Term Paper on "Corporate Finance Investment Assessment Questions a Business"

Term Paper 7 pages (2676 words) Sources: 8

[EXCERPT] . . . .

Corporate Finance

Investment Assessment Questions

A business will have a number of choices to make regarding investments. In any commercial environment, even the richest of firms will not have unlimited capital for investment; each investment undertaken is likely to be at the cost of any potential alternate investment. This means a firm has to make decisions to assess which investments are likely to offer the greatest return for the firm. The way the firm appraises the investments and chooses which to pursue and which to reject will have a direct impact on their financial performance. Therefore, it is important that the processes used to assess the potential investments are able to add value to the firm.

Different firms may use different assessment techniques; these may include general assessment and the use of gut feelings, assessment processes may also include other approaches such as pay back period and discounted cash flow models including net present value (NPV) and internal rate of return (IRR) (Cooper at al, 2011, p20; Bennouna et al., 2010, p225). While there may be a discussion regarding which method is superior, different firms may value differing models based on their own situation. The key in understanding how an assessment can add value to a firm is to look at the way assessment may lead to a better decision making process which helps to optimize either the desired returns, or further the organizational goals.

For every investment chosen there is likely to be an associated opportunity cost (Heymann and Bloom, 1990, p7). An opportunity cost is the loss of return from an investment which cannot be made when the capital is used elsewhere. An investment in one project may use the capital which would otherwise be invested in an alternate project. By assessing the potential direct and/or indirect returns a company may choose the option which gives them the best return. This means that the rejected project has a lower return, the company has minimized the opportunity cost as the opportunity cost is the return which will not be realized following the investment choice (Heymann and Bloom, 1990, p7). By assessing the different choices value may be created by minimizing this opportunity cost. Theoretically, if no assessment were taking place, it would be possible that the firm would not choose the optimal investment, demonstrating the way in which value is added.

It may also be argued that further value may be created by taking into account the specific situation of a company, and balancing the different requirements to meet organizational strategies. If an organization needs rapid cash flow, short-term investments with a fast payback period may be more beneficial than more valuable projects which will require a higher level of investment and take longer to provide the needed cash flow. Decisions may also influenced by the amount of capital which is available, or terms and conditions associated with different sources of capital that may be used for various projects. Therefore, an assessment will not only consider which investments may be the most valuable, there will also provide a framework by which the investments which are most suited to the specific company needs may be identified. The processes may sometimes be flawed, but without an assessment process there is a greater potential that non-optimal strategies will be pursued, therefore, by implementing processes which reflect the firms needs, strategies and goals value is created with the ability of the firm to choose optimal, or at least better investment choices compared to a position where no assessment takes place.

Part B

The way assessment take place may vary, three which are often seen are the playback period, NPV and the IRR. Looking at two potential investments, the way these are used may be demonstrated. Each project will be examined using the three methods in order to determine which may be the best for the firm.

Payback period

The payback period assessment is one of the most simple. This method simply takes the net revenues of the project, looking at the accumulated total to determine at which point the initial investment is recouped (Weetman, 2010, p263). This is initially assessed on an annual basis, where the repayment of the initial investment takes place during the year, the revenue for the year is usually assumed to be earned evenly over the year, allowing the assessment to determine the point in the year the payback is achieved (Weetman, 2010, p263).

Project a

Table 1 Payback period for project a

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Revenue

-18,000

4,500

4,500

4,500

4,500

4,500

Accumulative total

-18,000

-13,500

-9,000

-4,500

0

4,500

This shows that the payback is achieved at the end of the forth year for project a

Project B

Table 2 Payback period for project B

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Revenue

-27,000

6,500

7,000

8,500

7,500

6,000

Accumulative revenue

-27,000

-20,500

-13,500

-5,000

2,500

8,500

This shows that the break even point is at some point in year 4. To assess this in detail the surplus over the initial investment is divided by the amount earned that year giving 2,000/7,500 = 0.3333. This is the proportion of the year which the firm was earning over the initial investment, converting this into months it is 0.285714 x 12 = 4. Deducting this from 12 months gives 8 months, so the payback period is 3 years 8 months.

Net Present Value

The net present value method is a discounted cash flow (DCF) method, which takes the future net cash flows of a project or investment and then discounts them into today's terms to allow for the time value of money (Weetman, 2010, p267). Then question in using this approach is to determine the most appropriate rate of return. An appropriate approach is to use the weighted average cost of capital (WACC), as this is the cost of the money to the firm. Each year's net revenue is calculated, taking the future value, which is the project net revenue and calculating a present value (toady's value) by discounting the value at the given discount rate. After calculating each years' net revenue in present value terms, they are added together and the initial investment is deducted. The equation which may be used is PV = FV / (1+r) n (Kruschwitz and Loeffler, 2005, p80). Here FV is the future value, PV is the present value, r is the discount rate and n is the number of years in the future the revenue occurs (Kruschwitz and Loeffler, 2005, p81). The percentage for the discount rate is shown as a decimal, so 10% is 0.1, 14% would be 0.15 etc. (Kruschwitz and Loeffler, 2005, p81). Alternatively a division may be used, where the discount factor is calculated for each year which is then used to multiply the net revenue for each year. The latter approach will be used in this paper. Both projects use the discount rate of 11.5%.

Project a

Table 3 NPV for project a with 11.5% discount rate

Year

Profit

Discount Rate

Discounted Cash Flow

Accumulative Total

Year 1

4,500

0.89686099

4,036

4,036

Year 2

4,500

0.80435963

3,620

7,655

Year 3

4,500

0.72139877

3,246

10,902

Year 4

4,500

0.64699441

2,911

13,813

Year 5

4,500

0.58026405

2,611

16,424

Less initial investment

18,000

NPV

-1,576

This shows that will a discount rate of 11.5% the net present value of the project is -1,576.

Project B

Table 4 NPV for project B. At 11.5% discount rate

Year

Profit

discount rate discounted cash flow

Accumulative total

Year 1

6,500

0.896861

5,830

5,830

Year 2

7,000

0.80436

5,631

11,460

Year 3

8,500

0.721399

6,132

17,592

Year 4

7,500

0.646994

4,852

22,444

Year 5

6,000

0.580264

3,482

25,926

Less initial investment

27,000

NPV

-1,074

This shows that with a discount rate of 11.5% the NPV of the project is -1,074.

Internal Rate of Return

The internal rate of return is based in the use of discounted cash flows with the aim of assess the actual rate of return created by the investment. A key assumption is that money will be reinvested at the same rate. To calculate this, the use of an NPV calculation and then a negative calculation assuming the first was positive, or positive where there was a negative, is used with the following equation

Lower rate of interest or discount rate + (positive value / difference between positive value and negative value x lower discount or interest rate) = IRR

In both cases the rate of 2% is used to create a positive value using the same process above, this gives project a a positive value of 3,211 and for project B. A positive value of 6,471. These are used in the calculation shown below. As the calculations are reversed the IRR will be negative.

Table 5 IRR for Project a

Lowest interest rate

Positive value

Difference between positive and negative

IRR

2

3,211

-4,786

-0.66%

This gives an IRR for project a of -0.66%

Table 6… READ MORE

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