Financial Management – Theory and Application (Coursework Sample)
Financial anlysis and questions responsesource..
Financial Management – Theory and Application
* Explanation of inflation effects on required rate of return and distinction between real and nominal approach of evaluation of investment project
The rate of return quantifies the measure of return that an investment is going to yield from the particular required rate. This implies that the investment has a Return On Investment (ROI) which is placed at a certain quantified percentage which is the rate of return. When the inflation rises, financial professionals have realized that it rises with the required rate of return. This significantly reduces the returns anticipated from the investment since the Net Present Value that will be acquired from the investment will have to diminish with the increasing required rate of return. This works to diminish the overall figure of the Return On Investment for the project at hand making the investors lose money directed into the project. Inflation also works in a way that it increases the required rate of return expected by the shareholders of the investment. Some of the shareholders are the money lenders to the project. Their expected rate of return takes into consideration inflation rates and also factors in the interest rate to be acquired after lending their money to the project investors. When inflation rises, the expected rate of return by the stakeholders also rises which typically increases the cost of acquiring capital for the investment project (Titman et al., 2017). This majorly becomes an advantage to the lenders but has a significant impact on the project investors who have difficulties in affording the cost of capital for the money lent to them for the investment.
The difference between real and nominal approach to evaluation of projects is sharply distinguished on the considerations taken by the two approaches when evaluating a project investment. In the real approach, the interests and others costs associated to the project are accounted for which simply reveals the true cost and returns to be anticipated from the project. On the other hand, nominal approach assumes interest such as inflation and other costs by failing to account for them which seeks to seeks to cushion the consumer of make it affordable for the people investing into the project. This therefore means that the results got from the figures calculated for the project investment do not reflect the true and fair value of the project and are adjusted to appear appealing to the eyes of the investors (Titman et al., 2017). The other distinction is that the nominal approach is widely applied in the internal operations of an organization while the real approach is widely applied in the real market where every aspect of interest has to be accounted for an example in the accounting and valuation of shares and bonds. This is because the real market cannot afford to make the risk of excluding such fundamental interest rates and costs associated with finances because they are very influential in the decision making regarding investments for the projects. If they are assumed, wrong investment decisions can easily be reached into by individuals thinking that they have made a viable investment decision when actually the particular investment decision might be the poorest decision made (Vernimmen et al., 2014).
ii) Comments on the project to be chosen for the investment
Project A should be the one to be chosen for investment in M&R plc Company. This is by one of the simplest yet eminent reasons that project A is the one with the highest NPV as compared to the all other projects. Project A has a NPV value 28, 437 which implies that the discounted returns for the project at the end of the three years of investment are satisfactorily to the company and to the shareholders as well. When the returns of an investment are satisfactorily, the least thing an investor can do is to accept the project as an investment option since the good returns are anticipated despite the fact that they are not guaranteed to produce the same figure at the end of the period due to other market factors. The concept is also explained in Titman et al., (2017).
Similarly, project A is the only project that has positive returns across the period. Looking at the three years of investment, Project A forms the only project that the organization can enjoy positive profits across the period. This simply means that there is no period in time that the organization will interfere with the organizational finances to support the project after they have made the initial investment (Vernimmen et al., 2014). The other projects have negative cash flows in some points across the periods which will force the organization to direct organizational finances to support the operations of the projects. Therefore, to avoid further direction of organizational finances to the investments, Project A forms the best option for investment for the organization.
Project A is also the investment project that has the highest initial investment amount. This implies that is it the riskiest project to invest in by the organization since it takes a lot of courage and effective decision to direct a lot of organizational finances to a project. The fact that it is the riskiest, the project falls into the category of projects that have characteristics of high returns. It is generally known in the field of finance that the higher the risk of a project, the higher the returns. Therefore, the project has high risks thus higher returns are anticipated as also confirmed by the NPV calculated for the three projects. The project thus forms the most viable and most profitable project for the organization bearing in mind that the bottom line of any organization is to maximize profits (Burns and Walker, 2015).
The project also will be the best performing in the market. The rate used for the computation of NPV for the projects is the market rate of 10 percent. By revealing good NPV cash flows throughout the period of three years also implies that the operations of the project in the market are also anticipated to be well. These operations are reflected in the cash flows anticipated to emanate from the investment of the project thus presenting the project as the best option of investment by the M&R plc Company.
c) Discussion whether the company’s decision not to borrow is in the best interest of its shareholders
The decision by the company not to borrow is a wise decision made and it can be said from the very beginning that it is for the best interest of the shareholders of the company. Weighing the advantages and disadvantages of borrowing, it can be confidently said that the organization’s decision not to borrow is the best decision ever made by the organizational management in terms of financial management for the organization. This is a broader aspect and it has to be deeply understood to enhance better decision making which will help safeguard organizational financial operations (Gilchrist et al., 2015).
Having commended the decision as one in the best interest of the shareholders, it must be understood that borrowing is an exercise that entails acquisition of finances for the organization from the external sources of financing such as acquiring loans. This exercise comes with a cost to the organization since the external sources of finance attract interests on the principal amount of the loans. The higher the borrowing, the higher the accumulation of costs that are associated with the finances borrowed. An example, given an increasing amount of loans, even at a constant interest rate, the loan interest will accumulate as time goes making the amount owed by the organization to be more and more. Such costs of acquiring finances from the external environment of the organization are treated as expenses for the organization. The expenses are catered for by the shareholders. This is because the amount attributable to shareholders has to cater for the organizational expenses before it is apportioned to the various stakeholders. In simple language, the borrowing of finances minimizes the amount of dividends that can be attributed to each shareholder (Garin, 2015). Thus the decision not to borrow is in the best interest of the shareholders.
Similarly, borrowing is an exercise that involves taking finances from a corporation with the promise of refunding the principal plus the interest accrued and investing the borrowed money to a project that is only anticipated to yield returns that are not guaranteed. Borrowing is therefore regarded as an exercise of taking a risk because it is not a guarantee that the organization will get the finances to refund to whoever they borrowed from. They also have to undertake another risk by investing the borrowed money to a project which is only anticipated to yield profits that they are not sure of. This engagement presents the organization into a series of risks over a single source of finances. The borrowed funds therefore have two risks; the interest risk and the returns risk. This subjects the organization to double standard risks which are hard to cope with. These risks not only impact organizational performance but also interferes with the organizational finances in a significant manner. The truth is that whenever the organization is challenged, the shocks are felt by the shareholders since they are the owners of the business (Acolin et al., 2016). Therefore, limiting borrowing is in the best interest of the shareholders.
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