Evaluation Of Investment Alternatives Essay

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A critical role of a financial manager is the evaluation of capital projects.  This is a very important task because the money involved in such activities is significant and the benefit or loss derived from will highly influence the financial performance of the whole organisation (Brockington R. B. 1996, p 102).  Indeed, Nobel laureates Modigliani and Miller suggested in their theory of capital structure that the value of a company is not affected by its gearing, but the primary factor that influences such value is the investment in wealth creating projects (Pike R. et al.  1999. p 557 and 577).

1.1  Evaluation of plans if their risk equals that of the firm

1.1.1 Net Present Value Method

Net Present Value €349,720

Net Present Value €428,970

Source:  Drury C. 1996, p 389.

1.1.2 Internal Rate of Return Method

PLAN X

PLAN Y

Source: Horngren T. C. et al. 1997, p 785 787.

1.1.3 Evaluation of projects

Plan Y is more financially feasible under both methods.  The net present value of Plan Y is €79,250 [€428,970 €349,720] higher than Plan X.  The internal rate of return of Plan Y is also 2.61% higher than the other plan, indicating a higher margin of safety on losses in case the expected cash flows are not achieved (Randall H. 1996, p 446).

1.2 Examination of plans at different risk profiles

1.2.1 Net Present Value Method

Net Present Value €261,111

Net Present Value €225,417

Source:  Hirschey M. et al. 1995, p 799.

1.2.2 Comparison of decisions at different risk rates

When the discount rate of the project is considered instead of the overall rate of the company, the financial viability of Plan Y diminishes because this plan is a riskier project than the other one and hence, a higher discount rate is chosen.  The process of discounting arises from the time-value of money principle, and the higher the discount rate the lower the present value from the cash flows generated from the project (Pike R. et al. 1999, p 66 & 67).  In such a stance, Plan Y is no longer the most optimal project because Plan X net present value exceeds that of Plan Y by €35,694 (€261,111 €225,417).

1.3 Analysis of real option data for plans

1.3.1 Net Present Value Method

Net Present Value: -€1,147,949 + (€100,000 x 25%) = -€1,122,949

Net Present Value: €225,417 + (€500,000 x 20%) = €325,417

Source:  Lucey T. 2003, p 416.

1.3.2 Comparison of real option plans with original plans

If we consider and apply the real options available, Project Y becomes the best project, on the contrary of the conclusion noted in sub-section 1.2.2.  It is also worth nothing that the application of the real option for Plan X is not financially viable because we will end up with a negative net present value.  If we compare the net present value of Plan Y under the real options scheme with the net present value of Plan X we can deduce that Plan Y real options project is more feasible than the other plan since the net present value is €64,306 higher [€325,417 €261,111].

1.4 Effect of Capital Rationing

Capital rationing is an absolute restriction on the amount of finance available for a project irrelevant of cost.  This should not be confused with scarcity of economic resources.  Capital rationing on projects is sometimes applied even though the organization posses or can attain available finance.  For example, a capital rationing may be imposed on the amounts of debts an organisation can take in order to limit the gearing of the firm (Brockington R. B. 1996, p 151).

When conditions of capital rationing are imposed, there is the possibility that the most optimum project is not selected.  Therefore yes capital rationing may effect the selection of Plan X or Plan Y.  For example if a capital rationing is adopted by the firm which states that the initial investment cannot exceed €2,000,000 due to its effect on gearing.

Under such conditions no Plan would be selected by the firm.  Another example of capital rationing that will affect the project choice is if management decided to restrict expansion of the factory, because they fear that control on employees may be lost affecting negatively their relationship and control on staff.  In this case Plan X would be excluded, even though it is the most optimal project as denoted in sub-section 1.2.2., and the available choice would be Plan Y.

1.5 Financial instruments available for private companies

The alternative financial instruments that the firm can use, apart from shares are:




1.5.1 Advantages and disadvantages of corporate bonds/debentures

The advantages related to corporate bonds are (E*Trade Financial website):

The disadvantages encountered with corporate bonds are:

1.5.2 Advantages and disadvantages of bank overdraft facility

A bank overdraft facility can provide the following benefits (tutur2u website):

The disadvantages imposed by an overdraft facility are (tutur2u website):




1.5.3 Advantages and disadvantages of bank loans

These are the advantages derived from bank loans (tutur2u website):

Limitations of this type of finance are (tutur2u website):

1.5.4 Advantages and disadvantages of venture capital

The advantages of venture capital are (Business Link website):

The disadvantages incurred by using such medium of finance are (Business Link website):

 

 

15.5 Advantages and disadvantages of leasing

The advantages obtained from leasing are (Enterprise. Financial Solutions website):

The disadvantages encountered through leasing finance are (Auto Leasing Software Lease Tips website):







References:




Auto Leasing Software Lease Tips.  Disadvantages of leasing (on line).  Available from:  http://www.autoleasingsoftware.com/LeaseTips/Disadvantages.htm (Accessed 13th March 2007).




Brockington R. B. (1996).  Financial Management.  Sixth Edition.  London:  DB Publications.




Business Link.  Equity Finance (on line).  Available from:  http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1075081582 (Accessed 13th March 2007).




Drury C. (1996).  Management and Cost Accounting.  Fourth Edition.  London:  Thomson Business Press.




Enterprise.Financial Solutions.  Advantages of leasing (on line).  Available from:  http://www.efsolutionsinc.com/Advantages_of_leasing.htm (Accessed 13th March 2007).




E*Trade Financial.  Corporate Bonds Overview (on line).  Available from:  https://us.etrade.com/e/t/kc/KnowArticle?topicId=13200&groupId=8722&articleId=8723 (Accessed 13th March 2007).




Hirschey M; Pappas L. J. (1995).  Fundamental of Managerial Economics.  Fifth Edition.  Orlando:  The Dryden Press




Horngren T. C.; Foster G.; Srikant M. D. (1997).  Cost Accounting A Managerial Emphasis.  Ninth Edition.  London:  Prentice-Hall International (UK) Limited.




Lucey T. (2003).  Management Accounting.  Fifth Edition.  Great Britain:  Biddles Ltd.




Pike R.; Neale B. (1999).  Corporate Finance and Investment.  Third Edition.  London:  Prentice-Hall International (UK) Limited.




Randall H. (1999).  A Level Accounting.  Third Edition.  Great Britain:  Ashford Colour Press Ltd.




Tutur2u.  Bank Loans and Overdrafts (on line).  Available from:  http://www.tutor2u.net/business/gcse/finance_bank_loans_overdrafts.htm (Accessed 13th March 2007).




Veale R. S. (2000).  Stocks, Bonds, Options and Futures.  Second Edition.  United States of America:  New York Institute of Finance.

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