Evaluation Of Investment Alternatives Essay

Introduction ceiling budgetingA critical role of a financial manager is the evaluation of gravid decl ar oneselfs. This is a very central task because the money involved in such(prenominal) activities is significant and the benefit or loss derived from go away highly influence the financial performance of the whole musical arrangement (Brockington R. B. 1996, p 102). Indeed, Nobel laureates Modigliani and Miller suggested in their guess of capital structure that the value of a company is not affected by its gearing, but the master(a) factor that influences such value is the investment in wealth creating brooks (Pike R. et al. 1999. p 557 and 577).1.1 Evaluation of plans if their find equals that of the fast(a)1.1.1 mesh topologyt defend hold dear Method jut Xinside information000010002000300040005000 sign Investment(2,700) funds Flows4706109509701,500 remuneration Cash inflow/(Outflow)(2,700)4706109509701,50012% Discount Rate1.00000.892860.797190.711780.635520.56743 give birth prize(2,700)419.64486.29676.19616.45851.15 terminate Present Value 349,720PLAN Y detail000010002000300040005000Initial Investment(2,100)Cash Flows3807008006001,200Net Cash Inflow/(Outflow)(2,100)3807008006001,20012% Discount Rate1.00000.892860.797190.711780.635520.56743Present Value(2,100)339.29558.03569.42381.31680.92Net Present Value 428,970Source 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)1380,0000.847460.84034322,034.80319,329.202700,0000.718180.70616502,726.00494,312.0038 00,0000.608630.59342486,904.00474,736.004600,0000.515790.49867309,474.00299,202.0051,200,0000.437110.41905524,532.00502,860.00Net Present Value45,670.80(9,560.80)Source Horngren T. C. et al. 1997, p 785 787.1.1.3 Evaluation of projectsPlan Y is more financi solelyy operable under both methods. The net indicate value of Plan Y is 79,250 428,970 349,720 higher than Plan X. The indwelling rate of return of Plan Y is also 2.61% higher than the other plan, indicating a higher marge of safety on losses in case the expected cash flows ar 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 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 225,417Source Hirschey M. et al. 1995, p 799.1.2.2 Comparison of decisions at different risk rangeWhen 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 dish up of discounting arises from the time-value of money principle, and the higher the discount rate the lower the present 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 optimal project because Plan X net present value exceeds that of Plan Y by 35,694 (261,111 225,417).1.3 outline of real resource data for plans1.3.1 Net Present Value Method PLAN 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 finding noted in sub-section 1.2.2. It is also worth nothing that the application of the real option for Plan X is not financially viable because we will end up with a negative net present value. If we compare the net present value of Pl an Y under the real options scheme with the net present value of Plan X we can 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 rationing is an absolute restriction on the amount of finance available for a project irrelevant of cost. This should not be confused with scarcity of economic resources. Capital rationing on projects is sometimes applied even though the organization posses or can attain available finance. For example, a capital rationing may be impose on the amounts of debts an organisation can take in order to limit the gearing of the firm (Brockington R. B. 1996, p 151).When conditions of capital rationing are imposed, there is the hap that the most optimum project is not selected. Therefore yes capital rationing may effect the pickax of Plan X or Plan Y. For example if a capital rationing is adopted by the firm which states that the initial investment cannot exceed 2,000,000 collectable 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 pickaxe is if management decided to restrict expansion of the factory, because they fear that control on employees may be lost affecting negatively their relationship and control on staff. In this case 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, away from shares areCorporate Bonds & DebenturesOverdraft facility by the bankBank loanVenture capital andLeasing1.5.1 Advantages and disadvantages of merged bonds/debenturesThe advantages related to corporate bonds are (E*Trade Financial website)Corporate bonds are usually lent at a longer period of time (Veale R. S. 2000, p 1 55).Interest payments for bonds are tax deductible.Interest rates of corporate bonds are frequently lower than those of banks.Percentage ownership of shareholders is not weaken by the disclose 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, so increasing the risk of bankruptcy 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 following benefits (tutur2u website)Allows flexibility of finance. The company can increase the overdraft facility within acceptable limits.Interest is only charged on the amount used and is tax deductible.Percentage ownership of shareholders is not reduce by taking 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. ordinarily 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 type of finance are (tutur2u website)Interest has to be paid within a specified date.Less flexible than an overdraft facility.1.5.4 Advantages and disadvantages of venture capitalThe advantages of venture capital are (Business Link 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 fi nance are (Business Link website)Require detailed financial reporting like business organisation plans and financial estimates.Legal and accountancy fees are incurred in the negotiation process.Firm require a turn up track record to take such finance.High 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 sturdy to obtain.Minimal paperwork required to acquire lease.Acts as hedging against inflation.Flexible 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 bundle Lease Tips website)The organisation is committed to the entire validity period of the lease.High amounts of insurance coverage are frequently demand ed 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). Available 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. justice Finance (on line). Available from http//www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1075081582 (Accessed 13th March 2007).Drury C. (1996). Management and Cost Accounting. after part 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). Available 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). Fu ndamental of Managerial Economics. Fifth Edition. Orlando The Dryden PressHorngren T. C. bring up 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. not bad(p) 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. commodious 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 the States New York Institute of Finance.