The funds available for companies’ projects are limited in supply while there is an unlimited list of profitable projects open to firms. Companies like individual consumers must therefore be rational in their investment pattern, while individuals would want to maximise their utility, firms aim at maximising shareholders’ wealth. To achieve this aims the financial manager usually takes a careful step in appraising the available projects to determine their feasibility.
Investment Appraisal may be done under either of two underlining assumptions about the flows of funds over the life of the project. The first assumption holds that a monetary unit of Naira today is of the same value as that in the future. The other holds to the contrary that one Naira today is not the same as one naira tomorrow.
This latter assumption is called time value of money. Under the second assumption a special procedure is undertaken to bring all future cashflows to their present values. This procedure is known as discounting. The non-discounted methods include the payback period and accounting rate of return while the discounted methods include the Net-Present Value methods. Internal rate of return, profitability index and the adjusted payback period method.
Payback Period Method
The payback period, or capital recovery period is the time it takes a project to pay back its initial capital outlay. It is the number of years it takes the cash inflows to cover the cash outflows of the project. The rational decision-maker accepts any project whose payback period meets management’s predetermined payback period project.
For mutually exclusive projects, that is, a set of projects which cannot be undertaken together, the decision-maker accepts the project with the least payback period provided it also meets the first-order requirement. The method is simple to understand, considers the riskiness of the project as well as liquidity.
However, it is limited to the extent that it does not consider the time value of money, disregards cashflow arising after the payback period; and ignores the profitability of the project. In addition, the method of setting the predetermined payback period by management is also subjective.
Accounting Rate of Return
While the payback period method considers cashflow, the accounting rate of return considers accounting profits in the determination of feasible projects. Accounting Rate of Return relates the estimated average profit to the estimated average investment on the project. Estimated Average Profit
ARR= Estimated Average profit divided by Estimated Average Investment
Where Estimated Average Investment is :- Initial Capital Outlay +Scrap Value divided by 2.
The Scrap value is the difference between the historical cost of the investment and the accumulated depreciation. The decision rule is to accept the project if its Accounting Rate of Return is equal to or greater than the required rate of return. For mutually exclusive projects the project with the highest accounting rate of return is chosen provided it also meets the required rate of return.
Accounting rate of return is simple to compute and understand: consistent with the return on investment approach which most managers are conversant with. It also focuses on all profits during the life of the project. However, accounting rate of return fails to consider the time value of money. The yardstick for establishing the cut-off rate is subjective.
Net Present Value Method
This is the best investment appraisal method and one, which considers the time value of money. The NPV of a project is the difference between the present value of future cashflow and the initial capital outlay. A project with a positive NPV is feasible and acceptable otherwise it is rejected.
A positive NPV means that the wealth of the shareholders would increase by the amount of the positive value. The higher the NPV the better the project. The criterion for discounting the future flows is the company’s cost of capital which represents the minimum rate of return required by providers of funds.
Internal Rate of Return
This is another discounted cashflow method. It is also known as yield on investment, marginal efficiency of capital, rate of return over cost and time adjustment rate of return among others. The internal rate of return is the rate return, which equates the present value of future cashflow with the initial capital outlay.
To obtain this rate involves a trial and error process. A rate is assumed which gives a positive NPV. The rate is then increase until a negative NPV is derived. The initial rate of return is then obtained by interpolation using the formula.
The decision rule is to accept the project if its internal rate of return is higher than the cost of capital or the required rate of return. While the IRR method recognises time value of money, it brings about multiple rate when the cash flows are non conventional.
Profitability Index
This is also known as benefit-cost ratio. It is the ratio of the present value of cashflows discounted at the required rate of return to the initial cashflow of the project. The decision rule using this method is to accept the project if its profitability Index is equal to or greater than one, the method is consistent with the NPV method. A project with profitability index of equal to or greater than one has a positive NPV. The greater the PI the better the project.
Adjusted Payback Period Method
This method modifies the non-discounted payback method by discounting the future cashflow before obtaining the payback period.
Dividend Policy
A firm’s dividend policy relates to the determination of earnings which may be distributed regularly, usually, monthly, quarterly, semi-annually or annually to shareholders. Dividends can be paid in form of cash and/or shares. Cash dividends entitles the shareholder to receive money per share held. Dividends in form of shares are called stock, Scrap or bonus issue.
They are used when the firm finds it difficult to pay cash as the liquidity position may be affected or such payment may negatively impact on other project requiring cash. The following factors may influence the dividend policy of a company.
Liquidity
Ultimately whatever dividends are declared will have been paid out of cash and funds must be available to meet the payments. In addition, a company will consider the level of liquidity required to facilitate its expected operations and ensure that dividend payments do not impose undue strain on its liquidity.
Loan Covenants:
When large companies borrow money from banks or issue debentures, the loan agreement may contain clauses placing limitations on dividends.
Investment and financing opportunities
If external finance is not available or available only after incurring significant transaction costs, then the payment of dividends may mean foregoing worthwhile investment opportunities.
Stability of Earnings
Companies in different industries will have earnings, which are subject to varying degree of risk. The greater the variability of earning (risk) the greater the likelihood of the dividend having to be cut due to a sudden drop in earnings. Companies in high-risk industries may adopt a low payout policy so that dividends can be maintained if earnings, temporarily fall.
Rate of Business Expansion
The greater the rate of business expansion, the less cash there will be available for paying dividends.
Dividend, policy of similar companies
When deciding on their own dividend policy, companies will tend to follow a similar policy to that of similar companies.
Taxation
Income distributions and capital gains have different tax implication: This will affect the relative desirability of dividend and retained earnings. Hence, the marginal rate of tax of the dormant shareholder can be an important consideration determining dividend policy.