Table of Contents
Investment is a major part of developing a business. New assets like machineries can help boost productivity in the firm, decrease the costs, as well as make the firm competitive. Besides, investment in new technology, expertise and new market mainly allows an exciting growth of opportunities in an organization. At times, an organization management needs to evade the overstretching limited financial resources or restricting it ability in order to pursue other options. Hence, deciding where to focus the organization key investment is a significant part of making most of its potential business decisions. Any organization needs to subject its proposed projects under investment appraisal practices in order to identify the project that is more likely to yield the highest profit for the firm. Therefore, current report aims at critically analyzing the major investment appraisal techniques that Biz Systems Consultants Ltd should employ in order to evaluate the best option among the three projects. Further, the report aims at critically analyzing how Biz Systems Consultants Ltd will raise £1,700,000, as well as giving recommendation of the three key sources of finance that the organization can utilize to finance all its operations.
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If proper investment appraisal technique is utilized by Biz Systems Consultants Ltd, the firm would achieve better resources exploitation, as well as high profit margin. Capital investment appraisal is a key decision that the Biz Systems Consultants Ltd managers have to make in order to ensure maximization of the shareholders’ wealth. Besides, financial managers should utilize an accurate technique which will assist the firm to maximize its overall profit. They should also consider a project if it adds some value to the firm. It implies that the financial managers should undertake and identify all projects that add some value to the firm in order to ensure maximization of shareholders value. Profitable projects lead to growth of the firm and if profitability of the firm is low then the investment will decrease. Over the past few decades, numerous techniques have been proposed that can help in improving investment decision-making of an organization. Thus, there are several techniques available in assisting the firm to make wise investment decisions among the three projects proposed. First, the firm can make use of the non-discounting cash flow techniques, such as an average rate of return and payback period or discounting cash flow techniques including the internal rate of return and net present value.
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Choice of project by use of payback period is founded on timeframe required to create cash flows that cover the startup investment. Biz Systems Consultants Ltd can use the payback method to choose the project with a short payback period. If the company has an already set payback period, then it should choose the projects that have a timeframe lower than the indicated one (Hermes, Smid & Yao 2006). The payback method has the advantages of simplicity and ease of implementation, as well as understanding. It also offers an idea of the risk and degree of liquidity of the project. If Biz Systems Consultants Ltd experiences financial instability, the application of such method in the choice of the projects can ensure higher investment security. However, the payback period is disadvantaged in two major ways. Firstly, the method assumes cash flows that occur after payback. It can imply rejection of a beneficial project which will need a longer time to recover the initial payment. Secondly, the method does not take into consideration the time value of money when estimating the cash flows. It breaks the rule of financial mathematics and the best way of dealing with the problem is use of discounting method in estimating the cash flow (Afonso & Cunha 2009).
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Another method that Biz Systems Consultants Ltd can use to determine the best project among the three is the ARR. Accounting Average Rate of Return is calculated as a ratio among projected average income and investments average accounting value. The ratio is compared to the organization accounting rate of return or outside firm’s benchmark, such as average value of the industry. In this case, if expected ARR is higher than management’s rate of return, the firm should accept the investment project, otherwise, the firm should reject the project. The major advantage of using current method is the ease of use and it is simple to understand due to the fact that the figures used in computation of average rate of return are taken from the accounting reports (Davila 2005). Further, accounting average rate of return method is considered better than the payback period method because it takes into account the total lifecycle of the project. Nonetheless, accounting average rate of return method has three major disadvantages. Firstly, it does not account for the time value of money which is fundamental to financial mathematics. Secondly, the fact that it is grounded on accounting returns rather than the cash flow of the project implies that it is abstractly not correct. Thirdly, the method demands for setting a target return rate before applying for project appraisal.
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NPV is the investment appraisal technique that is mainly based on discounting of the expected cash flow in a given investment project. More precisely, NPV is viewed as the difference between present value of cash flows and cost of investment (Scheepers 2003). It is the measure of how much is added or created in an organization by undertaking a particular investment project. Further, NPV usually discounts expected cash flows of the investment project by utilizing the determined discount rate. Apparently, NPV is able to determine increase in wealth of the organization which would mainly results from embarking on a given investment project (Dayananda, Irons, Harrison, Herbohn & Rowland 2002). NPV enables the management of the organization to compare the three proposed projects and make correct investment decisions on the best option. It would be based on the following fact: present value of an organization investment projects’ inflows should surpass present value of the project outflows if the investment project is to be considered as the best option amongst the projects proposed by the management (Davila 2005). Besides, since the three projects are mutually exclusive, Biz Systems Consultants Ltd financial managers should consider undertaking the investment project that has high or positive NPV. The investment project with negative NPV should not be considered as a good investment project, since it would lower value of the organization, as well as shareholders’ wealth (Hermes, Smid & Yao 2006).
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On the other hand, Biz Systems Consultants Ltd can make use of IRR in evaluating the best option amongst the three proposed projects. Such technique includes an investment technique that is widely utilized for evaluating the investment projects in an organization, since it usually considers the percentage rate of returns as its key decision variable. More specifically, IRR will be usually determined by evaluating discount rate in a given project for which NPV is set to be zero (Afonso & Cunha 2009). Decision to reject or accept the proposed projects by the company will be mainly based on comparison between opportunity cost of the capital and IRR. In this case, if an investment project IRR surpasses opportunity cost of the capital, the firm should consider undertaking the investment project. However, if IRR of the investment project is less than opportunity cost of the project capital, the firm should reject the project.
Raising £1,700,000 Capital for the Company
Biz Systems Consultants Ltd can receive money from various sources. The company can make use of one or a variety of options available to fund the project and increase it to the required level of profitability. Depending on the financial needs of an organization, the sources can be determined by several factors, such as the type and size of the project, the time required for the business to receive full returns and the risks involved in acquiring the finances. Most traditionally, such great investment in the organization requires the company to look for the long term capital that can sustain the project until it begins to generate its own income (Shim 2009). For a company like Biz Systems Consultants Ltd, the following are some of the potential sources of capital.
Equity or Ordinary Shares
These are finances provided for by the owners of the company. The shares have a face value which has a relationship to the par value. The issue price should be equivalent to the nominal value of the shares and should seek to achieve the requested amount of capital as authorized by the regulators of the capital market. In addition, there also exist different types of shares within the market which the company can capitalize on (De, Aronoff & Ward 2011). They are:
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Deferred ordinary shares – these are special types of shares where shareholders become entitled to dividends only after a passage of a particular time when its prices rise above certain amount. The owners of such shares allow the profit retention back to the company’s projects instead of paying them out in dividends every year. Such strategy helps the company accessing a simple low cost source of finance. The main limitation to such types of shares is that there is a possibility that the source may not provide the required amount of funds to finance the project worth £1,700,000. The value of the shares in this case can be determined by the amount required and the number of shares issued i.e. £1,700,000/X shares (Maynard & Warren 2010).
In the process of outsourcing money through the share capital, the company can also opt to offer rights issue to their existing shareholders. Such offer is only available to the existing shareholders to receive additional shares to their shareholding at a minimized cost (Gregoriou, Kooli & Kräussl 2007). The process of issuing shares follows the same procedure like the others. However, such source is not ultimately reliable because not all existing shareholders would accept the offer, thus failing to provide the company with the estimated funds.
Long-Term Debt Financing
It is a form of capital that the company can raise under which interest is paid either semi-annually or monthly on a fixed rate. When a company opts to be a holder of a loan stock, it becomes a long-term creditor to the lender, the government, bank or any other financial institution. Debt financing involves borrowing a specified amount of money from a creditor with the expectation of repaying the rendered amount at an interest over a specified time. The debt financing may be either secured or unsecured depending on the terms of agreement. Secured loans require the loaned to provide an asset as collateral attached to satisfy the loan in case the loanee defaults in payment (Burnstan & McKinsey 2000).
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Banks are the prominent source of finance for commercial projects. The lender requires that the lender provides a detailed business plan to assist in investing as a way of assessing whether the lender is capable of paying the debt back. The bank is able to led Biz Systems Consultants Ltd a sum amount of £1,700,000 for upgrading the system at the rate of 5% per year. The advantage of such financing system is that the company can access a wide array of terms, fees and applications required. In addition, the funds provided through a bank loan can be released at a short notice after following the necessary procedures unlike the share capital where lengthy procedures and protocols have to be followed. The shares have also to be advertised in the media, give the customer time to buy before the company can be given the forthright to make use of the funds.
A lease is an agreement entered between two parties known as the occupier and the lessor. The lessor is the property owner who allows the occupier to make use of the asset at an agreeable fee. The occupier submits payment to the lessor under the terms of the lease agreement for a specified period of time. Thus, according to Riding and Canada (2006) leasehold is a form of obtaining capital by rending out idle company property to a third party who needs them for a certain amount of time.
Suppose Biz Systems Consultants Ltd needs to develop the upgrading project under financial lease. The supplier would provide the materials and the labor force required under the terms of the contract. A financier will act as the lessor by paying the bills of the leasing agreement and also purchasing the new system from the supplier. According to Hamlin and Lyons (2003), the financier will then hire the project to Biz Systems Consultants Ltd after taking its ownership and passing the possession to the company. After that the lease agreement comes to effect. Thus, the company will eventually pay the financier the full amount at once or on regular basis under the terms of the lease.
Such form of finance helps the company use the assets for the purpose of the business without actually using either the equity or debt financing options. The legal agreement created between the two parties becomes a legally bidding contract that the rental usage will be a payable source of tangible resource rendered to the company. Upon the expiry of the leasehold agreement, the assets are repossessed by the lessor automatically unless the lease agreement is renewed or the asset sold out. The leasehold policy may have an advantage basically because there are no funds that are involved in the project. It allows the purchaser to use the available cash to develop the project further and spread the repayment period of the initial investment over a period of time. Although some payment is usually required at the beginning of the term, the leasehold matures at the end giving the business more time to generate the funds (Timmons, Spinelli & Zacharakis 2005).
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Conclusion and Recommendation
Biz Systems Consultants Ltd has to undertake a due diligence on the particular source of finance presented by potential lenders and business partners. The choice selected should have the lowest cost of finance and should provide the maximum benefit to the company. The rates of returns should be reasonable enough to reduce the risks involved in the project.
Although capital financing through the internal mechanism is low and cheap to acquire, the legal procedures required to seek finance from the shareholders is lengthy. It may create a business opportunity to delay and thus, miss the opportunity to make full exploitation of the project. In addition, the lease financing option is also very cheap to the company and can give it an opportunity to benefit before paying the cost. However, there are always very few financiers who are ready to face a risk. The level of willingness to finance through leasehold is very low. Therefore, the most suitable source of finance is debt financing due to the ease of access and the low rate of interest, by 5%. The risks of entering into a contract with an unsure source of finance are highly reduced.