Question3: In respect of capital appraisal all the relevant cash flows which have to be taken into the account and the cash flows to be excluded by the project management team?
ESTIMATING CASH FLOWS:
It is the most important and the most difficult step in capital budgeting to estimate projects cash flows. The annual net cash flows and the investment outlays after a project go into operation. Many variables are included, and in this process many individuals and departments participate in the process. The capital outlays connected to the new project or product are normally maintained by the engineering and product development staffs. On the other hands, if we see costs are estimated by the cost accountants, production experts, personal specialists and the purchasing agents.
(Book Cash Flow Estimation And Risk Analysis Chapter N. 12, p. 548)
IDETIFYING THE RELEVANT CASH FLOWS:
In the start of any capital budgeting analysis is identifying the relevant cash flows as defined specific set of cash flows should be considered in making the decision at hand. There are often errors while in estimating cash flows, but there is only two cardinal rules which can help to avoid making the mistakes. Which are as follow.
1) The decision of capital budgeting must be based on cash flows instead of doing accounting income.
2) Only increment cash flows are relevant.
PURCHASE OF FIXED ASSETS:
Many projects require for the fixed assets, and the purchase of the fixed assets represent negative cash flows. The income of accounting is not decreased but the value of deprecation expense each year is deducted from the assets. But after the project life when it is sold in that case the after-tax cash proceeds to positive cash flows. It is also noted that full costs of a fixed assets involves any shipping and installation costs.
FREE CASH FLOW:
Is cash flows are available for the distribution to the investors? In the nutshell all the relevant cash flow for the project is the additional free cash flow which the company can expect if it implements the projects. It is all what the company could expect and it is the cash flow, if does not implement the project.
Free cash flow=NOPAT+ depreciation- Gross fixed asset expenditure- change in net operating working capital.
NON CASH CHARGES:
In order to calculate the net income value, the accountants normally use to subtract depreciation from revenue. So when the accountant does not subtract the purchase price of fixed assets when they calculate accounting income, they do subtract a charge for depreciation each year. The depreciation itself is not a cash flow but it has an impact on cash flow. So when it has an impact in cash flows it should be added in net income when estimating a projects cash flow.
CHANGES IN NET OPERATING WORKING CAPITAL:
At the end of the project's life the inventories will be used, but it will not to replace and the receivables will be collected without corresponding replacements because of these changes will occur, the firm will receive the cash flows. By doing this at the end we will get the result, that all the investment in operating working capital will be back by the end of the project's life.
THE EXPENSES OF INTEREST IS NOT INCLUDED IN PROJECT CASH FLOWS:
The weight of the WACC is the cost of capital and the rate of return necessary to satisfy all the firm's investors which are stockholders and the debt holders. the main and the most common errors or we can say mistake is of subtracting the interest payments when estimating a project's cash flows. So by doing this and subtracting the amount of interest payment from the project cash flow will increase double counting interest costs.
There fore, we should not subtract the amount of interest expenses when finding a project's cash flows.
INCREMENTAL CASH FLOWS:
In order to evaluate the project, we focus on all those cash flows that occur if and only if we accept the project. These kinds of cash flows are called incremental cash flows, it also represent the change in the firm's of total cash flow which will occurs as the direct result of accepting the project.
The cash outlay which has already been incurred and it cannot be recovered regardless of whether the project is accepted or rejected. The capital budgeting is to estimate the cash flows is available for the equity holders.
The second main problem relates to opportunity costs. It is cash flows that could be generated from the assets and it is not used in the project for question.
EFFECT ON OTHER PARTS OF THE FIRM: (EXTERNALITIES)
The third big problem is that effect on other parts of the firms. The economists call it externalities. The new project takes the sales from the existing product, this is often called cannibalization. The firm do not like to cannibalization their existing product naturally. But they have to do it because if they will not do it someone else will do it on their behalf.
ANNUAL PROJECT CASH FLOW:
The operating cash flow is the net operating profit after taxes plus depreciation.
Link: (financial management Text and cases author Eugene. F. Brigham, Indian edition, year 2008)
Link: (fundamentals of Financial Management 12 edition authors James C.Van Horne, John M. Wachowicz jr, year, 2009)
Question4: what are the method available to Financial Managers when assessing projects and briefly explain the approaches available together with a discussion of their merits and demerits?
Ans: It is the decision process of the capital budgeting that the financial manager's takes in order identify those projects which are added to the firm value. The most important responsibility and the work done by the financial manager's are as follow.
METHOD USED BY FINANCIAL MANAGER'S:
There are following six methods which are used to check the status of the projects and make a decision whether they should accept or reject the project for inclusion in the capital budget. They are as follow:
2) Discounted Payback.
3) Net Present value.
4) Internal rate of return.
5) Modified internal rate of return.
6) Profitability Index.
Now we shall explain them separately to understand it more nicely and briefly. Which are as follow.
The payback period can be defined as the expected numbers of years which are required in order to recover the original investment. Let's take an example which will make us to understand more nicely i.e. if the initial investment is of 1000 and the future cash flow we have is for 4 years is 500 for year 1, 400 for the second year, 300 for the year 3 , and 100 will be for the year 4. So the payback period for this project is going to be as follows:
ADVANTAGES AND DISADVANTAGES OF PAYBACK PERIOD:
There are following advantages and disadvantages of payback period. Which are as follow.
a) The one of the advantages of the payback period is that it will give you the exact period to pay back the loan or financing difference in between the Cash inflows and the Outflows are also outlined.
a) The payback period has limitation with the inflation as well as the rise of the inflation can create series problem and damage to the organization's finance.
b) The rate of interest is also entirely covered; however we can calculate the interest rate but it also has some limitation for it.
2) DISCOUNTED PAYBACK:
All the excepted cash flows are discounted by the project cost of capital. It has also been defined as the number of years required in order to recover the investment from the discounted net cash flows. So it is called discounted payback period.
EVALUTING PAYBACK AND THE DISCOUNTED PAYBACK:
The payback does not consider the cost of capital regular or we can say the cost of the debt or the equity to undertake the project is reflected in the calculation or we can say in the cash flows. The
The most important drawback of both the payback and the discounted payback methods is that both of them ignore the cash flows which are paid or received after the payback period.
The merits for both of them are that they provide the information recording how long the funds will be tied up in a project. How shorter the period will be the project liquidity is will be greater.
3) NET PRESENT VALUE:
There is a time series of cash flows for both, the net present value (NPV) or net net present worth (NPW) in finance both incoming and outgoing is defined as the sum of the present value (PVs) of the individuals cash flows. There are few steps to calculate it. Which are as follow.
a) First of all find the present value of each cash flow also including all the inflows and outflows, discounted at the project's cost of capital.
b) Sum all the discounted cash flows, this sum is also defined as the project's NPV
4) INTERNAL RATE OF RETURN: (IRR)
The internal rate of return is defined as the discount rate that equates the present value of a project's accepted cash inflows to the present value of the project's costs.
P (inflows) = P (investment costs)
ADVANTAGES AND DISADVANTAGES OF THE NPV AND IRR METHODS:
There are some useful NPV and IRR methods which is used to make the decision whether to accept the project or not. There following advantages and disadvantages of the net present value and internal rate of return. Which are given as follows.
a) The advantages of the NPV method is that it is direct measure of the dollar contribution to the stockholders.
b) The benefit of IRR is that it gives and show the return on the original money invested.
a) One of the big disadvantages in NPV is that the size of the project is not measured.
b) Whereas the disadvantages of IRR is that at times, it can give you the conflicting answers but whenever you compare with NPV for mutually exclusive projects.
5) MODIFIED INTERNAL RATE OF RETURN: (MIRR)
In the modified internal rate of return (MIRR) we take the future value of the future excepted cash flows on the terminal year, and after considering this as the future value and the initial investment as present value we will calculate the interest rate.
It is also called the best method of capital budgeting. As we say up to now there are no disadvantages of it. There is only advantages for it, and the most important and the common use is that MIRR assume that the cash flows from all projects are reinvested at the cost of the capital.
6) PROFITABILITY INDEX: (PI)
In this method it shows that how much he/ she has invested to earn on each dollar.
PI=PV of future cash flows / Initial costs
Question5) In addition to the financial aspects of the capital investment decision there are also other areas which warrant attention. Briefly discuss these non- financial factors?
Ans: There are many non- financial factors which warrant attention while to choose for a project implementation. There are three main which we will discuss them briefly, so we can understand it more nicely and easy. These three factors are as follows.
1) Environment Issues.
2) Cultural Issues.
3) Political Issues
Now we will explain them separately to understand them more nicely.
1) ENVIRONMENTAL ISSUES:
Environmental stands for environment, it means the one has to take the decision very carefully before starting or taking the project that it should not be affected to the atmosphere or the environment of the place where they are starting to start their new project. Let us give an example it will help us more nicely to understand. i.e. if you have started a project in some place which has caused so much damage to the environment that you are fined or have to pay a lot of taxed that it exceed the profit earned from the project.
So one has to think before taking or starting any business or project that minimizes damaged inflicted to the environment so that the goodwill and the profit of your company is not harmfully affected.
2) CULTURAL ISSUES:
In cultural issues one has to make the decision before starting or implementing on a project that it should not be affected to the peoples who are living there. The company should not be considering and implementing the project of those areas that can hurt the cultural as well as the moral value of peoples living in that area.
In all over the world every country cultural is different from other country. They are so many religions peoples living in this world. Every one has different cultural and different way of living eating, wearing and thinking as well. There is one example which will help us to understand it more nice and briefly. i.e. A company who is willing to set a business of Alcoholic in Pakistan it will affect all the peoples living over there because it is Muslims country. It is prohibited in the religion of Muslims even if the project will earn very big profit.
3) POLITICAL ISSUES:
In the political issues one has to take each and every step very carefully. One has to think for the current political scenario of the place when the company is planning to build or start their new project. It is all dependants on the circumstances of the country. If the company political condition is good then it is good for them to start the project, but encase if the company is willing to start their project in the country which is not politically stable it should not be implement the project over there. There is a risk factor involved and it is not good for the company to invest the money in any place like that which is not political stable, because like that the company is putting money in risk so it is better to invest the money to those country which is political stable and there is no risk factor involved while investing money in such kind of places.