North Sea Oil - Principles of Finance for the Private Sector Portfolio Project - Example

PROJECT ANALYSIS NORTH SEA OIL Number Introduction The main aim of any Company is to ensure its going concern is not threatened. To achieve this, it must remain profitable at all times (Enderle, 2009). One major way to maintain profitability is to carefully analyze all investment opportunities to ensure they add value. Project analysis becomes handy in order to pick the best investment opportunity especially where availability of funds is a constraint. This report shall consider a case study of one Company known as North Sea Oil. The report shall establish North Sea’s average cost of capital (WACC) which will be used in evaluating two of its projects through three techniques which are net present value (NPV), Internal rate of return (IRR), and Payback period. WACC for North Sea Oil According to Mian & Velez-Pareja (2007) WACC is the average cost of the various existing financing sources that a company employs as part of its capital structure. These sources include debt, preferred stock, and common stock. This means that a section of each source is taken into account based on its overall weight on the capital structure, in calculation of WACC. An increase in WACC signifies an increase in risk and WACC is concerned with history of financing rather than future financing (Wang, 1994) WACC = We×Ke + Wp×Kp +Wd×Kd(1-t) (Brigham & Houston, 2004). Where We = Weight of equity, Ke is cost of equity Wp =Weight of preferred stock, Kp is the cost of preferred stock Wd = Weight of debt, Kd is the cost of equity, and t is tax WACC = 0.5 × 20% + 0.25 × 19% + 0.25 × 7% = 16.5% (tax assumed to be zero since it is not mentioned) NPV, IRR, and Payback period NPV, IRR, and Payback period are techniques used in investment analysis. They help in choosing from a pool of investment projects, which project is suitable and cost effective in comparison to the income it generates. NPV compares the present value of inflows with the present value of outflows (Michel, 2001). The decision criterion is based on the outcome with three options: rejecting, accepting, and being indifferent. IRR is the rate of return at which NPV is zero (Kara, 2010). At this rate the present value of inflows is equal to present value of outflows. Its decision criterion is based on comparison with the WACC. Payback period is the period a given project will take in order to return the initial outlay of investment (Brigham & Houston, 2004). Project A NPV Present Value (PV) = Future value (FV)*Present value interest factor (PVIF) (Brigham & Houston, 2004). Year 1: FV*PVIF16.5%, 1=$25,000 × 0.8584=$21,460 Year 2: FV*PVIF16.5%, 2=$35,000 × 0.7368=$25,788 Year 3: FV*PVIF16.5%, 3=$45,000 × 0.6324=$28,458 Year 4: FV*PVIF16.5%, 4=$50,000 × 0.5429=$27,145 Year 5: FV*PVIF16.5%, 5=$55,000*0.4660=$25,630 Total PV of inflows $128,481 Total investment ($130,000) NPV ($1,519) IRR This project has single value cash inflow. Therefore the only applicable method to compute IRR is the use of formula method based on trial and error. Fabozzi & Peterson (2003) highlights the following steps for the trial and error method; Using a particular discounting rate NPV is calculated If the NPV calculated is positive then the process is repeated by using a higher discounting rate in order to obtain a negative NPV But if the NPV calculated is negative then the process is repeated using a lower discounting rate until a positive NPV is found. A formula is then applied to calculate the IRR: LDR is the Lower discounting rate. HDR is the higher discounting rate. Since NPV for project A is negative, a lower discounting rate is applied as per steps above in order to get positive NPV. With 10% the results are as follows: Year 1: FV*PVIF10%, 1=$25,000 × 0.9091=$22,727.5 Year 2: FV*PVIF10%, 2=$35,000 × 0.8264=$28,924 Year 3: FV*PVIF10%, 3=$45,000 × 0.7513=$33,808.5 Year 4: FV*PVIF10%, 4=$50,000 × 0.6830=$34,150 Year 5: FV*PVIF10%, 5=$55,000*0.6209=$34,149.5 Total PV of inflows $153,759.5 Total investment ($130,000) NPV $23,759.5 = 16.12% Payback period Project A Year Amount Balance ($) ($) 0 (130,000) (130,000) 1 25,000 (105,000) 2 35,000 (70,000) 3 45,000 (25,000) 4 50,000 5 55,000 The project will take 3 full years and part of the 4th year to payback. Payback period = 3 + 25,000/50,000 = 3.5 years. Project B NPV Year 1: FV*PVIF16.5%, 1=$40,000 × 0.8584=$34,336 Year 2: FV*PVIF16.5%, 2=$35,000 × 0.7368=$25,788 Year 3: FV*PVIF16.5%, 3=$30,000 × 0.6324=$18,972 Year 4: FV*PVIF16.5%, 4=$10,000 × 0.5429=$5,429 Year 5: FV*PVIF16.5%, 5=$5,000*0.4660= $2,330 Total PV of inflows $86,855 Total investment ($85,000) NPV $1,855 IRR Since NPV for project B is positive, a higher discounting rate is applied as per steps above in order to get negative NPV. A trial of 20% gives the results below: Year 1: FV*PVIF20%, 1=$40,000 × 0.8333=$33,332 Year 2: FV*PVIF20%, 2=$35,000 × 0.6944=$24,304 Year 3: FV*PVIF20%, 3=$30,000 × 0.5787=$17,361 Year 4: FV*PVIF20%, 4=$10,000 × 0.4823=$4,823 Year 5: FV*PVIF20%, 5=$5,000*0.4019= $2,009.5 Total PV of inflows $81,829.5 Total investment ($85,000) NPV ($3,170.5) (Brigham & Houston, 2004). = 17.79% Payback period Project A Year Amount Balance ($) ($) 0 (85,000) (85,000) 1 40,000 (45,000) 2 35,000 (10,000) 3 45,000 4 50,000 5 55,000 The project will take 2 full years and part of the 3rd year to payback. Payback period = 2 + 10,000/45,000 = 2.2 years. The project to be implemented is project B since it has a positive NPV, the IRR is more than WACC and the payback period is shorter (Alesii, 2006). Assuming project B is implemented using equity If the project is implemented by use of equity, then the new capital structure as given in the case study becomes 60% of equity, 20% of preferred stock, and 20% of common stock. The new WACC is as follows: WACC = We×Ke + Wp×Kp +Wd×Kd(1-t) (Brigham & Houston, 2004). = 0.6 × 20% + 0.20 × 19% + 0.20 × 7% = 17.2% (tax assumed to be zero since it is not mentioned) WACC increases from 16.5% to 17.2%. This signifies that the project is risky given the capital structure. Investors are classified into three categories which are risk takers, risk averse, and risk neutral (Raffer, 2007).The risk takers will prefer to support investment in this project; however risk averse investors may not be willing to support the investment. To the market, the increase implies and signifies that the cost of borrowing is on the upward trend. The investors therefore will demand a premium to compensate them from the increased risk. Executive Summary The consideration to invest on new projects is important decision by North Sea Oil. This decision is in line with the investor’s wealth maximization goal since it will generate extra earnings to them (Enderle, 2009). The initial stage of this report entailed analyzing two projects in order to find out which project is best given that North Sea Oil had a constraint of funds. To do this, summarized information regarding the initial finances, capital structure, and cash flows expected for each of the project was availed by North Sea Oil. Then three project evaluation techniques were used to achieve this. The techniques were internal rate of return (IRR), net present value (NPV) and payback period. A summary of the findings for each of the project was as follows: NPV NPV involves discounting all cash flows, both inflow and out flow and then comparing the two to find the net value. According to Brigham & Houston (2004) the decision criterion for this technique is as follows: Accept the project if the NPV is greater than zero. Reject the project if the NPV is less than zero. Be indifferent if the NPV is equal to zero. The analysis shows that the NPV of project A was -$1,519. This result suggests that project A should not be accepted since the NPV is less than zero. Project B showed that its NPV was $1,855. This implied that project B is the best and should be accepted since its NPV more than zero. IRR IRR technique requires the calculation of the return when NPV is zero. This technique normally helps when NPV has failed to give a conclusive result that is when there is indifference as regards to NPV. The decision criterion for IRR is as follows (Brigham & Houston 2004): Accept if the IRR is more than the desired rate of return or cost of capital. Reject if the IRR is less than the desired rate of return. Be indifferent if the IRR is equal to the desired rate of return. The analysis showed that IRR for project A was 16.12% while that of project B was 17.79%. The WACC for North Sea was is 16.5%, therefore this analysis suggests that the project B should be accepted since the rate of return has surpassed the WACC. Project A should be rejected. Payback period This is a technique concerned with how long it takes to return back the cash invested. It therefore considers the cash flows up to the time the project pays back and ignores the remaining cash flows. If there is more than one project then the decision is based on selecting the project with the shortest payback but if it is only one project, the management will set an arbitrary payback period (Brigham & Houston 2004). The analysis shows that the payback period for Project A is 3.5 years while that of project B is 2.2 years. This means that project B will take a shorter period to return the invested cash unlike project A. This result indicates that project B is the best and therefore given preference over project A. Element of risk Based on the assumption that project B is finally implemented as per the favorable results, the WACC increases since there is a change in capital structure which puts more weight into using internally generated funds (equity). The increase signifies that the project is risky. High returns have high risks (Kenan et. Al 2012). The risk element is analyzed using various techniques that include sensitivity analysis. It requires that the key financial variables affecting profitability be identified and subjected to adverse changes. Its decision criterion depends on the risk attitude of the investor. Therefore the three states of investor attitude need to be considered by management before undertaking the project. They are risk averse, risk taker and risk neutral. Conclusion All the analysis techniques show that project B is to be accepted while project A is to be rejected. Since a high risk means a high return then overall recommendation is that project B should be undertaken. List of References Alesii, G. (2006). Payback Period and Internal Rate of Return in Real Options Analysis. Engineering Economist. 2006, 51(3), 237-257 Brigham, Houston (2004). Fundamentals of Financial Management, (10th ed.). New York: John Wiley & Sons, 2004. Enderle, G. (2009). A Rich Concept of Wealth Creation Beyond Profit Maximization and Adding Value. Journal of Business Ethics, 84, 281-295 Fabozzi F.J, Peterson P.P. (2003). Financial Management & Analysis, (2nd ed.), New Jersey: John Wiley & Sons. Kara, O. (2010). Comparing two approaches to the rate of return to investment in education. Education Economics. 18(2), 153-165 Kenan A., Kunyu S., Guang Y., Jiping H. (2012). Risk-Return Relationship in a Complex Adaptive System. PLoS ONE, 7 (3), 1-8. Mian, M. A., Velez-Pareja, I. (2007). Applicability of the Classic WACC concept in practice. Latin American Business Review. 8 (2), 19-40. Michel, R. G. (2001). Net Present Value Analysis: A Primer for Finance Officers. Government Finance Review. 17 (1), 27 Raffer, K. (2007). Risks of Lending and Liability of Lenders. Ethics & International Affairs, 21 (1), 85-106 Wang, L. K. (1994). The weighted average cost of capital and sequential marginal costing: A clarification. Engineering Economist, 39(2), 187. Read More