Project Analysis of PASE Plc - Assignment Example

Finance Project Answer to Question The UK based company PASE plc is contemplating investments in host country Gujistan for the purpose of construction of a base power station to augment the energy sector of this country. While the motive is indeed judicious, the gentlemen on the Board of Directors of this Company in London are circumspect about the future of this project, especially in terms of its economic viability and potental cost recoveries. Thus, it has become necessary, or even imperative to conduct a cost assessment of this project vis-à-vis its future earning capacity and cost implications. This project may be an unmitigated disaster or an unqualified success, depending upon the way the top management at UK look at it. Initially it may be encumbered with tremendous cost burdens with low inflows, which might impinge upon their other productive projects also since funds may need to be diverted to meet these obligations.  But it is possible that it may yield handsome earnings in later years, even after the payback period, and a negative NPV, which may more than recompense for earlier losses, and churn out large profits for the parent company back home in UK. 1(a) The answer to this question could be seen in the light of whether taking up this project could be economically viable and financially feasible for the investing Company, in terms of a positive net present value, (+NPV), positive discounted pay back within seven years and ability of this project to earn profits that could be repatriated to the original parent company in the United Kingdom. There are two main aspects that underline this case study and they are discounted payback system and present value system of capital investment appraisal. It is planned to commence a study of both these strategic interventions in order to determine whether the company should go ahead with taking up this capital intensive project or not. Besides, it is also seen that top management needs to consider whether principal criteria that this proposed investments in Gujistan are met: Criteria One: Discounted payback repays within a seven year period Criteria Two: Present value of this project is positive. Discounted Payback Period System: “A capital budgeting procedure used to determine the profitability of a project. In contrast to an NPV analysis, which provides the overall value of a project, a discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure.” (Discounted payback period, 2010). Fundamentally speaking, the discounted payback period is defined as the number of years required to recover the initial investments from discounted net cash flows. In other words, DPP system is akin to a break even calculation in that the firm is waiting to see when their investments would bear results, in this case the initial G $1m and again the investments in Plant and Machinery for G$ 900m. The main difference between just payback and discounted payback is that the latter considers the time value of investments. In this case if G$10m is gained back through regular equal inflows of G$2.5m each time, the project would payback in just 10/2.5 = 4 years. But this is not the case. In the case of Gujisthan, the net inflows are not regular and consistent which makes it essential to take up calculation of discounted payback after adjusting depreciation, municipal taxes and other levies. The incomes that are shown are pre tax and pre deprecation figures and thus this has to be adjusted in order to arrive at the right figures (Refer Appendix 1 and 2 at the end of this paper). Financially speaking, the DPS considers the time period within which the investment outlay is rewarded to the promoters through cash inflows. When comparing diverse investment options, the Finance Director would seek to choose earliest investment recouping projects, or in which the discounted payback period is lesser, since these would be more economically viable for the company, in terms of returns on investments or ROI. The more delay in break even, or gaining back investments, the more risky the projects would become since expenses need to be maintained without any concomitant revenue generations. In this Case Study of PASE Plc, the first thing that needs to be considered is the yearly outflows from the project. Computation of Cost of Capital: “In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.” (Which is a better measure for capital budgeting IRR or NPV? 2010). For the purpose of calculating Cost of Capital, only PASE (parent investor company figures are considered) The major elements to be considered when determining cost of capital and the hurdle rate. “The required rate of return in a discounted cash flow analysis, above which an investment makes sense and below which it does not.” (Hurdle rate, n.d.). 1. Equity capital rate – 7.5% 2. Rate of inflation –   2.5% 3. Hurdle Rate -          5. 0% Total                      15% The hurdle rate refers to the cost of capital – and this should consider the cost of debt, the inflation and the hurdle rate accretion that could occur in future when the project is in stream. Investments for this project has been taken at G$1000m (900+ 100 preliminary expenses for the project) excluding documentation and working capital costs. It is necessary to conduct computation of Payback discount in order to decide whether this investment would be able to payback at the end of seven years, which is the primary pre-condition stipulated by the promoters back home in the UK. The detailed calculation of this is detailed below Computation of Payback discount (in millions) Year Cash Outflows (G$) Cash  Inflows (G$) Discount Factor (15%)  (G$) Total (G$) Cumulative 1. 1. (1000)   30   .8696   + 26 (1000)  +26 2. 177 .7561 + 133 +159 3. 229 .6575 + 150 +309 4. 238 .5718 +136 +445 5. 264 .4972 +131 +576 6. 282 .4323 + 121 + 697 7. 309 .3759 +116 + 813 From the above it is evident that there is an uncovered deficit of 1000 – 813=G$187 The above depictions of inflows and outflows of PASE are clearly reflective of the fact that this project does not break even, or earn revenues even after seventh Year. Thus, it does not really meet the requirements of PASE, since the conditions clearly stipulate that the gestation period could only be 7 years which has not been the case here. This project does not give room to believe that the costs could be break evened within 7 years time. Thus from the point of view of the Payment discount method, this project is not viable in that it cannot meet criteria of paying back investments within the first 7 years of the project’s working. Thus, in as far as this parameter is concerned, the top management may be averse to take up this assignment. Besides, even if this project was taken up in the first place, it cannot provide for the working capital expenses needed to keep this project alive. Net Present Value (NPV): NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.” (Investopedia explains net present value – NPV, 2010). (B) Under Net Present Value Method:   The NPV has its task clearly cut out. An NPV of zero signifies that the project’s cash flows are exactly sufficient to repay invested capital and to provide required rate of return on that capital. In the event the project has a positive NPV, it is able to generate more cash that what is needed to service the debt and to provide the necessary returns to shareholders and this excess accrues to the firms’ parent company and share hodlers back home in the United Kingdoms and could be repatriated to them after conversion into UK Pound Sterling using the current rate of exchange on the date of exchange transaction. Usually, NPV concern themselves with just cash movements and not notional figures like depreciation since this is not a cash outflow but a notional amount. Detailed workings are shown in Appendix 1 and 2. Under Net Present Value Method (millions)  Year Cash Outflows (G$) Cash  Inflows        (G$) Discount Factor (15%)  (G$)   Total     (G$)   Cumulative 1. 1.       (1000)   30   .8696   26 (1000)  26 2.   200 .7561 151 177 3.     250 .6575 164 341 4.   258 .5718 148 489 5.   283 .4972 140 629 6.   300 .4323 130 759 7.             326 .3759 122      881                       NPV       -119   The NPV in this case is negative and thus this project cannot be rendered feasible. From the above deliberations, it is clear that this project does not meet the criteria for both Discounted Payback as well as Net present value. It is seen that NPV needs to be equal to or above 0 and must be positive. Here it is negative -119. Thus, this cannot be considered for the present case study. Limitations of this project: One of the major failing of the Discounted Payback method is that it fails to consider the cash flows that occur after the payback period – in this case, it does not consider paybacks that occur during the 8th, 9th, 10th year and so on. Besides, it would not be advisable for the parent company in the UK to throw up the gauntlet at the end of the 7th year it needs to wait for at least 10 years. Besides energy projects are characterised by long cost ridden gestation period and time- cost overruns, perhaps causing economic vitiation of the projects. It is necessary to consider a long term perspective and not necessarily a seven year period, since the impact of depreciation, taxation and other impacts need to be considered. When the discounted factors of the inflows are considered it perhaps does not meet the criteria of acceptance of this project. Thus, since both NPV and Payback Discount are not positive, and even Internal Rate of Return (IRR) may not be fructuous, this project may not be considered or could be shelved for the present moment till economic situation improves. It is quite possible that the initial cash inflows may be low, but it may return with dominant inflows after a specified period of time, say in the 8th or 9th years, even compensating for earlier loss of earnings. 1 b) Discuss the major risks which PASE plc will face if it decides to implement the project. Your answer should include a discussion of how the risks can be mitigated or managed by the company. This project may be an unmitigated disaster or an unqualified success, depending upon the way the top management looks at it. Initially it may be encumbered with tremendous cost burdens which might impinge upon their other productive projects also.  But it is possible that it may yield handsome earnings in later years. The several risks that PASE could encounter during this period could be classified and discussed under the following factors – political, currency fluctuations, culture, inflationary trends in the economy and risks relating to currency rate fluctuations. Coming to the first risk, this country could not really get a good political base for its products and services; the political climate in this country is quite warm, but not conducive to business. It needs improvement in the way the political climate is vitiating the main business in this place. Besides it is necessary to protect major assets of the company. Currency rate fluctuations are the bane of many industries in the UK and the management needs to take strong and robust action to remedy it. Currency rate fluctuations could vitiate the bottom line. The culture in this part of the subcontinent India has vitiated prospective investors who more inclined to should need to be visualised as better marketability options in this product is forthcoming, Coming to culture, this has been in the forefront of business and is now not always conducive for business. Further it is believed that inflationary risks may erode the profits of business. 1 c) Comment on the sources of capital employed by PASE plc in financing its operations. Capital employed means the investment that PASE plc needs to operate the investment function. In order to finance its operations a company needs to make use of both its long term and short term finances. In financing an investment project it is better to raise funds in UK with a amalgamation of both debt and equity capital. For long term projects it is better that the company uses long term finance loans at fixed rates of interest. Answer to Question 2: 2 (a) Spot Rates for Euro /GBP =  1 GBP = Euro 1.11          The Spot Rates for GBP/US$ = 1 GBP = US $ 1.49           Similarly, for 30 days forward trading:             1 GBP = Euro 0.877             1 GBP = 1.53 US $ From the above it is seen that the spot rates between Euro/GBP is 1.11 while for GBP/US$ is 1.49. Thus the spot rates for US $ is more than that for Euros. Similarly coming to the forward trading, it is seen that GBP dollar rate is more than US $. This could be due to volatile currency market fluctuations caused by economic and non-economic factors and country specific economic conditions. It could also be due to the influence of dominant currencies like US $ or Euro. The British pound has steadily losing its value, which may affect demand –supply nexus and also impact upon UK business as a whole. In the context of this project, it is also seen that there exists a parallel economy in Gulistan, which has its own unofficial exchange rates. The brunt of this unofficial business impacts upon the official one also. Besides world wide fluctuations in currency does affect the workings of this business also. 2 (b) It is seen that the pooling of cash balances is more profitable rather than individual holdings  since this could ensure greater degree of liquidity and ease of procedure.  Besides it is seen that the inadequacies and reversals of one currency could be compensated by the other strong currencies and balances. Thus, it is possible that the mutual benefits and advantages of all kinds of currencies could be gained through pooling which could entail large and discrete resources, profitable, or deficit. c) Discuss the benefits and possible drawbacks to the parent company and to each subsidiary if a system of pooling were to be introduced as a general policy of the group. Cash pooling is a system of cash management system in which the credit and debit positions are combined into a single account.”The cash pooling solution can be achieved through notional or physical pooling where in both cases the need to perform FX and/or swap transactions is eliminated.” (Global multi currency cash pooling system, 2010). It is a system of cash management in which debit balance in an exchange is neutralized by credit balance of the other. The concept of cash pooling is based on the foundation of a Zero based concept in which credits are offset against debits. The system of cash pooling lowers interest rate expense and simultaneously maximizes interest profits. The subsidiary company should make remittances to the parent company. Cash pooling is a system of cash management. The benefits of the cash pooling system to the whole group of parents and subsidiary companies are that the liquidity of the companies in a group is controlled through the system of cash pooling. The deliberation of cash management through the cash pooling system leads to an efficient and open cash management system.  The benefits to a parent company are that the parent company has better commanding powers over the liquid assets of the subsidiary group of companies. The parent company also can use the funds flexibly by transferring funds from rich to poor subsidiaries. The parent company also gets higher rate of RoI on investments through the method of cash pooling. The parent company also has the risk and may have to bear the liability in case if it does not supply adequate funds to the subsidiary for its operations. The subsidiaries companies benefit because cash floats in accordance to their requirement through system of cash pooling. The benefit of the cash pooling system is that it reduces need for external financing in subsidiary companies as it improves net interest rate. The drawback for the subsidiary company is that is totally dependent on the parent company for funds in the case of cash pooling. However, the cash pooling system has numerous benefits also. Especially for the purpose of working capital loans and intercompany adjustments of fx fund this could be indeed useful as a tool that could be of guidance when foreign acquisition and amalgamations of businesses take place. It could also be seen in terms of cash and fund management which is indeed centralised, with more effective levels of management. There are, indeed concerns regarding the cash pooling which could cut both ways. While it could hide the weaker and less efficient units by the more efficient ones, the weaknesses in the systems could be exploited by competitors. Moreover, there are concerns about the secrecy and confidentiality of business which operate on cash pooling systems. Reference List Discounted payback period, 2010. [Online] Investopedia. Available at: http://www.investopedia.com/terms/d/discounted-payback-period.asp [Accessed 12 Apr 2010]. Global multi currency cash pooling system, 2010. [Online] Banks mendes gans. Available at: http://www.ingcommercialbanking.com/eCache/ENG/16/760.html [Accessed 12 Apr 2010]. Gundzik, J P., 2006. Market oblivious to geopolitical risks. [Online] Asia times online. Available at: http://www.atimes.com/atimes/Global_Economy/HC15Dj01.html [Accessed 12 Apr 2010]. Hurdle rate, n.d. [Online] Investorwords.com. Available at: http://www.investorwords.com/2362/hurdle_rate.html [Accessed 12 Apr 2010]. Investopedia explains net present value – NPV, 2010. [Online] Investopedia. Available at: http://www.investopedia.com/terms/n/npv.asp [Accessed 12 Apr 2010]. Which is a better measure for capital budgeting IRR or NPV? 2010. [Online] Investopedia. Available at: http://www.investopedia.com/ask/answers/05/irrvsnpvcapitalbudgeting.asp [Accessed 12 Apr 2010]. APPENDIX – 1 Value of Plant and Equipment for year 2010             G$ 900,000,000 Less 50% Depreciation written off during the year   G$ 450,000,000 Written down value at beginning of 2011                 G$ 450,000,000 Less : 5% Dep during 2011                                               22,500,000 Written down value at beginning of 2012                 G$ 427,500,000 Less : 5% Dep during 2012                                               21,375,000      Written down value at beginning of 2013                  G$406,125,000 Less: 5% Dep during 2013                                                20,306,250 Written down value at the beginning of 2014            G$385,818,750    Less5% Dep .during  2014                                                19,290,938      Written down value at the beginning of 2015           G$ 366,527,812        Less : 5%  Dep. during 2015                                            18,326,390 Written down value at the beginning of 2016           G$348,201,422   Less: 5% Dep during 2016                                               17,410,071       Written down value at the beginning of 2017       G$330,791,351        APPENDIX – 2 narration 2010     2011    2012     2013     2014 2015 2016   Profits   Less Dep.(5% wdv)    30      200         23     250       21      300         20      330         19   350      18   380      17       Less:   Tax (15% from 4th year)   Corporation tax holiday For three years 2010- 2012) .    30     nil      177        nil    229      nil       280          42       311          47    332       50   363     54     Net profits   30     177      229        238        264       282   309         Read More