Investment Appraisal in Business

INTRODUCTION

In the contemporary business environment, companies have adopted various strategies for improving business efficiency and profitability. For this purpose, management uses different kinds of investment appraisal approaches for the attainment of long term business goals. This report evaluates different investment appraisal approaches for assessing best investment decisions (Ball, Li and Shivakumar, 2015). In addition to that this report also examines different risks factors that could be addressed in investment decisions. Furthermore, this report is going to evaluate the impact of exchange rates and corporate tax on international investment decisions.

1. Explaining the investment decisions with reference to different investment appraisal tactics such as net present value, payback period and average rate of return

Firm leadership is focused on an investment decision in which management has considered three investment proposals such as Investment option A (100% investment of Chinese manufacturing company), Investment option B (100% investment of Brazilian manufacturing company) and Investment Option C (100% investment of British manufacturing company).

1. Net present value

It is termed as the most important tool for evaluating investment proposals. According to this approach, an organisation considers the net present value of future cash inflow with reference to a certain discount rate (Pacter, 2014). This approach assists an organisation in conducting a comparison of the net present value of different investment proposals.

Calculation of net cash flow of Investment Option B

Calculation of net cash flow for investment Option C

With reference to the above calculation, the Investment option A (100% investment of Chinese manufacturing company) is offering higher Net present value as compared to other projects (Barth, Landsman, Young and Zhuang, 2014). In this context, it has found that investment in Brazilian manufacturing company will offer negative net present value and Option C is offering lower NPV as compared to investment Option A.

2. Payback period

The approach of the payback period is found very effective for analysing time duration in which the whole initial investment would be recovered. By considering this investment appraisal approach, top management is able to estimate project duration and profitability (Fiechter, Halberkann and Meyer, 2018). This information has found very effective for examining the long term investment decisions.

As per the analysis of the payback period of different investment options, the payback period of investment Option A is lower than the payback period of the other 2 option. The comparison of Option A and Option B has shown that Option A will recover the whole initial investment 2.41 years and Option B will recover its investment within 5.10 years.

3. The average rate of return (ARR)

The approach of the average rate of return has found very effective for evaluating the profitability of different investment proposal. This information assists an organisation in order to estimate future returns and profitability (Raffournier, 2017). It assists managers in the selection of best project as per the requirement of the company

Calculation of ARR for investment Option A

Calculation of ARR for investment Option B

Calculation of ARR for investment Option C

The above calculation of the average rate of return (ARR) has found that Investment Option A, B and C is offering 57%, 22% and 10%. In this context, it has evaluated that investment option in a Chinese manufacturing firm is offering the highest return on investment due to higher ARR. Therefore, investment proposal A will offer higher earnings. For managing growth of business, a leadership team has considered three investment projects such as Investment option A (100% investment of Chinese manufacturing company), Investment option B (100% investment of Brazilian manufacturing company) and Investment Option C (100% investment of British manufacturing company) with reference to different approaches of investment appraisal such as NPV, Payback period and Average rate of return (Ramirez, 2015). In this context, Investment Option in a Chinese manufacturing company will be most appropriate because it will offer higher net present value and the average rate of return. This investment option will recover initial investment in less time duration as compared to other projects such as Brazilian manufacturing company and British manufacturing company.

2. DISCUSSING AND EVALUATING THE VARIOUS RISKS ASSOCIATED WITH INVESTMENTS A, B AND C

For the French manufacturing company, various investment proposals are examined for outsourcing business operations. For this purpose, the company is examined three different projects that include 100% investment of Chinese manufacturing company, 100% investment of Brazilian manufacturing company and 100% investment of British manufacturing company. In this regards, the evaluation of different risk factors is carried out below that could be faced by a French manufacturing company (Gotze, Northcott and Schuster, 2016):

Political risk

Political risk is being termed as government interference in the business operations in various companies that are doing business in a particular country. If the management of French manufacturing company considers Chinese manufacturing firm for outsourcing business operation then than the management of business entity could address a unique form of political risk that could be occurred in the business operations within China (Harris, 2017). In China, there is constant battle addressed between the country’s central government and the local governments over the applicability of law along with observance or non-observance of different regulations. These issues between central and local government are creating several difficulties for companies operating in China because companies are addressing various issues due to continuous change in government rules and regulations (Higham, Fortun and Boothman, 2016). Therefore, it can be stated that the French company could address several issues while expanding business with investment in a Chinese manufacturing firm. Therefore, these difficulties would lead to several issues for new companies. For managing the business expansion, the management of French manufacturing company has also considered Brazilian manufacturing company as an investment option. Therefore, there is a wide range of political risk identified for the business in Brazil. In this context, it is examined that Brazil is being considered a developing nation and also interpreted as a precursor for ‘high growth levels, But, several areas of the economy of Brazil has remained underdeveloped (Throsby, 2016). In the context of Brazil, political policies based on consumer base, regulatory environment along with the sphere of investment are not attained maturity level that must be similar to developed nations. In addition to that Bureaucracy is termed as the most important political barrier in order to promote business practices within nations. It has found that The reform of the laws and regulations for opening and running a business in Brazil has not been adopted at the rate with which the economy has grown, presenting many hurdles to overseas corporations (Schlegel, Frank and Britzelmaier, 2016). As per the current market trends, the French manufacturing company has also considered a British manufacturing company for investment proposal. However, companies are addressed several political risks that are associated with interstate conflict, the failure of national governance along with the outbreaks of nationalism that are covered all part of the geopolitical landscape (Warren and Seal, 2018). All these are having a great impact on the overall business performance and economic outcomes of companies. In addition to that stability in the UK sometimes breaks down after crumbling gradually and frequently collapsed with little warning. This political situation leads several losses for investors, lenders and contractors due to the collapse of the business. Therefore, it can be stated that political risk factors play the most important role in creating barriers in business growth and development.

Cultural risk

In the business decision-making process, the culture of the country is having a significant impact on business efficiency. The culture of nations is associated with the perception of people, beliefs and religion. In the present case, business entity evaluates different investment proposals such as Chinese manufacturing company, Brazilian manufacturing company and British manufacturing company in different locations. For this purpose, the French organisation has to consider cultural aspect or risk factors (Abdel-Kader, Dugdale and Taylor, 2018). In this regards, it has found that the culture of China is significantly influenced by communism. It is examined that Chinese leaders, as well as business managers, expect obedience of their subordinates without any question. Therefore, an important concept of the master is termed as “face.” Face represents a person’s reputation as well as feelings of prestige among different level of societies such as workplace, family, and friends. For instance, an American subordinate can easily present their views and perception within the meeting. On the other hand, counter questions would be a serious face-losing situation for a different individual such as subordinate and boss within China (Harrison, 2017). Therefore, this approach has to consider in business structure while expanding business in China. The analysis of Brazilian culture has found that culture of Brazil thrives with a fusion of Portuguese, African and indigenous Indian influences that have played an important role in diversifying culture of the country. It plays a critical role in influencing interest and perception of people (Uhl and Gollenia, 2016). Therefore, the management of French manufacturing company has to examine the cultural interest of people while considering Brazil for outsourcing of business. In this process, the company could face different risk factors such as language, interest, perception and requirement of people as a result of highly diversifying cultural environment. In the context of Option C (British Manufacturing Company), the organisation has to consider the class system of the UK. The social class system is being emerged due to inequality in income, power and position of people in the society of the UK (Wang and Lu, 2016). Therefore, it could be acted as a business risk for French Manufacturing Company because top management has to consider interest and requirement of people while developing short and long term business plans and objectives. This is because improper consideration of cultural aspects could hamper overall business efficiency and outcomes.

Financial system risk

For handling investment decisions, the management of French manufacturing company has considered three companies associated with three countries for potential investment. The first option is an investment in Chinese manufacturing firm, but business entity could address different issues based on the financial system of the country while taking investment decisions (Hillson and Murray-Webster, 2017). In this context, it has addressed that the high leverage, as well as soaring housing prices, have been influenced due to risks and instability of China’s financial system. In addition to that government authorities in China always try to devalue its currency that could lead to a negative impact on business operations based on the import and exports. In this context, it is examined that the Chinese yuan was being depreciated by 10% in 2016 against the USD and by 15% with consideration of currencies weighted by trade. Although the exchange rate has been stabilised recently, this situation would occur for the national interest that could hamper overall business performance and efficiency (Brustbauer, 2016). Apart from that the subsequent rapid development of the financial markets and China has loosened its direct controls of the financial system that provides an opportunity to management business expansion. Moreover, a softer budget constraint would intensify favouritism among state-run organisations that have developed the situation of monopoly that could create a negative impact on the growth and development of private companies in some areas because government firms are dominating the certain industry. In the context of financial system risk, Credit risks in Brazil have addressed significant growth. This approach has increased that chances insolvencies as a result of increase as financial conditions in the market tighten. Therefore, every organisation in Brazil tries to manage different risk factors based on finance (Hopkin, 2018). Brazil’s overall country risk has been considered medium for 13 consecutive quarters, but frequent changes are addressed in the political and financial regulation which are having a huge impact on the business policies and expansion projects of overseas nations. As per the present case, the management of French manufacturing company has also considered an option of investing in the UK’s company (Soltanizadeh, Abdul Rasid, Mottaghi Golshan and Wan Ismail, 2016). In this context, the UK financial market has faced several issues as a result of Brexit. This approach has lowered business opportunities with various other partner nations in the EU within the UK. In addition to that, there is a significant increase in the current account deficit of UK so as new companies could address some issues during the export and imports (Rugman and Eden, 2017). Further investigation has determined that The UK’s financial system remains at very high risk as a result of various regulatory changes undertaken since the 2008 banking crisis. This regulatory changes in the financial system create difficulties for new overseas companies for analysing current trends in the banking system, growth rate and cost capital etc.

Demographic risk

The demographics of the population is having a significant impact on business strategies in overseas business expansion. For the present investigation, there are three locations for investment proposals considered by the management of French firms such as the UK, China and Brazil. The demographics of the population is determined by the population of statistics and age group (Davies, Martin, Parenti and Toubal, 2018). The analysis of demographic trends of all three nations has found that all three countries are facing issues due to increase in a number of old age people that include the availability of manpower, the requirement of health care services and consumption pattern. Therefore, a French manufacturing company could assess risk factor such as costly workforce, increased expenditure on health care of workers, lower market demand of different products and services. All these factors are playing a critical role for ensuring overall business growth and efficiency. Therefore, management has to consider all areas for assessing an appropriate business partner in overseas locations.

3. EXPLAINING HOW EXCHANGE RATE RISK CAN INFLUENCE INTERNATIONAL BUSINESS DECISIONS

In the global business operation and international investment decisions, exchange rates are playing an important role in influencing different aspects of management decision. It leads both positive and negative impact on the efficiency of business operations. It is evaluated that the fluctuation of exchange rates are having a significant impact on the corporation’s cash flow and management decision (Klassen, Lisowsky and Mescall, 2017). These factors include transaction risk, translation risks, and economic exposure risk. In this context, some important elements are discussed below influenced by exchange rate risk:

Translation risk

For managing overseas business operations, translation risk is termed as the most important risk based on the exchange rate that is occurred due to changes done within the financial statements of the multinational companies. In this regards, the financial statement is normally measured and examined in its local currency, and each financial statement should be translated into the currency of the parent company of multinational organisation (Vicard, 2015). It is identified that exchange rates are fluctuated by time and this translation of financial statements into different currency is also influenced by the exchange rate changes. This translation risks based on the fluctuation of currency exchange rate could influence loss or gain in the translation of annual accounts of multinational companies. For this purpose, overseas companies are tired to assess a balanced balance sheet. It is termed as translations risk as a main source of risk. Therefore, translation profit or loss is having a huge impact on the business profitability of the company that could generate more negative impact in the form of operational activities such sales and profit margins (Monsenego, 2015). All these factors are creating huge impact management decision of overseas multinational firms. In the context of the accounting perspective, foreign currency translation of business assets and liabilities is carried out with reference to the exchange rate at the balance sheet date. In this context, it is examined that the profit or loss related information of the company is translated as per an average rate for the whole financial year or at the exchange rate of the closing year. On the other hand, the share capital of the company is translated with reference to the historical rate of exchange that is considered as a rate when it was first issued (Ball, Li and Shivakumar, 2015). These results are mentioned within the income statement for assessing changes in assets and liabilities. All these factors are playing an important role in international business operations. Moreover, some multinational corporations are followed a greater degree of translation exposure as compared to other organisation (Pacter, 2014). An international corporation’s degree of translation exposure is highly influenced by various domestic and international factors such as the proportion of total business that has been conducted by foreign subsidiaries, the locations of different foreign subsidiaries and variation in accounting norms. Therefore, translation risk is being seemed like the most critical risk that could be occurred in overseas business plans.

Transaction risk

The transaction risk also influences the exchange rate fluctuation. It is termed as a cash flow related risk that is occurred by region currencies. Transaction exposure emerges when the expected future cash and other business transactions of an organisation are affected by exchange rate fluctuations that could lead both positive and negative impact (Barth, Landsman, Young and Zhuang, 2014). Transaction risk is being identified much easier approach as compared to translation risk because this risk can measure and reduce with hedging policies. In the contemporary business environment, multinational companies have always adopted different hedging policies against transaction risk, but these hedging policies are not being used for translation of balance sheet account and translation risk. In the context of translation risk, there are two reasons which have been considered by multinational corporations not to hedge against translation practices. The first reason is that the deflation, as well as reduction in value of a company in particular country, will affect its branches of a particular organisation in other countries (Fiechter, Halberkann and Meyer, 2018). The Second reason is determined that the long term the net worth and value of a business entity will not be affected by exchange rate fluctuation. This is because the exchange rate is significantly affected by the productivity of the business entity. It shows that exchange rates are creating a huge impact on the business decisions based on cash flow and future earnings of multinational companies. Therefore, it can be stated that transaction risk is identified as the clearest and appropriate form of exchange rate risk. It is also addressed as a cash flow risk through which corporations are tried to convert their foreign currencies within currencies of the parent company in order to avoid and decrease these risk factors (Raffournier, 2017). If management of an organisation is addressed transaction risk, then the business entity has to face three major tasks. First one, the company should have to identify the level of transaction risk. The second task is associated with checking hedge exposure. The third section is associated with the decision of the company in order to decide the hedge all or some part of the exposure so as management choose one hedging tactic as per the distinct business requirement.

Economic exposure

The third type of exchange rate risks is associated with Economic exposure risk. This risk element is definitely the change within the financial performance of the company due to fluctuation in the rate of exchange (Ramirez, 2015). In addition to that economic exposure determines any impact of exchange rate fluctuations that could be addressed in a corporation’s future cash flows. Furthermore, corporate cash flows can be influenced by exchange rate up-down in such ways that are not directly associated with international business transactions. Therefore, multinational corporations should have to verify their economic exposure while handling overseas expansion project. Apart from that, the company must pass an ability to determine a company’s exposure of each currency with optimum consideration of cash inflows and outflows (Gotze, Northcott and Schuster, 2016). Therefore, corporations are not only focused on hedging of parent company’s payables or receivables but also examine all their cash flows that would be affected by possible exchange rate movements. In addition to that multinational organisations are usually faced different management issues for managing economic risks that could be the result of exchange rate on net cash flow as well as handling economic risk, and it is also termed as a serious challenge for multinational corporations as a result of currency fluctuations.

4. EVALUATING THE DIFFERENT APPROACHES TO TRANSFER PRICING

There are different approaches available related to transfer pricing. In this context, some most important approaches are explained below:

The cup method

In the context of business operations, a cup method is found very effective for comparing different terms and conditions that are controlled third-party transactions. It helps management in corporate taxation. There are two types of third-party transactions identified in which the first transaction shows the relationship between the taxpayer and an organisation that is called the internal cup (Harris, 2017). The second transaction is associated with an external cup that evaluates the transactions between two independent enterprises.

For example, A company (X) is going to sale a new vacuum cleaner that is named “Buster 3.0.”. This product is 10 times stronger than a competitor product that is named “Dragon Buster”. As per the cup model, company X is trying to determine an appropriate price. For this purpose, a business entity has considered 2 options based on Cup Method. The first option is determined that X looks at the certain price in which business entity sells “Buster 3.0” to a third party distributor that is called as Internal CUP. In the second option, X focused on certain for which Z sells “Dragon Buster” to the third party distributor that is also called as External CUP.

The Resale Price method

This approach has started with a price in which an enterprise sells a product to the third party that is called as “Resale price”. This price is decreased with a gross margin that is determined by comparing gross margin with consideration of comparable uncontrolled transactions. It also considers the cost related to product purchase, customs duties, etc (Higham, Fortun and Boothman, 2016).

For example, Apple & Pear based on Hong Kong offers a very exclusive non-alcoholic beverage that is called “the Mountain.” This company is mainly sold its beverage to high-end nightclubs around Asia via associated distributors. The company sells “the Mountain” is USD. Apple & Pear is not selling the beverage to independent distributors, but a comparable distributor is selling “the Vulcano.” It is termed as an alcoholic beverage that is brewed by Gin & Juice, a company also based in Hong Kong. On the other hand, Apple & Pear is wanted to set the transfer price for ensuring the supply of “the Mountain” to the associated distributors (Throsby, 2016). Therefore, the company has considered resale pricing approach with consideration of customs duties and profit margin.

The Cost Plus Method

In this approach, the management of an organisation compares gross profit for assessing the cost of sales. The first step is to determine the costs that are addressed by the supplier in a controlled transaction for products that have been transferred to an associated purchaser. Secondly, an appropriate mark-up must be added to that particular cost for making an appropriate profit (Schlegel, Frank and Britzelmaier, 2016). After implementing this (market-based) mark-up to these costs, a new price would be created as per the requirement of an organisation. The application of the Cost Plus Method is required an appropriate identification of a mark-up on costs that could be applied for comparing transactions between independent enterprises.

For example, Candy Casing (X) is being identified as associated enterprises, and Ali Accessories (B) are being termed independent enterprise. Both companies are offering similar types of product such as iPhone cases so as Candy Casing has considered cost-plus price method with reference to the price of Ali Accessories (B).

The Transactional Net Margin Method

In the Transactional Net Margin Method (TNMM), an organisation has to determine the net profit based on the controlled transaction of the tested party. In addition to that this net profit is going be compared with net profit that has been realised by comparable uncontrolled transactions of independent enterprises (Warren and Seal, 2018). On the contrary to other transfer pricing methods, the TNMM needs to evaluate different transactions that are “broadly similar” to qualify as comparable. “Broadly similar” is termed as those compared transactions that do not require to become exactly like the controlled transaction. In the context of the current business environment, a comparable uncontrolled transaction can be identified between an associated enterprise along with an independent enterprise (internal comparable) (Abdel-Kader, Dugdale and Taylor, 2018). These types of transactions are also addressed between two independent enterprises or external comparables.

For example Company X offers administrative support services that include invoicing and bookkeeping. Associated enterprise Y asks X to provide invoicing services. Y has evaluated that business entity is needed about 1.000 hours of such services. In a similar way, an organisation (B) is also offering similar services. Company X is looking toward to Enterprise B for determining a good length price.

The profit split method

This approach considers transactions of associated enterprises and these transactions are very interrelated so as these transactions are not being examined on a separate basis. For these types of transactions, companies have considered the approach to splitting the profits (Harrison, 2017). In the context of the contemporary business environment, the Profit Split Method has found very effective for examining the terms and conditions of a wide range of controlled transactions by evaluating the division of profits that have been realised by independent enterprises that are engaged in those types of business transactions.

For example Business entity (X) has managed the partnership with the company (Y) for selling a wide range of food products so as this joint venture has adopted a profit split method for pricing of different food products.

CONCLUSION

On the basis of the above assessment, this report has concluded that different investment appraisal approaches for analysing profitability and reliability of different projects. This report has examined that an organisation addressed various risk such as political risk, financial system risk, cultural risk and more while expanding business operations in new emerging markets. This report has concluded that exchange rates are having a great impact on management decision for handling business operations in overseas nations. It has addressed that transfer pricing decision has provided significant support to an organisation in pricing decision in different business conditions.

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