In Pursuit of Evaluating Capital Investment Projects, the Most Appropriate Procedure That May Be Suitable Considering

SOLUTION.

Part (a)

In pursuit of evaluating capital investment projects, the most appropriate procedure that may be suitable considering is detailed below:

Firstly, it is essential to identify the relevant cash flows of the project. Inherent characteristics of them all, that enable us its recognition, would be their: future perspective, incremental effect and capacity to make a real cash inflow or outflow. These are the requirements that must be fulfilled so that they are taken into account in the project assessment. We must always keep in mind that these cash flows are expected figures. Then, we have to consider that depending on the internal and external information we dispose of, our experience and market behavior, the real cash flows may vary from our expectations.

Relevant cash flows have to be arranged in order of appearance, subtracting the project's initial investment, at time zero, from the present value of its cash inflows. To express the present value, we have to apply a discount to cash flows at a rate that reflects the minimum return on the project necessary to maintain corporate market value unchanged.(Gitman and Madura, 2000, p. 331). Cost of financing and inflation compose this rate of return, later explained. When all these cash flows already discounted are summed, net present value (NPV) is obtained. This is, therefore, the initial and most valuable technique we have to measure capital investment projects. Net Present Value Method enables us determining which projects create value to the firm. The decision rule is extremely simple, as only those projects that entail positive NPVs will be accepted.

Furthermore, now that we know to what extent the investment project creates value to the company in terms of total earnings, it would be beneficial to calculate it in terms of the compound annual rate of return that the firm is earning each year. The internal rate of return (IRR) "is the rate of return that equates present value of expected net cash flows with the initial outlay for the investment", (Gallinger and Poe, 1995, p. 512), in other words, the rate of return that makes NPV equal zero. The project should be accepted when the internal rate of return exceeds the required rate of the project determined by cost of financing and inflation. To obtain it we have to equate the initial investment to the sum of future cash inflows discounted by the IRR, which is the unknown factor. Even though IRR calculations seem complex, there are financial calculators that make it simple. As the concept it represents is extremely easy to comprehend, it has a significant value for assessing an investment project.

Nevertheless, Gallinger and Poe (1995, p. 512) argue that, although it is assumed that all cash flows will be reinvested at the IRR rate, it is impossible in practice. Employees, suppliers, interest expense...have to be paid and are deducted from the yield obtained each year. Therefore, IRR will probably differ from the true rate on the investment. As well as this, management has a huge influence on decision-making when using NPV or IRR. We can never forget that we are dealing with future values considered to be normal, expected. However, there is a degree of uncertainty in both the size and timing of cash flows, and cases where NPV is relatively close to zero, compared to the cash flows it is composed of, might be risky to undertake. Managers should evaluate the consequences of that investment decision, whether finally it is an acceptance or not. Acceptance might mean bankruptcy, whereas rejection wastage of corporate resources. Required rate of return by investors and inflation effect that are particularly tightened to IRR, summed to the inaccurate expected cash flows, would also increase our risk.

In order to maximize stockholders' wealth, and thus, increase corporate market value as much as we can, the theory says that we should accept every positive NPV project. However, we are normally constrained by funding capacity and will be interested in finding the investment projects mix that jointly