Debt Financing for the Project Rattle Company - Coursework Example

Introduction Rattle Co (or “Rattle” or “The company is about to reject a proposed project due to its negative net present value (NPV). However, it may decide to accept the same project if positive NPV is produced after proper adjustments are made, based on facts in the case study. The company is also required to determine the risk involved with the proposed project and to find ways to reduce said risk. It further plans to use of 100% debt financing for the project. This paper will attempt to help Rattle Co in making a decision by answering at least four questions, including critiquing the use of 100% debt financing for the project. Question one. Calculate the adjusted present value (APV) for the project, correcting any errors made in the net present value estimate above, and conclude whether the project should be accepted or not. Show all relevant calculations. (25 marks) Before any attempt should be made to prepare the adjusted present value of the proposed project, Rattle Co must carefully study how the given projected cash flow statement for four years was made, to know where some should remain because they are already correct or whether they need further adjustments. When the needed adjustments are known, the framework is established to do the same with each item in the prepared cash flows, asking whether it should be adjusted or not. Starting with the revenue, it appears that one critical issue would be whether it should be presented with inflation or net of inflation. The answer would depend on what discount rate is used. If the discount rate is with inflation, then the revenue must include the inflation. In the case facts, the inflation was given however, if the discount rate is used with the real rate, i.e. not the nominal one, then presenting the net of inflation of the inflation rate is the proper thing. The 8% inflation rate increase for revenues and 4% inflation rate increase for cost of sales become irrelevant. Working capital requirements appear not to be reflected in the given cash flow. These need to be determined, as they are a factor in any decision. A business cannot operate without working capital. Since the amount of working capital at the beginning of each year is 20% of the forecasted revenue per year, just multiply each given sales figure per year, then it is possible to generate a working capital requirement per year. As computed in the revised and adjusted projected cash flow in Appendix A, the working capital amounts come to £4,606,000, £7,320,000, £9,814,000 and £5,428,000 for the first, second , third, and forth year, respectively. Another adjustment to be made, before calculating the APV, is the depreciation allowance. Since the given cash flow does not specifically reflect this, it cannot be assumed that it was not deducted from the revenues. It is a valid inference to assume that depreciation per year was already made part of the direct cost that reduced the revenues per year. As such, there is a need to add back this depreciation for purposes of computing the corrected cash flows. To compute the depreciation allowance , there is need to refer to case facts, which indicates that computation is based on a declining balance of 50% in the initial year and 25% per year thereafter. By so doing this in a supporting schedule of Appendix A, the computed value of depreciation allowance comes to £8,000,000, £2,000,000, £1,500,000 and £500,000 for year 1, year 2, year 3 and year 4, respectively. It appears that interest expenses are not stated at real values before they are deducted from the revenues in the given projected cash flow. Part of the case facts include Rattle Co’s normal borrowing rate to be 150 basis points, which is higher than the real value of 100 points. This means the amounts to be used for interest expense must be stated at 100 points. Dividing every given figure of interest expense by 1.5 would produce the real values of interest, as they are being used in an adjusted flow in Appendix A. As seen in the same appendix, the correct interest expense is £800,000 per year for four years. After combining all the adjustments for depreciation allowance, interest expense and working capital, preserving amounts of revenues and applying the applicable tax rate of 20% based on adjusted net income before tax, the cash flow per year is generated and is now reading for discounting at the proper rate. As to what discount rate should be used, it should be the one that is applicable to lines of business other than Rattle. Since Lifeline is in the same industry being entered into by Rattle, the former’s cost of capital of 10% should be used to determine Rattle Co’s discount rate as well. Such a rate can be computed by adding the risk-free rate of 2% and market-premium of 8%. This computation is consistent with the capital asset pricing model (CAPM) used in computing the required of return (Brigham & Ehrhardt 2010; Brigham & Ehrhardt, 2002). After applying the appropriate discount rate to the projected net cash inflows, the adjusted net present value amounted to £ (14,110,032). The amount is still expressed in the negative figure so decision to reject the proposal is justified. Question two. Discuss with reference to relevant academic literature the principal uncertainties associated with this project. (25 marks) Going into business involves visualizing a future that will yield favourable results after investments. Each type of business therefore comes with its own uncertainty simply because nobody is perfect enough to know what will really happen in the future. But events that have happened in the past may happen again under different possibilities or probabilities. The possibilities that business may rise, fall or stagnate are always there, but it is the job of managers to plan for them and manage them to minimize or bring them to a controllable level that would justifying making investments that would produce sufficient return in relation to given risks. As reported in the case facts, Rattle has a cost of capital of 7%, while Lifeline has a cost of capital of 10%. This proves the presence of different cost of capital under different situations. What will cause the situations to vary is the place of doing business, which may have different economic and political conditions (Baumol & Blinder, 2008). This also brings to the surface the differences in currencies, inflation rates and political risks, which are also uncertainties in themselves, as contrasted with what the investor experiences in his home country. Since case facts do not provide information on what country the project will take place, this paper discusses in general the uncertainties that may be associated with conducting business in differing locations. This paper assumes that Rattle is UK-based and that the project would be located outside its home country. Rattle will now have to realize the unique currency of the foreign country. This unique currency will be subject to foreign currency exchange rates, which will be material for capital budgeting. Since exchange rates do not stay stable across countries, it is crucial to understand and manage them. Who would want unstable currency in a foreign country? As shown in their financial statements (Johnson, et al, 2003; Kieso, et al, 2007), companies can actually experience foreign exchange gain or loss in material amounts if they fail to manage these types of foreign exchange risks (Barth, 2006: Epstein & Lee, 2008). Along with foreign currency risk is the differing inflation prevailing in the country where the project would be undertaken. Inflation rates cause money to devaluate. Prices could become higher even though the real values of products remain the same. Said inflation level is actually affected by how the central monetary authority of the country will address the same, since the amount of money in circulation will affect the level of inflation, along with interest rates allowed by said central monetary authority (Francis, Olsson & Schipper, 2008; Brigham & Houston, 2002). A company may have higher prices that result in higher revenues, but if 50% of the reported revenues are due to an inflation rate of about 10%, the total revenues are already inflated or overstated. This makes planning somewhat complicated if inflation is not taken into consideration. Connected with foreign currency risk and inflation risk are the political risks in the host country. A host country is usually an independent state inhabited by a different group of people than that of the home country. As to how the government will handle changing political conditions, it is outside the control of the home country. Wars, rebellion, and acts of terrorism could happen in the host country. This could drive foreign business entities, including the so- called expropriation, when the government is forced to buy the assets of foreign companies if there are violations of the law and constitution of the host country where the project investment is made. All these risks could increase the cost of capital, and should be carefully considered. In the case facts, the higher weighted average of cost of capital (WACC) of Lifeline may explain the higher risk associated with the project after considering all the factors as discussed above. Question three. Discuss the possible actions Rattle Co could take to reduce the risk that the project fails to increase shareholder value. (20 marks) As stated earlier, risks and uncertainties come with making decisions that are affected by the changing conditions of the future. The risk that the project fails to increase shareholder value is high, as forecasted revenues may not actually happen sometimes because one or two of different risks in doing the same may come true. As to the risk of inflation discussed in the preceding section, this is normally managed through hedging, but this strategy is most applicable to the parent company, which must carefully understand the host country where the project would be done. This is possible when the assumption holds that the project is in another country. The same can be said about foreign exchange risks and political risks. The simple way to manage those risks would be to increase the required rate of return to factor them in. But if the project were to be conducted in UK, as far specific project management is concerned for the purpose of this paper, the way to reduce risks would come from identifying and applying the possible real options that come with the project. Management must ask how it can influence the cash flows of the project, and it must ask for possible actions to do so. Projects are not things which may enable one to make decisions that produce higher values or minimize the danger of lower values if the project fails. Management must ask whether there is a chance of abandoning the project within the four year period if the chance to realize what was forecasted disappears because of more pervading conditions that were not really anticipated when the project was implemented. If, for example, a simple political problem in the host country was understated when planning was done, and eventually the business could no longer function as expected, then management must be ready to salvage the value of investment by shutting down the project and selling it to a company in the host country which may find a need for the output of the project. Another possible option is the need to accelerate the project when higher cash values would come as a result. Sometimes the economy of the host country suddenly adopts expansionary policies, which would make it cost effective to accelerate the completion of the project; in that case, by all means, management must be able to take advantage of this so as to influence higher cash values. In such a case, there is the need for Rattle to have flexibility in the source of its financing for the project, including the sources of its working capital (Needles & Powers, 2010; Pagach, et. al, 2006; Stice & Stice, 2011). If all of a sudden interest rates become very low, allowing the company to borrow at a minimal cost to keep the business running earlier than anticipated, management must be ready for the challenge. There are also chances that may allow the company to take on related projects that further increase its cash flows. Sometimes actual opportunities are brighter than earlier forecasted, and management must be willing to harvest the gold mine when the opportunities lend itself. Sometimes planning is just seeing one or two windows and reality may actually show more windows as in the latter time the manager now see more trees than when he or she was looking at the forest. Sometimes technological changes suddenly afford better ways of doing things. Such events will actually allow flexibility to for Rattle to modify its operations over the course of the project. If more profits and better cash inflows result from taking advantage of technological developments, then it would be lack of management skill not do have it to benefit the company. After all, management is sometimes tactical but not always strategic where there is need to change ways to improve the cash position of the company. Shareholder value must be maximized at all times, but if not possible, its reduction should be minimized by properly managing or reducing risks. Management must keep itself aware of opportunities to alter expected cash flows if the same is justified while the project is on-going, or even before it will get implemented. It must visualize the possibilities of shutting down or accelerating the project, enabling it to explore other potentially lucrative future projects related to the existing project, and the flexibility options in modifying its operations. It must, however, be careful to use the proper cost of capital in managing these risks for discounting purposes, in order to have correct information for decision making. Question four. A critique of the main issues of Rattle using 100% debt funding to finance the project and the effect this would have on the appraisal above. (30 marks) Funding the project using 100% debt simply sends the message that it will all be financed by creditors. If the present capital structure of Rattle justifies the same, then there is no problem with it. Although the project is a separate one, the results will still affect Rattle as its parent company. The assets invested and debts incurred will still form part of the financial conditions of Rattle, so the decision to have 100% debt financing cannot be isolated from looking at the company as a whole. By combining the total assets, liabilities and equity of the company after it would have financed the project, it must be easy to see the resulting capital structure of the company and whether it is highly leveraged or not. Rattle is assumed to have other competitors in the industry against which its cost of capital and market position, as well as its gearing position, should be compared. The capital structure is normally measured using a debt to equity ratio. The higher the ratio, the higher the gearing and the more risky the company is (Falkenstein 2009; Ineichen 2002; Nakisa 2010). Increasing the ratio of the company would surely affect its cost of capital and its price per share in the stock market. Having too high a financial leverage or gearing may actually make the company too risky to invest in. Normally a company will have a combined source of financing – from debt and equity. Actually, companies start with equity, and as outside investors increase their trust in the company, the latter could now go into borrowing. As long the company is profitable and will have good relationships with creditors, it can use debt financing as a source of its capital. This source of capital is, however, market-determined in relation to how the creditors will evaluate the financial capability to pay back creditors and the capacity of management to honour its obligations. Therefore, before arguing whether 100% debt financing is possible, Rattle Co must be evaluated as a whole from an independent point of view. As there is no further information about the capital structure of the company aside from its cost of capital of 7%, it cannot be assumed that financing the project with 100% debt will not alter or increase is cost of capital when it will get more risky by taking on additional debts. Therefore, the option of raising capital using 100% debt financing should be analysed along with the idea of alternative equity financing. Equity financing comes from selling shares of stocks, reissuing treasure shares or using retained earnings instead of giving the latter as dividends to shareholders. Therefore, evaluating the good and bad points of 100% debt financing should consider the alternative method of equity financing, if possible. The case facts do not include information that would allow further analysis on choosing equity financing, except (again) the information on cost of capital. Thus, for the purpose of this paper, a theoretical comparison of advantages and disadvantage of debt financing in relation to alternative sources is done. Debt financing normally includes the interest expense to be paid to creditors, and this would give tax savings to the company in terms of additional cash flow because there would be fewer taxes that would come from deductibility of interest expense from taxable income (Megginson, Lucey, & Smart, 2008; Merna, & Al-Thani, 2011). The advantage is clear. However, its drawback comes from the possibility of making the company to have a very high leverage, even as against the rest of the industry in which to it operates, which would make the company riskier for investors (Ross et. al, 1996; Shapiro, 2005; Brigham & Houston, 2002). Too much debt could put the company in a difficult position if forecasted revenues do not happen 100% as expected and forecasted, and this would mean possible drain in the cash flow of the company (Lack, 2013; Lee, 2007; McHugh, Baldacci, & Petrova, 2011). Equity financing, in comparison, may not incur interest expense since only dividends will be given to investors. Dividends are not tax deductible and will not produce cash flow savings as with interest expenses. The advantage of equity financing is that it does not make the company too risky, as compared to debt financing. Its other advantages, however, include fewer dividends for existing shareholders, as there would be more shareholders to share in the profits (Graham & Smart, 2011; Helfert, 2011; Higgins, 2007). The best result, then, comes not from doing one extreme to the exclusion of the other. Companies balance profitability and risk to build sustainable shareholder value, and the same act of balancing comes from capital structure, which is determined by the mix financing sources. Conclusion The management of Rattle can now decide to reject the proposed project even after preparing the adjusted net present value, as the same is still negative. Pursuing the same is a folly, as it will decrease shareholders’ wealth. This paper has also identified possible risks of the project and ways of reducing the same. The idea of 100% debt financing is not necessarily bad if justified by the capital structure of Rattle. In the absence of the clear chance that using debt financing will not affect the cost of capital of Rattle, it is better to play it safe and see its effects before the same could be chosen to the exclusion of debt financing. In order not to err to the one extreme, Rattle is advised to compare first with mix of equity and debt financing before a decision is made. References: Barth, M. (2006). International Accounting Standards and Accounting Quality. Retrieved 3 April 2014 from Baumol, W. and A. Blinder (2008). Economics: Principles and Policy. Cengage Learning Brigham & Ehrhardt (2002). Financial Management Theory and Practice, 10th edn. Harcourt College, Fort Worth, TX Brigham, E. & M. Ehrhardt (2010). 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