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MBA Global Finance: Financial Enterprise And Social Responsibility
Case – The Wonderpump Project
This report provides a discussion of investment appraisal methods which are typically used in corporate settings. The main investment appraisal methods used in this report are net present value, internal rate of return, payback period and accounting rate of return. The focus of the report is on the Wonderpump project, an acceptable investment given the high returns achieved by the project based on the forecasts presented. Even with the sensitivity analysis applied, the Wonderpump investment provides adequate returns and a positive NPV which supports the acceptance of the investment. The adjustments made to bring the assumptions to logical levels led to lower NPV and IRR values but the project remained as a project that would be recommended for execution given the positive NPV result, an IRR higher than the hurdle rate, and a low payback period.
Table of Contents
- CASH FLOW FORECAST FOR WONDERPUMP.. 5
- INVESTMENT APPRAISAL OF WONDERPUMP.. 5
- CRITICAL EVALUATION OF INVESTMENT ANALYSIS TECHNIQUES.. 7
- ADDITIONAL ANALYSIS FOR INVESTMENT COMMITTEE.. 9
The free cash flow forecast for the Wonderpump investment is detailed in appendix 1. The free cash flows over the period from year 0 to year 8 are presented in exhibit 1 below. The year 0 cash flow is the capital expenditure needed assuming that this is agreed to by the investment committee. With the establishment of the business and the capital expenditures provided in the current period before the start of the business, the free cash flows of the Wonderpump business is immediately positive in year 1 with €354,795. The free cash flows increase during the period up to a peak of €1,107,397 in the second year before a decrease to a level of €406,849 in year 8 of the business.
Exhibit 1: Wonderpump Free Cash Flows
For the assumptions in the base case, the impact of inflation has not been included in the calculations as this has not been provided as part of the information in the case study. For this analysis to be a proper discounted cash flow analysis, the assumption is that the free cash flows are in real terms and that the discount rate provided for the investment appraisal is also a ‘real’ figure, and not nominal. This approach is considered to be equivalent with the use of nominal cash flows discounted using a nominal discount rate expected to lead to the same result with the use of real cash flows using a real discount rate (Berk & DeMarzo, 2016, p.139). The research and development costs are not included in the free cash flow analysis as these are sunk costs that would not be considered as part of the investment appraisal at this current moment from year 0 onwards. Nevertheless, from a cash flow perspective and looking at the cash flows historically, then these would still be part of the cash flows.
The investment for the Wonderpump business is appraised using different techniques which include the net present value (NPV), payback period, internal rate of return, and accounting rate of return. The results for each of these are presented below with a discussion of the techniques and assumptions made. The details of the calculations are provided in appendix 2.
For the NPV analysis, the business is seen to have an NPV of €3.0 million. As the result is a positive value, the recommendation would be for the Wonderpump business to be pursued. The decision rule for the NPV analysis is that any projects evaluated that have a positive value meaning a net present value of greater than zero should be executed (Berk & DeMarzo, 2016, p.101). For this investment appraisal, the NPV is significantly higher than zero thereby providing a strong rationale for the execution of the business. The assumption for this to hold sway is that all the estimates and assumptions made are robust and acceptable as logical values for the business. The net present value is the sum of the discounted cash flows for each year included in the appraisal which, in this case, is from year 0 to year 8. The details are provided in exhibit 2 below.
Exhibit 2: NPV Calculations for Wonderpump
The internal rate of return analysis typically provides a similar result as an NPV analysis is the cash flows do not move between positive and negative values during the period of appraisal (Hillier & Ross, 2010, p.148). As this is the case for the Wonderpump cash flows, the IRR would be expected to have the same result as the NPV analysis in that the investment would be pursued. Indeed, the IRR of 83.0% is higher than the discount rate of 12% for the assessment thereby leading to the acceptance of the investment as one that would be recommended to be pursued. The IRR is calculated from the free cash flows as shown in exhibit 3 with the Excel formula used in this approach to calculate the IRR.
Exhibit 3: IRR Calculations for Wonderpump
For the payback for this investment, this is seen to be achieved by year 2 with the cumulative cash flows moving into a positive value by this time as shown in exhibit 4. The payback period for the investment is effectively at 1.4 years with a positive free cash flow achieved at about 40% of the way in the second year. The case has not provided the standard for the payback period for the investment to be accepted but the low payback period would certainly have this quality as an acceptable investment. The assumption in this case is that the payback period is longer than the 1.4 years of payback achieved by this investment.
Exhibit 4: Payback Period for Wonderpump
The accounting rate of return for the investment is 718% as shown in exhibit 5. This is a calculation from the yearly profits achieved by the investment and the effective annual investment provided. The large profits achieved by the project provide for the high accounting rate of return.
Exhibit 5: Accounting Rate of Return for Wonderpump
Each of the investment appraisal techniques provides advantages and disadvantages. The NPV analysis, the IRR analysis, and the payback rule (in this case) utilise discounted values whereas the accounting rate of return does not (Watson & Head, 2016, p.196). In addition, the first three investment appraisal techniques use cash flow figures while the accounting rate of return utilises accounting values from the income statement (Pike & Neale, 2015, p.95). The advice would be to use the NPV analysis or the IRR analysis as the main method of investment appraisal complemented by the discounted payback method in order to assess if the investment meets the standards defined for the company for acceptable investments. Based on the results achieved, the investment should be pursued as this would lead to value for the company.
The payback, NPV and IRR analyses are commonly used investment appraisal techniques that companies utilise in the evaluation of investments for consideration (Pasqual, Padilla & Jadotte, 2013, p.205). The NPV analysis is extensively utilised by companies as a key appraisal method with this analysis considered to be robust and consistent in theoretical underpinning (Pike & Neale, 2015 p.85). Nevertheless, there are different factors that can be argued as weaknesses of the NPV analysis which companies can adjust based on preferences. For example, the assumption in NPV analysis is that the cash flows occur at the end of the period which is not the case as the cash flows are continuous throughout the period (Pogue, 2004, p.565). This leads to some companies having a preference for the use of the IRR analysis and the payback rule which do not make this similar assumption of the cash flows occurring at the end of the period (Pogue, 2004, p.565). Taken as the investment appraisal method in one investment, the net present value analysis partly loses its appeal in that the NPV analysis works best when used as a way to compare different investment opportunities (Magni, 2015). In the case, study, the Wonderpump business proposal was the sole investment being evaluated and thus, the main decision criteria relates to the investment having a positive NPV result. This was the outcome and the recommendation would be for the investment to be pursued.
Similar to the NPV analysis, the IRR analysis is extensively used by companies for investment appraisal (Lefley, 2008, p.235). A weakness of the IRR is that if the cash flows during the period fluctuate significantly to have positive and negative values at different times over the investment appraisal period, the results could be misleading with the IRR analysis providing more than one IRR value (Patrick & French, 2016, p.664). The IRR is preferred by some companies for its simplicity in that the result can be compared to a benchmark discount rate that is considered as the hurdle rate that investments must compare against (Watson & Head, 2016, p.183). The sign changes in the cash flows of many investments being appraised limits the application and relevance of the IRR analysis because of the several results that the IRR analysis provides (Bas, 2013, p.5901). For the case, there is only one sign change in the cash flows and the result is only one IRR which provides a clear assessment of acceptance or rejection when the IRR is compared to the hurdle rate. With the IRR at 75.8% which is higher than the 12% hurdle rate, the Wonderpump business should be pursued which is the result that the NPV analysis also provides.
The payback rule is less utilised compared to the NPV analysis and IRR analysis, and it is typically used to complement other investment appraisal methods (Watson & Head, 2016, p.175). While less used than the NPV and IRR analyses, it is still often utilised by companies for its simplicity and ease of application to investment appraisal processes (Yard, 2000, p.155). Nevertheless, the application of the payback rule can sometimes result in an arbitrary hurdle that leads to investments and projects with longer periods before positive cash flows to be rejected by this approach (Abadie, Ortiz & Galarraga, 2012, p.555). This is a weakness of the payback rule and this is why the approach seems best applied to complement other investment appraisal methods as high NPV projects which do not meet payback rules can be re-evaluated for further consideration.
Based on the additional information on the market and the assumptions made initially for the Woderpump business, there are areas which would require a sensitivity analysis to have a broader understanding of the likely results of the investment appraisal and the impact of changes to the assumptions made for the investment forecasts. These changes are in the following areas: unit price of Wonderpump in the initial years; units sold of the Wonderpump in the initial years; the cost per unit for the later years; and, the administrative expenses related to the technical support for the Wonderpump business in the later years. Each of these has an impact on the investment appraisal and the impacts are discussed further individually and then collectively.
Unit Price of Wonderpump in the Initial Years
The reduction of the unit price of the Wonderpump in the initial years is based on the perspective that the €12,000 per unit price is a full price and would be difficult to achieve given current levels of pumps, and the latest pumps developed by the main competitor with the pumps retailing at about €6,000 to €7,000 per unit. The reduction is from the initial assumption of €12,000 per unit to a more acceptable €10,000 per unit in the first two years before this price level reduces to €8,000 per unit in years 3 as with the original assumptions. The result of the change in the price level is a reduction of €0.6 million in NPV. The investment remains viable with a high NPV of €2.4 million. The IRR is 58.9% and the payback period is 2.2 years. The accounting rate of return is 630%. The results indicate that the impact of the reduction of the unit price in the first two years is substantial but not enough to change the perception for the investment. The metrics all provide a positive result in the acceptance of the investment even with the revised unit price in the first two years.
Units Sold of the Wonderpump in the Initial Years
For the reduction in units sold in the first two years as indicated in the case, the impact is more substantial. The NPV reduces to €2.0 million, the IRR is 49.1%, the payback period is 3.0 years, and the accounting rate of return is 564%. The metrics are worse than in the unit price reduction but the results still show positive outcomes to support acceptance of the investment.
Cost per unit for the Later Years
The increase in the cost per unit from year 3 is made on the assumption that competitors enter the market which results in the shortage of raw materials that increases the cost per unit. The impact of an increase of 20% in the unit cost from year 3 to the end of the investment period is a reduction of the NPV to €2.0 million, IRR of 65.7%, payback period of 1.4 years, and accounting rate of return of 508%. The results still support acceptance of the investment.
Administrative Expenses Related to the Technical Support
The assumption is the instead of the technical support reducing to 33% of the cost in the first two years, the cost for technical support remains at 66% of the level in the first two years. The impact of this change in assumption is minimal. The NPV is €2.9 million, IRR is 81.6%, payback period is 1.4 years, and accounting rate of return is 691%. The investment is accepted based on these results.
The combination of the changes in the assumptions embedding the four revisions results in a reduced case for the investment as the metrics are all lower. The combined impacts lead to a net present value of €0.5 million, IRR of 21.7%, payback period of 4.6 years, and accounting rate of return of 284%. Based on these results, the investment is still recommended for acceptance. The results from the sensitivity analysis provided for a more logical result of the business. The revised calculations for the sensitivity analysis are provided in exhibit 6.
Exhibit 6: Sensitivity Analysis Results
Using the capital asset pricing model, the cost of equity is defined as the risk-free rate plus the beta multiplied by the expected market return (Berk & DeMarzo, 2016, p.440). From the details provided in the case, the cost of equity for Bestpump is as follows:
Cost of equity = risk-free rate + beta * expected market return
Cost of equity = 4% + 1.15 * 10%
Cost of equity = 15.5%
Assuming that the Wonderpump project has a business risk more similar to Bestpump then the cost of equity of Bestpump of 15.5% can be the cost of equity for Wonderpump. The equivalent discount rate is the weighted average cost of capital (WACC). As AGT is debt-free then the WACC is effectively the cost of equity. For Wonderpump, the discount rate or the WACC can be represented by the cost of equity of 15.5%.
The use of the revised discount rate of 15.5% leads to lower NPV and IRR figures. The NPV for the revised discount rate for the Wonderpump investment is €0.3 million and the IRR is 21.7%. These figures are lower than the results for the sensitivity analysis with the adjustments included for the investment. The payback period with the revised discount rate is 4.6 years and the accounting rate of return is 284%. The full results are presented in exhibit 7.
Exhibit 7: Forecasts Using Revised Discount Rate
Debt and equity financing have different features and can have varied implications on the consideration of investment appraisals. The use of debt leads to the debt tax shield which provides an increase in the valuation of the firm as the use of debt leads to tax benefits for firms taking on the debt capital (Kemsley & Nissim, 2002, p.2045). In investment appraisal, this is reflected in a lower discount rate as the impact of the tax shield is embedded in the WACC calculation with the application of the tax shield in the cost of debt component calculation.
Equity financing does not have the similar advantage of the tax shield and the cost of equity component in the WACC calculation does not have the same tax shield application in the WACC equation. The CAPM is used in the cost of equity calculation with the use of equity capital for financing leading to lower financial distress risk compared to the use of higher debt components in financing investments (Da, Guo & Jagannathan, 2012, p.205). When comparing directly in the WACC calculation, the higher discount rate from the cost of equity component is partly a result of the lack of tax shield benefits. The higher discount rate leads to lower valuations of investments and businesses, and aligns with the perspective of lower expected returns with the lower risks emanating from the higher equity component of financing
It may seem logical to utilise the AGT WACC as the discount rate for the Wonderpump investment. However, as seen on the discussions with the Bestpump discount rate, the appropriate discount rate is one that properly represents the risks of the investment. As a result, it could be argued that the capital structure of AGY does not impact the discount rate for the Wonderpump project. Corporate finance theory “suggests that companies evaluate investment projects using discount rates that reflect the debt capacity and the unique risks of the projects” (Martin & Titman, 2008, p.79). This indicates that the relevant discount rate for the Wonderpump project would not be impacted by the capital structure of AGT. However, it was has also been noted that while corporate finance theory suggests this approach, the typical corporate will apply the corporate discount rate for the assessment of projects as the company-wide WACC is the closest discount rate that the companies can apply that does not involve significant complexity in the estimation of the individual project risks (Martin & Titman, 2008, p.79). In addition, this takes out the subjectivity that can occur in the consideration of individual project discount rates (Martin & Titman, 2008, p.79). For the Wonderpump project, the most logical discount rate would not need to consider the AGT capital structure in the calculation of the WACC for the evaluation of the investment. The applicable discount rate for the Wonderpump investment appraisal is not the same discount rate for AGT as the company risks and project risks are different.
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Appendix 1: Income Statement and Free Cash Flow Calculation for Wonderpump Business – Base Case
Appendix 1 provides the details of the assumptions, the income statement and the free cash flows for the investment in Wonderpump. The comments provide details of the assumptions made and the calculations for the different line items in the income statement and free cash flow statement. The forecast continues only until year 8 which is the basis for the calculations with new pumps expected to be introduced to the market by this time.
Appendix 2: Investment Appraisal of Wonderpump
The investment appraisal results for the Wonderpump business results in an NPV of €3.0 million. The results follow the base case assumptions defined for the Wonderpump business as shown in appendix 1. The results show a significantly favourable investment case in executing the Wonderpump business with high levels of NPV and IRR. The payback period is very quick at 1.4 years thereby providing an additional support for the acceptance of the investment. The accounting rate of return is also considerably positive even though this is not a metric that is typically used in investment appraisal given the lack of inclusion of discounted cash flow principles. From the results of the investment appraisal methods, the investment in Wonderpump should be pursued as this would lead to significant positive value for the business. However, the high return figures achieved should provide caution to the evaluators and present a case or challenging the assumptions made in the forecasts as the high return figures could be an indication that some assumptions may not be fully developed and correctly established.