Report to the board of directors (BoD), Grape Co
Introduction
This report evaluates, and provides a justification and decision, on whether Grape Co should pursue Project Wan or Project Lan, based on the important factors identified by the company, namely the returns generated by the projects, the projects’ risks and non-financial aspects.
Evaluation
Financing
Using forward markets to hedge the expected receipt in six months’ time results in the higher receipt equalling Y$25,462,000 approximately. If the money markets hedge is used the receipt is Y$25,234,936 (appendix 1).
Using forward markets to hedge the expected receipt would therefore minimise the amount of debt borrowing. However, the amount receivable from the money markets hedge is based on the annual bank investment rate available to Grape Co of 2.4%. Grape Co may be able to use the funds borrowed to generate a higher return than the bank investment and therefore using money markets to undertake the hedge may be financially advisable. Grape Co should investigate any opportunities for higher income, but based on the current results, the forward market hedge is recommended to minimise the amount of debt finance needed.
Minimum amount of debt borrowing required is Y$24,538,000 approximately.
Project returns and risk
|
Project Wan |
Project Lan |
Base case net present value (NPV) (in six months’ time) |
Y$5,272,000 (appendix 2a) |
Y$5,100,000 (appendix 2a) |
Adjusted present value (APV) |
Y$6,897,218 (appendix 2b) |
Y$6,725,218 (appendix 2b) |
Project duration |
3.04 years (appendix 2c) |
2.43 years (given) |
Project Wan’s and Project Lan’s base case NPVs and APVs are similar to each other, with Project Wan expected to yield a small amount in excess to the yield expected from Project Lan. However, Project Lan’s project duration is significantly lower. This is because a higher proportion of Project Lan’s cash flows come earlier in the project’s life, compared to Project Wan. There is more certainty to earlier cash flows and this is reflected in the lower duration for Project Lan. Project Lan’s risk is lower than Project Wan.
In estimating the base case NPV and APV for Project Wan, it is assumed that the cash flows are known with reasonable certainty and the inflation rates will not change during the life of the project. It is also assumed that the future exchange rate between the Y$ and the £ will change in accordance with the purchasing power parity differential. Furthermore, it is assumed that the prices and costs related to Project Wan will increase in line with inflation during the six months before the project starts. For Project Wan, it is assumed that the initial working capital requirement is funded by the company and not from the funds raised from the subsidised loan, similar to the assumption made for Project Lan. However, for both projects, Grape Co needs to consider, and take account of, the opportunity costs related to this.
In terms of the Project Wan’s discount rate, it is assumed that the given discount rate accurately reflects the business risk of the project.
Whilst this level of detail is not provided for Project Lan, it is assumed that similar assumptions will have been made for Project Lan as well. In the case of both projects, Grape Co should assess the accuracy or reasonableness of the assumptions, and if necessary, conduct sensitivity analysis to observe how much the projects’ values change if input variables are altered.
Notwithstanding the assumptions and caveats made above, it would appear that Project Lan would be preferable to Project Wan, given that it has a similar APV but a significantly lower risk.
Nevertheless, there may be good strategic reasons why Grape Co may select Project Wan over Project Lan. For example, these reasons may include providing access to new markets, enabling Grape Co to erect barriers to entry against competitors or looking at follow-on opportunities as possible real options.
Justification
Due to the substantially lower risk (as measured by the project duration) and similar APV, it is recommended that Project Lan be selected by Grape Co. It is also recommended that forward markets are used to hedge the income expected in six months’ time to part fund the project. This would minimise the debt borrowing needed.
However, this decision is predicated on the fact that the implications of the assumptions and the wider strategic reasons discussed above have been carefully considered by Grape Co.
Report compiled by:
Date
(Note: Credit will be given for alternative and valid evaluative comments)
(Max 8 marks)
(Maximum 7 marks if no considered justification given)
Appendices:
Appendix 1 (Part (b) (i)):
Expected receipt in six months’ time, using forward markets
€10,000,000 × 2.5462 = Y$25,462,000
Expected receipt in six months’ time, using money markets
€10,000,000/ (1 + 0.022/2) = €9,891,197
€9,891,197 × 2.5210 = Y$24,935,708
Y$24,935,708 × (1 + 0.024/2) = Y$25,234,936
Minimum amount of debt borrowing Grape Co would require
Y$50,000,000 – Y$25,462,000 = Y$24,538,000
(4 marks)
Appendix 2a (Part (b) (ii)): Projects Wan and Lan, base case net present value, in six months’ time
Base case net present value before considering financing side effects. All figures are in Y$000s.
Year |
1 |
2 |
3 |
4 |
5 |
Sales revenue (w1) |
|
17,325 |
34,304 |
62,890 |
33,821 |
Less: Production costs (w2) |
|
(6,365) |
(11,584) |
(24,095) |
(9,546) |
Component costs (w3) |
|
(3,708)
––––––– |
(5,670)
––––––– |
(11,877)
––––––– |
(4,578)
––––––– |
Cash flows before tax |
|
7,252 |
17,050 |
26,918 |
19,697 |
Tax (w4) |
|
1,050 |
(1,535) |
(3,977) |
(1,721) |
Working capital |
(1,733) |
(2,547) |
(4,288) |
4,360 |
4,208 |
Plant purchase and sale |
(50,000)
––––––– |
––––––– |
––––––– |
––––––– |
10,000
––––––– |
Net cash flows |
(51,733)
––––––– |
5,755
––––––– |
11,227
––––––– |
27,301
––––––– |
32,184
––––––– |
Base case present value of cash flows (discounted at 10%) |
(51,733)
––––––– |
5,232
––––––– |
9,279
––––––– |
20,512
––––––– |
21,982
––––––– |
Approximate, base case net present value (NPV) of Project Wan = Y$5,272,000.
Base case net present value (NPV) of Project Lan
= Y$(8,450,000 + 19,360,000 + 22,340,000 + 4,950,000) – Y$50,000,000 = Y$ 5,100,000
Workings:
Working 1 (w1): Sales revenue
Year |
1 |
2 |
3 |
4 |
Pre-inflated revenues (Y$ 000s) |
15,750 |
28,350 |
47,250 |
23,100 |
Inflation |
× 1.11 |
× 1.12 |
× 1.13 |
× 1.14 |
Post-inflated revenues (Y$ 000s) |
17,325 |
34,304 |
62,890 |
33,821 |
Working 2 (w2): Production costs
Year |
1 |
2 |
3 |
4 |
Pre-inflated production costs (Y$ 000s) |
6,120 |
10,710 |
21,420 |
8,160 |
Inflation |
× 1.041 |
× 1.042 |
× 1.043 |
× 1.044 |
Post-inflated production costs (Y$ 000s) |
6,365 |
11,584 |
24,095 |
9,546 |
Component costs are not inflated, but future exchange rates are based on purchasing power parity (PPP).
Working 3 (w3): Component cost
Year |
1 |
2 |
3 |
4 |
PPP multiplier |
3.03 ×
1.04/1.02 |
3.09 ×
1.04/1.02 |
3.15 ×
1.04/1.02 |
3.21 ×
1.04/1.02 |
Forecast Y$ per £1 |
3.09 |
3.15 |
3.21 |
3.27 |
Component cost (£) |
1,200 |
1,800 |
3,700 |
1,400 |
Component cost (Y$) |
3,708 |
5,670 |
11,877 |
4,578 |
Working 4 (w4): Tax
Year |
1 |
2 |
3 |
4 |
Cash flows before tax |
7,252 |
17,050 |
26,918 |
19,697 |
Tax allowable depreciation |
(12,500)
––––––– |
(9,375)
––––––– |
(7,031)
––––––– |
(11,094)
––––––– |
Taxable cash flows |
(5,248)
––––––– |
7,675
––––––– |
19,887
––––––– |
8,603
––––––– |
Tax payable (20%) |
(1,050) |
1,535 |
3,977 |
1,721 |
(12 marks)
Appendix 2b (Part (b) (ii)): Projects Wan and Lan, adjusted present value (APV), in six months’ time
Issue costs = 3/97 × Y$24,538,000 = Y$758,907
Annual tax shield = 2.1% × Y$24,538,000 × 20% = Y$103,060
Annual interest saved on subsidised loan = 2.9% × Y$24,538,000 × 80% = Y$569,282
Annuity factor, years 1 to 4 at 5% interest = 3.546
Present value of the tax shield and loan subsidy benefit = (Y$103,060 + Y$569,282) × 3.546 = Y$2,384,125
Project Wan APV |
Y$ |
Bas e case NPV of Project Wan (appendix 2a) |
5,272,000 |
Issue costs |
(758,907) |
Present value of the tax shield and loan subsidy benefit |
2,384,125
––––––––– |
APV |
6,897,218
_________ |
Project Lan APV |
Y$ |
Base case NPV of Project Lan (appendix 2a) |
5,100,000 |
Issue costs |
(758,907) |
Present value of the tax shield and loan subsidy benefit |
2,384,125
–––––––––– |
APV |
6,725,218
__________ |
(6 marks)
Appendix 2c (Part (b) (ii)): Project Wan’s duration based on its base case present values of cash flows
Project Wan
Year |
1 |
2 |
3 |
4 |
PVs × years |
5,232,000 × 1
= 5,232,000 |
9,279,000 × 2
= 18,558,000 |
20,512,000 × 3
= 61,536,000 |
21,982,000 × 4
= 87,928,000 |
Total PVs × time = 173,254,000 approximately
Total PVs = 57,005,000 approximately
Project Wan duration = 173,254,000/57,005,000 = 3.04 years
(2 marks)
(Professional marks for part (b) 4 marks)