There are various techniques used to evaluate viability of investments and in comparing different investments. These techniques include net present value, payback period, accounting rate of return and internal rate of return . Net present value is preferred when evaluating projects because in takes into consideration time value of money unlike Payback period and accounting rate of return. Although internal rate of return considers time value of money it is confusing to compute and conceptualize .
Net Present value is computed by discounting annual cash flows at a given discounting rate. Annual cash flows are determined by subtracting annual cash outflows from annual cash inflows or cash savings. The feasibility study cost is ignored since it is a sunk cost that has to be incurred regardless of the alternative chosen.
Depreciation is a non cash expense and therefore it should be included in the cash flow statement. It is however subtracted before tax computation and then added back to reflect depreciation tax shield benefit .
In order to obtain the net present value, the cash flows should be discounted at AUCU discount rate. The discount rate will be obtained by the Capital Asset Pricing Model (CAPM) since the firm is 100% equity financed. CAPM is incorporates both the risk free rate of return to equity holders plus beta which is a measure of the firm’s risk level. CAPM is given by;
Australian University Credit Union (AUCU) should choose the Australian Banking Software since it offers a higher net present value than that of the Universal Financial Solutions.
A fall in the tax rate from 30% to 25% will increase the net present value expected from adopting either of the systems.
Universal Financial Solutions
Reduction in tax will be;
(30%-25%) * 71,000 = 3550
The expected return of a firm comprises of the prevailing risk free rate and a risk premium to compensate investors given by beta. The capital asset pricing model is used to estimate the expected rate of return by AUCU shareholders
Risk free rate of return
Risk free rate of return is the return on investments with zero risk. In practise investments with very low level of risk are assumed to have risk free rate since it is impossible to have investments with zero risk. The rate of return on government bonds is used as the estimate of risk free interest rate since they have the backing of the government and investors are certain of their returns if they hold them to maturity . The 10 year-Treasury bond yield that is used in estimating the risk free rate of return averaged 4.2% per annum as at September 1 2011.
Market risk premium
Market risk premium, E(rm – rf) is the excess return given to investors to compensate them for uncertainty in the returns on their investments. It is computed on the assumption that historical monthly market returns on a security reflects future returns . S&P/ASX200 Index data over the period from March 2000 to March 2010 was used. The risk premium is then computed as the difference between the monthly rate of return and the risk free rate return. The most recent data is chosen to accurately reflect the prevailing market risk premium. The expected market risk premium, based on the data set, is computed as 0.92% per month. This translates into an annual estimate of 11.04% .
Since AUCU is not a publicly traded company, it would be impossible to calculate its beta directly from its share price. The average of betas of publicly listed companies in the same industry will be used to obtain the proxy beta for a firm that is not publicly listed. In the case of AUCU, Westpac Banking Corp and ANZ Banking Group will be used to obtain the proxy beta since they are both companies offering financial services that are publicly listed at the Australian Stock Exchange.
Computation of the proxy beta assumes that historical returns can be used to predict the future and that the market risk is similar for all the firms in a particular industry. These assumptions however may not always hold. The financial markets have been turbulent and unpredictable following the global financial meltdown and the European debt crisis. There is a likelihood that the proxy beta could be different from the one calculated which may affect the returns on the investments .
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