Background on Bahrain Duty Free
Issues about the investment landscape of BDF are numerous. To this need, there are a number of investment appraisal techniques that can be used to increase the profitability and generation of cash flows from their investment. Assets must be allocated efficiently while liabilities and equity must be coordinated to come-up with the right mixture of financing. This cannot be done without relevant appraisal techniques. The role of Board of Directors in BDF investment proposals is superior to any of individual managers and employees of the corporation. As a result, their very decision will be the carry-over to the future engagement of the firm. However, there are several projects that are studied. And one cannot be measured on profitability criteria without imploring investment appraisal techniques.
Different techniques have their strengths and weaknesses. Some are able to forecast the future performance of the firm while others are able to set comparable figures against other projects. With value judgment, the BOD must incorporate quantitative data into their decision-making. Financial information is far more important to settle investment decisions rather than simply hunch, experience or even academic learning. The former presents an unbiased glance on where the firm will go after making a decision and what impacts are to be expected if the project fails or succeeds. Investment appraisal techniques are good source of information because it incorporates economics, financial management, accounting methods and even subjective view on proposals.
Different Investment Appraisal Techniques
Time value of money or TVM is an investment principle in which investors prefers to receive the money as early as possible and that the value attached to present money holdings is greater than future or expected money holdings even they have the same nominal values (Mcmenamin 1999; Investopedia 2006). This is because market effects such as inflation, change in interest rates and regulations can increase or decrease the future value of assets, thus, making them more exposed to risks (Mcmenamin 1999). Deferral in consumption has also some forms of sacrifices which happens when an investor dedicatees present income and wealth to investments. In effect, the investor would demand interest to compensate such investment due to these reasons. For example, a loan requires interest payments, collateral and other forms of guarantees which indicate that TVM principle holds in the transaction. Further, equity investments in the form of stocks also provide dividends in both money and other assets as well as capital gains in the price of the stock. These are mere resolution of investors to compensate their sacrifices through the guide of TVM principle.
TVM is the foundation of discounting future cash flows although applied in most big business that plans to undergo huge financing for a project or several projects. The table below shows an investment project with cash flows that can contribute to firm’s value up to three years. As observed, forecasted sales needed to be converted in to their present values to be able to adhere to TVM principle. There is a standard table of future/ present values in which a particular discounts rate and specific year can be cross referenced to determine the discount rate for the particular year (e.g. .901).
As observed, as the value of future sales increase and/ or their timing go further from the present, the discount rate tends to be lower which means future inflows are deducted with relatively more discounts. Thus, discounting is a practical application on how investors assess associated risks for a particular return. That is, as returns tend to go further into the future, their value depreciates because moving further to the future suggests more ambiguity than the current time. And so, the higher the returns of these futuristic returns, the higher will be the deductions of the discount. This situation is consistent to the positive relationship of risk and return.
Project 1: DIY Renovations
Year
Sales
Initial Outlay
Discount rate (at 11%)
PV
-
-
75,000.00
1.000
75,000.00
1.00
10,000.00
-
.901
9,010.00
2.00
30,000.00
-
.812
24,360.00
3.00
100,000.00
-
.731
73,100.00
NPV =
31,470.00
The terminal year cash flow is relevant in financial analysis particularly in investment and budgeting because of its ability to estimate annual cash flows that a firm can have at specific number of years in the future (Mcmenamin 1999). The method allows the inclusion of the value of future cash flows to mitigate valuing problems. Computation is less complex since the use of constant rate for a going concern firm is suggested. When computed in present value terms, it can readily be added to the present value of free cash flows to determine the value of the business. On the other hand, when the firm is planning for dissolution, the approach can easily show the bearing to defer or expedite dissolution stages as getting the returns for a certain number of years in the future is possible.
Thus, the approach is flexible and a tool for forecasting. However, this strength have back clash making it necessary to consider some important factors. The discount rate and growth rate undergo perpetuity which means that there value remain constant from year 1 to year N (the final year). In the contrary, market conditions as well as internal performance of the firm are always vague especially on hi-tech and internet-based industries. In effect, environmental scanning and internal audit should be used to be able to have a more accurate representation of future PESTEL, industry, competitor and corporate strategy implications to discount and growth rate.
The weighted average cost of capital (WACC) determines the cost of main individual sources of capital which can be in the form of debt capital, equity capital and retained earnings (Mcmenamin 1999 p. 436). Thus, discount rate should also represent not only WACC but also other costs occurring in the phase of investing such money in stock or money markets. With this, the firm can have NPVs which can be readily used to evaluate investment decision without the anxiety of missing out some “costs” of funding. WACC is also often referred as discount rate expected by investors. Thus, WACC harmonize the stance of investors and ease of attaining an acceptable level of discount rate for a particular security.
On the contrary, WACC cannot by itself classify whether an individual source of capital is being used to finance a new investment or not (Mcmenamin 1999 p. 437). There is a need to install monitoring system to account the financing performance of each project which can result to additional monitoring cost otherwise WACC would be inconsistent across time horizons. Also, as WACC offers a scientific basis for a firm to have minimum financing rate and available discount rate (which is used in NPV calculation), it is a common approach for firms to have its own preferred cost of capital (p. 440). Due to this, WACC does not reflect the practical problems and evaluation criteria that most managerial decision-making uses.
Payback period method is advantageous when a firm tightly adheres to the time value of money concept, that is, the money to be received in the future has higher risks and lower value than the same amount of money on-hand today. This becomes crucial when a firm is bound to be acquired in which its objective is not to maximize profits rather minimize the time required to recoup investments (say) for a period of two years in which it is also bound to be formally acquired. Alternatively, its computation (see appendix 2) ignores time value of money due to the absence of discounting cash inflows to find their present values (Mcmenamin 1999 p. 359) unlike NPV or IRR. Nonetheless, it is used frequently because it is the most popular and easily understood investment appraisal techniques (p. 357). Easy it is because it is internally-driven from the view and subjectivity of the firm preventing technical calculations and market research in favor of the “fastest way to recover investment” rule. .
The key in determining NPV is the discount rate. Used in capital budgeting, NPV is the most dynamic and widely used method in evaluating long-term projects. Its major criteria state that “projects that have positive NPVs are worthwhile while those with negative are not”. But NPVs are not perfect. Although analytical tools like net present value (NPV) are helpful, the greatest obstacle to minimize the need for working/ physical capital to be able to enhance free cash flows is not guaranteed. There is some work to do even after computing for NPVs. By locating inefficiencies and value-adding activities, deferral or elimination of projects that can be a deceptive action (due to savings) can be re-analyzed to locate possible opportunities that are kept untapped (Copeland & Ostrowski, 1993). NPVs are simply the summation of discounted annual cash flows of a project. It is derived after the net income of the project is illustrated (e.g. expenses like marketing costs are deducted or non-cash transactions like depreciation expense are brought back to the net income).
Capital budgeting directly affects the long-term investment decisions of the firm (see appendix 1) to remain consistent to its goals (Dayananda et al 2002 p. 2). It embodies the intention of the firm and sustains the relationship its culture affords to offer to its stakeholders. Thus, when capital budgeting has erred to protect its intentions and fails to derive its culture planted to (say) debtors, it may not receive the previous support from their financing. This can be in the case when the firm fails to accurately forecast its cash inflows that tell the profitability of an engagement. As it is strategic in nature, the capital budgets should be flawless when prepared and translated to a project.
As an example, Airbus and Boeing had committed substantial resources to build A380 and Sonic Cruiser respectively (Hitt et al 2003 p. 160). If their capital budgeting has flaws, it is difficult to reverse the strategy due to the substantial costs of initial outlay or some outstanding contracts with suppliers as well as customer expectations for improved technology. And when Airbus or Boeing continued overturn their budget loopholes, they would suffer from stakeholder doubts that can result to reduce share attractiveness, broken supplier relationship, cancelled orders and lost opportunity in the airline industry. These case studies only reflect that the ability to know quantitative side of investment will create competitive advantage to companies.
Bibliography
Mcmenamin, J 1999, Financial Management: An Introduction, Routledge, London.
Stickney, C & Weil, R 1997, Financial Accounting: An Introduction to Concepts, Methods and Uses, 8th Edition, Harcourt Brace and Company, Fl.
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