Financial Management of Paddle Your Own Canoe Plc - Assignment Example

I. Question A. Prepare calculations and advice Paddle Your Own Canoe Plc whether the project should be undertaken, using Payback, Net Present Value and Internal Rate of Return. Assume all the revenues and costs rise at the end of the year to which they relate and ignore taxation and inflation in your calculation. In assessing capital budgeting decisions, net present value, internal rate of return and payback period are the usual techniques that are used to come up with a decision. Cash flows are vital to all these analyses; but discounted cash flows are more important for the two methods such as the net present value and the internal rate of return. The relevant cash flows include: the initial cash outlay, in the case of Paddle Your Own Canoe Plc, this amounts to 5,150,000 (see Figure 1 in Appendices) in the form of investment in plant and machinery as well as the additional working capital; the annual operating cash flows, which is derived by getting the net income of the operations then adding back the depreciation expenses; and the terminal cash flow, in the case of the company, this amounts to 1,775,000 (see Figure 1 in Appendices)—the sum of the estimated salvage value of the initial investment and the recovery of working capital at the end of the project. The initial outlay does not include the investment in the initial development which amounts to 750,000 (see Figure 1 in Appendices). What are included are the estimated cost of building the plant and machinery which amounts to 4,250,000 (see Figure 1 in Appendices), as well as the additional investment in working capital in order to run the plant, which amounts to 900,000 (see Figure 1 in Appendices). Another thing to note is that the investment in working capital occurs in two years, the 900,000 in 2009, and the 450,000 in 2010 (see Figure 1 in Appendices). The 450,000 in 2010 is added to the operating cash flows in 2010 and discounted back in order to provide a more accurate analysis. After the initial outlay, the cash flows from operations are determined. This can be done by looking at the schedule provided in the case, solving for the annual revenues by multiplying the projected annual sales volume, as well as the price (see Figure 1 in Appendices): in 2010, this amounts to 8,000,000; 2011, this figure is 8,800,000; 9,600,000 in 2012; 7,200,000 in 2013; and 6,000,000 in 2014, respectively. The variable cost of labour amounts to 25 per unit, the variable cost of material amounts to 30, and the variable cost of overhead amounts to 50% of the cost of labour, or 12.5. Multiplying these to the respective sales volume per year, the gross margin per year is (see Figure 1 in Appendices): 1,250,000 in 2010; 1375,000 in 2011, 1,500,000 in 2012; 1,125,000 in 2013; and 600,000 in 2014. After deducting the additional fixed costs amounting to 1,150,000 and the depreciation of the machinery and plant, which amounts to 850,000 per year as the company uses a straight-line method of depreciation and depreciates the assets in five years, the company has negative profits over the period. The companys profits over the years include negative 750,000 in 2010, negative 625,000 in 2011, negative 500,000 in 2012, negative 875,000 in 2013, and negative 1,400,000 in 2014. As the depreciation expenses are added back in order to get cash flows, the figures amount to 100,000 in 2010, 225,000 in 2011, 350,000 in 2012, negative 25,000 in 2013, and negative 550,000 in 2014. The total cash flows amount to negative 5,150,000 in 2009, the sum of the capital investment and initial investment in working capital; negative 350,000 in 2010, the sum of the investment in working capital and the cash flow from operations; 225,000, 350,000 and negative 25,000 in 2011, 2012, and 2013 respectively; and 1,225,000 in 2014, the sum of the salvage value of the initial investment, the recovery of investment in working capital, as well as the cash flows from operations (see Figure 1, Given the total cash flows, by discounting them using the 13% discount factor, we can get the net present value of the project which amounts to a negative figure of negative 4,391,370; an undefined negative internal rate of return, as there is no rate where the present value of the cash flows will equal zero, and an indeterminate payback period, because within the time frame of the project, the investment cannot be recoup. Given all those investment appraisal, this project is not good for Paddle Your Own Canoe Plc, as it will only create a negative value to the firm over the years. B. In response to questions from various members of the Board, provide a rationale for your treatment of the following: - initial research – depreciation – working capital, supporting your comments by reference to academic theory. When analysing a project investment, what matters is the incremental only that is the incremental cash flows that the project provides. By comparing the scenarios where the project is pursued with the scenario where the project is not pursued, the additional or the incremental is the only cash flow that matters in the analysis. The discounted cash flow analysis in finance takes note of the incremental costs and benefits to a firm only in order to make future decisions. Therefore, the initial cost of the research of Paddle Your Own Canoe Plc is already considered sunk cost and should not be included in the analysis. Depreciation is defined as “the allocation of a plant asset’s expense over its useful life (Horngren, Harrison & Bamber 2002, G-2).” This allocation of a plant asset’s expense does not entail a cash outflow for the company. It is therefore important that in the analysis the company’s income statement, we see that the accounting profit is different from the cash flows within the organization. Because cash flow is not affected by depreciation, the depreciation expense that is subtracted from the net profit is added back in order to get the real cash flow figure. And in analysing the investment’s net present value, we are more interested in cash flow which we can discount according to the hurdle rate, rather than accounting profits. Paddle Your Own Canoe Plcs investment in plant and machinery needs additional investment in working capital in order to make the plant run. Without this additional working capital, the operations of the plant would not resume, therefore this amount is also important to be included in the initial outlay of the company. This additional working capital requirement entails more cash, more accounts receivable, or more supplies or inventories in the process as part of the project. Therefore, it is only important to note these changes when doing the analysis for the capital investment project. Also, at the end of the project it is usual that this investment in working capital is recovered and that it should be included in computing for the terminal cash flow. C. Briefly appraise the use of Payback, Net Present Value and Internal Rate of Return as methods of investment appraisal. The goal of capital budgeting is to choose projects that will contribute and add value to the company. This increase in value is reflected by the time value of money, a principle in finance that states that there is an opportunity cost to holding money, thus companies are obliged as agents to the owners to choose projects that would yield higher returns than the opportunity cost of investing money in other ventures. This is the way the company creates value to its shareholders wealth. In line with this, three appraisal methods are used to evaluate projects—with the net present value as the strongest of the methods as it incorporates the concept of the time value of money in the analysis, and uses the investors required rate of return as the hurdle rate as basis on what projects will be chosen. The internal rate of return is also a good method, however, it is less favoured than the NPV method because with this method, it is assumed that the returns are reinvested at the rate of the IRR instead of the required rate of return of investors, which is mostly the case in the real world. The weakest among the three methods is the payback period, which measures the length of time before the initial investment is recoup with the annual cash flows, without reference to the concept of time value of money. II. Question 2 A. Linking your comments to the quotation from McLaney above, advise the Board of Paddle Your Own Canoe Plc on the use of discounted payback and risk adjusted discount factors as possible methods of accounting for risk in the appraisal of the investment project in the question. Discounted payback, in contrast to traditional payback, uses discounted cash flows and takes note of the cash flow’s timing and its implications on the time value of money. By using a discount rate that incorporates the additional risk on the investment, the recovery of the initial outlay is measured by the present value of the cash flows in contrast to the undiscounted value which is used by traditional payback method. As McLaney has stated it, with the payback using the cash flows that are discounted according to the required return to the investors according to their perception of risk, this incorporates a better analysis. The risk-adjusted discount factors emphasise investors concern over additional returns for a level of risk that they bear by choosing to invest in the firm. Discounted payback method is more appropriate in determining profitable projects in terms of the number of years a firm wants to recover its initial investment. When the discount rate that is used incorporates the appropriate risks, the recovery reflects use of the cash flows which are discounted to bring them to their present value. The present value incorporates the risks that come in the required rate of return which is used as the hurdle rate, therefore represents the opportunity cost of capital, and therefore is a better measure for recoup of initial investment compared to the undiscounted cash flow that is used in traditional payback. B. Evaluate the alternatives of issuing shares or borrowing to finance an investment project commenting on the impact of the preferred choice on the gearing and capital structure of a company such as Paddle Your Own Canoe Plc. Paddle Your Own Canoe Plc is mostly equity financed, with very little debt financing as regards its capital structure. By issuing more shares, the capital structure increases the mix toward equity, and reduces the proportion of debt. As the proportion of equity increases and the proportion of debt decreases when Paddle Your Own Canoe Plc decides to issue more share, the weighted average cost of capital of the company increases because the return on equity is distributed over a larger proportion in the entire capital structure. The use of leverage is decreased. By using debt financing however, the company employs financial leverage which decreases the weighted average cost of capital, which is the gearing ratio. III. Question 3 (600) A. With reference to the above, comment on the ability of mergers to create shareholder value by means of synergy. When companies merge and their competitive advantages complement each other, the value they create when they are merged is bigger than the value they hold when they stand alone. According to Hodgkinson and Partington: In a synergistic takeover, wealth is created by combining the resources of acquirer and target in such a way that the value of the combined entity is greater than the sum of the separate entities values (2008, 102). This synergy results in the companies ability to utilise the technical know-hows of each other, thus resulting either in higher earning capability due to higher profits, or huge saving potential (Al-shakras, Hassan & Lawrence 2008, 50; Venema 2006). These factors contribute to the creation of value due to synergy. Companies usually merge in order to take advantage of the technical know-hows of the other organisation, which the acquirer currently lacks (Chiu 1990). With the merger, not only the resources are merged, but also the intangibles of the organisation which is represented by goodwill, such as the targets business system, customers, infrastructure that can be valuable to the acquirer. This may come in the form of huge saving potential for the acquirer, or a strategic move to further expand the business (Woodlock & Peng 2009). This increase in the earning potential of both organisations drive the prices of the stocks of the company because of the prospect of synergy, thus increasing the shareholder value. Since market value is dependent on a companys earning potential, the impact of mergers to the operations of the two companies, from a fundamental perspective creates value in the form of incorporation of benefits to the prices; with the efficient market theory, it is assumed that investors are rational and incorporate the future benefit of such a move in the form of higher prices in the market. B. Evaluate the importance of non-financial factors in contributing to the success of a merger. Non-financial factors are also important to the success of a merger (Tokic & Beyea 2009). These include factors such as the role of the target in the larger strategic plan of the acquirer, the alignment of corporate values, and factors like organisational culture and strategies. In order for a merger to be successful, it has to be strategic. Usually, mergers are done in order for a company to grow inorganically, thus resorting into acquiring its competitors to increase its share in the market (Woodlock 2008). In other instances, competitors merge in order to consolidate their strategic capabilities and thus dominate the market with their effort (Woodlock & Peng 2009). Or, if companies merge with other companies that are not their competitors, their usual reason is to take advantage of the strategic capability of the target which is valuable to the acquirer, either to increase revenues or decrease costs, and increase overall earnings. If the merger is strategic, factors in line with the internal systems are the usual issues. For example, how the target fits the perception of the acquirers brand is an important consideration. Also, in order for two companies to work harmoniously, there should not be a clash of values. The two organisations, when merged should be able to create a culture that would consolidate them in order to take advantage of their capabilities. Culture clashes are detrimental to the two organisations and are the usual causes for mergers to fail. IV. Question 4 A. Evaluate the above with reference to the recent developments in the financial markets throughout the world. Bubbles occur when the valuation of a stock of a company deviates from the sum of the expected value of the stock in terms of its present earnings and ability to earn in the future (Black, Fraser, & Hoesli 2006, 1535). With the occurrences of bubbles in different financial markets across the globe, followed by a crash, theses events are totally not aligned with the efficient theory of market, which is based on the assumption that investors are rational and try to incorporate the information in the prices of the stocks. According to Black, Fraser & Hoesli, there are three instances to describe a bubble—the momentum investor behaviour, the explosive, and the intrinsic bubble (2006, 1535). According to them, out of these three behaviours, only the momentum investor behaviour is driven by price and can be considered irrational. As the price rises, investors expect the price to continue to rise, without regard to the fundamental value. On the other hand, the explosive and the intrinsic bubble are rather based on rational behaviours. According to them, explosive bubbles are driven by factors extraneous to asset value (Black, Fraser, & Hoesli 2006, 1535), an example would be a take-over situation (Alexandridis, Antoniou & Petmezas 2007, 439; Antoniou, Petmezas, & Zhao 2007, 1221). The intrinsic bubbles deviate not so farther from the asset value, however, these are driven by exogenous fundamentals rather than extraneous factors (Black, Fraser, Hoesli 2006, 1536), an example would be a self-fulfilling expectation which could drive the prices of a stock. Therefore, the efficient market theory can still hold in some events when bubbles exist. In MacDonalds study of the UK stock market in 1994, he has found out mixed conclusions as regards the efficient market hypothesis and stock bubbles (74). According to him, one of the conclusions is to say that the stock market is driven by fad and that the market is therefore irrational (MacDonald 1994, 74). Also, according to him, another plausible conclusion why the efficient market theory does not hold in his study is that rational bubbles are at work for the sample period and therefore the transversality assumption is violated (MacDonald 1994, 74). In the study of Tokic, on the other hand, four technology companies are probed in order to assess the existence of bubbles and whether these bubbles are grounded on the irrationality of investors, thus not being in line with the efficient stock market theory. By assessing the stock prices of Google, Apple, Amazon.com and Research in Motion, it has been found out that their stocks are richly valued and therefore, no irrational speculative bubbles are traced (Tokic 2008, 19). All these provide some evidence to the strength of the efficient theory of the stock market. While there are bubbles in most of the stock markets across the globe, some of these bubbles are not driven by irrationality. Therefore, these bubbles are consistent with the theory; according to some of them, when these bubbles burst, it is not a result of irrationality but rather different factors such as the prolonged recession in the global economy (Tokic 2008, 19), as of the current. Appendices Figure 1 References Alexandridis, G., Antoniou, A., & Petmezas, D. (2007 April/May). “Divergence of opinion and post-acquisition performance.” Journal of Business Finance and Accounting. Date accessed: May 17, 2009 from http://web.ebscohost.com/ehost/pdf?vid=1&hid=5&sid=729eeb9d-90bd-48ea-80de-a5a169e20063%40SRCSM2 Al-Sharkas, A. A., Hassan, & M. K., Lawrence, S. (2008 January/March). “The impact of mergers and acquisitions on the efficiency of the US banking industry: further evidence.” Journal of Business Finance and Accounting. Date accessed: May 17, 2009 from http://web.ebscohost.com/ehost/pdf?vid=1&hid=5&sid=73be8889-db31-4884-a39b-03e5d6eb93a3%40sessionmgr3 Antoniou, A., Petmezas, D., & Zhao, H. (2007 September/October). “Bidder gains and losses of firms involved in many acquisitions.” Journal of Business Finance and Accounting. Date accessed: May 17, 2009 from http://web.ebscohost.com/ehost/pdf?vid=1&hid=5&sid=20e03d76-e364-4cee-ae10-781dac12a693%40sessionmgr9 Black, A., Fraser, P., & Hoesli, M. (2006 November/December). “House prices, fundamentals and bubbles.” Journal of Business Finance and Accounting. Date accessed: May 17, 2009 from http://web.ebscohost.com/ehost/pdf?vid=1&hid=102&sid=ef61f5c3-319e-4363-b604-25f944fddadd%40sessionmgr109 Brealey, R. A., Myers, S. C., & Marcus, A. J. (2004) Fundamentals of Corporate Finance. New York: McGraw Hill. Chiu, P. (1990 Fall). “Mergers and acquisitions considerations” Journal of Corporate Accounting and Finance. Volume 2 Issue 1, pp. 103-107. Date accessed: May 17, 2009 from http://www3.interscience.wiley.com/cgi-bin/fulltext/112774893/PDFSTART Hodgkinson, L., & Partington, G. H. (2008 January/March). “The motivation for takeovers in the UK.” Journal of Business Finance and Accounting. Date accessed: May 17, 2009 from http://web.ebscohost.com/ehost/pdf?vid=1&hid=5&sid=7cb98322-e142-412d-b159-07ef0f0974ff%40SRCSM2 Horngren, C. T, Harrison, W. T., & Bamber, L. S. (2002) Accounting. New Jersey: Prentice Hall, Inc. Keown, A. J., Martin, J. D., Petty, J. W., & Scott, D. F. (2002) Financial Management: Principles and Applications. New Jersey: Prentice Hall, Inc. MacDonald, Ronald. (1994 January). “Stock prices and excessive volatility: some evidence for the FT ordinary share index.” Journal of Business Finance and Accounting. Date accessed: May 17, 2009 from http://web.ebscohost.com/ehost/pdf?vid=1&hid=102&sid=c7198723-2956-495a-9d32-9dfb7acf39a4%40sessionmgr104 Tokic, D. (2008 July/August). “The four horsement of tech: Has another bubble burst?” Journal of Corporate Accounting and Finance. Volume 19 Issue 5, pp. 15-20. Date accessed: May 17, 2009 from http://www3.interscience.wiley.com/cgi-bin/fulltext/119882571/PDFSTART Tokic, S., & Beyea, G. (2009 January/February). “An M&A lesson: Should money always talk?” Journal of Corporate Accounting and Finance. Volume 20 Issue 2, pp. 9-16. Date accessed: May 17, 2009 from http://www3.interscience.wiley.com/cgi-bin/fulltext/121575666/PDFSTART Venema. (2006 March/April). “Managing M&A costs.” Journal of Corporate Accounting and Finance. Volume 17 Issue 3, pp. 31-35. Date accessed: May 17, 2009 from http://www3.interscience.wiley.com/cgi-bin/fulltext/112412056/PDFSTART Woodlock, P. (2008 January/February). “New Rules Affect Post-M&A Controls” Journal of Corporate Accounting and Finance. Volume 19 Issue 2, pp. 43-48. Date accessed: May 17, 2009 from http://www3.interscience.wiley.com/cgi-bin/fulltext/117874666/PDFSTART Woodlock, P. & Peng, G. (2009 May/June). “How will valuation changes affect M&A deals?” Journal of Corporate Accounting and Finance. Volume 20 Issue 4, pp. 49-61. Date accessed: May 17, 2009 from http://www3.interscience.wiley.com/cgi-bin/fulltext/122316828/PDFSTART Read More