Beruflich Dokumente
Kultur Dokumente
AND MANAGEMENT
Student Name |
Student ID
B0436DHDH1112
CONTENTS
INTRODUCTION................................................................................................2
LITERATURE REVIEW........................................................................................3
Non-discount Methods..................................................................................3
Accounting Rate of Return.........................................................................3
Payback Period..........................................................................................5
Discounted Cash Flows (DCF) Analysis Methods..........................................8
Net Present Value (NPV)............................................................................8
Internal Rate of Return (IRR)...................................................................11
Advantages and Disadvantages of DCF Methods....................................11
CONCLUSION..................................................................................................14
REFERENCES..................................................................................................15
INTRODUCTION
Over the past decades, the fluctuations of interest rate, inflations and
foreign currencies exchange has made the financial risk management
become important matter beside the other risks related to the industrial
operation. Regarding to Vernimmen, et al. (2009), the role of financial
managers have been increased since their primary role is ensuring the
sufficient supply of capital.
However, there are variety of methods that can be applied to help the
managers enhancing their investment decisions. The very first part mentions
about the traditional or non-discounted cashflows methods: Average Rate of
Return (ARR) and Payback Method. The common sense of these two
techniques is that they do not include the time value of money.
The discounted cashflows analysis would help the both public and
private sectors to resolve those related issues. However, there would be the
difference in analysing the risks factors as well as cost of capital between the
two sectors.
LITERATURE REVIEW
NON-DISCOUNT METHODS
Accounting Rate of Return
The Accounting Rate of Return (ARR) or the Return on Capital
Employed (ROCE) is the figure that shows the companys efficiency in
creating the profits based from the employed assets (Pike & Neale, 2009). It
is helpful to measure the return of per invested dollar (Brealey, et al., 2011).
The formula to calculate the ARR is:
Profit Before Interest Tax
100
Capital Employed ( AssetsCurrent Liabilities)
The ARR relates totally to the profits and concerns to the employed
capital; hence, it is easy to understand and communicate among managers.
It has become one of the main business ratio. The ARR is later can be used to
calculate the Economic Value Added (EVA) which can help to shows the
current performance of the firm (Vernimmen, et al., 2009):
EVA = Capital Employed (ROCE WACC (Weighted Average Cost of
Capital))
For example, a company which has the income statement and balance
sheet as below:
INCOME STATEMENT
Revenue
Cost of sales
Wages and Salaries
Other costs
Profit before interest and
000
24,000
8,000
5,000
4,000
7,000
taxation
Interest
Tax
Profit after interest and taxation
900
1,000
6,000
3
BALANCE SHEET
Total assets
Shareholders equity
000
17,600
6,000
Non-current liabilities
Bank loan
4,900
Current liabilities
Payable account
Bank overdraft
3,800
2,900
6,700
ignored. Once these people interests are ignored, it would not surprise if the
business cannot withstand on the marketplace.
Payback Period
The payback method is the simplest approach regarding to the
investment appraisal and mostly preferred by the small business owners or
sole traders because of its obvious simplicity. Regarding to Brealey, et al.
(2011), payback method is used to rate the project paybacks period which is
counted by the number of years it takes before the cumulative cash flow
equals the initial investment. With the payback method, there are two cases
that happen (Zutter & Gitman, 2012); firstly, in the case of an annuity, the
payback period can be counted by dividing the initial investment by the
annual cash inflow. Secondly, if the cash inflows is mixed stream, the yearly
cash flow must be accumulated until the initial investment is recovered.
Since the calculation of the payback method is quite simple; hence, the
decision criteria of this method is basically accept or reject decision.
Regarding to Ross, et al. (2008), the applied decision criteria for this method
would be:
In the case that calculated payback period is less than the planned
For example, the table below illustrates the cash flow of two projects:
Project A and Project B. An assumption is made that both projects have the
innitial investment of 1,200,000:
Year
Project A
Project B
1
2
3
4
5
(000)
400
400
400
400
400
(000)
250
355
490
595
675
6
Total
2000
2365
For the Project A, because it has the annuity of cash inflows, the
payback period is:
1200
=3 years
400
For the Project B, with the mixed stream of cash inflows, the payback
period would be:
Payback=4 years+
Year
Project
Cumulative Cash
0
1
2
3
4
5
B
-1200
250
355
490
595
675
Inflows
-1200
-950
-595
-105
105
365=4 years64 days
595
The payback ignores all the cash flows after the cut-off date. It is
not concerned with the profitability of the projects. Regarding to the
aspect of the private sector, this means it totally ignores the
The Net Present Value (NPV) is one of the discounted cash flows
investment appraisal techniques. The NPV has the formula as below:
n
NPV =
t=1
CF t
(1+r )t
C 0
The decision making process based on the value of the NPV then can
be considered simply as: an investment should be accepted in case the NPV
is positive and rejected if the NPVs value is negative (Ross, et al., 2008).
opportunity costs.
Ignoring the sunk costs since they are in the past and
overhead costs.
The salvage value of the project should be mentioned.
3. The inflation should be treated consistently. This means the
managers must discount the nominal cash flows at a nominal
discount rate and treat the discount real cash flows with the real
rate. It is not wise to mix the different types of cash flows and rate.
For example of NPV, a company wants to make investment and the
managers have three projects with the discount rate of 12%, the detailed
tables are:
Year
(Initial
investment)
1
2
3
4
5
Project A
(000)
-1500
Project B
(000)
-1500
Project C
(000)
-1500
235
390
567
721
811
115
218
765
826
985
325
339
409
514
535
Project A
Present Value @
r
1
2
3
4
235
390
567
721
12%
0.893
0.797
0.712
0.636
(DCF)
209.855
310.83
403.704
458.556
10
0.567
459.837
Total DCF
1842.78
Initial Investment
1500
NPV
342.78
The NPV of the Project A is positive, therefore, it can be accepted.
Yea
811
Project B
Present Value @
Discounted Cashflow
r
1
2
3
4
5
12%
(DCF)
115
0.893
102.70
218
0.797
173.75
765
0.712
544.68
826
0.636
525.34
985
0.567
558.50
Total DCF
1904.95
Initial Investment
1500.00
NPV
404.95
The NPV of the Project B is also positive, therefore, it is accepted.
Yea
Project C
r
1
2
3
4
5
325
339
409
514
535
Present Value @
Discounted Cashflow
12%
(DCF)
0.893
290.23
0.797
270.18
0.712
291.21
0.636
326.90
0.567
303.35
Total DCF
1481.87
Initial Investment
1500.00
NPV
(18.14)
The NPV of the Project C is negative, it is neglected.
The NPV of the Project B is larger than the Project A; therefore, it would
be selected instead of Project A although the first two years of the Project A,
the cash flows may be greater.
IRR=R 1+
NPV 1
( R2R1 )
NPV 1NPV 2
Meanwhile:
R1 = Rate used to obtain the NPV1 with positive value
R2 = Rate used to obtain the NPV2 with negative value
NPV1 = Positive NPV
NPV2 = Negative NPV
12
relevant cash flows, not just only the break even point.
NPV focuses in the real business objectives that concern to the cost
of capital.
13
14
With the public sectors, the citizens in a democracy context will play
the role of shareholders and they help to elect the government. Regarding to
Brealey, et al. (1997), the voters not only have the divergent objectives but
there is also no guarantee that a majority voting system will let the
government act so as to maximize the aggregate net benefits to all voters:
Voters and government consider not only with the issue of maximizing the
net benefits but also the government must ensure the equitable wealth
distribution among the voters. As a result, the investment in public sectors
may only respond to political economy motives rather than simple economic
efficiency considerations (Dabla-Norris, et al., 2012). Moreover, the disparate
objectives of the voters can help enhancing the discretion of the government
and further their scope for self-serving behaviour (Brealey, et al., 1997).
Consequently, regarding to Lant Pritchett (2000) in a journal of Dabla-Norris
et al., (2012), no probable behavioral model would occur in which every
dollar that the public sector spends as investment creates economically
valuable capital. The judgment regarding to the government efficiency,
hence, is much more challenging.
In the other hand, it is quite difficult in practice for the private sectors
to estimate the appropriate discount rate and the NPV is quite difficult to
understand regarding to the non-financial managers (Pike & Neale, 2009).
Therefore, it is quite important for the managers to analyse carefully the risk
that can occur in the future context of the project. With the public sector, the
government can make the intervention in order to ensure the welfare
maximization. Hence, the risk pressure for the government to make the
investment is low. Regarding to Brealey, et al. (1997), the government has
the right to make the taxation in order to overcome the free-ride problem.
The free-ride refers to the consumers who have the incentive to benefit from
the resources, goods, or service without paying the costs. In another way,
the government may regulate the price of the monopoly.
15
16
Yea
Net Profit
Profit
(000)
after tax @
345
490
568
736
913
15%
293.25
416.5
482.8
625.6
776.05
1
2
3
4
5
PV @ 12%
DCF
(000)
0.893
0.797
0.712
0.636
0.567
Total DCF
Initial
261.87
331.95
343.75
397.88
440.02
1775.48
1500.00
Investment
NPV
275.48
The NPV of this project for private sector would be 275,480.00.
The tax appearance in the NPV table means that the private sectors
would have the motivation to pursuit the tax-minimizing strategies in order
to increase the NPV of the project. Moreover, the managers must also take
into account the risk that the tax may vary in the future. The government,
however, surely ignore it since regarding to Bailey and Jensen (1972) in a
journal of Brealy, et al. (1997) stated that: (a) the risk of public-sector
projects is distributed over the entire population, (b) the risks are diversified
through the ownership of government can enhance eliminating the risks to a
very large extent and (c) the diversification can be accomplished more
cheaply by the government than the financial markets. As a result, when
applying the NPV or IRR or any DCF methods, the public-sector projects
should be valued by discounting their pre-tax cash flows by the pre-tax
interest rate (Brealey, et al., 1997).
17
CONCLUSION
In conclusion, every investment appraisal method has its own
strengths and weaknesses. It would depend on the purpose and ability of the
users. The non-financial users would like to have the simple format of non
DCF methods while the financial directors would need to have the detail
capital budgeting report to give out appropriate decision. In the business
context, while the private corporate can be united in the common objective
of maximizing the shareholders benefit, the public sector in another hand
focuses in analyzing the projects in order to adapt with the various
requirements of the citizens. This can lead to the different projects approach
between the two sectors. The private firms financial managers must
acknowledge about the risk as well as the fluctuation regarding to the
discount rate that can have impact toward the employed capital. The public
sector can have the ability to make the intervention toward the investment
environment and diversify the risk factors.
REFERENCES
1. Atrill, P. & McLaney, E., 2006. Accounting and Finance for NonSpecialists. 5th ed. s.l.:Prentice Hall.
2. Bock, K. & Truck, S., 2011. Assessing Uncertainty and Risk in Public
Sector Investment Projects. Technology and Investment, Volume 2,
pp. 105-123.
3. Brealey, R. A., Cooper, I. A. & Habib, M. A., 1997. Investment
Appraisal in Public Sector. Oxford Review of Economic Policy, 13(4),
pp. 12-26.
4. Brealey, R. A., Myers, S. C. & Allen, F., 2011. Principles of Corporate
Finance. 10th ed. s.l.:McGraw-Hill Irwin.
5. Connolly, M. B., 2007. International Business Finance. s.l.:Routledge.
18
19