http://www.my-course.co.uk/mod/hsuforum/discuss.php?

d=85144

As Dilbag mentions, managers need to wisely decide the organizations long-term financing
balance between equity and debt by assessing the costs and benefits associated with each source
of funding. Companies which are imbalanced towards excess debt financing might not be able to
repay its cost of capital and therefore be burden in debt. On the same time, it is quite unlikely
that a company will be able to finance its growth solely by equity capital (Marx, 1998).
Additionally, funding by equity may not only be advantageous to the organization funded but
also to the investors who source the funds. As presented in McLaney & Atril (2014: 416),
investors can potentially yield higher returns when a company is financed by equity capital,
while expected returns to investors are less with financing on loan capital.

An interesting relationship between equity and debt financing is presented in McLaney & Atril
(2014: 418). Data collected by Financing Statistics about UK companies, reveal a negative
correlation between the two sources of financing before 1997 (i.e. when total equity financing
increases, loan financing decreases), while after 1997 the two sources of financing move in the
same direction. From this we can infer that before 1997 companies favored one source over
another (as the graph shows, equity was favored over debt), while after 1997 UK companies
choose to capitalize on both sources simultaneously and thus their favorable source of financing
is a mixture of equity and debt. Finally, the data show that despites the advantages present by
equity sources of finance, for the majority of time funding sourced by loans is favorable.

What does the class thinks about the drivers behind these relationships?

References

Marx, L. (1998). Efficient venture capital financing combining debt and equity.
Review of Economic Design , 3 (4), 371-387.

McLaney, E., & Atrill, P. (2014). Accounting and Finance: An Introduction. London:
Pearson 7th Edition.
http://www.my-course.co.uk/mod/hsuforum/discuss.php?d=85103

As it is seen in the discussion forum so far, a number of disadvantages are associated with capital
sourced by loans, which may reveal that equity source of capital might be advantageous and thus
companies should favor it. It has been reported that banks have tighten terms on loans after the
financial crisis of 2007/2008 (Guha, 2009). This makes it more difficult for organizations to be
financed on debt and collateral security measures become stricter. This greatly affects small to
medium sized companies, which have limited assets to use in order to back their loans.
Therefore, such companies are presented with limited opportunities in the debt capital markets
and in any case have to favor equity as their major, long-term source of capital.

However, as Carla correctly mentions, equity capital financing comes with its disadvantages such
as surrender of some control over operations to new shareholders. This means that managers
have less flexibility to steer the organization as they see fit, but need to work within the margin
that is set by the shareholders. Moreover, equity capital markets also involve costs for companies
which wish to secure funding. Raising equity involves legal, accounting, and investment banking
fees, which eat up at least three to five percent of the amount raised (Hamburg, 2009).

Managers face the challenging question which is deciding the source of finance their
organization utilizes. A quick outlook on the pros and cons of each source of finance indicates
that debt source of capital may introduce a number of disadvantages and therefore companies
should always favor equity as a source of finance. However, in a deeper review of the subject, it
can be seen that equity also has a number of disadvantages, which means that the decision about
which source of finance cannot be taken on theoretical grounds but depends on a companys
current situation.

References

Guha, K. (2009, November 10). Fed survey says banks tighten loan terms. Financial
Times .

Hamburg, J. (2009, December 5). Raising Capital: Equity vs. Debt. Bloomberg .
http://www.my-course.co.uk/mod/hsuforum/discuss.php?d=84980

There is an interesting debate about if equity should be a favorable source of finance. This
assumes that a company, through its managers, is presented by a choice as to which source they
wish to use for raising long-term funding. However, in many cases this cannot be decided by the
managers of an organization, but it is dictated by the industry within the organization operates.
Continuing from Claudias question about types of businesses using a specific financing
structure, an interesting point is revealed.

For example, during the tech-boom, software and other technological companies could easily
secure equity funds as there was a high supply of institutions such as venture capital companies
which were very interested to invest in the industry. On the same time, the same companies had
limited options to secure capital in the debt markets as their assets were intangible and thus could
not be used as collateral for sustainable loans (Brown et. al., 2009).

Additionally, companies within capital-intensive industries such as the oil and gas industry are
required to raise significant funds to cover the high CAPEX of their operations. Such companies
find debt source of funding better suited to their long-term needs, as they can easily use their oil
fields as collateral in order to receive loans with low interest rates (Weijermars, 2011).

In conclusion, which source of finance should be favored by companies largely depends on the
industry in which companies are in. As presented, in capital intensive industries loans should be
the favored source of finance, while in emerging industries equity should be favored as a source
of finance.

References

Brown, J., Fazzari, S., & Petersen, B. (2009). Financing innovation and growth: Cash
flow, external equity, and the 1990s R&D boom. The Journal of Finance , 64 (1), 151-
185.

Weijermars, R. (2011). Credit Ratings and Cash-Flow Analysis of Oil and Gas
Companies: Competitive Disadavantage in Financing Costs for Smaller Companies in
Tight Capital Markets. SPE Economics & Management , 3 (2), 54-67.
Unit 7 examines the various options available to companies for long term funding. It
was seen that businesses can raise capital either from equity sold or loan taken and the
ratio between equity and debt defines a companys capital structure. Both types of
finance sources have their advantages and disadvantages and the debt-to-equity ratio
needs to be carefully and correctly decided by managers. Additionally, the debt-to-
equity ratio may sometimes be dictated by the industry within company operates and
thus managers have little control over choosing financing channels. For example,
software companies during the tech-boom could secure significant capital by selling
equity, while on the same time could not secure loans due to having intangible assets.

In Unit 8 various methods of capital investment appraisal were assessed. Net Present
Value (NPV), ARR (Accounting Rate of Return), Payback Period (PP) and Internal
Rate of Return (IRR) are the four basic method used by organizations to evaluate
investment opportunities and assist managers in making investment decisions. It was
also seen that each method has its uses and drawbacks and thus managers may need to
well understand the above metrics and also employ a combination of analyses before
making a decision.

I found NPV analysis very interesting as I think it provides clear guidelines to

managers and it is applicable in almost any situation. The final rule for NPV is simple;
If its positive then the investment will add value, which simplicity was striking. In my
future work, I intend to employ this technique when assessing investment decisions.
Many variables such as risk and inflation, can be accounted for within this method
and thus results can become very accurate. This technique alongside with good ideas
and organization may provide the edge when I come to the position of managing
various projects.
Investment appraisal in capital accounting has been characterized as an ineffective approach an
organization can utilize to realize customer and shareholder value as well as organizational
competitive position (Langfield-Smith, 2008). The author argues that it is because investment
appraisal encompasses developing long-term project cash flows wasting valuable time for the
firm. The investment appraisal approach assumes that net cash inflows that originate from long-
term projects can be reinvested to yield a similar outcome in value of returns; however, this
assumption is not feasible.
Additionally, NPV is usually assumed as the foreseen return for a project, when the appraised
return is high than the pre-established target then the approach becomes feasible. However, if the
result is lower than the target, then the project is determined as not feasible. Moreover, the
approach may fail to realize potentially profitable outcomes in the future since it assumes the
relative size of investment.
A study by (Bennouna et. al., 2010: 225) suggests that investment appraisal approach does not
account for the annual return from capital investment and ignore the intermediate cash flows,
which cannot be reinvested in equal measures to yield similar project outcomes. Therefore, the
author admits that using the investment appraisal approach cannot be effective to warrant an
organization customer and shareholder value and a competitive advantage. It is built on the fact
that the outcomes of invested capital returns will certainly yield lower profits in the actual than in
theory (Bennouna et. al., 2010: 225).
In my opinion, although investment appraisal methods are criticized as being ineffective, they
still provide valuable insights to managers when it comes to choosing between investments,
which is the reason they have been long used. Managers commonly use their gut-feeling
alongside investment appraisal methods, probably to cover for the inefficiencies of the methods
themselves.

References

Bennouna, K., Meredith, G.G. and Marchant, T., 2010. Improved capital budgeting
decision making: evidence from Canada. Management decision, 48(2), pp.225-247.

Langfield-Smith, K., 2008. Strategic management accounting: how far have we

come in 25 years?. Accounting, Auditing & Accountability Journal, 21(2), pp.204-
228.
Investment appraisal methods may be considered as waste of time as they cannot evaluate
investments with absolute certainty. Firstly, investment appraisal calculations do not accurately
take in consideration future costs, which also vary with the decision taken. In addition, the above
methods do not consider the advantages and disadvantages associated with opportunity costs.
Furthermore there are many other factors such as taxation, interest rates and non quantitative
factors, which increase the complexity of investment appraisal techniques and thus the accuracy
of forecasted results may be questioned (McLaney & Atril, 2014).

Further to the general uncertainties associated with investment appraisal methods, each method
has its own limitations which raise further questions about the usefulness of these techniques.
For example, payback period (PP) and accounting rate of return (ARR) are not directly related
with shareholders wealth and also do not take into account the time value of money (McLaney
& Atril, 2014). Based on the number of limitations, the accuracy of investment appraisal
methods may be challenged as time waste for organizations (Gtze et. al., 2015).

In my opinion, although investment appraisal methods accuracy is criticized, there methods

which enable organizations to quantify the uncertainty associated with the results. For example
Monte-Carlo simulation is used in many industries for the evaluation of investment projects. In
the simulation, many factors can be taken to account which lowers the uncertainty related to
investment decisions (Savvides, 1994).

References

Gtze, U., Northcott, D., & Schuster, P. (2015). Investment Appraisal 2nd Ed..
Chemnitz: Springer.

McLaney, E., & Atrill, P. (2014). Accounting and Finance: An Introduction. London:
Pearson 7th Edition.

Savvides, S. (1994). Risk analysis in investment appraisal. Project Appraisal , 9 (1),

3-18.
Payback method can be an effective and widely used approach toward the realization of strategic
objectives in accounting, despites the fact that it ignores the time value of money and total return
(Bennouna et. al., 2010: 225). Ideally, most professional accountants utilize this method for their
capital budgeting alternatives since its underlying principles are easy to master and results can be
easily communicated with managers and investors (Langfield-Smith, 2008:217). In simple terms,
the payback method indicates to an organization the time it would take to recover viable
revenues in any investment option.

The payback method is particularly used by small organizations which do not have the means to
utilize more complex and expensive techniques. Moreover, the same type of companies even find
it an effective method, as their liquidity is low and their project completion periods short and
thus the time value of money does not practically affect their investment expectations
significantly. In essence, the chances of risk occurrence in realizing returns reduce significantly
due to the short scope of the projects and therefore there is high probability that the expected
investment outcome is as dictated by the payback method, making it a useful technique despite
the limitations previously mentioned (Langfield-Smith, 2008).

However, as the method ignores the aspects of time in value for money a firm may fail to
recognize long-term benefits since long range planning on capital investments becomes
comprised. Also, the method does not integrate more sophisticated investment appraisal
techniques such as NPV despite the additional benefits associated with the later. In conclusion,
the payback method is a useful tool, as long as a more accurate technique cannot be used and the
scope of the project is short.

References

Bennouna, K., Meredith, G.G. and Marchant, T., 2010. Improved capital budgeting
decision making: evidence from Canada. Management decision, 48(2), pp.225-247.

Langfield-Smith, K., 2008. Strategic management accounting: how far have we

come in 25 years?. Accounting, Auditing & Accountability Journal, 21(2), pp.204-
228.
A survey of UK business practice presented in McLaney & Atril (2014: 564) suggest that
payback method is the second favorable method among other investment appraisal techniques for
non-strategic projects and third for strategic projects, as evaluated by 83 financial managers. The
reasons behind the popularity of the payback method, despite the fact that it ignores the time
value of money and total return, are numerous. It is not just the simplicity of the method that
makes it favorable in many cases, but also the scope through which the method evaluates cash
flows. For example, as the method is only concerned with the project period that leads to the full
payback, the future cash flows after that period are no longer required to be forecasted which
means that the limitations and disadvantages associated with forecasting are avoided. Moreover,
the technique gives emphasis on the short-term cash flows, which are known with a higher
accuracy (Boardman et. al., 2014).

In my opinion, managers need to utilize a combination of investment appraisal techniques to

guarantee a higher accuracy for decision making, which is also supported by the survey
mentioned above, with 98% of managers saying that they use more than one method before
making investment decisions. A manager who only uses payback method may be criticized for
having lack of sophistication and he is more prone to taking inaccurate decisions. For example,
the payback method makes no consideration about increasing wealth, which is always a priority
for any organization. Lastly, even though the statement in question is indeed correct i.e. payback
is a valid method of investment appraisal despite ignoring the time value of money and total
return, this doesnt mean that it is the best method to be used as the advantages of other methods
over the payback method are numerous.

References

Boardman, M., Reinhart, J. & Celec, E., 1982. The role of the payback period in the
theory and application of duration to capital budgeting. Journal of Business Finance
& Accounting, 9(4), pp.511-522.

McLaney, E., & Atrill, P. (2014). Accounting and Finance: An Introduction. London:
Pearson 7th Edition.