Monday, December 30, 2019

Principals of Corporate Finance - Motorway Access Ltd - Free Essay Example

Sample details Pages: 10 Words: 3102 Downloads: 7 Date added: 2017/06/26 Category Finance Essay Did you like this example? Introduction The question of whether or not to proceed with a project requiring significant capital expenditure is one which involves considerations running the gamut of issues facing the firm.   Taking a purely financial perspective the firm is required by Fischers Separation Theorem to return the maximum amount of wealth to shareholders  (Fischer, Reprinted 1977).   In the modern firm ownership is separated from control in the form of the capital of the company being held, traditionally at least by shareholders who have little to do with the day to day running of the firm, this being entrusted to the Directors appointed to the board by the trustees and shareholders.   As such in the modern finance world there is a considerable agency problem whereby the owners of the firms capital have a degree of separation from the control of their capital  (Farma, 1978).   As such it is expected, and enforced by the market in terms of the willingness of investors to place capital under a firms control, that a firm will return wealth consummate with an acceptable degree of risk.   Indeed it is the risk of an investment which dries the importance of investment appraisal in firms and understanding the difference between systematic and un-systematic risk underpins much of the following discussion of the investment appraisal process  (Hirshliefer, 1961). Un-systematic risk is the risk associated with the unique operations and conditions of the firm and is relatively unimportant (at least in terms of the financial theory) whilst systematic risk, especially as represented as the Beta of the firm (more of which later) is the risk of the class of share within the market  (Pogue, 2004).   The theory is that a share price is determined by its relation to the capital market line, in terms of the random walk theory, which governs the movement of the share with the market.   Shares move as the market moves, generally speaking, and so how much they move represents the syste matic risk to the shareholder.   Beta is now one of the most common ways to measure the value of equity capital and is also used heavily in portfolio theory.   It is not without controversy or criticism.  Ã‚   Betas are worked out using a wide range of financial data from the past and as such many commentators have argued that Beta has little to tell us about the future.   There are significant problems with translating accounting data into price relevant information, particularly there is at best a tenuous link between earnings and book values of assets and prices observed in the market.   Particularly the Ohlson model which it is argued demonstrates a coefficient between these figures and price (also which it is assumed makes sense of both the Modigliani and Miller relevancy hypothesis and Gordon and Shapiros value metrics)  (Pogue, 2004).   Notwithstanding these criticisms and the accepted criticism of the random walk theory, which are considerable, Beta is still wi dely accepted as a way of dealing with systematic risk. What does this mean for Investment Appraisal techniques?   In terms of the accepted methodology of investment appraisal the goal of such appraisal has to be the increase in wealth of the shareholders, and as such many of the techniques which are readily deployed by managers have no theoretical basis.   In the following appraisal of the project a number of techniques are used to give decision relevant information of the project  (Graham, 2001).   The company has two criteria which it uses to judge the acceptability of a project, the Return on Investment, which it states must be above 15% and the payback period, which must be within three years.   Both of these methods give information in terms of in the first case, accounting data, and in the second a rule of thumb for recouping the initial investment within a specified time period.   Neither of these methods tell us much about the financial and wealth creating as pects of the project in question  (Hajddasinski, 1993).   Payback is simply a measure of the amount of time it takes to recoup the initial investment, and as such has little to do with maximising shareholder wealth, it is entirely possible for a project to recoup the initial investment very quickly but them go on to actually destroy wealth in later years, particularly when a project runs for a significant period of time.   The Accounting rate of return similarly tells us little about the wealth creation of the project, considering as it usually does non financial items such as depreciation which have little to do with the amount of actual wealth returned to shareholders. Don’t waste time! Our writers will create an original "Principals of Corporate Finance Motorway Access Ltd" essay for you Create order Neither of these techniques takes into consideration systematic risk to shareholders, and as such ignores an important and fundamental aspect of modern finance theory.   Indeed it is only Net Present Value (NPV) which can tell us about the wealth creating and destroying aspects of a project and as such it is this technique (along with the similar technique of Internal Rate of Return (IRR)) which can give decision relevant information in terms of shareholder wealth  (Lefley, 2004). Briefly NPV uses a discount factor, based upon the Weighted Average Cost of Capital (WACC) which adjusts the incremental net cashflows of a project for systemic risk, thus ensuring that the wealth created for the company reflects the time value of money  (Amran, 1999).   Much of the methodology in NPV requires one to recognise incremental cashflows and to remove those which have no relevance to wealth creation, particularly accounting derivations such as depreciation.   Other cashflows which need not be included are sunk costs and other costs which would exist regardless of the projects acceptance.   Thus the analysis concentrates on the wealth creating (or destroying) aspects of projects rather than the book conventions and ephemeral of other techniques.   It results in a cash figure, in terms of either wealth added or destroyed by the acceptance of the project and is particularly useful for the ranking of projects in times of capital rationing.   NPV is a powerful decision making tool, but not without considerable problems in and of itself.   NPV requires the firm to estimate future cashflows, and as will be seen, the accuracy of these cashflows are of significant importance to the viability of the project  (Amran, 1999).   Further the use of NPV is considered by many to be far more complex than most other techniques and non specialists may find the results and even the preparation of this analysis to be a significant challenge.   Further the discount factor itself is often controversial, WACC is only one of a range of factors which can be used, but is most theoretically correct (as will be seen in the discussion later of the capital gearing theory), but without a very accurate discount factor the analysis is at serious risk of error  (Hillier, 1963).   Notwithstanding these problems NPV is one of the most relevant and reliable tools of investment appraisal and satisfies much of the theoretical underpinning of the subject of finance. This report finds that the project returns a positive NPV and satisfies all of the other investment criteria and therefore should be undertaken  (Graham, 2001). Results Findings Please see appendix A for the full derivation of the results and findings. Net Profit ( £) 2792009 Payback 2.5 years ARR% 55.84018 NPV 1767785 IRR 21% This is based on a cost of equity capital of 6% which in turn is based on the calculation for Equity Capital under the Capital Asset Pricing Model (CapM): Where Ke is the cost of equity capital, rf is the risk free rate (often gilts) ? is the assigned Beta of the share and rm is the market risk.   For the company this equates to 5.31% which has been rounded up to the nearest whole (under the assumption that it is better to err on the side of caution) Discussion and Analysis As has been established in the introduction the primacy of the NPV technique carries with it a significant theoretical advantage over other methods.   IRR too is based on the same methodology and gives the cost of capital at which the NV of the project would be zero, as such it provides for the maximum cost of capita at which the project would be viable.   It would seem that this project is worth undertaking, not only does it satisfy all of the existing criteria for the firm, but it also returns wealth to the shareholders given the risk class of the share.   The problems of NPV have to, however, be considered in line with the predictability of cashflows and the sensitivity of the project to the accuracy of these cashflows  (Kim S.H. Crick, 1986).   If the cars per day through the toll booths were a thousand less the project returns a negative NPV and in effect destroys wealth for shareholders: Time 0 1 2 3 4 Income    Vehicles (Est) p/day 0 2000 1400 1200 1000    Toll p/car ( £) 0 4 5 5.5 6    Income p/day 0 8000 7000 6600 6000    Income p/annum 0 2920000 2555000 2409000 2190000 Expenditure    Operating costs (@ £ p/vehicle) 0 2 2.5 3 3.5    Total Operating costs 0 1460000 1277500 1314000 1277500    Wages (@ £288 p/day * 365) 0 105120 105120 105120 105120    Outlay 5000000 Total Expenditure 5000000 1565122 1382623 1419123 1382624 Net Income -5000000 1354878 1172378 989877 807376.5 Net Profit -675491 ARR% -13.5098 Discount @ 6% (Cost of Equity Capital) 0.942 0.888 0.8375 0.7903 DCF -5000000 1276295 1041071 829022 638069.6 NPV -1215542 As wages are fixed this cost is not sensitive to change, but other costs may be, if operating costs rise by 50% then the project also destroys wealth: Time 0 1 2 3 4 Income    Vehicles (Est) p/day 0 3000 2400 2200 2000    Toll p/car ( £) 0 4 5 5.5 6    Income p/day 0 12000 12000 12100 12000    Income p/annum 0 4380000 4380000 4416500 4380000 Expenditure    Operating costs (@ £ p/vehicle) 0 3 3.75 4.5 4.75    Total Operating costs 0 3285000 3285000 3613500 3467500    Wages (@ £288 p/day * 365) 0 105120 105120 105120 105120    Outlay 5000000 Total Expenditure 5000000 3390123 3390124 3718625 3572625 Net Income -5000000 989877 989876.3 697875.5 807375.3 Net Profit -1514996 ARR% -30.2999 Discount @ 6% (Cost of Equity Capital) 0.942 0.888 0.8375 0.7903 DCF -5000000 932464.1 879010.1 584470.7 638068.7 NPV -1965986 IRR -14% In both these scenarios the changes to the cashflows has a devastating effect on the viability of the project, one which is not communicated adequately (especially in terms of the costs) by ARR, or even payback.   Imagine not quantative factors that may cause these scenarios to happen.   Drivers believe that the price of the toll is too high and find alternative routes to avoid paying the toll.   In the case of costs hikes in energy prices or other operating costs could easily impact on the viability.   These quick examples demonstrate the dangers of making assumptions about the future, and as such one must be very careful about the assumptions made n cashflows.   One way of adjusting for these un systematic risks is to conduct sensitivity analysis, and to use statistical techniques to adjust the NPV, this is often termed Expected Net Present Value (ENPV) and uses standard deviation to adjust for risk.   Further the cost of capital is a significant factor in the reliabi lity of NPV  (Pogue, 2004).   Herein the cost of equity capital is used, as the firm is geared to all equity this is probably a realistic cost of capital, but perhaps investors see the direction of the firm as particularly risky and require further compensation.   Using WACC is only one option for managers and indeed the use of WACC does not always adequately adjust for the risk seen as inherently bigger as cashflow move forward in time.   Consideration needs to be given to the discount factor used. Lastly, and in particular reference to the WACC it is important to consider the nature of the capital structure o the company  (Harris, 1991).   Capital structure generally refers to the mixture of debt and equity which goes to make up the capital of the company, known as gearing, and represented as a proportional ration.   Assume that the company has  £5,000,000 of equity, as is stated, in the form of equity and has no debt.   As this is a large capital project the company is faced with a decision as to how to finance the project.   Assuming that the only options are a rights issue to generate more equity or debt (in the form of debentures, typical of long term borrowing) then a decision needs to be made as to which course is better for the company as a whole.   Gearing is another contentious issue in finance with no correct answer to the problem of optimal gearing.   A number of theoretical approaches can be applied to the problem, most notably the work of Modigliani and Miller (MM) and their irrelevancy propositions  (Modigliani, 1958).   To understand this, it is important to understand a number of features of both debt and equity.   Equity as has been said is governed by the risk it represents for equity holders, often in the form of Beta, Debt is not governed by this and is rather a cost in terms of the interest payments over the life of the debenture and the repayment of the capital sum at the end of the loan.   Therefore D ebt is often cheaper than equity as the risk is considered lower than that of a shareholder.   If one thinks of an Income Statement from a set of accounts, one can clearly see that Interest is payable regardless of the profit attributable to shareholders, in effect the bank gets paid first.   Further there is a tax shield on interest payments, as these are a cost of the company and therefore reduce the amount of corporation tax payable.   Therefore consider the following example.   The company currently has  £5m in equity and requires a further  £5m to finance the toll booth project.   It s cost of equity capital is 6% but it is able to borrow at 5% debentures, the rate of corporation tax is 30%.   A it stands the WACC is 6% and if the company issues a further  £5m to finance the project it will remain so, if however the company borrows the  £5m the following holds: Debt Equity % Cost 5 6 Gearing 0.5 0.5 Wacc 5.5 With a further reduction of (1-T) to represent the tax shield this figure becomes 5.15%, the cost of capital has been effectively lowered.   This means that future projects (as it is important to use the existing cost of capital for investment appraisal regardless of how the project is to be financed for NPV calculations) will be return more wealth to shareholders.   The work of MM, however, pointed out that in a theoretically perfect world (no tax, symmetry of information and borrowing rates as well as other theoretical suppositions) the reduction is exactly off set by the increased risk from extending borrowing as follows: (Source, G Arnold, Corporate Financial Management. 3rd Edition, London: Prentice Hall) Therefore there is an increase of risk to equity shareholders with the introduction of debt, as debt takes primary importance when paying out the proceeds of projects.   AS such it is important to find the optimal level of gearing, which is likely to be differen t for each firm.   In this case, however, there is no existing debt, and as such it is logical to assume that the company could sustain a level of gearing other than 100% equity  (Harris, 1991). Recommendations The report makes the following recommendations o the managers of the company. The project, as it is presented in the brief is a viable project given the cost of capital the company has.   There are a number of concerns, however, and these need to be taken into consideration before proceeding.   These are The cashflows of the project are sensitive, specifically the revenue and operating costs of the project, changes to these will change the profitability and wealth generation of the project.   It is recommended that further sensitivity analysis be undertaken. The cost of capital is the hurdle rate used for the analysis, the Directors may wish to use other figures to demonstrate other risks in terms of the project. As to Gearing, given that the company is at present wholly geared by equity it is felt that the company can stand some debt and effectively lower the WACC in the future.   The optimal gearing level will depend on a number of factors these are: The price of the debt and the marginal tax rate. The Preference of equity holders. The amount of risk of financial distress posed by the debt. AS such it is important to consider these factors and to evaluate the possible effects of all of these factors and others discussed in this report. Conclusions This report has summarised some of the key themes in modern financial thought, tracing its roots back to the seminal work of the key players in the field, especially Modigliani and Miller.   Finance is neither science or art , rather it is an amalgam of the two, there are no ‘off the peg solutions and many of the techniques discussed herein are merely tools with which one can transform the data at hand into more relevant information.   None of the approaches alone can give one a ‘right answer from available data.   One must consider the full range of issues, from the theoretical strengths and weaknesses of the appraisal techniques and gearing theory, to the specific features of the project and company themselves to arrive at an optimal decision.   As such one needs to understand how finance operates at a fundamental level of the firm and the consequences of decisions made by managers on firm performance and investor attitude.   The recommendations made herein are based on the limited data available via the brief and many other factors are likely to come into play. 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