A) Investment Decision Making

Financial manager. Our company is working on an investment project. What do you think we should take into account in our work?

Consultant: First, I'd like to know something about your project. Could you describe it in general terms?

P.M.: Yes, sure. The project is aimed at investing in fixed assets. The market research we've carried out has revealed that the demand for our products exceeds our supply. So we are intending to buy new equipment abroad, to expand our production facilities and to increase output, which will allow us to increase sales and get higher profits.

Con.: Have you drawn up the capital budget?

P.M.: We are not through yet, but we've calculated the project outlays, estimated the anticipated flow of future benefits from our investments, operational and financial activities.

Con.: What time period do your calculations cover?

P.M.: We proceed from standard service life of major technological equipment, with adjustment for depreciation. In our case, it is five years.

Con.: Any project needs funding, doesn't it? What sources of financing do you intend using?

P.M.: Internally generated funds and borrowed resources. We are going to issue shares and obtain long-tern Rouble and hard-currency loans. The estimates of the actual cash flow has been based on this plan.

Con.: You've adjusted your calculations for inflation, haven't you? What if the inflation rate happens to be higher than the interest rate? You may have problems with creditors.

P.M.: Yes, to avoid the situation, commercial banks insist on monthly interest payments.

Con.: Speaking about the loan repayment I would like to know which loan will be repaid first – the Rouble or the hard currency loan.

P.M.: The one with a higher interest rate.

Con.: Right. Now that you've estimated the real cash flow, you should prepare your company's profit and loss statements as well as balance sheets for each stage of the project.

P.M.: Well, I agree that the profit and loss statement is useful for the evaluation of the project. Is the balance sheet necessary?

Con.: Manuals on project evaluation recommend to do it, UNIDO's manuals in particular. The balance sheet allows to forecast the company's financial position during various stages of the project implementation. Besides, having done it you'll be able to check your estimates.

P.M.: I see your point. The statements are also important from the point of view of taxes. What else should we focus on while working on the capital budget?

Con.: I know from my experience that the key problems in capital budgeting are forecasting sales, calculation of the cost of capital as well as analysis and estimates of cash flow risks.

P.M.: Thank you. I'll tell my staff to be most careful about these things.

B) Investment Project Appraisal

P.M.: How can an investment project be evaluated?

Con.: There are different techniques. Most common today are UNIDO techniques based on payback period, net discounted cash flow and internal rate of return.

P.M.: What criteria should be used in our case? What do they imply?

Con.: Let's start with the payback period, which is the number of years required to recover the investment needed for the project.

F.M.: Experience has shown that the payback method does not provide reliable information about the project's contribution to the market value of a company. Besides, it disregards time value of money. It's common knowledge that the value of our Rouble today is more than its value to be received after some time.

Con.: Yes, the sum of money to be received in future is less valuable than it is today.

P.M.: What can you say about the other criteria?

Con.: In the opinion of a number of scientists, net discounted cash flow appraisal, based on cash flow discounted at a certain discount rate, is a more effective technique. Net discounted cash flow gives a wider picture of investment results.

P.M.: From my experience, I, for one, think that this technique is more reliable because it takes into consideration all benefits and costs occurring during the entire life of the project.

Con.: Net discounted cash flow is a difference between the cash flow over the project life expressed in terms of its present value and investments in the project.

P.M.: I see. How can the third criterion be determined, I mean the internal rate of return? Does this method have any advantages over the others?

Con: The IRR method also considers the time value of money by discounting the cash streams. But the rate of return is not predetermined. The IRR is based on facts which are internal to the proposal. The idea of the method is that the internal rate of return is equal to the maximum borrowing interest rate that can be repaid over the period of the project life, if the project is financed only from borrowed funds. So the IRR is a measure of investment effectiveness.

P.M.: Which method, do you think, suits us best?

Con.: It's a difficult question to answer. The choice of the method depends on the company's position, size of the investment project, the situation in financial markets. It would be a good idea to use all the methods.

P.M.: It's a hell of a job, isn't it?

Con.: Yes, but these criteria can be easily determined using modern computer equipment.

Words you may need:

capital budget смета капиталовложений

service life срок службы

depreciation n износ, амортизация

profit and loss statement счет прибылей и убытков

UNIDO (United Nations Industrial Development Organization) Организация Объединенных Наций по промышленному развитию

manual n руководство, справочник

cash flow risks риск денежного потока

payback period срок окупаемости

discounted cash flow будущие поступления наличными, приведенные в оценке настоящего времени

internal rate of return внутренняя норма доходности

time value of money временная стоимость денег

present value приведенная стоимость

Capital Structure and Cost of Capital

The capital structure refers to the weight which different types of capital have in the total capital employed. The question of capital structure becomes particularly significant when a choice of debt and equity capital is made. The relationship between the long-term debt and equity capital invested in the business is called gearing.

Gearing is the indicator of the relative proportion of debt capital and equity capital. The higher the proportion of debt, the more highly geared is the company. The degree of gearing affects the overall cost of capital.

The conventional view is that at very low levels of gearing debt capital will be cheaper than equity capital because the level of risk is low, with debt interest being a prior charge. The overall cost of capital is thus brought down with the use of debt. As the debt-equity ratio increases, interest becomes a bigger proportion of expected profits. The higher the gearing, the more exposed the company is at times of economic difficulty.

The concept is difficult to measure in practice. The most elementary measure is nominal value of fixed-interest capital versus nominal value of equity capital.

The ratio has limitations as it ignores some types of interest-bearing finance such as bank loans and mortgages.

* * *

Cost of capital is the cost measured as a percentage rate of the various sources of capital required to finance capital expenditure. All sources of capital have a cost which can be a direct one as, say, with a loan or an opportunity cost as, say, with retained earnings. At any time a company's cost of capital will be the weighted average of the cost of each type of capital: ordinary shares, preference shares and long-term debt.

Companies have a choice of the capital structure which they adopt and will generally try to minimize the overall cost of capital in making their choice.

Liquidation

If a company is unsuccessful in its operations, or if for any other reason it decides to go out of business, it goes into liquidation. There are two kinds of liquidation – voluntary and compulsory.

Voluntary liquidation may be brought about by the shareholders passing a resolution directing the company to go into voluntary liquidation. When this happens one or more liquidators are appointed whose duties are to realize (to sell) the assets, pay all liabilities, and distribute the balance assets of the company, if any.

Compulsory liquidation can be brought about for a variety of reasons connected with the failure to fulfil the rules laid down by the Companies Act. But a company is usually compulsorily liquidated by order of the court given on a creditor's petition, when the creditor is unable to obtain satisfaction of his debt from the company.

When a winding-up order is granted by the court, the directors are deposed, the employees of the company receive notice that their agreements with the company are at an end, and the company's business is stopped.

Whatever assets remain after the claims of all the creditors have been settled, will be distributed among the shareholders in accordance with the rights carried by their shares.

The Cash Flow Concept

The concept of cash flow is one of the central elements of financial analysis, planning, and resource allocation decisions. Cash flows are important because the financial health of a firm depends on its ability to generate sufficient amounts of cash to pay its creditors, employees, suppliers, and owners.

Only cash can be spent.

Sometimes firms are expected to have an excellent year but unexpectedly cash shortages arise. Shortages of cash may arise for several reasons.

First, not all sales are expected to be for cash or to be credit sales (accounts receivable) collected during the year.

Firms may have debt repayment obligations. Payment of taxes, interest and a cash dividend may further reduce the firm's cash position.

The firm's managers have to arrange to meet this cash shortfall through actions such as borrowing, the sale of new common equity, a reduction in dividend payments, sale of accounts receivable, or increases in accounts payable.

Preparation of a cash budget is useful in helping a firm plan for its cash needs over some future period of time.

Financial managers know that generally accepted accounting principles (GAAP) provide considerable latitude in the determination of the net income of a firm. As a consequence, GAAP concepts of net income do not provide a clear indication of the economic performance of a firm. Cash flow concepts provide a clear measure of the performance of a firm.

To evaluate the cash flows generated from the firm's activities managers use the net present value concept.

Net present value represents the difference between the present value of future cash flows associated with a project and the present value of the initial investments to acquire that project. It is the most commonly used technique to evaluate capital budgeting proposals.