1. Critical evaluation of the use of Net Present Value method as the key analytical tool in capital investment appraisal
Businesses should undertake adequate procedures while planning to invest large amount of money to make sure that the project will generate higher value after allocating necessary resources. The investments made for longer period of time are costly and the advantages derived from it are spread over large number of years. Therefore, appropriate decision models while evaluating the cost and returns of the projected investment is crucial. The feasibility of those large investments can be effectively done by using the Net Present Value method as it undertakes all capital costs, expenses, revenues that are forming the part of an investment in its Free Cash Flow (De Marco 2018). Also, it considers the timing of every cash flow that have a large influence on the present value of overall investment. The analysis done on the basis of NPV is regarded as the intrinsic valuation and is used to determine the estimated value of business, capital project, investment security, cost reduction scenario and for other purposes involving cash flows.
Net Present Value method is often considered as a capital budgeting method by various companies as it is helpful in evaluating several projects to check whether it would be beneficial to investment large amount of money in a new project. Net Present Value is calculated by subtracting the present value of cash outflows from the present value of cash inflows of the project (Benamraoui et al. 2017). It is generally used to analyse the returns from the investment. The main purpose of using this method is to lay emphasis on maximising the wealth for shareholder and other key stakeholders of the company. This method is more effective as compared to other methods like discounted payback period method in terms of both time of value or mathematical calculations. It is regarded as the efficient method concerned with the evaluating the various physical projects where the company have a desire to invest. These projects are generally large with regard to both money and scope like construction of new building, purchase of large machinery or equipment, etc.
This method makes use of cash flows discounted at a required rate of return to undertake effective analysis. It is therefore, considered as the precise method as compared to other methods of capital budgeting. Both time and risk variables are considered in Net Present Value method. Under this method, an analysis is done after undertaking various assumptions and variables. The cash flows are forecasted and evaluated by discounting them to the present period with the help of given project information like initial cost of project, its time span, cost of capital, etc. After evaluation, if the NPV arrives positive, then the firm must invest in project otherwise not. Negative NPV indicates that the firm should not invest as the project may not provide adequate returns in future time period (Nanda and Rhodes-Kropf 2017).
In addition to this, NPV method helps the business firms to make adjustments to cope up with the working challenges posed by limited funds. A set of decision rules is framed under Net Present Value method. For instance, it is suggested that if the NPV of an independent project is more than 0 then the project must be accepted otherwise not. In case of mutually exclusive projects, the project with higher NPV must be accepted or both the projects must be rejected if both have negative NPV.
However, there are some disadvantages of using NPV method as a key analytical tool in capital investment appraisal. This method may lead to inefficient decisions as there is a risk of wrong formula inputs and ineffective assumptions. Moreover, project overall cost and estimated cash flows are affected by unforeseen and unexpected events. The calculation of profitability of projects is evaluated based on an estimated discount rate, forecasted cost and expected projected returns (Jagannath et al. 2016). This method might not be helpful in case of delays in project, unforeseen expenditure or some other issues that may arise at early or in between the project. It does not take into account all the potential risks and assumes maximum amount of cash inflows in each year of the project duration. The estimated discount rate and the accounted cash flows may not get achieved and it may lead the investors to make decision based on false calculations.
In order to meet these challenges, IRR (Internal Rate of Return) method is also used to evaluate the project for investment purposes which is based on NPV formula (Patrick and French 2016). This is different from NPV formula as it undertakes only the cash inflows from each period and do not take into account the initial investment. Proper discount rate is used in IRR formula instead of estimated discount rate like in case of NPV formula.
2. Principle uncertainties associated with the project
It is considered important to conduct analysis on negative NPV investments like it is done in case of positive NPV investments. There are times when the companies have to make decisions under high degree of uncertainty. The strategy implemented by the company for doing investment in the project has large influence on the profitability and growth of the company (Nagle and Muller 2017). Estimated cash inflows from a project are uncertain as both expenditure and income with regard to project are meant for the future period. The project being valued on the basis of NPV method may not effectively captures the flexibility offered by the project at times and thus, may generate undervalues from the project. As there are no standard guidelines followed to determine the rate of return on a project and left only to discretion of the specific company to set any such rate. This may lead to the situation of having inaccurate NPV because of inappropriate return rate (Schroeder et al. 2019).
There are uncertainties with regard to the sunk costs, hidden costs or various other types of preliminary costs that have incurred while carrying out the project. These costs are not taken into account while calculating NPV and thus, may severely impact the profitability from the project as NPV is showing inaccurate results. The project with negative NPV will lead to the fall in the overall value of the company. The main objective of the company is to provide positive and maximum return to the shareholders as they have invested funds in the company’s business. The cash flows that may result from the project are uncertain as both expenditure and income are concerned with the future purpose (Barker et al. 2017).
The chances of achieving specific scenarios are completely unknown because of various factors like insufficient historical data, diversity in the definitions of probability, lack of adequate knowledge regarding the potential states of nature, etc. As the Ridley Co. has negative NPV in an estimated project, it may not be able to provide adequate return to the shareholders in future or if it becomes successful in raising the funds at the initial stage then the investors may not invest again in this company. It is important for the company to retain the shareholders for a longer period of time for its growth and survival. There is uncertainty with regard to the decline in the overall value of the company.
However, there are various methods that are particularly designed to take uncertainty level into account like application of sensitivity analysis, rise in the discount rate, forecasting the cash flows with the help of scenario planning and probability distribution methods or the effective comparison between optimistic and pessimistic cash flows (Gaspars-Wieloch 2019). Sensitivity analysis can be applied successfully to the NPV method of project evaluation to assess how the value of NPV changes on the basis of the level of specific cash flows. Thus, it is considered as a useful tool that can be used effectively for decision making process. It helps in knowing the changes in rankings on the basis of the level of discount rate, forecasted net cash flows and the coefficient of optimism and pessimism.
3. Possible actions that could be taken by Ridley Co. to reduce the risk that the project fails to increase shareholder value.
Companies always try and look for the potential opportunities that will help them in improving the overall performance and value of their businesses. There are number of actions that could be taken by Ridley Co. in order to reduce the risk associated with the project to generate maximum value to the shareholders. These are as follows:
4. Main issues of Ridley using 100% debt funding to finance the project
Capital required to carry out the operations of the business can be raised in two ways, namely, by issuing shares in the market or by borrowing from the bank or public. In case of equity shares, some of the control and ownership is given to the shareholders while debt financing helps in retaining control and ownership in the company (Parsonage and Berglund 2017). However, there are various other risks which are present while using debt financing methods to raise the finance for the project. These are as follows:
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