lease it back from them. This is termed sales and lease back. The advantage here is that the company receives an injection of cash and can spread the repayments over a number of years.
WAPDAÂ can use note payable method to raise a capital for its project. A promissory note, referred to as a note payable. Or can say commonly as just a NOTE, it is a contract where one party makes an unconditional promise in writing to pay a sum of money to the other party or can say company (payee) either at a fixed or determinable future time or on demand of the payee, under specific terms and conditions.
Common stock is another way to raised fund in form of WAPDA equity ownership. It is a type of security.
In case of common stock holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company's board of directors. Some holders of common stock also receive preventative rights, which enable them to keep their proportional ownership in a company. There is no fixed dividend will be paid to common stock holders and so their returns are undecided, dependent on earnings, company reinvestment, and proficiency of the market to value and sell stock.
Different Appraisal Methods for Investment
Net present value as a superior method of investment appraisal.
Net present value
- NPV is a precursor of how much value an investment or project adds to the firm. With a specific project, if return value is a positive value, then project is in the status of discounted cash inflow in the time of time. But if NPV comes in a negative value, the project is in the status of discounted cash outflow of time. Some time with positive value of NPV risk could be accepted
- A present value is the value now invested for the cash flow it could be negative value or positive value. The value of each cash flow is needed to be adjusted for risk and the time value of money for a project.
- A net present value (NPV) considers all cash flows that including initial cash flows for example the cost of purchasing of an asset, whereas a present value does not. The simple present value is useful where the negative cash flow is an initial one-off, as when buying a security.
A discount rate allied like this
NPV = CF0 + CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3...
Where CF 1 is the cash flow the investor receives in the first year, CF2 the cash flow the investor receives in the second year etc.
and r is the discount rate.( Ref: moneyterms.co.uk accessed on 11th May 2010)
The series will typically end in a visual display unit value, which is a rough estimate of the value at that point. It is usual for this to be adequately far in the future to have only a minor effect on the NPV, so as rough estimate, usually based on a estimation ratio, that is acceptable.
Periods other than a year could be used, but the discount rate needs to be adjusted. Assuming we start from an annual discount rate then to adjust to another period we would use, to get a rate i, given annual rate r, for a period x, where x is a fraction or a multiple of the number of years:
i + 1 = (r + 1)x
To use discount rates that vary over time (so r1 is the rate in the first period, r2 = rate in the second period etc.) we would have to resort to a more basic form of the calculation:
NPV = CF0 + CF1/(1+r1) + CF2/((1+r1) Ã-(1+r2)) + CF3/((1+r1) Ã-(1+r2) Ã-(1+r3))...
This would be tedious to calculate by hand but is fairly easy to implement in a spreadsheet
It will give the accurate decision advice assuming a perfect capital market. It will also give right ranking for mutually exclusive projects.
NPV gives an absolute value.
NPV allows for the time value for the cash flows.
It is very difficult to identify the correct discount rate in the given project.
NPV as method of investment assessment requires the decision criteria to be specified before the appraisal can be undertaken
In contrast of NPV there are other three methods of investment appraisal
- Pay back
- Internal rate of return
- Accounting rate of return
In business and financial side refers to the period of time required for the return on an investment to "pay back" the sum of the original investment.
- Payback period which dealings the time required for the cash inflows to equal the original expense. It measures risk, not return.
- It will give you exact period to pay back Loan or finance, Difference between Cash inflows and Outflows are also outlined
- The payback period is both theoretically simple and easy to calculate. It is also a seriously unsound method of evaluating investments.
- The payback period is the time in use to recover the initial investment or initial capital. So a £1m investment that will make a profit of £200,000 a year has a payback period of five years. Investments with a short-term payback period are favored to those with a long period. Most companies using payback period as a regular will have a maximum acceptable period.
The payback period has a number of serious flaws/Demerits:
- It attaches no value to cash flows after the end of the payback period.
- It makes no adjustments for risk.
- It is not directly related to wealth maximization as NPV is.
- It ignores the time value of money
- The cut off period is arbitrary.
To compensate for some of these deficiencies, one can adjust the cash flow by discounting the cash flow using the WACC and then calculating the payback period. This only really adjusts for the time value of money and it therefore does not address the other deficiencies of the payback period.
One justification for the use of the payback period is that it is conservative, as it values only short term returns which can be foreseen with reasonable certainty. However this argument does not really stand up to scrutiny; the NPV also adjusts for the uncertainty of future cash flows and does so correctly.
Simple to compute
Provides some information on the risk of the investment
Provides a crude measure of liquidity
It is not for very long financing, It doesn't deal with Time value of money so many times companies have to pay more than they actually acquire, Pay back period has limitations with Inflation as well, rise of inflation can cause serious damage to organization's finance. Interest rates are also not entirely covered, however we can calculate interest rate over pay back period, but it has some limitations. It makes no adjustment for risk as well.
INTERNAL RATE OF RETURN
- The internal rate of return that is called (IRR) is a rate of return that is used in capital budgeting as a tool to calculate and compare the profitability of investment in the project. It is also called the discounted cash flow rate of returnÂ or simply the rate of return that is called ROR
- The Internal Rate of Return is the discount rate that generates a zero net present value for a sequence of future cash flows. This basically means that IRR is the rate of return that makes the amount of present value of future cash flows and the final market value of a project that equal its current market value.
- Internal Rate of Return provides a simple ‘hurdle rate', whereby any project should be avoided if the cost of capital exceeds this rate. Usually a financial calculator has to be used to calculate this IRR, though it can also be mathematically calculated using the following formula
Internal Rate of Return is the flip side of Net Present Value (NPV), where NPV is the discounted value of a stream of cash flows, generated from an investment. IRR thus computes the break-even rate of return showing the discount rate, below which an investment results in a positive NPV.
It calculates Break-even, IRR calculates an alternative cost of capital including an appropriate risk premium. (Ref: www.scribd.com/doc/.../Capital-Budgeting-of-Canteen-Walaaccessed on 15th May 2010)
Academicians have long predictable the superiority of net present value (NPV) over internal rate of return (IRR), yet financial managers carry on to use IRR as a capital budgeting measure.
IRR cannot not be use to rate mutually exclusive projects, mutually exclusive are those where you have to choose one project not both. The IRR also cannot be use in the usual manner for projects that start with an initial positive cash inflow, like Deposit in Fixed account by Customer, intermediate cash flows are never reinvested or considered at the project's IRR, thus making IRR little edgy as compared to NPV
Accounting Rate of Return
In finance, and accounting, it measures the excess or shortfall of. Input the cash flows and a discount rate or discount curve and outputting
The accounting rate of return (ARR) is a very simple (in fact overly simple) rate of return:
Average profit ÷ average investment
As a percentage. Where average means arithmetic mean
The profit number used is operating profit usually from a particular project).
The average investment is the book value asset tied up. This is important as the profit figure used is after depreciation and amortization the means that value of assets used should also be after depreciation and amortization as well.
ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organization. It is rarely used by investors, and should not be used at all, because:
- Cash flows are more important to investors, and ARR is based on numbers that include non-cash items.
- ARR does not take into account the time value of money the value of cash flows does not diminish with time as is the case with NPV
- It does not adjust for the greater risk to longer term forecasts.
- There are better alternatives which are not significantly more difficult to calculate.
The accounting rate of return is conceptually similar to pay back, and its flaws, in particular, are similar. A very important difference is that it tends to favour higher risk decisions (because future profits are insufficiently discounted for risk, as well as for time value), whereas use of the payback period leads to overly conservative decisions.
Because ARR does not take into account the time value of money, and because it is wholly unadjusted for non-cash items, any method of selecting investments based on it is necessarily seriously flawed. Its only advantage is that it is very easy to calculate. It is fairly easy to construct (realistic) examples where it will lead to different choices from NPV, and the NPV led decision is clearly correct.
Considers the time value of money
Considers the risk of the project's cash flows (through the cost of capital)
No concrete decision criteria that indicate whether the investment increases the firm's value
Requires an estimate of the cost of capital in order to calculate the payback
Ignores cash flows beyond the discounted payback period
An efficient understanding of present value concepts is of great support in the understanding of a wide range of areas of business decision making. The concepts are particularly important in managerial decision making, since many decisions made today affect the firm's cash flows over future time periods for any project.
In this report I have only discussed how to take the timing of the cash flows into concern.
Risk and tax considerations must still be defined before the real-world decision maker has a tool that can be successfully applied. In addition, there are may be many qualitative factors that management wants to think before accepting or rejecting an investment. One another important thing is that NPV helps management in decision making for the approval and rejection of the project.
Financial ratio analysis is the computation and comparison of ratios which are derived from the information of the company's financial statements. We calculated different ratio's to analyze company's financial position. Ratios are shown below
Calculation of ratios for both years of Amber Lights Ltd, a high street fashion store
RETURN ON CAPITAL EMPLOYED (ROCE)
Capital employed is in general measured as fixed assets add current assets subtract Current liabilities and represents the long term investment in the business, or owner's capital plus long term liabilities. Return on capital employed is frequently regarded as the best measure of profitability.
ROCE = Net profit before tax & interest / Capital employed
Capital employed= total asset - current liabilities
LAST YEAR £
THIS YEAR £
ROCE = 22,000/144,000
ROCE = 35,000/142,000
Financial ratio analysis helps an organization to evaluate their employee performance, credit policies and also over all performance and efficiency of the company.
After doing ratio analysis of the company it tell us that how company is improving its performance gradually. Some of its ratios shows sudden increase in certain areas like return on capital employed which has increased in this year from 15% to 25% that shows the increase in profitability of a company. Its mean company is optimum utilising their asset to earn more profit.
In other words if we looked at ratio analysis of last year and this year which indicates that over all company performed well in this year that's mean company is efficiently utilising its asset and other resources they have minimised their liabilities. But overall the result of this year is better than the previous one.
Limitations of ratios
Following are the limitations of ratio analysis.
- The first and important limitation of the ratio category is Accounting information that means the different accounting policies which may misrepresent inter company comparisons. And secondly, through inventive accounting some accounts of the company are adjusted therefore, ratio analysis can give false explanations to the users.
- The second limitation of ratio is Information problems. The limitations problem in information are there because ratios are not ultimate measures, invalid information is presented in the financial statements, historical costs is not good for decision making, and ratios give general interpretations.
- Third form of limitation is Comparison of performance over the time. These limitations can caused by ratio analysis because of price changes, technology changes, changes in accounting policy and impact of organization size
- Many ratios are calculated on the basis of the balance sheet figures of the company. These figures are as on the balance-sheet date only and may not be suggestive of the year round position.
- It can present current and past trends, but not future trends.
- Impact of inflation is not properly reflected the ratios analysis , as many figures are taken at historical for of data that is several years old.
- The ratios are only as good or bad as the essential information used to calculate them.
In business strategy we emphasised on the role of the business environment in shaping strategic thinking and decision-making.
The external environment in which a business is operating can creates a lot of opportunities which a business can exploit, as well as threats that could damage a business as well. However, to be in a position to take advantage of opportunities or react to threats, a business needs to have the right resources and capabilities in place. After analysing The Amber LIGHTS LTD financial statement we recommend that company must focus on the resource auditing to identify the resources available to a business as well as best utilisation of the resources. Some of these can be owned e.g. plant, building and machinery, retail outlets whereas other resources can be obtained through partnerships, mergers or simply supplier arrangements with other businesses.
The resource auditing analysis helps to define the capabilities for AMBER LIGHTS LTD. An most important objective of a strategic auditing is to make sure that the business portfolio is strong and that business units requiring investment and management attention are highlighted.