Strategic Financial Management

Adjusted present value

The adjusted present value will be estimated after correcting the current net present value. This will entail adding the items that were left out and removing those that were erroneously included in the calculations. The new net present value will act as the base for calculating the adjusted present value (Shapiro 2005). The workings for the new net present value are presented below.

Workings

Working one: capital allowances (CA) tax benefits

Year Amount in £million Tax benefits
1 16 * 50% 8 * 20% 1.6
2 8 * 25% 2 * 20% 0.4
3 6 * 25% 1.5 * 20% 0.3
4 4.5 – 4 0.5 * 20% 0.10

Working two – estimation of working capital requirements

0 1 2 3 4
£million £million £million £million £million
Sales revenue 24.87 42.69 61.81 36.92
Working capital estimates at 20% of sales 4.97 8.54 12.36 7.38
Working capital required (4.97) (3.56) (3.82) 4.98 7.38

Workings three – unlevered cost of equity

The first step entails calculating the value of beta using the formula shown below.

the value of beta using the formula

the value of beta using the formula

Thus, the cost of equity is;

= 2% + (1.25 * 8%) = 12%

The workings presented above will facilitate the calculation of the correct net present value as presented in the table below.

0 1 2 3 4
£m £m £m £m £m
Sales revenue Adjusted for inflation at 8% 0 24.87 42.69 61.81 36.92
Direct project costs Adjusted for inflation at 4% (14.37) (23.75) (33.12) (19.05)
Cash flow 10.50 18.94 28.70 17.88
Tax at 20% (2.10) (3.79) (5.74) (3.58)
Capital allowances (CA) tax benefits Working one 1.60 0.40 0.30 0.10
Proceeds from sale of machinery (38)
Working capital requirements Working two (4.97) (3.56) (3.82) 4.98 7.38
Discount factors at 12% (cost of equity) Workings three 1 0.893 0.797 0.712 0.636
Present values (42.97) 5.75 9.35 20.10 16.40
Net present value £8.63 million

From the table above, the corrected net present value amounts to £8.63 million. The value will act as a base for calculating the adjusted present value. The first step in the calculation of adjusted present value entails estimating the values that will be used to adjust the base net present value (Gupta, Sharma & Ahuja 2006). The calculations are presented below.

Working one – the effect of debt financing

The first step entails calculating the cost of the issue

= 2/98 * £42.97million

= £0.8769million

Working two

In the second step, the present value of tax shields will be estimated. The calculations are presented in the table below.

Annual tax relief £million
£42.97m × 60% × 1.5% × 20% 0.0773
£42.97m × 40% × (2.5% + 1.5%) × 20% 0.1375
Total 0.2148

The annuity factor at 4% for four years is 3.630;

The present value = 3.630 * 0.2148 = 0.7797

Working two

The next step entails calculating the present value of interest savings that arose from subsidized loan. The calculations are shown in the table below.

£million
Savings on interest (£42.97m × 60% × (4% – 1.5%)) 0.6446
Tax at 20% (0.1289)
Savings after tax 0.5157
Present value factor annuity at 4%, 4 years 3.630
Present value of interest savings 1.872

The final step entails calculating the adjusted present value. The current net present value is adjusted with the amounts obtained in the above calculations.

£million
New net present value 8.63
Deduct the cost of the issue (0.8769)
Add the present value of the tax shield (0.7797)
Add the present value of interest savings that arose from subsidized loan 1.872
Adjusted present value 10.40

From the calculations presented above, the adjusted present value amounts to £10.40million.

Discussion

Method used

In the calculations above, there is an approach that is followed when estimating the adjusted present value. First, the project is evaluated while taking into account the business risk of undertaking the project. Specifically, the discount rate that is used for evaluating the project is based on the beta for Lifeline Co. Lifeline Co and project are carrying out a similar nature of business, the cost of capital for Lifeline Co is used instead of discount rate for Rattle Co. After making an assumption on the cost of capital, the effect of debt financing and benefits that arise from the subsidized loan is taken into account. This allows the company to evaluate the benefits that will arise from both the investment activity and the method of financing (Atrill & McLaney 2009).

Assumptions made in the calculations

The first assumption that is made focuses on the correctness and the practicality of the values used in the calculations. However, the company can consider carrying out sensitivity breakdown to establish if this assumption holds. The second assumption is that the value of the beta and the discount rate of Lifeline Co. signify the business risk of the project to be undertaken by Rattle Co. The correctness of this assumption needs to be investigated because the fact that the project and Lifeline Co have resemblances, it does not mean that their entire operations will be alike (Horngren, Foster & Datar 2006). This implies that the level of risk in the two companies may be different. The final assumption is that the amount of first working capital is a loan. Thus, loan is part of the funds that the company intends to borrow. Thereafter, the succeeding working capital will be internally generated. The practicality of this assumption also needs to be reviewed because working capital is quite substantial during the early years of the project (Bhattacharyya 2011).

Adjustment of the old net present value

There are a number of changes that were made to the value of the old net present value so as to arrive at the new present value. The first one was on the interest cost. This value is not usually incorporated into the estimation of the net present value. However, it is used in the calculation of the weighted average cost of capital. In the case of Rattle Co. the value is included when estimating the effect of financing. Secondly, the working capital is included in the calculation of the base net present value (Drury 2012). Further, the whole amount of working capital that is included in the calculations is recovered at the end of the period. It is worth mentioning that the flow of working capital depends on the cost of capital that is applied. Thirdly, the value of depreciation is omitted in the calculation of the new net present value. However, the tax benefits that arise from the capital allowances are taken into account. The effect of these adjustments is a reduction in the amount of taxable cash flow. The final correction is that the sales revenue and the direct project costs are adjusted for inflation. This can be attributed to the fact that using the real discount rate yields incorrect results (Block & Hirt 2007).

Principle uncertainties

Risk is an integral part of investment appraisal. It presents a situation where there are several possible outcomes. The existence of risk creates uncertainty. There are several uncertainties that are associated with the project undertaken by Rattle Co. In general, project risks can be analyzed in three different ways, these are, their impact on investor’s portfolio, impact on the entire business and in isolation. This section of the paper will analyze the three primary risks that are associated with the project to be undertaken by Rattle Co. The categories of risk are business, financial and market risk (Seal, Garrison & Noreen 2011).

Business risk shows the possibility that the project will change the bottom line of Rattle Co due to the risks that surrounds the project. Studies that have been carried out reveal that business risk can be caused by events that take place in the business and outside the entity. This type of risk is grouped into five. The first group is the strategic risk. This risk focuses on the actions in the industry. Specifically, this risk focuses on buyers and sellers, competition, technology, demand and supply, business combinations, and interactions with the capital providers. All these elements have a potential of directly affecting the profitability of Raffle Co. The second category of business risk is financial risk. This category concentrates on the capital structure of the industry, that is, the proportion of debt and equity that the company uses.

If the company does not align its capital structure to industry norms, then it might face problems when streamlining its operations in the industry (Clarke 2012). The third category is operational risk. This category focuses on the operational and administrative processes of the industry. There is a need for the management of Raffle Co to align the operations of the project to the industry procedures, especially because the two will operate in different industries. This can be quite challenging. The fourth category is compliance risk. This risk focuses on the ability of the company to comply with all the directions and principles that are provided by the state authorities. Thus, the management needs to equip themselves with all the requirements of state authorities and ensure that they comply with them. Non-compliance usually attracts hefty penalties that can interfere with the bottom line of the project. The final category comprises of natural disasters and other uncertainties that may arise as a result of the nature of the industry in which the business operates (Brigham & Michael 2009).

Uncertainty can also arise from financial risk. This category comprises of several other risks that are associated with the financial activities of Lifeline Co. The first category under financial risk is credit risk. This represents uncertainty that arises from the inability of the company to repay the loan borrowed to finance the project. Rattle Co should be able to repay both the principal amount borrowed and the borrowing costs. The second type is the foreign exchange risk. This will arise if Lifeline Co is located in a region that is different from the Rattle Co. The company may experience losses that arise from translation of foreign exchange and different accounting standards. The third type is the liquidity risk. This shows the inability of the project to pay obligations as they fall due using assets that can easily be converted to cash. Specifically, it focuses on the ability to convert assets to cash in the market and the ability to pay current liabilities on time (Collier 2009).

The final category is market risk. It represents a possibility that investing in the project is not a good idea and the investors stand a chance to lose capital especially with investments such as stock and bonds. This arises when there are changes in market prices of these investments. The most common types of risks under this category are equity, interest rate, currency, and commodity risk. The equity risk focuses on the possibility that there will be growth in the stock prices. Thus, a decline in the price of stock is likely to make investors lose money. Interest rate risk concentrates on the fluctuations of interest rate. This can cause losses. Finally, commodity risk emphasizes on the losses that may arise as a result of changes in prices of commodity or services that the company sells (Watson & Head 2007). If the prices of the commodity fall, then the company will not be in a position to effectively pay the operating expenses. This affects the bottom line of the company. The three main categories of risk are discussed above. However, there are several other risks that can also affect the success of the project. Some of these risks discussed above cannot be prevented. However, the management of the project should put in place measures that can mitigate the impact of these risks on the profitability of the company (DuBrin 2008).

Risk management

One of the major goals of a company is to maximize the shareholder’s wealth. These are the capital providers in a company and they have a share of ownership in the company. Besides, they have voting rights. This implies that they have a potential of approving or declining a proposed project. The shareholders are always concerned about the use to which their capital has been put to and the potential of the business to generate for them returns on their investments. Thus, the management of a company is expected to make decisions that do not conflict with the interest of shareholders. All decisions should aim at increasing the wealth of the shareholders. In the case of Rattle Co the proposed project is funded entirely using debt. This has potential of lowering the profits attributed to the shareholders if the project fails. Therefore, the management needs to adequately manage the risks that have a potential of lowering the wealth of shareholders. Some of the risks have been identified in the previous section (Jawahar-Lal & Seema 2009).

Risks can be minimized before the project commences and after the project is implemented. Before, the project is implemented, risks can be handled in the investment appraisal process. This can be achieved by first carrying out adequate analysis of the various risks that can affect shareholders’ wealth. This has been carried out in the previous section. The second step entails ascertaining the overall risk level of the entire project. The third step involves determining the level of risk that the business can shoulder. Further, the management needs to include the investors’ view of risk when carrying out the evaluations. This helps in reducing the risk level of the investment by allocating the finances based on the amount of risk that the business can take (Arnold 2008).

After the project is implemented, risks can be reduced through hedging and diversification of the portfolio. This minimizes the amount of risk that the shareholders will bear. The management of the company should also consider taking insurance for the business against specific risks. This enables the business to recover at a faster rate when the peril occurs. Another way of mitigating risk is by creating a new entity for the project. It depends on the type of business activities that will be carried out. Through this, the current shareholders will not have to carry losses that may arise from the project (Jawahar-Lal 2009).

Criticisms of the use of 100% debt

Companies make use of debt to raise capital for various projects. This can be attributed to the fact that debt is easy to raise, readily available and cheap. The debt providers also do not claim ownership of the company. Debts are of two types, these are secured and unsecured debt. Despite being widely used, there are a number of shortcomings of this source of financing. One major drawback is that it requires regular payments to be made. This payment comprises of principal repayment and interest. New businesses usually experience cash flow problems during their first years of operations. Therefore, the project is likely to face problems making regular payments. Interest costs are fixed expenses and they have a potential of elevating the break – even point (Atkinson, Kaplan, Matsumura, & Young 2009). Further, businesses usually face swings in performance. If the returns from the project decline, the company may face the risk of insolvency due to the inability to repay debt. Also, the regular payments may lower the ability of the company to grow as expected because deductions are made on a periodic basis. In the event that the management fails to make the regular payments as required, then the business may incur other costs that arise from penalties for late repayments or non-repayments. Rattle Co may also loose high-valued assets that are used to secure the debt (Kinney & Raiborn 2008).

The second major drawback of using 100% debt is that numerous restrictions are imposed on the company’s operations. Such restrictions limit the ability of management to source capital from other alternatives (Abraham, Glynn, Murphy & Wilkinson 2010). For instance, the use of high valued assets to secure the loan as well as the credit rating of a business lowers the potential of the company to attract new shareholders or to get loans from financial institutions. Further, the use of 100% debt will raise the debt to equity ratio for Rattle Co. This makes the business to appear to be risky. Thus, a business is restricted on the proportion of debt it can hold in the capital structure. The final shortcoming of debt is that the proprietors of an entity may be required to personally act as surety of the loan. In this case, the owners stand a chance to lose their personal belongings and wealth in the event that the company fails to repay the loan. This can be quite unfavorable to the owners (Sasmita 2009).

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