Operation Management
The Financial Feasibility Analysis of a Project Process
Nature of capital investment: Capital investment is essential for the long-term survival of a business. Existing fixed assets, for example, will wear out and need replacing. The capital investment decision operationalises the strategic, long term plans of a business. The following table shows, long term capital expenditure decisions can be distinguished from short-term decisions by their time span, topic, nature and level of expenditure, by external factors taken into account and by the techniques used.
Characteristics | Short-Term | Long-Term |
1.Time span 2.Topic 3.Nature 4. Level of expenditure 5. External factors 6. Sample techniques | Maximum 1 to 2 years, mostly present situation Usually concerned with current operating decision, e.g., discontinue present product Operational Small to medium Generally not so important. Contribution analysis, break-even analysis | Upwards from 2 years Concerned with future expenditure decisions, e.g., build new factory. Strategic Medium to great Very important, especially interest rate, inflation rate. Payback, accounting rate of return, NP, and IRR |
Figure: Comparison of short-term decisions and long-term capital investment decisions.
Assumptions in capital investment decisions: A big problem in any capital investment decision is the assumptions that underpin it. Can we think of any of these?
- Costs of initial outlay.
- Tax effects
- Cost of capital
- Inflation
- Cash inflows and outflows over period of project. These, in turn, may depend on pricing policy, external demand, value of production etc.
Capital investment appraisal techniques: The 4 main techniques used in capital investment decisions are payback, accounting rate of return, NPV, and IRR. An overview of these 4 techniques is presented in following table.
Feature | Payback | ARR | NPV | IRR |
Nature Ease of use Takes time value of money into account Main assumptions Focus | Measure time period in which cumulative cash inflows overtake cumulative cash inflows Very easy No Value and volume of cash flows Cash flows | Assesses profitability of initial investment Easy No Reliability of annual profits Profits | Discounts future cash flows to present May be difficult Yes Value and volume of cash flows, cost of capital Cash flows | Determine the rate of return at which a project breaks even Quite difficult Yes Value and volume of cash flows, cost of capital Cash flows |
Figure: Four main types of investment appraisal techniques.
Each of the four capital investment appraisal techniques is examined using the information in following figure;
Illustrative example of an ABC financial service company wishing to invest in a new on-line banking service.
The ABC Financial Service Company Ltd. is contemplating launching a new on-line banking service, called Falcon. There are three approaches, each involving $20,000 initial outlay. In this case, cash inflows can be taken to be the same as profit. Cost of capital 10%. | |||
Year Cash flows | Project A | Project B | Project C |
0 (i.e. now) 1 2 3 4 5 | $ (20,000) 4000 4000 8000 6000 6000 | $ (20,000) 8000 6000 6000 3000 2000 | $ (20,000) 8000 8000 6000 6000 3000 |
Payback Period: The payback period is a relatively straightforward method of investment appraisal. It simply measures the cumulative cash inflows against the cumulative cash outflows until the project recovers its initial investments. The payback method is useful for screening projects for an early return on the investment. Ideally, it should be complemented by another method such as NPV (Net Present Value).
Payback using ABC Financial Service Company Ltd.
Year Cash flows | Project A | Project B | Project C |
0(i.e. now)COF CCI 1 2 3 4 5 Payback year | $ (20,000) 4000 8000 16000 22000 28000 3.67 years | $ (20,000) 8000 14000 20000 23000 25000 3 years | $ (20,000) 8000 16000 22000 28000 31000 2.67 years |
Specific advantages of payback:
- Easy to use and understand.
- Conservative.
Specific disadvantages of payback:
- Fails to take into account cash flows after payback
- Does not take into account the time value of money
Accounting rate of return: ARR is capital investment appraisal method which assesses the viability of a project using annual profit and initial capital invested. We can define it as;
Average annual profit before interest and taxation
ARR= -------------------------------------------------------------
Initial capital investment
Year Cash flows | Project A | Project B | Project C |
0 (i.e. now) 1 2 3 4 5 Total Average profit ARR is therefore; | $ (20,000) 4000 4000 8000 6000 6000 28,000 $28,000 5 years = 5,600 $5,600 $20,000 =28% | $ (20,000) 8000 6000 6000 3000 2000 25,000 $25,000 5 years = 5,000 $5,000 $20,000 =25% | $ (20,000) 8000 8000 6000 6000 3000 31,000 $31,000 5 years =6,200 $6,200 $20,000 =31% |
We would therefore, choose project C, bcz. ARR is highest.
Note: In this case, cash inflow equals net profit. This will not
always be the case.
Specific advantages of ARR:
- Tales the whole life of a project
- Similar to normal accounting ratios.
Specific disadvantages of ARR:
- Many definitions of profit and capital investment possible.
- Does not consider the time value of money.
Net Present Value (NPV): The net present value and internal rate of return (IRR) can be distinguished from the payback period and accounting rate of return because they take into account the time value of money. Essentially, time is money. Fortunately, we do not have to calculate discount rates all the time! We use discount tables. So to obtain a 10% interest rate in two year’s time, we look up the number of years (two) and the discount rate (10%). We find a discount factor of 0.8264.
When using the net present value, it is useful to follow the steps laid out as follows;
- Calculate initial cash flows
- Choose a discount rate (usually given), normally based on the company’s cost of capital.
- Discount original cash flows using discount rate.
- Match discounted cash flows against initial investment to arrive at net present value.
- Positive net present values are good investments. Negative ones are poor investments.
- Choose the highest net present value. This is the project that will most increase the shareholders wealth.
Specific advantages of NPV:
- Looks at all the cash flows.
- Takes into account the time value of money
Specific disadvantages of NPV:
- Estimation of cost of capital may be difficult
- Assumes all cash flows occur at end of year.
- Can be complex.
Internal Rate of Return (IRR): The IRR represents the discount rate required to give a NPV of zero. It pays a company to invest in a project if it can borrow money for less than the IRR. Moreover, the internal rate of return is a more sophisticated discounting technique than NPV. It can be defined as the rate of discount required to give a net present value of zero. Another way of looking at this is the maximum rate of interest that a company can afford to pay without suffering a loss on the project. Projects are accepted if the company’s cost of capital is less than the IRR. Similarly, projects are accepted if the company’s cost of capital is higher than the IRR. The advantages of the IRR are that it takes into account the time value of money and calculates a break-even rate of return. However, it is complex and difficult to understand.
Figure: IRR as applied to the ABC Financial Company Ltd.
Relationship between the NPV and IRR
The management of working capital and sources of finance:
Sources of finance are vital to the survival and growth of a business.
Short – term and long – term sources of finance are normally matched with current assets and long term, infrastructure assets, respectively. However, short term internal sources of finance concern the more efficient use of cash, debtors and stock. Techniques for the internal management of working capital involve the debtors’ collection model, the economic order quantity and JIT stock management. Short term external sources of finance, on the other hand, include a bank over draft, a bank loan, debt factoring, invoice discounting, and the sale and buy back of stock. Retained profits are where a company finances itself from internal funds. Furthermore, three major sources of external long term financing are leasing, share capital and long term loans.
Fig: Calculation of cost of capital for a student
If a student finances his university course as follows; General expenses, by credit card $ 3,000 at 25% interest per annum Accommodation, by bank loan $ 4,000 at 10% interest per annum Car, by loan from uncle $ 3,000 at 5% interest per annum What is the over all weighted average cost of capital (WACC)? | ||||
Source of finance | Amount | Proportion % | Cost of capital % | WACC % |
1.Credit card 2.Bank loan 3. Personal loan | $ 3,000 $ 4,000 $ 3,000 $10,000 | 30 40 30 100 | 25 10 5 | 7.5 4.0 1.5 13.0 |
3000
Help note: Credits card = -------- X 25% = 7.5%
10000
Square Pharma Ltd has 800,000 TK. 1 ordinary shares currently quoted on the stock market at TK 2.50 each. It pays a dividend of 20p per share. Squire Pharma also has TK 200,000 worth of debt capital currently worth TK 1,000,000 on the Dhaka Stock Market. The loan interest payable is TK 60,000. What Squire Pharma’s WACC? | ||||
Source of finance | Market value | Proportion % | Cost of capital % | WACC |
Equity Debt | TK 2,000,000 TK 1,000,000 ---------------- TK 3,000,000 | 66.67 33.33 ------------ 100.00 | 8% (0.20 ÷2.50) 6% (60000 ÷ 1,000,000) | 5.3% 2.0% ------------ 7.3% |
Help note: We need to take the market value of the capital, not the original nominal value of the capital, as this is the value that the capital is currently worth. The cost of equity capital is simply the dividend divided by the share price and the cost of debt capital is the interest payable by the market price of the debt.
--------------------------- Md Aminul Islam | maihbd@gmail.com
