Calculation of the Net Present Value for Wonderland

The Net Present Value and its various components are based on the given facts and figures: Wonderland has just spent 400,000 on market research into the theme park, and is encouraged by the findings. The theme park is expected to attract an average of 20,000 visitors per day for at least five years The price of admission to the theme park is expected to be 25 per adult and 15 per child. 70% of visitors are forecast to be children. In addition to admission revenues, it is expected that the average visitor will spend 10 on food and drinks, (of which 40% is contribution, and 7 on gifts and souvenirs, (of which 45% is contribution). All costs and receipts (excluding maintenance and construction costs and the realisable value) are shown at current prices; the company expects all costs and receipts to rise by 5% per year from current on a compound bases. The theme park would cost a total of 500 million and could be constructed and working after 1 year of investment (I.e. revenue will start in year 2). Half of the 500 million would be payable immediately, and half in one years time. In addition working capital of 60 million will be required from the beginning of the project. The non-current asset has an after tax realisable value between 100 million and 200 million after five years of the project. Operation costs (excluding labour (please see below) are expected to be 17 million in the first year of operation, increasing by 5 million per year. Insurance costs per annum are 3 million, of which 2 million per year is due directly to the theme park project. Insurance and labour cost will be increased in line with the Consumer price i.e. 5% per annum compounded annually The project would require 1000 employees with a cost of 35 million per annum (at current prices). The dual use of existing advertising campaigns restaurant theme park will save a 3 million per year in advertising expenses. Wonderland has no previous experience of theme park management. However as part of the finance team, you have investigated the current risk and financial structure of its closest theme park competitor, Alice Limited. Details are summarised below.

ALICE LIMITED, SUMMARISED BALANCE SHEET m Non-current assets (net) 1,710

Current assets Less current liabilities

630 (570) 1,770

Financed by: 1 ordinary shares Reserves Medium and long term debt

500 700 1200 570 1,770

After carrying out preliminary search for financing and investigating the industry further, your team has been able to gather the following information: a) Wonderland can procure a loan of 400 million loan at 8% fixed rate to provide the necessary finance for the theme park. b) 300 million of the investment will attract 25% per year capital allowances on a reducing balance basis while the remainder will not, and tax is paid in the year it is incurred. c) Corporate tax is at a rate of 35%. d) The expected market return on equity is 12% and the risk free rate 3.5%. e) Wonderlands current weighted average cost of capital is 9%. f) Wonderlands market weighted gearing if the theme park project is undertaken is estimated to be 65% equity and 35% debt. g) Wonderlands equity beta is 0.80. h) The current share price of Wonderland is 200 pence, and of Alice 400 pence. i) Alices medium and long term debt comprises long term bonds with a par value of 100 and current market price of 93. j) Alices equity beta is 1.50

Liabilities
year 1 Market Research Operation Costs Insurance Employees Construction Cost Advertising Savings Total 0.4 17 2 35 310 -3 361 year 2 0 22 2.1 36.75 250 -3.15 307.7 year 3 0 27 2.205 38.5875 0 -3.3075 64.485 year 4 year 5 0 0 32 37 2.31525 2.4310125 40.516875 42.5427188 0 0 -3.472875 -3.6465188 71.35925 78.3272125

Revenues
70% of 20,000 visitors per day are children for which the entry costs 15 each. That's 14,000 children a day bringing 210,000 a day, or 76.65 million a year 30% of 20,000 visitors per day are adults for which the entry costs 25 each. That's 6,000 adults a day bringing 150,000 a day, or 54.75 million a year 40% of the 10 spent on food and drinks and 45% of the 7 gifts and souvenirs each visitors is expected to spent is actual revenue. Annually, that comes to 77.015 million of revenue. year 1 year 2 year 3 year 4 131.4 137.97 144.8685 152.111925 77.015 80.86575 84.9090375 89.1544894 208.415 218.83575 229.777538 241.266414 year 5 159.717521 93.6122138 253.329735

Admission Fees Food, Drinks, Souvenirs and Gifts Total

Cash Flows
Revenues Liabilities Net Operating Cash Flows Capital Allowances* Net Taxable Cash Flow Taxation Add back Capital Allowances Capital Allowances* Net Project Cash Flows Discount Factors (5%) Discounted Cash Flows *Based on 300 million of the investment at 25% per year capital allowances on a reducing balance basis year 1 year 2 year 3 year 4 year 5 208.415 218.83575 229.777538 241.266414 253.329735 -361 -307.7 -64.485 -71.35925 -78.327213 -152.585 -88.86425 165.292538 169.907164 175.002523 -0.075 -0.05625 -0.0421875 -0.0316406 -0.0737305 -152.51 -88.808 165.334725 169.938805 175.076253 0 0 -57.867154 -59.478582 -61.276689 0.075 0.05625 0.0421875 0.03164063 0.07373047 0.3 -152.135 -88.75175 107.509759 110.491864 113.873295 1 0.95 0.9525 0.92375 0.9538125 -152.135

-84.314163 102.403045 102.066859 108.613772 76.6345141

Discussion
The Net Present Value is 76,634,514. This remarkable amount would lead to recommendation of the project on financial grounds. It is interesting to note that the revenues have been calculated on a constant number of visitors from day 1 to year 5. In reality, it would be expected that there would be a small amount of visitors in the first few days to then increase dramatically as words-of-mouth and advertising hit the public, to finally stabilise to an average amount of weekly visitors for peak and non-peak periods. Indeed school holidays and weekend are likely to be much more popular than any other times. Considering that we are provided with the closest theme park competitor (Alice), we can entertain that their risk characteristics are very similar to the ones for Wonderland. We can therefore use their figures as suitable surrogates. This will enable us to use the Capital Asset Pricing Model as an alternative to the Net Present Value for a project assessment which considers the level of project risk. The market weighted gearing of Alice Ltd 1 ordinary shares amounts 500 million GBP = owns 500 million shares. Market value of shares = 500*4 = 2000 million Market value of bonds = 5.7*93 = 530.1 million Market value of debt = 530.1 million Total value = 200+530.1 = 2530.1 million Fraction debt = 530.1/2530.1 = 20.95% Fraction equity = 2000/2530.1 = 79.05% Asset beta for Alice Ltd based on: Asset beta = equity beta x [market value of equity / (market value of equity + market value of debt x (1 corporate tax rate))] 1.5 x [79.5 / (79.5 + 20.95 x (1-35)] = 1.28 Asset beta for Wonderland: 0.8 x [65 / (65 + 35 x (1-35)] = 0.59 Proxy Asset Beta = (1.28 + 0.59) / 2 = 0.935 Regearing the proxy asset beta for Wonderland based on: Equity beta = equity be assed beta x [market value of equity / (market value of equity + market value of debt x (1 corporate tax rate))] 0.935 x [65 / (65 + 35 x (1-35)] = 0.69 Security Market Line based on: Rate of return on security = risk-free rate of return + (beta coefficient of security x (return of the market risk-free rate of return)) 0.035 + (0.69 x (0.12 0.035)) = 0.09; i.e. 9%. The discount rate is 9% which is lower than the expected market return on equity (12%) which would indicate that Wonderland should not go ahead with the project as the risk involved is higher than the return.

But while the net present values role is to measure the possible profit to be gained in the project by discounting the cash-flow, the notion of economic profit per se is commonly used under various synonyms in the financial literature. As such we can find iterations of it being called excess profit (Preinreich, 1938); excess realizable profit (Edwards and Bell, 1961); excess income (Peasnell, 1982); abnormal earnings (Ohlson, 1995); supernormal profit (Begg et al., 1984, p. 121); residual income (Solomons, 1965; Biddle et al., 1999; and Martin et al., 2003); and economic value added (Stewart, 1991). This notion is more rarely criticised in academic papers than is the Capital Asset Pricing Model model. However some papers still question the net present value model and suggest that the alleged equivalence of net present value and economic profit does not hold, as argued by Carlo Alberto Magni (2008). He arguments that such net present value does not represent economic profit and, in addition, it is a biased measure because it is non-additive. This said, it is important to note that Capital Asset Pricing Model considers that transactions take place over one year only. Considering the Wonderland project has high initial construction costs which are only incurred in the first 2 years, using the net present value model which reflects a 5year project, including inflation, seems more realistic. The limitation of the Capital Asset Pricing Model model in this instance is too great to be ignored and a financial director is likely to base his decision on the net present value. However, one of the Net Present Values weakness, along with most other project appraisal methods, is its failure to deal with uncertainty. Conversably, uncertainty is a difficult matter to deal with as by definition it relates to the unforeseen events that can occur in a project. In todays business environment, traditional capital budgeting methods are no longer adequate to reflect the dynamic world of new economy. Real options are a very powerful method for evaluating project under uncertainty. Real options approach is a method of evaluating project investment decisions in an uncertain business environment. They relate strongly to strategic decisions which tend favourably involve many people and groups who all pursuing divergent interests (Astley, Axelsson, Butler, Hickson, & Wilson, 1982). Real option has the advantage of incorporating within one single approach the various concerns expressed by the stakeholders. The approach does not eliminate any uncertainty regarding the success of the new technology or the strategy followed by the main competitor. Nevertheless, it provides the management with a framework in which hypotheses can be discussed and their impact measured through a sensitivity analysis. One of the real option commonly used I abandonment. If the project was abandoned at this stage, the cost would be minimal as only market research has been a matter of expense along with the finance-staff time spent in appraising its viability. However based on the net present value , Wonderland Confectionaries could be missing out on a potentially lucrative business. Considering that a loan is already secured, most financial directors who base their decisions on financial data would not encourage to abandon the project at this stage. However being aware that abandoning the project should the financial situation deteriorates for whatever economical reason acts as a safety net for shareholders and managers alike. Abandonment is an approach most commonly used with high uncertainty projects, such as pharmaceutical companies developing a new drug. Considering the high insecurity of Research and Development as well as testing of the drug, management usually chooses to create a strategic abandonment option. Deferring is another type of real option which could be use should the economic situation is expected to get better, or if a specific event is expected. This for example could be the launch of a new technology, additional capital, political changes, or any other external event likely to occur in the short-term. When this type of real option is chosen, it is important that management keeps

track of the changes taking place in the period of time between which the project was appraised and the actual deadline they have given themselves. Some unexpected situation could lead to the project being deferred for less than planned. In the case of Wonderland, there is no external factor other than potential additional capital, that would lead management to believe that deferring the project would in any be financially favourable. Other options in deciding how to pursue this project based on the preceding appraisals are to expand further the theme park to allow more revenue gain, or to combine its existing successful restaurants with the offering of the theme park. The first option, although likely to offer more revenue in the long-term, would have higher initial costs. It would therefore be wise to raise more capital before choosing to undertake such a possibility. Raising more capital would also increase the capital asset pricing model which could increase the shareholders confidence in pursuing the project. The value of the firm can exceed the market value of the projects currently in place because the firm may have the opportunity to undertake positive net present value projects in the future. Standard capital budgeting techniques involve establishing the present value of these projects based on anticipated implementation dates. However, this implicitly assumes that the firm is committed to go ahead with the projects. Since management need not make such a commitment, they retain the option to exercise only those projects that appear to be profitable at the time of initiation. But the choice of capital structure can also affect the value of the project. Like operating flexibility, financial flexibility can be measured by the value of the financial options made available to the firm by its choice of capital structure. Interaction between financial and operating options can be strong -- especially for long-term investment projects with a lot of uncertainty. In the case of Wonderland, we have already established the influence of its long-term investment. Most real options owe their value to the flexibility it gives the company. Flexibility adds value in two ways. First, management can defer an investment. Because of the time value of money, managers are better off paying the investment cost later rather than sooner. Second, the value of the project can change before the option expires. If the value goes up, we're better off. If the value goes down, we're no worse off because we don't have to invest in the project. One benefit of RO is to encourage management to preserve flexibility of choice and to modify the investment project according to economic circumstances (McGrath, Ferrier, & Mendelow, 2004). More recently, the literature has warned about the limits of RO. These include three main shortcomings: the framework does not apply to all investment decisions, it raises serious implementation issues, and it does not take into account behavioural and organizational biases (Krychowski & Quelin, 2010).

Astley, W. G., Axelsson, R., Butler, R. J., Hickson, D. J., & Wilson, D. C. (1982). Complexity and cleavage: Dual explanations of strategic decision-making. Journal of Management Studies, 19(4), 357375. Begg D, Fischer S and Dornbusch R (1984), Economics, British Edition, McGraw-Hill. Edwards E and Bell P (1961), The Theory and Measurement of Business Income, University of California Press, Berkeley. Krychowski C. & Quelin B.V. (2010) Real Options and Strategic Investment Decisions: Can They Be of Use to Scholars?. Academy of Management Perspectives, pp65-78.

Magni (2008) Economic Profit, net present value and capital asset pricing model: Biases and Violations of Modigliani and Miller's Proposition I, CFAI Journal of Applied Finance, Oct2008, Vol. 14 Issue 10, p59-72, 14p
McGrath, R. G., Ferrier, W. J., & Mendelow, A. L. (2004). Real options as engines of choice and heterogeneity. Academy of Management Review, 29(1), 86101. Ohlson J A (1995), Earnings, Book Values, and Dividends in Equity Valuation, Contemporary Accounting Research, Vol. 11, No. 2, pp. 661-687. Peasnell K V (1982), Some Formal Connections Between Economic Values and Yields and Accounting Numbers, Journal of Business Finance & Accounting, Vol. 9, No. 3, pp. 361-381. Preinreich G (1938), Annual Survey of Economic Theory: The Theory of Depreciation, Econometrica, Vol. 6, No. 1, pp. 219-241. Solomons D (1965), Divisional Performance: Measurement and Control, Richard D Irwin, Homewood, IL. Stewart G B (1991), The Quest for Value: The EVA Management Guide, Haper Collins, Publishers Inc., New York.