Financial Management & Analysis: Capital Budgeting Tools
Capital budgeting tools is an approach used to make effective decisions about identified projects. In case the management of a given firm identifies the mutually exclusive projects, a financial process is assumed to establish whether or not either of these projects should be pursued. The focus of this assignment thus rests with the examination of the best techniques that management of Biz Systems Consultancy Ltd can use in order to come up with effective decisions on which of the three mutually exclusive projects should be undertaken. It is important to note that the paper will provide sufficient evidence to postulate that even though there are many different techniques that can be used for this purpose still the adoption of NPV would be considered effective in executing the decision.
Decision Making Techniques
This is the most fundamental and simple decision approach used in financial analysis. This technique is used for purpose of establishing the exact period that it would take to pay back the initial investment amount accessed by a firm, which is required for the completion of a project at hand (Benninga, 2008). In order to arrive at a perfect decision, using this approach requires that the total costs that is to be incurred for the entire project is divided by the amount of cash inflow expected to be received each year as result of the project operations. It is important to note that the payback period is one of the perfect approaches that are used whenever dealing with smaller and simple level investment projects (Benninga, 2008). In case businesses are able to generate a stable level of cash flow that would allow a certain project to regain its initial investment amounts in a short period, then payback period technique is deemed highly effective and efficient way to review the project at hand. Whenever dealing with mutually exclusive projects like in the case of Biz Systems Consultancy Ltd, which has three mutually exclusive projects, the project that depicts a shorter payback period should be adopted (Benninga, 2008).
Internal Rate of Return
This decision technique is based on discount rates. It is popularly adopted to establish the level of return a potential investor can expect to gain from engaging in distinctive projects. Specifically, it is a decision technique that identifies the discount rate that would occur in the event that a project is break even or in the case when its net present value is equal to zero (Benninga, 2008). The fundamental decision to adopt for projects using this technique requires that selection of the project whose IRR is deemed higher in comparison to the immediate costs incurred while financing it. This basically means that a greater gap or difference between the financing costs incurred and the IRR translates to a rather attractive project for adoption. In cases of independent projects, IRR is deemed to be an efficient tool however; the problem arises whenever mutually exclusive projects are concerned. This is because of the fact that two or three mutually exclusive projects might depict conflicting IRR and NPV values (Benninga, 2008).
This is a simple decision tool that is used for capital rationing in project investment evaluations. It is deemed to be only effective for businesses that depict a barrier in terms of current period only and has one or two projects to analyze. It is focused on providing a rough estimate on the immediate measure of NPV that a given business would get for every dollar invested (Benninga, 2008). Despite the fact that the PI is deemed a useful tool, its limitations are substantial. For instance, it only assumes that capital rationing is only a barrier within the first few years of operations and also, it fails to involve investment requirements in the immediate future operations.
Net Present Value
Net present value is a decision based approach that is most popular and also, more efficient and effective way of reviewing the viability of projects. This tool is deemed effective and efficient at the same time because it adopts the discounted cash flow analysis. This means that future cash flows are discounted at a discount rate for purposes of compensating possible risks attributed to these future cash flows (Benninga, 2008). The process of discounting the future cash flows back to their immediate present values creates an effective way of comparing between these cash flows. For independent projects, NPV is accepted whenever it depicts a positive value and rejected in case it portrays a negative value. In the course of mutually exclusive projects, it is established that the project with a higher NPV should be adopted.
For the case of Biz Systems Consultancy Ltd, it would be fair that either IRR or NPV decision tool be used given that both operate on a time-weighted philosophy. However, NPV is deemed efficient and effective in coming up with a simple and straightforward decision rule in establishing which of the three mutually exclusive projects should be undertaken (McGowan, 2013). The NPV, unlike the IRR, is able to postulate that intermediate cash flows of a project are reinvested at their respective discount rates as opposed to their IRR. This makes it an effective tool given that it focuses on eliminating possibility of future uncertainties of the cash inflows to the business at hand. It is important to realize that NPV decision model is much more effective whenever it comes to ranking projects that portray a large investment hence cannot be used for projects that exhibit limited capital (McGowan, 2013). In this case, Biz Systems Consultancy Ltd’s project requires a substantial amount of £1,700,000 thus, NPV is fairly positioned to analyze whether the project should be undertaken or not. This is based on the fact that it is able to discern the possible of uncertainties in the future cash flows of the projects hence adopt the project with a higher NPV value. Profitability index cannot be used in this case because it is only focused on analyzing a single or two projects yet Biz Systems Consultancy Ltd is based three mutually exclusive projects. Consequently, the decision model fails to involve the requirements of the project investments in future periods.
Possible Sources of Finance for the Investment Project
For any given business entity, the access to funds is highly dependent on the relative easement under which the funds of different forms are accessible and this, is turn, affected by the immediate level of a company’s assets, the seasonality of its volume of operations or transactions, its fundamental level of growth, size and profit anticipations. Biz Systems Consultancy Ltd is no exception to these regulations. Some of the possible sources of funds for the business are discussed as below;
First, the business can access funds through the discounting process. This finance is accessed when goods or services sold on a contractual term of business with the clients. On completion of the transfer of products or services, a bill is raised with an agreed due date (Berger and Udell, 2002). This bill is then assigned as a negotiable instrument that can be sold to a discount house for readily available cash. The discount house is responsible for performing credit checks on the client of the business in order to assess the degree of risk involved, as well as computing the commission or discount that they will deduct from the total money owed to the business. The advantages attributed to this method of financing rests with the fact that it compares in a favorable position with the overdraft rates given that the discount rates is considered to be fixed at all times (Berger and Udell, 2002). The other advantage is that the business is not entitled to use its assets base a security base. The only disadvantage of the method is that it is meant for limited amount of capital that should not surpass £ 25,000 in total (Berger and Udell, 2002).
Second, the business can utilize the use of factoring as a source of financing the projects. It is a perfect source especially when cash is needed urgently in order to execute projects as planned despite the clients that are deemed slow in paying their respective bills (Berger and Udell, 2002). . It involves the selling of debt hence a valuable financial approach that enhances fast improvements in regards to cash flows by way of converting invoices raised into money in the bank of choice. There are four ways of factoring that ranges from sales ledger administration to simple invoice discounting. Invoice discounting is deemed to be a fast growing area of business financing that is not as expensive as either recourse of non-recourse factoring (Berger and Udell, 2002). It is executed by way of enhancing cash on the immediate level of debts of particular customers that cannot be made aware of the factors involvement. The administration of the sales ledger is kept still by a business as the factors ignores assuming risks on the level of debt. However, it assists in availing money in the bank before even it is earned and thus, helps with cash flow issues immensely (Berger and Udell, 2002).
Third, the business can explore the aspect of leasing as a formidable finance option. This option is mostly practiced by larger companies but with recent developments, smaller businesses have also been able to access it. It enables a business to acquire equipments and pay the amounts attributed to its purchase in an agreeable mode that might be from monthly income. The fundamental objective of this option rests with the fact that it lessens the level of strain that is exerted on the available scarce resources (Graham and Campbell, 2001). Subsequently, payments attributed to the equipment are set against the accessible monthly income so that a business’ tax liabilities are eliminated or dropped off completely. It is established that leases are flexible enough to allow a business meet its other immediate needs. For instance, some of the arrangements can be made in order to accommodate seasonal level of income while low-start leases can be organized in a way that is less expensive equipment are able to allow an immediate outflow of cash resources within a shorter period (Graham and Campbell, 2001).
Fourth, the firm might choose to explore the path of grants offered to small business as a formidable way of financing. Most grants are offered by central governments through local agencies (Huyghebaert, 2001). For instance, a SMART scheme was recently developed to assist businesses with technical development of products as well as bringing their respective products into the market. Information is offered to businesses through Business Links Offices established at different local authorities. This office can also assist a business in exploring new schemes where TCD and client firms employs personnel of high caliber to undertake the process of developing the project on behalf of the central government. It is important to note that a substantial level of costs associated with the payment of the personnel is paid off by TCD funds (Huyghebaert, 2001).
Fifth, the business can also opt to explore EC based funds. The EC provides a substantial amount of grant assistance to businesses. It provides assistance in regards to the “fourth Framework”, which is a technology focused scheme that targets small and medium sized business enterprises (Huyghebaert, 2001). Another scheme referred to as the ANIMATE has also been availed through this platform to provide funds for firms in order to comprehend and create innovative tools for their businesses. The funding provided also covers costs attributed to assisting with corporate culture changes as well as possible technological changes and advancements. More details in regards to the requirements of qualifying for the grant are availed in Business Links Offices (Huyghebaert, 2001).
Sixth, the business can opt for funds provided by banking institutions. Banks expects that a business holds an account with them for a period of time before they can qualify for a loan. There is basically a fundamental need for overdraft and thus, it is negotiated as a part of the overall funding package (Kumar and Liu, 2005). Apart from the aforementioned condition, banks also require that businesses provides asset base to act as security for the amount of loan offered. The amount of assets would also determine the level of loan that a business can access at any given time (Langford-Wood & Salter, 1998).
Seventh, the business can seek funds from the Enterprise Investment Scheme, popularly known as the EIS. This was program was formulated to replace Business Expansion Scheme. It is focused on newer equity investments in unquoted trading based firms (Servon, Visser & Fairlie, 2010). It avails an income tax relief of about 20 per cent on investments that are upwards of £100,000 per year, which is integrated with capital gains sourced from tax exemptions on disposal of shares (Audretsch, MC Keilbach and EE Lehmann, 2004). This finance option is meant to encourage participation of business angels-investors that are likely to become directors of the firm. They are expected to enhance their immediate business expertise to small and medium sized enterprises.
Eighth, a business is able to access funds through Loan Guarantee Scheme (LGS). This is mainly offered due to the fact that in many occasions small and medium sized businesses fail to secure traditional loans from banks due to a myriad number of reasons that can include the lack of security base of positive track record (Baldock and Smallbone, 2003). It is formulated as an agreement between the Department of Trade and Industry with commercial banks. The government department avails a guarantee against any possible loan defaulters hence allowing the commercial banks and other financial based institutions to lend money of up to £100,000 to both new and existing business entities (Baldock and Smallbone, 2003).
Ninth, another possible finance option is based on venture capital. The option is focused on larger business entities that have already set ground on the market. It does not commit the lender to prove existence of substantial security however; the capitalist is able to take ownership of the business as well as profits attributed to its immediate operations (Kumar and Liu, 2005). Thus, a venture capitalist is tasked with the duty of assuming risks and financing non-certainties ventures. It is important to note that most of the venture capitalists are mostly interested with business entities that searching for investments in need of more than £ 250,000 (Audretsch, MC Keilbach and EE Lehmann, 2004).
Conclusion & Recommendation
From the discussion above, it can be seen that Biz Systems Consultancy Ltd has a wide variety of sources for funds to choose from in its underlying project investments. However, they cannot access all of these funds given that each of the sources has its own requirements and qualifications. It is stated that the firm can borrow the money from the bank at 5% interest rate per annum. This means that the firm will be parting with at least £ 85,000; (5/100*1,700,000) in interest rates alone. This is a substantial amount of money especially because the business is operating under the small and medium sized platform hence the interest expenses might be substantial. Therefore, the firm should not go with the path of sourcing for financial loans from the banks also because the institutions require substantial level of security in terms of assets, which might be a problem at the moment.
The three formidable finance options the firm can go with include; first, it can source for grants that are offered by numerous government agencies through the Department of Industry and Trade. These grants are not necessary payable by a firm since they are covered by such government funds like TCD funds. Second, the business can opt for EC funds. This is because it is focused on availing assistance for technological based advancements for SMEs. ANIMATE is one of the most popular programs offered under EC that can be used by the business to advance its technological advancements in retail markets. Therefore, the personnel of the business can go ahead and visit Business Link Offices for more information. Third, the business entity can also embark on sourcing for venture capitalists that have the financial capacity to invest with the business. These capitalists would require that the 7.5% expected return is shared between them and the original business owners. They are also entitled to a certain ownership of the business and its operations.,..