Estimate the benefits of potential projects Essay Example

a company considers introducing a new product that may compete with existing products, estimated sales-based cash flows for the new product should not be presented alone; potential cannibalization must also be taken into account. Sales forecasts typically involve reviewing sales from the past five to ten years to predict future growth. Companies also need to project future balance sheets and income statements.

Analyzing Historical Ratios: The purpose of historical information is to calculate future or pro forma financial statements. The percentage of sale method assumes that costs in a given year will be a certain percentage of that year's sales.Companies start their analysis by calculating the cost-to-sales ratio for previous years. They also forecast their income statement and balance sheet for the upcoming year to aid in investment decision-making. Analyzing ratios involving assets, sales, inventory, and receivables helps company directors make decisions about future projects. Financial forecasting begins with projecting a company's sales in units and dollars. The financial needs can be calculated using either the projected or pro forma financial statement method. Using the financial statement method is more reliable as it provides ratios that assess different business plans. To determine additional required funds, one calculates the amount needed to support projected sales and subtracts self-generated finances from operations. Companies then decide how to raise these additional funds efficiently, considering factors such as economies of scale, excess capacity, or adding assets in large increments that may require adjustments.Linear regression and adjustments for excess capacity can be utilized to determine asset requirements in situations where assets are not projected to grow at the same rate as sales. The provided text outlines various sources of funds that

WAPDA, an organization responsible for expanding the Mangla Dam, can tap into including businesses, individuals, and governments. The primary purpose of the dam is to provide water to irrigated areas in Pakistan and Azad Jammu Kashmir. As population growth and seasonal crop needs lead to an anticipated increase in demand, WAPDA faces a shortage of finances. To address this issue, they must secure capital through equity, debt, preferred stock issuance or borrowing which will offer flexibility and safeguard against uncertainties. Additionally, there are specific methods mentioned in the text that companies like WAPDA can employ. One such option is obtaining a line of credit or revolving credit from a bank or financial institution. Another possibility involves issuing bonds and borrowing funds with a commitment to repay them along with interest at regular intervals. Renting equipment is also suggested as an alternative means of raising capital since it helps reduce cash outflow while providing tax advantages; furthermore, maintenance charges are included upfront ensuring full awareness of total costs beforehand. At the conclusion of the rental period, three choices arise: returning the asset, exercising an option to purchase it outright or negotiating a new rental agreement for different equipment options.Renting is a convenient option for companies to have the latest equipment without purchasing it outright. If they want to keep the equipment permanently, there are two choices: entering a new rental agreement or making a purchase. Another alternative is selling an asset to a financial institution and then renting it back, known as sales and rent back. This choice provides immediate cash injection and spreads repayment over several years. Additionally, note collectible is mentioned as another method

for WAPDAA to raise capital by creating promissory notes with guaranteed payment conditions.

Moreover, common stock ownership offers WAPDA an opportunity to generate funds through equity ownership, granting voting rights on important matters in the corporation. The returns for common stockholders depend on factors such as net incomes, company reinvestment, and market valuation of the stock.

In undertaking 2, various appraisal methods for investment are discussed. Net present value (NPV) serves as an effective method used in evaluating investments by indicating the value added by an investment or project to the company. A positive NPV represents discounted cash inflow over time while negative NPV indicates discounted cash outflow over time. Risks associated with positive NPVs can be accepted if desired.

The text emphasizes adjusting cash flows for risk and considering the time value of money when assessing present value's significance.
The text explains the concept of present value and net present value (NPV), as well as how to calculate NPV using a discount rate. It also mentions the use of rough estimations based on an appraisal ratio, the adjustment of discount rates for different time periods, and the need for a simpler calculation method if discount rates change over time. The described method is accurate in determining values in a perfect capital market and ranking projects. NPV allows for both absolute value assessment and consideration of discounted cash flows. Determining the correct discount rate requires predefined criteria before assessing NPV. Additionally, three other methods of investment appraisal are mentioned: payback period, internal rate of return, and accounting rate of return. Payback refers to the time it takes for an investment's return to equal its original investment, measuring risk rather

than return.The text discusses the payback period method and its limitations in evaluating investments. It mentions that despite being a simple calculation, it is considered an unsound method. Investments with shorter payback periods are generally preferred. Companies using this method often have a maximum acceptable period. The payback period has several limitations: it does not consider cash flows beyond the payback period, risk, or wealth maximization like NPV. It also ignores the time value of money and has an arbitrary cutoff period.

To address some limitations, one can discount the cash flow using WACC and calculate the payback period. However, this adjustment only addresses the time value of money and does not solve other limitations. One argument in favor of using the payback period is its conservatism in valuing predictable short-term returns. However, scrutiny reveals that NPV accurately adjusts for future cash flow uncertainty as well.

Strengths

- The Internal Rate of Return (IRR), also known as the Discounted Cash Flow Rate of Return or simply the Rate of Return (ROR), is simple to calculate.
- It provides some information on investment risk.
- It gives a rough measure of liquidity.

Weaknesses

- The IRR is not suitable for long-term funding.
- It does not account for the time value of money, which can result in potential overpayment.
- It has limitations with inflation, which can significantly impact an organization's finances.
- Although interest rates are not entirely covered, we can calculate the interest rate over the wage back period with some restrictions.

The IRR is a tool used in capital budgeting to calculate and compare the profitability of an investment. However, it does not account for risk. The IRR is determined by finding the discount

rate that results in a net present value of zero for a series of future cash flows. In other words, it is the rate of return that makes the sum of the present value of future cash flows and the final market value equal to its current market value.

The IRR provides a "hurdle rate" where any project should be avoided if the cost of capital exceeds this rate. While it can be calculated using mathematical formulas, a financial calculator is typically used. The IRR calculates the minimum rate at which an investment generates a positive Net Present Value (NPV), taking into account factors such as price reduction rates and an alternate cost of capital with a suitable risk premium.However, academics generally recognize that NPV is a superior measure for capital budgeting compared to IRR. One limitation of IRR is its inability to evaluate mutually exclusive projects, where only one project can be chosen. Another financial measure called Accounting Rate of Return (ARR) assesses cash inflows and outflows to determine excess or deficit. ARR calculates average net profit as a percentage of mean investment using cash flows and either a discount rate or curve. The mean investment value includes book value and tied-up assets, considering depreciation and amortization when calculating net income. However, it is important to consider these factors in asset values as well. ARR is commonly used internally for project selection and performance measurement within organizations but is not favored by investors due to its reliance on non-cash items and failure to consider the time value of money like NPV does. Moreover, IRR cannot be applied in cases where initial positive cash inflows

occur without reinvestment, making NPV more reliable than IRR in those scenarios. ARR also disregards the increased risk associated with longer-term forecasts. There are alternative methods available that are not significantly harder to calculate.ARR, or Accounting Rate of Return, is similar to payback in concept but has flaws as it does not adequately account for risk or the time value of future earnings. The use of the payback period often leads to overly cautious decisions. However, selecting investments based on ARR disregards the time value of money and non-cash items. Despite being easy to calculate and potentially resulting in different choices compared to net present value (NPV), NPV ultimately represents the correct decision.

The strengths of ARR include considering the time value of money and cash flow risks by factoring in the cost of capital. However, it also has weaknesses such as lacking specific decision criteria for increasing firm value, requiring an estimate of the cost of capital for calculation, and neglecting cash flows beyond the discounted payback period.

Recommendations emphasize understanding concepts like present value in various areas of business decision-making, particularly managerial decisions that affect future cash flows. Successful real-world decision-making tools must consider risk, taxes, and qualitative factors. NPV plays a crucial role in project approval or rejection.

In Project 3 Part (a), Amber Lights Ltd., a high street fashion shop, undergoes financial ratio analysis to assess its financial position over two years. Various ratios are calculated for this purpose.Return on Capital Employed (ROCE) is a ratio that represents the long-term investment in the business and is often considered the best measure of profitability. The formula for ROCE is net income before tax & interest

divided by capital employed, which can be calculated by subtracting current liabilities from total assets.

Financial ratio analysis helps organizations measure employee performance, recognition policies, and overall company performance and efficiency. Analyzing the company's ratios reveals gradual improvement in performance. Certain ratios, such as return on capital employed (ROCE), show sudden increases in profitability from 15% to 25% this year. The company effectively utilizes its assets to maximize profits. Comparing last year's ratio analysis with this year's indicates the overall improved performance and efficient use of assets and resources, leading to minimized liabilities. In summary, this year's results are better than the previous year's.

Restrictions and Limitations of Ratio Analysis

The use of ratio analysis in comparing companies is limited by discrepancies in accounting information resulting from different accounting policies. This hinders the ability to make accurate inter-company comparisons. Additionally, there is a risk of misleading users through imaginative accounting, which manipulates historical data.

Another restriction is that ratios are not ultimate measures and can present invalid information in financial statements. Historical costs, which ratios are based on, may not be appropriate for decision making. While ratios provide general readings, they can be influenced by factors such as price changes, technological advancements, accounting policy changes, and organization size when comparing performance over time.

Ratio analysis also has limitations in terms of its ability to predict future trends accurately due to reliance on historical data that may be several years old. Furthermore, the accuracy of ratios depends on the quality of information used in their calculation.

In considering business strategy, it is important to

recognize how the operational environment presents both opportunities and threats that impact a company's success.

In order to take advantage of opportunities or deal with threats, it is important for AMBER LIGHTS LTD to have enough resources and capabilities. Therefore, it is advised that the company focuses on auditing its resources to find out what is available and how they can be best used. These resources can either be owned by the company or obtained through partnerships, mergers, or supplier agreements within AMBER LIGHTS LTD. Auditing resources helps determine the company's abilities, while strategic auditing assists in maintaining a strong business portfolio by identifying units that require investment and management attention.