The Financial Analysis and Interpretation of Caf Lola - Case Study Example

Finance for Managers Task Table of Contents Executive summary 3 The assumptions 3 The financial analysis and interpretation 4 The potential impact of external and internal business context factors on the investment decision 8 The external factors 8 Internal factors 9 The strengths and weaknesses of the appraisal tools 10 Conclusion and Recommendations 11 List of References 12 Appendix 1: Annual profit before tax for option A and B 15 Appendix 2: Cash flow from option A and B 15 Appendix 3: Payback period for option A and B 16 Appendix 4: NPV and IRR for option A and B 16 Appendix 5: The Accounting Rate of Return for option A and B 17 Appendix 6: Sensitivity analysis 17 Executive summary The paper presents a report on the Café Lola regarding the plan to expand the restaurant. There are two options for the managers. Option A would increase the seating capacity by 30%, whereas, Option B would increase the seating capacity by 50%. The analyses of the investment options have been done using the following methods: the preparation of the profit statement, the annual cash flow and overall net annual cash inflow, the payback period, the net present value, the capital investment analysis, and the sensitivity analysis on the net present value. In addition, both the external and internal factors affecting the business and the weaknesses and strength of NPV, Payback period, IRR and accounting rate of return are provided. The expansion plan has been analysed using various investment appraisal tools such as the NPV, IRR, ARR and payback period. Based on the NPV, option B has a higher value than option A. Based on the IRR, option A has a higher rate than option B. Based on the ARR, option B has a higher rate of return than option A. Last, based on the payback period, option A has the shorter period than option B. The two options are dominant in two methods out of the four. Therefore, a different factor has been considered when deciding the best option, the advantage of the premise. Option B is accompanied by a premise that could be used for small functions or private dining. Therefore, the premise has more revenue generation potential. As a result, Option B is deemed more suitable than option A. The assumptions The following assumptions have been made to facilitate the analysis: Café Lola will continue to operate for five nights a week, and there are 48 weeks per year. The average price charged for food and drink will be £ 60 per customer. The residual values of both kitchen equipment and fixtures and fittings are zero. The useful life of both the equipment is 15 years. The utilisation rate in both cases is 85%. Revenue increases by 3% annually. Both variable and fixed costs increase by 3.5% annually. The fixed costs are for the whole year. The average dividend paid signifies the cost of the common stock. The financial analysis and interpretation The following supplementary calculations accompany the financial analysis: the depreciation expense and the weighted cost of capital. The company plans to acquire two assets (the kitchen equipment and fixtures and fittings). It is assumed that the useful life of the assets is 15 years. In addition, it is assumed that the salvage value of the assets at the end of the useful life is £ 0. Therefore, the depreciation expenses using the straight-line method for both options are as below (Ben-Shahar, D., Margalioth, Y. & Sulganik, E. 2009, pp. 1-4). Based on the table above, under Option A, the annual depreciation expense for the kitchen equipment and fixtures and fittings is £ 5,000 and £ 3,000 respectively. Under option B, the annual depreciation expense for the kitchen equipment and fixtures and fittings is £ 6,000 and £ 4,000 respectively. The WACC represents the cost of the funds sought by the company with respect to their proportion in the capital structure. The costs are weighted when the company relies on more than one source of capital. The WACC of the Café Lola restaurant has been determined based on the assumption that the average payment signifies the cost of capital. The post-tax cost of debt takes into account the effect of tax on debt finance. Therefore, the WACC is shown in the table below (Farber, A., Gillet, R. & Szafarz 2007, pp. 2-4). WACC Equity Debt WACC Cost 10% 8% Ratio 0.4 0.6 Weighted 4 4.8 WACC (4 + 4.8) 8.80% The annual profit before tax represents the revenues less the total costs of operation, the depreciation and tax. However, in the case of Café Lola, the effect of tax has not been taken into account. The profit before tax has been determined by both the options (Option A and B). Based on option A, the revenue determined for the first year has taken into account the following: first, the seating capacity will be increased by 30%. Second, the capacity utilization rate is 85%. Third, the restaurant will operate five times per week. Fourth, there are 48 weeks in a year. Based on that, the revenue for year one is £ 954,720. However, the revenues for the third and the fourth year are higher due to the assumption that a 3% increase is expected annually. The variable costs share similar assumptions. The variable cost for year one is £ 556,920. The figure increased by 3% each year, £ 576,412.2 in the second year and £ 596,586.6 in year three. Earnings before tax in year 1, 2 and 3 are £ 79,800, £ 88,949, and £ 98,276 respectively see Appendix 1. On the other hand, the both the revenue and earnings before tax are higher for option B than for option A. The revenue and the variable cost for the first year is £ 1,101,600 and £ 642,600 respectively. Earnings before tax for year 1,2 and 3 are £ 98,000, £ 111,770, and £ 125,953 respectively, which are higher than £ 79,800, £ 88,949, and £ 98,276 for option A, see Appendix 1. The cash flow under for both the options have been determined using a similar procedure used when determining earnings before tax. The only difference is adding back the depreciation expense. Therefore, the net cash flow = (earnings before tax + depreciation expense). Based on that, the net cash flows are higher than the earnings before tax in every. Comparatively, the net cash flows under option B are higher than the net cash flows from option A, see Appendix 2. Therefore, when the management of the Café Lola restaurant decides to pursue the second option, the revenue and cash flow generation level will be higher than when choice B is pursued. Consequently, the Café Lola restaurant should pursue Option B. The payback is the period taken before the amount invested is recovered. The payback period has been determined for the two options. When the company decides to pursue choice B, it will take one year, 3.986 months to recover the amount originally invested, which is £ 120,000. The payback period has been determined using the undiscounted cash flows for the three years. On the contrary, if the managers of the Café Lola restaurant decide to pursue choice B, it would take one year, 4.139 months to recover the amount originally invested. Therefore, based on the analysis, option A has a shorter payback period than option B, see Appendix 3 (Hajdasinski 1993, pp. 1-9). The NPV is arrived at by adding the discounted cash flow less the initial outlay. The cost of capital is used to discounted the cash flows. In this case, Café Lola restaurant relies on more that one source of finance (common stock and debt). Therefore, the weighted average cost of capital has been determined (8.8%). If the management decided to pursue choice A, the net present value of the project would be £ 125,116.8. On the other hand, if the management of Café Lola decided to pursue choice B, the project’s net present value would be £ 157,693.9. Comparatively, the net present value would be higher if option B were pursued. That is, option B generates more cash flow than option A, thus creates more value to the restaurant that option A, see Appendix 4 (Dennis & Smith 2014, pp. 45-50). The internal rate of return signifies the maximum cost of capital that the company can bear when pursuing an investment. The internal rate of return is usually compared with the actual cost of capital. A viable investment has a lower NPV than the IRR. That is, if the internal rate of return of a project is higher than the costs of capital, the investment is considered viable. The cost of capital used when determining the IRR is 8.8%. Therefore, using the trial and error method, a higher cost of capital should be used. 60% cost of capital was chosen. Under option A, the resulting NPV is - £ 1,308.01 (Hazen 2009, pp. 3-16). The internal rate of return for option A is 59.47%, which is higher than the actual cost of capital for the company (8.8%). Based on the analysis, option A is viable. The 59.47% implies that, if the company pursues choice A, it will be capable of meeting a cost of capital of up to 59.47%. On the other hand, the internal rate of return for option B is 59.44%. Based on the analysis, option B is viable. The figure implies that if the company pursues choice B, it will be capable of meeting a cost of capital of up to 59.44%. Comparatively, the internal rate of return for option A is higher than that for the option, see Appendix 4 (Hazen 2009, pp. 3-16). The accounting rate of return (ARR) indicates the return generated by an investment. The accounting rate of return is determined by dividing the average accounting profit by the amount invested. Based on the appraisal tool, a project with a higher ARR is preferred to that with a lower ARR. Based on the analysis, the accounting rate of return for option A is 74.17%. On the other hand, the accounting rate of return for option B is 74.61%. Comparatively, option B has a higher accounting rate of return than option A, see Appendix 5 (Elmendorf 1993, pp. 2-9) The sensitivity analysis is based on the effect of an increase or a decrease in the capacity utilization rate by 15%. The current capacity utilisation rate is at 85%. A 15% increase means 100% utilisation rate while, a 15% decrease means 70% utilisation rate. Regarding option A, a 15% increase or decrease in the capacity utilisation rate leads to 87.96% increase or decrease in earnings before tax. On the other hand, regarding choice B, a 15% increase or decrease leads to 82.65% increase or decrease in earnings before tax, see Appendix 6. The potential impact of external and internal business context factors on the investment decision The external factors The following are the influence of the external factors on the investment decision: the customer base, infrastructure, and finance. First, the customer base is one of the most important factors that would influence the decision made by the management of the Café Lola restaurant. The availability of the customers in two locations is a factor to be considered. When the customer base is large in a location, there is a greater opportunity to increase revenue generation. Increased revenue generation leads to an increase in the profitability level. On the other hand, a location with a small customer base has less opportunity to improve revenue generation. Companies cannot generate a high level of profits when operating in areas with a low number of customers (Ray 2015). Second, the availability of infrastructure such as clean water services, sewerage services, accessible roads, etc. is necessary for the success of the business. The availability of the mentioned services in a location determines the quality, and the cost of the services offered. For instance, the Café Lola restaurant provides foodstuffs to its clients. The level of hygiene in the restaurant is, therefore, an important factor. The continuous availability of clean water improves the level of hygiene at the restaurant. Therefore, the restaurant should be located in places with the necessary infrastructure (Ray 2015). Third, the availability of affordable sources of finance is another determining factor. Business expansion process requires a substantial amount of money, which in most instances may not be readily available for companies. Option B requires more funds than option A. If the restaurant decides to pursue choice B, more funds will be needed. Therefore, the availability and the cost of funds will influence the decision made by the restaurant’s managers (Ray 2015). Internal factors The following internal factors influence the investment decision made by the managers of Café Lola: employee competency, reputation, and credit worthiness. First, businesses comprise of policies and strategies that are implemented to ensure smooth operation. The level of skills of the employees influences the operation and competitiveness of the business. A competitive business can only survive a location filled with competent rivals. The opposing argument is true. Therefore, the level of employee skills influences the investment decision (Lindblad n.d.). Second, business reputation affects the relationship between the business and the stakeholders. Reputation building is an internal affair and can be controlled. It can be built through the continuous provision of quality to the clients. It can also be built through engaging in social activities that have a positive impact on the society. The reputation of Café Lola will influence its performance in either of the locations. Therefore, reputation influences investment decisions (Lindblad n.d.). Third, the credit worthiness of the Café Lola shows its ability to meet both long and short-term obligations. Creditworthiness influences the accessibility to sources of finance. A credit worthy company has an upper hand to access funds, unlike a credit unworthy business. Access to funds influences the size of an investment. Therefore, credit worthiness influences the investment decision (Lindblad n.d.). The strengths and weaknesses of the appraisal tools The net present value method is preferable because of the following: first, it takes into account the time value of money. Second, it conforms to the shareholders’ wealth maximization objective because a positive NPV has the effect of increasing the net worth of owners of equity. Last, it considers the entire cash inflows thus, provides a realistic valuation of a venture. However, the method is not without limitations. The following are the drawbacks of the method: first, the cost of finance is composed of both the implicit and the explicit. The net present value method ignores the implicit cost of finance (considers only the explicit costs). Second, the method is preferred under certain circumstances. That is; it disregards risk, thus is not appropriate under risky situations (Advantages and disadvantages of NPV 2015). The payback period is a project valuation method that involves the determination of the length of time taken to recuperate the amount invested in a project. Every investor has a preferred payback period. This method is appropriate for analysing projects under high risks. In a risky situation, a project with a shorter payback period is preferred. However, the drawbacks of the method are as follows: it does not take into account the concept of time value of money. In addition, the method does not indicate the impact of a project on the shareholders’ value creation objective (Advantages and disadvantages of payback period, 2015). The IRR method is preferred for the following reasons: First, it takes into account the time value of money. Second, it takes into account all the cash flows of the project. Last, it enhances the realization of the shareholder wealth maximization. On the contrary, the following are the weaknesses: first, it is difficult to use. Second, there are various procedures (trial and error, interpolation, etc.) that give different results. Thus, it is not easy to identify the accurate procedure (Advantages and disadvantages of IRR, 2015). The ARR has the following strengths: First, it relies on the accounting information, thus, does not require any special data. Second, the method is simple to use and understand. Third, it shows the profitability and the return on an investment. On the other hand, the following are the weaknesses: first, the method does not take into account the time value of money. Second, it does not take into account the project’s terminal value (Advantages and disadvantages of ARR, 2015). Conclusion and Recommendations Based on the financial analysis above, option B generates the highest earnings before tax and the cash flows. Based on the payback period, option A has the shortest payback period; approximately one month less than the payback period for option B. The NPV analysis shows that option B has the highest value. The IRR analysis indicates that option A has the highest IRR (59,47%). Based on the ARR analysis, option B has the highest rate of return (74.61%). Last, the sensitivity analyses show that a change in the capacity utilization rate has a greater influence on option A (87.96%) than option B (82.65%). In addition, option B will see the restaurant move to the up-market location. The premise has an additional room that could be used for small functions or private dining. Therefore, the premise has more revenue generation potential. Therefore, since choice B has the highest NPV and ARR, and it leads to renting a premise that has more revenue generation potential, the management of the Café Lola restaurant should consider pursuing choice B. List of References Advantages and disadvantages of ARR, 2015, viewed 26 April 2015, http://accountlearning.blogspot.com/2011/07/advantages-and-disadvantages-of.html Advantages and disadvantages of IRR, 2015, viewed 26 April 2015, http://accountlearning.blogspot.com/2011/07/conceptadvantages-disadvantages.html Advantages and disadvantages of NPV, 2015, viewed 26 April 2015, http://accountlearning.blogspot.com/2011/07/advantages-and-disadvantages-of-net.html Advantages and disadvantages of payback period, 2015, viewed 26 April 2015, http://accountlearning.blogspot.com/2011/07/advanyages-and-disadvantages-of-pay.html Ben-Shahar, D., Margalioth, Y. & Sulganik, E. 2009, "The Straight-Line Depreciation is Wanted, Dead or Alive", The Journal of Real Estate Research, vol. 31, no. 3, pp. 351-370. Dennis, S.A. & Smith, W.S. 2014, "TWO NEW MEASURES FOR ASSESSING PROJECT UNCERTAINTY", Corporate Finance Review, vol. 19, no. 1, pp. 11-18. Elmendorf, R.G. 1993, "Accounting rates of return as proxies for the economic rate of return: An empirical investigation", Journal of Applied Business Research, vol. 9, no. 2, pp. 62. Farber, A., Gillet, R. & Szafarz, A. 2007, "A General Formula for the WACC: A Reply", International Journal of Business, vol. 12, no. 3, pp. 405-411. Hajdasinski, M.M. 1993, "The Payback Period as a Measure of Profitability and Liquidity", The Engineering Economist, vol. 38, no. 3, pp. 177-191. Hazen, G. 2009, "An Extension of the Internal Rate of Return to Stochastic Cash Flows", Management Science, vol. 55, no. 6, pp. 1030-1034. Lindblad, M n.d., Internal & External Factors that affect on Organization, viewed 26 April 2015, http://yourbusiness.azcentral.com/internal-external-factors-affect-organization-11641.html Ray, L 2015, Seven External Factors of Business, Viewed 26 April 2015, http://smallbusiness.chron.com/seven-external-factors-business-21960.html Appendix 1: Annual profit before tax for option A and B Appendix 2: Cash flow from option A and B Appendix 3: Payback period for option A and B Appendix 4: NPV and IRR for option A and B Appendix 5: The Accounting Rate of Return for option A and B Appendix 6: Sensitivity analysis Read More