Introduction
In this assignment, the first
question is about projects evaluations. In my answer to this question I will
try to demonstrate my understanding to the concept of project valuation by
using the different formulas in order to get the answered required. In the
second question, I am going to talk about the seven identifiable strategies
that can be used in developing an organization and the problems associated with
each strategy. In my answer to question two, I shall attempt to use some
examples to support my discussion. Finally, I will write my conclusion indicating
the main point that I include it in the assignment.
2. Question (1)
Provide an evaluation of the following two proposed
projects. They both have expected lives of 5 years. The required rate of return
on both projects is 12%. The expected cash flows from each project are as
follows:
|
|
Project A
|
Project B
|
|
Initial Outlay
|
-£110,000
|
-£110,000
|
|
Year 1
|
20,000
|
40,000
|
|
Year 2
|
30,000
|
40,000
|
|
Year 3
|
40,000
|
40,000
|
|
Year 4
|
50,000
|
40,000
|
|
Year 5
|
70,000
|
40,000
|
2.1 What
recommendations would you give to a management team, which is considering
whether or not to invest in these projects?
|
Project
A
|
|||||
|
Initial
Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
-110,000
|
20,000
|
30,000
|
40,000
|
50,000
|
70,000
|
|
0.89286
|
0.79719
|
0.71178
|
0.63552
|
0.56743
|
|
|
17,857.14286
|
23,915.81633
|
28,471.20991
|
31,775.90392
|
39,719.87990
|
|
|
Project
A total PV =
|
141,739.95292
|
|
Project
B
|
|||||
|
Initial
Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
-110,000
|
40,000
|
40,000
|
40,000
|
40,000
|
40,000
|
|
0.89286
|
0.79719
|
0.71178
|
0.63552
|
0.56743
|
|
|
35,714.28571
|
31,887.75510
|
28,471.20991
|
25,420.72314
|
22,697.07423
|
|
|
Project
B total PV =
|
144,191.04809
|
|
|
Initial
Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|||
|
Project
A
|
-110,000
|
20,000
|
30,000
|
40,000
|
50,000
|
70,000
|
31,739.95292
|
0.20970
|
0.28855
|
|
Project
B
|
-110,000
|
40,000
|
40,000
|
40,000
|
40,000
|
40,000
|
34,191.04809
|
0.23919
|
0.31083
|
Terminology
C = Cash Flow
t = time period of the investment
r = “opportunity cost of capital”
Internal Rate of Return (IRR) - Discount rate at
which NPV = 0.
Profitability Index = NPV/ Investment
Project (A)
IRR = 20.97%
PI = 31,739.95292/110,000= 0.28855
Project (B)
IRR = 23.919%
PI = 34,191.04809/110,000= 0.31083
According to my analysis to these
two projects, I will recommend to the management team to invest in project (B). Project
(A) displays a lower NPV and would be unlikely to be selected unless other
factors are presented and the equations revaluated.
2.2 What is the payback
period on each project? If a 3-year payback period is required which of the
projects should be accepted?
Payback Period is the time until cash flows recover the initial
investment of the project. Therefore, the payback period for project A
is four years and three years for project B.
|
|
Initial
Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
Payback
|
|
Project
A
|
-110,000
|
20,000
|
30,000
|
40,000
|
50,000
|
70,000
|
4 Years
|
|
Project
B
|
-110,000
|
40,000
|
40,000
|
40,000
|
40,000
|
40,000
|
3 Years
|
The payback rule
specifies that a project be accepted if its payback period is less than the
specified cutoff period. The cutoff period required is three years. Therefore,
project B should be accepted according to the payback rule.
2.3 What are the criticisms of the payback method?
This method is very flawed,
primarily because it ignores later year cash flows and the present value of
future cash flows. The payback rule says only accept projects that “payback” in
the desired period or less but a big mistake could be done. An example of this
mistake that if we have two projects with an equivalent payback period and we
choose any of these projects as per the payback rules. The payback method explicitly takes into account the time value
of money; it still ignores what might happen after the payback horizon. A
project may be rejected even if the expected cash flows from the desired period
and beyond are very large, as might be the case in a research and development
project. A project might be accepted even if there is a large cleanup cost that
would have to be paid after the payback horizon. We
should choose between them the project with the highest NPV value.
|
|
Initial
Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
|
Project
A
|
-110,000
|
20,000
|
30,000
|
40,000
|
50,000
|
70,000
|
Discounted
Payback
|
|
PV
|
|
17,857
|
23,916
|
28,471
|
31,776
|
39,720
|
5 Years
|
|
Project
B
|
-110,000
|
40,000
|
40,000
|
40,000
|
40,000
|
40,000
|
Discounted
Payback
|
|
PV
|
|
35,714
|
31,888
|
28,471
|
25,421
|
22,697
|
4 Years
|
2.5 What is the logic that lies behind the net present value?
Every investor
requires a specific rate of return, which is based on his or her time
preference. The net present value NPV method, which is on of the discounting
methods, is founded on the concept of the time value of money. Therefore, a
project is only accepted if it generates a rate of return more than the minimum
required by the investor. As a result, I could say that the logic that lies behind
the net present value method is the opportunity costs. The NPV as it is
founded by the concept of the time value of money will give us the tool to
evaluate the opportunity costs.
2.6 What would happen to the net present value for each project if
the required rate of return:
(i) Increased?
If we increased the required rate of return
to 14% from 12% for project A, the NPV for project A
will decreased from 31,739.95292 to 23,586.56653.
|
Project
A
|
|
|||||
|
Initial
Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
NPV
|
|
-110,000
|
20,000
|
30,000
|
40,000
|
50,000
|
70,000
|
|
|
DF
|
0.87719
|
0.76947
|
0.67497
|
0.59208
|
0.51937
|
|
|
PV
|
17,543.85965
|
23,084.02585
|
26,998.86065
|
29,604.01387
|
36,355.80651
|
23,586.56653
|
(ii)
Decreased?
If we decreased the required rate of return
to 10% from 12% for project A, the NPV for project A
will increased from 31,739.95292 to 40,642.96403.
|
Project
A
|
|
|||||
|
Initial
Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
NPV
|
|
-110,000
|
20,000
|
30,000
|
40,000
|
50,000
|
70,000
|
|
|
DF
|
0.90909
|
0.82645
|
0.75131
|
0.68301
|
0.62092
|
|
|
PV
|
18,181.81818
|
24,793.38843
|
30,052.59204
|
34,150.67277
|
43,464.49261
|
40,642.96403
|
2.7 Determine the internal rate of
return for each project.
Internal Rate of Return (IRR) - Discount rate at
which NPV = 0.
Project (A)
IRR = 20.97%
Project (B)
IRR = 23.919%
|
|
Initial Outlay
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
IRR
|
|
Project A
|
-110,000
|
20,000
|
30,000
|
40,000
|
50,000
|
70,000
|
0.20970
|
|
Project B
|
-110,000
|
40,000
|
40,000
|
40,000
|
40,000
|
40,000
|
0.23919
|
2.8 How should risk be taken into
account?
All the investment decisions that have been
taken previously in this question were assuming that all future cash flows are
known for certain but this assumption rarely happen in reality. Future returns
cannot usually be predicted with total accuracy. The most common methods that are
used when dealing with risk are sensitivity analysis and use of probabilities. We
should keep in mind that no investment project is totally safe. The market condition
could affect the investment decision that built upon certainty. Therefore, choosing
a specific project based on the assumption that the future cash flows in known
our investment decision could be wrong in the market condition change toward
growth or even recession. As a result, the risk should be taken in account when
we are dealing with project valuation by using sensitivity analysis and
probabilities. The expected value of a project “ENPV” is one of the common
tools that are used to deal with uncertainties but ENPV will not make the decision
for us. The ENPV will only summaries the information of the possible outcome
and the actual decision will depend on the attitude to risk in the
organization.
3. Question (2)
“A
company is considering how it might grow and develop. What strategies are
available to it and what are the problems associated with each strategy that it
should be aware of.”
3.1 Introduction
In my answer to this question, I am
going to talk about the seven identifiable strategies that can be used in developing
an organization. While I am demonstrating my understanding to these strategies,
I will try to identify the problem associated with each of them that the
management should be aware about it. I shall attempt to support my argument by
some real example. Finally, I will write my conclusion.
3.2
Main body
There are seven strategies that
could by used to develop an organization (1):
- Forward integration defined as gaining ownership or increased control over distributors or retailer.
- Backward integration defined as seeking ownership or increased control of a firm’s suppliers.
- Horizontal integration defined as selling ownership or increased control over competitors.
- Vertical integration defined as either backward or forward integration (or both together).
- Concentric diversification defined as adding new, but related, products or services.
- Conglomerate diversification defined as adding new, but unrelated, products or services.
- Horizontal diversification defined as adding new, unrelated products or services for present customers.
As we can see from these definitions, the
developing strategy could be either Integration or Diversification.
In theory, the integration can be
total from the raw ore to the distribution of the final products to consumers but
diversification is adding something new. Vertical integration is the joiner of
two or more successive stages of production. Efficiencies, avoiding government
restrictions and to take advantage of monopoly-related conditions are the three
categories of reasons why firms adopt vertical integration. Vertical
integration is favoured by companies that desire a high level of control over
their channels. For example, Sears obtains over 50 percent of the goods it
sells from companies that it partly or wholly owns; Sherwin-Williams make paint
but also own and operate 2,000 retail outlets (2). Often a business’s sales and
profits can be increased through backward integration (acquiring a supplier),
forward integration (acquiring a distributor), or horizontal integration
(acquiring a competitor).
The aim of integration in this case for
expanding firm is to capture these profit but we said previously often. In some
cases, the more threat of integration may lead suppliers to reduce their prices
for components, or customers to offer more attractive terms. We should understand
that if one’s suppliers appear to be earning excessive profits, there is no
guarantee that a firm integrate backward will be able to achieve such returns. Control over suppliers “may” reduce costs but over
integration can cause the opposite effect (3). One of the most known examples
of that is Nissan, before it has been taken over by Renault; backward
integration caused the opposite effect to them. The integration by existing suppliers
will increase the capital requirement of entry into a market and will put
potential entrants at a cost disadvantage. Mergers, acquisitions and joint
ventures can be methods used to allow companies to achieve company diversification
strategies.
Acquisitions
and Mergers are the quickest way for a company to diversify. Growth through diversification can be achieved in two ways,
either by internal expansion or externally by acquiring, consolidating with, or
merging other firms. A purchase of another business is an acquisition. A sales
contract is executed under, which the buyer assumes all or some of the seller's
assets and assumes all, some, or none of the seller's liabilities. The sale of
the RCA computer division to Sperry-Univac in 1971 was through acquisition. A
merger is absorption of one company by another company, including all its
assets and liabilities. In 1937, Nash Motors absorbed the Kelvinator
Corporation, and changed its name to Nash-Kelvinator Corp. Then, in 1954 , the
Nash-Kelvinator Corp., changed its name to American Motors, and merged with the
Hudson Motor Car Company (4).
The
1990s witnessed record levels of mergers and acquisitions not only in the U.S. U.S.
As we mentioned before, the integration can be total from the raw ore to the distribution of
the final products to consumers but diversification is adding something new.
The aim of integration is to capture more profit but control over suppliers or distributors “may”
reduce costs but over integration can cause the opposite effect. Yes, Acquisitions
and Mergers are the quickest way for a company to diversify but there are some
limitations to that. The internal growth will reduce equity position to investor's and it will take the
organization time to build additional market share and profit. On the other
hand, the external growth as it requires stockholder’s consent it may also
require added funds to accommodate acquisition to needs and the integrating
acquires firm into operations can be a problem. However,
another leading strategist, Igor Ansoff, argued that a company should first ask
whether a new product had a “common thread” with its existing products. He
defined the common thread as a firm’s “mission” or its commitment to exploit an
existing need in the market as a whole. Ansoff noted, “Sometimes the customer
is erroneously identified as the common thread of a firm’s business (6). As
a result, we should be aware about these type of problems associated with the
strategies that could be used for organizational development before we make our
development decisions.
3.3 Conclusion
In my answer to this question, I tried to describe and discusses the
strategies that could be used for
organizational development. I explained the difference between the integration
and diversification. I used some example to demonstrate to the reader my
understanding to the problem associated with these strategies.
4. Conclusion
By using the textbook and other references, I was able to answer the
questions. In question one; I did demonstrate my understanding for the formulas
and how to deal with this type of questions. In question two, I explained the
seven strategies that could be used for organizational development. I did support
my discussion with example in order to identify the problem associated with these strategies.
5. Limitation
of the Sample
My answer to the question 2 in this
assignment is based on a limited amount of references. The topic of
organizational growth and development is so important and it requires more
research. Most of the research in this topic is purely a Western study and we
do need to make more research about in our part of the world, as the result
could be different concerning the problem associated. Therefore, my conclusion could possibly be
faulty or incomplete because of the limitation of the sample. My conclusion
cannot generalize on all Muslim countries; more research would be needed.
6. References
- Management Centre, Module 4 MBA, Finance
and Growth Strategies,
- Philip Kotler, Marketing Management Millenium Edition, 10th Ed, Chapter 13.
- Brealey and Myers, Principles of Corporate Finance, Sixth Edition, Chapter 33.
- http://www.mgmtguru.com/mgt499/TN8_2.htm
- ERICH A. HELFERT, FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES,
Page 411
6. Igor Ansoff, Corporate Strategy (New York, 1965), 106–9.
No comments:
Post a Comment