Capital Budgeting Decision of Companies

In the given assignment, two sections of corporate finance have been given. 1^st part of the first section deals with the capital budgeting decision of the company and how the net present value calculation including inflation has to be done and the second part deals with the issues with the net present value technique and how the same can corrected (Belton, 2017). It also highlights whether or not present value technique is the best appraisal technique and is consistent with the goals of the firm. The second section of the assignment deals with the internal and external factors affecting the dividend policy of the company. For the purpose of the same, one of the companies Halma Plc has been used for analysis. The dividend policy of the company has been analysed from the annual report of the company for the last 3 years. The dividend relevance and irrelevance theories has been analysed for the same. 

1. The net present value of the given project has been computed using the various inflation factors which have been given(Werner, 2017):

(Amt in £)
Particulars	0	1 Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	2	3	4
Outflows:
Amount to be invested in non-current Assets	500,000	212,000
Amount to be invested in working capital	330,000
Incremental Fixed Cost	545,000	566,800	589,472	613,051	637,573
Overall outflows	1,375,000	778,800	589,472	613,051	637,573
Inflows:
Selling price per unit	22.00	23.10	24.26	25.47	26.74
Variable cost per unit	16.00	17.12	18.32	19.60	20.97
No. of units sold	120,000	120,000	120,000	120,000	120,000
Contribution per unit	6.00	5.98	5.94	5.87	5.77
Overall contribution	720,000	717,600	712,392	704,047	692,208
Working capital recovery					432,563
Overall inflows	720,000	717,600	712,392	704,047	1,124,771
Net project inflow/(outflows)	-655,000	-61,200	122,920	90,997	487,198
Present value @ 7.5%	-655,000	-56,930	106,367	73,249	364,814
Net Present Value of the project					-167,501

The above project should not be accepted as the net present value in the given case is negative. In case the net present value would have been zero or positive, then the project could have been accepted.

1. Issues involved in capital budgeting:The capital budgeting is one of the widely used investment appraisal techniques being used for assessing the organization’s long term objectives like those of implementation of new factory, machinery, equipment or new development projects or replacement options (Alexander, 2016). It also involves assessing what will be best source of financing the project and how the resources are going to be allocated to the projects. The primary goals of the capital budgeting decision includes increasing the profitability of the company and value of the firm and its shareholders. Some of the commonly used capital budgeting techniques include net present value, accounting rate of return, payback period of the project, discounted payback period, internal rate of return and modified internal rate of return and profitability index, etc. Most of these techniques are based on the calculations of incremental cash flow and the return on investment. However, the technique of capital budgeting suffers from a number of issues which has been listed below:
2. Independent vs mutually exclusive projects: It is very important to understand that whether or not the projects are mutually exclusive or are independent at the time of evaluation of the projects as it creates a lot of difference. An independent project is the one where the selection of one project does not precludes the other option whereas in the mutually exclusive project, only one out of the given alternatives can be selected(Bromwich & Scapens, 2016).
3. Capital Rationing: Capital rationing is the situation when the funds to be invested in the project on an overall basis during the given time period is limited and the company has various options for investment. Therefore, based on the inflows and the outflows the company needs to determine which all projects to invest in. the objective is to increase the profitability and the return for the company. Thus, at times, capital rationing can lead to rejection of even the profitable projects(Choy, 2018).
4. Project Sequencing: there are certain projects or ventures in which the investment is needed in a particular order or in a sequence. Such an order or a sequence may result in the acceptance of several projects. Suppose a profitable project now may result into profitable project an year later as well. Similarly, it may be that if the project is not chosen in a particular sequence or in an order the same might result into losses in some other projects for the company(Oberoi, 2018).

Besides all the above mentioned factors, there is always an element of uncertainty which is always there in the capital budgeting projects as the same is based on the forecasts. There are ways to mitigate these risks such as those of scenario analysis and the sensitivity analysis and simulation analysis. All these techniques are more or less the same with minor differences. They deal with “what if” questions and thus allows the managers to know what all changes in variables can be accommodated and what are the possible income conditions and outputs in all such scenarios (Dichev, 2017).  

Net present value combines all the outflows and inflows of cash at present values discounted at an appropriate rate of return. In case the same is positive the project is accepted as the same leads to value creation for the shareholders and in case the same is negative, the project may be rejected as the same is not financially feasible and it leads to erosion of the wealth of the shareholders. When the net present value is zero, it denotes that the project has broken even (Timothy, 2004). Net present value is by far considered to be the superior capital budgeting technique out of all the other options. This is due to the reasons mentioned below:

1. Net present value takes into account the time value of money. The concept of time value of money is very critical and significant in the capital budgeting and forecasting techniques as the money tends to depreciate over the period of time due to the effects of inflation, interest and risk over the project period. The only way to negotiate and take into account all those variable and give a correct picture of the assessment is to use discounting factor appropriately.
2. The process gives the absolute return on the project and is thus a measure of the actual surplus gained out of the given project. It thus, tends to fulfil the very objective of capital budgeting as it makes clear what would be value added to the shareholder’s wealth and value for the firm in a given time period(Jefferson, 2017).
3. There have always been debates on the profitability front and the cash flow front and it is very important that the project is profitable in terms on cash flow as well. NPC tends to overcome this issue as it is based on the concept of the cash flows and not the profits. It makes the process much more reliable as compared to the payback period and the internal rate of return which gives the absolute value.
4. The other good thing about NET PRESENT VALUE is that it takes into account the entire life of the project whereas some other techniques like those of payback period takes into account or considers only a portion of the project period(Heminway, 2017).
5. Lastly, it can be said that the technique of NET PRESENT VALUE is consistent with the goals of the firm which is basically the increase in the shareholder’s wealth. In case the discount rate being used reflects the required rate of return of the investors the NET PRESENT VALUE reflects the increase in the shareholder’s overall wealth.

Net Present Value Calculation and Risk Mitigation Techniques

The question discusses on the dividend policy of the company being used over the period of last few years. The question discusses on how the dividend policy of the company is impacted and affected by internal and external factors like those of industry to which it belongs to, the operating and financing decision of the company, the capital structure and the dividend policy of the past. The company being used for analysis is Halma Plc(Linden & Freeman, 2017). It is one of the technology companies which makes the products for life protection and hazards protection. It is one of the pioneer companies in London and is listed on the London Stock Exchange. It is also a constituent of the FTSE 100 Index. It was established in 1894 and has had a major series of acquisitions in the field of mechanical, electronic and electrical engineering sector. The company has four major sectors namely, Environmental & Analysis, medical, process safety and lastly Infrastructure safety.

The company’s present dividend policy is like the shareholders can either opt for the same in the form of cash payments or alternatively they can use their dividend payments to buy additional shares of the company using the dividend reinvestment plan (DRIP) which is being used majorly by many of the top companies off late. The process to opt for the same is that the registrar of the company “Computershare Investor Services PLC” should receive the applications for the same within 15 working days before the date of next dividend payment by the company (Dumay & Baard, 2017).

Going through the annual report of the company, it can be seen that the company belongs to the technology industry and the most of the companies in the same industry are offering the same policy and have adopted it because of the long term benefits that the plan has to offer. The company also has a long term progressive dividend policy which aims to provide consistent, sustainable and affordable growth together with maintaining a prudent level of dividend cover. The company’s aim has always been to increase the dividend amount per year with approximately 35-40% being paid as interim dividend. The company has had a clear and focused strategy all throughout these years and had made multiple acquisitions and also maintained the cumulative revenue growth of 11% (Kewell & Linsley, 2017). The company also had maintained the growth of nearly 5% in dividend and aims to maintain the same in the future. This has been incorporated in the new vision and mission strategy of the company named as Halma 4.0 growth strategy. IN terms of the reporting requirements of the company, the dividend payable by the company to the shareholders is being shown as a liability in the balance sheet in the period in which the same has been approved by the shareholders (Sithole, et al., 2017). The excerpt of the dividend being paid by the company over the last 2 years has been shown below and it clearly shows the increase in the dividend.

Dividend Policy Impact by Internal and External Factors

The company’s capital structure has been more of equity oriented as the company uses very less of debt and borrowings and more of equity in the capital structure. The same is evident from the debt equity ratio which has been near to 33% all throughout the past 3 years. This goes on to show the company believes in reinvestment of the profit and therefore the same option has also been given to the shareholders. It not only helps in multiplying the value of the company and the shareholders as a whole but also helps the company in not losing and diluting the ownership of the company (Fay & Negangard, 2017).

The company’s past dividend policy plays a very major role in deciding the dividend policy for the future as it is the base and gives the company and management the idea as to whether or not the same has led to growth. In the given case, the company has proven results of the past that dividend reinvestment has reaped rich results for the company and it has been able to grow annually in terms of dividend payment and enhancing of shareholder’s wealth. Thus, it can be said that all the three factors namely the industry in which the company operates, the company’s operating strategies and capital structures and the company’s past dividend policies affect the selection of the dividend policy a lot (Marques, 2018).

Pay-out policy of the company is defined in different ways in which the company decides to pay off the free cash flows to the equity holders. There are various options available with the company, some of them are reinvestment or can also be paid to the equity holders. Again, in case the same is retained, it can either be invested in the new projects by the company or can help in increasing the cash reserves of the company. On the other hand, in case the company opts for pay out, the same may be paid as dividends and the shareholders can be asked to repurchase the shares. Dividend is a part of the profit or earning of the company that is being distributed amongst the shareholders(Covaleski, et al., 2003). There has always been one debate and controversial question as to whether the dividend policy of the company is relevant and it adds value to the firm’s value. As such the dividend relevance and dividend irrelevance theories were being devised. As per the dividend irrelevance theory, Modigliani-Miller (MM, 1961) states that the dividends do not affect the firm’s value and investors do not care about the pay-out value. They advocate that it makes no difference if the projects are being financed through reduction in dividend pay-out or through outside sources. However, the same is based on some of the unrealistic assumptions which do not hold goods as they are based on perfect capital market where there are no taxes and no brokerage or transaction costs (Vieira, et al., 2017). But in the real world, taxes do play a major role as huge taxes are being imposed on the dividend distribution and hence the companies prefer to reinvest the same. In the given case, Halma’s dividend policy is in line with the dividend relevance theories as the company has been giving an option to the shareholders’ to either opt for the pay out or to reinvest the same by buying additional shares. The company does considers it relevant due to the free cash flow impact and the taxation impact. In case the company is not paying off the cash to the shareholders, the cash would be left unutilised.

Halma Plc: Engineering Company and Dividend Relevance

From the above discussion and analysis, it is evident that the capital budgeting do have some issues which can be sorted through some of the procedures and net present value is undoubtedly one of the best and probably the superior technique over all the other capital budgeting techniques. Furthermore, the dividend policy of the company do gets affected by a number of factors and it depends on the plans of the company as to whether to reinvest the same or to pay off the same.

References 

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