This research will begin with the statement that net present value refers to a technique of appraising projects to determine their viability and hence whether the firm should undertake them or not. The decision criteria are that projects with a positive Net present value should be undertaken while those with negative Net present value should be ignored. To get the net present value, the cashflows accusing from the project discounted at a given discounting rate. However, it should be noted by Jovi plc that not all projects with a positive NPV should be undertaken. It all depends on the availability of sufficient capital to undertake such project(s). If the firm undertakes projects requiring huge initial cash outlays however viable they might be in terms of NPV it is likely to have cashflow problems. On the other hand, the Net present value method of appraising projects suffers from one drawback – It assumes that the cost of capital /discounting rate remains constant during the economic life of the project. This is unrealistic since the riskness of the firm changes over time and the cost of capital should also change. Jovi plc should toy to improve its cashflows by for instance increasing its sales volume. Though, it should ensure that there exists a stringent credit policy whereby customers are given short duration to pay up their debts. It should also encourage sales on a cash basis since credit sales tie money up leading to cashflow problems. Preference should be given to projects whose payback period is short….
This will enhance the company’s profitability.
Revising the current debt policy, can greatly improve the net cashflow. This can be done by a departure from credit sale to cash sale but after analyzing the effects of each. Adopting an optimal credit policy can easily necessitate 10 million to finance new capital investment. Take for example if Jovi p/c were to embrace a stringent/ tied credit policy. This would
i) Decrease its bad debts
ii) Decrease in debtors hence capital will be released and made available for investment.
iii) Increased profitability will be:
Decrease in debtors (released tied up capital) x ROI
iv) It will lead to a reduction in credit administration and debt collection expenses.
There exists various ways of financing activities/investments of the organization. But on the decision concerning the best financing option would depend on a number of factors one of them being the costs associated with obtaining those finances. 2
Derivation of the marginal cost of capital for each source of finance:
a) Ordinary share capital (equity, e)
Ke = do = Whereby Ke is the marginal cost of ordinary share capital
do = D.P.S paid in the last accounting period
K = Discounting rate/ required rate of return
Po = mps
P/E = M.P.S = 10
E.P. S (million)
Pfl after tax = 3
E.P.S = Pfl after tax = 3 = 0.4
No. of shares 7.5
MPS = 10
MPS = 10 = MPS = 4
Ke = do = 0 = 0
The marginal cost of ordinary share capital is zero
Marginal cost of irredeemable 8% loan stock
Cost of 8% loan stock (Kd) is given as
Kd = Interest p.a
Where Pd = Market value of a debenture interest = par value
Assumption: The market value of the 8% loan stock is the same