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Biz Systems Consultants Ltd’s Financial Management Research Paper

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Updated: Jun 26th, 2020

Executive summary

Implementation of a new project is a major capital decision. It is important to evaluate such projects before capital is committed. In this case, the Biz Systems Consultants Limited intends to implement a project on computerization of their processes. Therefore, the company will use investment appraisal techniques to evaluate three projects and select the best based on the results. The analysis shows that project C is the most suitable for the Biz Systems Consultants Limited. Further, a review of sources of finance shows that the company will use a combination of debt, share capital, and retained earnings.

Introduction

Capital budgeting is a multi-dimensional process with distinctive stages. A commonly used model comprises of strategic planning, making accept or reject decisions, project implementation and monitoring, and project implementation audit. The essence of this procedure is to ensure that a project manager selects a viable project for investment. This is necessary because capital investments require a large amount of initial outlay. Secondly, the streams of benefits received from such investments flow for a long period. Thirdly, capital investment decisions in most cases deal with an organization’s optimal capital structure, in terms of sourcing for funds for debt and equity. Also, the decisions are irreversible. Finally, capital is a limited resource. Organizations lack adequate resources to invest in all viable projects. Thus, it is necessary to appraise all feasible projects and resources should be dedicated to only viable projects (Dayananda, Irons, Harrison, Herbohn, & Rowland 2002). The paper seeks to carry out investment appraisal for the projects that Biz System Consultants intend to invest in.

Investment appraisal tools

Description of the three projects

The Biz Systems Consultants Limited intends to upgrade from manual to electronic system. In line with this, the company intends to implement a project after comparing three possible options. The project will be implemented in the City of London. The amount of initial investment is £1,700,000. The cost of capital (discount rate) is 7.5% and the bank rate is 5%. The three projects will run for a period five years. The table presented below shows the stream of future benefit that is expected by the company.

Project A

Year Initial investment Net savings Depreciation Running cost Net cash flow
0 1,700,000 -1,700,000
1 150,000 340,000 50,000 440,000
2 200,000 340,000 50,000 490,000
3 300,000 340,000 50,000 590,000
4 450,000 340,000 50,000 740,000
5 500,000 340,000 50,000 790,000

Project B

Year Initial investment Net savings Depreciation Running cost Net cash flow
0 1,700,000 -1,700,000
1 300,000 340,000 20,000 620,000
2 300,000 340,000 20,000 620,000
3 300,000 340,000 20,000 620,000
4 300,000 340,000 20,000 620,000
5 300,000 340,000 20,000 620,000

Project C

Year Initial investment Net savings Depreciation Running cost Net cash flow
0 1,700,000 -1,700,000
1 500,000 340,000 40,000 800,000
2 450,000 340,000 40,000 750,000
3 400,000 340,000 40,000 700,000
4 250,000 340,000 40,000 550,000
5 150,000 340,000 40,000 450,000

Profitability index

The profitability index depicts the relationship between the costs and benefits of a project. It is arrived at by dividing the present value of benefits the initial investment cost.

A B C
Initial investment 1,700,000.00 1,700,000.00 1,700,000.00
1 409,302.33 576744.186 744,186.0465
2 424,012.98 536506.2196 648,999.4592
3 474,926.74 499075.5531 563,472.3987
4 554,112.39 464256.3285 411,840.2914
5 550,281.32 431866.3521 313,451.3846
Present value of cash inflow 2,412,635.75 2,508,448.64 2,681,949.58
Profitability index 1.419197502 1.475558023 1.5776174

Project C will be selected based on this criterion because it has the highest profitability index.

Internal rate of return

Internal rate of return (IRR) is a unique discount rate which, when applied to both cash inflows and cash outflows over the investment’s economic life, provides a zero net present value. Thus, it is tool of investment appraisal, which gives the discount rate that equates the present value of cost to the present value of benefits. Interpolation can be used to estimate the value of IRR (Durnev, Morck, & Bernard 2004). One of the three projects will be accepted if it generates an IRR that is greater than the required rate of return.

A B C
IRR 12.13% 15.41% 20.67%

The internal rate of return for the three projects is higher than the discount rate of 7.5%. However, project C will be selected because it has the highest internal rate of return of 20.67%.

Accounting rate of return

This appraisal technique gives information on the amount of profit an investor expects based on the investment made. When using this method, the average profit is divided by the initial investment so as to obtain the rate of return. The method is easy to compute and straight forward. Besides, it can be used to evaluate a number of projects. On the other hand, it ignores the concept of the time value of money and cash flows.

Project Average net income Depreciation Accounting rate of return
A 1,350,000/5 = 270,000 340,000 79.41%
B 1,400,000/5 = 280,000 340,000 82.35%
C 1,550,000/5 = 310,000 340,000 91.18%

The accounting rate of return for the three projects is high. However, project C has the highest accounting rate of return. Therefore, it will be used based on this criterion.

Payback period

The payback period gives analyst information on duration in years that it will take the project to recover the initial investment which amounts to £1,700,000. This approach has a number of drawbacks. First, it does not use all the cash flow generated by a project. Secondly, it does not take into account the time value of money. The decisive criterion is to accept a project with a shorter payback period or to accept a project whose payback period is lower than period predetermined by the management.

A B C
Payback period 2 years, 4 months 2 years, 9 months 2 years, 3 months

It can be noted that the company will recover the initial cost in less than three years for all the projects. However, project C had the least payback period. The company will recover the initial cost of investment within the shortest period of time when it implements project C.

Discounted payback period

This investment analysis tool gives the duration of time that the business will take to recover the initial cost of investment based on the discounted cash flow. The method is superior to the payback period because it takes into account the time value of money. The discounted payback period is mostly used for ranking of projects or for assessing high risk projects. In such projects, the investors require return within a short duration (Ross, Westerfield, & Jordan 2008). A project with a shorter discounted payback period is often preferred.

A B C
Discounted payback period 3 years, 8 months 3 years, 2 months 2 years, 5 months

The discounted payback period shows that the company will take more than 3 years to recover the initial investment if project A and B are implemented. However, the discounted payback period for project C is 2 years and 5 months. Therefore, it will be the preferred choice.

Net present value

Net present value is one the most widely used criterion for appraising projects. Both businesses and nations use this criterion to evaluate development projects before putting capital in them. NPV is the difference between the present value of a project’s cash inflow and outflows. This approach shows how much a project contributes to the shareholders fund. High returns will result in an increase in share prices. The advantage of the net present value is that it is easy to compute. Also, the cash flow generated during the life of a project is taken into account when calculating NPV. Further, it takes into account the time value of time (Shapiro 2005). The drawback of this approach is that a higher discount rate can result in lower or negative NPV. The selection criterion will be the amount of the net present value. A project with a positive net present value is considered to be viable.

A B C
Net present value 712,635.75 808,448.64 981,949.58

All the projects have positive NPV and this means that they are viable. However, project A has the least NPV while project C has the highest NPV. Therefore, project C will be selected because it has the highest NPV.

Equivalent annuity

This approach is suitable for comparing projects that have different economic life. It compares the annual NPV of the projects. The procedure of estimating equivalent annuity entails dividing the NPV with the economic life of a project.

A B C
Net present value 712,635.75 808,448.64 981,949.58
Equivalent annuity 142,527.15 161,689.73 196,389.92

Based on the table above, project C had the highest equivalent annuity. Therefore, it will be selected based on this criterion. All the criteria show that project C is the most suitable as compared to the other projects.

Sources of Finance

Business financing has become a challenge for the companies aspiring to expand an existing business, start a business, or implement a new project. Thus, this section attempts to explicitly review the sources of funding options available for the Biz Systems Consultants Limited. Besides, it explores cost aspects of each source of business financing and the importance of financial planning (Brigham & Ehrhardt 2010).

Sources of finance available to the Biz Systems Consultants Ltd

Internal Sources

The internal financing options available for the company include personal sources such as retained profits and share capital. Basically, the retained profit is the funds generated by the initial business when it generates a profit. Considering the duration that the company has taken, the shared profits will substantially contribute to the funding for the project. Reflectively, retained profits is necessary in financing further expansion of projects and since the business has been making profits for some duration. Besides, the company has the option of acquiring funding from the share capital, which has been the main source of funding for the previous years. Through share capital, the Biz Systems Consultants Limited will be in a position to retain full control and ownership of the company, especially if the group of owners are the sole contributors (Steven 2007).

External Funding Sources

Among the most viable external funding sources available for the Biz Systems Consultants Limited includes debt capital in the form of bank overdraft or bank loan and engaging external investors.

Bank loan/ Overdraft

Under a bank loan option, the company will be in a position to receive funding that is fixed over a period of time. The loan(s) will attract different interest rates depending on the type and amount that the business will borrow. Reflectively, bank loans are repaid over a longer period of time and repayment schedules are fixed. Besides the bank loan, the company has the option of acquiring financing through bank overdraft. Basically, bank overdraft is a short term loan. Bank overdrafts are a very flexible source of business financing since they can be used to handle cash flow fluctuations in the company that are temporary. Besides, bank overdrafts may offer the company a lifeline when it experiences temporary cash flow challenges.

Share Capital from Outside Investors

Another source of financing available for the company is the use of funds from outside investors such as contributions from interested investors who will be given shares in the company according to their contribution. The fund contributors will be allocated shares in line with the total capital that the company requires for the expanding the business. Basically, the main external investors that the company may rely on for financing are the businessmen who will give the company an upper hand in quick establishment and high returns since they often invest a substantial amount of funds in businesses (Steven 2007).

The appropriate sources of financing for the Biz Systems Consultants Limited

Considering the nature of the business and the project to be implemented, the most appropriate source of funding would be bank loan and share capital from external investors funding. The bank loan will give the company leverage against the required amount of money for expansion. The company may also rely on share funding from external investors to boost its capital base. Share capital funding is the safest source of funds for the company since it attracts no interest rates on the funds, and any negative eventually in the company will be shared among the investors. Finally, the Biz Systems Consultants Limited can use retained earnings to invest in the project (Visscher 2006).

The costs associated with different financing sources

The cost of bank loans (debt financing) is mainly the interest charged which is 5% per annum and other costs associated with obtaining a bank loan such as legal fees and valuation of securities. On the other hand, the cost of investments (equity financing) includes profit share and dividends and other expenses such as floatation fees and legal fees (Powell & Baker 2005). Comparative analysis of the two costs of financing sources involves reviewing the interest rates charged on the loans in relation to the proportion of accumulated profits or retained earnings of the Biz Systems Consultants Limited.

Under debt financing, it is important to compare the payment terms and interest rates of different banks. In addition, it is critical to review the total cost of interest in relation to the lifeline of each loan. Reflectively, small variations in this value may significantly increase the cost of loans in the long term. As a matter of fact, long term loans attract a slightly lower interest rate higher rate of interest. For equity financing (share funding from external investors), the company must consider the cost of the venture or risk capital since the share capital will determine distribution of returns among the investors (Melicher & Leach 2009). The company must review the required funds against the share contributions in order to estimate and draw risk and loss sharing balance. Besides, the company must review its network of interested investors against their contribution. Thus, full knowledge of these costs will be instrumental in deciding the most cost benefits funding sources available for the Biz Systems Consultants Limited.

Impact of different sources of Financing for the company

Equity financing is critical in leveraging the Biz Systems Consultants Limited and improving the capital structure. On the other hand, debt financing will cushion the company against unfavourable business climate, especially through bank loans that provides a lifeline to temporary cash flow problems. The retained earning is the most easily available source of finance for the Biz Systems Consultants Limited (McLaney & Atrill 2008).

Conclusion

In summary, the project that the Biz Systems Consultants Limited intends to implement on computerization is viable and is quite important for the future success of the business. Besides, most businesses use the digital platform to reach out to customers and catalyse growth. The criteria for investment approval used above shows that the project C will be the most viable among the three projects at the Biz Systems Consultants Limited. Besides, the company will use debt, equity, and retained earnings to finance the project C.

Reference List

Brigham, F & Ehrhardt, M 2010, Financial management theory and practice, Cengage Learning, United States of America.

Dayananda, D, Irons, R, Harrison, S, Herbohn, J, & Rowland, P 2002, Capital budgeting: Financial appraisal of investment projects, The Press Syndicate of the University of Cambridge, United Kingdom.

Durnev, A, Morck, R & Bernard, Y 2004, ‘Value-enhancing capital budgeting and firm-specific stock return variation’, The Journal of Finance, vol. 59, no.1, pp.65-105.

McLaney, E & Atrill, P 2008, Financial accounting for decision makers, Prentice Hall, United States.

Melicher, R & Leach, C 2009, Entrepreneurial finance, Cengage Learning, United States of America.

Powell, G & Baker, H 2005, Understanding financial management: A practical guide, Blackwell Publishing, Australia.

Ross, S, Westerfield, R & Jordan, B 2008. Fundamentals of corporate finance, McGraw-Hill Publishing Company Limited, USA.

Shapiro, A 2005, Capital budgeting and investment analysis, Pearson Education India, India.

Steven, B 2007, Financial analysis a controllers guide: Financial analysis, John Wiley & Sons, New York.

Visscher, F 2006,. Web.

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