Exam Number: F11079

Word Count: 1490

CRANFIELD SCHOOL OF MANAGEMENT

Full Time MBA Programme 2011/12

Term: 2

Part: 1

Financial Management

WAC

This assessment/report is all my own work and conforms to the

University’s regulations on plagiarism 
An identical copy of this document has been submitted to the Turnitin
system 
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Contents

1. Executive Summary 1

2. Introduction 2

2.1 Background 2

2.2 Purpose 2

3. Appraising Capital Projects 3

3.1 The Concept of Time Value of Money 3

3.2 Discounted Cash Flow Methods: NPV and IRR 3

3.2.1 NPV or IRR? 3

3.3 Payback Period 3

4. Zurich Project Analysis 4

4.1 Incremental Costs 4

4.2 Profit 4

4.3 Sunk Costs 4

4.4 WACC 4

4.5 Net Present Value 5

4.6 Sensitivity Analysis 5

4.7 Currency Risk 5

4.8 Payback Period 6

4.9 Measuring Non-financial Benefits 6

5. Conclusions 7

6. Recommendations 8

7. Appendices 9

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7.1 Appendix G.1: Cost of Equity (Ke) 9

7.1.1 Appendix G.1.1 – Dividend Growth Model (DGM) 9
7.1.2 Appendix G.1.2 – Capital Asset Pricing Model (CAPM) 9
7.1.3 Appendix G.1.3 – Average Cost of Equity 10

7.2 Appendix G.2: Cost of debt (Kd) 10

7.3 Appendix G.3: Proportion of Debt to Equity (Gearing ratio) 11

7.3.1 Appendix G.3.1: Book value 11
7.3.2 Appendix G.3.2: Market value 11

7.4 Appendix G.4: Weighted Average Cost of Capital 13

7.5 Appendix G.5: Discounted Cash Flow 14

7.5.1 Appendix G.5.1: Base case – Discount Rate 7.57% 15
7.5.2 Appendix G.5.2: Sensitivity Analysis 16
7.5.3 Appendix G.5.3: Residual Equipment Value – Discount Rate 7.57% 17

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1. Executive Summary

The purpose of this report is to analyse the financial consequences of the proposed
expansion of operations to Zurich and make recommendations to the board of directors.

This report comprises of six main parts. The first section is the executive summary and
section two introduces the Zurich project. Section three looks at capital appraisal issues
while section four analyses the viability of the Zurich factory. Section five is the
conclusion and recommendations are presented in section six.

On the basis of the Zurich project analysis, the following are recommended:
1. Appraise capital projects using the NPV technique.
2. Use market derived WACC adjusted for inflation.
3. Implement the Zurich project based on the NPV and IRR values.
4. Use sensitivity analysis to develop a better understanding of the relationship
between project assumptions and the NPV.

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2. Introduction

2.1 Background

Winter’s automatic timers have enjoyed tremendous success since its introduction in
2006. Production capacity constraints have limited the quantity of timers produced to
10,000 a year. Increased demand for timers in 2011 has made certain that all 10,000
units are sold within the year. In response to the increased demand, the company intends
to increase production capacity of automatic timer by establishing a factory in Zurich. It
is projected that this new factory will increase the volume of sales by 200% to 30,000
units of automatic timers per year after a two-year introductory period.

2.2 Purpose

The purpose of this report is to analyse the financial consequences of the proposed
expansion of operations to Zurich and make recommendations to the board of directors.

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3. Appraising Capital Projects

3.1 The Concept of Time Value of Money

In financial management, the value of money is dependent on timing due to: risk,
inflation and personal consumption preference. Money can be rented to earn interest.

3.2 Discounted Cash Flow Methods: NPV and IRR

The net present value of a project is determined by adding the cash flows discounted at
the cost of capital less initial investment. It seeks to ensure that only projects that
maximise shareholder value are selected by accepting all investments offering a positive
NPV.

The internal rate of return (IRR) is that discount rate which, when applied to project
cash flows, produces a zero NPV. Projects with IRRs above the required return are
acceptable.

3.2.1 NPV or IRR?

Most times, the choice between the use of the NPV and IRR is down to preference.
However, the choice matters when: appraising mutually exclusive projects, projects
with variable discount rates and projects with unconventional cash flows.

3.3 Payback Period

The payback period defined as the period of time taken for the future net cash inflows to
match the initial cash outlay. Its major limitation is that it does not account for the time
value of money, risk, financing or opportunity cost.

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4. Zurich Project Analysis

4.1 Incremental Costs

The sales and expense figures given in Exhibit 1 represent the total sales and expenses
of the timers. Investment decision analysis should be based on incremental cash flows
arising as a consequence of the decision to expand operation to Zurich which can be
determined by the difference between the forecast cash flows from accepting or not
accepting the project.

4.2 Profit

There is a general misconception of using ‘profitability’ as a performance measure for

appraising capital projects. Profit is an accounting principle and does not represent
actual cash flows. Also, the use of profitability ratios takes no account of the size and
life of the investment, or the timing of cash flows.

4.3 Sunk Costs

Costs incurred to a decision are not relevant cash flows; they are sunk costs. Hence, the
cost of the market survey for the potential factory capacity expansion (CHF10, 000) is a
sunk cost and is excluded from project appraisal analysis as we are only concerned with
future cash flows relevant to the Zurich expansion project. Also, depreciation charges
should be excluded.

4.4 WACC

This measures the rate of return to be achieved to satisfy all of the firm’s investors.

For the use of WACC to be justified, the project must be a marginal addition to the
company’s existing activities and whose financing doesn’t not require a deviation from
the current capital structure.

The WACC is calculated by taking into account the relative weights of each component
of the capital structure and has been utilised as a basis for the discount rate used as the
hurdle rate in appraising the Zurich project. As the future cash flows are in real
monetary terms, the calculated WACC has been adjusted for inflation to give a discount
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rate of 7.57% in real terms (see Appendix G.4 for calculations) as inflation can have a
major impact on the ultimate success or failure of capital projects. Therefore, ignoring
inflation may lead to selecting projects which end up being unviable (See Appendix
G.1.1 and G.1.2 for calculations).

4.5 Net Present Value

The discounted cash flow calculations show that the Zurich project is viable at an NPV
of CHF865,363. Also, the calculated Internal Rate of Return, IRR is 15% which is
greater than the WACC of 7.57%. Therefore, the project is viable on the basis of both
techniques. See Appendix G.5.1 for calculations.

4.6 Sensitivity Analysis

Appendix G.5.2 and G.5.3 show the potential impact of deviations from the sales
volume and variations in the salvage value of the Zurich equipment on the expected
values of the NPV respectively. When sales volume is increased by 10%, NPV
increases to CHF1,459,950 and falls to CHF-175,322 when sales volume decreases by
18%. NPV becomes zero when sales volume decreases by about 15% implying that the
project ceases to be profitable beyond this point. This shows that NPV is very sensitive
to sales volume changes.

Similarly, at a salvage value of CHF50,000 for the Zurich equipment, NPV is CHF
878,619 and decreases to CHF 852,106 when salvage value falls to CHF-5,000. There is
negligible sensitivity of the NPV to changes in the equipment salvage values between
these ranges. Therefore the project is more sensitive to changes in sales volumes than to
changes in the salvage values of the Zurich equipment.

4.7 Currency Risk

As half of the company’s sales are made in other countries, fluctuations in exchange
rates over lengthy time periods are largely unpredictable. Thus, investment projects
have different levels of risk on the basis of whether the products are to be sold
domestically or abroad which poses discount rate estimation problems.

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4.8 Payback Period

The payback period of eight months contained in the preliminary profitability estimate
of the Zurich timer factory has been calculated on the assumptions that the sales and
expenses figures will be achieved in the first year of operation which is incorrect. It has
also incorrectly neglected all other cash outflows except equipment costs. Furthermore,
because of the inherent limitations discussed earlier, it should not be used as a capital
project appraisal tool.

4.9 Measuring Non-financial Benefits

Stakeholder theory requires decision to be in the interest of all the firm’s stakeholders
including shareholders, employees, customers, local communities, etc. Thus the
donation of computer equipment to the local primary school would help the firm
achieve its obligations to its stakeholders, the local community. Investors are also
becoming more socially aware and many are channelling their funds into companies that
employ environmentally and socially responsible practices which have huge cost and
benefits which will not be reflected in conventional net present value analysis. Although
the costs are easy to quantify, the benefits are harder to determine. Hence, the greater
sense of social responsibility may be expensive but could have long-term benefits if the
enhanced corporate image results in more business and improved shareholder value.

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5. Conclusions

Capital project appraisals must consider time value of money for proper decision
making. The payback period, used for the preliminary profitability estimate fails to
consider the time value of money. Thus the NPV and IRR, which are discounted cash
flow method, are more appropriate. However, when selecting mutually exclusive
projects, the NPV should be used because of the limitations of the IRR.

Investment decision analysis should be based on the incremental cash flows arising as a
consequence of the decision to go ahead with a project. Sunk cost, profit, depreciation,
and overheads and other non-cash flow items should be excluded from investment
appraisal analysis.

Discount rate for future cash flows should be the WACC adjusted for inflation to avoid
erroneous selection of non-profitable projects.

Sensitivity analysis is very crucial in identifying potential impact of risk on a project’s

value by identifying the impact on NPV of changes to key assumptions.

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6. Recommendations

On the basis of the Zurich project analysis, the following are recommended:
1. Appraise capital projects using the NPV technique.
2. Use market derived WACC adjusted for inflation.
3. Implement the Zurich project based on the NPV and IRR values.
4. Use sensitivity analysis to develop a better understanding of the relationship
between project assumptions and the NPV.

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7. Appendices

7.1 Appendix G.1: Cost of Equity (Ke)

The cost of equity can be calculated using two different methods.

7.1.1 Appendix G.1.1 – Dividend Growth Model (DGM)

The DGM defines the Cost of Equity as:

Ke = d0( 1 + g)/P + g

Where d0 = Dividend paid in current year

P = Current share price
g = Annual dividend growth rate

Hence, Ke can be calculated using the values provided:

Ke = 28.02 * (1 + 0.06) / 495 + 0.06
= 0.06 + 0.06
= 0.12
= 12%

7.1.2 Appendix G.1.2 – Capital Asset Pricing Model (CAPM)

CAPM defines the cost of equity as:

Ke = rf + β (rm – rf)

Where rf = risk-free rate

rf = market risk premium
β = measure of sensitivity compared to market changes

Note that rm – rf is equivalent to the Market Risk Premium value provided in the case.
Hence, Ke can be calculated as:
Ke = 4% + 1.1 * 7%
= 4% + 7.7%
= 11.7%

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7.1.3 Appendix G.1.3 – Average Cost of Equity

As can be seen above, the two models provide slightly different values for the Cost of
Equity (Ke). In the following sections a simple linear average of these two values is
used.
Ke (Avg) = 12% + 11.7% / 2
= 11.85%

7.2 Appendix G.2: Cost of debt (Kd)

Book value:
Coupon rate = 8%
Corporation Tax = 30%
Effective cost of debt = 5.6%

Market value: Bonds are for 10 years and first year interest is paid
Year 0 1 2 3 4 5 6 7 8 9 10
Price of Bond -110
Interest 8 8 8 8 8 8 8 8 8
- - - - - - - - -
Less Tax Relief 2.4 2.4 2.4 2.4 2.4 2.4 2.4 2.4 2.4
Principal 100
Cash Flow -110 5.6 5.6 5.6 5.6 5.6 5.6 5.6 5.6 106

After Tax Cost of Debt = 4.24%

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7.3 Appendix G.3: Proportion of Debt to Equity (Gearing ratio)

The proportion of debt to equity can be calculated using two different models.

7.3.1 Appendix G.3.1: Book value

Using this method the ratio is calculated using the assets’ book value.
Book Value of Equity = Number of shares * book value of each share
= 10m * CHF 2.5
= CHF 25m
Book Value of Debt = Number of bonds issued * face value of bond
= 250,000 * CHF 100
= CHF 25m
Hence, the gearing ratio is calculated as:
Gearing Ratio = 25 / (25 + 25)
= 25 / 50
= 0.5

7.3.2 Appendix G.3.2: Market value

Using this method the ratio is calculated using the current market values.
Market Value of Equity = Number of shares * Current share price
= 10m * CHF 4.95
= CHF 49.5m
Market value of Debt (discounted by the YTM calculated above)
Years 1-9 10
Cash flows (CHF m) 2.00 27.000
Factor @ 7.27% 6.441 0.495
Present value (PV) 12.88 13.365

NPV = CHF 26.245m

Hence, the gearing ratio is calculated as:

1
This value is taken from the standard annuity lookup tables
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Gearing = 26.245/(26.245 + 49.5)

= 0.35

As can be seen, the two methods result in significantly different values for the gearing
ratio. For the purposes of this report the value derived using the market value method
has been used, as this is generally considered to provide a more representative figure.

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7.4 Appendix G.4: Weighted Average Cost of Capital

The definition of the Weighted Average Cost of Capital (WACC) is as follows:

WACC = (Cost of debt * Proportion of debt)
+ (Cost of equity * Proportion of Equity)

Therefore, using the figures calculated above:

WACC = 4.24% * 35% + 11.85% * 65%
= 1.48% + 7.70%
= 9.18%
This value is the nominal, inflation-inclusive figure.

In order to calculate the WACC in real terms inflation must be stripped from the
nominal value as follows:
rr = ( (1+rn) / (1+i) ) - 1
Where rr = real discount rate
rn = nominal discount rate
i = inflation
Therefore:
rr = ( (1+0.0918) / (1+0.015) ) - 1
= 0.078
= 7.57%

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7.5 Appendix G.5: Discounted Cash Flow

Consideration Assumption
Marketing CNF 10,000 market survey Sunk cost therefore excluded from cash flow
cost
Depreciation Used for accountancy Used in analysis of written down allowance for tax
purposes only not a cash flow only
Re-Sale of Varying estimates provided Average figure of machine disposal used CHF 22,500
Equipment between CHF 50,000 and
CHF (5,000)
Clearing CHF 20,000 needed to clear This is not an incremental cash flow as it is relevant to
Costs both potential sites after use both alternatives
Inflation Rate of inflation given at Used real cash flows excluding inflation then removed
1.5% pa. inflation form the nominal cost of capital.
Cost of Gordon (Dividend) Growth Book value and market values considered for dividend
Equity Model and Capital Asset growth model, yet CAPM and market values were
Pricing Model used as they are more accurate
Cost of Debt Value of Debt Value of debt calculated for 10 years done on the
basis of 9 periods as year 1 was already considered to
be paid
Payback & Time to recover initial Initial outlays included all expenses for establishing
Discounted outlays through net and the project
Payback discounted cash flows
Sales Sales volumes Cash flows considered for 4 quantities, nominal,
+10%, -18% & -15% of forecasted volumes
Funding CHF 1,307,000 is required We assume this is going to be funded through
The as a capital outflow in year 0 available cash not by increasing debt or equity for this
Investment evaluation
Risk Profile Companies risk profile as This was similar to the project being appraised
calculated through the
WACC

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7.5.1 Appendix G.5.1: Base case – Discount Rate 7.57%

Winter Year Year Year Year Year Year Year Year Year Year Year
CHF'000 0 1 2 3 4 5 6 7 8 9 10
Contribution 800000 1050000 1320000 1320000 1320000 1320000 1320000 1320000 1320000 1320000
-
Fixed Costs -240,000.00 -240,000.00 -240,000.00 -240,000.00 -240,000.00 -240,000.00 -240,000.00 -240,000.00 -240,000.00
240,000.00
-
Marketing -520,000.00 -320,000.00 -320,000.00 -320,000.00 -320,000.00 -320,000.00 -320,000.00 -320,000.00 -320,000.00
520,000.00
-
Contribution -380,000.00 -380,000.00 -380,000.00 -380,000.00 -380,000.00 -380,000.00 -380,000.00 -380,000.00 -380,000.00
380,000.00
Fixed Costs 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00
Marketing 120000 120000 120000 120000 120000 120000 120000 120000 120000 120000
Moving Costs -10000
Profits -10000 -200000 50000 520000 520000 520000 520000 520000 520000 520000 520000
Tax @ 30% 3000 60000 -15000 -156000 -156000 -156000 -156000 -156000 -156000 -156000 -156000
WDA Tax Saving 30000 30000 30000 30000 30000
Working Capital -1,400,000 -100,000 -100,000 1600000
Working Capital 600000 -600000
Equipment -500000 22,500
Net Cash Flow -1307000 -210000 -35000 394000 394000 394000 364000 364000 364000 364000 1386500
WACC @ 7.57% 1.00 0.93 0.86 0.80 0.75 0.69 0.65 0.60 0.56 0.52 0.48
Discounted CF -1,307,000 -195,222 -30,247 316,536 294,260 273,552 234,939 218,405 203,036 188,747 668,357

NPV 865,363 Payback 6.01 Years

IRR 15% Discounted Payback 7.94 Years

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7.5.2 Appendix G.5.2: Sensitivity Analysis

Sensitivity Analysis
Zero NPV
Units Sales -15% 10% -18% -5%
Sales Price -8%
Variable Cost 14%
Fixed Costs 76%
Marketing 77%
NPV 0% 1,459,950 -175,322 583,912
Payback 6.8 Years
Discount Payback 9.1 Years
For break-even we have assumed all changes year 3 onwards

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7.5.3 Appendix G.5.3: Residual Equipment Value – Discount Rate 7.57%

At a valuation of CHF 50,000 the flowing is held to be true:

Total Net Present Value: CHF 878,619
IRR: 15.4%

At a valuation of CHF -5,000 the flowing is held to be true:

Total Net Present Value: CHF 852,106
IRR: 15.2%

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