STRATEGIC FINANCIAL MANAGEMENT AF4S31-V1-13590
MODULE ASSESSMENT 2
Course: MBA – Master of Business Administration – V1
Teacher: Muhammad Almezweq
Student ID: R1607D1662592
Date of submission: 10 November 2019
Abstract
This report studies the capital budgeting of two separate projects known as ‘Aspire’ and ‘Wolf’ which are quite different but each of which has the potential to increase AYR Co.’s market share. The author will conduct a financial appraisal to determine which project should be taken forward as AYR Co. can only afford one project at this time. A calculation of NPV, IRR and payback periods for two projects was determined. NPV and IRR were calculated as it appropriate to determine if company will achieve its primary goal of increasing the value of stock or not. Payback period ignores the time value of money therefore may diminish the value of shareholder’s equity. Project Aspire was recommended as it showed higher cash flows and NPV when compared to Project Wolf. However, some of the factors and information that are needed to be considered before making a final decision are highlighted in the report.
Introduction
Capital investment appraisal is a planning process that analyse whether the project is worthwhile especially in long term assets. Several techniques are used to determine which investment is worth undertaking and financial methods are payback period, net present value (NPV) and internal rate of return (IRR) and profitability index. This report will focus on calculation of payback period, IRR and NPV where results determine which project is desirable.
Furthermore, we discuss the sources of income most suitable for AYR Co.’s and analyse the effect of selection of source of finance may have on weighted average cost of capital (WACC) and assessment of impact on current and potential shareholders and lenders.
Assumption for Project Aspire
- The amount spent on market research, $120, 000 is not a cash flow and will never be recovered and therefore not considered in the Net present value analysis. This amount is referred to as sunk cost and irrelevant to investment decision making. (Ross et al, 2016)
- The working capital of $140, 000 have an impact on future cash flows but difficult to include in the NPV analysis as information is missing on how it will be used across the years, because net working capital changes as sales change. Nonetheless, the firm will recover net working capital towards the end of the project.
- Initial investment of $2,250, 000 and scrap value of $375,000 will be used to determine the NPV for a period of 5 years.
- Cash inflows will be determined using the given inflation of 7.5% per annum, by multiplying $650, 000 by 1.075 for year 2 to year 5 inclusive. Demand of sales of products is estimated.
- Variable costs will be calculated by multiplying $27,000 for year 1 by 1.0675 for year 2 to 5 inclusive. Inflation rate is estimated, so true NPV need to be measured by conducting a sensitivity analysis. Sensitivity analysis was performed to address problems of uncertainty.
Capital allowances are given for capital expenditures in Project Aspire. Capital allowances constitutes amount of allowances that are excluded when tax is deducted. Capital allowances were used to calculate tax benefits. Capital allowances are available on the plant and machinery as follows:
| $ | |
| Year 1 Year 2 Year 3 Year 4 Year 5 |
600,000 390,000 345,000 300,000 240,000 |
- Corporation tax of 20% was applied to taxable profit or loss payable in one year arrears. Tax rates may change affecting the feasibility of the project.
- Weighted average cost of capital of 10% was assumed to equal discount rate, because in its application discount rate is calculated by considering real cost of capital employed, i.e. by calculating weighted average cost of debt and equity.
- Depreciation of 20% on non-current assets was ignored in NPV analysis as it is a non cash deduction.
Assumption for Project Wolf
- The same initial investment and period of project applies to Project Wolf.
- Tax benefits are omitted as project does not attract any capital allowances.
- To calculate material costs we multiplied $14,400 by 1.075 per annum for year 2 to 5 inclusive.
- Other expenses were measured by multiplying $18,000 by 0.925 per annum for year 2 to 5 inclusive.
- Rental income of $75, 000 is included in NPV analysis as its money lost as a result of introduction of the project Wolf. This cost is considered as spill over effect (Ross, et al 2016). In this case, cash flows of project Wolf should be down adjusted to account for the loss of profit of other business lines of AYR Co.
DEFINITIONS OF TERMS
Payback period refers to the number of years required for the undiscounted sum of the returns (net cash inflows) at least to equal the initial outlay (Scicluna, 2016). The general rule of payback is to take a project that has a shorter payback period. This method has been criticised heavily because it ignores the time value of money, ignores risk, and cash flows after payback are irrelevant (Ross, et al 2016). In spite of this, payback period is widely used in capital investment appraisals because of its simplicity, liquidity and risk assessment (Awomewe and Ogundele, 2008).
The payback period was calculated by identifying net cash flows for each project. We calculated a running balance, where initial investment is cash outflow. When the total net cash flow becomes positive this is the end of the payback period. However, the payback period can be achieved in between two periods. We identify the period of last negative cumulative net cash flow and calculate a proportion of the positive cumulative cash flow using Excel or manually.
Discounted cash flows (Net present value) take account of the time value of money by translating all future cash flows in today’s money using appropriate discount rate then adding the sum of future cash flows to the cost of investment. If the net present value of the project is positive then it is worth pursuing as it creates value for the company. The discount rate reflects opportunity cost of capital which estimates the riskiness of the project (Žižlavskýa, 2014). Riskier projects are expected to provide higher returns. This means that NPV technique adjust risk of future cash flows unlike payback period or internal rate of return. The equation of net present value is as follows:
Ct = net cash flow at time t, C0 = initial investment, r = discount rate.
Internal rate of return (IRR) is a discount rate at which NPV becomes zero. If the IRR exceeds the weighted average cost of capital, the project is desirable to undertake as it creates value for shareholders. Otherwise it should be rejected. The investment is economically a break-even point when NPV equals zero, because the wealth is neither created nor destroyed (Ross et al, 2016). The general principle of IRR is that if all the other factors are the same for different projects then the project with the highest IRR should be considered. IRR is simply calculated by setting NPV to zero and solve the rate. We used trial and error in Excel to determine IRR or simply put the IRR formula.
However, this analysis is clouded when there are multiple IRRs which occur when positive and negative cash flows occurring during the lifetime of a project (Hartman and Schafrick, 2004). Consequently, this tells us that when IRR is not conventional, IRR is not the best analysis in investment appraisal compared with NPV which always gives the best answer. Both projects have shown conventional cash flows. Using Excel to determine crossover rate, where NPV equals for both projects, we notice that Project Aspire is superior for most of the time (see data on appendix).
ANALYSIS OF THE INVESTMENT APPRAISAL FOR PROJECT ASPIRE AND WOLF
Table 1. Payback period for project Aspire and Wolf
| Project Aspire | Project Wolf | |
| Payback period in years | 3,42 | 3,07 |
Project Aspire took 3 years 5 months to payback the initial investment whilst Project Wolf took 3 years 3 ½ weeks. Table 1 shows the number of years it took projects under investigation to get cost of project back. Payback emphasises on the speed of return and therefore good for markets which change rapidly. Payback is useful to managers who want to make minor investment decisions especially for liquidity purposes or to ‘escape’ future risks. It focuses on cash flows so it’s simple to calculate. In case of the two projects, Project Wolf would be favoured over Project Aspire but it doesn’t answer the relevant question of increasing the market share.
Table 2. Net present value for project Aspire and Wolf
| Project Aspire | Project Wolf | |
| NPV, $’000 | 425,06 | 379,42 |
Both projects have a positive NPV and therefore viable but project Aspire has the highest NPV as shown on Table 2. As demonstrated by calculations in the appendix we therefore recommend Project Aspire on that basis, as the stock value is also higher. The cash flows for project Aspire will need to be adjusted accordingly for net working capital that was borrowed from other lines of business. Investigating the sensitivity of NPV, inflation of variable costs was set at 10% and 20% for both projects and the results produced positive NPVs. Both projects are desirable.
Table 3. IRR for project Aspire and Wolf
| Project Aspire | Project Wolf | |
| IRR, % | 16,80% | 16,97% |
Both projects have an IRR higher than the discount rate of 10% and therefore worth undertaking. However, Project Wolf has a greater IRR but when examining cumulative cash flows for each project, Project Aspire has higher total cash flows than Project Wolf at the end of the project (see Appendix). In this case, the time value of money is not considered. We opt for a project Aspire over Wolf as the IRR are relatively equally with a marginal difference and also evidenced by crossover rate. The table above tells us that at 16.97% project Wolf and 16.80% project Aspire will have an NPV of zero.
FACTORS TO BE CONSIDERED FOR MAKING A FINAL INVESTMENT DECISION
It is important to note that, we never have complete confidence in projections henceforth further analysis need to be done. Though Project Aspire was recommended the following factors need to be considered before production and marketing can begin since the result of NPV is an estimate. Non-financial factors include but not limited to;
- Economic prospects
A business may want to invest if the GDP will rise or reject if otherwise. - Organisational Culture
Managers have different attitudes to risk related to the entrepreneurial culture. Some business may support risk or risk averse and that will dictate whether or not to proceed with the project. Project Wolf will invest in a new market and a new product which increases further risk unlike project Aspire which will expand its products and appeal to both existing and potential customers. - Social or ethical considerations
A business may take the wishes of all stakeholders into account before proceeding with the most profitable business, such as complying with rules and regulations set by government. Companies need to invest in businesses that are ethically responsible for long term survival and gain commercial success. - Impact on functional areas
A business need to look at how this new project will affect each department, do staff need more training, how will it affect morale of staff, brand image etc. - Environmental factors
A business that will have a negative effect in the environment should not be considered as it may cause health issues of the local community and workers. - Availability of project resources and land. We assumed that project Aspire does not need land as it is expanding its product portfolio while project Wolf takes up space in other business lines increasing further risks. Project Aspire is more desirable in this case.
- Exploring strategic options
SOURCES OF FINANCE
Long term projects need funding to run the business. Sources of finances can be in the form of equity or long term borrowing or debt. These sources of finance will require a return above the risk free rate for investing in the business. Since this is a cost to the company is referred to as cost of capital. Different forms of capital may have different costs associated with them. Ross et al (2016) allude that cost of capital depends on how we use this capital and not the source. AYR Co. is considering increasing equity by issuing new shares or taking a loan in the form of a bank at a fixed rate of interest. AYR Co. is currently financed as follows:
| Capital employed | $ million |
| Equity holder funds | 20 |
| long term debt | 18 |
| Total | 38 |
Equity
Equity financing is whereby a company advertises shares for sale to raise money. Equity financing involves issuance of shares to owners or use of retained earnings. Cost of equity refers to the return that investors holding shares in a firm require (Ross, et al 2016).
Debt
Debt financing occurs when a company raises long term finance by borrowing money from banks. Cost of debt requires the company to pay a specified principal amount and periodic interest. Debt financing involves taking out long term loans and selling corporate bonds (Scicluna, 2016)
The decision on source of financing by AYR Co. should be weighed on cost-benefit and financial risk analysis.
EFFECT OF THE SELECTION OF SOURCE OF FINANCE
Equity financing is considered more expensive as the equity holders require a higher return for taking the risk. This is because the company will share all the profits made by the business with investors, dividends paid to investors are not tax deductible. As more shares are sold, the company will give up on decision making of the business. Consequently, this dilutes the ownership and the interest current owners have on the company. Contrary, equity holders may lose their investments if the business goes bankrupt and only get residual income upon winding up of entity. Benefits of equity financing include the flexibility it provides over debt financing. Equity financing does not increase risk of default as interest payment is not needed.
In most cases debt financing is preferred to equity because it is a lot cheaper. AYR Co. creditors charge a fixed interest which is cheaper than floating rates. The risk is lower to lenders therefore can charge lower interest rate. Interest payments are tax deductible. The company will not be required to publicly disclose their financial plans as a condition of funding, thus allows company to maintain some degree of secrecy. Debt financing avoids dilution of ownership. Debt financing is committing to make fixed payments which decrease cash flows. Loans may come with restrictions such as collateral and covenants. Collateral restrictions require a firm to pledge an asset against the loan. If the firm defaults on payment, the bank can seize the asset and sell it to recover their payments. Covenants are terms placed on the loan that the firm must adhere to as a condition of the loan. Covenants can include restrictions on additional funding and restrictions on paying dividends.
Weighted average cost of capital (WACC) is an average of cost of equity and after tax cost of debt. To calculate the overall firm’s cost of capital we use the formula below;
WACC = (E/V) × RE +(D/V)×RD ×(1−TC)
E/V = percentage of equity, RE = cost of equity, D/V= percentage of debt, RD = cost of debt, (1-TC) = after tax rate
Introduction of debt into the capital structure causes WACC to fall because debt is cheaper than equity. As more debt is introduced (increased gearing) the equity holders will become worried and ask for higher returns as the risk of default is also increasing. This will have an impact on WACC.
At some point higher gearing will cause both debt and equity holders to demand higher return causing WACC to increase. The traditional view claims that there is an optimal capital structure where WACC is at its minimum.
M & M (1958) argues that companies that differ only in capital structure should have same total value of debt and equity indicating that capital structure is irrelevant in determining the value of the business (Scicluna, 2016).
The WACC of any financing package will decide if the project should be undertaken. WACC is based upon company’s current costs of equity and debt. It is useful in investment appraisal where there are no changes that may introduce new risks. An aspect of financial strategy says the higher the level of gearing the greater value of the company. Other scholars have advised that a mix of debt and equity financing is desirable for a successful business.
CONCLUSION
After incorporating financial and non financial factors in capital budgeting analysis, we recommend AYR Co. to undertake project Aspire. We are interested in the higher total cash flows generated by project Aspire and the net present value measured higher even after sensitivity testing. Even though the non discounted cash flows like internal rate of return and payback period favoured project Wolf, these methods do not incorporate uncertainty and ignores time value of money and therefore we cannot rely on them. Crossover rate of return established that Project Aspire is more worthy by adding a great deal of overall value to the company. We assumed that all the non financial factors like business strategy, culture, resource availability, environmental factors are considered and favoured Project Aspire. In a nutshell, a project with the lowest risks is worthwhile. The main objective of AYR Co management is to maximise shareholder value which is achieved by minimising cost of capital. Capital providers need to be compensated a minimum rate they can expect. We advise that AYR Co considers debt financing to equity for the fact that the company already has higher costs related to current cost of equity which is greatly expensive.
APPENDICES
| PROJECT ASPIRE | |||||||
| Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Yr 6 | |
| $’000 | $’000 | $’000 | $’000 | $’000 | $’000 | $’000 | |
| Initial investment | 2250 | ||||||
| scrap value | 375 | ||||||
| cash inflows | 650 | 698,75 | 751,15625 | 807,4929688 | 868,0549414 | ||
| variable costs | -27 | -28,8225 | -30,76801875 | -32,84486002 | -35,06188807 | ||
| EBIT (PROFIT/LOSS) | 623 | 669,9275 | 720,3882313 | 774,6481087 | 1207,993053 | ||
| Tax @ 20% | -124,6 | -133,9855 | -144,0776463 | -154,9296217 | -241,5986107 | ||
| CAPITAL ALLOWANCES | 600 | 390 | 345 | 300 | 240 | ||
| TAX BENEFITS | 120 | 78 | 69 | 60 | 48 | ||
| NET CASH FLOW | -2250 | 623 | 665,3275 | 664,4027313 | 699,5704625 | 1113,063432 | -193,5986107 |
| CUMULATIVE CASH FLOW | -2250 | -1627 | -961,6725 | -297,2697688 | 402,3006937 | 1515,364125 | 1321,765515 |
| DF @ 10% | 1 | 0,909090909 | 0,826446281 | 0,751314801 | 0,683013455 | 0,620921323 | 0,56447393 |
| Present Values (PV) | -2250 | 566,3636364 | 549,857438 | 499,1756057 | 477,8160389 | 691,1248186 | -109,2813686 |
| PAYBACK | 3,424931847 | 3 YEARS 5 MONTHS | |||||
| NPV MANUAL | 425,056169 | NPV fx | $425,06 | ||||
| IRR fx | 16,80% | ||||||
| PROJECT WOLF | |||||||
| Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Yr 6 | |
| $’000 | $’000 | $’000 | $’000 | $’000 | $’000 | $’000 | |
| Initial investment/scrap value | 2250 | 0 | |||||
| Cash inflows | 955 | 955 | 955 | 955 | 955 | ||
| Material costs | -14,4 | -15,48 | -16,641 | -17,889075 | -19,23075563 | ||
| Other expenses | -18 | -16,65 | -15,40125 | -14,24615625 | -13,17769453 | ||
| Rental income | -75 | -75 | -75 | -75 | -75 | ||
| EBIT( Profit/LOSS) | -2250 | 847,6 | 847,87 | 847,95775 | 847,8647688 | 847,5915498 | |
| Tax @ 20% | -169,52 | -169,574 | -169,59155 | -169,5729538 | -169,51831 | ||
| payable in 1 yr arrears | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Yr 6 | ||
| NET CASH FLOWS | -2250 | 847,6 | 678,35 | 678,38375 | 678,2732188 | 678,0185961 | -169,51831 |
| CUMULATIVE CASH FLOW | -2250 | -1402,4 | -724,05 | -45,66625 | 632,6069688 | 1310,625565 | 1141,107255 |
| PAYBACK | 3,06732722 | 3 YEARS 3,5 WEEKS | |||||
| DF @ 10% | 1 | 0,909090909 | 0,826446281 | 0,751314801 | 0,683013455 | 0,620921323 | 0,56447393 |
| PV | -2250 | 770,5454545 | 560,6198347 | 509,6797521 | 463,2697348 | 420,9962037 | -95,68866664 |
| NPV | 379,4223132 | NPV fx | $379,42 | ||||
| IRR fx | 16,97% | ||||||
| Project Wolf | ||
| Discount rate, % r | NPV, $’000 | |
| 5 | 721,3001256 | |
| 10 | 379,4223132 | |
| 15 | 97,6344053 | |
| 20 | -137,1986078 | |
|
Project Aspire |
||
| Discount rate, % r | NPV, $ ‘000 | |
| 5 | 823,9274588 | |
| 10 | 425,056169 | |
| 15 | 101,3507905 | |
| 20 | -164,4585648 | |
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