Table of Contents
In any business entity, the most challenging role of the managerial team is making critical company decisions. Managerial decisions are classified into three main sections: production, marketing, and financial decisions. The main goal of critical decision-making is to achieve optimal utilization of company’s resources in a way that would exhaust available capital resources. A project is preferred if it is mutually exclusive and selection is based on the best available option (Smith 2010). Tactical approaches should form short-run or long run goals of the company. Focusing on financial decision-making options, a firm can employ any of three appraisal methods, namely Discounted Payback (DPB), Payback (PB) and Net Present Value (NPV). This report therefore evaluates the best appraisal technique for financial decision-making. It suggests that NPV is the best suited technique for Asdy project; but other than financial measures, risk mitigation would also be an important factor in the success of the project.
Risks and Risk Management for Asdy
The global business community has witnessed the proliferation of private equity in the integrated market bringing on new opportunities. Asdy is an international firm from the US seeking to venture into the UK market. The new investment brings in risks, which pose additional tests on due diligence of the partners in limited liability companies. Risks of a new business in the overseas market at the macroeconomic level are a function of quality of the global business environment. Due to currency difference between the US and the UK, foreign exchange risk factors are a challenge to investment. Consequently, at a microeconomic level, Asdy must assess the qualification of funds manager. Hedging is one of the most preferred interventions in alleviating foreign exchange risks. According to Cornelius (2011), The Blackstore Group hedges its currency risk when transacting and managing international debts. However, when it comes to hedging of equity, the chances are very limited.
A number of corporations collapsed in the 1990s in the UK because of poor policies on corporate governance and risk management. “The objective of corporate governance is to provide a blueprint for companies to manage in the interests of all stakeholders – not just the managers,” (Frost, Allen, Porter & Bloodworth 2001, p. 287). Corporate governance is a control mechanism seeking to find equilibrium between management’s ability to take risks and the role of entrepreneurship energy. The entrepreneurial energy helps in monitoring in order to make sure that managerial interests are tied to interests of shareholders. Risk management and corporate governance converge to even include assessment of risks and internal audit. There are a number of other risks that must be managed in the overseas market. In the Turnbull Report, corporate governance bears the responsibility of managing ‘all relevant risks’ as the UK corporate policy requires firms “to consider the potential risks of environmentally unfriendly policies, corporate ethics, changes in the market, new technology, sexual harassment, and so on,” (Frost et al. 2001, p. 289). In consequences of a poor corporate culture in the UK, the newly structured and legally binding corporate culture requires critical analysis. Asdy should thoroughly study the potential risks in the market and respond to the challenges by undertaking risks assessment and complying. The policies on corporate governance will be a good starting point. Luo, Shenkar, & Nyaw (2002) propose to reduce the liability of foreignness (LOF) by undertaking both the offensive and defensive realignments.
Techniques of Financial Appraisal
Financial methods of appraisal are classified based on those returning a number - as the three mentioned above - or those returning a percentage (such as Accounting Rate Return, ARR, and Internal Rate of Return, IRR). In this regard, PB method measures cash flows by equating time taken in cash inflows to not only match outflows but also repay resources used to fund the project at the initial stages. For PB financial appraisal method to be successful, an initiated project has to pay back within the stipulated time limit. The method also favours liquidity and no complex re-accounting restrictions (Drury 2005).
The second financial appraisal method is DPB, which value is deliberated using discounted cash flows. DPB has a number of merits; it is easy to understand and arrive to final figures because it focuses on cash flows. The process values time value of money (Röhrich 2007). Third approach, ARR, is a popular method despite it is potentially inaccurate. ARR uses accounting profits to appraise values. This method includes the use of profit in project appraisal and is simple and easy to understand (2008).
Another method is IRR, which accounts for variations in NPV. The figures represent discount rate where net present value is zero. In order to judge a viable project using this method, company managers need to award projects with greater IRR values than cost of capital. According to Siddiqui, IRR is also applied in cases where there is a single project for financial appraisal (2005). There is no specific formula of measuring at IRR; but, the point where NPV is zero can be arrived at through interpolation of discounted the rates.
IRR also has both strengths and weaknesses. The strong side of this method is that it enables company managers to familiarize themselves with percentages and that there is no need of predicting discount rates. Moreover, IRR endows managers the right of judgement. In the contrary, the method is cumbersome as it requires complex mathematical concepts for interpolation. Its accuracy is based on whether resultant values are negative or positive and if negative cash flows are involved, the figures are bound to mislead for future years’ values (Ryan 2007).
Net Present Value and its Risk Problems
Net present value is principally the best method of project appraisal because it is theoretically superior and ensures maximum realization of shareholders’ wealth. According to Moyer, McGuigan & Kretlow (2008) shareholders’ wealth is important because it shows the magnitude of time and risks related to forecasted benefits that are bound to be received. NPV also measures value of money currently and for different years. Just the same, cash flows are valued separately in each year and then their values are translated into present values using discounted rate/present value factor. To achieve these values, net cash flows at different periods of the project are discounted via use of rate of return that is determined prior to this stage.
NPV shows that the amount a firm is keen to pay today in order to expect benefits in the future. The interests are evaluated using current interest rates and discounted at future values. On the other hand, IRR figures represent debit value when NPV is zero. In IRR private firms always prefer using between 12-12% of cash inflows while public sector organization use between 5-6% (Rouse 2007). The percentages differ because companies in the private sector have higher uncertainty ratios than public corporations. When using IRR, firms make projections, which may not necessarily reflect the true status in future, and it is misleading to judge success of projects on uncertainties.