Report of the business

The ARR on the other hand is generated from the historical financial report of the business. The formula is Net income divided by the total investment for the year, and the rate obtained is called the ARR or the ROI representing return on investment or ROA, which means return on investments. The net income figure is providing in the income statement of a business and the figure for the total investment or assets is provided by balance sheet It is different from the PBM, because the ARR now expresses the measurement in rates, which now may be compared with the cost of capital.
Since this project refers to whether the proposal to manufacture and sell, we should equate this ARR with the incremental profit rate for Noel PLC which is measured to be 17% during the first year. See Appendix A. To evaluate which should be accepted depends also on company, policy. If say projects having ARR of above 10% in any year then the project will be accepted. Concept of time value of money What is the time value of money? Why is it important?
If we go back to the definition of the cost of capital, there is a need to restate a portion of the definition as “the rate of return that could be earned in the capital market on securities of equivalent risk. ” (Office of Communications, n. d. ). It goes into how an investor looks the valuation of its stock in terms of return and risk trade-off. When one talks of valuation of an investment, one normally refers to the market value of an investment. Market value is more akin into the “price” that the buyers are willing to offer and that the seller is willing to sell in a free interaction of the market forces.

Hence, market values are prospective in nature and not retroactive. In other words, it considers what it can get in the future not how much it has got in the past. This is where the concept of ARR cannot qualify to be market based. This is because net income is a historical figure and therefore it does not consider the “time value” of money in the future. This could be made clearer by understanding the meaning of time value of money by relating the same with the concept of “discounted cash flow”. What is cash flow? How is it computed?
These questions must be answered? Eugene F. Brigham and Joel F. Houston in Fundamentals of Financial Management •, says that “ the most important, but also the most difficult, step in capital budgeting is estimating projects’ cash flows—the investment outlays and the annual net cash inflows after a project goes into operation. Many variables are involved and many individuals and department participate in the process. ” From this statement, we thus can see the preparation of cash flow based on estimates from the different departments of an organization.
Mr. Brigham and Mr. Houston (2002) give the following formula to compute cash flow “Free cash flow= After-tax operating income plus depreciation less capital expenditure less change in operating working capital?. ” The NPV The NPV, according to [email protected] Off-Line Content “is the method of evaluating project that recognizes that the dollar received immediately is preferable to a dollar received at some future date. It discounts the cash flow to take into the account the time value of money.
This approach finds the present value of expected net cash flows of an investment, discounted at cost of capital and subtract from it the initial cash outlay of the project. ” [email protected] Off-Line Content (n. d. ) said that in case the present value is positive, the project will be accepted; if negative, it should be rejected. ” It further said that: “If the projects under consideration are mutually exclusive the one with the highest net present value should be chosen. ” In the case at bar the NPV of the project as discounted at an assumed cost of capital of 10% yields more than 700,000 pounds.
Note however, NPV has also limitations and these include difficulty to explain to non-finance people and that the solution is in figures, not percentage rates of return. In the case of Noel PLC the company will have a net present value ? 787,043. 06 At the discount rate of 8% or ? 700,302. 01 at the discount rate of 10%. See Appendix . This means that the project is acceptable since the net present values are positive after discounting the future cash flows given the cost of capital. It must be made clear only values for five years are provided since case facts say; that the “Christmas Star” will have will have a market life of up to 5 years.
The IRR The IRR also is a method that uses time value of money but uses rates to express the answer. It is very much related with NPV in the sense that if NPV is set to zero, the discount rate that is used in computing the NPV is actually the IRR of the project. For purposes of using this method of whether to accept a project proposal, the IRR of said proposal must be higher than the cost of capital of 10% (after adding the 2% risk premium); otherwise, the proposal must be rejected. Which is the better method, NPV or IRR? Brigham and Houston (2002) claimed the superiority on NPV over IRR in decision making.
The authors said that in case of independent projects the use of the two methods are complementary since what the one recommends, the other also accepts. However, in case of mutually exclusive project, a conflict between the two could arise and from that point the authors recommended the use of NPV over IRR because the assumption that cash flows are reinvested at cost of capital is more believable than that of use of IRR, which assumes that cash flows are reinvested at the internal rated of return. In the case of Noel plc, we have applied NPV more than that of IRR in forming the basis of out recommendation.
See Appendix A. Wider business issues which may impact the decision Accepting the proposal to manufacture and still is not limited the present profitability. I could an expanded business of the company and hence more market share. In addition profitability will lead to growth and its benefits to the Noel could be far reaching. With increased profits the company could give higher salaries to employees, hence the Noel PLC would be promoting loyalty and building competitive loyalty to the company could lead to competitive advantages and hence could mean faster ad bigger growth in the future.
It should be stated that the discount factor that is used to get the present values of PLC should be net of inflation factor since if the not , the cost of capital would be understated and the computed values for purposes of evaluating investment would be overvalued and hence the decision would turn out to be distorted. Conclusion Based on analysis made, to proceed with the manufacture of the Christmas Star is the better option in terms of better profitability and affording the company growth.
This is consistent with the case facts about the marketing director confidence that the new product will be attractive to the existing customer base and also generate new business in what is more generally, a highly competitive market place. In addition based on the comparison made among the different appraisal methods there is a trade off between too simple and being just logical if non-discounted cash flow methods are compared with discounted cash flow methods. The technique may be too simple yet it is not sound, hence the decision maker must be prepared to be logical to avoid the disadvantages of becoming too simple.
To be simple, use PBM or ARR, to be more logical use IRR or NPV. It must be clear however that PBM and ARR requires company standard to apply them to use. Using NPV and IRR the project has basis to be accepted while using PBM and ARR, a company policy was not stated per case facts to enable us to make use of them. Appendices Appendix A. -Projected Cash Flow Statement, See excel file, APPEND Appendix B – Computation of discount factor, See excel File APPEND
Bibliography: Brigham, Eugene F. and Houston, Joel F., (2002) Fundamentals of Financial Management, ninth edition, Thomson, South-Western, USA, [email protected] Off-Line (n. d. ) Project Evaluation and Selection Analysis Techniques, {www document} URL (http://cbdd. wsu. edu/kewlcontent/cdoutput/TR505r/page15. htm), Accessed December 15, 2006 Office of Communications (n. d), Annex F – Glossary, Statement on Wholesale Mobile Voice Call Termination consultation Glossary, {www document} URL www. ofcom. org. uk/consult/condocs/mobile_call_termination/wmvct/annexf/#, Accessed December 15, 2006