Project appraisal using NPV, MIRR and duration appraisal methods

This report is prepared to evaluate different aspects of accounting and finance. Three major topics discussed in this report are business proposal appraisal, cost of capital and foreign exchange management. All of these topics are very important and common topics for a business organisation. But errors in accounting of these topics can have vital impact on business operations and profitability. For example error in project appraisal can lead to incorrect decision making process which would ultimately result in financial as well as loss of opportunity for the company (Scarborough, 2016). Therefore it can be said that these topics are some of the most important strategic decisions that are involved in a business.     

Dovolenka Glam Plc.

Dovolenka Glam Plc. is currently working in gampling site industry and its operations have been successful over the period of time. After getting success in the current business structure, company is thinking of expanding its business in theme park industry. Various estimations of cost and revenue that can be generated during the first four operational years has been estimated by management of the company. This part of the report will evaluate the financial viability of the plan proposed by management of the company by various appraisal technique set as net present value method, MIRR and duration appraisal technique (Hatten, 2015).

A) Project appraisal using NPV, MIRR and duration appraisal methods

Net present value method

There are around 17000 visitors that are expected to come each day and it is also estimated that around 65% of these annual visitors are children. The rate of ticket for children and adults are different from each other. Total annual revenue generated by theme park from the sale of tickets is calculated in appendix 1.

In addition to that these visitors are also expected to spend money on food and gifts which is also expected to generate revenue for the company. Contribution from food and gifts spend by average visitor is expected to be £3.5 and £3.5 respectively. Therefore total contribution to be generated from gifts and food would be £42840000 (7*17000*360) (Larson et.al, 2014).

Net present value of the proposed plan is calculated with the help of other estimation given by the management of the company. The table showing net present value for first four years of operation has been presented in appendix 1.  

According to the calculation NPV of the proposed plan is 163598589.2. It shows that company will incur a loss of around 163 million in first four years of operation of the theme park if the proposed project becomes operational. Main reason of this loss is the initial investment cost of land and construction that should be incurred for the theme park (Kerzner and Kerzner, 2017). Initial cost of investment in these non-current asset is expected to be 500 million and after just four years its recovery value is only 250 million. On the basis of this projection it is advised to the company that this project should not be accepted.     

Useful information for DGP for making investment decision

MIRR (Modified internal rate of return)

MIRR (Modified internal rate of return)

IN this method a rate of return of the company is calculated to evaluate the rate at which the project can give profits to the company. This MIRR is compared with the average cost of capital of the company. Cost of capital rate is the minimum rate at which company is expecting to recover its investments (Gotze, Northcott and Schuster, 2016). Calculation of MIRR shown in appendix –

MIRR 3.91% of shows that the returns from the proposed project are not adequate and hence it is not financially viable to accept the project. It follows the interpretation derived from net present value method (Sims, Powell and Vidgen, 2015).

Duration appraisal technique

This is another project appraisal method that helps management of the company to evaluate the duration of time in which a particular project would be able to recover the amount of investment made for its operation. Number of year to recover investment cost is 4.32 years which is calculated in appendix 4. From this evaluation it can be said that project should be accepted but from evaluating other two methods it can be said that duration appraisal technique is not presenting total facts of this project proposal (Harris, 2017).

Evaluation of all the above mentioned project appraisal techniques have come to same conclusion i.e. it is not financially viable for the company to accept the proposed diversification (Bader, Al-Nawaiseh and Nawaiseh, 2018).  

B) Useful information for DGP for making investment decision

Other factors that should be considered by management of the company are as follows-

Nature of diversification

Currently this business organization is engaged in providing services of luxury camping sites to its customer and its business is going very well. Now the company wants to diversify its business in theme park industry. The cost to be incurred in making the theme park operational is very high and company does not have any experience in this area which will also increase the overall cost of business.

Period of evaluating proposal

In the given case study, period for which operations of the business is being evaluated is 4 years. The time period selected for such evaluation is very low as the initial cost of investment in these businesses is very hard and it is not practical to assume that the investment will be recovered in 4 years (Ng and Beruvides, 2015). Therefore the investment should be evaluated for at least 10 years of its initial operation.

Advantages of diversification of business

Capital structure

Capital structure is also important factor that should be considered while evaluating investment proposal cost of debt and equity are important part of the company. In the given case study the company is maintaining capital structure of 64.4% equity and 35.6% debt. In evaluating one of the competitive and closest theme park in the area that is SpineChills Plc. management of the country has evaluated that it has a capital structure of 50% equity 50% debt. Management should try to maintain capital structure equal to that of their competitors as they are in business for longer period of time as compared to a new business (Yemshanov et.al, 2015).

C) Advantages of diversification of business

Following are some of the advantages of diversification of business-

1. Economic changes in a country can have different impact on different type of industries. Diversification of business will help an entity to maintain a specific level of overall profit throughout financial year irrespective of ups and downs in industry. This will help in bringing a sense of stability in business operations (Gaspars-Wieloch, 2017).
2. Changes in preference of customers can have negative impact on a single organisation as their whole operation is dependent on a particular product or service. But this is not the case in diversified business. A diversified business can close their one or more line of product and services without affecting overall profitability of the company (Aversa and Haefliger, 2017).
3. Diversification of business also help in utilising all the available resources of the company to their full potential. A partially utilised resource in one business can be used in other business for its full utilisation. This will also decrease overall cost of resources for the business and profitability of the company will increase over the period of time.
4. There are various products and services that are only preferred by customer in a specific season. These type of businesses are called as seasonal businesses. If organisation has only one seasonal product or service then in such case there will be no profit or revenue for business during off season. This problem can be solved with the help of diversification of business as business organisation can conduct another type of business during off seasons (Zott, Amit and Massa, 2011).
5. Diversification of business also helps in establishing a brand name for the organisation. Branding of organisation help in getting profit from the product or services that are not very popular among customers (Bosch, Tait and Venter, 2018). It also helps in launching of new products as product can be sold in market with the help of brand name. This will have direct impact on overall profitability of the company.

CEO of the company also believe that the diversification in theme park will create a brand value for the company which can have positive impact on returns available to the shareholders. This represented by CEO is justifiable as per the views presented in favour of diversification of business. But the proposal presented by the company is not financially viable as the overall cost of investment is higher in comparison with the returns from the theme park. Other industry can be evaluated for diversification of business.

For evaluating the decision of diversification in detail, management of the company has also conducted analysis of one of the closest theme part in the area named SpineChills Plc. following factors can be extracted from the financial structure of the company-

1. Liquidity position of the company is not very effective as current liabilities are higher as compared to current assets that indicates a current ratio of less than 1. This would not be problem in this situation as DGP is a large organisation and its current ratio will set off the current ratio of new venture.
2. The equity component in the company is around 2.02 times of the total debt in the company. This ratio is also in favour of diversification as it is important that with diversification the share of the owner in the company also increases.
3. Current share price of SpineChills is 386 pence which is much better in comparison with current price of DGP which is 148 pence. It can be said after consideration of current market price of SpineChills that overall price of DGP will increase if business is diversified into theme park industry.
4. Beta of the market is considered as 1 and beta of SpineChills is 1.47 which is not very far from beta of the market. It shows that if the market changes by 1% then price of SpineChills is expected to change by 1.47% in the same direction. The level of risk is appropriate in case of SpineChills as low beta generally means lower rate of return on investment.                   

      D) Assessment and evaluation of the specific points raised by Lesley in relation to technological developments

Leslie is head of the accounts and Finance Department and she has recently attended a conference on advances in finance with the help of technology. Previous topic topics that were discussed in the conference and following are the three topics that can be useful for the organisation-

1. Cloud computing

Cloud Computing Independence service that combines hardware and software to provide storage services through a common medium such as internet. The use of Cloud Computing in business has been increasing due to its various advantages. One of the biggest reason for using Cloud Computing is that it is cost efficient and an amount of data can be stored to cloud computing. In addition to that capital expenditures to be incurred by company also decreases. Vision capital expenditure in relation to information technology are the cost of hardware and software. Cloud Computing provides the services of software on demand as well as some of the hardware such a storage devices (Rittinghouse and Ransome, 2016).    

Another biggest advantage of cloud computing is that an employee or member of management access the information stored in database at any time and from anywhere. It is not essential that he or she should be at the office for accessing such data.

Application of Cloud computing in DGP will be very useful for the management of the organisation. DGP has various chains of glamping sites that means that means that it would have different offices at these locations. The cost of hardware, software and storage devices have to be incurred by management of the company on each of these sites. Subscribing to efficient cloud service provider will help in reduction of these costs to the company so that overall profitability margins can be decreased.   

1. Big data analytics

Big Data Analytics can be defined as a Process that a business organisation use to assess and define pattern in large amount of data collected by management. It is a fact that priority of operational strategic strategies of business are formed on the basis of data collected in relation to product and services. For large organisations, this analysis of large amount of data can be very difficult as it is not viable to asses such amount of data manually (Gandomi, A. and Haider, 2015). Here big data analytics comes in handy as it can evaluate large amount of data in less period of time. Due to this advantage of Data Analytics majority of the organisations are using these software specially organisation that are customer requirement specific.

Success and failure of an amusement park is totally based on the quality of services provided by management and whether customer is satisfied with the entertainment factors in the park. Big data analytics can help in collecting and analysing large amount of data in relation to customers visiting DGP’s theme park. Services can be improved by data collected in form of feedback from the customers.  

1. Block chain Technology

Transfer of data has become a very common among the internet users as people are transferring various types of data on a regular basis. In addition to that users are also doing online transactions that involve transfer of money from one account to another account. These type of transactions are fascinated with the help of third party organisations. Block chain Technology will help in creation of an open decentralized database for any type of transaction that will involve any type of value whether it is Data, money, value, property etc.

this technology is expected to remove third party organisations that are currently facilitating transfer of money from one account to another. Current this technology is being used in Bit coin and Crypto-currency (Pilkington, 2016). This technology is still in its development stage but it is expected to make internet more secure and efficient for business organisations.

Making the platform of transfer of money from customer to the bank account of DGP should be secure as it is a legal requirement on every company to secure the customer’s personal information. DGP will be collecting online from their customers and therefore block chain Technology will be very useful for the organisation. 

DGP is a business organisation that is involved in forwarding services of luxury camping site to customers. It is also considering the option of diversification into other type of businesses. Advancement of Technology has become an essential need for any type of business organisation that is working in current business environment. Above mentioned aspects of Technology will be very helpful for DGP. Other Technologies like cloud computing and Big Data Analytics will also be useful as the company grows and its cost increases.

Dovolenka Fly Plc.

Dovolenka Fly Plc. (DFP) is a business organisation that is working in airline industry. Incorporation of the company established in Europe and Asia major source of revenue is North Eastern European airport. DFP has a good reputation in the market as company has provided high standards of safety, service and punctuality. DFP is thinking of getting into joint venture with GreatFlight Limited which is medium sized airline company. IN this part of the report Greatflight limited is to be evaluated financially and operationally to identify whether it would be a good joint venture or not.

A) Capital asset pricing model

Capital Asset pricing model is a pricing model that is used by business investors and business organisations to evaluate expected return from an asset. This model also helps in relationship between risk and expected return of a stock or any other type of securities asset. In this part of the report, CAPM will be used identify cost of equity for GreatFlight Limited. 

Formula

Risk free return in market is 3% and risk premium of the company is 7%. Debt to equity ratio of the company is 160% (1.6:1). Equity beta of the company is 1.45 and debt beta of the company along with cost of equity is calculated in the Appendix 5. Therefore cost of capital of the company according to CAPM method is 12.1%.   

There are some examples that are required to be made while calculating cost of capital through Capital Asset pricing model. These assumption are as follows-

1. It is expected that investors will make all the decision in market on the basis of only two factors that are risk and return (KUEHN, Simutin and Wang, 2017).
2. Transaction related to purchase and sale of securities can be taken in any number of units.
3. The nature of market is perfect competition and a single investor is not able to influence prices of share and transaction cost.
4. There is no limit on selling or purchasing of shares (Barberis et.al, 2015).
5. There is no tax on personal income generated by an individual.
6. Loan for purchasing of shares and securities are available at risk free rate.
7. B) Value of GreatFlight using the Free Cash Flows to Equity (FCFE) method.

This is a method which is used by a business organisations to calculate the amount of cash available to equity shareholders of the company (Bekaert and Hodrick, 2017). Cash should be calculated after deducting all the expenses, re-investments and debt that is required to be paid during the financial year. This method is used to value a particular organisation with the help of cash inflows available to the company on yearly basis.

Formula for calculation of FCFE is as follows-

FCFE = Net Income – Net Capital Expenditure + New Debt -Debt Repayment (Chen, Sun and Xu, 2016).

For the purpose of calculating value of business, this FCFE is divided by the return on equity.

All calculation in relation to valuation of GreatFlight limited has been done in appendix 4.

FCEE= £56.2 million (Appendix-6)

Value of GreatFlight Limited= £803.2 (Appendix-7)

Management of the company should consider some of the limitation of this model before actually taking investment decision with the help of FCFE model. These limitations are as follows-

1. In this method FCFE is calculated by using financial figures of current year or past financial year but it is not essential that same financial performance of the company will continue after merger.
2. The error in estimation of cost of equity can change the whole decision making process.
3. This method calculates the value of equity of the firm rather than its entire valuation.
4. C) Advantages and disadvantages of types of growth 

Advantages of growth through acquisition as compared to internal growth –

1. Rate of growth in growth through acquisition is much higher as compared to organic growth as the business which is acquired is already running and operation. In addition to that Synergy benefit also increases the rate of development. Internal growth rate of company is generally very poor as compared to growth due to acquisition (Hill, Jones and Schilling, 2014).
2. It is a General assumption that acquisition of other businesses is key indicator of financial performance, therefore it is preferred by shareholders of the company. Whereas in case of internal growth, shareholders are not generally aware in respect of the growth of the company.
3. It is one of the easiest methods to diversify business organisation. Acquisition of organisation that is in different business industry helps in diversification of business. Business organisation would have to face various barriers is diversification is done through other methods (Rahatullah, 2014).
4. Acquisition of an organisation that has lower share value can result in capital gain for the company. This would also result in cost saving for the company as financial resources of two organisation will combine to form synergy benefits (Greve and Man Zhang, 2017).

Disadvantages of growth through acquisition as compared to internal growth

1. It requires a huge amount of cash or other securities which has to be paid in exchange of acquisition of other business. This would not have been situation in case of internal growth.
2. There might be some integration problems with both of the organisations as management style of both purchaser and seller might be totally different from each other (Rugman and Nguyen, 2014).
3. It is not always essential that diversification of business results in Synergy benefit for the company. Business organisation might not be able to manage the different line of product and services.
4. Acquisition process is very long and complex functions and it will distract management of the company from main operations of business.

Dovolenka Garden Ltd (DGL)

A) Expected outcomes of future

From interest rate futures   

It is expected that interest rates are expected to up in the future then the company should go short. The company will require future contract of March as they are expected to pay the amount to event manager in April (Hull and Basu, 2016).

Appendix 8 shows the calculation in relation to interest rate futures.  

From interest rate options

Here also there is expected increase in interest rate, therefore company will but put option for 184 contracts (Martínez and Torró¸2015). 

Appendix 9 shows the relevant calculations

From Forward rate agreement

In this case a simple loan will be taken from bank at prevailing interest rate. Expected interest rate prevailing after 5 months is 5.85%.

Appendix 10 shows the relevant calculations.

Net interest rate of borrowing in all the above cases are summarised in this table-

From the evaluation of above table it can be said that interest rate option hedging should be selected in both the situation i.e. LIBOR rate increases or decreases. The net borrowing in case of interest rate option is lower if option @ 4% is taken by the company.        

B) Advantages of centralised treasury department

1. Centralised Treasury Department helps in making currency management of a company easy and simple. This is very useful for organizations that are dealing in foreign currency. This would be very beneficial for DGL as it is dealing in foreign currency on regular basis (Miller, M. and Hadley, 2016).
2. Availability of cash becomes very easy a cash management is one of the most important function of centralised Treasury Department. This would help in Working Capital Management of DGL.
3. Proper cash management treasury department will help in reducing the amount of reserves cash maintained by DGL.
4. Risk involved red foreign currency management will also be reduced with the help of centralised Treasury Department (Moir, 2014).
5. Overall rate of interest can also be reduced as some of the capital expenditure can be financed through centralised treasury department.

Conclusion

This report has discussed various types of Management techniques which generally management of the company faces in course of business. Each of the task have some specific problem and this report has tried to solve these problems efficiency and effectiveness. This report can also be taken as a management report which can help management of different organisations to deal with practical situations.

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