In uncertain and ultra-competitive market, companies need to be update itself with the sudden changes and adjust their financial plans and policies accordingly to meet their financial goals. Strategic financial management refers to a plan that focuses only on the financial resources. It is a process of planning, organizing, supervising, directing and controlling the money related transactions. Procurement of funds with balanced capital structure, its effective utilization, cost controlling and others are the main focus of the financial management. The current investigation targets to assess how project evaluation methods are helpful for Plaggio Ltd to select the most beneficial investment project. Second section will discusses about the cost of capital calculation and critically evaluates four different sources of raising money. The section will also determines cost of equity using CAPM (Capital Assets Pricing Model), cost of bond and weighted average cost of capital (WACC) as well.
Now-a-days, upcoming of new and latest technologies necessitates for the firms to replace existing machinery with the newer techniques. It helps them in meeting their production targets and drive efficiency in their operations. Due to technological obsolescence, PLaggio Ltd is looking for replacing its old machinery with the new production machine so as to meet increase in its production volume and thereby meet maximum potential demand of customers. There are three different alternatives from where company can purchase new machine categorized as Tender A, Tender B and Tender C. All these proposals are totally mutually-exclusive projects however, company needs to select only one which is highly profitable. Capital Budgeting, also called investment appraisal or project evaluation are the great ways that Plaggio Ltd can use to determine the most profitable option among these three alternatives. The methods assists firm in evaluating potential investment or expenses on future long-lived investments that requires huge sum of money (Götze, Northcott and Schuster, 2015). Different capital budgeting methods are applying here to validate the attractiveness of every tender proposal.
Payback period method evaluates many projects by determining the length of time that an investment would take to repay its beginning outlay. It is usually used by small-sized businesses because they are more concerned about liquidity and require large sum of cash flows in the business therefore, prefer quick recovery of investment (Götze, Northcott and Schuster, 2015). Its decision criteria demonstrates that project with shorter recovery duration is preferable over other alternatives.
Cumulative cash flows
Accounting rate of return acronym as ARR find profit that can be gain on the money that firm requires to invest. It is determined by dividing the average annual profit that company expects over project life cycle with the average capital employed. The decision rule of the method suggests a concern to invest money in the project with the maximum ARR (Gotze, Northcott and Schuster, 2016). In the scenario, it is stated that Plaggio Ltd follows straight line method (SLM) for depreciation wherein a fixed amount of depreciation is charged every year
Accounting ra.e of return: Annual average profit /Average investment*100
It is a discounted method of evaluating a project which discounts project cash flows over the life cycle of the project with a discounting factor and determines their present value. The sum of the PV of cash inflows is subtracted from the cost of capital and remainder is represented as Net Present Value (NPV) (Götze, Northcott and Schuster, 2015). It helps to evaluates profitability on the future proposal. The method suggests an establishment to undertake investment in such project proposal that has largest NPV.
Discount factor @12%
Discounted Cash Flows
Present Value (PV) of cash inflows
Less: Beginning investment
Net Present Value
Internal rate of return (IRR) metric is used in the investment appraisal methods in order to project the profitability of potential investment opportunities or capital projects. IRR represents a discounting rate that makes discounted cash flows and beginning outlay equivalent, as a result, NPV is nil (Guerra, Magni and Stefanini, 2014). Likewise, NPV, project with greater IRR seems preferable over others because it is a signpost of attractive profitability.
As per the results of payback period method, payback period of Tender A, B and C is 3 years 4 month, 3 years and 2 years 8 month respectively. Considering the decision criteria of the method, tender C seems preferable. Although these project requires highest investment of RM 380,000, still, money invested can be recover quickly in just a time of 2 years 8 month that is comparatively shorter than other two tender proposals. However, still without taking into account the measures of other investment appraisal method, final decision cannot be made. Even payback period alone is not a right method because it neither pays attention to the profit after payback nor it discount cash flows hence, time value of money is totally ignored. Other than this, the method did not evaluates cash flows for the entire life cycle of the project and does not examines the pattern and timing of cash flows, due to which, in the practical world, payback period does not seems a justifiable method (Baum and Crosby, 2014). Although, time value of money aspect can be considered by computing discounted payback period, still, it avoids cash flows for the subsequent years. Therefore, here it cannot be recommended to the company to undertake investment in Tender C.
The results under ARR method reveals that tender A, B and C are expected to generate a return of 17.50%, 21.94% and 19.38% on the total capital employed. The results reflect on the basis of ARR, tender B is beneficial for the Plaggio Ltd and must accept this one. However, this method does not remain free from the criticism and analyst warned about the shortcoming stating that similar to payback, it is also a non-discounting method. In spite of this, another drawback of the method is it uses accounting profit which takes into account those transactions also which does not affect cash position. In the given case, depreciation has been deducted from the cash inflow to determine the accounting profit. It is based on the accounting principle, as per which, all the current year transactions are recorded on the basis of accrual accounting concept (Upton and et.al., 2015). It is regardless of their impact over cash means a transaction of current trading period will be recorded in the profitability statement whether it affects cash or not is not relevant. Thus, the method mainly criticized because accounting profit presents artificial amount and does not use cash inflows.
Considering the finding of discounted cash flow (DCF) method, NPV for all the three tenders, A, B and C is discovered to RM 17,622.52, RM 47,857.39 and RM 33,811.14 respectively. The research results evaluates that tender B is highly profitable because of higher NPV yields over other two projects. Thus, Plaggio Ltd can be advised to undertake investment in this project and accept the proposal. This method of investment appraisal is quite good and considered as the most accurate measures of investment opportunities. From the mathematical perspective, this method seems preferable over any other method like payback period or discounted payback period. Even, the method is considered as an accurate technique than internal rate of return and Profitability Index (PI) as well. The main reason why the technique is treated superior is it uses discounted cash flows and reflect their today’s values (Peavler, 2018). Thus, by this way, the method considers risks as well as time variables. Moreover, this method examines the cash flows throughout the entire life span of the project and uses a weighted average cost of capital (WACC). It suggests firm to invest, if a project expects to have favorable return or vice-versa.
In the context to Plaggio Ltd, although all the tenders are mutually exclusive, still, as company can invest in only one therefore Tender B seems a justifiable choice because it is projected to generate greater sum of return. At the same time, the project is subjected with several downfall sides. It is that it is not easy or even too complicated to identify a correct factor for discounting. Moreover, market changes such as interest and inflation have a direct impact on it. Despite this, managers forecasted future cash flows however, in the changing world, actual cash inflows may vary with managerial projections (Almarri and Blackwell, 2014). Still, as the method uses present value and provides net results or profit, hence, it is a justifiable method.
Another DCF method is IRR which is found 14%, 19% and 16% for Tender A, B and C, greatest for B. Thus, it suggests Plaggio Ltd to invest in project B. Thus, the outcome of both the DCF methods that are NPV and IRR are consistent and both suggest undertaking investment in Tender B. This method is justified due to its simplicity, time-value of money concept and no requirement of hurdle rate, however, criticized because it ignores project side and reinvestment rate (Guerra, Magni and Stefanini, 2014).
Taking into account the results of all the method, it is better to recommend Plaggio Ltd to undertake investment in Tender B because of greater NPV and IRR.
As per the current scenario, Plaggio Ltd’s financial manager believes that cost of capital influence the value of the firm. It means firm’s value is strongly relevant to the capital structure policy means the proportion of debt and equity the firm uses in the capital composition to meet out their long-term financial requirements. Debt and equity both has different implications on the business concern (Andreasen, Schindler and Valenzuela, 2017). As per the given case, Plaggio Ltd uses 30% proportion of their capital through debt an rest 70% requirement satisfies through equity capital.
As per the outcome of the study, it is determined that after-tax cost of debt is 8.4%. ON the amount of debt invested in Plaggio Ltd, cost is calculated after deducting tax. The main reason behind finding out after tax cost of debt rather than before tax is that interest is a deductible or allowable expenditures for the purpose of tax. Thus, it means it can be said that on the debt money, company is allowable to cut their interest and on the remaining profit, tax is charged. It is the main reason why debt source is treated as cheaper source of funds on which tax deduction is allowed.
CAPM (Capital Assets Pricing Model) is a great model that helps to evaluates sensitivity risk and return on a stock (KUEHN, Simutim and Wang, 2017). Thus, the method helps firm evaluating risk-return relationship on a security. In the given scenario, cost of equity is determined here using CAPM as follows:
According to the calculation, there is a good market return in the industry and its surplus over risk-free rate, which is called market premium is found 9.5%. At 1.6 beta coefficient, the cost of equity source is determined to 2.652%.
Weighted average cost of capital: Plaggio Ltd’s capital mix consists of both the debt and equity sources in the proportion of 30% and 70%. Thus, its weighted average cost of capital is computed here as follows:
Source of funds
Cost of capital
Weighted cost of capital
The results of WACC denotes that Plaggio Ltd weighted average cost of capital is 4.376%( Olson and Pagano, 2017).
There are many uncontrollable factors which company cannot control and have a direct impact over their cost of capital. Two important factors are discussed below:
Interest rate: On the loans which are subjected with fluctuating rate of interest, rates may goes up that directly affects business. It is because, whenever rates increases then Plaggio Ltd would be requires to pay greater amount of interest and manage their cash management accordingly. Thus, company cannot control the change in the interest rate which directly affects their debt burden capacity and profitability as well. Higher the rate of interest increases firm’s cost of capital or vice-versa.
Tax-rates: Plaggio Ltd is liable to pay a fixed percentage of profit as tax to the government. Tax is charged as per the policies of government thus, if in future, authorities decides to charge a high rate of tax on corporations, then, cost of debt declines or vice-versa.
Apart from these two, there are number of other factors that directly affects the cost of capital includes economic conditions, change in stock price, sudden or unforeseen circumstances that are uncontrollable by the business entity.
In the corporate scenario, every company requires money for various purpose, such as working capital to meet out regular payments, requires massive sum of money to meet out their requirements such as to purchase assets, buying a new technology, equipment and other fixed assets. Various sources from where company can raise money are explained below:
Bank borrowing: It is the most often use source of funding wherein companies borrow money from the banks. It can be taken for various time period like short-term, medium-term and long-term depending upon the purpose of the loan. On the debt, Plaggio Ltd requires paying regular installments inclusive of interest as per the applicable rates. The repayment as per the schedule is necessary. It helps companies in flexibility of payment because every time, business uses their profit to meet out their loan obligations. At the time of applying for a loan, it requires satisfying extensive formalities such as keeping any assets as collateral security of fixed charge over certain assets of the business (Radovic, 2016). Thus, loan brought fixed financial burden on the entity, contrasting it, tax benefit is an advantage which assists business entity in minimizing their taxation obligations. In addition to this, there is one more benefit that is debt does not provides lender authority to take part in the business decisions, it means they cannot alter decisions. In case of default in repayment, lenders just have right to sell-off the assets kept as collateral to recover the outstanding amount. Apart from this, in case of insolvency, lenders have full right to get money from the assets sold out in the open market, thus, bankruptcy implications exists.
Equity: It is a process wherein money is being raised by the issuance of shares which is available to public. Interest parties who wants to have stake in the business can purchase shares by paying application, allotments and call money. Unlike debt, equity has different implications because it does not necessitates for the Plaggio Ltd to pay a fixed rate of dividend to the shareholders. However, still, looking to the practical world, it is often seen that the dividend decisions does not remains free from the competitors action because investors expects a return on the money invested, hence, if they are not rewarded for the risk undertaken, then it may cause fear due to the possibility that investors may sell their holdings (Peirson and et.al., 2014). Dividend has no tax shields means tax deduction does not exists. Apart from this, investors have right to vote means they are authorized to take participation in board meetings and discuss on various decisions. Thus, business stake is transferred or diluted. However, it does not have bankruptcy implications means in case of insolvency, Plaggio Ltd needs to pay off lenders, creditors and other parties first and then remainder is pay off to the investors.
Retained earnings: This is a method wherein profits that are kept in the business in the past years can be reinvested further in the business growth plans. In other words, ploughing back the profits to meet financial requirement. The advantage of the method is it does not incur any financial cost (Khan, 2015). However, the drawback is excessive reinvestment of profit may leads to raise dissatisfaction among investors because if profit is not reinvested then, they can have greater return.
Lease: There is an option to Plaggio Ltd to take assets on lease rather than actually buying it. Lease is a contractual arrangement wherein one parties agrees to give his or her assets to another party on rental basis. The party who has actual ownership of the assets is called lessor and another is called tenant or lessee. The cost of the leasing agreement is rental charges often includes some interest rates. However, the benefit with lease is that it helps firm avoiding huge investment to purchase the assets. It also overcome the risk of technological obsolescence as risk can be easily shifted to the lessor. Leaseback option helps companies in liquidity management. Lease rental which includes interest charges is a tax deductible payment that offers Plaggio Ltd with tax benefits (Bhattacharya and Londhe, 2014). It facilitates entity in conveniental payment. However, on the other side, many-times, total rental payment throughout the lease period may goes beyond the actual buying cost of assets. Despite this, ownership benefits like allowance for depreciation & investment is not available to the lessee.
The study had discovered some interesting thoughts throughout the research. One of the interesting point about investment appraisal methods is pay-back and accounting rate of return ignores time value of the monetary value whereas both NPV and IRR respects it and uses discounted cash flows. Application of the methods had provided conflicting results, therefore, considering NPV as the best or accrual measures, it is recommended to the Plaggio Ltd to undertake invest in Tender B because it shows greater amount of return. Besides this, second part of the study that focuses on the cost of capital determined that while calculating the cost of debt, tax rate is deducted because interest is a deductible payment for tax purpose. However, calculation of equity is determined through CAPM model without subtracting the tax rate. Lastly, the study discovered that Plaggio Ltd can raise money through various alternatives such as borrowing, share issue, lease and retained earnings.
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