Capital Investment Appraisal Report for AYR Co PDF

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University of South Wales

Strategic Financial Management (AF4S31-V2) Module Assessment 2

Capital Investment Appraisal Report for AYR Co

Tutor: Dr. Anna Kochanova Student: Mohammed Wagiealla Abdalla (R1710D3600524) March 2019

Table of Contents Abstract……………………………………………………………………………………………………… ………..…..3 1.Introduction: …………………………………………………………………………………………………..……..3 1.1 Capital Appraisal………………………………………………………………………………3

Investment

1.2 AYR Co assumptions………………………………………………………………………………3

Projects

2. Methodology Techniques………………………………………………………………………………...3

and

2.1-Net Present Value ……………………………………………………………………………….……3

(NPV)

2.2-Internal Rate of Return ………………………………………………………………………….…4

(IRR)

2.3-Payback Period……………………………………………………………………………………………………5

3-PROJECT INVESTMENT ANALYSIS………………………………………………………………. ………5 3.1Calculations………………………………………………………………………………………………… ………5 3.2-Analysis and Recommendations: …………………………………………………………………………6 3.3-Factors to Be Consider…………………………………………………………………………………………7

4-Sources of Finance Analysis: ………………………………………………………………………………….7 4.1-Sources of Finance…………………………………………………………………………………………….…7 4.2-Cost of Finance: …………………………………………………………………………………………………..8 4.3-Effect on weight average cost of capital (WACC): ……………………………………………..…9

Conclusion…………………………………………………………………………………………………… ……………9

2

Appendics…………………………………………………………………………………………………… …..………10 A-Progect Aspire ……………10

Calculations…………………………………………………………………….

B-Project Wolf …………………………………………………………………………………..…11

Calculations

Reference: ………………………………………………………………………………………………………………12

3

Abstract The following report shows an analysis of two projects of AYR Co. by the names Aspire and Wolf. This report will show the calculations and results of three capital investment appraisal techniques to determine the future success of each of the projects. And also, we will discuss about the nonfinancial factors which will affect the choose of projects We are going to calculate the Net Present Value (NPV), Internal Rate of Return (IRR) and The Payback Periods.

1.Introduction: 1.1 Capital Investment Appraisal: Capital investment appraisal also known as capital budgeting is one of the planning processes used to easy the decision making in concerned investments either long term or short term. “Capital investment appraisal is the application of a set of methods of quantitative analysis which give guidance to managers in making decisions as to how best to invest long-term funds.” (Weetman 2010). Capital investment appraisal have 10 different techniques used in measurement of business projects capital investment appraisal, but in this report, we will use only three techniques.

1.2 AYR Co Projects assumptions: As the company spent $120,000 for market research for both projects, we can’t include the amount in the calculations, also the projects periods which is 5 years and $2,250,000 initial investment are equal for both aspire and wolf projects. We have to put the corporate tax -which is 20%- in consideration when calculating tax benefit for project Aspire. Also after 5 years project duration we consider machines scrap value $375,000 as cash inflow by the end of the project Aspire only since project Wolf does not have scrap value and capital allowance.

2. Methodology and Techniques: 2.1-Net Present Value (NPV): This capital investment appraisal technique measures the cash inflow or it’s a method to calculate the company return on investment for a specific project or expenditure (Gallo 2014). The NPV calculated as follow:

NPV =−c 0+

Where -C0 =Initial Investment C = cash flow R =discount rate T = time 4

c1 c2 + 1+r (1+r )2

+…

Net Present Value =

∑

Year n Total Cash Flow n (1+ Discount Rate)

Where n is the year whose cash flow is being discounted If the NVP came with negative value so that means the projects is not good and it is draining the cash from the business, on the other hand the larger positive net present value the greater the project benefit for the company. 2.2-Internal Rate of Return (IRR): The internal rate of return is the discount rate which used as a forecast of any project return when applied to project cash flows,” To perform the calculation, we need to take the cash flows of a project and calculate the discount factor that would produce NPV of zero.” (ACCA global)

Source: ACCAglobal.com

The IRR calculated as follow: IRR=r a + Where 5

NPV a (r −r ) NPV a−NPV b b a

Ra =lower discount rate chosen Rb =higher discount rate chosen Na =NPV at Ra Nb = NPV at Rb Or N

0=NPV =∑ n =0

CFn (1+IRR)n

Where N= Holding Period n= Each period c f n = Cash flow NPV = internal present value IRR= internal rate of return

2.3-Payback Period: Is the period of time required to cover negative project cash flow by a positive project and it always calculated based on the cash flow without the discounts (Tayari) and its calculated by the following formula:

payback period=

Initial investment Cash flow per period Or

payback period= A+

B C

Where: A: “the last year of negative cumulative cash flow” B: “the absolute value of cumulative cash flow at the end of year” “A” C: “the total cash flow during year” “A”

3-PROJECT INVESTMENT ANALYSIS: 3.1-Calculations In order to recommend any of two projects -Aspire and Wolf- we make an analysis for the AYR Co. as follow. Net Present Value (NVP) Used to analyze the discounted cash flow, in order to calculate net present value for Aspire and Wolf projects we used a 10% discount to put the cash flow to the present value. Technique “Net Present Value (NPV)” 6

Project Aspire 424,845

Project Wolf 379,801

When the net profit value came in positive that’s means there is profit.

Internal Rate of Return (IRR) The calculation of IRR used to determent the amount that investor can expect as return of investment. The decision of reject or accept any project is based mainly on the IRR rate,if the IRR is higher that the cost of finance and as larger the IRR the better the project. In order to calculate IRR using Excel we have to enter the intial cash flow n the spreadsheet and the initial investment should be negative figure ,then the subsequent cash flow will be entered for each period into cells , the final step will be entering excel command “=IRR(A1:Ax)” where x is the number of last cell. Then the IRR will display at the same cell. Technique Internal Rate of Return

Project Aspire 17%

Project Wolf 17%

Payback Period The payback period was calculated by determination of overall cumulative balance of cash flow in comparison with initial outlay. Most of the investors will find the shorter payback period is the most attractive method about projects making decision. Technique Payback Period

Project Aspire 3.45

Project Wolf 3.07

3.2-Analysis and Recommendations: NPV Analysis: Based on the project investment analysis findings came through the three techniques we can see that the project Aspire has the higher net present value (NPV) with $424,845 compare to $379,801 for project Wolf that means the inflow cash was significantly higher than the cash outflow during the calculation period. we can conclude that project Aspire will bring more income from littlie budget so theoretically the company should use project Aspire over project wolf. IRR Analysis: In this case both aspire and wolf projects have the same internal rate return which give no base to differentiate between the two projects and both projects have internal rate of return higher than 10% which is the capital investment which means both Aspire and Wolf can add some value to the company, but as we have a higher net present value the company should go to aspire project.

Payback Period Analysis: 7

We can see the project aspire require 3.45 years which is higher that project wolf with 3.07 years to payback the investment, however, the different in the duration is not big and project aspire will generate more income in almost the same period of the projects therefore the project aspire is still more desirable for AYR Co .

3.3-Factors to Be Consider: Before we can give an opinion to help the companies to decide which investment is the best to jump in there are non-financial factors should be considered 

Safety of Public and company Employees: in many cases viable projects could be dropped due to unsafe effect on employees or have a hazardous impact on social values. so, the project impact on safety is a very important.



Availability of Resources: The availability of raw materials, power…etc. and any other basic requirements must be assured also before taking any project because the failure of supply of any may cause huge financial loss.



Availability of manpower: The companies should make sure of manpower availability and the high level of motivation,



Environmental Factors: An any case the general public may feel any environmental hazards due to project establishment pollution or chemical and poisonous wastes that project may be a disaster for the company name and other projects.



Meet the Governmental roles: This is very important non-financial factor. the companies need to stick to governmental directions and requirements while the project selection processes.



Company Culture and Values: The company should check the computability of the new projects with the company culture, values and the management style.

4-Sources of Finance Analysis: 4.1-Sources of Finance: The business face three important issues when select new project source of finance:  The ability to finance the project from internal source or it have to be external financing?  In case of external finance what type of finance will it be, Debt or Credit?  If the company choose the debt finance, from where the debt finance will be raised? The board of AYR Co. considered two sources of finance which are Equity and Debt, respectively they are consist of new shares issues and borrowing some money from lenders. In this part we are going to discuss these two sources and their reflect on WACC and on stakeholders. Intended financing sources for AYR Co. 8

Capital employed Equity holder funds Long term debt Total

$million 20 18 38

% per source 52.63 47.37 100

Source: USW AF4S31 Assessment 2 Debt Finance Is the type of finance when the company raise its capital by borrowing money from bank or lender and the principal must be paid back by the due date. Debt may be in different forms like a lone or the sale of bonds.”One major benefit that is frequently overlooked is that business debt can also create more tax deductions. This may not have a big impact at the seed stage but can make a huge difference in net profits as you grow and yield positive revenues” (Cremades 2018). Also in debt finance liability well be over once the debit paid back full and then the profit will be completely for the investor. On the other hand, regardless the situation of your business or how well you are doing you have to pay your debit. Then AYR Co should consider the following points befor going for debt finance:  The loan duration: the shorter loan duration is the cheaper option.  Fixed and floating loan rate: the fixed rate is constant payment and floating is variable but the fixed rate is more expensive.  The statues of the organization as some rates and types of debt finance is only available for listed companies.  Currency of loan: because currency fluctuation may reflect as increase or decrease of the cost. Equity Finance In this type of finance, the company will gain money by selling shares or make a partnership and in this case there will be no fixed payments, but the investors will receive percentages from the profits (Cremedes 2018), this type of financing will bring good advantages for capital investment but the share loss may lead also to loss of absolute control because the shareholders may interfere in the day by day management so the main fear of equity finance is loss of control. So, both types of finance have a good and bad faces the most important thing is to know and understand which one will be more suitable and more beneficial to the type of business.

4.2-Cost of Finance: in the case of debt finance the cost is equal to the interest that well be paid by the company on its borrowings while the cost of equity finance is the return requires by shareholders, normally the cost of Debt finance is cheaper because debt finance is tax deductible and also the debt finance is paid off before equity debt in the liquidation event. Also, debt lenders normally demand a lower interest rate than the equity investors.in debt finance arrangement cost is lower than equity plus its tax deductible (ACCA global 2019) so AYR Co should consider going for debt finance because it is cheaper, and it may benefit also from tax deduction

4.3-Effect on weight average cost of capital (WACC):

9

The finance decision has a huge impact on the weight average cost of capital. ”The WACC is the simple weighted average of the cost of equity and the cost of debt” (ACCA global). So, the amount of debt and equity finance will affect automatically the value of WACC. To understand how this will affect the hole market value of the company we have to see how its calculated. Market value of a company = Future cash flows / WACC Then to have the higher market value of the company the WACC should be as lowest as possible ,to reach this result the company should replace some of equity finance -which is more expensive- with more of the lower price debt finance to reach the lowest possible weight average cost of capital without gearing or bankruptcy or any financial risks.(Lynch)

4.4-Possible Impact on Shareholders: As long as the sources of finance will affect the weight average cost of capital and reflects on market value company then the company owners and profitability will be affected by the source finance, if we took the debt finance effect will be on the net income due to the regular loan payments with the interest rate which will increase company liabilities and reduce the net profit. Debt finance got some pros for owners, the most important is ownership maintaining and right to run their business and in most cases the debt will classified as business expenses and will be tax deductible. While in the case of equity finance the ownership power will be reduced by increase the number of shareholders.

Conclusion: With taking into consideration the results of the three investment appraisal techniques we can advise the AYR Co. to go forward with the project Aspire due to the ability of the project to repay the investment within the investment period and also it can generate more cash than wolf project. On the other hand, project wolf is also can add some value to AYR Co because of the internal rate of return is more than the capital investment cost. On the financial part the company should find out the best balance between the debt and equity finance to finance the company projects and to find out the best rate to maintain low and safe weight average cost of capital to maintain a good company market value.

10

APPENDICS

A. Project Aspire Calculations Project aspire Year 0 Capital ($2,250,00 spending 0) Salvage value Cash Inflows Variable Costs EBIT Taxes (20%) Capital Allowanc e Tax benefits Net Cash Flows Cumulati ve Cash Flows Discount Factor Present Value Net Present Value (NPV) 11

Year 1

Year2

Year3

Year4

Year5

Year6

$375,000 $650,000

$698,750

($27,000)

$600,000

($28,823 ($30,768 ($32,845 ($35,062) ) ) ) $669,927 $720,388 $774,648 $1,207,9 93 ($124,60 ($133,98 ($144,07 ($154,93 0) 5) 8) 0) $390,000 $345,000 $300,000 $240,000

$0

$120,000

$78,000

$69,000

($2,250,00 0) ($2,250,00 0)

$623,000

$665,327

$664,403

$699,570

($1,627,00 0)

($961,67 3)

1

0.91

($2,250,00 0)

$566,930

$623,000 $0

$751,156

$807,493

$868,055

$241,599

$60,000

$48,000

($297,27 0)

$1,113,0 63 $402,300 $1,515,3 63

($193,59 9) $1,321,7 64

0.83

0.75

0.68

0.62

0.56

$552,22 1

$498,30 2

$475,70 8

$690,099

($108,41 5) $424,845

Internal Rate of Return (IRR) Payback Period

17%

3.45

B. Project Wolf Calculations: PROJECT WOLF Capital Spending Salvage Value Cash Inflows Material Costs Other Expenses Foregone Rental Income EBIT Taxes (20%) Net Cash flows Cumulative Cash Flows Discount Factor Present Values Net Present Value (NPV) Internal Rate of Return (IRR)

Payback Period 12

Year 0 $2,250,000

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

0 $955,000

$955,000

$955,000

$955,000

$955,000

($14,400)

($15,480)

($16,641)

($17,889)

($19,231)

($18,000)

($16,650)

($15,401)

($14,246)

($13,178)

($75,000)

($75,000)

($75,000)

($75,000)

($75,000)

$847,600 0

$847,870 $169,520

$847,958 $169,574

$847,865 $169,592

$847,591 $169,573

169518.2

($2,250,00 0) ($2,250,00 0)

$847,600

$678,350

$678,384

$678,273

$678,018

($169,518)

($1,402,400)

($724,050)

($45,666)

$632,607

$1,310,625

$1,141,10 7

1

0.91

0.83

0.75

0.68

0.62

0.56

-2,250,000

771316

563030.5

508788

461225.912

420371.16

-94930.19 $379,801

17%

3.07

References

ACCA global “Select Sources of Finance for Business” available at : https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-studyresources/f9/technical-articles/selecting-sources.html (accessed 15 March 2019) AF4S31 (2019) “Investment Appraisal II. In: Strategic Financial Management. University of South Wales”. Available at: https://vle-usw.unicaf.org/mod/resource/view.php?id=3642 1 (Accessed: 12 March 2019) AF4S31 (2019). “WACC. In: Strategic Financial Management” Available at: https://vleusw.unicaf.org/mod/resource/view.php?id=36401 (Accessed: 11 March 2019) AF4S31 (2019). “Capital Structure and Gearing. In: AF4S31 Strategic Financial Management. University of South Wales.” Available at: https://vle-usw.unicaf.org/mod/resource/view.php?id=36404 (Accessed: 11 March 2019) AF4S31 (2019)). “Cost of Capital - Introduction to Cost of Debt. In: Strategic Financial Management. University of South Wales.” Available at: https://vle-usw.unicaf.org...