Calculation Of Net Present Value Npv Accounting Essay

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EXECUTIVE SUMMARY

Wonderland is a successful chain of restaurant and they want to diversify the business and diversifying is a way to protect or grow the business. This helps spreading the business risk and also a way of increasing the company's sales revenue and/ or operating profit.

The purpose of diversification is to allow the company to enter lines of business that are different from current operations. When the new venture is strategically related to the existing lines of business, it is called concentric diversification. Conglomerate diversification occurs when there is no common thread of strategic fit or relationship between the new and old lines of business; the new and old businesses are unrelated which is the case with Wonderland Confectionaries Inc.

And there is option

Find new products for existing customers

Find new customers for existing products

Find new products for new markets

This report includes a case observation on Wonderland which is changing its industry from restaurant to theme park. The theme park project is an investment with multiple offers to multiple customers will help the company a lot from risk point of view but it can have a devastating effect to your business. This is because if your service and sales volume go down or you increase the cost you have no other option to survive in the market and on the other hand, if you have variety of products or customers it may not affect your overall business because you have some other options with you either in case of product or customers. So you revenue is getting generated in stable manner and you are still in to the business.

REPORT

From,

Ms Anuradha Chouhan

Finance Manager,

Wonderland Confectionaries Inc.

Date: 16-09-2010

To,

The Board of Directors,

Wonderland Confectionaries Inc.

Respected Management,

Subject: Report on the analysis of the investment of Wonderland Inc. into the theme park business.

I have herewith attached the critically evaluated report on the investment appraisal of Wonderland Inc. into the theme park business. I have also outlined the financial and non-financial issues that the management should address. Further in this respect I have also given a brief outline of the use of real options in the project appraisal. Your feedback will be kindly appreciated.

Thanking You,

Yours faithfully,

Anuradha Chouhan

CALCULATION OF NET PRESENT VALUE (NPV) OF INVESTMENT PROJECT FOR DIVERSIFICATION OF WONDERLAND INC. INTO THEME PARK BUSINESS

In order to assess the investment decision of Wonderland Inc. into the theme park industry, it is firstly essential to calculate the NPV of the investment project.

Generally, NPV can be calculated using the formula

NPV = Cashflow * Discount factor

In order to calculate the NPV of the investment project, we need the discount rate of the company if it would enter the theme park business. The calculation that discount rate to be used for the NPV calculation can be done by using the data of Alice Limited company which is the closest theme park competitor if Wonderland would enter into the business.

CALCULATION OF DISCOUNT RATE

To calculate discount rate for NPV calculation of Wonderland to enter the theme park industry, the following steps have to be performed using the details from the balance sheet of Alice Limited and the details from market research performed by the company. (See Appendix)

Step 1:- Take proxy beta (βE) = 1.50

Step 2:- De-gearing:

Remove financial risk by assuming Kd = 0, βd = 0

To calculate βA we use the formula

βA = βE* [E/E+D(1-CT)] + βd

where :

βA is asset beta

βE is equity beta = 1.50

βd is debt beta =0

E is amount of equity = 79% (See Appendix)

D is the amount of debt= 21 % (See Appendix)

CT is the corporation tax = 35%

Therefore βA = 1.5*[0.79/0.79+0.21(1-0.35)]

βA = 1.27

Step 3:- Re-gearing: Introducing the capital structure of Wonderland to calculate its βe

ΒE = βA [E+D(1-CT)] / E

E = 65% (given)

D = 35% (given)

βE = 1.27 [0.65+0.35(1-0.35)/0.65]

βE = 1.71

Step 4:- Substitute βE in CAPM equation to find KE

KE = rf + βE (rm - rf)

Where:

KE is the cost of equity

rf is the risk free rate = 3.5%

rm is the market return rate on equity = 12 %

Therefore KE= 0.035 + 1.71(0.12 - 0.035)

KE = 18.03%

Step 5:- Calculation of discount rate (Weighted average cost of capital)

We know that

KE = 18.03% and

KD = 8%

WACC = KE *[ E / (D+E)] + KD [D(1-CT) / (D+E)]

= 18 * 0.65 / 1 + 8(1-0.35) 0.35 / 1

= 11.7 + 1.82 = 13.52%

Discount Rate (WACC) = 14% approximately

CALCULATING THE NET PRESENT VALUE OF THE PROJECT:

The discount rate which will be used to calculate the NPV of the investment project has been found to be 14% approximately. The annual cash flow of the company can be found out from the details obtained from the market research performed by the company.

The following assumptions have been made to calculate the net present value:-

The theme park will be operating 365 day a year.

The net current asset has a realizable value of £ 150 million.

The market research cost of £400,000 is not relevant to assess the investment of Wonderland into theme park business since it is a sunk cost that has already occurred to the business whether the company takes up the project or not.

The discount rate calculated above (13.52%) is approximated to 14%

The following table shows the NPV calculation.

All the relevant values used in the following table have been calculated and shown in detail in the appendix section.

NPV CALCULATION TABLE:

YEAR 0

YEAR 1

YEAR 2

YEAR 3

YEAR 4

YEAR 5

Revenue (from admission)

131,400,000

131,400,000

131,400,000

131,400,000

Food & Drink (40% contribution)

29,200,000

30,660,000

32,193,000

33,802,650

Gifts (45% contribution)

22,995,000

24,144,750

25,351,988

26,619,587

Operation cost

(17,000,000)

(22,000,000)

(27,000,000)

(32,000,000)

(37,000,000)

Insurance cost

(2,000,000)

(2,100,000)

(2,205,000)

(2,315,250)

(2,431,013)

Labour cost

(35,000,000)

(36,750,000)

(38,587,500)

(40,516,875)

(42,542,719)

Savings

3,000,000

3,000,000

3,000,000

3,000,000

3,000,000

Operating Cash flow

(49,200,000)

125,745,000

121,412,250

117,112,863

112,848,505

Tax (35%)

(17,220,000)

(44,010,750)

(42,494,288)

(40,989,502)

(39,496,977)

Capital allowances

75,000,000

56,250,000

42,187,500

31,640,625

23,730,469

Investment

(250,000,000)

(250,000,000)

Working capital

(60,000,000)

YEAR 0

YEAR 1

YEAR 2

YEAR 3

YEAR 4

YEAR 5

Net current asset

150,000,000

Annual Cash Flow

(250,000,000)

(301,420,000)

137,984,250

121,105,462

107,763,986

247,108,997

Discount factor (14 %)

1

0.877

0.769

0.675

0.592

0.519

Present Value

(250,000,000)

(267,359,540)

106,109,888

81,746,186

63,796,279

128,249,570

NET PRESENT VALUE =

(137,457,617)

The NPV of the investment project is calculated to be (137,457,617)

SUGGESTION:

Even though the company wants to diversify its business activities and reduce the overall risk associated with the business, I would suggest the management not to undertake the project since it has a negative NPV value. It is possible for the cost to undertake the project if the ticket prices could be increased and also find cheaper labour. The prices of food and gifts could also be increased in order to add to the revenue. Further the company should also consider changing the insurance provider since the cost of insurance is getting expensive over the years.

FINANCIAL AND NON-FINANCIAL ISSUES:

In order to be a successful, the company has to consider both the financial and non-financial issues surrounding it. There are many different ways to measure financial performance, but all measures should be taken in aggregation. Line items such as revenue from operations, operating income or cash flow from operations can be used, as well as total unit sales. Furthermore, the analyst or investor may wish to look deeper into financial statements and seek out margin growth rates or any declining debt.

FINANCIAL ISSUES:

Following financial issues has to be considered by the Wonderland in order to achieve

a cost-effective growth in the company.

Capital Budgeting: It is the process of planning and managing the company's long term investment. The cost incurred by a company is of the greatest importance to a company. The company should always have an eye on its expenditures and revenues. Wonderland can manage these issues by carefully evaluating the areas in which it plans to invest. It should also keep in mind the long term worthiness of the investment. The company must also evaluate the size, timing and risk of the future cash flow.

To this end, the company must choose a project which gives a good return on investment and earlier payback periods

Capital Structure: The most important concern of a firm is regarding how it obtains the financing it need to support the long term investments. The company needs to make a decision on the appropriate mix of equity and debt financing the firm will use for its operation. Apart from that, attention should also be given on how and where to raise the money.

For this purpose the company has to address the expense associated with raising long term financing called the cost of capital. Choosing among lenders and among loan types should be should be done with utmost care.

Working Capital Management: Working capital refers to the company's short-term assets, such as inventory and its short term liabilities , such as debt to the suppliers. Managing the working capital is a company's dad-to-day activity that ensures the company has sufficient resources to continue its operation and avoid costly investments.

This can be managed by addressing the following points:

Amount of inventory to be kept in hand

Selling on credit to customers

Obtaining any needed short-time financing.

NON FINANCIAL issues

Non-financial issues of a company are of equal importance to a company are as financial issues. They are easier to understand and measure. They are characterized by the following.

There is a closer link to long-term organizational strategies.

Drivers of success in many industries are "intangible assets" such as intellectual capital and customer loyalty.

non-financial measures can be better indicators of future financial performance

The company need to be aware of the following non-financial issues:

MARKETING EFFECTIVENESS

The company performance can be measured by observing the trends in the market share.

Total number of customers of a company indicates how well it is performing

By observing the client contact hours per sales person, we can get a measure of how well it has attracted it customers.

SERVICE QUALITY

It measures the proportion of business repeated

Gives a measure of client turnover

Customer waiting time can be observed to provide better service

Delivery time should be as less as possible

PERSONNEL

High staff turnover indicates that a company is doing well and meets the basic employee needs.

Training time per employee can be measured

Day lost through absenteeism should be minimised

Number of complaints received indicates the whether a company is doing well or not.

PRODUCTION PERFORMANCE

Number of suppliers- More the suppliers better is the image of the company.

Manufacturing lead times should be less in order to increase production

Output per person shows the efficiency of the employees

Adherence to delivery dates should be met for the good will of the company

USE OF REAL OPTION IN PROJECT APPRAISAL

In reality, depending on what actually happens in future, there will always be ways and options to modify a project. These options are called as real options because they involve real assets. There are many of these options available. The way a product or service is priced, manufactured, advertised and produced can all be changed using these options. Few of these real options are discussed below:

Option to Expand:

This option is of importance particularly if we find a project that has positive NPV. The company then needs to find out if the project can be expanded to get an even larger NPV because in general, the static analysis assumes that the scale of the project is fixed.

For example: if the demand for a service or product is really higher than expected by the company, then we may consider increasing the production. If this is not possible for any reason, the company can always increase the price thereby increasing the cash flow. So finally the cash flow will be higher that the calculated value because we make an assumption that the project is static and not expanded, i.e , we underestimate the NPV.

Option to Abandon:

More often than not, the option to abandon a project is quite valuable. For example: If our project on theme park business does not even cover its own expenses, we might as well abandon the project. In this case, our discounted cash flow analysis implicitly assumes that we would keep operating. In reality if the sales demand is extremely below the company's expectations then we may be able to sell off some assets or put it to another use. The services could possibly be improved and redesigned.

Option to Sell: In reality, the company can be faced with a situation where the firm cannot cover its own cost, whereas another big player in the industry wants to take over the project. Under such circumstances, unlike the abandonment option, the company has an option to sell the project at a particular price to the company that wants to take over the project. This way the company can cover up for some of the losses it has made on the project instead of not getting anything on the amount it has invested, which is the case with the abandonment option.

Option to wait: We always consider the investment on a project as a yes or no decision. There is also a third option in this regard. The project can be postponed in hope of more favourable conditions. This is the option to wait

For example: Change in the discount rate in the future yielding a positive NPV thereby making the project feasible to undertake, which before gave a negative NPV. As long as there is some possible future scenario under which a project has a positive NPV, the option to wait is valuable.

The company has to consider these options and issues in order to make the best decision regarding the investment in to the theme park industry.

APPENDIX

The summarized balance sheet of Alice Limited is as follows:

ALICE LIMITED, SUMMARISED BALANCE SHEET

£ million

Non-current asset (net)

1,710

Current assets

630

Less current liabilities

(570)

1770

Financed by:

£1 Ordinary Shares

500

Reserves

700

1200

Medium and long term debt

570

1770

The market value of Equity (E) and Debt (D) for Alice Limited can be calculated from the Balance sheet above as follows:

Equity:

Book Value of £ 1 Ordinary Shares = £ 500 million

Therefore total number of shares = £ 500 million / £ 1 = 500 million share

The market rate of each share is 400 pence

Therefore the Market Value of Equity = 500 million share * £ 4

E = £ 2000 million

Debt:

Book Value of Debt (£ 100 bonds) = £ 570 million

Therefore number of bonds = £ 570 million / £ 100 = 57 million bonds

Market price of bonds = £ 93

Therefor Market Value of Debt = £93 * 57 million

Debt = £ 530,100,000

The percentage of Equity = 2000,000,000 / (2000,000,000+530,100,000)

= 79 %

The percentage of Debt = 530,100,000 / (2000,000,000+530,100,000)

= 21%

Appropriate calculation used in the NPV table:

Revenue calculation

Expected visitor 20,000 per day

20,000 * 365 = 7,300,000 per year.

Children 70% of 7,300,000 = 5,110,000

Adult 30% of 7,300,000= 2,190,000

The price of admission

Children £15

Adult £25

Hence total revenue per year = [(5,110,000 * 15) + (2,190,000 * 25)]

= £ 131,400,000

Food & Drinks:

Expected revenue from food & drink £ 10/ head

Total revenue =7,300,000 * 10

= £ 73,000,000

Contribution 40% of 73,000,000 = £ 29,200,000

2nd year = £ 29,200,000

Receipts rise by 5% per year compounded anually

3rd year =£ 30,660,000

4th year =£ 32,193,000

5th year =£ 33,802,650

Gifts:

Expected price £ 7 per visitor

Total revenue 7,300,000 * 7= £ 51,100,000

Contribution 45% of 51,100,000 = £ 22,995,000

2nd year £ 22,995,000

Receipts rise by 5% per year compounded annually

3rd year (22,995,000*.05) + 22,995,000= £ 24,144,750

4th year £ 25,351,988

5th year £ 26,619,587

Insurance Cost:

1st year £ 2,000,000

Increases by 5% compounded annually

2nd year 2,000,000 + 5% of 2,000,000 = £ 2,100,000

3rd year £ 2,205,000

4th year £ 2,315,250

5th year £ 2,431,013

Labour Cost:

1st year £ 35,000,000

Increases by 5 % per year

2nd year 35,000,000 + 5% of 35,000,000

35,000,000 + 1750000

= £ 36,750,000

3rd year = £ 38,587,500

4th year = £ 40,516,875

5th year = £ 42.542,719

Capital Allowance:

25% per year reducing balance on £ 300,000,000 of investment

1st year 25% of 300,000,000 = £75,000,000

2nd year = 300,000,000 - 75,000,000 = 225,000,000

25% of 225,000,000

= £ 56,250,000

3rd year 225,000,000 - 56,250,000 = 168750000

25% of 168,750,000 = £ 42,187,500

4th year 168,750,000 - 42,187,500 = 126562500

25% of 126,562,500

= £ 31,640,625

5th year 126562500 - 31640625 = 94,921,875

25% of 94921875

= £ 23,730,469

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