Corporate Finance Assignment MBS

MANCHESTER BUSINESS SCHOOL GLOBAL MBA ASSIGNMENT 1

MODULE: MBSW60237 CORPORATE FINANCE ACCELERATED (JULY 2011)

NAME

: TAN IRENE

STUDENT NUMBER

: 8011118

ASSIGNMENT REFERENCE : CFAP/July11/1

0

Question 1: Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. Net present value (NPV) approach is a widely accepted and relatively reliable methodology used in the market for investment appraisal. Let us first examine the rationale and mechanics of the NPV rule. In an investment appraisal, the company is evaluating the attractiveness of an investment proposal. So what is deemed attractive? The primary assumptions in our discussion are that the company’s objective is to maximize shareholders’ wealth and it operates in a perfect capital market. Hence, an attractive investment will be one that increases shareholders’ wealth. Following Fisher’s separation theorem, since the (efficient) capital market interest rates and returns give the same opportunity costs that both companies and individuals face in allocating resources over time, the company should focus on maximizing NPV rather than considering shareholders’ consumption preferences (decoupling). As long as the company accepts all projects with positive NPVs and rejects those with negative NPVs, shareholders’ utility (i.e. wealth) is maximized. This is because NPV represents the additional value/loss after covering the initial outlay and required rate of return. As NPV takes into consideration the time value of money (i.e. a dollar today is worth more than a dollar tomorrow), it gives an accurate view of investment gains in today’s terms. Table 1 below shows the effect of choosing investments with different NPVs on the shareholders’ utility.

Table 1: Effect of NPVs on shareholders’ utility NPV

Effect on shareholders’ utility

NPV = Present value of future investment cash inflows – initial investment outlay NPV < 0

Future cash flows generated from project are insufficient to

1

cover the initial outlay.  Shareholders will not be happy as they could invest the cash themselves to get higher returns. NPV = 0

Project breaks even - it generates exactly enough cash flows to: (1) recover the cost of the investment and (2) enable investors to earn their required rates of return (the opportunity cost of capital)  Shareholders are indifferent to whether the company accepts the project or not.

NPV > 0

Project generates more than enough cashflows to create value for shareholders  Shareholders’ wealth is maximized when company invests in positive NPV projects.

With reference to the above table, it is apparent that by accepting investments with positive NPV will increase shareholder’s wealth, which is the objective of the investment appraisal.

2

Two other commonly used approaches to investment appraisal are the payback period (PP) and internal rate of return (IRR). Table 2 shows a comparison of NPV rule against these two alternative approaches. Table 2: Strengths and weaknesses of three key investment appraisal methods Method

Strengths

NPV

Rule: Accept a project with positive NPV and reject those with negative NPV.  

 PP

recognize time value of money rely solely on forecasted cashflows & opportunity cost of capital can handle multiple discount rates

Weaknesses



Rule: Accept a project if its payback period is shorter than specified cutoff period.  

easy to compute and understand encourage cash generation

  

IRR

sensitive to discount rates

ignore the time value of money ignore all cashflows after cutoff date choice of cutoff period arbitrary

Rule: Accept a project if the IRR is higher than the opportunity cost of capital. 

recognize time value of money

Rule does not hold in the following scenarios:  lending vs borrowing position  multiple rates of return  mutually exclusive projects  multiple opportunity cost of capital

NPV is by far a more reliable method as compared to PP and IRR. It takes into consideration the time value of money, a very important economic concept that is also applied in IRR, but unfortunately omitted in PP which assigns equal weight to all cash flows. A variant to overcome this weakness of PP is the discounted payback period rule, whereby discounted cashflows are used instead in the 3

determination of payback period. By using present value, it allows summation of equivalent cashflows as cashflows at different points in time are not comparable. NPV rule relies solely on forecasted cashflows and opportunity cost of capital, hence not tainted by managerial preferences, choice of accounting method, profitability of existing business and other independent projects (Brealey et al, 2011). This is a more objective approach as compared to PP which uses an arbitrary cutoff period chosen by management. The payback rule is not without its merits. It is the easiest of the three rules to compute and understand, as it uses the concept of profitability and breakeven point. It is therefore a more persuasive approach in capital budgeting negotiations. NPV and IRR are rather abstract and complex in computation, thus not be easily apprehended. The payback rule also encourages cash generation and values early cash flows over late cash flows since distant cash flows are uncertain. However, it ignores all cash flows after cutoff period hence may wrongfully reject longer term projects that will still contribute to shareholder wealth. The IRR rule is a close relative to NPV rule and gives the same answer as long as the NPV of project is a smooth declining function of discount rate (Brealey et al, 2011). There are nevertheless a few scenarios whereby IRR will give a misleading conclusion. In the event that there are changes in the direction of cashflows in a project lifeline, there could either be multiple IRRs or even no IRR exists which will lead to inconclusive results. When deciding between mutually exclusive projects, IRR rule can be misleading due to different scale or cashflow patterns. When ranking projects of different scale, the company should look at the IRR on incremental cashflows. If the IRR on the incremental investment is greater than the cost of capital, the bigger scale project should be selected.

4

In addition, the IRR rule implicitly assumes that there is only one opportunity cost of capital throughout the project life; however, this might not be true in reality because the cost of capital might change over the years with fluctuations in the economic climate. In this situation, which cost of capital should the company compare the IRR against? Sometimes, the cashflow pattern will determine whether the company is in a lending or borrowing position. If the company is in a borrowing position (initial cash inflow), it will only accept the proposal if IRR is low such that future cash outflows will be minimized and vice versa for a lending position. In view of the above, it is evident that NPV rule is still the most reliable method. It is no wonder that more than 75% of companies use NPV for their investment appraisal.

5

Question 2: Appraise Laurentian Bakeries’ expansion into the US frozen pizza market. Laurentian Bakeries Inc. (Laurentian) was a manufacturer of frozen baked food products, headquartered in Montreal. It had three plants in Winnipeg, Toronto and Montreal, producing pizzas, cakes and pies respectively. Seeing the great potential in the North America market, management recognized the lost opportunity due to insufficient capacity. This issue had become more pressing as a large U.S.-based grocery chain offered an exclusive arrangement to Laurentian to supply privatelabel-brand frozen pizzas beginning in April 1996. Should Laurentian accept this agreement, it needed to increase capacity urgently to cope with the increased demand. To increase capacity, Laurentian had identified four options: Option 1 – Acquisition of competitor’s facility in Canada This had been rejected as the equipment would not satisfy the capacity needs nor achieve cost savings possible with Option 4 below. Option 2 – Acquisition of a competitor in United States This had been rejected as the capital investment required would be twice of that under Option 4. Option 3 – Expansion of Toronto plant This had been rejected as the capital outlay was also doubled of Option 4. Option 4 – Expansion of existing Winnipeg’s plant This option was preferred as economies of scale and consistent high product quality could be achieved. The next step is to assess the viability of Option 4 using the Net Present Value rule. Net Present Value (NPV) As part of the Capital Allocation Policy, the project’s NPV must be positive in order to qualify. For this paper, we will look at the NPV calculation in three main parts: initial investment outlay, forecasted cash flows and discount rate.

(I)

NPV  C0 

Initial

C1 C2 C3 C10    2 3  1  r  1  r  1  r  1  r  10

investment outlay

6

The list of capital expenditure required to start the expansion project is provided in Table 1 below, aggregating $5.2 million.

(II)

Forecasted cash flows A ten-year cash flow forecast is performed since the assets purchased for this project have a useful life of ten years. (a) Incremental revenue Under the exclusive arrangement, there will be a significant increase to the throughput as shown in Table 2, with various probabilities. To be conservative, we will assume the worst case scenario that the customer ordered only the guaranteed quantity. Other assumptions made include:  Agreement with U.S.-based grocery chain would last for at least 10



years (i.e. useful life of capital assets). Volume from 1999 onwards would be at the same level as that of



1998. Selling price to the U.S. grocery chain is assumed to be the same

as the selling price to Canadian customers ($1.70).  Inflation rate is assumed to be at a high 5%. Based on the above assumptions, the incremental revenue for each year is shown in Table 2.

7

(b) Incremental production costs Based on the contribution margin of pizza segment, the current unit product cost is derived as $0.58 in 1994. At an inflation rate of 5%, unit product cost will increase to $0.61 by 1995 and $0.64 by 1996, so on and so forth. Similarly, inflation is factored into the other savings that resulted from the new line. In addition, increased efficiency from the new line reduces the plant-wide unit cost which we assume, on grounds of prudence, that only 50% of that savings will be achieved for all 10 years. Other costs such as the time cost and expenses of sales staff incurred to secure the U.S. contract have been included as initial outlay (deemed opportunity cost that might be deployed to earn other income). Annual repairs and maintenance costs amounting to $520,000 each year will also be incurred to upkeep the equipment. However, the value of existing land (which we assume that there is no alternative use of the land since the existing plant is located on that same plot of land) and fixed salaries of administrative staff are excluded from the forecasted cash flows since they are sunk costs and not incremental. Table 3 shows a consolidation of incremental costs/savings.

8

Note that the above is computed based on the guaranteed 50% additional volume as discussed in Section (a). (c) Net earnings after tax This is derived by deducting incremental production costs, capital allowance and tax from incremental revenue. Capital allowance is based Exhibit 6 provided and tax rate is 38% per Canada Revenue Agency website. (d) Working capital movements Working capital is the net of current assets and liabilities. The incremental working capital is arrived as a function of incremental revenue, except for inventory which has been adjusted for the shorter inventory age (a function of COGS). The movement in working capital is then added to the cash flow analysis. (III)

Discount rate In the case of Laurentian, as the company is financed both by long-term debt and equity, the Weighted Average Cost of Capital (WACC) is an appropriate discount rate, with the following assumptions fulfilled:  risk of project matches overall risk of company  risk of company and its financing mix remain unchanged for the next ten years

9



target debt ratio remains unchanged with the new project (this ratio is not likely to change since the Board of Directors has established a target capital structure of 40% debt)

To answer Knowles’ query, the hurdle rate represents the required rate of return on investment, and may not necessarily be similar to the cost of capital. It is likely that the hurdle rate would be higher than the cost of capital such that it increases shareholders’ value. To calculate the WACC, we use the following formula:

WACC  rD 1  Tc 

D E  rE V V

(a) Cost of Equity Capital Using Capital Asset Pricing Model (CAPM) to compute rE,

rE  r f   rm  r f   E The risk-free (rf) is estimated to approximate the long-term Government of Canada Bond (8.06%). The ten-year bond is selected to match the project horizon. Market risk premium is assumed to be the difference between Toronto stock market return (r m) and long-term government bonds (r f), which is 6%. is equal to Laurentian’s stock beta (0.85) as provided. With these variables, rE, is determined as 13.16%. (b) Cost of Debt Capital Corporation bonds are debt instruments which are typically riskier than government bonds. Given that the spread between Government of Canada bonds and "BBB-rated" corporation bonds (similar rating as Laurentian) is 2%, we deduce that the cost of debt capital will be 10.06%, i.e. 2% higher than the government bond rate of 8.06%.

10

(c) WACC With the target capital structure of 40% debt, we assume that the weights of the company’s debt and equity are 40% (D/V) and 60% (E/V) respectively. This is consistent with the trend noted in the Balance Sheets where the debt-equity ratio increased from 33%:67% in 1993 to 39%:61% in 1995. Putting all the relevant values above into the formula, WACC is calculated to be 10.39%. (IV)

Computation The forecasted annual cash flows, assumed to happen at the end of each year, are discounted using the WACC rate, thus deriving a NPV of $6.7 million. If we use the hurdle rate as the discount rate, NPV is $3.1 million. In both scenarios, Laurentian should accept the project since it is generating positive shareholders’ value. Bearing in mind that we have adopted the worst case scenarios in the assessment, anything more than the guaranteed volume or minimum savings will further increase the project value. For detailed computation, please refer to spreadsheet “NPV Calculation.xls”

Alternative Investment Appraisal Rules Two other appraisal methods which are required in the Authorization for Expenditure Form are Internal Rate of Return (IRR) and Payback Period (PP). Using the same forecasted cash flows above, IRR is determined as 30%, which is higher than the hurdle rate (18%) and WACC (10.39%), hence the project should be accepted, consistent with NPV rule. Payback Period and Discounted Payback Period (a more accurate measure) are 3.65 and 4.54 years respectively. As the cutoff period is not given, we are unable to conclude based on PP. Other areas of consideration To comply with the company’s Capital Allocation Policy, the proposed Winnipeg plan project (Class 2 project) needs to meet the following requirements:  support continuous improvement – per Exhibit 5, the expansion project will resolve the issue of lost sales due to insufficient capacity

11



consider human resource and environment impact – no employees are affected adversely and environmental concerns had been factored into the

 

design of sanitary, water-regulating and refrigeration systems provide a sufficient ROI – ROI on this project is 129%! projects more than $300,000 to be included in Strategic Plan – this project



had been duly included in the Strategic Plan projects more than $1 million, operating division has to achieve its profit target – Winnipeg plant had met its profit target for the past three years

Conclusion Based on the above evaluation of NPV and IRR and having fulfilled all the other policy considerations, Laurentian should accept the expansion proposal and commence works no later than October 1995, in order to start supplying the U.S grocery chain in April 1996. This would be a good opportunity for Laurentian to break into the lucrative U.S. market.

12

References Brealey, R.A., Myers, S.C. and Allen, F. (2011). Principles of Corporate Finance Global Edition. 10th edition. New York: McGraw-Hill/Irwin Canada Revenue Agency. (2011). Corporation tax rates [online]. Available from: http://www.cra-arc.gc.ca/tx/bsnss/tpcs/crprtns/rts-eng.html [accessed date: 4 November 2011] Moneyterms.co.uk. (2011). Fisher separation [online]. Available from: http://moneyterms.co.uk/fisher-separation/ [accessed date: 4 November 2011]

13