Evaluation Of Investment Alternatives Essay

Introduction Capital budgetingA critical role of a monetary manager is the evaluation of bang-up projects. This is a very of the essence(p) task because the money involved in much(prenominal) activities is signifi toleratet and the make or loss derived from will highly influence the financial carrying into action of the whole system of rules (Brockington R. B. 1996, p 102). Indeed, Nobel laureates Modigliani and Miller suggested in their theory of pileus structure that the nourish of a company is non affected by its gearing, but the primary factor that influences such value is the investment funds in wealth creating projects (Pike R. et al. 1999. p 557 and 577).1.1 Evaluation of plans if their risk equals that of the stanch1.1.1 kale manifest protect Method forge X dilate000010002000300040005000initial Investment(2,700) notes Flows4706109509701,500profit Cash influx/(Outflow)(2,700)4706109509701,50012% brush off Rate1.00000.892860.797190.711780.635520.56743 consecpac e shelter(2,700)419.64486.29676.19616.45851.15 gelt familiarise harbor 349,720PLAN YDetails000010002000300040005000Initial Investment(2, degree Celsius)Cash Flows3807008006001,200 unclutter Cash Inflow/(Outflow)(2,100)3807008006001,20012% send away Rate1.00000.892860.797190.711780.635520.56743 accede revalue(2,100)339.29558.03569.42381.31680.92Net Present Value 428,970 line Drury C. 1996, p 389.1.1.2 Internal Rate of Return MethodPLAN XYearNet Cash Inflow/(Outflow)Discount Factor*Present Value16%17%16%17%0(2,700,000)1.00001.0000(2,700,000)(2,700,000)1470,0000.862070.85470405,172.90401,709.002610,0000.743160.73051453,327.60445,611.103950,0000.640660.62437608,627.00593,151.504970,0000.552290.53365535,721.30517,640.5051,500,0000.476110.45611714,165.00684,165.00Net Present Value17,014(57,723)PLAN YYearNet Cash Inflow/(Outflow)Discount Factor*Present Value18%19%18%19%0(2,100,000)1.00001.0000(2,100,000)(2,100,000)1380,0000.847460.84034322,034.80319,329.202700,0000.718180.70616502,7 26.00494,312.003800,0000.608630.59342486,904.00474,736.004600,0000.515790.49867309,474.00299,202.0051,200,0000.437110.41905524,532.00502,860.00Net Present Value45,670.80(9,560.80)Source Horngren T. C. et al. 1997, p 785 787.1.1.3 Evaluation of projects formulate Y is more financially feasible under both methods. The net familiarise value of intention Y is 79,250 428,970 349,720 high than final cause X. The internal ramble of return of Plan Y is also 2.61% higher than the other plan, indicating a higher margin of safety on losses in field the expected cash flows atomic number 18 not achieved (Randall H. 1996, p 446).1.2 Examination of plans at different risk profiles1.2.1 Net Present Value MethodPLAN XDetails000010002000300040005000Initial Investment(2,700)Cash Flows4706109509701,500Net Cash Inflow/(Outflow)(2,700)4706109509701,50013% Discount Rate1.00000.884960.783150.693050.613320.54276Present Value(2,700)415.931477.722658.398594.920814.140Net Present Value 261,111PLAN YD etails000010002000300040005000Initial Investment(2,100)Cash Flows3807008006001,200Net Cash Inflow/(Outflow)(2,100)3807008006001,20015% Discount Rate1.00000.869570.756140.657520.571750.49718Present Value(2,100)330.437529.298526.016343.050596.616Net Present Value 225,417Source Hirschey M. et al. 1995, p 799.1.2.2 Comparison of decisions at different risk ratesWhen the discount rate of the project is considered instead of the overall rate of the company, the financial viability of Plan Y diminishes because this plan is a riskier project than the other one and hence, a higher discount rate is chosen. The process of discounting arises from the time-value of money principle, and the higher the discount rate the lower berth the manifest value from the cash flows generated from the project (Pike R. et al. 1999, p 66 & 67). In such a stance, Plan Y is no longer the most crush project because Plan X net get value exceeds that of Plan Y by 35,694 (261,111 225,417).1.3 Analysis of cert ain cream data for plans1.3.1 Net Present Value MethodPLAN XDetails0000100020003000Initial Investment(2,700)Cash Flows470610950Net Cash Inflow/(Outflow)(2,700)47061095013% Discount Rate1.00000.884960.783150.69305Present Value(2,700)415.931477.722658.398Net Present Value -1,147,949 + (100,000 x 25%) = -1,122,949PLAN YDetails000010002000300040005000Initial Investment(2,100)Cash Flows3807008006001,200Net Cash Inflow/(Outflow)(2,100)3807008006001,20015% Discount Rate1.00000.869570.756140.657520.571750.49718Present Value(2,100)330.437529.298526.016343.050596.616Net Present Value 225,417 + (500,000 x 20%) = 325,417Source Lucey T. 2003, p 416.1.3.2 Comparison of real option plans with original plansIf we consider and apply the real options available, Project Y becomes the best project, on the contrary of the conclusion noted in sub-section 1.2.2. It is also charge nothing that the application of the real option for Plan X is not financially viable because we will end up with a ban net p resent value. If we compargon the net present value of Plan Y under the real options scheme with the net present value of Plan X we tolerate deduce that Plan Y real options project is more feasible than the other plan since the net present value is 64,306 higher 325,417 261,111.1.4 Effect of Capital RationingCapital circumscribe is an absolute reverberateion on the amount of finance available for a project irrelevant of cost. This should not be conf apply with scarcity of sparing resources. Capital confine on projects is sometimes applied even though the organization posses or can attain available finance. For example, a capital rationing may be oblige on the amounts of debts an organisation can take in order to frontier the gearing of the firm (Brockington R. B. 1996, p 151).When conditions of capital rationing argon imposed, there is the possibility that the most best project is not selected. Therefore yes capital rationing may set up the selection of Plan X or Plan Y. F or example if a capital rationing is adopted by the firm which states that the initial investment cannot exceed 2,000,000 due to its effect on gearing.Under such conditions no Plan would be selected by the firm. Another example of capital rationing that will affect the project choice is if management decided to restrict expansion of the factory, because they fear that control on employees may be mixed-up affecting negatively their relationship and control on staff. In this boldness Plan X would be excluded, even though it is the most optimal project as denoted in sub-section 1.2.2., and the available choice would be Plan Y.1.5 Financial instruments available for private companiesThe alternative financial instruments that the firm can use, apart from sh ars areCorporate Bonds & DebenturesOverdraft facility by the depository financial institution strand loanVenture capital andLeasing1.5.1 Advantages and disadvantages of integrated bonds/debenturesThe advantages related to corpora te bonds are (E*Trade Financial website)Corporate bonds are usually lent at a longer period of time (Veale R. S. 2000, p 155).Interest payments for bonds are tax income deductible.Interest rates of corporate bonds are frequently lower than those of banks.Percentage ownership of shareholders is not weaken by the issue of corporate bonds or debentures (Veale R. S. 2000, p 156)The disadvantages encountered with corporate bonds areObligation of interest on the firms cash flow, thus increasing the risk of unsuccessful person during periods of financial problems.Upon maturity, the company has to pay back all the amount of the bond.1.5.2 Advantages and disadvantages of bank overdraft facilityA bank overdraft facility can provide the by-line benefits (tutur2u website)Allows flexibility of finance. The company can increase the overdraft facility within satisfactory limits.Interest is only aerated on the amount used and is tax deductible.Percentage ownership of shareholders is not diluted b y victorious an overdraft facility.The disadvantages imposed by an overdraft facility are (tutur2u website)Rates of interest are higher than those of bank loans.Money due is repayable on demand.The facility limit can be changed by the bank according to its discretion.Usually used for short-term borrowing.1.5.3 Advantages and disadvantages of bank loansThese are the advantages derived from bank loans (tutur2u website)Loan is repaid back in regular payments thus allowing better cash management.Lower interest charged than bank overdraft.Percentage ownership of shareholders is not diluted by taking an overdraft facility.Large amounts can be borrowed for long term finance.Limitations of this image of finance are (tutur2u website)Interest has to be paid within a specify date.Less flexible than an overdraft facility.1.5.4 Advantages and disadvantages of gauge capitalThe advantages of venture capital are ( crease inter-group communication website)Obtain proficient management expertise, if they get involved in the firms operations.Large sums of finance can be obtained from venture capital.The disadvantages incurred by using such medium of finance are (Business Link website)Require detailed financial reporting standardized business plans and financial estimates.Legal and accountancy fees are incurred in the negotiation process.Firm read a proven track record to take such finance. risque returns are frequently expected from venture capitalists.15.5 Advantages and disadvantages of leasingThe advantages obtained from leasing are (Enterprise. Financial Solutions website)Provides 100% financing of asset.There is no need of credit lines with banks and other depositary associations, which are hard to obtain.Minimal paperwork required to acquire lease.Acts as hedging against inflation. limber payments are allowed in leasing.Interest on leasing is not subject to increases like bank overdrafts.The disadvantages encountered through leasing finance are (Auto Leasing Software deal Tips website)The organisation is committed to the entire validity period of the lease.High amounts of insurance reporting are frequently demanded in leases.No ownership of the asset the firm is using in the projects operations.ReferencesAuto Leasing Software Lease Tips. Disadvantages of leasing (on line). on hand(predicate) from http//www.autoleasingsoftware.com/LeaseTips/Disadvantages.htm (Accessed 13th March 2007).Brockington R. B. (1996). Financial Management. Sixth Edition. London DB Publications.Business Link. Equity Finance (on line). gettable from http//www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1075081582 (Accessed 13th March 2007).Drury C. (1996). Management and Cost Accounting. Fourth Edition. London Thomson Business Press.Enterprise.Financial Solutions. Advantages of leasing (on line). Available from http//www.efsolutionsinc.com/Advantages_of_leasing.htm (Accessed 13th March 2007).E*Trade Financial. Corporate Bonds Overview (on line). Avai lable from https//us.etrade.com/e/t/kc/KnowArticle?topicId=13200&groupId=8722&articleId=8723 (Accessed 13th March 2007).Hirschey M Pappas L. J. (1995). total of Managerial Economics. Fifth Edition. Orlando The Dryden PressHorngren T. C. Foster G. Srikant M. D. (1997). Cost Accounting A Managerial Emphasis. Ninth Edition. London Prentice-Hall International (UK) Limited.Lucey T. (2003). Management Accounting. Fifth Edition. massive Britain Biddles Ltd.Pike R. Neale B. (1999). Corporate Finance and Investment. Third Edition. London Prentice-Hall International (UK) Limited.Randall H. (1999). A Level Accounting. Third Edition. Great Britain Ashford Colour Press Ltd.Tutur2u. Bank Loans and Overdrafts (on line). Available from http//www.tutor2u.net/business/gcse/finance_bank_loans_overdrafts.htm (Accessed 13th March 2007).Veale R. S. (2000). Stocks, Bonds, Options and Futures. Second Edition. United States of America spic-and-span York Institute of Finance.