Organic Farm Foods Plc
Without a doubt, the trend of diversifying the portfolio with a mix of local and as well as foreign investment has become the part and parcel of the modern business strategies. While assessing the portfolio of investments the modern day managers use various investment appraisal techniques such as the Net Present Value (NPV), Adjusted Present Value (APV), Payback period, and various calculations to ascertain the expected rate of return if the intended project becomes financially viable. In this report, we discuss various investment appraisal techniques and specifically NPV to evaluate the Irish Investment project and its financial viability.
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Whilst undertaking an investment appraisal it is significant to decide the suitable cost of capital to discount the cash flows of the project spread across the assessment period of the investment project appraisal. The importance and weight age of cost of capital or WACC as an financial tool for the investor and the entities and also the research analysts. It is very important for entities to make their financing decisions to assess or estimate the future and present value of their projects. Before going into a project its financial viability in terms of computation of NPV, APV, EVA, is ascertained at priority.
Executive Summary
Using Net Present Value technique to evaluate the financial viability of the specified project is ideal as it incorporates all the project cash flows spread across the project life cycle. Owing to the advancements in the financial management world the evolution of the adjusted present value technique has made the PV technique more relevant to the adapting needs of the various business models.
In the Net Present Value calculation not only the cash flows are accounted for but also the tax impact is taken whether the tax impact arises in the same year or in arrears. Moreover the weighted average cost of capital (WACC) is used for discounting the cash flows to arrive at the present values and after subtracting it from the initial investment the net present value is derived. Furthermore, project specific cost of capital is used depending on the determination of the project specific cost of capital.
A positive Net Present Value indicates that the project under consideration is financially viable but it is important to consider here that that it may not always be viable to proceed with the project when it is only viable on the financial grounds. It is also important to incorporate the impact of the non financial impact of the project to determine its future outcome. For example if a project requires construction of the manufacturing facilities at a place where a school is presently constructed may lead to relocation of the school. Non happening of which would result in breach of corporate social responsibility of the entity executing the project and may lead to severe penalties by the corporate governance bodies or the pressure groups.
One of the other investment appraisal technique it the calculation of the payback period. The payback period refers to the period in which the amount of money invested into the would be recovered. As a manager it would be desired that the initial investment is recovered quickly so that the money that would be created after the recovery of the initial investment would serve as money created by sole profits. Another aspect which is why a payback period would be ideal to know is when the finance is raised through borrowings. A bank would likely to lend knowing how much time management expects that their money would come out and then borrowings to be adjusted.
Another financial management technique to evaluate the project includes the Internal Rate of Return (IRR). The rate given by Internal Rate of Return is where the NPV is zero. Means that the Internal Rate of Return provides the rate where the entity intending to execute the project under consideration would be able to pay to external lenders and resulting in zero net present value.
Net Present Value – Irish Investment Project
Looking at the Net Present Value computation in the Appendix, it appears that the project is viable on the financial grounds. However as stated earlier that it is important to consider other factor i.e. the non financial factors such as the negotiations between the European Union and other countries by the British Government. The outcome of the project is fairly depended on the outcome of these negotiations. If this does not materialize in the future then it may raise questions on the success of the Organic Food Project. As evident from the case study that the cash flows may be less than 30% of those which have been assumed and used in the NPV calculations if the negotiations are not favourable. It is evenly possible that when the impact of the 30% curtailment is taken into effect then the NPV may turn negative and the project which at present appears to be financially viable may not actually be viable, provided that the negotiations are not successful.
WACC
WACC is defined as the total cost of capital (expecting the return by provides of capital) of the firm which is mainly used for considering the position of the firm and used for calculating the proposed project with change in capital structure. Wacc is also known as composite cost of capital, over all cost of capital, or average cost of capital.
Cost of Equity
The expense of value is the arrival an organization requires to choose if a venture meets capital return prerequisites.
Cost of debt
Cost of debt is defined as the interest of a company pays on its borrowings. It is expressed as a percentage rate.
Internal Rate of Return
Rate of return (IRR) is a measurement utilized in capital planning to appraise the benefit of potential ventures.
Net Cash Flow
Net cash flow is defined as the difference between a company’s cash inflows and outflows in a given time of period.
Potential Impact of Foreign Risk
Whenever a project is based outside the jurisdiction of the company then it is referred to as the Foreign Direct Investment, and involves the Net Present Value calculation in the local currency of the investment currency after which the cash flows are remitted to the parent companies jurisdiction and here is where the impact of foreign exchange comes into play. But in the context of the case study of Organic Farm Food Plc the investment which is under consideration is based in the jurisdiction of Ireland which is within the United Kingdom, therefore it won’t attract the impact of foreign exchange rate risk since the currency used in both the countries is pound. However foreign risk is not only limited to exchange rate fluctuation risk. It also involves the country risk which may be different in both the jurisdictions. In order to ascertain the business climate of Ireland it would be advisable to conduct the PESTEL analysis, which includes Political, Economical, Social, Technological, Ecological and Legal risks to be identified.
Alternatives of Project Financing
There are many ways to finance a project. Generally, there are three types of sources of finance available to any corporation, also known as the pecking order
theory, which are
– Internal Cash Flow Generation
– Debt
– Equity
When a corporation arranges finance or generates cash flow through internal cash flows it means that the working capital cycle of the company is not adverse. For example the cash conversion cycle CCC of the corporation is smooth and cash is not stuck in inventory or receivables and payables are delayed as per the market practice, and not too much, because delaying payables may result in difficulties for the corporation to get raw material on credit. However, utilization of funds from retained earnings or internal cash flow generation may be readily available without any arrangement cost.
On the other hand, debt is another option, where a corporation can strike a deal from a Financial Institution / Bank to get the required amount of financing. However it would attract at borrowing rate which would be charge by the lending institution. Obtaining loan from the bank would depend on the repayment capacity of the corporation, its existing gearing and leverage ratios and overall financial position, business model of the corporation. Business model would be essential to determine the repayments, for example if the business model of the corporation is such that the credit sales are converted into cash in period of 60 to 90 days. Then it may be suitable for the company to agree quarterly repayments from its bank to repay the loan.
Whereas, equity is an expensive source of finance where the corporation would need to float its shares onto the stock market. This also results in creating more owners which would attend and participate in the annual general meetings and be able to influence company decisions and policies. Comparing a listed entity with an unlisted one does not involve other shareholders, and the holding revolves in the hand of few family members. But for listed companies adequate disclosures in the financial statement would need to be given and price sensitive information would also be required to be disclosed on the stock exchange. Non compliance of which
would result in penalization of the company.
Investment Appraisal is essential for taking insightful decision proceeding to injecting capital in any industry. In the case study the Organic Farm Food Plc, it appears that the project in viable on the financial grounds but there are other non financial factors that may turn a viable project into an unviable one. For example while undertaking the Net Present Value calculations we make various assumptions and if they materially deviate from it was initially assumed then the ultimate outcome may not be as such, as perceived. For example if tax rate is considerably increased by the government to address the adverse economic situation prevailing within a country then it may lead towards a negative Net Present Value and may make the project unviable in the future. So it’s important to take reliable assumptions considering the dynamic business risks and every changing business trends.
Appendices
W1: Sales Revenue
Year
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Sales
968.00
1,161.60
1,393.92
1,672.70
2,007.24
2,408.69
2,890.43
3,468.52
4,162.22
4,994.67
W2: Variable Cost
Year
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
VC
395,000
406,850
419,056
431,627
444,576
457,913
471,651
485,800
500,374
515,385
W3: Fixed Cost
Year
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
FC
130,000
132,600
135,252
137,957
140,716
143,531
146,401
149,329
152,316
155,362
W4: Cost of Equity (Ke)
Ke under CAPM = Rf(Rm-Rf)Be
Ke = 1.32%+(5.3%-1.32%)1.45
Ke=7.09%
W5: WACC
WACC=E/(D+E)×rE+D/(D+E)×rD×(1−t)
WACC=7.09%.(500+2342)+1.32%(500+2342)(1-12.5%)
WACC=6.05 or 6%
W6: Tax Savings from Capital Allowance
Year
Capital Allowance
Tax Savings @ 12.5%
2020
121,000
15,125.0
2021
121,000
15,125.0
2022
121,000
15,125.0
2023
121,000
15,125.0
2024
121,000
15,125.0
2025
121,000
15,125.0
2026
121,000
15,125.0
2027
121,000
15,125.0
2028
121,000
15,125.0
2029
121,000
15,125.0
Net Present Value (NPV)
Net Present Value (NPV)
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Initial Investment;
Land
(8,088,000)
Machinery
(1,210,000)
Sales Revenue (W1)
968,000
1,161,600
1,393,920
1,672,704
2,007,245
2,408,694
2,890,433
3,468,519
4,162,223
4,994,667
Variable Costs (W2)
(395,000)
(406,850)
(419,056)
(431,627)
(444,576)
(457,913)
(471,651)
(485,800)
(500,374)
(515,385)
Fixed Costs (W3)
(130,000)
(132,600)
(135,252)
(137,957)
(140,716)
(143,531)
(146,401)
(149,329)
(152,316)
(155,362)
Tax Savings (W6)
15,125
15,125
15,125
15,125
15,125
15,125
15,125
15,125
15,125
15,125
Net Cash Flows
458,125
637,275
854,738
1,118,245
1,437,078
1,822,375
2,287,506
2,848,515
3,524,658
4,339,045
Taxation @ 12.5%
57,265.63
79,659.38
106,842.19
139,780.60
179,634.70
227,796.87
285,938.22
356,064.34
440,582.24
542,380.62
After Tax Cash flows
(9,298,000)
400,859.38
557,615.63
747,895.31
978,464.20
1,257,442.93
1,594,578.12
2,001,567.52
2,492,450.36
3,084,075.68
3,796,664.32
WACC
1
0.9434
0.8900
0.8396
0.7921
0.7473
0.7050
0.6651
0.6274
0.5919
0.5584
Present Value
(9,298,000)
378,170.73
496,277.91
627,947.86
775,031.70
939,636.81
1,124,113.79
1,331,162.50
1,563,788.28
1,825,464.39
2,120,019.39
Net Present Value (NPV) in Ireland
1,883,613.37
Impact of Exchange rate
(9,298,000)
400,859
557,616
747,895
978,464
1,257,443
1,594,578
2,001,568
2,492,450
3,084,076
3,796,664
Impact of tax difference 19%-12.5%=7%
28,060
39,033
52,353
68,492
88,021
111,620
140,110
174,472
215,885
265,767
(9,298,000)
372,799
518,583
695,543
909,972
1,169,422
1,482,958
1,861,458
2,317,979
2,868,190
3,530,898
£1 = €1.21.
(7,684,297.52)
308,098.53
428,580.60
574,828.63
752,042.73
966,464.40
1,225,584.84
1,538,394.87
1,915,684.99
2,370,405.27
2,918,097.37
1
0.9434
0.8900
0.8396
0.7921
0.7473
0.7050
0.6651
0.6274
0.5919
0.5584
Cash Flows in £
(7,684,297.52)
290,660.15
381,436.74
482,637.61
595,685.53
722,200.19
863,988.29
1,023,124.89
1,201,919.92
1,403,042.88
1,629,436.39
NPV £
909,835.07
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