Finance and Growth Strategies - Assignment Example

Finance and Growth Strategies 1 Calculate the Net Present Value. The net present value (NPV) of a project represents the present value of the total cash inflows and outflows. The NPV can be calculated by discounting the cash flows according to the required rate of return. In the case of Fijisawa, NPV is computed as the present value of the future cash inflows less the initial investment. Thus, the NPV can be mathematically represented as: (equation 1) where Ct is the cash flow in time t, Co is the cash flow during the first year, and r is the required rate of return. Table 1. Present Value of Cash Flows (Year 0-Year 6) During the first year, Fijisawa will incur 10,950,000 cash outlay in financing the investment. However, this is expected to be compensated by cash inflow of 4,500,000 for the next six years. In calculating the NPV, these figures are discounted by the respective present value factor using 9% as the required rate of return. The results are shown in Table 1. To get the NPV, present values of all cash flows are taken together. This will yield a positive NPV of 9,235,200. 1.2 Calculate the Internal Rate of Return The internal rate of return is the cost of capital that will equate the present value of future cash flows to zero. In other words, it is the required rate of return which will yield a zero NPV. Thus, equation 1 can be modified such that NPV is replaced by 0. NPV calculations can be done manually but the process is tedious as it requires calculating the NPV by using different values of cost of capital. Another is the use of software like Microsoft Excel to generate a more accurate figure. The NPV of the project generated by manual calculation and corrected by Excel is 33.996%. It should be noted that at a required rate of 33%, NPV is 220,800 while at 34% the NPV dips at -1950. 1.3 Should the project be accepted The decision whether the project should be accepted or not will be based on the results of the financial and strategic analyses using techniques like NPV and IRR. In using NPV as a tool, the general rule is to accept projects or investments which generates a positive NPV while reject those which yields negative NPV. The result of the NPV has a direct implication on the value of IRR relative to the required rate of return. Accordingly, a project is pursued if the IRR is equal to or higher than the required rate of return. In contrast, a project with a lower IRR than the cost of capital is turned down. It should be noted that a positive NPV is indicative of an IRR which is higher than the required rate of return. The project considered by Fijisawa, which is the expansion of its product line should be accepted based on the quantitative analyses using NPV and IRR techniques. The investment yields a relatively high NPV of 9,235,200. The IRR of 33.996% is very high compared to the required rate of return of 9%. Thus, Fijisawa will reap higher benefits than its capital outlay in the proposed project. However, it should also be noted that quantitative analyses are often not enough in ascertaining whether an investment should be pursued or not. Though expansion of the product is quantitatively profitable, qualitative factors like consumer demand and others should also be taken into account. 2. Why is the capital budgeting decision such an important process Why are capital budgeting errors so costly Capital budgeting is an extremely important aspect of a business organization's financial management. Capital budgeting is defined as the "decision making process used in the acquisition of long term physical assets (Capital Budgeting 2006)." These long term investments can be the replacement of the current machinery, the acquisition of new equipment, establishment of new plants, introduction of new products, and investment in research and development activities. The importance of capital budgeting in a company cannot be overstated. Chatfield and Dalbor (2004) stressed that capital budgeting decisions are very much crucial in maintaining the firm's long-run financial health. Thus, it should be taken as seriously as possible. Three points are given as to why this activity is at the lifeblood of the organization. Chatfield and Dalbor (2004) emphasized that "Successful capital budgeting projects usually generate a positive cash flow for a long period of time." Cash flow is very crucial in the operation of a business organization. Cash is often used to pay suppliers, employees, creditors, and even the government for tax purposes. As capital budgeting is often concerned with the cash flow from the prospective investments, it should not be taken for granted. This activity helps the company in determining profitable investments which will provide cash flows to support other strategic plans. Since decisions concerning capital budgeting involves long-term, selecting the right project or investment is needed to ensure that long-term cash flow will be attained. In contrast, Chatfield and Darbor (2004) also illustrated what can happen if a company failed in its capital decision process: "Unsuccessful capital budgeting projects do not return sufficient cash flow to justify the investment. Such projects usually continue to generate losses or are liquidated for a large one-time loss." The above statement stresses the importance of having an efficient capital budgeting process. As investments involve in capital budgeting decisions requires substantial cash outlay, they should be justified by substantial returns for the company's benefit. When an investment fails to generate the expected returns, it will send a negative repercussion in the company's operation not only in its cash position and generation but also in the strategies it is pursuing. Disruptions in the operation of the company brought about by unanticipated negative externalities attributed to unsuccessful capital budgeting decisions will significantly impact the activities of all the organization's functional units. This point will be further elaborated and illustrated in discussing the negative effects of erroneous capital budgeting decision. Lastly, "capital budgeting decisions set a firm's future course by determining what services will be offered, how they will be offered, and where they will be offered (Chatfield and Dalbor 2004)." This statement recognizes the fact that capital budgeting decisions is a tool used in assessing the different growth strategies considered by a business organization. As discussed above, this activity involves long-term investment decisions which will determine the course or set of actions that the company will undertake. Thus, capital budgeting is a tool which helps business organizations choose from a set of different strategies the most profitable and efficient action for the company. Also, it helps the company to asses the viability of the considered plans. To further elaborate; let's look at a company which is currently considering to pursue only one of the following choices: introduce a new product; invest in the research and development; or acquire new equipment which will significantly bring down the cost of production. Each of the aforementioned investment choices represents growth strategies which can be taken advantage of by a business organization. However, given the limited resource that the company has, the capital budgeting process helps in eliminating the least profitable choices and aids the company in choosing the best alternative. Thus, capital budgeting became the determinant on the growth strategy that the company will undertake. In the above example, we can also say that capital budgeting activity helps business entities in fulfilling their economic goals of profit maximization. Economically, companies thrive because of the presence of profit in the market. As business entities only have limited resources, they should invest it in a project with the highest return. Capital budgeting help firms accomplish that by seeing t it that investments or cash outlays are maximized. If that's the case, this process helps business organizations maximize profits. Now, we will briefly consider the risks which are associated with errors in capital budgeting. As stated above, errors in the process will lead to wrong decisions and unsuccessful investments which will be counted as huge losses. It is also worth mentioning that as capital budgeting often involves long-term investments, mistakes will serve as a burden of the company in the long run. As the company is stuck with that specific decision, it will face the risk of living with it. The company can terminate the project, but the investment will be counted as a huge loss. Mistakes also forego the company's chance of undertaking a profitable investment. To illustrate, let's take the case of the company who erroneously chose to invest in new machine. This new machine is expected to generate cost savings and more efficiency by shorter lead time. However, if the company makes mistake in choosing this alternative and the expected returns did not materialize it will disrupt the whole operation of the business organization. First, if the machine is not functioning as expected, the company will suffer losses instead of savings in the form of insufficient production. The company won't be able to generate the expected cash needed to finance other projects. This will cause a stir with the clients and suppliers as the company is not meeting the agreed upon production level. In summary, capital budgeting should be taken seriously as aids the company is eliminating unprofitable ventures while allowing them to choose the profitable ones. Thus, this process becomes the lifeblood of a company as it determines and support strategic decisions and directions. 3. What are the criticisms of the use of the payback method as a capital budgeting technique What are its advantages Why is it used so frequently The payback method is one of the most popular tools in conducting capital budgeting decision. The payback period tells the company the length of time required to recoup the original investment through investment cash flows. This is essentially the time when the company breaks even-the initial capital outlay is equal to the cash flows. The payback period is computed as the follows: Payback = Initial Investment Annual Cash Flow (equation 2) Other things being equal, the investment with a low payback period is chosen as it implies less risk for the company. As the investment is recouped in a shorter period of time, it also indicates that the investment is less likely to fail. There are essentially three reasons why the payback method is popular among business circles. First of all, the payback method is simple. The computation is less complicated and is easily grasped by managers. The payback method is "easy to compute and easy to understand." Secondly, the payback method is gives some indication of risk. As this technique indicates the length of time that the investment can be recouped, it gives the company an opportunity to separate long-term projects to short-term ones. This also makes the payback method a good screening tool for prospective projects and alternatives. Lastly, this tool helps the company gain a more accurate and reliable assessment of a project by taking into account taxes and depreciation (Lightfoot 2003). It should be noted that the in the computation of cash inflow from operation, the aforementioned expenses are not overlooked. However, the use of the pay back period in assessing the profitability of an investment also suffers limitation. There have been a lot of criticisms on the efficiency of this method as a capital-budgeting tool. As with its advantages, there are also three main criticisms of this analytical tool. The payback method is not a reliable method of profitability because it stresses the return of investment and not on the return on investment. Instead of taking into account how much profit an investment can generate for a business entity, the payback method only tells the length of the time the investment is "returned." Thus, the payback method only emphasizes the return of investment but not the return on investment (Lightfoot 2003). Secondly, the payback method also falls short in measuring profitability as it ignores the cash flow after the payback period. It should be noted that after the company breaks even, there are still profits which are generated from the investment. Failure in including these cash flows will lead to understatement of profits. When a company is considering two projects and bases only its decisions of the payback period, it is bound to make mistakes. As the payback method prioritizes investments which can be recouped immediately, it doesn't take into account the full profitability of competing alternatives. Even if an investment generates more cash flow, relying only on the payback method will tilt the preference of the managers if the initial investment is relatively longer to recoup (Lightfoot 2003). Lastly, the payback method ignores a very important principle-the time value of money. It is very important to include the time value of money in assessing the profitability of investments as the value of money today is relatively higher than its value say, a year or two years from now. Thus, managers who want to really know if the proposed project is really good for the company should discount cash flows. In conclusion, the payback period is popular and widely used because of its relative simplicity, serves as a good screening tool, and accounts for depreciation and taxes. However, this capital budgeting tool is also flawed as it is not a reliable measure of profitability as it does not take into account the cash flow after the payback period as well as the time value of money. 4. In some countries the expropriation of foreign investments a common practice If you were considering investing in one of these countries, how would you take this risk into account The impact of globalization in the international business arena can never be quantified. The integration of goods, capital and financial markets gave way to the proliferation of multinationals in developing countries. This also leads to the phenomenal growth of international investment agreements. Operations in foreign countries expose companies into additional risks. These risks can be in the form of exchange rate risks, labor unions, and fluctuating input prices. However, one of the most popular risks shouldered by companies is expropriation of foreign investments. Expropriation is the "act of removing from control the owner of the property (Expropriation 2006)." Using this idea in the case of foreign investments, expropriation is usually a government's act of removing an asset form the hands of foreign investors. However, it can also be through a series of discriminatory actions, which is called "creeping expropriation." This practice is often characterized by "the confiscation of the foreign asset and a pittance payment." The payment from the government is sometimes only a formality as the foreign investor and the authority have not agreed to a specific price. Thus, it is not acceptable reparation. Oftentimes, the companies being expropriated are already successful and established rather than highly risky or failing. These expropriations "deprive the owners of their reasonable expectations of reliable returns from such a proven business." Expropriations are often warranted by the confiscating government for various reasons. Sometimes, for instance, the expropriated business owners pay little or no attention to the host contry's assertion that royalty payments are too small relative to the resources being extracted from the host country. Some host country political complaints may relate to the treatment of its nationals as employees of the business. At other times, the host government may judge that strategic decisions about the business entity are simply wrong-headed and ill-advised, as applied to the host country, however right they may seem to the owners. Such judgments may also occur when the business entity fails to include the host country's interests and concerns, legitimate or not, as matters of ordinary consultation and effective participation in the operational plans of the business entity (Expropriation 2006). These reasons are further supported by real world examples. In the Philippines, a multinational was required to raise salaries. This depleted the company's resources and profits leading to the closure of the company. This can be referred to as a "creeping expropriation" for $37 million. In Egypt, the government confiscated a hotel property claiming that it was built on "holy ground." However, the government currently runs the confiscated hotel. Whatever the reason for expropriation, the company should take into account that operating in foreign lands involves these types of risks. Thus, in assessing if a foreign market is lucrative or not, a business organization should carefully review the foreign investment law in the targeted economy. Also, as in some cases, the government only confiscates properties due to political and self-serving reasons a company should also review the state of politics and corruption in countries considered. Expropriation risks are different from country to country. As illustrated in the in the examples of Philippines and Egypt, different governments have different ways and motives in confiscating foreign investor's assets. These risks can be taken into account by conducting individual country risks assessments which includes factors such as investment laws, level of corruption and political stand. 5. "Mergers and acquisitions seldom deliver the value added that is expected." Discuss this statement Mergers and acquisitions have become prevalent in our present societies. The global economy has witnessed the consolidation of both large and small companies in the hope of better performance. The rationale for mergers and acquisitions is simple and can be elucidated by the "special alchemy of mergers and acquisitions" that is, one plus one equals three. Thus, the key principle in buying a company is to create shareholder value over and above that of the sum of two companies. This is also equivalent into saying that two companies are better if they work together than if they operate on their own. In fact, mergers and acquisition produces more than the strength of the two companies combine. Thus, these consolidations are considered as strategic synergies. This paper will further illustrate why mergers and acquisitions are being conducted. These consolidations are often prevalent when there are business cycles or when times are tough. Stronger and stable companies will seek to buy small and failing firms in order to "create a more competitive, cost efficient firm." These companies agreed to come together in order to enlarge their market share and to achieve greater efficiency. Mergers and acquisitions are often favored as companies hope to gain the following benefits: staff reduction, economies of scale, acquiring technology, and improved market reach and visibility. Staff reductions are often implications of consolidations as companies needs to reduce employees and downsize. In the cost side, this will imply huge savings and more profit for the companies. Economies of scale are often expected on mergers and acquisitions as two companies will benefit from their combined size in terms of operation. Also, this will leverage the buying power of both firms and will boost their capacities against suppliers. Large companies often seek to buy small firms with unique technology to develop a new capacity or competitive edge (The Basics of Mergers and Acquisitions n.d). However, real world examples show that the expected benefits from mergers and acquisitions are often overstated. The Weekly Corporate Growth Report states that "70% of mergers fail to achieve their anticipated values" while Harvard Management Update reports that "Most [mergers] fail to add shareholder value-indeed, post-merger, two-thirds of the newly formed companies perform well below the industry average (Palmer n.d.)." These only prove that consolidations do not often deliver their anticipated value. There are a lot of reasons why failures and acquisitions generally fail. Consolidations often drive down the value of both companies' stocks into their original level. Looking closer, mergers and acquisitions become unsuccessful because of "flawed intentions" and economies of scale which did not materialize. Companies stocks often suffer during consolidations because the market sees the company's efforts and activities as merely glory seeking than strategic actions: "The executive ego, which is boosted by buying the competition, is a major force in M&A (mergers and acquisitions), especially when combined with the influences from the bankers, lawyers and other assorted advisers who can earn big fees from clients engaged in mergers. Most CEOs get to where they are because they want to be the biggest and the best, and many top executives get a big bonus for merger deals, no matter what happens to the share price later (The Basics of Mergers and Acquisitions n.d.)." Mergers can also be driven by fear. Sometimes, companies feel that they should pursue acquisition before being acquired or faced by a larger competitor. Another reason for failure during consolidations can be termed as "business myopia." The company acquiring a smaller firm often manages to integrate the businesses but overlooked the important aspect of "human integration." Experts report that "Cultural integration is ignored in the majority of business combinations. This is a major reason why 60 percent to 80 percent of all business combinations undergo a slow, painful demise' and "85 percent of failed acquisitions are attributable to mismanagement of cultural issues." As human resource is very important in the strategies that companies pursue, they should be overlooked during consolidations. First, the people who focus on the acquisition are skilled in strategy, the industry and in finance. Second, the people most affected by the action-the employees of the purchased organization-do not know the business objectives, see change as a threat, have no real influence over the events, and wonder immediately how they will be affected personally (Palmer n.d.). Mergers and acquisitions should always be consistent with the organizations strategies. Failure of these consolidations should not be blamed on mergers and acquisition but on the company's motivation and management after the deal. References Antes, G 2003, ROI Guide: Payback Period, Retrieved 29 June 2006, from http://www.computerworld.com/managementtopics/roi/story/0,10801,78529,00.html Chatfield, R & Dalbor, M 2004, Hospitality Financial Management, New York: Prentice Hall Expropriation 2006, Retrieved 29 June 2006, from http://en.wikipedia.org/wiki/Expropriation Expropriation Case Sampling, n.d., Retrieved 29 June 2006, http://www.aon.com/us/busi/risk_management/risk_transfer/trade_credit/political_risk/to ols_and_solutions/claims_sampling.jsp Lightfoot, D. 20003, Return on Investment in CTP, Retrieved 29 June 2006, from http://www.newsandtech.com/ctp_chicago/presentations/ROI.pdf Palmer, B n.d., Why 70% of Mergers and Acquisitions Fail, Retrieved 29 June 2006, from http://www.interlinkbusiness.com/artmergers.html The Basics of Mergers and Acquisitions, n.d., Retrieved 29 June 2006, from http://www.investopedia.com/university/mergers/mergers5.asp Read More