Maritsa Plcs Using the Capital Asset Pricing Model - Essay Example

Maritsa Plc’s Using the Capital Asset Pricing Model 1. Cost of Capital Using the CAPM The capital asset pricing model (CAPM) is one of the most popular tools in finance which is used to determine a theoretically required rate of return of an asset, if that asset is added to an already well diversified portfolio, given the asset’s non-diversifiable risk1. Using the Capital Asset Pricing Model, the cost of capital is computed as: kc = krf + ß (km-krf) where: kc is the cost of capital; krf is the risk free rate; ß is the systematic risk of the common stock’s return relative to the market as a whole; and km-krf is the market risk premium, which is equal to the difference in the expected rate of return for the market as a whole2. In the case of Maritsa, the cost of capital is computed as: kc = .08 + (0.2) (.13-0.08) kc = 0.8 + 0.01 kc = 8.1% In order to simplify the computation of the return on investment, a rate of 8% will be used. 1. Computation of Net Present Value In order to choose the most profitable investment to be pursued, the Net Present Value (NPV) technique will be used. This method of capital budgeting is widely used because of its recognition of the time value of money3. Thus, annual cash flows will be discounted order to arrive at their present values. Table 1 shows the computation of NPV for the first option which is to renew the rent contract and extend the facility for higher production. It should be noted that the values are expressed in unit £. It can be seen that the rent payments are adjusted each year to take into account the annual 5% inflation. The NPV for Option 1 is computed as -£2,562,594. Table 1. NPV for Option 1: Rent and Extend Table 2 shows the computation of NPV for the second option which is to purchase a larger facility to accommodate the increasing demand for the products. Like in the first option, all values are expressed in unit £. Consistent with the case, this paper assumes that the company is able to secure financing through five-year debenture with an 11.5% annual interest. It is also assumed that the company borrows the whole amount that it used to purchase the building which is equivalent to £2,500,000. This paper also assumes that interest payments are taxable thus; it opts to deduct the tax shield from interest payments in the cash outflow. This paper also assumes that the building will be sold at £5,000,000 after the ten-year period. The computed NPV for the ten-year period is -£1,674,701. Table 2. NPV for Option 2: Buy Larger, Locally Table 3 shows the computation of NPV for the third option which is to build a new facility. Consistent, with the case, the NPV computation is limited only to 15 years eve n though the company can use the facility indefinitely. Thus, at the end of 2021, this paper expects that the market value of the facility will be £5,000,000. It is also assumed that Marista PLC will be depreciating its building using the straight line method. Like in Option 2, this paper assumes the company will be financing this investment with five-year debenture with 11.5% annual interests. The cost of the land and the building are assumed to be covered by five-year debenture. The tax-shield from interest payment is also treated as incremental tax flow. It can be seen that the cash flows from 2012-2020 are lumped together and multiplied by the sum of the individual unit present values. The computed NPV of option 3 is £398,114. Table 3. NPV for Option 3: Build New 2. Report to the CEO Introduction For a business organization, it is imperative that the company’s resources should be channeled to investments which yield the highest profit in order to maximize shareholder value. Due to increasing demand for the musical products manufactured by Maritsa Plc, it is necessary that the company also increase its production capacity to accommodate higher levels of production. Thus, the company must choose among three options: 1. Extend the rental agreement and request for an extension 2. Buy a larger property located near the current site which is around 20 years old 3. Build a new factory and office premises in an Enterprise Zone which is approximately 150 miles away. This report is a formal recommendation based on the analysis of annual cash flows of the three options. The first section will look at the computation of the discount rates. Next, the three options will be evaluated using the Net Present Value Model. Lastly, this report will offer its recommendation regarding according to the risks and the non-financial risks associated with the options. Calculation of the Discount Rate Discount rate or cost of capital which is defined by Keown, et. al, as “the required rate of return of the firm’s investor.”4 In evaluating the prospects of Maritsa, Plc, the cost of capital will be computed by using the Capital Asset Pricing Model (CAPM). The rationale for using CAPM is that it is relatively simpler and easier to understand as well as to implement. It should be noted that the variables in the formula can be easily accessed from public sources. The discount rate according to CAPM is 8.1%. However, for the sake of simplifying the computation, this report will assume a discount rate of 8.0 %. Calculation of NPV for the Three Options In terms of NPV, option three which is to build a new facility appears to be more profitable. It should be noted that the three projects are expected to provide negative NPVs. Furthermore, the three projects have different life spans: the first option covers only five years; the second spans ten years; while the third covers 15 years. However, the logical choice will be the option which will give the highest NPV at the longest year. Thus, in terms of financials, Option 3 is selected. Marista Plc should build a new factory. Qualitative Considerations The quantitative aspects of analysis should also be supplemented with evaluation of qualitative factors. In order to identify the best alternative for Maritsa Plc, qualitative considerations will also be taken into account. For the first alternative, Maritsa Plc will not undergo many changes as they will be staying and operating on the same location and facility. The company won’t also have any problem with the financing because it will be getting the fund from its operation. However, as the current facility is regulated by the government, Maritsa Plc is also subject to governmental regulations. There is a possibility that the government will not allow the company to build the needed extension. In option 2, the company will need to deal with more non-financial problems. It should be noted that Maritsa Plc will need to deal with hesitance from the human resource to transfer to the new location especially those live farther away. The company also needs to evaluate the efficiency of the facility as it has been built for 20 years. Also, the company also faces the risk of not acquiring the much-needed financing. In option 3, Maritsa will be adjusting to numerous changes. F or one, the relocation 150 miles from the original facility will necessitate encouraging the company’s current employees to stay with Maritsa. Otherwise, the company needs to train new people to take over the manufacturing activity. As with the second option, the company will also need to find ways to acquire the necessary funds. Recommendation and Conclusion It is recommended that Marista Plc choose option 3 as the expected benefits will outweigh the costs in the long run. In building its own facility, the company can specifically tailor the facility to suit its own needs. Marista Plc is also able to get rid of renewing rental contracts every now and then freeing resources and time to be devoted to achieve other company objectives. Staying in an Enterprise Zone will enable knowledge spillover which can aid the company in enhancing its efficiency. 3. Shortcomings of the Capital Asset Pricing Model The capital asset pricing model (CAPM), though typically used in making financial decisions is not without criticisms. In the case of Maritsa Plc, the CAPM method does not thoroughly account for the cost of capital. It should be noted that the CAPM model assumes the absence of bankruptcy costs. In the real world, all companies have to deal with bankruptcy costs. Also, the formulation of beta coefficient based on historical data distorts the value of the true cost of capital. It can be recalled that business finance is concerned with the future of a business organisation. Instead of relying on the CAPM in determining the cost of capital, Maritsa can also use the weighted average cost of capital which is the “weighted average of the after tax costs of each capital used by a firm to finance a project, where the weights reflect the proportion of total financing raised from each source.”5 This technique recognizes that creditors and stockholders desire different levels of investment returns. The WACC, thus, satisfies both investors and creditors. 4. Uncertainty and Discount Rate The discount rate as stated above indicates the investors required rate of return, that is, “the minimum rate of return necessary to attract an investor.”6 In the case of Maritsa Plc, the company should be able to use a discount rate which reflects all the associated risks with the investment. Projects which have higher level of risks require higher returns, thus, higher discount rates. However, the CEO should be able to recognize the difference between risks and uncertainty before adjusting the discount rate by a notional percentage. Schultz (2004) identifies risk and uncertainty asserting that they are “closely related but not identical.”7 He states that “uncertainty may involve things that are completely unknown, whereas risks are often understood via calculable probabilities.”8 It can be seen that uncertainty can indicate risk, implying that as uncertainty increases, the risk also increases. In the case of Maritsa Plc, adjusting the discount rate to accommodate higher uncertainty is logical. However, the uncertainty should be thoroughly evaluated in order to suggest an appropriate percentage increase. The CEO cannot just mandate a 2% adjustment without prior analysis. 5. Venture Capital Venture capital is often referred to as “private equity finance.” This type of financing is typically harder to secure as venture capitalists often look at the profit potential and return of investment. Thus, they look for companies who have profitable and feasible business plans. The major advantage of utilizing private equity finance is that they don’t only provide large sums of money but can also bring financial and managerial expertise in the business organization. Their involvement with the company will also make it relatively easier to secure more financing, win contracts, and secure trade. However, employing venture capital will mean diluting the ownership of the firm. In order to secure financing, the company needs to provide a very detailed business plan in order for the venture capitalists to examine the proposal. The process of acquiring financing is also very complex and can be very long which can delay the investment9. Executive Summary The highlights of the report are as follows: 1. Maritsa Plc’s computed cost of capital using the Capital Asset Pricing Model is 8.1%; 2. In terms of NPV and other qualitative considerations, option 3 is most profitable; 3. The CAPM is not a reliable measure of cost of capital because it uses historical data for the computation of beta coefficient and assumes the absence of bankruptcy cost, instead Maritsa Plc can use the weighted average cost of capital which take into account the satisfaction of investors and creditors; 4. Discount rate should be adjusted for risk and uncertainty; and 5. Employing venture capital to finance investment not just injects the company with financing but managerial expertise, yet, requires a complex and long process. Bibliography Brealey and Myers (2005) Principles of corporate finance, McGraw-Hill, 8th Edition. Capital Asset Pricing Model (2006) Retrieved 13 November 2006, from http://en.wikipedia.org/wiki/Capital_asset_pricing_model Equity Finance. (2006). Retrieved 13 November 2006, from http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemID Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, (2005) Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition. Schultz, N. (2004) Uncertainty. Retrieved 13 November 2006, from http://www.beyondintractability.org/essay/fact_finding_limits/ Read More