Free «FMA: Investment Appraisal» Essay Sample

a) Critically evaluate the techniques that can be used to aid in deciding the best options.

Investment appraisal refers to the procedures employed by business firms in the assessment of capital projects before undertaking the investments (Watson & Head, 2013). The procedures help a business organization to determine the level of the returns that should be expected from a given project under a specified level of expenditure. Secondly, the investment appraisal procedures enable the business entity to estimate approximate future costs and benefits associated with the projects life. With regard to investment appraisal also called capital budgeting, the bottom line is that the investment projects considered often require hefty cash outflows and commitments. A good number of investment appraisal approaches or techniques can be employed to a project including NPV. These methods are discussed herein.

The non-discounted payback period helps to take the time that it would take before the company gets back the money spent on it. The method is based on the absolute values of the expected cash flows per period. The non-discounted payback period is described as the project’s measure of liquidity. Where the periodic cash flows happen to be constant, the non-discounted payback period is determined by diving the absolute amount of the initial investment with the periodic cash inflows. The decision rule with this technique requires the adoption of the project with the shortest PBP (Brealey, Myers, & Allen, 2014).

The non-discounted payback period technique of investment appraisal provides the management on the length of the period during which the funds are tied up in the project. This characteristic, due to its simplicity, makes it an attractive investment appraisal tool. However, the method is subject to the management estimations of periodic cash flows. Secondly, the method fails to consider the cash flow amounts after the payback period. Lastly, non-discounted payback period method does not consider or else ignores the time value of money concept. The latter weakness gives way to the second investment appraisal procedure, which is called the discounted payback period method.

The discounted payback period method happens to be similar to the above discussed method in approach and computation except for the fact that DPBP method takes into account the time value of money concept. This means that the DPBP addresses the inadequacies of the PBP method in that it recognizes that a unit of currency received today happens to be worth more than the one received in future. The payback period will therefore be a little bit longer when computed under the DPBP as opposed to that found under the PBP method. The decision rule and evaluation criteria are, however, the same in both procedures (Berk, 2013).

The third technique refers to the net present value (NPV) method. NPV solves the problems associated with PBP and DPBP methods including the fact that PBP and DPBP techniques are not put into consideration the cash flows after the payback period has been determined. The net present value of a specified project is determined by deducting the PV of initial cash outflows (cost) from the PV of all the expected cash inflows. The decision criteria for any project is that it should be adopted only if the obtained NPV is a positive value and where more than one project is involved into the adopted the projects so that the NPV values giving that with the highest NPV the first priority. Mutually exclusive projects adopt that with the highest NPV. However, the NPV technique has its weaknesses including the fact that the determination of the cash flows is based on estimates which makes it subjective (Nolop, 2012).

The fourth technique is the profitability index. The PI can be considered similar to the NPV. Both PI and NPV exhibit the same weaknesses. However, instead of subtracting the initial cost of projects like it is done with NPV, the PI requires that one divides the PV of cash inflows with the PV of the initial cost. The project should be taken into account only if the profitability index happens to be greater than 1. Among mutually exclusive projects, the one with the higher profitability index ought to be undertaken (McGuigan & Moyer, 2012).

The fifth technique is referred to as the internal rate of return (IRR). The internal rate of return gives the point at which the PV of the project’s cash inflows is equal to the project’s initial cash outlays (Ross, Westerfield, & Jordan, 2014). In other words, IRR equates the projects NPV to zero. The evaluation criteria or the decision-making criteria applied to IRR is that the project ought to be undertaken or accepted only if the computed IRR happens to be higher than the cost of capital; if the IRR is lower, the project must be dropped off the list. One key weakness of this method is that at times it may result in cases where there are multiple values for IRR or the computations fail to produce any IRR. Due to the two shortcomings mentioned above, the modified internal rate of return came into being. The key difference between the IRR and MIRR is that IRR implies that a project’s cash inflows get reinvested at the IRR while MIRR assumes that the cash inflows get reinvested at the business entity’s cost of capital while the initial cost outlays are covered at the firm’s cost (Parrino, Kidwell, & Bates, 2012).

b) Critically evaluate how the £1,700,000 can be raised and recommend three sources of finance justifying your reasons.

Biz Systems Consultants Ltd is a new consultancy firm with a number of possible sources of capital to finance its operations. The sources include the proprietors’ savings, debt capital, venture capital, donations, and issuing ordinary shares to the public. The above sources of capital have their advantages and disadvantages. This explains why one source of capital would be more preferable than others. This section recommends the use of proprietors savings, debt capital, and issuing of ordinary share as justified in the following few paragraphs.

Firms maintain a specified desirable capital structure. For corporations, the capital structure mainly comprises of the debt capital and capital raised through the issue of shares. The shares of capital may include ordinary shares and the preference shares as the main types of shares when raising capital. The capital structure may be a little different for sole proprietorship and partnerships to include savings made by the owners and reinvested in the business. Regardless of what components of capital are contained in the capital, the structure and the objective of the business entity will always stand to be maintaining the cost of capital at the lowest point possible. This is why this paper focuses on the savings, debt capital, and shareholder’s equity as the most appropriate sources of capital for Biz Systems Consultants Ltd.

When starting a business, one always considers the easiest and least expensive source of capital as well as the minimum possible cost of capital over the life of the business entity. At the starting point as is the case with Biz Systems Consultants Ltd, the lowest cost of capital will always be linked to personal savings. Before delving further into this discussion, it is of paramount importance to note that the use of personal savings is the path majorly taken by sole proprietorships and partnerships; when considered in the case of a corporate body, personal savings only get recognized to the point of the promotion of the company. The rationale in this statement is that the limited company operates as a separate legal entity with ultimate independence from its owners and promoters. That is why personal savings do not feature in a corporation’s capital structure.

With personal savings, the investor’s cost of capital is the required rate of return of the funds’ owner. The required rate of return could be higher than the interest rate on loans and even the required return by shareholders in case of issued share capital. However, the use of personal savings happens to be an attractive avenue simply because the savings have few or no obligations as the only available obligations are self-afflicted. For instance, when using personal savings, the maximum loss that the investor can suffer is limited to the amount of personal savings invested in the firm. In the case of other sources of capital such as loans, the loss happens to be unlimited as there exists periodic interest payments that persist as long as the repayments are not completed.

However, the proprietors may not be able to raise the required amount of capital which in this case amounts to £1,700,000 meaning that they have to consider other options. The limited capital happens to be the major reason why people choose to launch other forms of business such as partnerships and limited companies. The partnerships allow more capital input through the respective contributions of the partners. On the other hand, the limited companies access more capital from the public through the share capital to investors. Additionally, the partnerships and limited companies have a higher chance of acquiring debt capital than a sole proprietor. The following few paragraphs discuss in details the debt capital and issuance of share capital as sources of capital.

Biz Systems Consultants Ltd can opt to apply for a bank loan also known as debt capital. The cost of debt capital equals the interest charged on the loan in addition to the cost of processing the loan where applicable. In the case of Biz Systems Consultants Ltd, the cost of accessing or acquiring debt capital equals 5% which is the annual interest rate on borrowed funds as charged by the lender. When the borrower is a corporate entity, the use of debt capital will always be the easiest way because the cost of debt (kd) is usually lower than (ke+kr) the cost of equity; secondly, interest expenses happen to be tax deductible.

The use of debt capital represents a creditor’s claim on the assets of the business firm. This means that in many occasions, the lender will require the borrower to provide collateral and show that he has the capacity to repay the loan and interest. The business firm must also check the borrower’s ability to pay while the borrower must also be of good character. The last concern of the lender will always be the issued capital. However, this requirement applies to business entities with issued share capital; it assumes that the business entity is not allowed to reduce its capital which acts as the lender’s security just in case the borrower fails to repay the loan and the firm goes into liquidation. The factors discussed in this paragraph describe the 5C’s of credit which are used to assess the borrower’s credit worthiness.

The third option relates to issuing of share capital. This involves what is famously known as the shareholders equity. As a starting point, issuing share capital would require that Biz Systems Consultants Ltd establishes itself as a corporate body. The rationale in this requirement is that the entity can only issue capital if registered as a corporate body.

Issuing share capital also requires the business entity to publish a prospectus. The prospectus provides the prospective investors with the information on the operations of the business. According to this information, prospective and current investors can decide whether to invest in the business or not. While the prospectus should be god enough to attract the investors, the promoters of the company and the management should avoid being overly optimistic regarding the information provided. This is because the information in the prospectus is used by the investors to gauge the performance of the business entity. The other issue with regard to excessive optimism is that the business may be tempted to provide misleading information through the misrepresentation, which may result into legal liabilities.

With regard to a firm’s share capital, the firm may opt to issue preference shares in addition to ordinary ones. The preference shares get their name from the fact that the preference shareholders have special rights including cumulative dividends and the right to the firm’s assets on liquidation prior to the ordinary shareholders. As a source of capital, the preference shares happen to need a lower cost of capital than ordinary shares, which is the required rate of return, in that the preference shareholders are faced by lower risk than the ordinary shareholders. Nevertheless, a business entity cannot issue preference shares if it has not issued ordinary shares; for Biz Systems Consultants Ltd, it means that issuing preference shares fall off the grid leaving us with ordinary shares.

In an operational firm, shareholder’s equity generally contains the issued share capital and any amount of retained earnings. The retained earnings refer to the amount of profits that are not appropriate to the shareholders through the declaration of dividends. Under the ordinary circumstances, the retained earnings have a lower cost of capital than the ordinary share capital, but the cost of capital is often higher than the cost of capital required by debt holders. Irrespective of this, Biz Systems Consultants Ltd is starting; thus, it is assumed that not having any retained earnings means that this part of shareholders’ equity is not an appropriate source of capital leaving the firm with the ultimate source to be the issue of new shares.

Issuing new shares of capital is the most appropriate approach for Biz Systems Consultants Ltd. The company would be required to subdivide this capital into shares of equal value such as £10 per share. The £10 per share is the par value of the share; thus, the shares can be sold in the stock market. The process would require the management of Biz Systems Consultants Ltd to file the proposed issue of shares with the registrar of companies; after the registrar’s approval, the company sales the shares publicly. By issuing a new stock, the company has a higher edge in acquiring the required capital without many obligations other than the shareholder’s required return.

There are several advantages of issuing share capital that Biz Systems Consultants Ltd would enjoy choosing this option. One of the factors is that the firm would have an access to a wide pool of capital as provided by the prospective investors in the society in which the company operates. This gives the company the opportunity to raise £1,700,000. Secondly, shareholders’ capital is a long-term source of capital as compared to other sources of capital such as the debt capital which must be repaid with interest in periodic instalments over the life of the enterprise. For shareholder’s equity, the capital only gets out of the company on liquidation. This is because the reduction of shareholders’ capital is prohibited by the law.

In conclusion, there are various sources of capital that Biz Systems Consultants Ltd can use to source £1,700,000. The use of savings would be the cheapest source of capital, but then the proprietors may not be able to raise the required amount. The second option is the use of debt capital which would be more expensive than the use of personal savings and cheaper for 5% than shareholder’s equity. However, the use of debt capital would depend on the borrower’s credit worthiness; even then, there are very slim chances that a lender agrees to 100% financing. Lastly, Biz Systems Consultants Ltd can use shareholders’ equity as a source of capital by issuing new shares. This option provides the best opportunity of attaining the whole amount at the shareholders’ required rate of return, which stands at 7.5% per annum. By using debt capital, the firm will also be at a better position in that no periodic repayments are required. However, the issuing debt capital is regulated by the registrar of a company which means that he firm should be considering to ensure that it is compliant with all the requirements to be allowed to exploit the option.

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