Tools for Evaluating the Projects
Biz Systems Consultants Ltd is a firm that is set up by experienced persons. Now they are in consideration for the projects that have investment of 17, 00,000$ and three projects are mutually exclusive. In this report we will find out the ways and tools that can help the firm in accessing the feasibility of the project. There are different methods of accessing the feasibility of projects as well as many sources of finance but we will discuss here the three major sources of finance that are best suitable for the company (Bearse, 1993).
For the company Biz Systems Consultants Ltd projects they need 17, 00,000$ amount for projects. Following are some tools that can be used to see the project as a long term and short term investment objective. For this purpose appraisal investment techniques are used I which proper planning is being done for determination of given investment credibility. For this project it is necessary to find out the followings (Feltham & Ohlson, 1995).
- Net present value
- Adjusted present value
- Payback period
- Discounted payback period
- Internal rate of interest
- Modified internal rate of interest
- Profitability index
- Accounting rate of return
- Real option analysis
Net Present Value
The most important method to find out the best option among many projects is the method of net present value. When net present value will be positive that project will be accepted when net present value will be negative that project will not be accepted. For finding out net present value we will reduce the future cash flow with the same amount of current cash flow. A discounting rate will be applied for this .to use this method cash flow that will arise from these projects will be allotted to every year and a discount rate will be applied on it. In discount rate we will count all the values of money as well as the risk. When the risk level will increase discount rate will also increase and when interest rate will decrease it means there is low level of risk associated with it. The project with highest positive value will be acceptable for the company. While using this method of net present value the main thing is to find out the best interest rate or discounting factor (Gitman & Zutter, 2011).
Following formula will be used to determine the net present value of project.
R= cash flows
I = interest rate
The main variable for above formula is interest factor. This interest rate can be determined by weighted average cost of capital.
Following are some terms used to make decision for accepting or rejecting a project.
If NPV>0 it means project will add value for this company .we must accept this project
If NPV<0 then it means these projects will not be beneficial for the company and company have to bear loss then we will not accept these projects.
If NPV=0 it means these projects will not benefit the company in monitory term. There will be no loss and no gain for company. It means a company will do a project or not it will not affect the profitability of the company but here comes the other important factor that may take into the consideration, maybe the experience that will be gained from doing this project will be helpful in future. And company may get another a big project of same type but with greater profitability (Hermalin & Weisbach, 1991).
Accounting Rate of Return
This tool is used to find out the feasibility of project. In this process of deciding estimated profit that can be earned from this project will be compared with the initial investment that is required for these projects. The project that will earn high rate of return will be accepted others are rejected. This method does not need any interest rate or discount rate therefore this method does not satisfy the concept of time value of money (Heaton, 2002).
If, Estimated annual profit>initial investment
Then accept the projects, otherwise not.
Internal Rate of Return
Internal rate of return is a tool in which discount rate is used that gives zero value to net present value. This technique is somehow technical but it is an efficient way of deciding about the feasibility of the project. It is also called effective interest rate. It is actually the interest rate that equalizes the initial investment of the project and a present value of future cash.it is actually used to know about the desirability of the projects. If internal rate of return is higher for a project it will be more profitable. If all the projects have same amount of investment then we will chose the project that is with higher internal rate of return. All the projects will be taking into the account when coast of capital will be lesser than the internal rate of return (King & Levine, 2004).
Above formula is used to calculate the internal rate of return.
The main disadvantage for using internal rate of return as decision criteria for project is that it cannot compare the projects that have different length of time period. Internal rate of return does not consider about the risk associated with the projects.
Modified Internal Rate of Return
This rate of return will give a clearer picture about the project. It considers the cost of capital. Internal rate of return fails to show the real annual profitability of investment and this does not consider the
Cash that is reinvested in the project to equalize the project internal rate of return is the intermediate cash. To meet these problems modified internal rate of return is introduced that take into account the reinvestment cost as the cost of capital (King & Levine, 1993).
Adjusted Present Value
It is the modified form of the net present value .It is a valuation method in which all the financing is provided with the equity of the business. If the company uses the financing tool of issuing shares then this method is used to calculate the feasibility of the project. It is first used in 1973.the main benefit while using this method is actually the tax shield. Due to the fact that all the projects will be financed by the equity of the business there will be no value of interest payment that will be act as a tax shield for the project.
The method for calculating this method is given below
APV=free cash flows + NPV of terminal value
Operating Profit after Tax= EBIT- Taxes on EBIT
Free Cash Flows= No cash items in EBIT- change in Working Capital - Capital Expenditures
Then we will take the present value of the free cash flows that is discounted by the percentage of return on asset. And adding the present value of the terminal amount the final figure will show the value of unlevered asset. It means the value of asset that is financed by equity.
Equivalent Annual Annuity
If projects have different time spans then the equaling annuity approach can also be used to find out the best project .when projects having different time span then net present value of those projects will be divided by the annuity factor. The feasibility of the project is checked out by using the following method
- First of all net present value of all projects are find out
- Then this projected net present value is equalized to the PV of annuities.
- Then a comparison will be made and a project with highest equivalent annual annuity will be selected.
Payback Period
It is actually the calculation of the time in which we can get back our initial investment. It is the easiest method for comparing the different business projects. The projects that will have less payback period will be preferred over the longer payback periods projects. Payback Period is calculated by dividing the invested amount over the Estimated Net Cash flow
But there are some disadvantages of using payback period method. In this method time value of money is ignored. It only considers the project of short term profitability. It does not include the cash flows that will occur after time period of payback.
Discounted Payback Period
In simple payback period method the issue of time value of money is resolved. In this method we will add all the positive cash flows that are discounted that arises from the project. For calculations of this method company will determine the interest rate on which all the cash flows will be discounted for a specific time period. If already determined time for the project is greater than the discounted payback period then the project will be accepted otherwise it will be rejected.
Real Option Analysis
In this analysis the project manager actually try to find out all the real options that will affect the cash inflows and cash outflow for the specific project (Barr et al, 2002). These values are then added in net present values and calculations are made to find out the feasibility of the project.
Profitability Index
This method is used to calculate the value per unit of all investment. It actually shows the money that is invested for a specific project. It is also called profitability investment ratio.
Above formula is used to calculate the profitability index of the project.
Major Sources of Finance
The Project financing means providing capital for a project. Financing may be of short term and long term. The main thing that is very important for a project financing is the level of risk. Risk identification and then proper allocation of such risk is very necessary for the successfulness of a project. There are many sources of financing a business like loan from banks, retained earnings, venture capital, franchising, loan from government sources, and through capital markets by issuing right shares preferred shares and initial public offering.
For this company Biz Systems Consultants Ltd three best options of sources of finance are followings (Keasy & McGuinness, 1990)
- Issuance of new shares
- Bank borrowing
- Venture capitals
There are many parties that are involved in the process of financing a project like sponsor, lender, public, technical advisor, regulatory agencies, equity investors, shareholders, multilateral agencies and banks.
Issuance of New Shares
It is newly formed company and it needs 17, 00,000$ for their projects.
As the company is new so the best option for financing is issuance of new shares. Company will issue 170,000 number of shares .each share price will be 10$.by this way company can be quoted on stock market. Company can be quoted on stock market by following way (David, 2011).
- A sale offer
- Underwriting
A Sale Offer
A sale offer means that the company can issue the shares and then can sell on stock exchange to raise capital.
Underwriting
Under writing means company will contract with Lloyds bank in London for contract. This bank will give guarantee for the sale of the shares. If some shares are not sold out by the bank then the bank will itself buy all the stock of shares. In England there are many banks that provide the facility of underwriting. In compensation they want a high return from the company (Keasy & McGuinness, 1990).
Mostly when first time a company issues shares, they are sold out through initial public offering. In initial public offering, all the stock is sold out to professional investor institutions which then sale all the stock to general public. This process of public offering is complex .a detailed description of offerings are necessarily provided to the company in form of prospectus. This will be helpful for the company competitors as well. This process of initial public offering when done with the help of investment bank is called underwriting. The procedure for raising capital from this method is somehow very critical and many regulations to be followed for this purpose but the main thing why people mostly go for it is that when a company is listed in stock exchange and its shares are going to trade among general public, the good will of the company increases. In this case by using this source of funding company can give to their shareholders annual 7.5 % return that is a good thing and value of the share of this company will increase if company will take these projects (Commet & Saunders, 2003).
Bank Lending
Another important source for financing the bank is loan from banks. Company can take loan from bank on an annual interest rate of 5%.this type of loan will be medium term loan. The company will take loan of amount 17, 00,000$ on annual interest rate of 5%for ten years. If the project is start up then annual return will be 7.5% therefore company can easily afford this borrowing from bank. For purpose of taking loan from bank many issues are involves. So the partners of the company have good credit history and they are professionals as well they will be trust worthy for the bank and by submitting documents to the bank they can easily take loans for 10 years (De Bettignies & Ohlson, 2007). The equipment or the building of the company can be mortgaged against the loan from bank. The bank will charge the fix interest rate of 5% from the borrowing company. It means that additional cost of financing have to pay by the company. Then the question arises from which bank company will take loans. There are many options ahead. Here in this case company chosen Lloyds Banking Group bank for taking loan because the requirements of this bank is easy and then can easily give the loan of this amount (Brealey, 2012).
The bank will also check the details of PARTS. IT means
- P describes The purpose of taking loan
- A describe How much amount of loan is needed from bank
- R describe What will be repayment schedule
- A describe What will be term credit policy
- S describe What will be security behind taking this loan
Finance from Venture Capitals
A venture capital is the institute that gives money to company that want to start some new project. Venture capitals are actually the group of specialist of people who have large money to finance any business. It’s a game of gambling. There is a huge risk involved in financing the business but there are chances of high return also (Barry, Muscarella & Vetsuypens, 1990).
The company can also go for the option of taking finance from venture capitals. This will be an easy way for financing the project because companies have partners of good and experienced professionals. However the returns from these projects are obvious therefore they can easily get finance from venture capitals. However venture capitals want some sort of security in form of equity stake in the company. And they may ask the company to appoint their one person as a member of board of director. The only need is to convince them that if they provide finance for these projects, there must be profit and projects will work successfully. In London Company can go to the “Balderton capital” firm for financing.
In case if the deal is done between Balderton Company and Biz Systems Consultants Ltd then the company have to present following things to the financing company
- A business plan of those projects
- Detail list of all the management team and have to show the competency of management team
- All details of company accounts in all banks as well as the accounts of boards of directors.
- The prospectus of company
If Venture Capital Company will satisfy with all these arrangements then the financing will e approved.
In my opinion if Biz Systems Consultants Ltd uses the source of financing of raising capital from general public by offering the initial public offering and doing the contract of underwriting, then the company can evaluate its mutually exclusive projects by methods of modified internal rate of return and using the adjusted present value. By using the equity method for financing the project they will save the cost of financing a project by means of debt.
References
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