Businesses generally use more then one method to assess potential projects and there are some practicalities associated with investment appraisals. We need to consider, for example, inflation and taxation.
Taxation has implications on the returns associated with the business. Investments are carried out to increase profits and the tax liabilities will be higher. It is therefore important to assess for additional tax payments and include them in the investment appraisals. Taxation impact cashflows but there are also incentives from authorities to help with relevant developments. Some tax incentives may reduce the tax bill in the early years of investment. Tax allowances may be available for investment and reduce future company's corporation tax and these should be included in the investment appraisals.
Inflation may also affect future cashflows. It may be considered in the increase of the price over time and effectively loss in the purchasing power. Inflation may have a major impact on defining the future - either failure or success of a project. Inflation may affect the cashflows and the discount rate that is applied.
Costs also should be considered, but we must be careful on which costs are relevant. Past costs that have been paid are not relevant because they will not vary with the decision. Only future costs should be considered. Opportunity costs are generally considered as relevant since they arise for the benefit of the business.
Example
Let's look at one example.
Directors of Steel Ltd company considering closing one of the business's factories. There has been reduction in the demand for the products made at the factory in recent years. The directors are not optimistic about the long-term prospects for these products. The factory is situated in an area where the rate of unemployment is high.
The factory is leased with four years of the lease remaining. The directors are uncertain on whether the factory should be closed immediately or at the end of the period of the lease. Another business offered to sublease the premises from Steel Ltd at a rental of £40,000 a year for the reminder of the lease period.
The machinery and equipment at the factory cost £1,500.000. The value which they appear on the statement of financial position of £400,000. In the event of immediate closure, the machinery and equipment could be sold for £220,000. The working capital at the factory is £420,000. It could be liquidated for that amount immediately. Alternatively, the working capital could be liquidated in full at the end of the lease period.
Immediate closure could result in redundancy payments to employees of £180,000.
If the factory continues in operation to the end of the lease period, the following operating profits (losses) are expected:
Year 1 Year 2 Year 3 Year 4
£160,000 (£40,000) 30,000 £20,000
The above figure includes the charge of £90,000 a year for depreciation of machinery and equipment. The residual value of the machinery and equipment at the end of the lease period is estimated at £40,000.
Redundancy payments are expected to be £150,000 at the end of the lease period if the factory continues its operation. The business has an annual cost of capital of 12%.
We can determine the relevant cashflows arising from the decision to continue the operation until the end of the lease period rather then closing immediately.
We can also calculate the net present value of continuing the operations at the end of the lease rather then closing immediately.
The relevant cashflows are presented in figure below
Source: Atrill, P., McLaney, E., (2011) Accounting and Finance for non-specialists Prentice Hall.
Note 1: Each year's operating cashflows are calculated by adding back the depreciation charge for the year of the operating profit for the year. In the case of the operating loss, the depreciation charge is deducted.
Note 2: In the event of closure, machinery could be sold immediately, thus an opportunity cost of £200,000 is incurred if the operations continue.
Note 3: Continuing operations, there will be a saving in immediate redundancy costs of £180,000, however the redundancy cost of £150,000 would be paid at the last year of lease.
Note 4: Continuing operations will mean that the opportunity to sublease the factory will be foregone.
Note 5: Immediate closure would mean that working capital could be liquidated. If operations continue this opportunity is foregone. However, working capital can be liquidated in 4 years time.
The net present value of continuing the operation until the end of the lease period.
Source: Atrill, P., McLaney, E., (2011) Accounting and Finance for non-specialists Prentice Hall.
Before making the final decisions the directors also need to take into consideration additional factors on the timing of the factory closure.
Thse include:
* The overall strategy of the business as the business may need to set the decision within a broader context. It may be necessary to manufacture the product because the product is an integral part of the business product range. The business may wish to avoid redundancy in the area of high employment for as long as possible.
* Flexibility. The decision of closing of the factory is most likely irreversible. If the factory continues, there may be a chance, that the prospects for the factory will brighten in the future.
* Creditworthiness and sublease need to be investigated. Failure to receive the expected sublease would make the closure option less attractive.
* Accuracy of forecasts and those should be examined carefully. Inaccuracies or any underlying assumptions may change the expected outcome.
The NPV on the decision to continue operations rather then closure is positive. Therefore, the stakeholders would be better off if the directors would take this decision. The factory should continue in operations rather then close down. The decision is to be likely welcomed with employees and give the business more flexibility.
Working capital management
Working capital is technically defined as the current assets less the current liabilities. The working capital 'size" can vary from business to business. Most projects will require the business to invest in the working capital. It includes the cash necessary to run the business on a day-to-day basis. It does not include the excess cash which is not required to run the business, therefore it would be better employed elsewhere.
The Matching Principle
The matching principle states that short-term needs are financed with short-term debt and long-term needs are financed with long-term debt. It would not be wise to try and finance a long-term need with a short-term financing. At some point the short-term financing will expire, but the project will not be finished.
Permanent working capital - is the amount that the firm must keep invested in short-term assets to continue business operations. In continues with a long-term investment. Generally long-term funds have lower transaction costs then short-term form of funding.
Temporary working capital - it accounts receivables and inventory and results in seasonal fluctuations. This temporary working capital is the difference between the actual level of investment in short term assets and permanent working capital investment.
Financing policy choices is when a part of the permanent working capital is funded with a short term-debt. A conservative financing policy s when is when firm finances short-term needs with long-term financing.
Procurement
Procurement is a process of obtaining goods or services from a supplier. Procurement of capital goods would affect the organisational statement of financial position as new assets are added. Those materials and services used in production would affect the business net income and inventory levels.
When considering engaging a supplier a manager must consider the factor of cost, time and quality. In the context of income and working capital management, cost control is an important consideration as lower costs will yield higher profits. However, time is also critical. A supplier with long term delivery may mean that we need to hold more inventory and raising costs. Quality must also be examined to ensure it meets the organisation's expectations.
Procurement costs
When designing a contract, many options are available for addressing cost. A 'Fixed price" contract specifies a price for each unit of the goods or service provided, it may or may not have a quantity specified as well as the terms of delivery. The benefit of this contract is that the unit price is known and unexpected high delivery costs are the risk of the supplier.
Alternatively a cost reimbursement contract may be formed. It requires the organisation to pay the supplier based on actual cost of delivering the goods or services. The customer can benefit if the delivery costs are lower then the initial estimated cost. The customer bears the risks of unexpected higher costs. Depending on the nature of the goods and service either fixed price or reimbursement cost contract may be required.
Terms and conditions
A contract is a legal document that is enforceable through the courts should any of its conditions be breached. It is impossible to cover all relevant contingencies when writing a contract, we need to ensure that basic contingencies are included. Common contracts include: late delivery, failure to deliver, substandard quality and financial penalties for the supplier. Through contract, supplier may offer a discount for an early payment as part of the working capital and cash management plan. Contract may also include penalties for non-payment by the due date of the invoice. Additional terms, such as intellectual property or exclusivity rights may be included in a contract.
Vertical integration
Instead of contracting with an outside supplier, an organisation may choose to produce goods and services itself, it is said to be 'vertically integrated'. This is common in many industries. If supplier is unreliable and company wants to maintain certain trade secrets or if it could produce inputs more cheaply internally, then the vertical integration can be beneficial. The cost of obtaining the goods from the outside supplier, the cost of creating the goods internally and the production process required to produce the goods or services, shall be examined. The company could adjust the production process, acquire necessary capital assets and hire workers. They could also purchase the product or service externally from a supplier.
Vertical integration is a business arrangement in which the company controls different stages along the supply chain. Instead of relying on external suppliers, the company strives to bring processes in-house to have better control over the production process. It is a strategy that allows a business to streamline its operations by taking direct ownership of various operations. A company may achieve vertical integration by acquiring or establishing its own supplies, manufacturers, distributors or retail locations rather then outsourcing them. It requires the company's direct ownership and can lead to greater efficacies, reduced costs and more control. It may often require a heavy upfront capital which may reduce company's long-term flexibility.
Vertical integration occurs when the company attempts to broaden its footprint across the supply chain or manufacturing process to become more self-reliant. For example, manufacturing may want own source of material or sell directly to customers. Vertical integration requires a company to take control of two or more steps involved in creation and sale of products and services. Companies can integrate to reduce their manufacturing costs. They can invest in the website and stores, van and fleet to control distribution.
All of these steps involve a substantial investments to set facilities and hire additional talent, but it also increase the size and complexity of internal operations.
Vertical integration can help a company to reduce costs and improve efficacy, but when executed poorly it may have negative consequences on the company. The primary goal is to gain a greater control over the supply chain and the manufacturing process. Well performed vertical integration may lead to lower costs, economies of scale and lower reliance on external parties. It may lead to lower transportation costs, smaller turnaround times and simpler logistics when the process is managed in-house. This may also result in higher quality products and direct control over the raw materials used through the manufacturing line.
But companies can't vertically integrate overnight and it is a long-term process that requires wide spread buy-in. It also includes heavy upfront capital expenditure to either acquire a company, integrate new systems and ensure staff is trained across the manufacturing process. Companies also sacrifice a little bit of flexibility. This is because they are committing capital to a particular product. Instead of being able to decline the purchase from external vendor they have committed money which need to be recovered. Knowledge may also be lost through different external vendors. It may also have several social impacts, where companies try to focus too much on different things and loose its main focus and goal.
Bibliography:
Atrill, P., McLaney, E., (2011) Accounting and Finance for non-specialists Prentice Hall.
Hayes A., 2022, "Vertical integration explained: How it works with types and examples", accessed from https://www.investopedia.com/terms/v/verticalintegration.asp#:~:text=Vertical%20integration%20is%20the%20business,control%20over%20the%20production%20process. accessed on 29/04/2023
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