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Foundations of Finance.

Introduction
Verse plc has been offered a contract to manufacture a batch of steel girders. This report calculates the present value of the contract and compares that to the net present value of rejecting the contract. It also highlights the pitfalls in analysing both options and their dependence on certain assumptions and the sensitivity of net present value to change in assumptions. It also looks at different ways of incorporating risks and uncertainty into net present value calculations.

Net present value of accepting the contract
We first calculate the net present value of the contract based on the following data

  1. Price of contract is £355,000 in current sterling. Adjusted price - increased in line with increases in the retail price index - will be paid in full at the end of two years.
  2. Cost of new machine is £100,000. The machine has zero
  3. Ten persons employed for two years at £10,000 per person in the first year and the second year wages increasing at 1.25 times the increase in retail index.
  4. Additional cost of 2000 units of steel would be £30 per unit increasing at a rate of 1.5 times the rate of increase in the retail price index. We have taken £30 per unit as the base price of steel because that is the current replacement cost.
  5. Discount rate of 15% per annum.
  6. Estimated increase in retail price index of 10% per annum.

The net present value of contract doesn't include the cost of 2000 units of steel already in stock as the money spent on acquiring steel is a sunk cost. A sunk cost is 'A cost that has already been incurred and, therefore, is irrelevant to the decision making process' (Horngren et. al, 1999).

Appendix 1 shows the net present value of accepting the contract. Based on the above assumptions, the net present value of the contract is -£7,221. So if we just look at the contract, it has a negative value of more than £7,000 pounds and hence Verse should not accept it.

But before we make a decision, we should also analyse the alternative scenario of rejecting the contract and the net present value of doing so.

Net present value of rejecting the contract
Additional assumptions used in calculating the net present value of rejecting the contract

  1. Redundancy costs per person £300.
  2. Re-hiring costs per person £750.
  3. Selling price of steel £2.25 per unit. The company hasn't got any other use of the special steel and would be forced to sell only. If company had any other use of steel, then we would have used the replacement cost of £30 per unit.

The costs associated with rejecting the contract are redundancy and rehiring costs. And the revenue comes from selling the existing inventory of 2,000 units of steel at Net present value of accepting the contract at £2.25 per unit. As in the case of calculating NPV of the contract, we have not included the cost of steel in inventory as that is a sunk cost.

Appendix 2 shows the net present value of rejecting the contract. Based on the above assumptions, the net present value of rejecting the contract is -£4,171.

So either accepting or rejecting the contract has a negative net present value. Accepting the contract will result in additional loss of £3,050 as compared rejecting the contract. So the company should reject the contract and limit its losses.

But the above analysis is based on a number of assumptions like rate of increase in retail price index, rate of increase in wages, increase in price of special steel and costs of re-hiring people.

Possible pitfalls in the above analysis

  1. Sensitivity to various assumptions. We have seen that difference in net present values changes significantly due to change in various assumptions used in calculation of net present value. Verse's management should try to look again at various assumptions before making the final decision.
  2. The above net present value analysis doesn't take into account the probability of client bankruptcy. As the payment is made only at the completion of work, Verse's revenues are at risk if the client goes bankrupt at any stage before the completion of steel girders. Client bankruptcy may not only result in some or all of revenue loss from this contract, it may also jeopardise the existence of Verse. This will depend upon the strength of Verse's balance sheet and cash flows and also the nature of covenants due to debt, if any.
  3. Client retention. Sometimes companies have to look at long term implications of accepting or rejecting a contract. If verse rejects this contract, depending upon its relationship with the client, it may lose all future contracts from that client. If the business from that client constitutes a major part of Verse's revenues, contract rejection may prove too costly for Verse. Sometimes companies do accept some contracts that alone may not be profitable but are vital to retain a client and grow other profitable businesses with them. Verse's management should take this into consideration before making any decision.
  4. Lowering barriers to competition. By rejecting this contract, Verse may open doors for other organisations to enter this business. Verse's client will try to source the same product from different companies and may find a better source than Verse. This scenario might be less likely in this case as Verse already has 2,000 units of special steel required for making steel girders and we have taken cost of inventory as sunk costs. If competitors don't have the same material, they will have to procure it and that would raise their costs and lower net present value significantly.

We now know that there is uncertainty even after accepting or rejecting the contract. Static cash flow models used above to calculate net present values of accepting or rejecting the contract just give one number. It doesn't take into account the different scenario that may happen during the implementation of the contract and the ways they would impact the success of the contract and also to some extent, the success of the organisation.

Incorporation of risk and uncertainty
Managers are constantly faced with two things - risk and uncertainty. Risk analysis helps decision makers into taking calculated risks. It allows management to gain better perception of risks and look at different ways of managing them. Risk management is more of reducing risk exposures than trying to avoid it all together. Risk and uncertainty management has normally three elements - sensitivity analysis, scenario analysis and decision analysis (Vlahos, 1997).

Sensitivity analysis
Sensitivity analysis is the starting point for any type of uncertainty analysis. Sensitivity analysis in this case is looking at various uncertain elements and evaluating the impact on net present values due to change in those elements. The net present value calculations for the contract are based on certain assumptions. It would be useful to look at the sensitivity of results due to changes in various assumptions.

  1. Rate of change in retail price index. An increase in retail price index will result in higher revenues at the end of two years. An increase in retail price index will also result in higher wages and steel costs. Appendix 3 shows the changes in the net present value of accepting and rejecting the contract. The net present value of accepting the contract increases with increase in retail price index whereas there is no effect on the net present value of rejecting the contract as the only costs in rejecting the contract are only related to fixed costs of redundancy and re-hiring. As can be seen from the table, the difference in net present values increases from -£11,298 to £5,413 when the rate of change in retail price index increases from 8.0% to 12.0%.
  2. Change in the re-employment costs. If the re-employment costs change by £100, the total change in re-employment costs at the end of two years would be £1,000. The present day value of £1,000 discounted at 15% per annum is £756.
  3. Change in the discount rate. Appendix 4 shows the effect of change in discount rate on the net present values of accepting and rejecting the contract. At lower discount rates, accepting contract is more beneficial than rejecting contract. This is due to the fact that revenues in case of accepting the contract are earned only at the end of second year. 1% increase in discount rate decreases the net present value of accepting the contract by about £3,000 whereas the increase in the net present value of rejecting the contract is about £100.

Above analysis would help management to understand the impact of various uncertain elements and also challenge the likelihood of their occurrence.

Scenario Analysis
Scenarios are defined as 'discrete views of how the world will look in future, which can be selected to bound the possible ranges of outcomes that might occur' (Porter, 1998). Verse's management can look at both pessimistic and optimistic outcomes of different decisions - accepting or rejecting the contract - and test the impact of each on their business. This will give them a range of possible outcomes under each scenario and also help in analyzing which of the risks they can take and what strategies should be implemented to deal with those scenarios. Particularly relevant would be the scenarios of client going bankrupt and possible entry of a competitor due to rejection of this contract.

Decision Analysis
Sensitivity and scenario analysis helps in looking at various possible outcomes but they take no account of likely probabilities of different outcomes. Once management is satisfied with the outcome of different scenarios, it would like to evaluate the possible outcome of a decision.

We now look at various risks associated with accepting the contract and the ways in which different risks and uncertainty could be incorporated in the net present value calculations.

  1. Risk of client's bankruptcy. To deal with the issue of probably client's bankruptcy, Verse should first try to analyse the probability of client's bankruptcy during the course of contract, mainly at the end of first and second year. A decision tree analysis would help Verse in better analysing the various outcomes and their probabilities. 'Decision Trees are excellent tools for helping you to choose between several courses of action' (Mindtools). By using a decision tree with probabilities, Verse can analyse different outcomes at the end of two years. Multiplying the difference in net present values with the end probability would give a better difference in net present value.
  2. Uncertainty in rate of change of retail price index. Verse makes more money when rate of change of retail price index increases. This is because increase in retail price index gets reflected on whole of the sale price but in costs it affects only the wages and purchase of 2000 units of steel at the end of first year. It makes sense for Verse to look for some hedging instruments where the firm can cap the lower level of rate of retail index. This hedge instrument should only cover revenues and so guarantee minimum revenues to the company. Company can take the costs of buying hedge instruments as costs incurred at the start.  

Another important thing to notice here is that the sales price is affected by rate of change in retail price index for both the years whereas costs are affected only by the rate of change in the first year. So it makes more sense for Verse to purchase hedge instrument at the beginning of second year.

Verse can also use Monte Carlo simulation to calculate the net present value of accepting the contract.

Conclusion
The decision to accept or reject a contract is based on the net present values of the outcomes. In this case, the net present value of accepting the contract is more negative than that of rejecting the outcome. So on the basis of static cash flow models alone, Verse should not accept the contract. But the decision doesn't take into account the various outcomes possible due to variation in assumptions used in calculating the net present values. Sensitivity analysis shows a big change in results with change in rate of retail price index. Verse should also look at both pessimistic and optimistic outcomes and assign probabilities to various scenarios. If it decides to go ahead with the contract, it should implement strategies like hedging to deal with downturns.

Appendix 1: Net present value of accepting the contract

Appendix 1


Appendix 2: Net present value of rejecting the contract

Appendix 2


Appendix 3: Sensitivity of net present values due to change in rate of retail price index

Appendix 3


Appendix 4: Sensitivity of net present values due to change in discount rate

Appendix 4

Bibliography and references
Horngren, C. T., Sundem, G.L. and Stratton, W.O.; 'Introduction to Management Accounting', Eleventh Edition, Prentice Hall International, 1999
Mindtools; http://www.mindtools.com/dectree.html
Porter, M.; 'Competitive Strategy: Techniques for analysing industries and competitors', Free Press, 1998.
Vlahos, K.; 'Taking the risk out of uncertainty', In the Complete MBA Companion, Editor G. Bickerstaffe, Pitman Publishing, 1997.

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