Part A
Introduction
Almost all firms recognize that they face major uncertainties about the future, yet most firms’ strategic investment decisions are primarily based on a single projection of future events. Although managers do recognize that the failure to include a consideration of uncertainty can lead to costly errors, the difficulty of such planning leads many to ignore the potential costs and hope that serious problems will not arise (Trigeorgis 1995). Suppose a company is considering a strategic decision, such as building a large now plant or embarking on a large research project. Major projects such as these require significant commitments of both capital and managerial attention. The reward from the project depends not only on its technical success, but also on the market conditions and industry structure at the time of completion. Uncertain future developments and the firm’s response to these developments can turn such projects into either resounding successes or abysmal failures. However, managers are often baffled by the question of how to include uncertain future outcomes and potential future strategic responses in a prospective analysis of a capital investment project. The actual staging of capital investment as a series of outlays over time creates valuable options to default at any given stage (Trigeorgis 1995). Capital investment projects are vital for the growth of the firm. For capital investment projects to achieve its goals it must make use of investment appraisal techniques. This part of the paper discusses in detail the usefulness of investment appraisal techniques. The investment appraisal technique that the paper will put its focus on is the NPV or Net present value
Investment Appraisal Techniques
From the firm’s perspective the objective of the investment appraisal process is to determine how the value of an investment is likely to affect the value of the firm. The goal is to increase the wealth of the firm by making investments which are expected to yield returns greater than their costs (Mcmenamin 1999). The investment appraisal process involves the evaluation of a prospective investment’s relevant cash flows which will occur over different time periods. In order to make a valid comparison of cash flows occurring over different time periods, it is necessary to convert them to a common base, or time period. People do this by either converting future cash flows back to their present day values, or by moving present cash flows out to a future date. The judicious application of investment appraisal techniques will enable management to select projects that will advance the organization’s objectives and plans and add to shareholder wealth. The financial techniques most commonly used to evaluate investment appraisal projects are payback method; accounting rate of return (ARR), or return on investment (ROI) and discounted cash flow (DCF) methods (Mcmenamin 1999).
In applying Discounted Cash Flow (DCF) the following techniques are commonly used: net present value (NPV); profitability index (PI); and internal rate of return (IRR). The payback method is the most popular and the most easily understood of the main appraisal techniques. It is essentially an expression of how long it will take to recover the initial cash outlay on an investment from the investment’s cash flow returns. The ARR is an unsophisticated technique. It is calculated by dividing a project’s average accounting profits by its average investment. The average profits figure is found by adding up the profits for each year of the investment and dividing by the number of years. The average investment is the sum of the initial investment or outlay plus the expected residual or realizable value of the asset, divided by two. The DCF is the incremental operating after-tax cash inflows which people use to measure the expected benefits from the project. The net present value (NPV) is the difference between the present value of future cash inflows and the present value of the initial outlay, discounted at the firm’s cost of capital. The profitability index (PI) is the ratio of the present value of all future net cash flows to the initial costs. While the NPV is an absolute measure of a project’s acceptability, the profitability index is a relative measure as it relates the benefits to the initial investment. The internal rate of return (IRR) or yield can be defined as: the discount rate which equates the present value of the expected initial cash investment, with the present value of the expected cash inflows (Mcmenamin 1999). The aim of investment appraisal techniques is not to replace the brilliant business tycoon or even to eliminate all elements of luck. Rather, it is to quantify all those factors that can be measured in order to provide management with as much information as possible about whether a project looks like adding value to the firm (Chrystal 1997). The investment appraisal techniques help in determining how the investments will create benefits or problems to a firm. Among the various Investment appraisal techniques NPV was chosen because of its familiarity.
Net Present value
The net-present-value (NPV) method of selecting capital budgeting projects is also commonly referred to as discounted present value, and present-value analysis. But whatever name is used, the nature of the technique is the same and is actually quite simple in concept (Droms 1997). The NPV method compares the present value of the expected future benefits of a project to the present value of the expected cost of the project. The NPV of the project is simply the difference between the present value of the benefits and the present value of the costs. If the NPV is positive or the present value of the benefits exceeds the present value of the cost hen the project would be accepted. If the reverse is true and the net present value is negative, the project would be rejected. In sum: NPV= PVB – PVC where NPV = net present value PVB = present value of benefits; PVC = present value of costs; If NPV positive, accept. If NPV negative, reject (Droms 1997).
Like most other time value of money problems NPV problems need not be solved using present-value tables. All but the most basic business-oriented electronic calculators can be programmed to solve capital budgeting problems. Personal computers also have simplified capital budgeting. Business-oriented spreadsheet applications can be set up to solve these problems, and special-purpose capital budgeting softwares are readily available. Normally, a firm would only undertake a project if it’s NPV is positive. In a situation where investments are large relative to the firm involved, it may not be enough to recommend investments which have satisfactorily high NPVs at the firm’s cost of capital even after allowing for the risk and uncertainty related to the cash flows. The estimates of adjusted, future, annual profits, value of surplus assets, and replacement costs of non surplus assets provide the one using NPV with the data necessary to compute the NPV of an acquisition. More precisely, the NPV of the adjusted annual profits and replacement costs of non surplus assets measures the value of the company to be acquired from the viewpoint of continuing the operation. Risk or uncertainty loading on the interest rate results in a decrease in the NPV of a project with no negative terms in its cash flow (Beenhakker 1996). The NPV technique is always considered the preferred criterion. NPV is after all a valuation technique and as the primary goal of financial management is maximizing the value of the firm, NPV is the only investment appraisal technique that is always consistent with this principal goal. Maximizing shareholder value can be achieved by maximizing the net present value of all the firm’s investment cash flows, subject to applying an appropriate discount rate (Beenhakker 1996). The NPV is known as a method that uses the time value of money to increase long-term projects. A lower NPV reduces the chances of acceptance for a project when competing with other projects. It is clear that this is what people want for projects with uncertainty and/or risk involved. It is noted that the method of loading on the interest rate fails to be effective if a project has so short a life that discounting cannot take effect. NPV measures cash flows particularly the excess or shortfall of cash flows. The problem with NPV is it is not flexible for any issues after project decision. NPV also has a weakness in dealing with intangible benefits.
Part B
Barclays Bank Plc
The scene is even more complicated in Europe by many more different types of competitors populating the landscape. In London, several fund managers affiliated with merchant banks and brokers, such as Mercury Asset Management, Kleinwort Benson, and Cazenove, manage funds that are to be invested abroad. There are also several independent investment management firms that serve pension funds and distribute their own mutual funds in London, and others that are based in Edinburgh (Smith & Walter 1997).Further, a number of insurance companies such as Prudential Assurance and banks like Barclays and National Westminster manage investments for pension funds for individual clients. Some have subsidiaries that specialize in private banking, like NatWest’s Coutts & Co., often referred to as the bankers to the Queen. Index funds have existed in the United States for a number of years. Most are based on the S&P 500, and many variations and re weightings of the 500 index have been introduced. A substantial amount of pension fund assets in the United States are now being indexed, on the grounds that most active managers fail to exceed the indexes, and passive management is much less expensive (Smith & Walter 1997).
Indexing has not been confined to the United States, although it is still used there more than anywhere else. Barclays de Zoete Wedd Investment Management and Baring International Management, for example, have index funds that they offer to clients. The Baring approach is to use active management to select and weight countries, and to use indexing to invest in stocks from those countries (Smith & Walter 1997). Such a low proportion of financial institutions among the largest British companies might appear surprising given the major role played by financial services in the British economy. However, relying on paid-up capital as a measure of size would in this case be misleading. English commercial banks, unlike their Continental counterparts, confined their activities to deposit banking operations that is, on the assets side, mostly short-term loans, discounts, and investments in highly marketable securities. They thus worked with a much smaller capital, but with larger deposits, than the French and German banks. On the eve of the First World War, five European commercial banks were roughly of equal size, with total assets exceeding £100 million. British banks reached a giant size through a long process of amalgamations which started in the mid-nineteenth century and reached its peak between 1890 and 1918. During these crucial years, Lloyds and Midland, until then medium-sized provincial institutions based in Birmingham, were transformed into City-based colossi with a network of branches covering the entire country. Barclays Bank was formed in 1896 by the merger of twenty private banks; and two old-established London banks, the London and Westminster and the London and County, had to merge in 1909 to keep their position at the top of the British banking hierarchy (Cassis 1999). Barclay’s headquarters is located at One Churchill Place in Canary Wharf, in London’s Docklands. The bank moved there in May 2005 from Lombard Street in the City of London. Barclays has around 1800 UK high street branches.
Asset Based Evaluation Techniques
These are, without question, critical dimensions to a business valuation, but they are not the only dimensions of a business valuation that are important. All too often, for a variety of reasons, individuals may fall into the trap of believing that business valuation is little more than a formulistic exercise. Nothing could be further from the truth. In comparison of the valuation of a business to the appraisal of a home, the more intangible factors that add to the value of the home, such as its architectural style, quality of the school district, and interior floor plan, are part of the art of appraisal and, by analogy, the art of business valuation. Disagreements regarding a final valuation estimate of a business, or the appraisal of a home, are in most cases based on differences in opinion about elements of what people call art. Business valuation is rapidly becoming a vocation unto itself (Boger & Link 1999). The art of business valuation deals with, among other things, the following concepts that include understanding the economically efficient life of productive assets, compared to the general accounting practice defined depreciable life of productive assets; understanding the economically relevant industry in which the business being valued operates; understanding the appropriateness of one valuation method or one statistical method over another; understanding the limitations of financial information from comparable businesses, and understanding the economic environment into which financial data are being extrapolated, and the appropriateness of such an extrapolation. One method to value a company is Asset based methods. Just as income-based valuation methods rely explicitly on the business’s income statement, an asset-based valuation method relies explicitly on the balance sheet for basic financial information (Robbie & Wright 1999). Companies need to make sure that they still have internal or external value because it is a factor in determining a firm’s success or failure. Proving that they have value is one goal of any company. Value can be determined through competitive advantage period, Market share, Growth in sales, Cost of finance and rate of tax applied to profits. The factors that create value include cost leadership, Differentiation and focus or niche. The company’s intrinsic value is an asset’s value regardless of the market price. When an analyst determines a stock’s intrinsic value is greater than its current market price, the analyst issues a buy recommendation and vice versa. The determination of intrinsic value may be subject to personal opinion and vary among individual analysts.
The comparable profits method (CPM) is a profit-based method, whereby the industry average net profit margin earned by comparable firms is used to back into the transfer price. Unrelated firms engaged in the same products or business segment are selected as comparable firms, with adjustments to their balance sheets being made for differences in responsibilities, risks assumed, resource capabilities, and any other material differences relative to the tested party (Rugman 2001). The comparable approach relies on discounted or capitalized estimates of future cash flows. Most of the time the future cash flows must be estimated using comparable income generating properties. Discount rates and capitalization rates are frequently estimated using recent sales of comparable properties, with appropriate adjustments to account for differential risk between the comparable and the subject. The comparable approach considers the earnings and shares of the company. Earnings, also called net income or net profit, is the money that is left over after a company pays all of its bills. To allow for comparisons of certain business aspects, most people who look at earnings and measure them according to earnings per share.
One method to know the value of the company is through asset based methods. Asset based methods puts its focus on the balance sheet of the company. This valuation method is used to know the value of the company without including its cost. The asset based methods puts attention on the company’s equity. Whether it’s tangible properties like cash, current assets, working capital and shareholder’s equity, or intangible things like management or brand name, equity is everything that a company has if it were to suddenly stop selling products and stop making money tomorrow, and pay off all its creditors. A company has value when it has competitive earnings. Barclay’s income in 2006 Increased in 2007, it rose from €21,595 to €23,000. This proves that although the company had some financial problems in the past, it maintained its financial status. A company needs to have acceptable rates of competitive earnings and outstanding shares. Barclay achieved this and has maintained the balanced between its earnings and shares. The ratio between shares and earnings can distinguish whether the company can still attract clients. When the company has low shares and earnings, the future might not be bright for a company.
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Credit:ivythesis.typepad.com
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