Corporate Finance Strategy Written Coursework Assignment
Corporate Finance Strategy Written Coursework Assignment
This paper serves to present a learning activity for interested parties interested in understanding Net Present Value (NPV), Internal Rate of Return (IRR), two other common capital budgeting techniques and weighted average cost of capital (WACC). The paper also endeavors to prepare numerical examples relating to capital budgeting techniques. This task will be facilitated by a sample project will all related considerations. The paper also offers criticism over wrong assumptions given for cash flows. In this regard, many people consider them as funds made available for the firm. It also studies, modifies and criticizes the IRR method of adjusting B/CR as a means of making them coincide with the ranking of NPV.
NPV, IRR AND WACC
For a significant period, Internal Rate of Return (IRR) and Net Present Value (NPV) have evolved to overwhelming decision and choice makers used in the measurement of the financial benefits of investment opportunities. Both are implemented in the evaluation of alternatives from a variety of circumstances (KE?A & PANTI 2012, P. 42). From real estate and equipment acquisitions to company purchases to intellectual party valuation, and the introduction of new products to factory close down decisions. NPV reduces or discounts forecasted cash inflows at a rate in reflection of three factors: investors desire to withhold cash for a better opportunity, expected inflation, and the risk of the investment. If the total of the forecasted cash inflows exceeds the required funding cash, then the NVP exhibits as a positive meaning the project is financially stable. It is capable of adding value to the firm or investor.
IRR can be referred to as the percentage return rate that ultimately causes the total of forecasted cash inflows to equal the cash outflow. If the IRR happens to be greater than the return rate that fits the investors, then the investment becomes financially stable. Many studies suggest that both methods are used in their respective but IRR has a higher preference because it bears an intuitive appeal (PSUNDER 2002, p. 35). Regardless of the popularity these two methods exhibit, neither the IRR nor the NPV method has been designed to have an effective treatment on the vast problems associated with investments, especially periodic cashflows generate between purchase period and sale period. The modified IRR is capable of accounting for cashflows of this nature.
Given the vast implementation of the IRR and NPV methods in worldwide companies, it is therefore crucial to appreciate their value, as well as their limitations. It is also fundamental to explain extensively the meaning of the Internal Rate of Return to correct the incorrect conception it is given and its misuse. Spreadsheet programs of the current technological setting- such as MS- Excel- have been programmed to calculate IRR (KE?A & PANTI 2012, P. 58). However, these programs have not been designed with capabilities of dealing with cash flows involved. This article will in this regard endeavor to explain the problems associated with both the IRR and NPV.
Both IRR and NPV have a common problem. To prove this, an example has been provided that demonstrates the correct use of IRR and NPV. A restaurateur is pondering the action of purchasing a piece of art that retails at $50,000. He has a plan resell the piece of art after a period of five years and thereby replace it with another. His experience informs that he will make double profit if he sells the piece of art five years later since the art will have a 14.87% IRR. If the restaurateur’s capital cost is ten percent and use this value as rate of discount, then his NPV amounts to $12,092. If the capital cost is doubled to twenty percent, then there is a possibility of losing an economic value of $9,812. Both the IRR and NPV give a clear and accurate description of the potential results the investment can give.
It is notable that the example above is lacking in free cash flow periodic and dividends present in common investments. Cash flows from these kinds of investments are presumably invested in ventures with a view of earning returns. However, the main issue rises from the most suitable rate of return. Technically, both NPV and IRR are not answerable on this issue. The reinvestment rate of the NPV can in this case be taken as the rate of discount used. From another perspective, the rate of discount is taken to determine the rate of reinvestment. In the case of the restaurateur, $50,000 represents the alternative opportunity that provides a ten percent return per year and will therefore yield $80,525.50. When this yield is deducted from the $100,000 made from the art sale, it amounts to $19,475. When this amount is discounted back for a period of five years, the result is an NPV of $12,092; the same amount is that calculated using the capital cost of ten percent.
Regarding the weighted average cost capital (WACC), this serves as a measurement of a firm’s capital structure. It forms part of the formula that calculates the expected new cost capital and acts as a representation of the rate of finance a company expects to pay for its assets. WACC is calculated by putting into consideration the relative weight of each capital structure component of the company. The calculation puts into use the market values represented by the components instead of their book values. The result offers significant difference. Components to this calculation may include debt (exchangeable, convertible, and straight), equity (both preferred and common), options, warrants, pension, stock options, and liabilities. More financing sources may also be used in the calculation if they are available and in significant amounts. Calculating the WACC for a company with a complex capital structure may prove to be a daunting task.
Capital Budgeting Techniques
Other than the NPV and IRR, there exist other capital budgeting techniques. Among them, include the payback technique and the annual rate of return method. The payback method is a measurement of the time length a company requires to recover its initial cash investment (WILKES 2002, p. 23). The calculation involves dividing the capital investment with the total cash flow of the year. Consider an example where a company is considering buying equipment worth $150,000. The equipment has a salvage value of $5000 after exhausting five years of service. The annual cash inflow is estimated at $250,000 and cash outflows at $200,000. For the scenario above, the cash payback period amounts to three years. This figure is calculated by dividing the capital investment of $150,000 by the net annual cashflows of $50,000 ($250,000 cash inflows -200,000 cash outflows). $150,000/$50,000 = 3years.
YEAREXPECTED NET CASH FLOWSCUMULATIVE NET CASH FLOWS0$(150,000)$(150,000)130,000(120,000)250,000(70,000)355,000(15,000)460,00045,000560,000105,000
The other capital budgeting technique is referred to as the annual rate of return method. This principle uses accrual based net income when calculating the expected profitability of a project. The annual rate of return is thereafter compared to the required rate of return of the company. If the value of the annual rate of return is higher than that of the required rate of return, then the project is beneficial (WILKES 2002, p. 29). Assume the above example where the same company expects an annual net $5,572 net income with a salvage value of $5,000 and investment of $150,000. Then, the proposed project bears an annual rate of 7.2%. This value was achieved by dividing $5,572 net income with $77,500 average investment.
Dividend Policies set by Major US Firms
The primary budgeting technique used by major US firms lies behind four key principles. Take, for example, Diageo Company. Zindar (2002, p. 32) points out that the company’s capital budgeting technique starts with a mission statement. This confirms the business of the company, the interests of the shareholders and the governing rules. The other consideration of setting the dividend policy is through a strategic plan. This plan highlights the strategic vision of the company, the company’s growth, finance, and how it plans to achieve its. The third consideration is the liquidity assessment. Diageo Company endeavors to make a periodic assessment of the liquidity needs entitled to various shareholder groups. This consideration is achieved through group meeting, interviews, and questionnaires. The fourth and final consideration used for setting dividend policies by Diageo Company and other leading US firms is through liquidity programs. The liquidity program primarily attends to the three considerations mentioned above (RAMACHANDRAN, PACKKIRISAMY & RAMACHANDRAN 2010, p. 18). This consideration encourages the annual stock redemption program that allows shareholders to engage in periodic sale of their stock.
This paper has given an informative review of four primary methods of capital budgeting techniques. The informative review highlighted the situations where the techniques are applied, and limitations were found especially in the payback method and the annual rate of return method. The NPV and IRR methods were found to be most suitable judging by their extensive application on a number of fields. The paper also gave an insight on the dividend policies implemented by key Firms in the United States and focused on Diageo Company. This endeavor yielded four major considerations used to determine dividend policies.
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