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Financial Decision Making in Organizations

Introduction

Capital investment appraisal is very important to the United Kingdom public limited companies in the 21st century. The increase of competition has made companies more sensitive to projects that are profitable to the organization. An investment decision to be undertaken by the company will influence the growth of the firm in short and long run as well as affect the risk of the firm in continues growth. The firms in the Unites Kingdom are faced with various decisions which require huge investments of the companies’ funds. The decisions the firms face include replacement decisions, expansions and diversification of companies operations and expansion of the exiting business. All this has been brought by the fact competition is increasing in United Kingdom. Capital investment appraisal techniques have changed over time because of various factors such as existence of multiple projects that are mutually exclusive, independent projects and contingent investment. Inflation rates and other complexities have made investment decision making or evaluation techniques change over time (Haka, 1987).

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This has led to the development of various capital investment appraisal and management technique over time. Some of the investment appraisal methods that have been developed include: net present value, internal rate of return, profitability index, payback period and accounting rate of return (Arnold, 2008).

Organizations initially were using non- discounted cash flow methods i.e. payback period and accounting rate of return which are easy to use have short term effects, are cost effective but they do not take into consideration the time value of money. As inflation, became a source of problems in investment decisions management of various institutions thought it wise to change methods of evaluating investments( Ryan and Ryan, 2002).

Capital budgeting is the process through which businesses determine the relative strengths and merits of alternatives available. Capital Budgeting is the process businesses employ to determine priorities and plan capital spending on long-term projects requiring significant investment of capital. Since availability of capital is usually limited, careful evaluation of the alternative routes for productive investment is essential for meeting business objectives. Qualitative and quantitative analysis become necessary elements of capital investment decisions. They also have projects requiring different amounts of capital and with different financial projections. In comparing projects for possible authorization, companies use a ‘profitability index’. The index divides the present value of the cash flows expected from the investment (Pandey 2008). These methods are discussed below:-

Payback period method

The payback period was the most popular and widely used in evaluating investment projects among firms in the United Kingdom. The payback period can be defined as the number of years required to recover the original cash investment. The payback period is calculated as:

Payback = initial investment

Annual cash flows

This is for an investment with annual cash flows that is uniform. However those investments with uneven cash flows are calculated in a different manner. Usually it is calculated by adding up the cash flows annually until the total is equal to the initial investment outlet. Usually the payback period required by the firm is pre-determined and the work of the investment manager is to calculate the payback period of the project to be calculated. If it is equal to or less than what is required by the firm than the project Is acceptable and the maximum period that is accepted by the firm should be that payback period that is equal to the standard payback period as predetermined. The payback period method has many limitations which led to the development of a new payback period called discounted payback period (Pandey, 2008).

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The payback period does not take into consideration cash flows that is generated after the payback period. This means that it does not consider all cash flows generated thus ignores profitability (Ryan and Ryan 2002). It also serves as another setback of taking into consideration periods rather than cash flows because some projects may be rejected because if cash flows come later in their lives. In order to understand this case properly I shall consider the casuals generated from this case which are as follows:

Details 0 1 2 3 4 5 6
Initial investment (20,000,000) (2,000,000)
Sales revenue 20,000,000 36,000,000 37,500,000 40,000,000 25,000,000 10,000,000
Variable costs 12,800,000 22,400,000 24,000,000 25,600,000 16,000,000 6,400,000
Incremental fixed overhead 1,600,000 1,600,000 1,600,000 1,600,000 1,600,000 1,600,000
Marketing variable cost 1,600,000 2,800,000 3,000,000 3,200,000 2,000,000 800,000
Net cash flow (20,000,000) 4,000,000 8,200,000 8,900,000 9,600,000 5,400,000 3,200,000
Present value factor 1 0.87 0.756 0.659 0.572 0.497 0.432
Present value 20,000,000 3.478,000 6200,000 5852,000 5489,000 2685,000 1383,000

The payback period that will be calculated from this cash flows as calculated above will be as follows:

Payback Cumulative cash flow Discounted payback Cumulative cash flow
0 (20,000) (20,000 0 (20,000) (20,000)
1 4000 (16000) 1 3478 (16522)
2 8200 (7600) 2 6200 (10321)
3 8900 1100 3 6852 4459
4 9600 10,700 4 5489 1019
5 6400 5 2685 3704
6 3200 6 1383
Payback within 3 years Payback within 4 years

The payback period as per the traditional payback period is three years. Therefore the project is acceptable. As mentioned earlier the traditional payback period was found to have many short comings therefore a discounted payback period method was invented and in the case above the discounted payback period is 4 years. And as mentioned earlier the payback period for the project that is acceptable by the company is supposed to be three years. It means that the projects under consideration in this case are not acceptable as it is above the three years required by the company. The discounted payback period uses discounted cash flows. Thus it considers the time value for money. However it has also shortcomings of not considering all the cash flows after the payback period (Arnold, 2008). This calls for other methods which consider all cash flows.

Accounting rate of return

Another method that was usually used before the discounted cash flow method was accounting rate of return. This method is at times called return on investment. The method uses accounting profits to measure the investments. It considers profits after tax and the average investments. It is usually calculated as:

Accounting rate of return = average income

Average investment

In this case, since there is no tax it will be calculated as follows:

PROFIT & LOSS ACCOUNT DEPRECIATION
EBTDA 3000 p.a Net profit
Year
1 4000 3000 1000
2 8200 3000 6200
3 8900 3000 6900
4 9600 3000 6600
5 6400 3000 2400
1200 3000 -1800
6 68000 18000 19300

Average annual profit

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19,300/6 = 3217

Average investment is

(20000 + 2000)/2 = 11,000

Accounting rate of return = 3217/11000 = 29%

The rule for accepting rechecking the investment project under the accounting rate of return is accept those projects with hire accounting rate of return by the management. This method has many advantages and disadvantages. Among the advantages is that it is simple to understand and calculate as it uses accounting profits. It also uses all accounting information therefore does not suffer the weakness of avoiding some cash flows Ryan and Ryan 2002). However is suffers the following shortcomings:-

  • It ignores the time value of money
  • It uses an arbitrary cut off criteria presided by the management.
  • It uses profits in accounting data which arises from arbitrary assumptions.

In this projects the management has given a criteria of 30% therefore this project is not acceptable according to this method (Ryan and Ryan, 2002).

Net present value

Net present value is a method that uses discounted cash flows in determining the profitability of the project. Therefore it considers the time value of money. Discounting brings all cash flows to one point i.e. year 0 before they are comparing. The decision rule in the net present value criteria is that all projects with a positive net present value should be accepted because they enhance shareholders wealthy maximization objective. However in case of mutually exclusive projects and existence of constrains the project with the highest net present value should be accepted. The net present value method takes into consideration all relevant information relating to the project (Pandey, 2008).

The net present value requires that all the cash flows of investment to be forecasted in realistic manner and appropriate discount rate used to discount the cash flows( McLaney, 2003);. The net present value is calculated as follows:

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Net present value

Net present value

Where Ct is the cash flows from year 1 to year N.

K is the cost of capital

Co is initial investment

n is the expected life of the investment.

From the calculations shown in the table below the net present value for this project is calculated

Details 0 1 2 3 4 5 6
Initial investment (20,000,000) (2,000,000)
Sales revenue 20,000,000 36,000,000 37,500,000 40,000,000 25,000,000 10,000,000
Variable costs 12,800,000 22,400,000 24,000,000 25,600,000 16,000,000 6,400,000
Incremental fixed overhead 1,600,000 1,600,000 1,600,000 1,600,000 1,600,000 1,600,000
Marketing variable cost 1,600,000 2,800,000 3,000,000 3,200,000 2,000,000 800,000
Net cash flow (20,000,000) 4,000,000 8,200,000 8,900,000 9,600,000 5,400,000 3,200,000
Present value factor 1 0.87 0.756 0.659 0.572 0.497 0.432
Present value 20,000,000 3.478,000 6200,000 5852,000 5489,000 2685,000 1383,000

= 25088 – 20000 = 5058000

According to these criteria the project has a positive net present value therefore it is acceptable. Net present value suffers the following shortcomings.

  • The cash flow estimation may be difficult due to uncertainty.
  • The discount rte that is usually used as a measure may be arbitrary decided by the management.
  • Mutually exclusive projects usually posses a problem when their project lives are different when there is a constraint in their resources.
  • The ranking of projects under the net present value is usually dependent on the cost of capital used. If different cost of capital is used the decision may be reversed (Pandey, 2008).

However in this case there is only one project which does not require changes in cost of capital, cash flows and many others. This method is the most commonly used in the united kingdom by most companies (Graham & Harvey, 2001).

Internal rate of return

This method also relies on the concept of calculation of present values. The IRR determines the interest yield of the capital project at which the net present value becomes zero. Returning to the NPV calculation, we note that a discount rate, based on the needed rate of return of the business, determines the present value of future cash flows. In the case of IRR calculations, the reverse is true, the rate is calculated using the net future cash flows and the IRR is the rate at which the discount will bring the net cash flow to zero, i.e. the present value of the net cash flows and the investment required are the same. Where the IRR is greater than the expected return or the cost of funds the project is financially viable and projects with higher IRR are more viable (McLaney, 2003).

Calculation of the IRR requires two steps. The first step is to calculate the internal rate of return factor using the formula:

Return Factor = Capital Investment ÷ Net Annual Cash Flow

The next step consists of locating this factor in the ‘Present Value of an Annuity of 1’ table using the productive life of the capital assets for the number of periods. The discount rate corresponding to these axes is the Internal Rate of Return( McLaney, 2003).

Simpler method is to use spreadsheet software such as Microsoft Excel that allows direct calculation of the IRR from a table of projected cash flows.

The internal rate of return

Profitability index

Profitability index considers discounted cash flows and the initial cash outlay. It is calculated as:

Profitability index = present value of cash inflows

Initial cash outlay

The acceptance criteria is that accept the project with profitability index greater than 1 and reject the project with profitability index less than 1. Like other methods using discounted cash flows, it considers the time value of money (Graham & Harvey, 2001).

Non-Financial Measures

The use of non-financial measures then becomes the other supporting approach to capital budgeting. The shortcomings of the DCF analysis as an inability to capture the benefits of future growth and flexibility and concludes that for rational decision-making it is essential that these considerations find due importance in project evaluation (Myers, 1984). There should be integration of strategic cost management into capital budgeting using methods that consist of value-chain analysis, cost-driver analysis, and competitive-advantage analysis (Klammer 1993 and Shank and Govindarajan 1992). Therefore, there is need to understand a investment proposal from may different angles to determine its viability and future economic performance. Capital budgeting techniques discussed here and their merit cannot be detracted from since these are time tested methods (Shank and Govindarajan 1992).

Recommendations

Based on the analysis carried out in relations to this project the project should be accepted because it provides a positive net present value and an internal rate of return which is greater than the cost of capital. However, traditional methods have indicated the project should be rejected but in our case it should not be the case because traditional methods avoid a number of important issues that are related to evaluation of projects (Pandey, 2008).

References

Arnold, G. (2008); Corporate financial management; 4th ed.. – Harlow: Financial Times Prentice Hall.

Graham, J. & Harvey, C. (2001): ‘The theory and practice of corporate finance: Evidence from the field’. Journal of Financial Economics, vol. 60, pp. 187-243.

Haka, S. F. (1987): Capital budgeting techniques and firm specific contingencies: A correlational analysis, Accounting, Organizations and Society 12: pp: 31–48.

Klammer, T. (1993): Improving investment decisions. Management Accounting: 35–43.

Myers, S. C. (1984): Finance theory and financial strategy. The Institute of Management Sciences 14: pp: 126–137.

McLaney E., (2003); Business finance theory and practice; Prentice Hall ISBN 0-273-67356-4.

Pandey I M (2008); Financial management; Vikas Publishing House PVT ltd.

Ryan, P. A., and G. P. Ryan. (2002): Capital budgeting practices of the Fortune 1000: How have things changed? Journal of Business and Economics 8: 355–364.

Shank, J. K., and V. Govindarajan. (1992): Strategic cost analysis of technological investments. Sloan Management Review, Fall: 39–51.

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