Introduction
This paper seeks to advice a company (hereinafter named ABC Company) for considering investing the amount of £350 million in extending its production capacity. Speficifically, the conclusion that derived will be used to advise the Finance Director about how best to appraise this proposal. It is given from the financial press that the general view on the global economy is heading for a recession over the next two years. Since the source of money is not mentioned whether external or internal, this paper will also discuss both scenarios for decision making purposes.
In addition since what is given is about extending production capacity, this paper assumes that the company seeking to invest the money belongs to the manufacturing industry. The paper will also explain the reasons for the advice and as well as point out the limitations of the approach that will be adopted.
Analysis and Discussion
Assessing the understanding of capital budgeting and how to deal with risk
This part will include the discussion of the two valuation methods: Net Present Value method and the IRR method by answering the question: “Which is between the two methods of capital budgeting is better, the NPV or the IRR should be used in evaluating this kind of investment?” Understanding the different methods capital budgeting will allow the reader to use the best or proper method in evaluating investment proposals especially if the result of one method conflicts with the other.
In attempting to answer this question this paper is going to test the application and evaluation of investment appraisal techniques, namely the IRR and the NPV by making assuming that ABC Company which will expand its production capacity must be assumed to be making a choice of an investment which will guide it to deciding on which one will give it a better return or which one is the more profitable or advantageous option. This also evaluates whether the company could make both the NPV and IRR evaluating the acceptability of the investments.
Cost of Capital and its importance to decision making
Cost of Capital is an estimate of the rate of return that could be earned in the capital market on from investment securities that have more or equivalent risks. It is financial truism that with higher the risks faced an investor the same must be must be matched higher cost of capital as compensation for greater risk. Another way of looking at it is to consider the cost of capital as the opportunity cost of choosing another alternative which is best expressed by the discount rate that is used in discounting cash flows in capital budgeting.
To illustrate when one borrows at 12% effective interest rate, such rate is the discount rate or cost of capital which must be taken into consideration by the same businessman in accepting or rejecting investments for the money borrowed. His or her choosing of investment options lower than 12% is an act of lack of wisdom because such is tantamount to losing money. One will notice therefore that the 12% discount rate of cost of capital is the benchmark being used to evaluate investments.
The same principle may then used in the case at hand in analyzing the investment option upon which the amount of £350 million should be made into by ABC Company.
The Two Investment Appraisal Methods and Time Value of Money
The idea of discounting of cash flows was introduced in the preceding subsection and these cash flows refers to the periodic flow of cash into the company over a given period of time and which is usually measured on a per year basis.
Both methods do take into consideration the time value of money. Time value of money implies giving greater value to a £10 today than a £10 a day or longer period of time from now. To account for the difference of the two values there is a need to discount the £10 to bring the same to its present value by using a discount rate upon which it may be assumed that the said present value may be invested today to reach that given present value in the future. Here lies then the concept of discounting, net present value and internal rate of return which is also in evaluating long term investments to capital budgeting decisions. The next subsections will make it clearer by focusing on NPV and the IRR methods with their advantages and limitations of use.
The NPV Method
This method does accepts the idea as illustrated that earlier money received to day is more valuable than an equivalent amount received in some future time. In initial investment situation, an initial cash outflow is normally made and subsequently cash inflows will be received over a period of time and discounts the same over a period of time using a discount rate.
A positive net present value will indicate acceptance while negative value should indicate rejection. The formula is useful especially in evaluating projects that are mutually exclusive. Mutually exclusive projects are different from two independent projects. Under the first an acceptance of one option rejects the other option while in the second such is not the case. In the case at hand if the 350 sterling pounds million is assumed to be invested only into one capital project to the exclusion of other, then it is considered that the projects are mutually explosive hence the NPV over the IRR should be used. It has however some limitations which will be best described earlier.
The Internal rate of return (IRR) Method
As stated earlier the use of time value of money and discounted cash flows is also evident in the cash flow method using the internal rate of return. IRR has indeed a very close relationship with NPV method. One difference between the two lies in the use of value amount in NPV while the IRR uses rate or return as expressed in percentage. By setting the value of the NPV of a project to zero, the computed discount rate is the approximation of the IRR.
Application of the Two Methods and the necessary analysis
Certain assumptions must be made as to amount of cash inflows and outflows will have to be estimated for the few years for this paper to appreciate the application of the two methods as far as the investment of 350 million sterling pounds is concerned.
The table below contains the e summary of information generated as result of assumptions made. It must be made clear that the assumptions are already in terms of cash flows. Cash flow preparation requires first the presence of income statement and balance sheet in practice since the changes in the balance sheet accounts must be reconciled with the income statement accounts. The cash flows therefore indicate below already assumed that the projected income statement and balance sheets are already prepared.
Note: Computed using Excel
Note that the above table presents that ABC is assuming to make a capital expenditure of about £350 millions in either investment options A or B. IF the NPV is used, B is a better option than B because the net present is higher than that of A. However, if the IRR is used, Option A has a higher rate at 11% compared with B with IRR of 10%.
It appears therefore that there is a conflict between the two discounted cash flow methods and between discounted cash flow methods and non-discounted cash flow methods. In resolving the conflict, there is need to find the value of generating sooner than latter or vice versa. It can be posited that the value of early cash flows depends on the return one can earn on those cash flows, that is, the rate at which it can be reinvested.
Using NPV presupposes that the rate at which cash flows can be reinvested is the company’s cost of capital, while the IRR method assumes that the firm can reinvest at the IRR. Which of the two assumptions are correct? Brigham and Houston (2002) found that that the best reinvestment rate is the cost of capital, which is consistent with the NPV method. The authors therefore thus emphasized that when projects are independent, the NPV and IRR methods would produce the same accept/reject decision. Nevertheless, the said principle could not be applied in case of projects that are mutually exclusive. This must be so in the differences of scale and/or timing of the cash flows (Brigham and Houston, 2002, p. 515).
Using therefore this guideline the conflict in the assumed situations on how ABC would invest the money and how much cash flows would be generated by applying either NPV or IRR could now be resolved. Option B should be chosen over option A since the NPV is higher although the IRR is lower.
Relationships Between IRR and NPV
Brigham and Houston (2002) argued that in case of independent of projects the two methods must have the same recommendations, which means that if one recommend acceptance of an option the other must also recommend acceptance while if the one recommends rejection, the other must do likewise.
In case however of mutually exclusive projects, the use of NPV is more preferable than IRR. A difficult issue comes out however when the NPV or the IRR methods are making different recommendations. Finance authors do accept situations where this could be encountered and normally the conflict comes because of timing differences in incremental cash flows and because of magnitude differences in incremental cash flows (Brigham and Houston, 2002).
Limitations of IRR and NPV
It was found out in the analysis of the methods that each has its own advantages over the other in evaluating investments and in case of doubt or in case of mutually exclusive projects, the NPV method should be used over the IRR method. This part will see the limitations of the methods in using for investment purposes.
Since the breakdown of cash flows for investing £350 million is just assumed, it also possible for the company to encounter these other limitations if the case assumptions are changed hence the need to further include them in this paper.
As discussed already, the first limitation of IRR is its being made subservient to NPV method in the case of mutually exclusive projects. Its second limitation is that it should not be used in the usual manner for projects that start with an initial positive cash inflow. This is possible if the company’s customer will be required to make deposits to the company before it starts the project. This may be applicable if the demand for company’s products us very high. This would result to single positive cash inflow and then followed by a series of negative cash flows, and this make IRR not applicable.
Another limitation is when in the series of cash flows (Van Horne, 1992; Weston and Brigham, 1993) there are multiple sign changes such as a positive amount being trailed by negative amount, another positive amount, then again another negative amount. A multiple IRR is evident hence the inapplicability of the IRR decision rule..
The next limitation is the twist caused by the assumption that IRR gauges the actual profitability of investment made with intermediate cash flows being reinvested at the project’s IRR rate. Overstated actual rate of return is the product of this wrong assumption. A Modified Internal Rate of Return (MIRR) is however a possible remedy (Droms,1990; Helfert, Erich (1994).
The question that should be asked then is: “What the consequences of disregarding IRR’s advantages and limitations?” Kelleher and McCormack responded by citing an academic research where they found that three-quarters of chief executive officers are almost always using the IRR when evaluating capital projects (Graham Harvey, 2001). Even in their own research, the they told that the desire to risky behavior exhibited by investors found in their informal survey of thirty corporate executives, hedge funds, and venture capital firms (Kelleher and MacCormack, 2004).
With their findings that not more than 25% from the 30 persons were fully aware of deficiencies of IRR’s, they were indeed surprised to confirm the more preferable use of the method. To prove their point they conducted a reanalysis of about two dozen actual investments that one of respondent company had entered into on the basis of attractive IRR. After their very systematic recalculation by correcting the use of the IRR Kelleher and MacCormack (2004) declared that decisions would have changed considerably.
To disregard therefore limitation are dangerous. It is also desirable to discuss further the wrong assumptions in the use of IRR. Kelleher and MacCormack know the trouble experienced by practitioners who most of the time takes the internal rate of return as the annual equivalent return on a given investment although such is the correct one. Give the intuitive appeal by the ease of comparison, IRR cannot be considered as a true indication of a project’s annual return on investment. This is premised on the fact the project generates no interim cash flows or those interim cash flows generated that were really reinvested at the actual IRR (Kelleher and MacCormack, 2004) since the real one is the cost of capital as explained earlier.
Kelleher and MacCormack (2004) also warned about the false assumption that IRR makes in terms of assumed additional projects, with equally attractive prospects, in which to invest the interim cash flows when not in fact existing. Thus the result could only be overestimation if the use of IRR is not corrected. Like the other authors, they also recommend the use of the NPV (Brigham, E and Houston, J., 2002; Meigs and Meigs , 1995). In so doing they emphasized the fact about the more believable general assumption of a company earning its cost of capital on interim cash flows.
How is the manufacturing industry affected by recession and in case where there is inflation & deflation?
A recession would mean fewer jobs for people and therefore less purchasing power to buy goods and services. As the car the manufacturing company is concerned it could mean less demand for company’s product and services and therefore fewer revenues. Fewer revenues would also mean less profitability and less liquidity and therefore more risks faced by the company.
Since recession may be associated with deflation or inflation, it would be nice to discuss effects of either case in the manufacturing industry. In case of falling prices brought by less purchasing power of consumer, the manufacturing industry may not be able to sell its products in the market would be produces. It may also be pointed out that in times of deflation, there will be a tight monetary supply (Slavin, 1996; Samuelson and Nordhaus, 1992; Carroll, Thomas, 1983) and this cause difficulty to obtain credit that would enhance purchasing power of consumers. Hence the is company in the case at issue may defer the expansion plan for its production capacity until after the recession passes by since producing goods that will not be sold will only cause the company waste of resources
In case of recession that is associated with inflation, the effect could be as bad, if not worse for the industry than recession associated with deflation since the increase in money in circulation would not add any value if there is no growth in the economy.
How does the source of money affect the decisions to be made? What happens if the source of funds is internal or borrowed?
This paper first assumes that the money is internally generated, that is in the past the company was able to accumulate this $350 millions extra funds from profitable operations. Hence under this assumption the company must be deduced must use its cost of capital in evaluating the best options from the use of the money. As used in the discussion of the NPV and IRR methods, the company must only make investments where it could generate returns other that cost of capital, in which case the use of the NPV and IRR methods are still very much material and relevant for decision making.
If the money is borrowed, it must be asked: At what rate on interest it was borrowed? This must be so since borrowed funds need to be paid back in return in terms of amortization of principal and interest. To afford the company to pay the same, the expected return of the investment generated in expanding operation must be higher than said interest rate on borrowed money. If it is assumed that the interest rate is the same as the cost of capital then the manner of evaluating whether the investment should push through should be
Conclusion and Recommendations
Based on the comparisons made between the two investment appraisal methods, it was found out that the two could be working together in case if independent projects but one must choose between the IRR and NPV if there is conflict between the two and the issue was already resolved in the analysis that in case of mutually exclusive projects, the NPV method should be used rather than the IRR even if IRR is higher for one option.
The advantages and limitations of each the model were thus made part of this paper and the one that will be used here is NPV because it is presumed here that the company would be using the money in mutually exclusive projects, in which case Investment option B would be better. The decision to accept a proposal to invest in either investment A or investment B is dependent on facts and other assumptions made which will determine the choice of the method whether it is NPV or IRR. It was found out that the two methods yielded difference results mainly because the difference assumptions as to additional fact and also based in theoretical frameworks under which is of the method is used.
Since a recession is coming for the US in next two years, there is basis to shelve the decision to expand facility by ABC Company since recession would fewer jobs, less purchasing power to buy goods and services and there would be dampening of demand which should warn ABC Company in not making its investment plans pursued for the meantime. As what was found either the recession may be associated with deflation (falling prices) and inflation (rising prices), the effect would be less demand for company’s products and which could only cause the company not to be able to sell its produced products.
The paper also was able to explain the whether or not the funds will be raised internally by means of profit or should it borrowed, the company is such case will use a criteria using cost of capital in accepting or rejecting the investment proposals. In case the company uses the internally generated funds the company must consider is cost of capital. If the proposed investment will give higher return than cost of capital then by all means the project will have to be accepted. If the money is borrowed, the interest rate may be used in borrowing may be used as guide in determining the cost of capital for purposes of evaluating investments. The effective interest rate should be used since nominal interest may not represent the correct ones.
As found in the computation, the application of NPV and IRR methods in either case should be used in making the evaluation of investments regardless therefore on the source of money for investments. This paper was able to show that making investment decision is not easy as there are considerations to be made. Mistake in making these types of decisions could be fatal both to the short term and long term health of ABC Company. The need therefore to have strategic decision (Porter, 1980; Pearson, G.1999) for the company is very important and such activity including studying the company external and internal environment.
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