Capital Investment Analysis: Strategic Corporate Finance (Essay Sample)

STRATEGIC CORPORATE FINANCE
Student’s Name
Course
Professor’s Name
Institutional Affiliation
Date
Capital Investment Analysis
Task 1
Capital investment requires that companies do an assessment of the investment options available to establish the profitability of the projects before they do the actual investment (Constantinides, & Ghosh, 2017, pg. 416). This is an analysis that is determined to come up with a supposed returns on a long term project so that management can forecast and make a decision whether to take up the project or not. In most cases, a company’s long term investment project would include fixed assets like equipment and machinery (Laux, 2008, pg. 626). Yorkshire Solar Farms Plc is considering two solar power plants for investment. The plants have been categorized as Small and Large plants. Capital investment analysis is done by evaluating the projects’ cashflow, risks associated with the options and the resale value. This way management is able to assess the appropriateness of taking up the investment through profitability.
The Yorkshire Solar Farms Plc, just like any other company that wants to make a decision on a long term project investment looks into assessing the projects’ cashflows so as to make a prudent investment decision. Investors want to ensure high returns on any investment project, low associated risks and greater resale value. According to Parrino, (2015, pg. 34) the corporate finance is a finance branch in any organization that looks into the investment options of particular corporations (Ozorio, et al 2013, pg. 29). The Yorkshire Company’s investment strategy can be assessed as below.
The investment management team of Yorkshire Solar Farms Plc has evaluated the two options using the Net profit Value (NPV) method, internal Rate of Return (IRR), Accounting Rate of Return (ARR) method and also the Payback Period (PP), (Sandahl, & Sjogren, 2003, pg. 564). The management will make a decision based on these findings corresponding to what Masini, & Menichetti. (2013, pg. 520) says. This is as shown below;
Net Present Value (NPV)
This model seeks to establish the profitability of a project by determining the projects time values of the cashflows from the project both inflows and outflows. NPV is the difference between the present value of the cash inflows and the present value of cash outflow of the projects in question. NPV is usually used when there is one investment outflow at the beginning of the project. The formula for NPV is;
NPV (i,N) = t=1nRt(1+r)^t
Whereby t is time of cashflows, r the discount rate and Rt the net cashflow at time t
Yorkshire Solar Farms NPV for the two projects is as below;
NPV small project = £7,089,000 and NPV Large project = £ 11,712,000 from the excel worksheet.
Decision making; a positive NPV indicates more money for the investors while a negative NPV is not advisable because it means the project won’t be bringing in money. A NPV of zero means no changes whatsoever in the present values of the cashflows. The higher the NPV the more attractive an investment is (Gallagher, 2000, pg. 65).
Internal Rate of Return (IRR)
This is a discounting rate which seeks to equate the net present value of the cashflows from a project to zero. Therefore it is an interest rate that brings the NPV at Zero.
The formula is from the NPV foemula NPV (i,N) = t=1nRt(1+r)^t where the NPV is equal to zero we solve for r. Therefore is t=1nRt(1+r)^t =0
The Small project has an IRR of 12.2% and large one has an IRR of 10.2% as shown in the excel worksheet.
Decision; It is advisable for a company to invest when the IRR is greater than the required rate of return which is usually pre-determined (Tsado, & Gunu, 2011). Yorkshire’s rquired rate of reurn is provided as 15%.
Accounting Rate of Return
ARR does not take into account the time value of money. It’s a percentage return of the average profit obtained from a project and its average investement. This is a simple model and for Yorkshire Solar Farm the ARR is 57% for the small project and 50% for the large investment.
Formula is ARR= average return during a period/average investment.
Decision; A desirable ARR is one that is greater than the required rate of return. When comparing projects, the higher the ARR the more attracive the investment.
Payback Period (PP)
Paybck period refers to the length of time that an invetsment can take to recover its initial outlay (Fazzari, Hubbard, & Peterson, 1998, pg. 141). A shorter PP is desirable because it means the project will take a shorter period to repay the investment cost as compared to an investment with a longer PP.
Payback period=Initial invetment/expected cash inflows
Yorkshire Solar Farm Plc determine the two preojects PP as shown in the excel worksheet.
PP for small plant is 8.39 years and that of large plant is 9.29 years.
Advice on the Desirable Project for Yorkshire Solar Farm Plc

NPV £“000”

IRR %

ARR %

PP (years)

Small Plant

7,089

12.2

57

8.39

Large Plant

11,712

10.2

50

9.29






An investment decision based on the above findings is that Yorkshire Solar Farm Plc should invest in the SMALL PLANT.
Reason is that comparing the analysis outcome for the two plants, Small plant has a shorter payback period,a higher ARR and a n IRR of 12.2% nearing required rate of return as opposed to the large on that has only a higher NPV and undesirable IRR, ARR and PP.When making an investment decision, the advise is to look at a variety of outcomes from different analysis models and make judgement based on dorminant desirable project.
Task 2
Sensitivity Analysis
Sensitivity analysis is a technique used in determining the impact of changes in certain independent variables in the dependent variable in a given situation (Hillier, Grinblatt, & Titman, 2011). For instance in the Yorkshire Solar Farm Plc analysis, we came up with a sensitivity analysis where we would alter the cashflow inputs one by one and determining the impact they have on the Net Present Value of the two projects. In our calculations, the variables we used in the exercise include the cost of capital, the insurance, wages, quantities produced, cash reserves and even the selling price among other factors.
The variables listed used in the analysis affects the NPV of the projects. This can be usedd to determine the importance of these variables in the investement decision making process of the company. This is true because the analysis helps analysts to predict the outcome of a decision based on some range of variables. Therefore, analysts get to understand how to adjust the variables so as to reach the desired outcome. Investors want to put their money in projects whose return is attractive, this means analysst can alter the random variables so that the outcome is acctually one that is desirable.

SMALL

SMALL

LARGE

LARGE

Variables

+10%

-10%

+10%

-10%

Quantity

UP

DN

UP

DN

Selling price

UP

DN

UP

DN

Government grant

UP

DN

UP

DN

Capital cost

DN

UP

DN

UP

insurance

DN

UP

DN

UP

Business rates

DN

UP

DN

UP

Wages

DN

UP

DN

UP

Management fee

DN

UP

DN

UP

Cash reserve

DN

UP

DN

UP

Other operating costs

DN

UP

DN

UP

Discount rate

DN

UP

DN

UP

Original NPV

7089

7089

11712

11712

In the table above, the sensitivity analysis shows how the NPV is impacted by the adjustments of the variables in the table. In the table, we have indicated using the initials UP to mean upward variation and Dn to indicate a downward variation of the NPV from the actual NPV for both small and large plant investment options (Tsado & Gunu, 2011). This analysis will help us in determining the necessary variable adjustments to ensure a better decision making for the two plants.
Advantages of Sensititity Analysis
The sensitivity analysis is used to identify variables that are critical in an analysis so that additional information can be obtained. For instance in our table above we can see that variables like quantity of produce and the selling price is so crucial. Their variances are too high indicating how sensitive they are to the decision making concerning which project the company can choose to invest in. This way, management can consider finding more information on this variables such that any necessary adjustments are in line with the company’s investment objective (Ross, Westerfield, & Jordan, 2008). Once enough data is available for these critical variables, the decision maker can then be able to identify weak points and make prudent variations for good decision making.
The model helps expose inappropriate forecasts so as to guide the decision investor to concentrate on relevant variables. In our case above, the relevant variables are those that actually makes an impact on the net present value of the investment options. The variables such as the selling price, the quantity of produce, the capital costs and even the discounting rate cannot be left out in an anlysis. This is because of the impact they have on the NPV during the calculation of a project’s profitability. Using sensitivity analysis helps companies avoid too much focus o...