Financial Tools of Ferro Plc - Case Study Example

Finance For Manager Introduction Ferro Plc has to decide about entering into a new market segment as a specialist manufacturer of new product ‘Tensilite’. There are two options for expansion plans and various forecasts to decide about expansion of its production capacity. Various financial tools like CVP, WACC, Average rate of return, and Net present value using DCF have been used in this report to help Ferro Plc in such decision making. Further the evaluation of the project also takes into account the future inflationary and risk factors. The analytical report follows as under: Manufacturing capacity decisions are basically related to profitability. Ferro Plc should enlarge its manufacturing capacity only when it maximizes its profitability. Marginal costing project analysis tool, also known as cost volume profit (CVP) analysis, is used here to analyze the profitability on expansion of capacity by Ferro Plc. This is “because CVP analysis emphasizes the interrelationships of costs, quantity sold, and price, it brings together all of the financial information of the firm. CVP analysis can be a valuable tool in identifying the extent and magnitude of economic trouble a company is facing and helping pinpoint the necessary solution” (Don R Hansen and others, page 590)i. Following computations based on CVP analysis show that the contribution margin of each alternative is applied towards fixed expenses and the profitability of the entity. It must be noted that “variable costs vary directly with volume of sales or production.”(Noel Capon, page 596)ii. The above CVP analysis reveals that contribution margin at manufacturing of 4000 units is the maximum. Contribution margin is “the excess of selling price over variable cost. The selling price and variable cost being constant per unit of output, the contribution margin per unit is also a constant amount. The total contribution margin is used to meet the fixed cost, and the excess, if any, represent the profit” (N D Vohra, page 934)iii Naturally, the alternative that produces highest contribution margin per unit will be preferred as it will add more to the net profit margin of the entity. Contribution margin per unit is 20% for manufacturing 1000 units, and 25% for manufacturing 4000 units annually. The reason for this is the availability of benefit economies of scale only when the production exceeds 1000 units. The variable cost for production above 1000 units is £7500 per unit as compared to £8000 per unit when production is less than 1000 units. Accordingly the result of CVP analysis is that Ferro PLC should go in for annual production of 4000 unit. The issue whether Ferro Plc should enter into the market or not needs analysis from the point of view of rate of return on capital invested and the recovery of capital investment. Let us start with the rate of return this business will provide to Ferro Plc. The company’s capital investment structure will be comprised of 60 percent equity investment and 40 % of debt capital. Ferro Plc will have to first settle its hurdle rate of return or required rate of return from the project on its investment. Hurdle rate is “the minimum acceptable rate of return for a proposed project to merit investment. Usually the hurdle rate is the opportunity cost of capital or the best return the company could get by investing the capital elsewhere. To be financially justifiable, a project’s internal rate of return must exceed the hurdle rate set by the firm for such project.”(Paul M. Swamidass, page 286)iv In order to set a hurdle rate of return it is important to compute Weighted Average Cost of Capital (WACC). The reason for this is that “the WACC approach begins with insight that projects of levered firms are simultaneously financed with both debt and equity” (Ross, page 576)v It is also important to note that “cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock. It can also be thought of as rate of return required by market suppliers of capital to their funds to the firm. If risk is held constant, projects with rate of return above the cost of capital will increase the value of the firm, and projects with a rate of return below the cost of capital will decrease the value of the firm.” (Lawrence J. Gitman, page 498)vi As per information Ferro Plc will invest equity with a cost at 14% and cost of debt capital is estimated at 6%. It is assumed here that cost of debt capital is after tax to be held by Ferro Plc. With this much information already in hand, it is possible to compute WACC. This is because WACC “simply represents the average cost of each dollar of financing, no matter its source, that the firm uses to purchase assets.” (Scott Besley and Eugene F. Brigham, page 485)vii. In fact, WACC reflects the expected return on its future average investment in the long run. It is calculated by weighing the cost of each source of funding used in the capital structuring of the company. In our case the weight age is 60% for equity capital and 40% for the debt capital. Using these weights the WACC of Ferro Plc is compute as under: WACC = (W1 *K1) + (Ws * Kn), where W1 = Proportion of debt capital in total capital employed Ws = Proportion of ordinary shares in capital structure K1 = after tax cost of debt capital, and Kn = Cost of equity capital Accordingly WACC is computed as under: WACC = (40% * 6%) + (60% * 14%) = (0.40 * 0.6) + (0.60 * 0.14) = 0.24 + 0.84 =1.084 = 10.84% Accordingly, the required rate of return for Ferro Plc is at least 10.84%. Any project providing return more than 10.84% is considerable as per composition of capital structure of the company. In order to compare the require rate of return we need to know the return on the “Tensilite’ project under consideration. Certain assumptions for the purpose of computations of returns from the project are as under: Ferro Plc has installed manufacturing plant at capital cost of £10,000,000 to produce 4000 units annually The useful life of the manufacturing plant is three years. As the depreciation policy of the company is to deprecate fixed assets in equal installments over their useful lives, the yearly depreciation of £10,000,000 cost of manufacturing plant comes to £3,333,333. The computations are made both for 20% of the most likely view of forecast market (i.e. annual demand of 6500 units), as well as 30% of the same forecast market. Accordingly the sales at 20% of forecast market are 1300 units, and at 30% of forecast market are 1950 units. The company produces only units that are sold during the year. That means there no stocks at the end of the year. Similarly there are no closing stocks of raw material as well. The computations of earnings are based on CVP costing methods. Tax rate is assumed to be 30%. There are no accounts receivable and accounts payable at the end of year. Capital investments is computed as under: Cost of manufacturing plant 10000000 Marketing Cost 2000000 Additional annual fixed cost 1000000 Total Capital investment £ 13000000 Contribution of capital: 60% as equities 7800000 40% as debt capital 5200000 Finance charges on debt capital @ 6% per annum on 5200000 are £3122000. The computations of accounting rate of return for comparison with required rate of return are as under: The results of rate of return and profitability calculations above show that sale at 20% of the forecast would yield an annual profit of £1053267, and working at 30% of the forecast would yield £2855767. For comparison purposes accounting rate of return is computed. “Accounting rate of return measures the returns on a project in terms of income, as opposed to using a project’s cash flows. Income is not equal to cash flows because of accruals and deferrals used in its computation” (Don R. Hansen and others, page 718)viii Though accounting rate of return is not a perfect measure of rate of return, as are net present value and internal rate of return, but accounting rate is the best choice under the given circumstances. This is because we do not have any information about cash flows. The available information is only about one accounting period, and this information cannot be true for coming accounting periods as well. Accounting rate of return for activity at 20% of forecast is 5.85%, and at 30% of forecast it is 15.87%. The required rate of return as calculated earlier is 10.84%, taking into consideration the weighted costs of different constituents of capital structure of the company. The company needs to earn at least the required rate of return of 10.84%. The accounting rate of return at 30% of forecast in operation exceeds the required rate of return. Accordingly Ferro PLC should enter into the market only to capture 30% of the forecasted sales by spending extra marketing expenditure. There is no point in undertaking manufacturing at 20% of forecast even though the company saves £1000000 on account of marketing expenditure, as at this option the accounting rate of return is lower than required rate of return, i.e., weighted average capital cost of the company. However, the above assessment method is a crude way of assessment of a project because of following reasons: The assessment is based on only one period of performance, whereas the license is for a period of three years. Cash flows from the project are not at all considered Inflation, that is reality in every economy, has not been taken into account. Also “the main disadvantages are that profit and capital investment have many possible definitions, and the accounting rate of return does not take into account the time value of money” (Michael Jones, page 458)ix Let us evaluate the project on cash flow basis taking into considerations the future cash flows for three years. It is assumed that all previous assumptions remain the same. The method used here for evaluation of project is Net present value that encompasses discounting of future cash flows to find their present values. “Net present value is a capital investment appraisal technique which discounts future expected cash flows to today’s monetary values using an appropriate cost of capital.” (Michael Jones, page 461)x Under this method present value of future cash inflows is compared with cash outflows in order to arrive at the decision. “Discounted cash flows follow the fundamental economic principle that the value of an asset is the present value of expected cash flows from using the asset.” (Constance Lutolf Carroll and Antii Pirnes, 2009, page 396)xi. This method involves the process of finding the present value of future cash flows of the project under consideration. “The process is actually the inverse of compounding interest. Instead of finding future value of present dollar at a given rate, discounting determines the present value of future amount, assuming an opportunity to earn a certain return of money” (Lawrence J Gitman, 2006, page 169)xii. Ours is an inflationary economy, and inflation tends to distort decisions. “Failure to account for these trends in projecting cash flows can lead to serious enormous results, thereby giving misleading profitability estimates.”(A. Kayode Coker and Ernest E. Ludwig, page 101)xiii. Another factor that will impact discounted cash flow process is depreciation. “Depreciation charges are based on original rather than replacement cost” (James C. Von Horne, page 168)xiv. Therefore depreciation remains a constant amount, but it does not involve cash outflows. Therefore it is essential that “in estimating cash flows, it is important that the individual company take anticipated inflation into account.” (James C. Von Horne, page 169)xv Assuming that the inflation rate is 7% during all the three years, the computations of net present value based on discounted cash flows are as under. Computations as per discounted cash flow method suggest that net present values of discounted cash flows exceed the outflow of investment only under option where sales of 30% of the forecast is achieved. The first option of sales at 20% of the forecast is not suitable for Ferro Plc. Accordingly both methods of evaluation, accounting rate of return as well as net present value method using discounted cash flows, suggest that project should be undertaken at the proposal where sales of 30% of forecast is achieved. Only at this stage the required rate of return is achieved. Conclusion Financial tools used in this report for Ferro Plc indicate that the company should enter into the market by expanding its annual capacity up to 4000 units at the capital cost of adding manufacturing plant worth £10,000,000.The analysis revealed that undertaking 30% of the forecast market by incurring marketing expenses of £2,000,000 will only bring in profitability exceeding the required rate of return, that is the weighted average cost of capital for this project. Discounted cash flow based Net present value method has confirmed the results of computation of Accounting rate of return method in deciding about the course of action to be followed by Ferro Plc. Moreover the effects of inflation and other business factors have also confirmed that evaluation based theoretical financial techniques are fruitful in taking project decision for Ferro Plc. Word Count: 2450 References Read More