Investment ecisions of firms - Essay Example

Financial Management Introduction Investments decisions are one of the most crucial decisions which firms are required to make. Financial managers are required to carefully assess different projects and capital assets before making investments in the same. The current project incorporates analysing the manner in which organizations take investment related decisions using the capital budgeting and ratio analysis techniques. The manner in which organizations use their fund at present is a crucial determinant of the profit earned in the future course of time. Additionally, the paper also undertakes a short analysis of the distinguishing factors between activity based costing and other traditional costing techniques. Question 1: Investment Decision of Alpha and Beta b) Investment Decision NENE limited is considering investing in one of the two mutually exclusive projects, Alpha and Beta. The investment decision would be taken on the basis of capital budgeting techniques. The calculations in respect of payback period, accounting rate of return (ARR) and net present value (NPV) carried out for both the projects are as follows: Figure1: Investment decision Alpha Beta Decision of better return Payback period 2.8 years 3.7 years Alpha ARR 29.4%. 1.6%. Alpha NPV 36,661 29,297 Alpha Based on the capital budgeting calculations carried out in respect of Alpha and Beta, it can be seen the returns available from Alpha are more acceptable and profitable. In terms of the payback period, the company with the lower period is accepted. This would signify that the project would be able to cover their initial cost of investment within a shorter duration and begin providing profits (Shapiro, 2005). Accordingly, Alpha is considered to be a better project. In case of other techniques used, the project with higher ARR and higher NPV is required to be chosen as they indicate higher returns. In this respect, project Alpha is seen to be better. Hence, the company must consider choosing Alpha and invest in the same (Atrill and McLaney, 2006). c) Investment Appraisal Methods Accounting Rate of Return Accounting rate of return can be expressed as the percentage or ratio between the average profit earned from a project with the average investments made in the same. In simpler words, it explains the returns available from a project on an annual basis. In case of mutually exclusive projects, the one with the higher ARR has greater chances of being selected. In case of a single project, higher ARR would indicate that the project would add more value to the organization (Marino and Matsusaka, 2005). The ARR technique of capital budgeting is simple and involves less calculations (Bierman Jr and Smidt, 2012). However, a major disadvantage of the ARR method of project appraisal is that it does not take into consideration the time value of money. A project which may be providing lower returns may be highly profitable when the time value of money is taken into consideration (Graham and Harvey, 2001). Hence many at times the ARR technique lead to wrong decision making, when no other appraisal techniques are used alongside (Zimmerman and Yahya-Zadeh, 2011). Payback Period The payback period facilitates in calculating the time period within which the initial investment can be earned back by the company. The payback periods is calculated in years and assists in comparing the net cash outlay with the earnings occurring each year. The profit for each year is considered to be fixed and equal in each year. Just like the ARR technique, the payback method is also an easy method. Since it measures the number of years in which the investor can gain back his initial cash outlay, the technique is a suitable method of deducing the risk aspect associated with every project (Grinblatt and Titman, 2002). The payback period does not take into account the time value of money which leads to faulty decision making and is considered to be a major disadvantage (Durnev, Morck and Yeung, 2004). Net Present Value The net present value can be explained as the current value of future cash inflows, which is obtained by deducting the present value of all future cash inflows from the initial investments made. NPV is considered to be one of the most reliable techniques of capita appraisal and is used widely. The foremost advantage of the NPV technique is that it takes into consideration the time value of money. This method also analyses the cash flows before and after the life span of the project (Bhimani, Datar and Foster, 2002). A significant drawback of the NPV system of project appraisal is that it does not facilitate accurate decision making when the initial cash outlay for mutually exclusive projects are the same (Hillier, et al., 2010). Similarly, if the life span of the projects is equal, NPV may not yield accurate results. Under such situations, it becomes essential to incorporate other system of appraisal as well. Since the technique incorporates discounting of future cash inflows, it is considered to be a more complex approach than ARR and the payback period methods (Garrison, Noreen and Brewer, 2003). Internal Rate of Return The internal rate of return (IRR) is considered to be that rate of return where the present value of future cash inflows is equal to the initial cash outlay. The internal rate of return helps in estimating whether a project yields the minimum required rate of return or not. Hence, before appraising a project using the IRR method it is essential to establish a target rate of return (Agarwal, 2003). IRR takes into consideration the time value of money. However the IRR technique is difficult to understand and not highly preferred due to complicacy in calculations (Block, 2005). Question 2: Ratio Analysis b) Ratio analysis of Benjamin Ltd and Peters Ltd Category of ratios 　Ratios Benjamin Ltd Peters Ltd Decision of selection Profitability ratios Return on capital employed % 23.81 34.09 Peters Gross profit margin % 25.00 20.00 Benjamin Operating profit margin % 12.50 12.50 - Liquidity ratio Acid test ratio 6 2.25 Peters Working capital management ratios Inventory days 91 67 Peters Trade receivable days 114 61 Peters Trade payable days 30 38 Peters Profitability ratios The profitability ratios are mainly the return on capital employed, gross profit and the operating profit ratio. Gross profit ratio measures the level of gross profit in respect to the net sales revenue. A high gross profit is essential for organizations as it helps in meeting all types of organizational expenses and to maintain suitable level of profits. Similarly, operating profit ratio measures the percentage of profit in respect to sales revenue available in an organization after meeting all operating expenses. It is essential to have a high level of operating profit as it facilitates in providing adequate returns to the shareholders and also to retain profit for the future (Dayananda, 2002). The operating profit in the case of Benjamin and Peters Ltd is seen to be the same where the gross profit ratio is higher for Benjamin. The return on capital employed ratio measures how effectively an organization is able to earn returns from their capital that has been provided. It is essentially a long term profitability ratio. The ROCE ratio is higher for Peters than for Benjamin. According to the profitability ratios, if NENE Ltd prefers avoiding liquidity issues it must select Benjamin Ltd, as its gross profit ratio is high However, from the context of long term profitability, Peters Ltd would be a better investment choice (Danielson and Scott, 2006). Liquidity ratio Acid test ratio measures the short term liquidity of an organization. It facilitates in understanding the immediate cash holdings of an organization. The higher the acid test ratio, the stronger is the liquidity position of the organization (Gitman, Juchau and Flanagan, 2010). On the basis of the calculation made in respect of the chosen companies, Benjamin Ltd is seen to be having better short term liquidity, as their acid test ratios are very high. However, a very high liquidity ratio might not be suitable as it leads to greater drainage of funds. A liquidity ratio which is above 1 is considered to be most advantageous. Hence Peters Ltd would be a better choice for making investments (Haka, 2006). Working Capital Management Ratios The working capital of an organization remains trapped in the form of stock of goods and receivables. Turnover ratios such as inventory and receivable days facilitate in understanding how soon organizations can convert their current assets into revenue (Alkaraan and Northcott, 2006). Hence when such ratios are smaller, the efficiency of the organization to convert stock into revenue is seen to be high. On the other hand, payables days are required to remain high. When the duration to pay off creditors is long, revenue is retained within the organization for a longer duration. As a result, greater interests can be earned. From the calculation made in respect of the chosen companies, it can be seen that the working capital ratios of Peters is more profitable than that of Benjamin (Bowman and Moskowitz, 2001). c) Limitations of ratio analysis Although ratio analysis serves as a useful tool for interpreting financial statements, they also contain certain drawbacks. Ratio analyses are based on a number of assumptions. These assumptions are facilitated as the financial regulatory policies themselves allow them (Ross, Westerfield and Jordan, 2008). As a result, the same ratios can be calculated in numerous ways by different organizations, leading to conflicting results. Ratio analysis only provides an analysis of a firms past performance. Whereas, investors are mainly interested to know how a firm is expected to perform in the future. Also it is necessary to understand that different firms operate in different market and industrial conditions. Therefore comparison cannot be done justifiably as different companies are governed and influenced by diverse economic, political, technological and human resource factors. Therefore while carrying out ratio analysis firms must incorporate external and internal business analysis using other models as well. Additionally a crucial drawback of the ratio analysis technique is that it ignores the impacts of inflations. Due to inflation the cash inflows occurring at present might not remain the same in the future time periods. As a result the decisions taken for future time periods on the basis of the ratio analysis conducted at present might not be effective in the long run. Moreover the accuracy of ratio analysis depends upon the truthfulness existing in the financial statements. If financial statements are prepared incorrectly, ratios are bound to remain inaccurate (Peterson and Fabozzi, 2002). Changes in operational procedures may require firms to change their traditional techniques of ratio analysis. One of the most crucial drawbacks of ratio analysis is that different firms may use different accounting techniques in respect of depreciation. As a result comparing companies on the basis of the same ratios becomes difficult when accosting policies differ. Ratio analysis might not always reflect the true profitability or liquidity position of a firm. For instance a current ratio of 2:1 might be perceived to be good, unless it is noticed that cash was generated through sales of fixed assets. Question 3: Activity Based Costing vs. Traditional Costing Methods Costing systems helps organizations to determine the cost of a product under various overheads. Activity based costing (ABC) and traditional costing are the two different types of costing systems which organizations follow for allocating expenses related to production under different overheads. Under the activity based costing method, expenses are allocated under different activities. Hence, under the ABC system the firm step is to identify the different activities which are involved in the production process, and accordingly allocate expenses. The ABC system assumes that activities are the primary drivers based on which costs are required to be allocated. The ABC technique leads towards establishing a cost-cause relationship. The system is flexible and allows allocation of expenses under overheads such as management, customers and other factors which are not directly associated or identified with the product (Akyol, Tuncel and Bayhan, 2005). The traditional costing system identifies different expenses on the basis of an average overhead value or rate. Accordingly, all indirect costs are allocated equally based on a single cost driver such as machine or labor hours. The underlying assumption in the case of traditional costing system is that products are the reason due to which different costs take place. This assumption may not always yield accurate cost related analysis as a number of activities which are associated with production may not be recognized and allocated (Vanhorne, 2000, (Gunasekaran, Williams and McGaughey, 2005). Conclusion The current paper vividly analyses the different perspectives of capital appraisal and investment decision making. The paper deals with providing suitable recommendations in respect of selecting investment proposals from mutually exclusive projects. NPV, payback period and the ARR were the prime capital budgeting techniques used for making investment decision. Similarly, in the case of selecting a suitable organization for investing, the ratio analysis method was exercised. The paper clearly makes use of the different financial decision making tools which managers use. 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