Note on Project Appraisal
Any financing decision should be based on the working capital ratio denoting the level of current assets against the current liabilities which should be maintained at 2:1 for many manufacturing companies. Any ratio below this level will have to be viewed carefully. A low current ratio tends to indicate that the company’s short term liquidity is in problem and may also indicate a short term insolvency of the company. The operating cycle of a manufacturing company is usually identified with its inventory turnover and the debtors repayment.
When the company has a low inventory turnover it is necessary that the company possess current assets far in excess of its current liabilities. In the case of XYZ Co plc the debtors repayment as well as the stock turnover ratios is in a better position indicating the company’s short term liquidity position as good. The debt to equity ratio is well maintained implying that the company can have more leverage of borrowed funds to augment its functioning. The company’s liquidity position and the interest coverage position show very good signs of the financial strength of the company.
The profitability of the company is also good in comparison with the average for the industry and is also on the increasing trend. The company has employed its assets in a well planned manner to use them effectively to improve the profitability of the company. Overall the company is showing a progressive trend with is sales showing improvement over the last year. In view of the fact that the company’s gearing ratio is already 50% any additional capital financing decision should be done based on the long-term debt position.
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In the present situation it is not wise to enhance the long – term debts any more as it will affect the gearing ratio. Hence it is advisable the company considers the option issuing additional shares to augment the funds for additional capital expenditure. The expected monetary gain or loss from a project can be calculated by adopting the ‘Net Present Value’ method. Under this method all the future expected cash flows are discounted at the required rate of return and compared with the outflows to the present point of time.
The projects with a zero or positive net present value are acceptable. When the net present value is positive it indicates that the rate of return form the project equals or exceeds the cost of capital. When all other things remain equal the higher the net present value the better is the investment. A negative net present value would indicate that the project should be ignored. The net present value of evaluating the project allows the consideration of the time value of the money.
It helps in finding the present value of the investments in today’s currency of the future expected net cash flow of a project. If there is more than one project the net present values of all the projects can be compared to select the best one which gives the best positive net present value. In the case of XYZ Co Plc the net present value of the expected returns is calculated as below: The chief advantage of the NPV method is that it recognizes the time value of money and produces more meaningful results than simple payback.
However this method is more complicated than the payback period method and it involves a number of complex calculations. However this complexity can be mitigated with computer programmes. Since this method takes the time value of money this method is considered superior to others. The above table indicates that there is a positive net present value from the project and hence the investment in the project can be considered. Though there are methods available to calculate the viability of any project the net present value is the easiest and most popular method of assessing any capital investment.
Thus it can be said out of the calculations of the net present value, that the cash flows from the project are adequate to 1. Recover the net initial investment in the project and 2. Earn a return greater than 10 percent on the investment tied up in the project over its useful life. The other methods that can be used to appraise the investments in the projects are: Internal Rate of Return The internal rate of return (IRR) calculates the discount rate at which the present value of expected cash flows from a project equals the present value of expected cash outflows.
This means that the IRR is the discount rate that makes the NPV – $0. However the NPV method has the advantage over the IRR as the NPV method gives the result of the computations in dollar terms and IRR is expressed as a percentage. The other advantage of NPV method is that it can be used in situations where the required rate of return varies over the life of the project. In the instant case of XYZ Co the present value of 296. 4 is almost equal to the initial investment of 300. Hence the IRR can be assumed to be 10% for the project.
Payback Period Payback measures the time it will take to recoup, in the form of expected future cash flows, the net initial investment in a project. Like NPV and IRR the payback method does not distinguish between the origins of cash flows like operations, purchase, or sale of equipment or investing or investing in or recovery of working capital. Unlike NPV and IRR payback ignores profitability. Payback is the simplest method to calculate when a project has uniform cash flows. The Payback period is calculated as below: