Strategic Corporate Finance: Yorkshire Wind Farm Company - Essay Example

Strategic Corporate Finance – Yorkshire Wind Farm Company Yorkshire Wind Farm Company is considering two capital projects. These projects are intended to increase the electricity generation capacity of the company. The extra generation capacity may likely to increase the revenues and returns of the company substantially. However, the company is facing a problem of capital rationing such that the company can pick either of these projects but it cannot accept both projects simultaneously. One of the projects is named as “onshore” project and the other one is “offshore”. Both these projects are expected to have a useful life of around 20 years and after that they are expected to be removed with a decommissioning cost of around £2,000 and £5,000 for onshore and offshore projects, respectively. Task 1 a) Adjustments in Profit and Loss Account As far as the adjustments are concerned, sales revenue has been the same for both projects and there is no change in either of profit and loss account and working of cash flows. Government grant has been adjusted such that the government grant would be received by the company in first year of the project which is £2,000 and £5,000 for both these projects respectively. However, in profit and loss account, government grant is spread to all 20 years in equal proportion which, however, is adjusted for the estimation of cash flows. Local taxes are included in the profit and loss statement however they have not been included in the estimation of cash flows as guided in the additional information. Being a non-cash expense, depreciation is not considered in the cash flow estimation which is however included in the profit and loss statement (Scott and Megginson, 2008). Cash reserve is in fact working capital which is not included in the profit and loss statement. However, an outflow of cash reserve is shown before the start of first year project and has been realized in the last year of the project with the same amount. b) NPV, IRR, ARR, PP Capital budgeting process has been conducted for both these projects in order to evaluate the financial viability of these projects. The financial viability can be envisaged using four types of investment appraisal techniques such as 1) Net Present Value (NPV) 2) Internal Rate of Return (IRR) 3) Accounting Rate of Return, and 4) Payback Period (PP). The following discussion incorporates each of these four techniques with respect to both “onshore” and “offshore” projects. Net Present Value (NPV) Net Present Value of any projects determines the present value of all the future cash flows discounted with an appropriate cost of capital of the firm after deducting the initial investment required to complete the project (Ehrhardt and Brigham, 2010). The figure obtained is in monetary a term, which is also referred to as absolute terms. If the NPV of both these projects are taken into consideration, it can be noted that the “onshore” projects can provide the ultimate benefit of around £3.708 million whereas the “offshore” project is expected to provide the NPV of around £3.114 million. In other words, “onshore” project can provide additional benefit of around £0.595 million. In this way, it is advised to the management of the Yorkshire Wind Farm Company to critically appraise the “onshore” project more than that of “offshore” project as the “onshore” project may likely to provide better results to the company. Internal rate of Return (IRR) Internal rate of return (IRR) is the return which is demanded by the providers of finance to the company such as the debt holders and shareholders (John, Smart and Megginson, 2009). For any given project, a company pays a certain cost in anticipation of a required return. The percentage of cost is known as cost of capital whereas the percentage of return is known as rate of return. In order for a project to be financially viable, the internal rate of return must exceed its cost of capital. The excess return is the net benefit available to the finance providers of the firm. As far as both these projects are concerned, it can be noted that the company is using the same cost of capital for both projects which is around 10%. However, IRR generated by “onshore” project is around 15% and by “offshore” project is 12%. The fundamental threshold for IRR has been met by both these projects as the IRR for both these projects, is exceeding the cost of capital. On comparative basis, it can be noted that the “onshore” project is providing 3% extra benefit than that of “offshore” project. Based on IRR, it seems that the “onshore” project is more financially feasible than “offshore” project as a result; the management of the company should focus more on the “onshore” project. Accounting Rate of Return (ARR) Accounting Rate of Return (ARR) can be defined as the rate of return which incorporates the accounting figures rather than the cash flows unlike NPV and IRR. This technique is uses average accounting income and average investment in order to compute ARR. ARR can be calculated by dividing the average profits with average initial investments. The average profits over next 20 years for both “onshore” and offshore” projects are expected to be around £1,045 and £1,530, respectively. The average initial investment will be around £6,000 and £12,500 for both these projects. The ARR for “onshore” project will be around 17% and for “offshore” project, it will remain around 12%. Therefore, on the basis of ARR, it is suggested to the management of the company that “onshore” project is more feasible as it may provide 5% extra accounting rate of return as compared to the “offshore” project. Hence, “onshore” project should be carefully considered. Payback Period Payback period can be defined as the period in which the initial investment of any project may likely be recovered. This technique works on the basis of cumulative cash flows with both normal and discounted cash flow streams. The decision making criteria for payback period is the project taking less amount of time in completion of the project. Under the given situation, cumulative discounted cash flow stream are accounted for calculating the payback period. The company has established the threshold period of 10 years for the recovery of the initial investment. Meeting upon this criterion, the initial investment of “onshore” project is likely to be recovered in 7.04 years whereas the initial investment for “offshore” project may likely be recovered in 7.89 years. Therefore, it can be noted that the initial investment for “onshore” project may likely be recovered in around 10 months earlier than the “offshore” project. On the basis of this estimation, again “onshore” project seems less risky as compare to “offshore” project as its initial investment is likely be recovered in much lesser time, therefore, it is advised to the management of the company to take “onshore” project more into consideration. On a concluding note, all four types of investment appraisal techniques are indicating the fact that the “onshore” project is much more feasible and viable for Yorkshire Wind Farm Company, as the results of “onshore” project have been way ahead under all these appraisal techniques as compared to “offshore” project. It is strongly advised and suggested to the company management to accept the “onshore” project as the project is financially sound enough to accomplish the strategic goals of the company which “offshore” project may not. c) Sensitivity Analysis Onshore No Change + 10% - 10%   NPV IRR NPV IRR NPV IRR     MWh generated 3,708 15% 5,556 18% 1,861 13% Price per MWh 3,708 15% 5,556 18% 1,861 13% Time   Sales Revenue 3,708 15% 5,556 18% 1,861 13% Government Grants 3,708 15% 3,890 16% 3,526 15% Wind Turbines 3,708 15% 2,763 14% 4,654 17% Civil and electrical infrastructure 3,708 15% 3,617 15% 3,799 16% Grid Connection 3,708 15% 3,617 15% 3,799 16% Refurbishment 3,708 15% 3,603 15% 3,814 15% Decommissioning Cost 3,708 15% 3,678 15% 3,738 15% Cash Reserve 3,708 15% 3,623 15% 3,793 16% Maintenance and Insurance 3,708 15% 3,495 15% 3,921 16% Net Other Cost 3,708 15% 3,610 15% 3,806 15% Discount Factor 3,708 15% 2,855 15% 4,665 15% Offshore No Change + 10% - 10%   NPV IRR NPV IRR NPV IRR     MWh generated 3,114 12% 6,093 15% 134 10% Price per MWh 3,114 12% 6,093 15% 134 10% Time   Sales Revenue 3,114 12% 6,093 15% 134 10% Government Grants 3,114 12% 3,568 13% 2,659 12% Wind Turbines 3,114 12% 1,186 11% 5,041 14% Civil and electrical infrastructure 3,114 12% 2,932 12% 3,295 13% Grid Connection 3,114 12% 2,977 12% 3,250 13% Refurbishment 3,114 12% 2,915 12% 3,312 13% Decommissioning Cost 3,114 12% 3,039 12% 3,188 12% Cash Reserve 3,114 12% 2,986 12% 3,241 13% Maintenance and Insurance 3,114 12% 2,688 12% 3,539 13% Net Other Cost 3,114 12% 3,063 12% 3,165 12% Discount Factor 3,114 12% 1,723 12% 4,670 12% Task 2 Risk Risk can be defined as the degree of adverse uncertainty relating to a specific outcome. There are various methods of calculating the amount of risk involved in a certain project such as using statistical tools techniques in the form of standard deviation, coefficient of variation etc. Probability techniques are also used to calculate the amount of risk. Some other measures include sensitivity analysis and simulation based techniques for calculating the amount of risk. Under the given scenario, the only technique which is used for calculating the amount of risk is sensitivity analysis. Sensitivity analysis is that technique in which the impact of the certain change of percentage in a specific variable is studied over the end results. In other words if a variable is changed by a certain percentage how much change would be felt in the outcome. For the purpose of the existing scenario, the impact of 10% change in each variable is taken into consideration on the Net Present Value and the Internal Rate of Return for this project. If a certain variable is increased or decreased by 10% what would be the change in the corresponding NPV and IRR of the project as a result of such change. Around 13 variables are studied in this scenario and their upward and downward variation is studied on the NPV and IRR of the project as compared to “no change” situation. “Onshore” Project The first variable to be studied under the scenario of “onshore” project is the power generation capacity. Under the existing situation, the NPV generated from current generation capacity would be around £3.708 million with the IRR of 15%. However, if the power generation capacity is increased to 10% percent, it would result in the increase of NPV and IRR, which would likely be £5.56 million and 18% respectively. However, if generation capacity is reduced by 10% it would result in the loss of NPV as well as IRR which would be lowered down to £1.86 million and 13% respectively. On the other hand, if the price per MWh for “onshore” project is increased or decreased by 10%, it would result in the same increase of NPV and IRR as determined previously for generation capacity. Similarly, sales revenue is the outcome price and generation capacity, therefore it will also result in the same direction as demonstrated by generation capacity and price per MHh. It can be noted that there is a very significant risk involved in the generation of NPV and IRR if the both or either of generation capacity and price are increased or decreased and will highly impact upon the feasibility of the project. Government grant is also another type of cash inflow associated with the project such that if there is an increase of 10% in government grants, it will increase the NPV and IRR of the project with a very little margin. IRR would be increased by merely 1%. A very meager increase would be felt in NPV. Conversely, if government grants are reduced by 10%, it would result in a very little decrease in NPV however IRR will still remain closer to 15%. Thus government grants do not pose much risk to this project. After these cash inflows, major types of risks are also involved in the cash outflows relating to projects (Lumby and Jones, 2003). Investment in wind turbine is the major cash outflow for the project such that if there is an increase in the cost of wind turbine by 10%, it would reduce the NPV as well as IRR of the project. The NPV would be lowered down to £2.763 million with the IRR of 14%. On the other hand, if there is a decrease of 10% in the cost of wind turbines, it would increase the NPV to £4.65 million with an IRR of 17%. From this analysis, cost of wind turbine is very sensitive to the overall project outcomes and benefits. Other costs such as civil and electrical infrastructure, grid connection, refurbishment, decommissioning cost, maintenance, etc. are the ones which rarely impact upon the results of the project such that the NPV is remains around £3.6 million with the increase of 10% in any of these variables with the constant IRR of 10%. Conversely, if there is a decrease of 10% in these variables, it would not fade the NPV and IRR results too much and the net benefits would remain almost the same. “Offshore” Project For “offshore” project, the first variable is the same as that of “onshore” project which is power generation capacity. Under the existing situation, the NPV generated from current generation capacity would be around £3.114 million with the IRR of 12%. However, if the power generation capacity is increased to 10% percent, it would result in the increase of NPV and IRR, which would likely be £6.093 million and 15% respectively. However, if generation capacity is reduced by 10% it would result in the loss of NPV as well as IRR which would be lowered down to £1.34 million and 10% respectively. On the other hand, if the price per MWh for “offshore” project is increased or decreased by 10%, it would result in the same increase of NPV and IRR as determined previously for generation capacity. Similarly, sales revenue is the outcome of price and generation capacity, therefore it will also result in the same direction as demonstrated by generation capacity and price per MHh. It can be noted that there is a very significant risk involved in the generation of NPV and IRR if both or either of generation capacity and price are increased or decreased and will highly impact upon the feasibility of the project. Government grant is also another type of cash inflow associated with the project such that if there is an increase of 10% in government grants, it will increase the NPV and IRR of the project with a very little margin. IRR would be increased by merely 1%. A very insufficient increase would be experienced in NPV. Conversely, if government grants are reduced by 10%, it would result in a very little decrease in NPV however IRR will still remain closer to 15%. Thus government grants do not pose much risk to this project. Major other types of risks are also involved in the cash outflows relating to “offshore” project. Investment in wind turbine is the major cash outflow for the project such that if there is an increase in the cost of wind turbine by 10%, it would reduce the NPV as well as IRR of the project. The NPV would be lowered down to £1.186 million with the IRR of 11%. On the other hand, if there is a decrease of 10% in the cost of wind turbines, it would increase the NPV to £5.041 million with an IRR of 14%. From this analysis, cost of wind turbine is very sensitive to the overall project outcomes and benefits. Other costs such as civil and electrical infrastructure, grid connection, refurbishment, decommissioning cost, maintenance, etc. are the ones which rarely impact upon the results of the project such that the NPV is remains around £2.9 million with the increase of 10% in any of these variables with the constant IRR of 10%. Conversely, if there is a decrease of 10% in these variables, it would not fade the NPV and IRR results too much and the net benefits would remain almost the same. On a concluding note, the “onshore” project is very sensitive to three major risks which are power generation capacity, price and cost of wind turbines. If there is a little variation found in any of these three variables, the overall project dynamics can show significant movements in either direction causing greater uncertainty to the project (Quiry, Fur, Salvi, Dallochio and Vernimmen, 2011). Works Cited B. Smart, Scott and William L. Megginson, Corporate Finance, Cengage Learning EMEA, Oxford, 2008. Michael C. Ehrhardt, Eugene Foster Brigham, Corporate Finance: A Focused Approach (Book Only), Cengage Learning, New York, 2010. Quiry, Pascal, Yann Le Fur, Antonio Salvi, Maurizio Dallochio and Pierre Vernimmen, Corporate Finance: Theory and Practice, John Wiley & Sons, London, 2011. R. Graham, John, Scott B. Smart and William L. Megginson, Corporate Finance: Linking Theory to What Companies Do, Cengage Learning, California, 2009. Steve Lumby, Chris M. Jones, Corporate Finance: Theory & Practice, Cengage Learning EMEA, New York, 2003. Read More