Archer's Organic Foods Plc - Coursework Example

Archers Organic Foods plc Table of Contents Background Information 3 Evaluation of the Investment Project 3 Cash Inflows: 4 Cost of Equity 4 WACC 5 NPV and the Maximum Price 6 Internal Rate of Return and the Payback Period 7 Impact of Foreign Exchange 8 Financing Options 10 Conclusion 12 Reference List 12 Background Information Archers Organic Foods plc is a quality food retailer set up the U.K. The company grows non chemical based fruit and vegetables. The company has been established in the form of a family business. With passing years and rising success of Archer, the members of the organization have decided to expand the operations of the firm. It has been identified by the directors as well as members of the Archer family that the success of the firm lies in diversification. Although there existed certain weakness in the financial position of the firm in the past financial years, such as insufficient liquidity, the firm is currently in a appropriate position to expand. Although a number of expansion options exist for Archer, the firm is currently considering expanding into the market of France and accordingly investing in Organique Co. Which is an unquoted French firm. The current paper evaluates Archer’s decision to invest in Organique by reviewing the cash inflows expected from making the investments using capital budgeting techniques. Accordingly, the paper also suggests the maximum price to be proposed by Archer so that the investment remains profitable. The paper also evaluates different financing options available for funding the investment. Evaluation of the Investment Project Whether Archers Organic Foods plc must invest in Organique Co. has been carried out using the capital budgeting technique. The capital budgeting technique is suitable for evaluating such investment proposals and aids in determining whether making such investments would lead to acquiring profits or not. In order to carry out the capital budgeting techniques, it is first essential to identify the cash inflows and the weighted average cost of capital which would be used as the rate of discount (Bierman and Smidt, 2012). Cash Inflows: If Archer’s considers making the investment, it is expected that the variable cost for the year 2016 would be £495,000. 40% and 60% of this costs consisted of the labor and other expenses respectively. The labor and the other variable costs were further expected to grow by 7% and 5% each year. Accordingly, the total variable costs for each year were calculated. Similarly, the total fixed costs were seen to rise by 5% per annum. The computed total costs were then deducted from the sales revenue to ascertain the cash inflow for each financial year. It is required to be noted here that the sales revenue had provided in Euro, while the calculations are being carried out in British Pounds, since Archer is a U.K based firm. Hence, the given sales revenue €1,100,000 for the year 2016 was converted into pounds by using the exchange rate €1.35 / £1. Accordingly, the sales revenue for the year 2016 was £814814.8. This sales revenue was subject to an annual increase of 8% per annum. Accordingly, the cash inflows were calculated. The calculated cash inflows reveal an increasing trend and are seen to be positive. Cost of Equity The cost of equity had been calculated on the basis of the CAPM (Capital Asset Pricing Model) model. The cost of equity has been calculated on the basis of the returns and beta factor of Archer’s in the U.K, since they are the acquiring company. The CAPM has been calculated using the following formula: r = Kr + β (Km - Kr) where, r= required rate of return Kr= Risk free rate of return. Β= Beta factor Km= Market rate of return Figure: CAPM calculation The calculated cost of capital is seen to be 0.07. WACC In order to determine the discounting factor, it becomes essential to calculate the weighted average cost of capital (WACC). The cost of equity has been already calculated and shown in the above section. Similarly, the cost of preference share dividend was also provided to be 10% or 0.10. However, since there existed corporate taxes, the cost of debt were required to be calculated using the following formula: Cost of debt= rD (1- Tc ) where, rD= Cost of debt (1- Tc )= Tax adjusted interest rate Calculation of cost of debt After computation of cost of debt the WACC had been calculated as follows: It is required to be noted that in order to ascertain the weights of the capital components, the total cost of capital was used. Accordingly, the WACC calculated was seen to be 0.08. This rate was used as the discounting rate for evaluation of the investment proposal (Durnev, Morck and Yeung, 2004). NPV and the Maximum Price The net present value (NPV) is one of the most popular project evaluation techniques used by corporate firms to take investment decisions. The NPV facilitates ascertaining whether the present investments made are equal to or less than the future cash inflows, using the discounting technique (Shapiro, 2005). The process discounts future cash inflows and compares the same with the initial investment to take investment related decisions. Organique Co’s nominal share capital was €550,000. The directors of Organique demanded a premium of 100%. Accordingly, the initial capital investment required for the project was seen to be €1,100,000. Since the amount is denominated in Euro, it is essential to convert the same into Pounds, since all calculation are being calculated in the same denomination. Hence, the initial cost of investment is £814814.81. This amount is considered as the maximum Price for investing in Organique. The cash inflows have already been calculated in the above section. Accordingly, the NPV has been computed and shown as follows: From the calculated NPV, it can be clearly seen that initial cost of investments is higher than the discounted cash inflows. This indicates that the project would not be considered profitable unless the initial investment is altered (Shapiro, 2005). Accordingly, Archer’s is required to revise their initial investment amount as follows: Hence, if Archer invest less than £777823.55 only then the project is likely to earn profits. The maximum price for making the investment is revised to be £777823.55. An amount greater the revised maximum price is likely to lead to losses for Archer. Internal Rate of Return and the Payback Period From the evaluation, it can be seen that the internal rate of return (IRR) is suitable only when the revised investment amount is considered. Under the revalue investment amount, the IRR is seen to be 8%. This is also the rate at which the cash inflows have been discounted under the NPV technique and hence is the minimum rate of profit which must be achieved so that the initial investment value can be realised from the project. However if the investment is made at a lower rate than the £777823.55, the IRR is likely to rise further (Zimmerman and Yahya-Zadeh, 2011). The evaluations carried out under the capital budgeting technique also reveal that the project has a more favourable payback period (PBP) under the revised initial investment. Figure: IRR and PBP Hence, from the overall evaluation of the project, it can be stated that the archer must consider investing less than €1,100,000 so that the project turns out to be profitable. The initial investment amount must be less than €1050061.79 so that positive returns can be procured. The analysis reveals that if Archer invests is Organique at the stated terms, the project is likely to turn out to be a loss. Organique demands a 100% premium upon their nominal share capital of €550,000. The proposal is required to be revised so as to yield sufficient profits. If Archer procures Organique at €1050061.79, it would require investing at a premium of 52.38% upon the nominal capital of €550,000. Impact of Foreign Exchange Foreign exchange fluctuations are common aspect which firms have endure due to the uncertain factors existing in the economy. Due to uncertain conditions existing in the international economic environment, capital markets have been seen to remain extremely volatile. The economic meltdown which took place in the year 2007 had slowed down the growth of many large organizations across the globe as trade and foreign investments were impacted negatively. Archers Organic Foods ordinary shares were seen to be traded at a lower level in the year 2015 as compared to the previous year, due the impact of such negative economic conditions (Meldrum, 2000). The directors of Archer are mainly concerned about the foreign exchange exposure of the firm due to such international expansion. However, the impacts are not forecasted to be very negative as the French economy is expected to grow steadily in the coming years. However, in order to account for uncertainties, Archer’s tries to predict the impact upon the sales if they consider investing in Organique Co. It was estimated by the financial professional’s of Archer that 1% depreciation in the Euro will cause a 1.2% reduction in the sales revenue. Accordingly, it is expected that the sales revenue of the organization is likely to fall as shown in the following figure: From the above figure, it can be seen that due to fluctuation in the foreign exchange rates, the sales revenue of the organization reduces. As a result, the company’s cash inflow (in Euro) reduces. From the calculations above, it is observed that if there are no foreign exchange risks and the cash inflows occur normally, then level of profitability is higher. The figure above also shows the loss in cash inflow occurring due to such foreign exchange rate risks. Since the cash inflows reduce, it is likely that the NPV and the IRR would also reduce. Under such circumstances, if the firm expects to earn a positive return, the initial investment or the maximum price further requires to be reduced (Nucci and Pozzolo, 2001). In general, going by the economic conditions prevailing in France, such a situation is less likely to occur as the nation displays steady rates of growth. Moreover, the food and beverage industry of France plays an important part in the nation’s exports. French economic forecasts also reveal a higher rate of growth given the current rate of economic investments and growth occurring in the nation’s primary and secondary sectors (Nucci and Pozzolo, 2001). Economic risks however cannot be totally ignored by Archer. Economic risks are important for firms who establish business subunits or have their investments made in other nation. If there are changes in the foreign exchange rates, it would drastically impact the end revenue earned by Archer. Also, it is required to be considered that on the basis of the proposed initial investment, investing in Organique is considered to be a loss as the firm would incur low IRR and negative NPV. Hence, it is highly essential that Archer considers revising their initial investments. On the basis of the calculations carried out, it is essential that Archer proposes to invest less than a premium of 52.38% upon their nominal capital so that positive NPV and higher IRR can be procured. Since the initial investments is likely to be lower than what has been proposed, it is essential that the firm revises the amount further after incorporating the element of foreign exchange risk (Dominguez and Tesar, 2006). Since the French economy is not very strong and has not shown very high rates of growth or stability, ignoring risks aspects would not be rational. Therefore, if such risks are considered, then the Archer must further reduce the premium percentage in a manner that the generated cash flows lead to positive NPV and IRR. Financing Options Till the year 2015, all expansion and up gradation activities of Archer in the nation of U.K has been undertaken on the basis of finance acquired from issuing debentures. Archer’s owners have clearly stated that the Archer family would retain 30% of the equity share holding upon the company and other long standing directors would own a further 25% of the net equity. The remaining share of the equity would be owned by other directors. There is no public share holding existing in the capital structure. Hence, the expansion of the firm and its investment requirements are completely based on debt capital. Debt capital induces immense amount of risk within an organization. It is therefore essential that there are stability of revenue and profits. Since the investment to be made in Organique Co. is immense, the company may consider undertaking options such as asset based financing or long term debt finance instruments. Asset financing is a technique whereby the finance required for procuring new assets are procured externally, while the rest of the financing requirements are met from internal sources such as retained profits. In case of Archer, the company may consider to undertake the debtor financing option. Under the debtor financing technique, the company may procure required assets from owners and keep the amount to be paid in pending. Since the amount of money to be repaid to the debtor is retained within the business for longer durations, the working capital situation can be improved. Accordingly, liquidity is retained within the organization. Such type of asset financing is also known as trade credit (Saunders, Cornett and McGraw, 2006). Archer may also consider the option of factoring for procuring the finance required for investing in Organique. Under the factoring option, the company is at first required to provide an estimate of the expected revenue from the investment to a factoring agent. The agent then provides the company with the necessary funds required in exchange for a certain percentage of profits for every period in the forthcoming years. Factoring and debtor financing technique is seen to be insecure techniques of debt financing. The more secure financing techniques are essentially procuring loans from banks and other financial institutions. Alternatively, archer may consider raising the required finance on the basis of issuing debentures. Since the company has previous experience of financing their expansion activities through debentures, it may be suitable for the company to follow the same for their current investment proposal (Campello, 2006). While adopting the debt financing option, Archer must ensure that sufficient profits are yielded from the project. It is essential to make timely interests payments on the debt fiancé procured so as to avoid increased installments. In addition to debt finance, on account of expansion, the company’s nominal capital shareholding is likely to expand, bringing in greater inflow of equity capital. However, a major portion of the equity capital is likely to be trapped in the assets which Organique already posses. The company may consider expanding their authorized share capital base by bringing in more members. Conclusion From the capital budgeting techniques carried out for evaluating the proposal, it is seen that Archer would not be able to earn sufficient profits if they consider paying 100% premium upon the nominal capital as initial investment. At this rate, the firm is likely to incur negative NPV and low IRR. Hence, the revised maximum price suggests that Archer’s investment must not be more than 52.38% premium upon the nominal capital. Majority portion of the investments is likely to be funded through debt financing. It would be beneficial if the investment is done through issue of debenture capital. Archer may also consider expanding their equity share capital base by bringing in new directors or involving other family members. Since the major portion of the investments is raised through debt, it is essential that the company earns adequate profits. Accordingly, the firm must consider investing rationally and agreeing upon a realistic acquisition price. Although Organique’s financial statements reveal adequate stability and growth, Archer firm must not avoid considering risks. After considering the risk implications such as foreign exchange rate fluctuations, the cash inflows are likely to reduce further. Hence, the maximum price to be invested in Organique requires further reduction than what has been proposed. Reference List Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. London: Routledge. Campello, M., 2006. Debt financing: Does it boost or hurt firm performance in product markets?. Journal of Financial Economics, 82(1), pp. 135-172. Dominguez, K. M. and Tesar, L. L., 2006. Exchange rate exposure. Journal of international Economics, 68(1), pp. 188-218. Durnev, A., Morck, R. and Yeung, B., 2004. Value‐enhancing capital budgeting and firm‐specific stock return variation. The Journal of Finance, 59(1), pp. 65-105. Meldrum, D., 2000. Country risk and foreign direct investment. Business economics, 35(1), pp. 33-40. Nucci, F. and Pozzolo, A. F., 2001. Investment and the exchange rate: An analysis with firm-level panel data. European Economic Review, 45(2), pp. 259-283. Saunders, A., Cornett, M. M. and McGraw, P. A., 2006. Financial institutions management: A risk management approach. New York: McGraw-Hill/Irwin. Shapiro, A. C., 2005. Capital budgeting and investment analysis. New Jersey: Prentice Hall. Zimmerman, J. L. and Yahya-Zadeh, M., 2011. Accounting for decision making and control. Issues in Accounting Education, 26(1), pp. 258-259. Read More