Net Present Value Vs Payback Period: Pros And Cons

Cash flow model for bid with payback in 3 years

Questions:

Question 1

Red Rose Railways is a UK publicly traded company that operates a range of bus and rail services. The company is currently considering bidding for an exclusive franchise to operate rail services from Manchester across the North of England. The board of directors has asked you to prepare a financial appraisal of this opportunity.

The franchise will be for a period of five years. The rail infrastructure is owned by a Government agency. The franchisee will need to own and operate all rolling stock.

The cost of the franchise will be paid to the Government in two instalments. 80% of the total amount bid is due at the start of the contract. The balance of 20% is due to be paid at the end of the second year.

Red Rose Railways will need to order £175m of new rolling stock but will also need to use £75m worth of older rolling stock that is currently sitting idle. £75m is the best estimate of what this older rolling stock could be sold for if not used in the new North of England contract. It is estimated that all the rolling stock could be sold for £100m at the end of the franchise period.

Accounts receivable and inventories will increase by £25m at the start of the franchise but only £20m of this is expected to be recovered at the end of the franchise period.

Based on expected levels of services, passenger numbers and regulated fare increases over the period, the best estimates of operating cash flows over the five year operating period are:

Assume that the company is exempt from corporation tax during the period of the franchise.

Answer the following questions:

• Red Rose Railways expects a minimum 8% return on all rail franchise bids. What is the maximum price you can bid?

• Red Rose Railways likes to achieve a three year payback on rail franchise operations. What is the maximum price you can bid and still achieve a three year payback?

• The board of directors asks you explain whether it is better to base their bid price on the NPV method or Payback method. Explain the advantages and disadvantages of the two methods. Which would you recommend and why?
 
Question 2

A.  Using AstraZeneca plc’s 2013 annual report and financial statements, explain how an adjusted book value approach to valuing assets and liabilities moves book value nearer to economic value.

You are required to provide a written response which highlights four specific elements in AstraZeneca plc’s balance sheet that might require adjusting to arrive at an economic value.

For each element, explain the type of adjustment and the type of information that might be required before an adjustment could be made to arrive at an economic value for AstraZeneca plc at its 2013 financial year-end.

B.  Calculate the following market multiple ratios for AstraZeneca plc at its 2013 financial year-end:

• EV/EBITDA

• Price-to-earnings ratio (PE ratio)

• Price-to-cash-flow ratio

• Contrast and explain the results of the different market multiple ratios that you calculated. Evaluate the usefulness of market multiple ratios in company valuation.
 
Question 3

Read the following article:

Danielson, M., and Scott J. (2006) ‘The capital budgeting decisions of small business’ Journal of Applied Finance, Fall/Winter, pp. 45–56.

After reading it closely answer the following questions:

a. What is the main aim of the article’s argument? How does the article seek to achieve this aim?

b. Review Section C ‘Project Evaluation Methods’ (pp. 51–54), that is, summarise the section and critically appraise it.

c. The authors put forward various reasons as to why small firms might evaluate projects differently. What are they? Do you find them convincing? Why or why not?

Advantages of net present value method

1. The complete details related to the auction of the Red Rose Railways have been provided. Based on the given information the annual cash flow for the company has been prepared. The general assumptions that have been made are as follows

• All the cash flows are assumed to happen at the end of the year. Only the bid amount that is payable at the start of the contract has been considered at the beginning.

• It is assumed that the company will sell the old rolling worth £75m at the start of the contract

• The resale value of the new rolling stock is £100m which is realized at the end of the franchise period.

Based on these assumptions the cash flow model for the different cases has been prepared.

1) Red Rose Railways expects a minimum 8% return on all rail franchise bids. In relation to the estimation of the maximum bid price it has been considered that the bid price may be kept in such a way that Net Present Value from the project is zero. The complete cash flow model that has been prepared is shown below:

Year	0	1	2	3	4	5
80% of Bid Amount	518.4
80% of Bid Amount			129.6
Operating Profit		150	160	170	180	190
Resale Value of old rolling	75
Cost of New Rolling	175
Resale Value of new rolling						100
Working Capital	25
Working Capital Payback						20
Net Cash Flow	-643.4	150	30.4	170	180	310
PV Factor	1.00	0.93	0.86	0.79	0.74	0.68
PV	-643.40	138.89	26.06	134.95	132.31	210.98
NPV	-0.21
Cumulative NPV	-643.40	-504.51	-478.45	-343.50	-211.19	-0.21

The above model has been prepared with bid amount of £648m.

2) In order to achieve the payback in three years the bid amount will have to be increased. The cumulative NPV as shown in the above case will change and will have NPV of approximately equal to zero at the end of third year. The cash flow model for this case has been shown below

Year	0	1	2	3	4	5
80% of Bid Amount	236
80% of Bid Amount			59
Operating Profit		150	160	170	180	190
Resale Value of old rolling	75
Cost of New Rolling	175
Resale Value of new rolling						100
Working Capital	25
Working Capital Payback						20
Net Cash Flow	-361	150	101	170	180	310
PV Factor	1.00	0.93	0.86	0.79	0.74	0.68
PV	-361.00	138.89	86.59	134.95	132.31	210.98
NPV	342.72
Cumulative NPV	-361.00	-222.11	-135.52	-0.57	131.74	342.72

The above model shows that the bid amount has to be £295m for payback of three years.

Net Present Value and Payback Period are the two most commonly used capital budgeting techniques that are employed in the business. There are several benefits and limitations of both the methods. These have been discussed below

Net Present Value: The net present value method of capital budgeting is the most popular capital budgeting method. The advantages of this method includes that it can be associated with the value that is added to the firm in terms of the cash. This is the direct method of valuation. Further this method employs the time value of money. Thus it ensures that the value that is added to the firm is backed by the actual value rather than absolute terms. Another important advantage of the NPV method is that it also provides provisions for the reinvestment or the cash outflows that might be there during the complete lifetime of the project rather cash outflow being at the start. This is to say that in the present case as well the 20% of the bid value is paid at the end of second year. NPV can easily incorporate such fluctuations in the cash flow.

On the other hand there can be certain disadvantages of NPV. The discount rate that is considered will have huge impact on the present value of the cash flow. In case of projects with long life the discount rate will considerably reduce the cash flow. Thus it is important that suitable value of discount rate is considered.

Payback Period: The payback period gives the estimation of time within which the amount equivalent to investment will be generated by the project. This type of estimation is simpler in comparison to NPV. Further it can provide, on the high level, an estimation of the liquidity that will be there. This is to say that the project with high payback period will have low liquidity.

The disadvantage of payback period is that it might be difficult to incorporate the cash outflow that may happen during the lifetime of the project. Further it does not give estimation of the value that is added. The projects will same payback period cannot be distinguished based on this technique. Further time value of money may be incorporated in payback period but this will lead to similar disadvantages as that of NPV without little value addition.

Overall the above discussion highlights that the NPV method is more suitable capital budgeting technique. However considering the importance of liquidity and the number of projects in which the investment can be made, the payback period is suitable for projects with small life.

Disadvantages of net present value method

2. A. Adjusted book value approach employs market value approach for valuation of assets. This method of valuation is primarily appropriate for not for profit organizations, businesses with little value goodwill or other intangible assets or the businesses that may be purchased by the competitors in the same business. Book value of the assets reflects the historical cost of the assets of the company in excess of the liabilities of the company. One of the important aspects of the adjusted book value approach is that in its computation intangible items including goodwill, patent and copyrights are excluded whereas the items including equipment, inventories and the real estate are adjusted for the fair value. However the adjustment to the intangible assets that have been mentioned above is also made under certain conditions. According to Green & Carroll ( ), adjustments are made to the book value of the various elements to reflect the economic value of these elements. The adjustment that will be made can result in both increase and decrease in the value of the assets.
 
The elements may be considered as undervalued in case, as a result of depreciation or amortization, results in lower book value in comparison to the economic use of the asset. The inverse of this will result in over valuation of assets. Such aspects are highlighted and incorporated in the adjusted book value. Thus it reflects closely the economic value of the asset or any other element of the balance sheet. The adjusted book value of the some of the elements such as internally generated assets is used for valuation. The value of these assets is not reflected in the book value at all.

The above discussion on the adjusted book value clearly reflects the impact that can be there on the various elements of the balance sheet of AstraZeneca. On the basis of this, four specific elements in AstraZeneca plc’s balance sheet that can be considered for adjusting to arrive at an economic value are

Property Plant & Equipment: The annual report of AstraZeneca shows that land and building valued at $5,683 million and plant & equipment valued at $8,453 million. Further the company has disposed off significant amount of these assets. The net book value has been mentioned based on the depreciation that has been accounted for these assets. The adjustment would certainly be required as there are considerable changes in the value of plant & equipment and land & building.  It has also been mentioned that manufacturing operations in China have been affected by the strategy changes whereas the restructuring has impacted the US business. The market factors will further influence the value of these assets and their contribution to the performance of the company. It is important to note that the impairment has been considered for these assets. This can be considered as the adjustment in the asset value.

Inventories: The analysis of the inventories held by the company shows that raw material & consumables, work in progress and the finished goods inventories have almost equal share in the inventories. Considering the products of the company includes the medicine in therapeutic area. These have limited life. As a result the company had to write off inventories amounting to $91 million.   

Intangible Assets: These are one of the most important aspects as that need to be considered as there is significant impairment that has taken place. Further there are several self generated patents of the company. The company has booked impairment reversal of $285 million. Such risks, impact and changes that can be there have to be attributed. Apart from this the company acquire or discover the products as a result of merger and acquisition which is quite company in this industry. Lastly the write down in value of intangible assets is also quite important and has huge impact on the value of the assets.

Interest Bearing Loans: the changes in the interest rate have an impact on the interest bearing loans of the company. The company gained $5 million on the fair value of bonds designated at fair value through profit or loss, due to increased credit risk. Similarly $39 million was gained on these bonds since their inception. The interest rates for discounting of future cash flows for fair value adjustments have been provided. Thus the adjustments have to be made in this context as well.

There are three ways in which the adjustments to the book value can be made. These are

Fair Market Value of the element

Realizable value of the element

Replacement value of the assets

The discussion on the various elements of the balance sheet shows that all these aspects can impact the value of these assets in a different way and adjustment in the book value lends more clarity and the actual value that these add to the business and thus takes the value mentioned in the annual report closer to the economic value.

The above discussion clearly shows that the adjusted book value may closely reflect the economic value as the value of the self produced elements is reflected and at the same time the values are increased, decreased or appropriated to approximate their value according to the market and thus the . However there are certain limitations that have to be considered. This is to say that the value of the business that is estimated based on the adjusted book value may be incorrect and effect of contingent liability may be there and affect the value. Further the impact of minority interest will also have to be considered.  These aspects will certainly have an impact with respect to AstraZeneca.

Concluding the discussion it reflects closely the economic value of the asset or any other element of the balance sheet. The adjusted book value of the some of the elements such as internally generated assets is used for valuation which has been the case with AstraZeneca. The aspects that have been highlighted are quite relevant to AstraZeneca. AstraZeneca operates in the industry where the adjustment can reflect huge changes and thus can be of huge importance for the company. The company has already considered it in the annual report and the financial statements that have been prepared.  

B.  The ratios have been calculated for AstraZeneca plc at its 2013 financial year. These have been shown below

Price-to-earnings ratio (PE ratio): 1.44

Price-to-cash-flow ratio: 1.75

The price to earnings ratio shows that the price of the shares has been higher in comparison to the earnings and the cash flow per share. This shows that the investors are quite interested in the company and have expectation that the earnings would increase in future. This is quite positive aspect for the company.

The analysis backed by market ratios are quite important and can be quite significant in the decision making. The market ratios are important as it not only employ market based data but also involves suitable values from the annual report that comprehend the market based values that are identified. This is to say that firstly market ratios highlight the expectation in the market in relation to the performance of the company and thus highlights that there are certain factors that might favour the company in future. Secondly it provides an insight into the suitable decision that can be taken. For example in case it is viewed that market ratio highlights overvaluation of the shares of the company in comparison to the book value, the investor may plan to draw the investment from the company. On the other hand if the share is highly undervalued more investment is made in the company. Thus the market ratios do provide additional supporting information on the investment that need to be made. Further it also highlights how relevant are the figures that are mentioned in the annual report of the company. The adjusted book value ensures that the market ratios are closer to unity. Overall it is important to consider market ratios in addition to the analysis that is made by the company. It is an important tool that can influence the decision on investment that is made.

3. The following key points have been discussed based on the article ‘The capital budgeting decisions of small business’ by Danielson and Scott

Advantages of payback period

The article ‘The capital budgeting decisions of small business’ by Danielson and Scott primarily analyzes the capital budgeting practices by small firms. This study is backed by the survey data compiled by the National Federation of Independent Business. It has been mentioned in the introduction of the article that despite the importance of capital investment to small firms, most capital budgeting surveys have focused on the investment decisions of large firms.

In order to identify the capital budgeting practices by small firms the research has been conducted wherein the different reasons based on which particular capital budgeting technique is employed by the firms as capital budgeting decisions of large firms are not likely to describe the procedures used by small firms. No separate study has been conducted in the research. Overall the target is to ensure that the capital budgeting techniques that are employed by the small firms are reliable and ways are identified to improve the evaluation of projects by small firms. This will ensure that the risk in the small businesses is reduced and the significant capability of these firms is there in the economic development. Since the article has broader prospects the data by the National Federation of Independent Business has been used in the research. Overall the focus is on the small firms by comparing the techniques being employed by large firms.

The ‘Project Evaluation Methods’ section of the article highlights that broadly three methods are employed i.e. Accounting rate of Return, Net Present Value and the Payback Period. Apart from this the firms also rely on gut feel to take decisions with respect to investment in the project. Further this section of the article has discussed each and every point with respect to the study that has been conducted. The key points that have highlighted have been mentioned below

• Owners without a college degree resort to it most frequently, and owners with advanced degrees least.
• Firms with written business plans and firms that make cash flow projections are significantly less likely to rely on gut feel.
• Small business owners use relatively unsophisticated methods of analysis to evaluate replacement options as these options are limited
• Owners with advanced/professional degrees are most likely to use discounted cash flow method
• Firms extending existing product lines are also significantly more likely to use discounted cash flow analysis.

The above discussion is quite important significant with respect to the study that is being conducted. However it is important to note that certain points are in harmony with the summary to this article. For example it has been mentioned above that firms extending existing product lines are also significantly more likely to use discounted cash flow analysis. This has been supported by the discussion in the summary wherein it has been mentioned that the new project launched by small firms may not have any historical or similar product with which cash flow can be related. This reduces the credibility and the utility of the other capital budgeting techniques as the cash flow can have huge impact on the project evaluation. Thus overall the  study has been quite helpful in analyzing the key points and also identifying the aspects that impact the performance of the company. Based on this study the reasons and possible solutions to improve the reliability of the capital budgeting techniques for the small firms have been identified. Overall the section has been quite helpful in identifying the capital budgeting practices by small firms the research has been conducted wherein the different reasons based on which particular capital budgeting technique is employed by the firms as capital budgeting decisions of large firms are not likely to describe the procedures used by small firms. It may be considered as the base for the study for the small firms that have a huge role to play in the economic development and thus suitable solutions may be provided. It may be helpful in reducing the reliance of the small firms on gut feel and employ more scientific approach in the decision making.

Disadvantages of payback period

The authors have put forward various reasons as to why small firms might evaluate projects differently. These are as below

• Limited formal education in the field
• Incomplete Management Teams
• Small staff size
• Imperfect Capital Markets
• Lack of Credibility of the owners
• Non Discretionary Investments
• Difficulty in quantifying future cash flows

The reasons that have been mentioned above do support the relying of the capital budgeting or to a certain extent on payback period. Further it can be seen that various points that have been mentioned above do cover broader prospects that is conceptually and in general. For example limited education in the field is an important factor. Using the capital budgeting techniques require understanding of the various methods, how these can be employed, limitations and benefits and selection of the suitable technique for valuation.

It has been discussed that gut feel and payback period are the most favoured method. This is because there are credit constraints due to lack of credibility and thus the small businesses rely primarily on internally generated funds. In such cases liquidity and the payback is the major concern. Further not much information is available for the small business. Thus there is difficulty in quantifying future cash flows. When future cash flows cannot be easily estimated, discounted cash flow analysis may not provide a reliable estimate of a project’s contribution to firm value. As stated in the article, the new project launched by small firms may not have any historical or similar product with which cash flow can be related. This reduces the credibility and the utility of the other capital budgeting techniques as the cash flow can have huge impact on the project evaluation.

The small businesses are also affected by the lack of management teams and the small size. If more staff is employed for ensuring complex techniques are employed, which might not be of much help, will impact the profitability of the small business. Since the profitability is the primary goal, it can be said that the target and viewpoint of small businesses are different from large businesses. Thus it is prudent to employ simple techniques without employing excess staff and involving complexity.

All these reasons that have been well supported by the discussion in the article do highlight why the small businesses rely on payback period method for project appraisal. Overall the constraints that have been mentioned may be reduced to a certain extent but it would be quite challenging to ensure that the other capital budgeting techniques such as NPV, which are employed by big firms, are also employed by small firms. Thus it can be said that the argument that has been given in the article related to employing payback period by small firms is in the right direction and development of markets or any other factor alone may not be appropriate to enable the shift. Overall the methods suitable for small firms are quite different from the methods employed by the large firms.

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