Introduction
Gupta and Synn (2010) argue that, to increase the wealth of the firm, managers must use the correct evaluation models to identify the right project. This recommendation was put forward by various researchers to resolve problems that emerged after using traditional approach in evaluating projects. This particular proposal is aimed at factoring in floatation costs in the investment decision. This issue emerged because the traditional approach displayed superior cost of capital and maintained the cash outlay unchanged (Gupta and Synn, 2010). Therefore, researchers demonstrated a different method that corrected the problem identified through the assignment of a superior initial outlay because of flotation costs whilst holding cost of capital constant. As such, this paper will assess this particular approach.
Discussion
Several approaches can be used to assess the firm’s project, and each approach has distinct disadvantages and advantages. Based on the traditional approach, researchers identified that such an approach did not factor in floatation costs that are important in investment decisions (Gupta and Synn, 2010). The experts attempted to improve the existing formulas to include floatation costs. Floatation costs are important costs or cash outflows that a firm has to give out to issue shares or bonds. Therefore, these costs normally add to the initial costs of any project.
Projects are usually evaluated using the best technique. Mostly, the best technique involves NPV; any other project that integrates a positive NPV is accepted while the one having a negative NPV is rejected (Gupta and Synn, 2010). Thus, a firm must have the right cost of capital, which is normally used to discount the cash flows emanating from the project. The use of incorrect discount rate contributes in making the wrong decision by managers. This means accepting a project that could have been rejected and rejecting a project that has a positive NPV. When a firm uses wrong cash flows, the decision made by the management will also be wrong, this would contribute to loss of value for the firm and eventually the firm is not able to maximize the owners’ wealth (Gupta and Synn, 2010).
Managers ignoring floatation costs in the evaluation of the project end up accepting all projects as many researchers have indicated in their study. This is because the initial cash outlay and the cost of capital are understated. To avoid this, any manager evaluating investment project should include floatation costs because they are relevant in decision-making (Gupta and Synn, 2010). Traditionally, the formula involved floatation costs in calculating individual cost of each sources of finance such as debt, preferred stock, and common stock (Gupta and Synn, 2010). However, this formula did not factor in the floatation costs in the cash outflow contributing the wrong financial decision.
Based on the example provided by authors, exclusion of the floatation costs in cash flows led to accepting the project that should have been rejected whilst rejecting a project that ought to be accepted (Gupta and Synn, 2010). For these reasons, the experts attempted to include floatation costs in the cash flows estimation to correct the problem. The inclusion of the floatation cost in the initial cash outflows solved the problem and reversed the management decision. As such, researchers were able to solve the problem identified in the traditional formulas leading to a correct financial decision.
Conclusion
The opinion is that, managers should incorporate floatation costs in the calculation of the cash outlay to make the right decision. Continued use of traditional formula has a financial risk and will contribute in making wrong decisions leading to reduction of the shareholders’ wealth.
Reference
Gupta, N., & Synn, W. (2010). Valuing investment decisions: Flotation costs and capital budgeting. Journal of Business & Economics Research, 8(2): pp. 73-78.