Capital Investment - Management accounting PDF

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CW2 CAPITAL INVESTMENT

1) Introduction Capital investment appraisal is a technique used in analyzing an investment into a new project. Through a case study of Ridley Company Limited, it tries to provide an analysis into various aspects of investment appraisal. It provides a critical evaluation of net present value covering positive and negative sides of NPV. Similarly, it gives an insight into uncertainties the company faces in the project and also provides an overview of activities that can be taken to reduce uncertainty. On the same way, it provides a critique on the use of 100% debt financing covering good and bad sides of debt financing. 2) Critical evaluation of net present value as a key tool of capital investment appraisal Capital investment appraisal is a capital budgeting tools facilitating in the determination of short term and long term value of capital investment decision. Payback period, net present value, internal rate of return and accounting rate of return are capital budgeting tools. Among different types of capital investment appraisal tools, NPV is the most popular and widely used by all types of companies across the world. Net Present Value is a capital budgeting technique showing how an investment project affects the firm’s wealth in present value. Maximization of shareholders’ wealth is a key goal of management. The project with positive NPV should be accepted as they enhance the wealth of shareholder’s. In recent time, usage of NPV has increased by heavily among in making an investment decision in a new project. 2A survey conducted by Payne (1999) shows that 75% of the companies sampled use NPV method. Similarly, 3Arnold and Hatzopoulos (2000) have shown through hi study that 80% of the sample companies from the UK uses NPV for making a capital investment decision. On the 1

1 https://efinancemanagement.com/investment-decisions/investment-appraisal-techniques 2 http://ijiset.com/vol2/v2s2/IJISET_V2_I2_62.pdf 3 https://www.sciencedirect.com/science/article/pii/S0970389617300587

same way, 4a study conducted by Bennouna and Merchant (2010) predicted that more than 94% of the Canadian firms use NPV. It is used as an investment planning tool to evaluate the profitability of a new project or investment venture. Positive net present value denotes actual earnings of a project exceeding anticipated costs. An investment has a positive NPV is profitable, and an investment with a negative NPV will represent a net loss. 5 Ogundele & Awomewe,(2008), describes NPV as a different present value of cash outflow and cash inflow. In other words, it refers to the investment project present value minus initial investment. Under NPV, cash flow of companies is discounted to present value by use of the required rate of return. An estimation of the NPV for a project needs to cover the measurement of future cash flow of a project by discounting to obtain an acceptable present value after deduction of the initial cost associated in the commencement of the project. 6According to Drury,(2004), rule of thumb associated with NPV, is that NPV of a project with positive net present value is acceptable. NPV encompasses inflation rate and returns in comparing the value of the project today to value of a project in future. 7The study conducted by Bhandari, (2009), indicates that the key factor making NPV as the best technique is a measurement of profitability, adjustment of risk, consideration of all cash flow and adjustment of the time value of money. 8 His study was supported by Sony, (2006), by stating that NPV considers the time value of an investment with discounting of cash flow. In an investment project, the time value of money affects the flow of future cash flow. Ignorance of it can lead to generating imbalance return on investment as a project needs to be adjusted with a change in various macroenvironmental factors.

Key benefits underlying is that computation of NPV is not affected by noncash expenditure such as amortization and depreciation. Other capital 4 https://himolde.brage.unit.no/himolde-xmlui/bitstream/handle/11250/2629798/master_anobil.pdf? sequence=1&isAllowed=y 5 https://edepot.wur.nl/178383 6 https://edepot.wur.nl/178383 7 https://www.grin.com/document/355210 8 https://edepot.wur.nl/178383

investment appraisal techniques are largely affected by the change in noncash expenditure over a period of a project. In contrary, other capital investment appraisal tools ignore cash flow in determining the future value of a project. An inclusion of discount rate covers the real cost of capital. All the cost occurring are adjusted with a change in the interest rate in the market. Moreover, it also supports in determining the impact of debtequity ratio in the future value of the project. High ratio of debt over equity affects the future course of a project and possible future investment. Similarly, the effect of equity position is seen in the future value of a project. Despite, NPV is very popular among many businessman and organization, there are certain drawbacks associated with its application. Inconsistent behaviour in the usage of NPV makes it less relevant to all types of business organization. 9Oehmke,(2000), has criticized NPV on being highly dependent on the discount rate. An increase or decrease in discount rate leads to affect the value of NPV. If the discount rate falls, NPV also decreases and if the discount rate increases, NPV also increases. It makes NPV irrelevant in evaluating a highly risky project and underestimates all types of investment project. Political risk, market risk and operational risk affect the future value of NPV. Another major challenge can arise in the selection of a discount rate. There are various types of discount rates available in the market and organization often fails in a selection of the right discount rate. With a likeliness of less relevancy for large projects, it is more likely to be replaced by other techniques in investment decision in future. Although, this method has many drawbacks associated and often makes complication is analyzing large projects. It is widely popular and exceeds other budgeting techniques in many areas. Thus, it can be considered as a key tool in analyzing an investment project.

3) Discussion on possible uncertainties involved with the new project 9 http://econmodels.com/upload7282/7e99146c988b4ab076c60355a8e19e08.pdf

Spahr,(2007) defines uncertainty and risk as a common element in an investment in a new project. Future is risky and is surrounded with many unforeseeable future circumstances. In fact, there is a high likeliness of occurrence of facing uncertainty. The business cycle, inflation and operational practice affect the project. Uncertainties can be defined as a situation where expected outcomes cannot be achieved. With an investment in a new project, Ridley Company Limited is surrounded by huge uncertainty and risk. A key factor contributing to the uncertainty are organizational structure, leadership, economic condition, government regulation and environmental factor. Likewise, change in technology and change in consumer demand affects the project future outcome.

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Blatt, (1979) has categorized types of uncertainties for a new project into political uncertainty, operational uncertainty, market uncertainty, financial uncertainty and technology uncertainty. Since then, various types of uncertainties has evolved in the business and investment world.

Poliitcal uncertainty Operational uncertainty Financial uncertainty Market uncertainty Technological uncertainty Figure 1: Uncertainties faced by Ridley Limited Company

10 https://www.tandfonline.com/doi/pdf/10.1080/00137918108956052

Market uncertainty is an uncertainty occurring from changes in market condition. The business market keeps on changing over time and it's really hard to control them. 11Patrick Slovik, has stated that Interest rate fluctuation, exchange rate fluctuation and recession are major types of market uncertainties. Such that can be faced by Ridley’s new project venture. In fact, an increase in the interest rate on loan and decline on demand for a product affects the company. A rise in interest rate will force the company to set a larger amount of fund for payment of debt and will lead to a decline in working capital for running the business. Operational uncertainty is the type of uncertainty encountered by an organization in running a business. The business environment holds a huge impact on various operational activities of the firm. 12The study conducted by Wilkinson,(1998) says that such types of uncertainties are at extreme in a newer project. The operational risks that might take place for the project are process risk and people risk. Difficulties in managing various types of employee and the manufacturing process affect Ridley Limited. Likewise, ineffective management of the project affects the project. 13 PIlania,(2011) has told that Technological uncertainty affects the project in a large way. Obsolesce of equipment and development of newer and advanced technology affects the productivity of the project. Likewise, the inability of a firm to select appropriate resources might affect the project.

Stockhammer,(2000) relates to financial loss faced by the firm. It largely affects income and shareholders value. If Ridley does not generate good returns for investors, the project might be in a jeopardized situation. It holds a greater impact on the income-generating ability and future endeavour of the firm. 14

11 https://www.bis.org/ifc/events/5ifcconf/slovik.pdf 12 https://www.academia.edu/14105938/Empowerment_Performance_and_Operational_Uncertainty_A_Theoretical _Integration 13 https://www.researchgate.net/publication/287237628_Technological_uncertainty_Exploring_factors_in_indian_sta rt-ups 14 https://www.researchgate.net/publication/23733022_Financial_Uncertainty_and_Business_Investment

Pastor and Veronesi,(2011), has mentioned that political uncertainty arise from unexpected political changes in an economy. It impacts sales, operation and overall project causing loss of millions of dollars. Rising geopolitical tension among economies and Brexit issue are a major political factor that affects the project. Besides these uncertainties, Ridley can face various types of uncertainties such as credit risk and liquidity risk. Credit risk takes place when it is unable to pay interest on debt on a regular interval to the lenders. As it 100% financed by debt, there is a high likeliness of facing credit risk. Liquidity risk relates to the inability of the firm in meeting short term obligation. It takes place as a result of weak sales and poor management of the company. These uncertainties affect the project in large scale and must be dealt with strategically. In modern time most of the project is affected by all these factors at some scale. Application of various types of strategy can help in overcoming uncertainty. Ridley must keep an eye on changes taking place in the macro and microenvironment of the project.

4) Discussion on action Ridley to reduce risk for increasing shareholder value

Risk analysis offers Ridley Corporation better information on overcoming risk that might take place and affect the investment project. Since risk can be costly to the firm, it should use an effective strategical move. Risk can be defined as an occurrence of variability between actual return and expected return. Techniques Ridley can use to reduce risk can be classified into conservative methods and modern methods (a) Conservative methods It includes risk-adjusted discount rate, shorter payback period and certainty – equivalent coefficient approach. (b) Modern methods It covers decision-tree analysis, probability analysis and sensitivity analysis.

Conservative Method

1. Shorter Payback Period 15

Payback period can be either shorter or longer one. Identification of a shorter payback period with a combination of “cut off period” leads to risk tolerance level for the firm. It can reject the project if cut off period is smaller than the payback period.

2. Risk Adjusted Discount Rate 16

Under it, an adjustment is made to discount rate with the degree of risk. Variance can be seen in the risk discount factor in accordance with the project and the amount of risk. It will be used along with NPV, if NPV is positive is less risky and if NPV is negative project is highly risky.

15 https://www.accountingtools.com/articles/2017/5/17/payback-method-payback-period-formula 16 https://www.myaccountingcourse.com/accounting-dictionary/risk-adjusted-discount-rate

M o d e Cr no nm s e tr hv ao tdi

Shorter payback period Risk adjusted discount rate Certainty-equivalent coeffici ent approach

Decision Tree Simulation Analysis Sensitivity analysis Scenario analysis

Figure 2: Techniques for overcoming uncertainties

3. Certainty-Equivalent Coefficient Approach Under this method, the project risk level will be created by adjusting the discount rate and expected cash inflow. When the value of the coefficient is below 0, the project is less risky and if the value is between 0 and 1, the project is highly risky.

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17 https://www.jstor.org/stable/3665777

(i) Modern methods (a) Sensitivity Analysis It shows information about the cash flow of a project into three assumptions: most likely, pessimistic and optimistic. It offers precise insight into variability into a return of project and degree of risk. Similarly, it shows how cash flow changes in the above circumstances. High difference between optimistic and pessimistic cash flow tends to be riskier. This technique is widely used by a large and small organization in analyzing new project. Ridley Ltd can use it to analyze the performance of various variables used in the project and there in turn impact on the project outcome. Especially, it can be used in analyzing the relationship of input variables such as raw materials, manpower and budget with the outcome of the project.

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(b) Scenario analysis 19 It is the process of predicting the future value of the project on the basis of changes observed in independent variables. This technique is mostly used in understanding the worst-case scenario and the unfavorable scenario of the project. Ridley can use it in determining favourable and unfavourable scenario of the project and invest in resources to offset the situation. risk can be categorized into their degree of impact from less risky to high risk. After the identification of risk, it can formulate the necessary strategic actions. 18 https://www.edupristine.com/blog/all-about-sensitivity-analysis 19 https://www.sciencedirect.com/topics/earth-and-planetary-sciences/scenario-analysis

(c) Simulation analysis: 20 It is used in predicting the outcome of various independent variables into the project future event. It can be defined as the technique in understanding uncertainty and predicting their impact on the project. As the new project is likely to face various uncertainties, it acts as a key tool for the firm. It can be used in estimating resource shortage, cost overrun, and quality of the project.

(d) Decision Tree Analysis It is another technique used in tackling risk and uncertainty in investment in the project. It provides a graphical relationship between future events and decision at the time of investment. Under it, risk and current actions are shown through pictorial representation in the form of a tree. Through it, the company present various types of risk and project estimation into one pictorial graph and depict an interrelationship between them. It allows the company to depict the possible future of a project and overcome uncertainty and enhance shareholder value.

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Thus, by a selection of best techniques, Ridley can increase shareholder value and reduce risk. But, it needs to apply the best techniques that fit with the nature of the project and the ability of the company.

5) A critique of the main issue on using 100% debt financing Financing refers to the process of raising funds for an organization. Debt and equity are the two major types of financing companies can choose. Ridley Company has borrowed £38 million for investing in the new project through subsidized loan and from normal borrowing sources. It has borrowed 60% of the fund from subsidized loan and 40% of them from other normal borrowing sources. The company has chosen debt financing 20 https://www.investopedia.com/terms/m/montecarlosimulation.asp 21 https://www.pmi.org/learning/library/decision-tree-analysis-expected-utility-8214

as a major source of finance for the new project. 22Debt financing means borrowing funds from a third party, i.e. banking and financial institutions. Major sources of debt financing include trade credit, loan, bonds and assetbased lenders. Debts are the most widely used method of financing for a firm. Organization usually borrows funds from commercial banks through keeping collateral. Such loans can take for a short term, mid-term and long term. New business and smaller companies choose it as a source of running and maintaining a business. The firm has been relying on loans from banks for operating and running a project on a primary basis. Major advantage underlying in the use of debt has attracted company in the borrowing of funds. A central advantage associated with the selection of debt is related to cheapness to borrow fund. Compared to other financing sources, it can easily borrow fund at cheap rate from banks and others. Leading to these factors, Ridley Limited has relied on 100% debt financing. Another key advantage relates to interest rates. Lower rate of interest on borrowing funds from banks compared to other sources offers a huge cost advantage to the firm. Similarly, the tax advantage is another advantage arising to the organization from debt financing. Free cash flow is very important for an organization on running a business, the existence of debt reduces wastage occurred in operating business. Likewise from the perspectives of operation, it is cheaper for the organization to finance with debt over equity. On the other hand, 100% of debt financing has lots of darker sides that may impact business performance. Interest needs to be paid on regular interval to the lenders and payments of interest is associated without the flow of funds. Steady cash flow is needed in business operation and payment of principal and debt might forego adequate working capital. It can get into bankruptcy by extremely relying on debt in the situation to meet the loan repayment. Enron can be taken as a great example of how higher debt structure puts the company into bankruptcy. Moreover, the future growth of the company can be affected by market perspectives. Investors and customers judge business mostly by analyzing the solvency ratio. From the perspectives of solvency ratio, a higher debt-equity ratio is not good for the company. A 22 https://economictimes.indiatimes.com/definition/debt-finance

higher proportion of debt indicates that creditors have higher claim over the owner on the business. A decline in value of assets for the firm over the time puts a risk on a fund for lender and shareholder. High reliance on 100% debt financing is better from short term perspectives, but it cannot fully freely rely on debt for financing business for a long time.

It is hard to state whether 100% of debt financing is good or bad for the company. Finding a balance between debt and equity financing is most. Most of the organization employs a weighted average cost of capital in determining the percentage of equity and debt. Similarly, general economic condition, operating decision and market conditions must be considered as well in the selection of financing. It needs to find an optimal balance in the capital structure to avoid the higher cost of capital and minimize business risk. But macro and micro environmental factors affect a selection of o...