Peach and Apricot cream cake machine is one of most advance cake making machine worldwide. With the use of the new technique equipment, the production will be promoted as well as the sale. In order to valuate the profitability of the project, several appraisal methods are used, including Payback Period, ARR, and NPV. By evaluating the value of the project using those methods and analyzing the relevant results, decisions can be made regarding whether to accept or reject the proposal. In addition, to generate adequate working capital, account receivables need careful management. One of the method is to offer discount for cash sale, so that cash will be collected in a timely manner, increasing working capital and the probability for future investment. Finally, a careful analysis of the financing methods will be examined. In order to finance a takeover, debt finance and equity finance are two alternatives. Conditions and other requirements should be considered when making financing decision.
The initial cost of the machine is £200,000, and it has a 5-year life expectancy. At the end of its life, the machine will have a scrap value of £20,000. The annual cash sale is projected to be £170,000, and the annual material and operating costs for machine will be £105,000. The discount rate is 10% and required rate of return is 30% per years. The maximum payback period is 2.5 year. All the information is included in Appendix I.
The Payback Period method is a traditional method to facilitate investment decision-making process. It is one of the simplest and commonly used method to evaluate the capital expenditure decision. It measures the time required for the project to pay back the original investment, and it is widely used as an initial screening method. The cash flow for each year a listed in Table 1.
Obviously, the payback period is between 3 and 4 years, which is longer than the maximum payback period of 2.5 years. Based on the result of payback period, the project should be rejected because the investor cannot get the investment recouped within required years.
Return on Capital Employed (ARR method)
The Return of Capital Employed method (the Average rate of Return, ARR) is the second traditional method to calculate return and budget capital. This method is based on accounting information rather than cash flows.
average annual accounting profit x 100
ARR = average investment
The average annual accounting profit of this project is expected to be £29,000, and the estimated average investment is £125,000, thus the ARR of the new machine project is 23.2%. Compared with 30%, the required rate of return on capital, the ARR is nearly 7% below the acceptance level. However, we cannot make hasty conclusion because ARR has some flaws, which will be mentioned later in the report.
Net Present Value
NPV is preferred for investment appraisal purpose due to its rare defects and the consistency with SHWM. It takes the time value of money, and all cash flows are expressed with their present values. The result of NPV valuation is as follows.
The NPV is a positive result, £236,515, so it is beneficial to accept the proposal because the return is larger than 0.
Among the three method of investment appraisal, NPV is the best valuation technique. The first merit validates its advantage is that NPV takes the time value of money into consideration, which is ignored by the first two methods. In addition, it takes the benefits from the whole project into consideration. The Payback Period method merely focuses on the period of time that the investment can be paid off, but it ignores the possibility that a major portion of the return will occur in the end of the project. Moreover, NPV allows for change in discount rate. By changing the denominator, the NPV method still remain applicable to the current situation. Furthermore, the investment decision should be in the best interest of the investors, and it is in accordance with the three factors that influence the wealth of shareholders, including time, cash, and risk. In addition, for exclusive project, the NPV gives an absolute measure for the return of project value, which is clean and easy to understand. As for the other two methods, although they are easy to compute and simple to understand, nor do they consider the time value of money or the risk associated with the cash flow. Additionally, neither of the two method takes the size of the project into account, resulting in a relative measure which is hard to compare. As a result, NPV method should be adopted. In this case, with NPV of £236,515, the project is profitable, thus should be accepted.
Currently, the annual sale of cakes is £4,000,000, the current debt is £900,000, and the bad debt is £40,000 per year. In order to encourage cash sales and early payment, a discount promotion is considered; offer credit customers 1% discount if early payment is made within 30 days. Cost of discount.
Based on information about, the evaluation of the policy is elaborated in Appendix II. The current receivable is £900,000. If the discount policy is implemented, 45% sale would be paid back within 30 days and 55% of the credit sale would be collected within 60 days. As a result, the number receivable now is £390,410.96 less than the original number, resulting a decrease in interest payment of £19,521 per year. In addition, the value of the decreased bad debt is £200, the benefit is £ 21,521 in total. Since the policy incurs additional administration cost, the net value of the policy now is - £4,779, thus it should not be implemented.
The cost of short-term debt finance is relatively higher than that of long-term debt financing. Short-term interest rates are usually lower than the rate of long-term debt. In addition, short-term debt is more flexible compared with long-term debt, such as the case where short-term overdraft is more flexible compared with a long-term fixed debt over several years. However, short-term debt is considered to be riskier. One reason behind is that the interest rate might change next time, or it is hard to renew the short-term debt for some other reason. The long-term secures capital for a certain amount of time, while short-term debt might suddenly become unavailable, putting the company in dangerous situation of lacking capital. As a result, company should balance the risk and cost of the two approaches of debt finance.
A matching funding policy will finance current assets with short-term funds in order to offset the negative effect resulting from the fluctuation and volatility of the current asset in value. Hedging programs are commonly used to hedge the risk of change in current asset value. For example, in order to hedge the risk of decrease in value of the raw materials in inventory, the company might purchase future or forward in the exchange market to offset the risk. The company will hold the derivatives until the current asset is mature.
The matching principle is included in the working capital financing policies. A matching policy match the current assets with short-term funds and permanent and non-current assets with long-term funds. In addition, the maturity of the funds matches the maturity of assets.
Debt Versus Equity
Debt means obligation while equity means ownership. The company who borrows money is obligated to pay back the interest and the principal according to the contract, while company who issues equity does not have to pay any money to shareholders, even the payment of dividend is not an obligation. Raising capital with debt adds burden to the company due to the payment of interest each period, especially when the interest rate is high. Equity usually does not incur additional burden on the company, but it will decrease the power and well-beings of current shareholders.
In the case of takeover, equity financing means issuing shares of common stock to the buyer in exchange for the control and ownership of the acquired company. While debt financing means borrowing money from financial institution without losing part of the ownership. It allows owners to remain control over the company.
Example of preference for debt financing
In the following situations, debt financing will be considered and preferred.
One example that debt financing is chose is when the interest rate and the expected interest rate is low. The company can increase its leverage and its working capital without incurring unbearable burden to its current financial situation. If the interest rate of borrowing is low, taking the time value of money into consideration, it is likely that the acquisition will become more profitable. Instead, if the company choose to issue equity, the value of each share will be diluted, and the interest of current shareholders will be harmed.
In the second example, there are legal constraints such as covenants or articles from association that forbid the company to issue more equity currently. In the case that equity financing is unnavigable, debt financing is the only way out.
The third example revolves around cost of issuing equity. The process of issuing equity is usually lengthy and costly that simply borrowing for the bank. With high M&A consulting fees regarding the issue of equity and the servicing costs, the equity financing might result in a less profitable takeover.
Long-term loans cannot be traded in the capital market directly while bonds can be traded in capital market publicly. As a result, if more flexibility is preferred, then the bonds will be a better choice; in the case of demand of working capital, the company can trade its bond and exchange for cash. In addition, the company should consider its ability to pay back interest. Annual payments and interest payment incur every certain amount of time. If the company cannot generate enough cash to payback the interest, it is better for the company to issue bond which will be paid in a lump sum when the bond is at maturity. Moreover, the underlying security should also be considered. Bonds are often secured by fixed charge on certain assets or floating charge on a class of assets while assets are often secured by assets of the company. Bonds can include covenant to protect investors, but the company has to pay back long-term loan first and leave the rest to the shareholders.
Compared the effectiveness and accuracy of the three investment appraisal methods, NPV is adopted. The valuation result shows that the purchase of the new equipment is profitable thus the project should be implement, since the NPV is a positive member. In addition, based on the calculation and analysis, the discount policy should not be implement, because it will decrease the value of the account receivables. Finally, equity financing and debt financing have their own advantages and disadvantages, the condition of the company and other external factors should be analyzed when making decision.