Benefits of Using NPV as an Appraisal Method (Term Paper Sample)
Structure of the Cash Flow Statement
The main components of the cash flow statement are:
Cash from operating activities
Cash from investing activities
Cash from financing activities
Disclosure of non-cash activities, which is sometimes included when prepared under generally accepted accounting principles (GAAP).1
It’s important to note that the CFS is distinct from the income statement and the balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded as revenues and expenses. Therefore, cash is not the same as net income—which, on the income statement, includes cash sales as well as sales made on credit.
READYREADY PLC REPORT
A) INVESTMENT IN ADDITIONAL EQUIPMENT
The calculations as attached in the appendices show that the NPV was negative. NPV uses the decision rule of investment in projects that have a positive NPV. In our current situation where it is negative, the project is said not to be worth since it would not generate long-run profits for the firm. The major assumption made were that cash flows from released working capital are realised in year 6, the scrap value forms the terminal cash flow.
B) RECOMMENDATION ADVISING ON VIABILITY OF THE PROJECT
From the analysis the project should not be undertaken since it has a negative NPV. Under the method projects are undertaken if the calculated NPV is positive. That is NPV ≥0. This is to mean that the total cash flow generated from the project should be greater than the cost invested. For our current project the cost is higher than the cash inflows making it not viable.
Investment appraisal methods
Investment decisions are undertaken in order to help achieve the company objective. The investment decisions are importance as they influence the size of the firm and increase the value of share. Therefore, firms need to evaluate possible projects so as to ensure efficient allocation of finances (Robert et.al 200. The firm could either make use of traditional appraisal methods including the payback period (PBP) and accounting rate of return (ARR), or could make use of the modern approaches including use of net present value (NPV), internal rate of return (IRR), and profitability index (PI). The method have their own strengths and weaknesses as well as their appraisal criteria as discussed below;
The PBP method makes use of the inflows and outflows to assess how soon the cost of investment would be realised. Therefore it has widely been referred to as the pay-out period method. It has been widely used for it is simple to use and interplate, it is a fast way used by managers to assess the time it takes to recoup the initial investment, it is important for preliminary screening of viability of a product, and it also gives rough idea on how profitable a project is expected to be (Robert et.al 2002). However, it does not show actual profits, does not care about cash flows realised after realisation of initial cost, and does not care about time value of money. Using this method the decision rule is acceptance of projects with minimum PBP compared to those set by management.
The ARR accounts profits from financial returns to assess viability of investment proposal by dividing the average income after tax with average investment. It is a more improved version compared to PBP as it uses profits and thus cares about all inflows, it is simple, and easier to ascertain. However, it also does not care about time value of money and does not care about recovery of costs. Using the method, projects with ARR higher than that set by the management are selected (Robert et.al 2002).
NPV method forms one of the modern approaches that discount future cash flows then compares to the initial cost of investment. Projects with a positive NPV are selected. It is based on the concept that a shilling tomorrow is not the same as a shilling today. The method has widely been applied for lump sum cash flows as well as annuity. It also has received considerable attention when it comes to evaluation of projects with unequal lives. The NPV is realised form deducting discounted cash outflow from discounted cash inflows. For projects with a positive NPV, investment is undertaken. The method is widely applied as it recognises time value of money, it uses entire cash flows, and is in line with the overall firm’s objective of wealth maximisation. However, it ignores PBP, it may not give efficient results for projects with unequal lives, it is difficult, and using the cost of finance is a difficult concept.
IRR makes use of the principles of NPV. It is the rate at which the NPV equals zero. That is the inflows equal the outflows. It is a representation of the highest interest a firm would be willing to pay to finance a project. The method has been widely accepted as it recognises time value of money, it considers cash flow over the entire period, and it does not use the cost of finance, and helps in maximisation of shareholders wealth (Robert et.al 2002). However, it is difficult to use, expensive, and time consuming. In addition, it may lead to multiple results making it hard for managers to apply.
The PI method also used the NPV approach but instead of subtracting the present values with cost it is divided. The method is simple to use, and recognises time value time value of money. However, it may be difficult to assert with certainty about the economic value of a project.
Benefits of using NPV as an appraisal method
The net present value method is important and has its benefits over the other method. Apart from its high recognition of time value of money, and being consistent with the investors objective as well as the wealth maximisation objective (Glynn 2004). The method is superior to other as it is best when the projects have unequal lives, it is also useful when comparing projects with cash outlay that are not the same, and could also be used when the cash flow patterns differ. Therefore, it is Mostly applied by firms in assessing investment projects more so those that have long periods.
c) Manager’s decisions, role in achieving corporate objective, and possible conflicts
Most managers have been held up in trying to bring the relationship between business finances and financial management. As a manager, they are responsible of ensuring proper financial allocation and preparation in accordance with law and set guidelines which is of essence to the firm making up business finance (James 1990). On the other hand, financial management which is a branch in finance that looks at allocation of resources which are scarce has to be assessed to ensure the firm resources are allocated efficiently (Robert et.al 2002). This is following the free market systems as well as ensuring the investors’ funds are wisely invested. Consequently, yielding the most of its best returns (James 1990). Therefore, looking at the needs on bases of them being basic as well as those that address shortages. This is of importance to the firm in achievement of its corporate objective. This is because the managers ensure projects that are underway are not left pending and funds allocated are not misused. In addition, the managers ensure that the funds available will not all be put into project work leaving administrative work pending. This roles are at times in conflict. This is because each department has its objectives and will attempt to have budgets pulled to their side (Kathleen 2014).
Therefore, managers make use of cash budgets as well as funds flow statements to ensure that they are able to minimise the gaps between the projected and the actuals with funds provision for shortages that may arise. Therefore, they do not lead unfinished projects (Thorsten et. al 2000). Therefore, the short-term needs must be managed to keep the company on its toes as well as properly liquid. Faced with the short-term objective, the managers has to ensure attainment to the long-term company objectives that are referred to as strategic decisions since they are useful in a number of ways (Robert et.al 2002). First, they influence the size of the company as they compose of the assets investments a firms would be willing to make. Managers who fail to invest do not move the company and it takes a firm so many years to grow as well as expand. Secondly, the long-term decisions influence growth since long-term investments generate cash flows that if re-invested lead to firm growth. Finally, it influences a firms going concerns and future sustainability (Felix and Valev 2004). This is because long-term commitments gives root to a firm as well as improve its networks. For this investments to be possible, the finance manager must calculate their sources of funding and come up with the most appropriate fiancé mix (Robert et.al 2002).
Therefore, a manager must be guided by principles of financial prudence including consultation with experts, involve investment committees, and ensure all stakeholders are not left out so as to come up with the most optimal finance mix. This all is to get involved with the firm stakeholder to ensure that they are all involves in giving their suggestions with regards to the investment project (James 1990). Therefore, ensuring that none is negatively affected thus not compromising future sustainability of the firm. However, in some instance, an attempt to satisfy all groups lead to conflicts. For instance, in the attempt to satisfy shareholders wealth maximisation, customers are hurt and the objective of profit maximisation is at stake. Also in the attempt to ensure customers welfares is maximised, the manager may conflict with profit maximisation objective since it reduces earnings (Thorsten et. al 2000).
Another bases for conflicting managerial functions has been on bases of scope. The managerial functions can be either routine or managerial in nature. The managerial functions require skilful planning, control and execution (Richard and Bill 2006). A manager has four key managerial functions including; investment of long-term assets mix decisions, it involves capital budgeting programs where the managers has to ensure investments to best projects. The firm is forces to commit its funds to assets that would generate future cash flows (Robert et.al 2002). Therefore, a finance manager has a role of evaluating the projects risks and returns to be able to evaluate their viability so that they do not commit a fi...
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