Finance the future of the energy sector - Free Essay Example

Question A A major problem for decision makers in enterprises is the evaluation of potential investment projects that can absorb capital assets. This evaluation, also known as investment appraisal, is really crucial for the future of any firm, since it determines the financial sources of the firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s budget and ultimately defines the level of the shareholders wealth. In theoretical finance, several methods of investment appraisal are developed in order to help financial managers or accountants to evaluate with increased certainty cash flows, viability and profitability of any investment project. However, many empirical studies have shown that financial decision makers do not always adhere to the investment appraisal methods that theory provides[1]. Business experience has shown that contrary to theory, the appraisal of some investment projects is far more difficult because even the implementation of a specific appraisal method is ambiguous and subject to factors beyond financial theory. This essay will discuss the problems associated with the implementation of different appraisal methods using a case study to illustrate the exact nature of these problems. The potential source of capital that will be used to finance the specific investment project might influence the long-term financial state of the firm, and of course the shareholdersà ¢Ã¢â€š ¬Ã¢â€ž ¢ wealth. Thus, the financial decision makers, who ultimately aim at the maximisation of the shareholders wealth, face an additional question to investment appraisal. This question will also be examined in this essay. The most fundamental investment evaluation method takes only into account the time period that is necessary for the invested capital to be paid back. This method is known as the payback period method. The primary advantage of this evaluation method is its simplicity, since a basic concern of financial managers is how soon the invested capital will be available for re-investing. Payback method is particularly useful to small firms that are in shortage of available cash, thus they want to track easily the time limits of their capital flows. However, a main drawback of payback is that it may lead to short-eyed decisions, since it ignores returns that might appear right after the end of the payback period. If an investment project yields high returns right after the end of the requested payback period, this method will evidently reject it. Another significant weakness of this method is that it ignores the broadly accepted fact that the value of money today is not the same as the value of money tomorrow. Essentially, between two investment opportunities with the same payback period, the one that yields more returns sooner should be clearly preferred. Thus payback method entirely fails to comprise different patterns of cash flows within the payback period. Another common method of investment appraisal is the accounted rate of return (also called Return On Investment or Return On Capital Employed). This method simply constitutes of a percentile average profitability-on-investment ratio and is popular due to its easy deduction from any given balance sheet. In this technique, as also in payback, no account is taken for the difference in the value of subsequent cashflows. Furthermore, since profitability is not certain at the beginning of the project, the ARR method is likely to be misleading in the process of investment appraisal. A more common use of this method is to measure the overall profitability after an investment project is over or the ability of a financial manager to evaluate and decide on the most profitable and less risky investments. The basic drawback of the two previous investment appraisal methods is that they fail to include the fact that the nominal value of a cashflow today is different from the real value of a cashflow with the same nominal value in the future[2]. Thus, if a technique can discount the future value of a cashflow into todayà ¢Ã¢â€š ¬Ã¢â€ž ¢s real terms, it could provide a better criterion on which investment project is more profitable. A technique that incorporates this discounting principle is the Net Present Value (NPV) method. In this method, all future cashflows can be interpreted in real present values, and so if inward cashflows are greater than outward cashflows the investment project can be selected. The discounting rate used for the decision is substantially the cost of capital, which of course has to be less than the rate of return. Under this principle, decision makers can chose between alternative and mutually exclusive projects, based on which NPV is highest. The aforementioned rate of return can be used alternatively in another investment appraisal technique, which also incorporates the discounting principle. Instead of discounting future values into present terms, one can compare directly the rate of return with the cost of capital. This technique is known as the Internal Rate of Return (IRR) method. This rate of return is the same one used to calculate NPV in the previous method. In practice, IRR can be difficult to calculate and its usefulness might be unclear to some decision makers. This is due to the fact that if the proposed investment requires more than a one-off outward cashflow, the rate of return might change in the duration of the project. Clearly, in an investment project that requires only one outward cashflow and regular inward cashflows both NPV and IRR methods will produce the same results. However, mutually exclusive investment projects are not easily compared since the discounting principle applies on the whole initial outward cashflow of each investment, allowing for some of the inward cashflows to be re-invested. An example of a real UK investment follows to show illustratively the problems in the selection of an appropriate investment appraisal method. The increased environmental sensitivity that has arisen in the last 25 years due to energy sources depletion issues and atmospheric pollution, provided motivation for research and evolution of renewable energy sources. In the UK, several renewable energy technologies have been put under consideration from the authorities. Renewable energy production technologies are very ambiguous investment proposals for several reasons: firstly, their research and application is still in very primary stages and their implementation requires extremely high costs; secondly, none of these technologies is adequate by itself to provide substantial energy capacity whereas several technologies have to be simultaneously developed (at least some of them) in order to provide a significant substitution to environmentally unfriendly technologies; finally, since none of these have been previously implemented, it is very hard to examine to which extent they will be accepted and whether they will be financially viable or not. Under these particularly unclear assumptions none of the technologies would ever be promoted, at least from a financial managerà ¢Ã¢â€š ¬Ã¢â€ž ¢s point of view since they all involve a large amount of financial risk. However, renewable energy is the future of the energy sector and several economic motivations have been created from the UK government in order to attract the interest of individual and corporate investors. The Non Fossil Fuel Obligation (NFFO) and the Kyoto Protocol force UK governments to ensure investors for high amounts of risk, so that renewable technology can proceed. In this case, the government pays a risk premium added to the price for each renewable energy unit produced. It is estimated that more than  £1bn capital value will be invested in the UK before 2010. Some of the first UK initiatives for renewable energy were The Wind Fund plc (that secured long-term capacity contracts under NFFO) and Baywind Energy Cooperative that firstly launched wind farms and small hydro plants in Cumbria. Other initiatives come from Fenland Green Power Investments and Eastern Generation. As an attempt to support these investment projects, local authorities have been invited to contribu te to the investment projects by contributing to the equity capital through local community funds. But how the investors will chose which investment opportunity is more profitable? Clearly, in this case the payback and ARR method cannot be of any use since a payback period is not acknowledged (it is uncertain if some technologies will ever be implemented at all) and accounting data are not yet available for most of them. Table 1 Discount rates, risk rating and economic estimates for the implementation of renewable energy production IRRe % Risk rating Estimated Output (MW) Capital Value ( £m) p/kWh Biomass-Biofuel 24.8 0.71 1 4 5.10 Municipal Waste Incineration 14.5 0.63 12 47.3 3.23 Small wind (600kW) 6.2 0.61 0.6 0.42 4.57 Large wind (20MW) 16.7 0.51 20 13 3.53 Small hydro (1MW) 10.5 0.48 0.89 1.3 4.25 Large hydro (5MW) 24.8 0.42 4.35 4.3 4.25 CCGT 14.0 0.46 475 142 2.50 Landfill gas 17.1 0.39 1 0.78 3.01 (source: Ernst Young, ref.K/FR/00090/REP) Obviously, the most appropriate techniques to be used in this case are the ones incorporating Discount Cashflow. The NPV approach, although sound for this kind of question, needs to put down specific values and also define time expectancy. On the other hand the IRR budgeting approach provides rates of return that are easy to interpret and for that reason this approach is generally preferred in industry level investments. Given the rate of return, a financial manager only has to know the interest rate (cost of capital) at which he can borrow in order to know instantly if the investment project is viable. Table 1 gives an idea of the discount rates calculated for each renewable technology. Notably these investment projects are not excluding each other, which means that evaluation with NPV would be very complicated. Hereby, this essay does not assume that IRR method is better or more preferred than the rest of the methods discussed above. On the contrary, this essay disputes that à ¢Ã¢ ‚ ¬Ã…“ à ¢Ã¢â€š ¬Ã‚ ¦Ãƒ ¢Ã¢â€š ¬Ã‚ ¦there may be a place for all the techniques of investment appraisal in the management accountantà ¢Ã¢â€š ¬Ã¢â€ž ¢s armoury. However, a thorough understanding of their theoretical nuances is importantà ¢Ã¢â€š ¬Ã‚ . Question B Once an investment project has been evaluated and approved, financial decision makers should decide how and from where they will acquire the necessary capital to fund the project. Firms can finance their investment projects using several capital sources: quoted shares, quoted long term loans, government subsidiaries (like in the case above for NFFO) or internal finance. All these different sources of capital create different sets of obligations to the firm and also are rated differently in terms of risk. The capital that is drawn from shareholders takes the form of equities. When a firm sells a share, it agrees to pay back the buyer a dividend at the end of each year. Thus the firmsà ¢Ã¢â€š ¬Ã¢â€ž ¢ obligation to the shareholders lasts to perpetuity. That is the main difference between the equity and the loan. A loan represents an investment of an individual or institution for a contractual fixed period that yields subsequent contractual returns, and also an obligation to the borrower to repay the whole capital and its cost in the contractual time periods. When a firm finances its investments with loans, an outward cashflow is created until the loans are redeemed. Obviously, the investment is supposed to create inward cashflows that can repay the loan (nominal capital plus interest). In case the firm is liquidated, all loans have to be repaid, by law, before any dividends can be paid back to the shareholders. In that sense equity providers face a higher risk than lenders. A firm acquires a long-term loan by issuing bonds, or otherwise notes that certify the nominal value of the bond, its cost to the lender (the coupon rate) and the specific repayment dates. The cost of the debt capital as expressed by the coupon rate is actually the rate of return for the creditors, but in the same time it is the opportunity cost for the firm. However, the important issue for financial managers is to acquire debt, at a specific level of risk, that can be repaid but also that gives the maximum expected rate of return. A firm has the ability to change its financial structure according to the prices of bonds and shares in the market. If bond prices are high, the firm can issue more bonds or if share prices are high the firm can issue more stocks. Of course, the extent of this decision lies entirely to the firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s predictability of profits. If an investment evaluation was accurate and the firm can guarantee repayments, then it can issue more bonds. If the firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s inward cashflows are volatile, creditors impose greater interest on loans and thus the firm will issue shares in order to acquire cheaper capital. In other words, debt capital should only be invested in projects that yield the highest possible returns for the same risk levels, especially if financial managers wish to maximise shareholders wealth. Thus, a company that issues more long-term bonds should make sure that the investing of this debt capital should be done in the highest possible rate of return. Otherwise, the shareholders face unnecessary increased debt capital risks and the firm should limit its borrowing to avoid bankruptcy. Since debt capital is less risky to creditors that equity capital to shareholders, the firm should be expecting a higher rate of return from investments financed from equity capital than investments financed from loans. However, this is not always possible because there is a limit to the number of shares that a company can issue. For this reason, firms issue preferred stock or different kinds of bonds in an attempt to acquire capital in the best possible terms but also to reduce the possibility of default. In conclusion, this essay examined the different techniques used in investment appraisal and their potential use from firms to evaluate investment opportunities. The payback method, based on a simple rational, is particularly useful to firms that do not have broad access to finance and need to invest with increased certainty. Otherwise, payback method can be very misleading. The Accounting Rate of Return method can be an easy median to evaluate investment decisions, especially after their fulfilment, but does not take into account the time devaluation property of money. Thus it can be also misleading when ARR is directly compared with the cost of capital. For this important reason, methods that incorporate the discounting principle can be more useful to decision makers. The Net Present Value method accounts for the time value of money and is more appropriate if the cost of capital needs to be re-invested or if the investment decision has to be made from mutually exclusive projects. O n the other hand, the Internal Rate of Return method, similar to the NPV method, provides a direct realistic comparison with the cost of capital and also can be very helpful when the investment decision can be made on two or more simultaneous projects. The usefulness of the four methods is examined on real investment opportunities that arise in the UK within the renewable energy upcoming industry. For the specific high-risk sector, the IRR method might be more appropriate although this result is by no means a generalisation of the usefulness of the different investment appraisal techniques. Furthermore, the discussion extents to the capital sources that firms use to finance their investments. It is argued that a firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s decision to increase debt capital in its capital structure should be accompanied by the ability to cover the firmsà ¢Ã¢â€š ¬Ã¢â€ž ¢ obligations to creditors. If a firm wishes to maximise the shareholders wealth, then the expected rate of return from investments that are financed with debt capital should not exceed the rate of return expected from investments financed with equity capital, otherwise the firm might face liquidation. References Arnold, G., (2002), Corporate Financial Management, (2nd edit.), Pitman Publishing Arnold, G., and Hatzopoulos, P., (2000), The Theory-Practice Gap in Capital Budgeting: evidence from the United Kingdom, Journal of Business Finance Accounting, 27(5) (6) June/July, p.603-624 Bratton, W., (2003), Corporate Finance: cases and material, (5th edit.), West Group publishing Brealey, R., and Myers, S., (1991), Principles of Corporate Finance, (7th edit.), Higher Education Publishers Dugdale, D., (1991), Is there a à ¢Ã¢â€š ¬Ã…“correctà ¢Ã¢â€š ¬Ã‚  method of investment appraisal, Management Accounting (UK), May, p.46-50 Dugdale, D and Jones, C., (1991), Discordant voices: accountantsà ¢Ã¢â€š ¬Ã¢â€ž ¢ views of investment appraisal, Management Accounting (UK), (November), p.46-50 Lefley, F., (1997), The sometimes overlooked discounted payback method, Management Accounting, vol.75, iss.10, (November), p.36 Lumby, S., and Jones, C., (2003), Corporate Finance: theory and practice, Thomson Publishers NIFES OPET (2000), Local community funds for sustainable energy investment projects: a technical briefing, (retrieved from www.cne-siar.gov.uk on 15/04/2005) Pike, R., (1996), A longitudinal survey on Capital Budgeting, Journal of Business Finance and Accounting, 23(1), (January), p. 79-91 Sangster, A., (1993), Capital Investment Appraisal Techniques: A survey of current usage, Journal of Business Finance and Accounting, vol.20, iss.3, (April), p. 307-333 Watson, D., and Head, A., (2003), Corporate Finance: principles and practice, (3rd edit.), Pitman Publishing 1 Deveraux Deloitte Footnotes [1] This is evident from a number of previous survey studies on what and for what reason firms select their investment appraisal methods. See Arnold Hatzopoulos (2000), Pike (1996) and Sangster (1993) [2] However, a discounted payback method is also available, see Lefley (1997), the analysis of which goes beyond the scope of this essay since this method is not broadly used.