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An Emerging Project For Mccain Food Ltd Finance Essay

McCain, the world largest frozen chips producer, is going to invest on the two projects ‘Waste Lagoon’ and ‘Wind Turbine system’ where both of the projects are for producing alternative source of energy. The two engineering companies (Omega Alternatives Plc and Alpha Renewable Plc) are in a bid for tender for the project. By applying all of the investment appraisal techniques for example, ARR, PP, NPV and IRR for the both project, the overall results strongly support the Waste Lagoon project. For selecting the better company for tender, the financial statements of last two years of that two companies have been analysed by using different financial ratios for example, ROCE, Capital Turnover, Net Profit Margin and Gross Profit Margin for determining the profitability ratios and Acid Test, Stock Turnover, Debtors Collection period and Creditor Payment period for determining the Liquidity and efficiency ratios of the two companies. The overall result of these ratios analysis is favourable for Alpha Renewable Plc and consequently it has been recommended to give the tender for Waste Lagoon Project to Alpha Renewable Plc because of its strong financial stability in compared to Omega Alternatives Plc.

McCain Food Ltd is one of the largest frozen chips producers in the world. Its first processing factory was opened in New Brunswick Canada in 1957; owned and managed by the McCain Family. The company grew rapidly and now it has become the market leader because of its continuous innovation on both variety and quality.

McCain Foods’ Whittlesey plant in Cambridgeshire turns potatoes into bags of McCain chips. As a major user of energy for its production process McCain is seeking to reduce how much gas and electricity it uses and recently it wants to invest in two projects ‘Wind turbine system’ and ‘Waste Water treatment system’ at the Whittlesey plant as an alternative source of energy which will cut their production cost and will help to reduce the carbon footprint as well. The two projects together will need a capital outlay of £150 million. McCain therefore needed to evaluate the expected financial benefits of both projects before going to proceed. The company has also selected two engineering company (Omega Alternatives and Alpha Renewable) for tender and it needs to know which company is better for tender for the projects.

I have been commission by the company to study on a comprehensive investment appraisal for the two projects, financial analysis of the two selected company for tender and appropriate source of funding if needed.

Methodology, Findings & discussion

Investment Appraisal on the two projects

Given the importance of investment decisions to the viability of business, it is essential that investment proposals are all properly screened. Ensuring that the business uses appropriate methods of evaluation is an important part of this screening process.

Research shows that there are basically four methods used in practice by businesses throughout the world to evaluate investment opportunities.

Accounting Rate of Return (ARR)

Payback period (PP)

Net present value (NPV)

Internal rate of return (IRR)

( Reff: Peter Atrill and Eddie McLaney, Management Accounting for Decision Makers, 5th Edition, p-246)

Accounting Rate of return

The accounting rate of return method takes average accounting profit that the investment will generate and expresses it as a percentage of the average investment in the project, as measured in accounting terms. Thus,

ARR = (Average annual profit / average investment to earn that profit x 100)

But for the two projects we have taken the denominator as ‘initial investment’ rather than average investment.

ARR of ‘Wind Turbine’ project

ARR of ‘Waste lagoon’ project

28.6%

30.64%

See the appendix A.

According to the writer Peter Atril and Eddie McLaney, users of ARR should apply the following decision rules:

For any project to be acceptable it must achieve a target ARR as a minimum

Where there are competing projects that all seem capable of exceeding this minimum rate, the one with the higher or highest ARR would normally be selected. ( Reff: Peter Atrill and Eddie McLaney, Management Accounting for Decision Makers, 5th Edition, p-248)

It is clear from the table that Waste lagoon project will be more profitable because of its higher ARR.

Merits

It clearly shows the profitability of the projects.

It allows easy comparison between project

The opportunity cost of investment can be taken into account

Demerits

More complex method

It does not take into account the effects of inflation on the value of money over a time period

Payback period

The payback period is the length of time it takes for an initial investment to be rapid out of the net cash inflows from a project.

According to the writer Peter Atril and Eddie McLaney, the decision rule for using PP is:

For a project to be acceptable it would need to have a payback period shorter than a maximum payback period set by the business.

If there were two or more competing projects that were both shorter than the maximum payback period recruitment, the decision maker should select the project with the shorter payback period. ( Reff: Peter Atrill and Eddie McLaney, Management Accounting for Decision Makers, 5th Edition, p-246)

PP of ‘Wind turbine’ project

PP of ‘Water lagoon’ project

3years 6months

3years 5months

See the appendix A

The PP of Water Lagoon is 3y 5m means that the project will be able to recover its initial investment by that time from the commencement of the project whereas the other project will take one month more to recover its initial investment.

Merit

It is extremely simple

Helps prevent cash flow problem- since money will be recovered as quickly as possible.

Demerit

Cash earned after the payback method is ignored.

It does not account for the real value of money.

Net Present Value

Under the NPV net cash flows are discounted to their present value and then compared to the capital outlay required by the investment. The difference between these two amounts is referred to as NPV.

A project is accepted when the net present value is zero or positive.

NPV = (Total PV of future CF’s – Initial investment)

NPV of ‘Wind Turbine’ Project (£ mill)

NPV of Waste Lagoon Project (£ mill)

(5.692)

0.154

See the appendix A

In case of Waste lagoon project, the NPV is positive, so we should accept the project. Investing in this project will make the business £0.154 million benefit. The gross benefits from investing in this project are worth a total of £(50+0.154)=£50.154 million today and since the business can get the benefits for just £50 million today, the investment should be made.

On the other hand, Wind Turbine project’s NPV is negative that means the present value of invested amount (£100 mill) is (100 – 5.692) = £94.308 million today which will be worthless investment.

Merits

Takes into account timing of all cash flows

Takes into account the time value of money

Simple decision rule

Can be used to compare alternative projects

Demerits

Need to calculate cost of capital

May be more difficult for lay people to understand

Basic model ignores inflation

Ignores timing of cash flows within individual years

Internal Rate of Return

The IRR is the discount rate at which NPV is zero. The IRR is calculated by discounting the net cash flows using different discount rates till it gives a net present value of zero.

IRR = [positive rate + {positive NPV/ (positive NPV+ negative NPV) x range of rates}]

IRR of ‘Wind turbine’ project

IRR of waste lagoon project

12.78%

15.134%

See the appendix A

In case of Waste lagoon project, the NPV is positive £0.134 million at 15% discounting factor (see appendix A) implies that the rate of return that the project generates is more than 15%. But the NPV of another project is negative (see appendix A) at the same discounting factor implies that rate of return that the project generates is less than 15%.

From the table it has been seen that the IRR of Waste lagoon is 15.134% means that the returns on its investment will be 15.134% which is an increased figure more than 15%. On the other hand, the IRR of wind turbine project is 12.78% means that the returns on its investment will be 12.78% which is lower than the cost of capital (15%).

Merits

No need to decide on cost of capital

Provides margin of error when IRR is compared with hurdle rate (minimum IRR requirements for the acceptance of a project)

Demerits

Investment may have more than one IRR

Can not choose between alternative projects using IRR

Can not be used for least cost situations

It completely ignores the scale of investment.

B) Financial analysis of the two engineering companies

Financial analysis is a comprehensive analysis of-

Strategy

Competition, regulation and taxes

Past, current and projected financial performance

Fundamental evaluation in relation to stock price

Planning for the future

>Operation

>Investment

>Financing

(Reff: Financial statement Analysis by Professor SP Kothari, June 18,2004)

There are different approaches for analyzing financial analysis and Ratio Analysis is one of the popular approaches.

Ratio Analysis is a technique by which we can –

Evaluate the financial performance and stability of an entity

Types of Ratios:

Profitability Ratio

Liquidity &Efficiency Ratios

Gearing Ratios

Investment Ratios

As McCain is not going to invest in those two companies, we only need to analyse the Profitability ratio and Liquidity & efficiency ratios.

Profitability Ratios:

“Profitability ratios are connected with the effectiveness of the business in generating profit. A very popular means of assessing a business is to assess the amount of wealth generated for the amount of wealth invested.” (Eddie McLaney,Business Finance 7th edition, Prentice Hall)

Return on capital investment (ROCE): “ROCE is used in finance as a measure of the returns that a company is realizing from its capital employed.” ( Wikipedia definition)

In case of Omega Alternatives, the trend of ROCE has decreased by 0.55% in 2008 from 2007 which implies that their efficiency in generating revenue from resources and management’s ability to control cost has decreased. On the other side, Alpha has got higher ROCE than Omega over the mentioned period and there also can be seen a rising trend of ROCE which means that Alpha’s business is much effective in generating revenue from its resources and has possessed strong management ability.

Capital turnover: “Capital turnover is a measure indicating how effectively investment capital is used to produce revenues. Capital turnover is expressed as a ratio of annual sales to invested capital” (Reff: http://financial-dictionary.thefreedictionary.com/Capital+Turnover

Capital turnover of omega 1.62 times in 2007 which implies that Omega has used its capital 1.62 times by that year to achieve its sales revenue. In case of both companies there can be seen a rising trend of capital turnover over the period but Alpha has used its employed capital 2.51 times (in 2008) which is 0.76 times higher than Omega over the same period (2008). But it is important to note that, “A high ratio is not necessarily beneficial if margins are so small that the net profit generated is unsatisfactory” (Eddie McLaney,Business Finance 7th edition, Prentice Hall) .So this measure ( capital turnover) is related to profit margin of company.

The net profit margin of Omega is 13.15% in 2007 which implies that the company has earned £13.15 million out of £100 million sales revenue after all of the expenses of running the business for that period. Though there is a slight decreasing trend of net profit margin of Alpha from year 2007 to 2008, it possess higher Net profit margin than that of Omega which means Alpha has been earning more profit based on its sales revenue.

A slight decline of gross profit margin by 0.51% has shown in 2008 from 2007 at Alpha whereas Omega’s gross profit margin has fallen by 1.62% over the same period. It can be noted that The Gross profit margin of Alpha is more than 4 times than that of Omega in the year of 2008 which implies that the amount of sales revenue remains after the expenses of making the stock available to the customer is more than 4times than Omega.

Liquidity and efficiency ratio

Liquidity ratios are used to try to asses how well the business manages its working capital. It is used to evaluate the solvency and financial stability of a business.

There are different types of liquidity ratios:

Acid Taste: The ratio of liquid assets and current liabilities is termed as Acid Test. It shows that how much a business is stable. The ratio should be 1:1.

According to the minimum required value for acid test (1: 1), both of the company shows satisfactory result. It is also remarkable that a common decline trend of their (both of the company) liquid assets has seen from the year 2007 to 2008 though Alpha possesses a bit of more liquid assets than Omega in 2008.

Stock Turnover: The ratio of cost of sales and average stock is termed as Stock turnover.

Both the companies have shown a rising trend of stock turnover from 2007 to 2008 but Omega’s stock turnover is appraisal over the mentioned period. Omega’s stock had been turn 2.23 times in 2008 which is higher than Alpha.

Debtor Collection period: This is the ratio which will tell us how long, on average, following the sale on credit, trade debtors take to meet their obligation to pay. A well-managed debtor policy will lead to debtors taking as short a time as possible to pay, without damaging good customer relation.( Eddie McLaney, Business Finance 7th edition, Prentice Hall, p-54)

It is very clear from the ratios that the lower the debtor collection period the better the outcome. The debtor collection period of Alpha is less than half of Omega over the mentioned period. For example, Alpha was able to collect it’s debts by only 36.26 days in 2008 whereas Omega has taken more than double time (89.63 days) to collect the debts in the same year.

Creditor payment period: This is the ratio that will tell us how long, on average, following a purchase on credit, the business takes to meet its obligation to pay for the goods or service bought. A well managed creditor policy will lead to as much ‘free’ credit being taken as possible without damaging the goodwill of suppliers.

The more the creditor payment period the more the outcome of the business. Alpha has shown an incredible creditor payment period (which is 15 times of Omega) in compared to Omega in 2008 which means that alpha will be able to increase and improves its overall cash flows more frequently over the period than Omega for the longer creditor payment period.

C) Graphical representation (cost savings Vs Year of operation) of the two Projects

X- Axis> Year of operation Y- Axis > Net cash flow

From the graph it is crystal clear that the net cash flows for both of the projects show an upward trend over the five years period. In case of Wind turbine project the cost of savings increases gradually over the period. But in case of waste lagoon project, there can be seen a sudden increase on its cost savings which starts from year 2 and a slight sharp increase continues up to year 5. By increasing the year of operation up to 7, it can be predicted that the cost savings of the both project will gradually increase on the next two years and consequently McCain will be gainer.

D) Summary and Conclusion

By taking consideration of all the results of financial appraisals measure, it can be easily assumed that which project will be more viable and feasible for McCain. To reach a conclusion we need to revise the following table

Wind turbine does not exceed its cost of capital (12.78%<15%) which means worthless investing

From the table it can be seen that, the NPV and IRR values are not favourable to invest for the wind turbine project, though it’s ARR and PP somewhat appraisal. All the above values, on the other hand, are mostly favourable for Waste lagoon Project that will be viable and feasible in terms of all values mentioned. So, I recommend the McCain Company to invest on the Waste Lagoon Project.

Again, by analyzing the financial statements of the two engineering companies, it can be summarized as follows from which we can conclude that to whom the project can be handed over as a tender.

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