Capital Investment Decisions: the Case of Diamond Plc

smashing Investment Decisions The case of Diamond PLC circumscribe PAGE PAGES 1. 1 Introduction 4 1. 2 Literature critical review.. 4-6 2. 1 Advantages and disadvantages of last march Value 6-7 2. 2 Advantages and disadvantages of Internal regularise of Return. 7-8 2. General beulas.. 9-14 3. 1 Critical Analysis 15-17 4. 1 conclusion 17-18 References 19-20 1. 1 Introduction This assignment is based on Capital enthronisation closings the case of DiamondChemicals plc. A critical analysis of this case tuition will examine the characteristics and concerns in the case field of operation. This research will question the use of Discounted funds Flow (DCF) techniques know as Net Present Value (NPV) and Internal pass judgment of Return (IRR), which argon the dickens roughly popular and primal techniques in enthronement lasts. Although these two techniques are closely-related, they behave fundamental diversitys between individually different. The IRR is the discount appraise that makes the extradite grade of a future stream of hard currency catamenias satisfactory to the initial enthronization(s). Arnold 2008. Whereas, NPV is the difference between a protrusions valuate and its embody Breadley, Myers and Allen, 2006. 1. 2 Literature Review Three research members will be reviewed focusing on the performances of NPV and IRR relating to real cases in investment evaluation. Do managers of South African manufacturing firms make optimal upper-case letter investment decisions? E. gilbert, 2003. The purpose of the study was to check over crown budgeting behaviour of firms in South Africa.It reveals that absolute majority of manufacturing firms use precisely the NPV technique when evaluating their great investment brooks, and of the DCF techniques used, the NPV technique is used more much than the IRR. Research tapes that manufacturing firms adjust the discount rate used in their NPV calculations to merged the proje ct specific assay according to the results of this research, majority of firms do this. It considers that the majority of firms use only the NPV technique when evaluating their dandy investment projects (i. e. no other techniques are used at all).However, on average, the IRR technique is used more very much than NPV (48% versus 47%). Nevertheless, in summary, the study suggests that manufacturing firms in South Africa leave from the behaviour prescribed by corporate pay opening because they do non use NPV in isolation with projects specific risk adjust discount rates when evaluating capital investment projects. The next article entitle Capital budgeting practices in the US. Forest product industry A reassessment L. S. Hogaboam and S. R. Shook, 2004. This study observed the capital investment practices of publicly owned woods roduct firms in the U. S. in 2001by replicating research reported by Cubbage and Redmond in 1985. In this research Baile et al (1979) conducted a re view and case study of capital budgeting in the forest products industry and comprise that most forest products companies had schematic budgeting systems, but these companies lacked post audit procedures, did not account for risk and utilised primitive risk adjustment methods. The researchers correlated the use of NPV and IRR to the size of the firm, purpose that firms that had smaller gross sales revenue primarily used retribution period for their projects.Nine firms ranked NPV either first or encourage in evaluation criteria importance, whereas IRR was considered most important evaluation criteria in the Idaho survey mutual exclusive projects. fiscal literature indicates NPV is best for capital rationing, and 7/15 of firms indicated that IRR was their primary choice in case of rationing. This survey specifies that the IRR technique is most popular for the evaluation of mutually exclusive projects, even though most financial literature considers it to be inaccurate when co mpared to NPV.The third article Capital Budgeting Practices A Survey in the Firms in Cyprus investigates 1. the methods used by the Cyprus companies to evaluate investments, and 2. the approach adopted to handle important estimation problems organic to the use of these methods. It was found that 54. 43% of projects evaluation is done by essence of a simplified evaluation technique and that 36. 71% of the companies use the retribution period technique. Among the methods that take into account the fourth dimension take account of money concept, the NPV method is the one most companies prefer, and only 8. 86% of them use IRR.In this study Hatfield, Horvath, and Webster (1998) investigated the importance of payback, average rate of paying back, IRR, and NPV capital budgeting techniques for the performance and nurse measures of firms. They found that firms analyzing all projects have higher share prices on average. They too found, in contrast to the theory of finance, that the NP V technique is not maximizing the value of the firm. Their results indicated that it is best not to rely on any single capital budgeting technique but instead to apply all of them or as many an(prenominal) of them possible for a project evaluation. 2. Advantages and Disadvantages of Net Present Value (NPV) NPV is a very popular method of project appraisal finding with the advantages agree to Pike and Neale (2006), the NPV rule accepts all investments offering positive NPVs when discounted at the combining weight market rate of interest. This results in an increase in the market value of the firm and thus the increase of the shareholders stake in the firm. NPV takes into account the season value of money It recognises that ? 1 today is greater than ? 1 tomorrow Breadley, Myers and Allen explain that it is because today can be invested to start earning interest immediately.They also argue that NPV rule allows thousands of shareholders who whitethorn have vastly different leve ls of wealth and attitudes toward risk to participate in the same try and to delegate its operations to a professional manager. One of the rules of Capital budgeting demands that managers be able to consider one project independently of all others this is known as the value-additivity principle, it implies that the value of the firm is equal the sum of the values of each of its projects. Copeland, Weston and Shastri (2005).Arnold states that NPV finds out not only which project gives a positive establish, but which one gives the greater positive return and that one of the major elements that leads to the metaphysical dominance of NPV is that it takes into account the scale of investments. NPV is a superior technique to IRR because it has less limitations. Those limitations include the fact that both in works and out races are measured in form of present dollars, not as share, many people find it complex to work with a dollar return quite a than a percentage return.Another l imitation would have to be the requirement of an estimate of the cost of capital to be able to calculate the NPV. William Megginson considered that financial managers find it unwaveringly to use NPV because it does not measure benefits relative to the amount invested. Though the NPV principle is constructive in evaluation of investment opportunities, the process is not faultless. 2. 2 Advantages and Disadvantages of Internal Rate of Return (IRR) Financial managers prefer IRR because it is attributable to the oecumenical isposition of melody people toward rates of return rather than actual dollars as interest rates, probability and so on are most often expressed as annual rates of return, making it an advantage of this technique. The calculations of IRR is an advantage, essence the fact that IRR is simply the discount rate that make the NPV equals to Zero is important because it tells us how to calculate the returns on more confused investments (Ross, Westerfield, Jordan 2006 ). IRR indicates the rate of return receivable when money is put into a project.Arnold (2008) acknowledges that IRR describes how much the interchange inflows top the bills outflows on an annualised percentage basis, taking into account of the timing of those cash flows. Like NPV, IRR also has the advantage of being a time-adjusted measure of profitability. Financial Theory and Corporate Policy by Ross, Westerfield and Jordan recognises that the IRR rule errs in some(prenominal) ways. It does not obey the value-additivity principle, and consequently managers who use the IRR cannot consider projects independently of each other.Second, the IRR rule assumes that funds invested in projects have opportunity costs equal to the IRR for the project. This implicit reinvestment rate assumption violates the requirement that cash flow be discounted at the market-determined opportunity cost of capital. Finally, IRR rule can lead to octuple rates of return whenever the sign of cash flow chan ges more than once. may give the wrong ranking of mutually exclusive projects that differ in economic life or in scale or call for investment. 2. 3 General radiation diagrams for Net Present Value (NPV) and Internal Rate of Return (IRR)Net Present Value (NPV) order Where CF0 = cash flow at time zero (t0), and CF1 = cash flow at the time one (t 1), one social class after time zero. The decision rules for enlighten present value are NPVpic0 Accept NPV < 0 Reject face applied to cash flow suggested by Frank Greystock Year change flow (? m) Discounted cash flow (? m) 0 -9 -9 1 1. 4 ? 1. 27 2 2. 66 ? 2. 0 3 3. 09 ? 2. 32 4 3. 06 ? 2. 09 5 3. 02 ? 1. 88 6 2. 49 ? 1. 41 7 2. 47 ? 1. 27 8 2. 45 ? 1. 14 9 2. 43 ? 1. 03 10 2. 1 ? 0. 93 11 1. 68 ? 0. 59 12 1. 68 ? 0. 54 13 1. 68 ? 0. 49 14 1. 68 ? 0. 44 15 1. 68 ? 0. 40 Total (NPV) ? 9. 00 Internal Rate of Return (IRR) formulaThe internal rate of return, r, is the discount rate at which the net present value is z ero. It is the value for r which makes the following equation hold Formula applied to cash flow suggested by Frank Greystock The following tables show the percentages utilized for the trial and error phase, in order to produce an NPV of zero. turn off 1 Yearly Cash Flows (? ) Discounted Cash Flow (? m) Intervals 0 -9. 00 -9. 00000 1 1. 40 1. 11111 2 2. 66 1. 67549 3 3. 9 1. 54471 4 3. 06 1. 21406 5 3. 02 0. 95094 6 2. 49 0. 62227 7 2. 47 0. 48990 8 2. 45 0. 8566 9 2. 43 0. 30358 10 2. 41 0. 23895 11 1. 68 0. 13220 12 1. 68 0. 10492 13 1. 68 0. 08327 14 1. 8 0. 06609 15 1. 68 0. 05245 26% Net Present Value (? m) -0. 02441 hold over 2 Yearly Cash Flows (? m) Discounted Cash Flow (? ) Intervals 0 -9. 00 -9. 00000 1 1. 40 1. 12000 2 2. 66 1. 70240 3 3. 09 1. 8208 4 3. 06 1. 25338 5 3. 02 0. 98959 6 2. 49 0. 65274 7 2. 47 0. 51800 8 2. 45 0. 41104 9 2. 43 0. 2615 10 2. 41 0. 25877 11 1. 68 0. 14431 12 1. 68 0. 11545 13 1. 68 0. 09236 14 1. 68 0. 07389 15 1. 68 0. 5911 25% Net Present Value (? m) 0. 29926 Table 3 Yearly Cash Flows (? m) Discounted Cash Flow (? m) Intervals 0 -9. 00 -9. 0000 1 1. 40 1. 07692 2 2. 66 1. 57396 3 3. 09 1. 40646 4 3. 06 1. 07139 5 3. 02 0. 81337 6 2. 49 0. 1587 7 2. 47 0. 39363 8 2. 45 0. 30034 9 2. 43 0. 22915 10 2. 41 0. 17482 11 1. 68 0. 09374 12 1. 68 0. 7211 13 1. 68 0. 05547 14 1. 68 0. 04267 15 1. 68 0. 03282 30% Net Present Value (? m) -1. 14726 Yearly Cash Flows (? ) Discounted Cash Flow (? m) Intervals 0 -9. 00 -9. 00000 1 1. 40 1. 09375 2 2. 66 1. 62354 3 3. 9 1. 47343 4 3. 06 1. 13994 5 3. 02 0. 87894 6 2. 49 0. 56616 7 2. 47 0. 43876 8 2. 45 0. 34001 9 2. 43 0. 6346 10 2. 41 0. 20413 11 1. 68 0. 11117 12 1. 68 0. 08685 13 1. 68 0. 06785 14 1. 68 0. 05301 15 1. 68 0. 4142 28% Net Present Value (? m) -0. 61758 Interpo lation illustrates that there is a yield rate (r) which lie between 25 per cent and 26 per cent which will produce an NPV of zero. The way to find that discount rate is to first find the distance between points A and B as a proportion of the entire distance between points A and C. 3. 1 Critical Analysis Greystock included in the first year of his regard preliminary engineering costs of ? 00,000, which had been spent over the preceding clubhouse months on efficiency and design studies of the renovation. The preliminary costs of ? 500,000 were ir germane(predicate) because it would not have been incurred if not for the possibility of Greystock going fore with the renovation because it was a sunk cost. The development cost of ? 500,000 should be ignore because they are bygones and are of the past as it was incurred nine months before and does not exigency to be added into the cash flow. The corporate manual stipulated that command overhead costs be reflected in project analyses at the rate of 3. % times the book value of assets acquired in the project per year. According to Arnold (2008), not all overhead costs are incremental when trying to assess the viability of a project only the incremental costs are incurred by going ahead are relevant. Those cost which are unaffected therefore irrelevant. Meaning that the capital projects which should reflect an annual pre-tax charge amounting to 3. 5% of the value of the initial asset investment for the project it should be entered in the incremental cash flow because it is an irrelevant overhead cost.Rotterdam sales are producing negative results due to the decision made by Greystock to shift capacity to Rotterdam away from Merseyside. His new business decision is having a negative effect on Rotterdam because all the disbursal is coming from Merseyside as he has decided to renovate it, cannibalizing Rotterdam. Even the music director of sales recognised there was oversupply in the works, which means that too much is being supplied for the project. In view of adjustment of cash flow must be consistent with inflation forecast imbedded in discount rate.The treasury staff was concerned because the project would impound a long-term inflation of 3% per year. The unrelated EPC project is not relevant as it would only increase prices when recession ended notwithstanding the ? 1 million pound renovation the criterion is that each individual investment promises an IRR greater than 10%, not that multiple projects promise an average return above this hurdle. Before submitting a project for senior management, at to the lowest degree three performance hurdles had to be met in order for scheme to be considered. -Impact on earnings per share = ? 0. 018 -Payback = 3. years -Discounted cash flow (NPV) = ? 9 Million Although the Merseyside project met all the criteria, Morris should have considered dividing the proposal into requires and go for expenditure ( relating to April Novelties). Concerns an d characteristics Merseyside The main concern for Merseyside is the old production process and how it is not regular at times, and it has a higher labour content than its competitors newer plants. However, regardless of these limitations the Merseyside plant has many good characteristics such as Receiving positive cash flows immediately Higher cash flows in the beginning Relatively nobble payback period Concerns and characteristics Rotterdam The lack of flexibility and commitment to plant project are concerns for the Rotterdam plant as it is not being renovated and we remain shy(p) as to whether Greystock will take on the project of renovation at Rotterdam. On the other hand, the fact that the polymerization process has become continuous is major strength, and also that the payment schedule is flexible (over four year period). In addition the Japanese technology has proven to be favored in Japan. . 1 Conclusion This assignment has summarized the Case study objet dart emph asizing important details of the concerns and characteristics of the Merseyside and Rotterdam plant. Opportunities such as Land value and Use of right of way can enable Rotterdam to develop positively, despite German technology posing as a threat and also losing right of way. Overall the Merseyside plant offers numerous opportunities to increase outputs and lower costs, opus also increasing competitiveness for their competitors.Nevertheless Merseyside faces a very extensive threat where they would have to close for 45 days causing their customers to deprave from their competitors, although the lost market share can still be regained. The investment appraisal process requires the use of sophisticated evaluation techniques such as Net present value (NPV) and Internal rate of return (IRR). These techniques help ensure that all relevant cost and other factors have been considered. The calculations of NPV and IRR are quite challenging, especially regarding the trial and error method I RR.The calculations to obtain NPV=0- was time consuming and more than twice as long as the NPV method. If risk adjustment is made through the discount rate there may be more than one cost of capital and the sponsor accordingly has to classify the project into say high or medium or low risk categories etc. Finally, it can be argued that the process of capital budgeting is a time-waster because the fundamental information used is seen to be undependable. As the estimates of cash proceeds are just guesses and that the use of anything other than the easiest technique of capital budgeting is as unsuccessful as making use of any complicated formulas.For example, in 1974 K. Larry Hastie published his classic paper, One Businessmans good deal of Capital Budgeting. His position is that firms should avoid excessively complex measurement techniques. He states Investmentdecision makingcould be improved significantly if the accent were placed on asking the appropriate strategic questions and providing better assumptions rather than on increasing the sophistication of measurement techniques (1974, p. 36).This research establishes that NPV and IRR are two major investment decision methods, which gratifies the criteria for the accurate evaluation of capital projects. REFERENCES Hogaboam, L. S. , Shook, S. R. (December 2004) Capital Budgeting practices in the U. S. forest product industry A reappraisal. Forest products journals. Gilbert E. (May 2003) Do managers of South African manufacturing firms make optimal capital investment decisions? Graduate School of Business, University of Cape Town. Lazaridis T. L. October 2004) Capital Budgeting Practices A Survey in the Firms in Cyprus Journal of Small Business Management Richard A, Breadley, Stuart C. Myers, Franklin Allen (2008) Principles of Corporate finance 9th edition McGraw-Hill, London Richard Pike, Bill Neale (2005) Corporate finance and investment decisions of strategies fifth edition Financial time prentice hall T homas E. Copeland, J. Fred Weston, Kuldeep Shastri (2005) Fiancial theory and Corporate policy 4th edition Pearson Addison Wesley, London Megginson, William L. (1997) Corporate finance theory Addison WesleyStephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan (2006) Coporate finance Fundamentals McGraw-Hill, London Glen Arnold (2008) Corporate financial management 4th edition Financial times prentice hall, England Investopedia (2010) Available at www. investopedia. com/study-guide/cfa-exam/level-1/corporate-finance/cfa13. asp Fao corporate document repository (1997) Chapter 6 Investment decision Capital budgeting Available at www. fao. org/docrep/w4343e/w4343e07. htm QFinance (2007) Available at www. qfinance. com/cash-flow-management-best-practice