Allocation of an Enterprises Long Term Capital Resources Finance Essay

This assignment is about financial strategies and paying special attention to the allocation of an enterprise’s long-term capital resources. Financial and investment decisions play an important role in the development and future existence of the firm dynamics. Firstly, the goal of this project is to determine the initial aim of the firm by making capital investments. Moreover, another section of assignment includes the capital budgeting process which is a significant researching procedure so as to defined capital opportunities. Then, these capital proposals are assessed from specialists in the evaluation procedure by utilizing and implementing Discounted Cash Flow techniques. Lastly, are presented the general conclusions of this survey which proves the importance of current trends and conditions. INTRODUCTION According to Lenos Trigeorgis (1995) the resource allocation procedure defines the leading levers for a firm’s strategic impulsion and additional determines its long-term competitive situation. Investments consist of exploitation of resources which will not be utilized completely in current time but determines firm’s attainment in future in the financial market. Generally, capital investment called as the commitment of financial resources in order to fixed capital expenses in the expectation of returns that compensate for the investment’s risk and the delay in the utilizing of these financial resources.(Richard Dobbins and Richard Pike,2007). Decisions which demand the use of resources are projects. These projects are made by firms so as to broaden strategic decisions, which concern invasion in emerging areas of business, emerging markets, and holding other firms. (Aswath Damodaram). For this reason, senior managers should be responsible and well-educated so as to take vital decisions concerned with the suitable capital investments. Thus, these significant decisions are defined from capital budgeting results. In utilizing this detailed technique, projects can give essential information if the imminent capital investment will have positive or negative effects in corporate performance. ( Cheng F. Lee and Joseph E. Finnerty ,1990). Strategic decisions are vital vehicles of corporate programming and advanced management discussions that provides a correct orientation to a firm. The procedure of capital budgeting by which companies allocate resources among long-term assets, gives essential information about company’s future development or general failure.(Van Son Lai and Lenos Trigeorgis). What is more, these strategic decisions come from the evaluation of cash flow methods. Many surveys have pointed out that most prevalent and widespread tools of evaluation are the Discounted Cash Flow methods mainly in large and medium companies.(Brealey and Myers, 1991). As well as, according to Aswath Damodaram the main investment theory governed from the following principles: Utilize “cash flow” rather than profits. Utilize “incremental cash flow” concerning to the investment decisions. In this case cash flows that happen as an effect of the decision, rather than overall cash flows. Utilize “time weighted returns”, worth cash flows that happen earlier than cash flows that happen later. THE AIM OF THE FIRM The financial target of the company is the maximization of shareholder’s richness. For this reason, the essential aim of investigation is to determine in which of the financial attributes of a company must focus on in order to maximizing the shareholder’s property. On account of the fact that firm’s development and profitability affected from many factors, each firm should take vital decisions concerning in the implementation of suitable investment strategy that follow so as to achieve the optimal result.( Richard Dobbins and Richard Pike,2007). This statement also confirmed by Levy and Sarnat that support the following theory “financial decision-making involves purposeful behavior, which implies the existence of a goal, or what is much more likely, some combination of goals”. In order to opt for among various investment methods and products it is essential to pose firm’s target. Furthermore, nowadays not only the maximization of gain is the unique enterprise’s target but also many targets are of the firm’s interest. Thus, for each enterprise some of these goals are mainly the increase of sales and manage to own a significant market share. Apart from this latest financial rule it is evident that many surveys have pointed out that managers attempt to carry out long -term investigations in order to earn “profitability” and “stability” rather than to succeed high levels in market worth. Moreover, important enterprise’s target is the survival. For this reason, managers should not accept projects which not put in risk the “profitability and stability” of enterprise. (Levy and Sarnat, 1978). What is more, the monitoring and planning of investment determines the company’s survival and prosperity in the future. Incorrect movements which referred to wrong evaluation of new investment chances can cause inefficiently impacts on a corporate performance. For this reason, it is evident that this estimation of opportunities determines from capital budgeting process. It is a significant procedure which shows the suitable evaluation method. (Haim Levy and Marshall Sarnat, 1994). THE CAPITAL BUDGETING PROCEDURE First of all, capital budgeting process is specified as the method of searching assets that are valued more than they cost. Many management executives attempt to commit limited financial recourses in order to succeed strategic important incentives and earn future advantages especially in the long-term of time. Furthermore, capital budgeting is a multidimensional corporate action which consists of seeking and determining new and effectively investment opportunities. Thus, in this process is made financial and economic analyses so as to define the most earning and least costly method to have an edge of an investment opportunity. This analysis is one section of capital budgeting procedure. (Richard Pike, 2007). Economic analysis defines investment as the interaction of the provision of capital and the torrent of investment chances. Additional it is observed that this theory point out that this incessant flow of investment chances need evaluation so as to estimate all potential versions. In order to take advantage from these opportunities senior managers should react in time by doing targeted movements and thoroughly studied proposals. (Cheng F.Lee and Joseph E.Finnetry, 1990). Therefore, capitals budgeting except for determining investment opportunities categorize them according to some reasonable framework utilized in the firm, assembling required information and data such as calculation of cash flows and recognition of access risk. Additional, capital budgeting balancing each projects advantages and relationship to strategic incentives opposite its risk and limitations. Furthermore, this process estimating sensitiveness of different hypothesis and factors to various economic cases.(Van Son Lai and Lenos Trigeorgis, 1995). Generally, an essential capital budgeting project consists of the selection between leasing and purchasing. (Murdick et. al., 1980). Moreover, it is important to clarify that corporate risk management is one of the crucial worries of managers when they implementing investment allocation decisions among various projects. For this reason, the most significant part of this analytical procedure is the financial evaluation which includes cash flow in projects and methods of risk estimation. (Xun Li and Zhenyu Wu, 2006). Taking everything into consideration, capital budgeting process plays the most important role in a company’s long-term “survival and viability”. The capital budgeting procedure consists of: Recognition of possible projects. Forecast of potential outcomes. Selection of project. Financing and application of selected project and inspection project performance. It should also be added, that managers in order to select the suitable project except for the economic prevailing thoughts, the most vital factors which affect this selection are preference and individual opinions. (C.S Agnes Cheng , D.Kite, R. Radtke, 1993). Advanced methods such as Payback Period, Net Present Value and Internal Rate of Return provides useful information concerning the suitable decisions which could applied in order to achieve the optimum result. Additional, more techniques gives significant elements in risk-return such as portfolio theory and planning with mathematical approach. (Richard Pike). EVALUATION APPROACH IN INVESTMENT SUGGESTIONS PAYBACK PERIOD (PP) Concerning with, the payback period the investment chances with the least cost replacement are the most positive and most acceptable. Moreover, this method illustrate the period that initial expenditure must be recovered overall. But, by utilizing payback period technique is observed lags on account of the fact that PP not pay attention in the time value of money. Various fluctuations in economical environments and high interest rates also ignored by PP method, on account of the fact that are events which have impacts in final decisions. (Avi Rushinek, 2007). Additional, such extension of PP method does not make it a detailed factor which assists in the general goal of any firm, such as the defining of investment opportunities. (Avi Rushinek,2007). Also, another drawback of this method is that it not takes into account the cash flows which come up after the Payback Period. ( Cheng F. Lee and Joseph E. Finnerty,1990). Besides this, this method determined from the fact that in usage is simplier and can be understood more easily than other method. The worries concerning the recovery’s costs are essential in a period when interest rates presenting increase and liquidity also presenting decline. (Avi Rushinek,2007). The PP is calculated by the following manner:

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Figure 1.

Payback Period=Investment Required/ Net Annual

Cash Inflows

Suggestions which are acceptable are those in which the Payback Period is less than the overall period required, but it rejected the project where the PP is longer than the overall period required. (Cheng F. Lee and Joseph E. Finnerty, 1990). In decision making stage, the PP technique could be utilized as a secondary factor in order to lead in desirable effects. Thus, the PP is used mainly in economical periods where prevail conditions of high interest rates and low liquidity. (Avi Rushinek, 2007). But, according to George M. Zinkhan and F.Chiristian Zinkhan (1994) at this day and age the most prevalent methods which are applied in capital budgeting are these methods which utilize a time value analysis of gain and called as the Net Present Value and Internal Rate of Return. Many studies have point out that the most financial managers have preference in the Internal Rate of Return method. (Stanley and Block, 1983). NET PRESENT VALUE (NPV) The theory about” the time value of money “point out that a dollar which accepted today is worth more than a dollar accepted in the future. This statement is supported because a dollar which could be reinvested in current time could offer positive results in the evolution of interest rates. Net Present value model belongs in the Discounted Cash Flow models which offer the meaning of take into account vital parameters such as uncertain risk and reinvestment profitability. This model estimates the change in the worth of a company as an effect of receiving an investment opportunity. (Avi Rushinek, 2007). During the calculation of Net Present Value is generated a receivable small percentage of rate of return. This rate of return which emerged from the calculation is “a weighted average Cost of Capital” which involves equity and dept parameters. (Wooller, 1981). After the procedure of calculating the Cost of Capital should be calculated the future project cash flows. Furthermore, in order to estimate the present value of future cash flows, in following these cash flows discounted back at the determined discount rate. In the final stage so as to achieve the Net Present Value first of all, the initial investment must be subtracted from preset values. As a result, acceptable projects should have positive NPV and projects with negative NPV are ignored and reject any investment opportunities. (Garrison, 1978). INTERNAL RATE OF RETURN (IRR) The Internal Rate of Return technique has many similarities with Net Present Value but a part of return on investment is defined as an opposite to “an absolute dollar value”. Moreover this method is implemented because have an edge to compare different investment opportunities by having the percentage of return over an absolute value. (Avi Rushinek, 2007). Utilizing the IRR in order to compare comprehensive investment projects in various currencies and extents, this method is assisted by the existence of percentages. Additional, it is significant to be said that estimating the IRR method demands the initial worth of the investment, however and the calculated future cash flows. (Avi Rushinek,2007). According to, Haim Levy and Marshall Sarnat (1994) IRR is determined as the “discount rate which equates” the predetermined value of the flow of net revenues with the initial expenditure. Thus, acceptable projects are those in which the IRR surpass the discount rate and in opposite site when the discount rate is bigger than the IRR these projects are rejected. To sum up, it is important to define that in Discount Cash Flow techniques is belonged the Net Present Value and Internal Rate of Return which are more complicated than Payback method. Besides this, these models are considered useful and profitable because including the time value of money and the Cost of Capital. For this reason, are the most prevalent models and prevail over PP method. Also, the PP model has vital usefulness in economic periods where dominated high interest rates and low liquidity. (Kim and Farragher, 1981). FACTORS WHICH AFFECT CAPITAL INVESTMENT PLANNING Another point worth mentioning is that in the appraisal procedure should take into consideration the full consequences of inflation. Cash flows estimation could be defined whether in money or real conditions. Whatever method is implemented it is significant that the determined rate of return is estimated in the same conditions. (Richard Dobbins and Richard Pike, 2007). What is more, Carsberg and Hope propose that the estimation of discount rates and cash flow should be represented in money terms. This statement arising from the appearance of various inflation rates on projects during the inflows and outflows, and the capital discounts are not indexed but defined in historical cost conditions. According to, (Johnson and Soenen, 1994) firms which operate and active in global basis should take into consideration the risk concern with currency fluctuations. Thus, when senior managers attempt to find the suitable capital budgeting method it is very essential to estimate the effect of a required investment on the economic exposure of a company. It is also be added that economic exposure idea is that in this case must take into consideration unpredictable changes on future cash flows in exchange rates. CONCLUSIONS In conclusion, in this assignment has become a descriptive analysis about the dominant methods that determine business decisions, whether a project must be accepted or not. This appraisal involves traditional techniques such as Payback Period in which does not take into account the “time value of money”, and Discounted Cash Flow techniques as Net Present Value and Internal Rate of Return. Discounted Cash Flow methods gradually decrease the value of cash flows accepted in the future. It is generally believed that Payback Period method is inferior to Discounted Cash Flow and Internal Rate of Return is inferior to Net Present Value. Thus, it is supported the fact that the superior method is NPV, due to the fact that IRR have lags in the ability of multiple rates of return and a not real reinvestment suppose which emerges in its calculation.(Michael Pogue, 2004). However,

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