Accounting and Financial Management


Business investment in most cases depends on the financial position and performance of a company. In some situations, companies have carried out investment decisions with less evaluation and analysis reports and in the end, results have been negative and detrimental to the business. Therefore, any kind of investment, be it expansion of the business, acquisition or merger needs detailed analysis of both external and internal environment of the business. This is normally compounded by financial reports that utilized financial ratios in making decisions. Therefore, this assignment is divided into three parts dealing with different sub-topics but all related to business investment and financial performance.

Part A

Making decisions in an organization concerning the future or performance of business largely relies on accounting ratios (Marriott, Howard and Mellett, 2002). The provided accounting ratios concerning the two companies; Harry Ltd and Devra Ltd provide the company with an opportunity to gauge the cost and benefit of take over of one of the companies or two of them at ones. Return on capital employed (ROCE) is widely used as a means of assessing the performance of a business (Gowthorpe, 2005).

The two ROCE of the companies indicate that performance of Harry in terms of returns on employed is far better than Devra Ltd. If this was the only yardstick of consideration for takeover, then it would be prudent for the company to go for Harry Ltd since profitability health of the business seems to be okay (Banjerjee, 2005). But other factors need to be put into consideration to provide wide overview and evaluation of the two companies before a decision is reached at. Return on equity is a ratio that generally indicates or determines the market value of the equity share, that is, the price at which it can be sold in the market (Brunner, 1975).

Comparison between the two companies on the performance of equity capital clearly shows that Harry Ltd shares perform better than Devra Shares in the market. As a way of analyzing this it can be stated that the overall performance of Harry Ltd and market confidence investors have in the company shows the likelihood of good performance if the company was to be taken up (Kwok, 2008). Debtor turnover ratio can also be used to assess then performance of a company in which case the period of time taken by debtors to make payments is important to a business (Brunner 1975). Debtors paying in time or as fast as possible are important to the continuity of business as compared to debtors delaying in their payments. In general, shorter term collection period, the better is the quality of debtors as short period implies quick payment of debtors (Brunner, 1975).

Higher payment period on the other hand imply inefficient collection performance which in turn affect the liquidity or short-term paying capacity of a company out of its current liabilities (Brunner, 1975). In this case, Devra Ltd performs better than Harry Ltd in terms of debtor settlement.

With regard to creditors’ turnover ratio, it is always assumed that the lower the ratio, the better is the liquidity position of the company and higher the ratio, less, liquidity is the position of the company (Brunner, 1975). As a result, Devra Ltd has a healthy creditor’s turnover ration than Harry Ltd. Current ratio of the two companies express the ability of the companies’ capacity to meet their short-term obligations (Brunner 1975).

The higher the ratio the more protected are the short-term creditors and also this may mean the company is in a good position to pay its creditors. Devra Ltd has its short-term creditors protected and more so it has capacity to pay its creditors than Harry Ltd. With regard to acid test ration, Harry Ltd and not Devra Ltd has high capacity of its assets being converted into cash and this shows how financial liquidity of the two companies can be part of the decision to acquire one or two of them (Brunner, 1975). Price earning ratio (PER) of the two companies also indicate the financial performance of the two companies and the overall investor confidence (Brunner, 1975).

In this case, Devra Ltd shares performs better than Harry Ltd shares and in making predictions then it is clear that Devra shares are likely to perform better than Harry shares. In terms of gross profit margin, fixed asset turnover, capital gearing ratio and net profit margin, it seems Harry Ltd performs better than Devra Ltd and during take over this should be the basis of evaluating financial performance of the companies. In summary, take over decision should be based on a multiplicity of factors both internal and external. The business should fast evaluate its past performance, current position and the future needs into making the decision to take over the companies. At the same time, financial performance of the company together with financial performance of the two companies should be compared to ensure the company is in position to realize its financial goals without compromise.

Part B

Investments are of different types and in general, there exist three major categories of investments. The three are physical investment such as the real property and machinery; financial investment such as the stocks and shares in various companies; and the intangible investments such investment in employee education, research and development (Rohrich, 2007). Given the existence of different types of investments, on principle it has been expressed that investment appraisals can be made regardless of how the investments are classified (Rohrich 2007). Therefore, it can be stated here that when companies decide to make investments there are various standard techniques which can be adopted and enable companies to compare projects by considering differing measurement criteria. Therefore this research paper will discuss three main methods of investment appraisal techniques and further evaluate which of the methods might best be used to create shareholder value.

Payback (PB) appraisal method

Payback period can be seen as the length of time taken for the inflows of cash to equal the original cost of investment (Lumby, 1988). As a result, the method looks at how quickly the initial investment is recovered. Research that has been done indicate that payback method of investment appraisal is the widely used technique (Lumby, 1988). A company using payback technique usually has in mind a period over which it feels or approximate a particular investment should be recovered and when a project seems to have payback period within this time approximation then the company is likely to accept the project. Generally, payback method has been used as a guide to investment decision making in two ways. First, when a company is faced with a straight accept-or-reject decision, then this method has the ability to provide a rule in which projects are only accepted if they payback the initial investment outlay within an estimated appropriate period of time (Lumby, 1988).

Furthermore, this method has the capacity to provide a rule when a comparison is required involving relative attractiveness of several equally and exclusive investments (Lumby 1988). In the second case, company may rank projects in terms of how fast such projects are likely to payback and the fastest paying-back projects get the node of the investors while the slowest paying-back projects are least favored. As a result, the project that exhibit high chances of paying-back within the shortest period of time is chosen for investment.

Some reasons (advantages) have been given as to why this method is preferred by many companies. For instance, the technique is regarded to be easy to calculate and more so understand (Pogue, 2010). Also, as a result of putting a lot of focus on early payback, there is always likelihood of enhancing liquidity while at the same time providing an estimate of the time the initial investment capital will be available for other investments (Pogue, 2010). Such undertakings may be important and critical especially when the financial capacity of the company experiences limited capital resources. Another advantage of the method is that projects that have longer payback periods can be regarded as more risky largely on the basis of greater uncertainty (Pogue 2010).

At the same time, payback method has been regarded to exhibit some weakness: the tendency of the method to ignore the timing of cash flows within the payback period and its tendency to ignore the cash flows once the payback period has been reached (Pogue, 2010). With regard to creating shareholder value, it has to be remembered that maximization of long-term shareholder wealth involves maximizing the market value of the company’s shares. Shareholder value can be created from the projects that exhibit the ability to give better returns whether in the long-run or in the short-run provided there is an overall positive return on the whole project. With payback method, it must be noted that for large investments, this method can be successfully only as an initial screening device before more powerful methods of appraisal are adopted.

Accounting rate of return (ARR) method

This appraisal method assumes numerous names and one such name is the return on capital employed-ROCE (Lumby, 1988). Due to presence of numerous names there exist a wide variety of different methods of computation. ARR method is where there is the calculation of ratio of the accounting profit earned by an investment project to the required capital outlay and normally expressed as a percentage (Lumby, 1988).

Variations normally occur by using this method of appraisal in calculating the two figures but in normal situations it has been recommended that profit calculation should be done after depreciation but before any allowances for taxation are made (Pogue, 2010). Further there should be the inclusion of capital employed and any increase in the working capital especially the one that would be required if the project was accepted (Pogue, 2010).

Expressing ARR can be done in two major ways: expressing the ratio of average annual profit realized over the life of the project, to its average capital value (Pogue 2010). The second one is the express the average annual profit as a ratio of the initial outlay (Pogue, 2010). Further it should be noted that ARR in its operation use accounting profits instead of cash flow that are used in other techniques and once the estimates have been generated, there is always a comparison between the ARR of the proposal and the required rate of return that the company has established.

ARR has become popular due o certain advantages the method exhibit. First, ARR is easy to calculate and interpret where expression of percentages makes it to make decision (Akalu, n.d). Also in making the calculations, the whole life of the project is put into consideration unlike in the case of payback method. Nevertheless, the major identified weaknesses of this method lie in the fact that the use of accounting profit and capital employed sometimes become problematic. This is especially due to various alternative measures for capital employed. Another weakness has to do with time, where unlike with payback method, ARR ignores the time value of money (Akalu, n.d).

In terms of this method creating shareholder value, there is always the need of the company to evaluate its expected rate of returns over a period of time. Further, the following line of advice has to be incorporated in the event that management team may be making decision. ARR has been found to be unsuitable method in the evaluation of multiple projects with different lives (Akalu, n.d). More so, the method demands and requires management to set a target rate of return as a prerequisite to apply the method. Furthermore, in a number of studies that have been carried out in USA and UK it has been established that ARR is negatively correlated with new technology projects (Akalu, n.d). As a fact, ARR has been suggested to be only appropriate when projects cash flows take stochastic rather than deterministic behavior (Akalu, n.d).

Net present value (NPV)

NPV constitute one of the discounted cash flow techniques. In essence, cash flow techniques are characterized by the process of including an adjustment for the time value of money achieved largely through the process of discounting (Ammon, 2009). This technique in large measure converts future cash flows to current value and through this it becomes possible to make a comparison with the initial outlay of the project (Ammon, 2009). NPV in its usage generally forecast cash flows a particular project is likely to realize and these forecasts are always converted into present value (Ammon, 2009). As a result NPV is the difference between the projected discounted cash inflows and discounted cash outflows (Ammon, 2009).

In this way, a decision to pursue with a project only become relevant and accepted when such projects exhibit positive NPV. Consequently, projects with negative NPV are done away with. In terms of shareholder wealth value, it should be noted that the use of NPV as an evaluation technique is usually consistent with the objective of shareholder wealth maximization. This is so because a positive NPV should, in normal circumstances, be able to produce an equivalent increase in shareholder wealth (Ammon, 2009).

Part C

For a long time many business entities have manifested a unique character of being self-reliance whereby the businesses normally rely on internal sources of funds to fund their investments (Smith, 2002). Such internal sources always include retained earnings and capital consumption allowances (Yescombe, 2002). When it comes to funding major projects in the business it normally dawns on management teams that internal sources of finance become inadequate and as a result external funding for the projects must be explored (Botha, Goodey, Lotter and Nortje-Roussouw, 2007).

External funding has become a necessity especially to businesses that experience robust growth that in most cases internal source of funding may not be enough for the projects (Melicher and Norton, 2010). In most cases, the proportion of internal to external funding varies according to the business cycle where during economic expansion; businesses in most cases rely on external funds while in economic contraction businesses rely on internal sourcing (Melicher and Norton, 2010).

Businesses are seen to go through different stages in their growth process and in each growth stage the business require funding from different sources (Weaver and Weston, 2007). For instance, during the start-up stage the business finances its projects largely from personal savings, personal loans, and government agencies (Weaver and Weston, 2007). During the rapid growth stage (second stage), the business relies on finances realized through internal sources or direct financing. Direct financing can be obtained in forms of loans from commercial bank, insurance company or pension fund (Smith, Merna and Jobling, 2006; Finnerty, 2011).

At the same time the business can obtain the finances from private equity placement with venture capitalists. In the third growth stage, the business growth is defined to be mature and financing of business projects may take place through going public and also through money and capital markets (Weaver and Weston, 2007). As a result, investment banks become key sources for finance during this period of growth. The last stage is the firm’s final phase in which case the business is seen to be mature and its major operations may be in decline. As a result, the finance sources for projects largely come from internal sources while repaying the debts and also from repurchasing of its shares (Weaver and Weston, 2007).

Direct financing was seen as one of finance sources for business in the early stages of growth. Avenues for direct financing were identified as commercial banks, insurance companies and pension schemes. Direct financing may be appropriate given the following advantages. First, seasonal short-term borrowing can be dispensed with and through this there can be reduction in the danger of non-renewal of loans or substantially higher interest rates (Weaver and Weston 2007). Also, through direct financing, the business has the capacity to avoid the expenses of Securities and Exchange Commission registration and the investment banker’s distribution (Weaver and Weston, 2007).

On a further note it should be stated that with direct financing, little time is always required with regard to obtaining loan as compared to time involved in bond issue (Weaver and Weston, 2007). Lastly, through direct financing unlike in bond holding, the borrower has the flexibility to modify the loan agreement in what is normally referred to as ‘indenture’ (Weaver and Weston, 2007).

Disadvantages of these financing sources include: interest rate may be higher on term loan as the lender has no time to review the borrower’s status effectively; the cash drain is always large due to regular amortization (Weaver and Weston, 2007). With direct financing, there are more credit standards instituted such as the requirement for borrowers to have strong financial position and also have current ratio, low debt-to-equity ratio, good activity ratios and good profitability ratios (Weaver and Weston, 2007).

It was further seen that businesses can obtain funding from private equity placement with venture capitalists. In most cases, firms that have capability for high growth are faced with greater risks, and due to their higher risk, such businesses require special types of financing (Weaver and Weston, 2007). Venture capitalists (VC) are some of the best finance sources for such businesses and in majority of cases VC are organized as partners (Metrick and Yasuda, 2009).

Sources of VC funding are numerous: investment banks and commercial banks that have established VC subsidiaries; VC specialists; ‘angel’ financing where some individuals with a lot of wealth carry out VC activities and lastly some wealthy and established business firms act as VC (Weaver and Weston, 2007).

Before a business can be accepted for VC, it has to go through vigorous examination and also Board advice plays key role in accepting or rejecting the application. Given that long-term business investment are likely to realize positive returns in future VC may be appropriate especially where the business is in need of financial, technical and human resource capacity. Such key aspects for the growth of business are likely to be realized through VC lending (Metrick and Yasuda, 2009).

Going public by listing to the stock exchange is another way a business may obtain funds for its long-term projects. Before going public, businesses are required to carry out thorough and efficient internal business analysis to identify the strengths and how to maximize and also the threats and how to minimize them (Weaver and Weston, 2007). A number of advantages exist that a public listing business may obtain such as: there will be more funds generated for the long-term projects; the disclosure and external monitoring may make it easier to raise additional funds and also listing led to lowering the required return, cost of capital as the exchanges content (Weaver and Weston, 2007).


Through the research it has been established decision to invest largely depends on various factors that a business needs to put into consideration. Financial capacity of the business is key among the factors to influence investment decisions. Before investments can be made there is need to decide on the appropriate investment appraisal technique that goes in line with business goals and market environment. Further making investment especially long-term investments require capital and this may require business to seek finance from different sources. In summary, the research has at best tried to deal with all key requirements and may influence future decisions in business investment if its adoption and implementation will be accepted.

Reference List

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Ammon, F., 2009. Financial Report to the Board of Directors of Arkle Plc: A Report about the Role and Nature of Financial Management, the Capital Structure and the Cost of Capital as Well as Investment Appraisals. Germany: GRIN Verlag. Web.

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Brunner, B., 1975. Six days to Sunday: A novel. New Delhi: Tata McGraw-Hill Education. Web.

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Rohrich, M., 2007. Fundamentals of Investment Appraisal: An Illustration Based on a Case Study. Oldenbourg Wissenschaftsverlag Publishers. Web.

Smith, N.J., 2002. Engineering project management. MA: Wiley-Blackwell. Web.

Smith, N.J., Merna, T. and Jobling, P., 2006. Managing risk in construction projects. MA: Wiley-Blackwell. Web.

Weaver, S.C. and Weston, J.F., 2007. Strategic financial management: applications of corporate finance. OH: Cengage Learning. Web.

Yescombe, E.R., 2002. Principles of project finance. CA: Academic Press. Web.

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