Capital Budgeting Case Study Essay

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Franchise



South Coast Railway is evaluating a proposal for a five-year franchise from the UK government. This proposal would be to operate a high speed commuter rail service from 2018 to 2022. The following report will examine the financials relating to this decision, and the decision-making heuristic.



Decision-Making



The decision at hand is essentially a capital budgeting decision. There are a few different ways to evaluate a capital budgeting decision. The most common is the net present value (NPV) technique. This relies on discounted future cash flows to make the decision. The principle behind the use of discounted cash flows is that money earned today can be reinvested, and because of that, a pound earned in the future is inherently worth less than a pound earned today. The value of future money decreases over time. The NPV method discounts those future cash flows back to present value, and compares then with the cash outlay (Investopedia, 2016). The basic decision-making heuristic for NPV is that a project with an NPV above zero should be undertaken, as such a project increases the value of the company. It is assumed that it does not matter what the project is in operational terms, as a business is in business to earn positive returns for shareholders.



There are a few other methods besides NPV that can be used in such a situation. A similar method is internal rate of return (IRR), which also compares discounted future cash flows to the present day outlay. The math behind IRR is the same as for NPV, but the value is expressed as a rate of return. Any return above 0 reflects a project that has a positive value. The reason a company should choose NPV ahead of IRR is that organisations have fixed amounts of capital available to invest, and as a consequence must sometimes face a situation where they are to choose the option that has the highest return. Highest return in such a situation reflects the option that adds the most value to the shareholders, not the value with the highest rate of return. A high return on a small investment is worth less in actual wealth terms than a lower return on a higher total investment. This is why NPV is superior to IRR in situations where the firm must choose between two positive but mutually exclusive options.



There are other methods of evaluating capital budgeting projects. Payback period is common. This method does not take into account the discounted value of future cash flows, but rather it assumes that shareholders want to earn a return as quickly as possible, and that managers are highly risk-averse and want the project to break even as quickly as possible for the preservation of their proverbial necks. The reason why payback period is inferior to net present value is that payback period does not take into account any cash flows that occur after the payback period. Thus, a project where the payoff is weighted towards latter years may ultimately add more value to the organisation, but would not be selected between mutually exclusive options. Again, the methodology that is best suited for meeting the criterion of enhancing shareholder wealth is net present value, whatever other benefits the other methods have (Gallo, 2014).



How to Make an NPV Decision



There are few rules that need to be taken into account when making a net present value calculation.

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The first is that the cash flows to be evaluated are the cash flows that are incremental to the decision at hand. Cash flows relating to other decisions should not be taken into account. Nor should cash flows that have already been spent -- sunk costs represent monies already gone, and thus they do not relate to the present decision. So for example, South Coast has invested £450,000 in a feasibility study. That total would not factor into this equation -- it is money already spent and it cannot be recovered, so it does not relate to the current decision.



Another issue with NPV is that the discount rate has to be determined. The discount rate is typically the firm's cost of capital. The cost of capital is normally considered to be the weighted average of its cost of debt and its cost of equity. This is the calculation that will be used here as well. The cost of capital is then used to discount the future cash flows. The reason is simply that this is the rate the firm theoretically earns on its asset base, so any future project should earn more than that.



A wildcard in this example is the impact of foreign exchange, since South Coast will be working with a German supply chain partner. That creates an exposure to foreign currency risk, in particular because of the contract nature that requires payments over a period of time. Foreign exchange rate risk will be discussed later in this report, but suffice to say there is an increased risk in the sterling-euro pairing on account of the uncertainty surrounding the Brexit vote (Chan, 2016).



The first number that has to be calculated is the cost of capital for South Coast. The formula is known as the weighted-average cost of capital. The weighted average cost of capital formula is as follows:



Source: Investopedia (2016, 2)



The market value is typically used to calculate WACC. The market value of the firm's equity is:



3.2 million * £5.56 = £17, 792,000



The market value of the firm's debt is:



7,000,000 * 1.06 = 7,420,000



The total size of the firm is £25,212,000, of which equity is 70.5% and debt is 29.5%.



The next step is to calculate the cost of debt and the cost of equity. Normally, the cost of equity will be higher than the cost of debt because equity is typically subordinated to debt. This means that equity is higher risk -- debtholders are paid out before net income, whereas equity holders only are paid out after net income. As such, equity typically carries with it higher risk and the expected return on equity therefore needs to be higher.



The cost of debt is 5%, though the effective yield is 4.717%, as derived using a bond calculator (Moneychimp, 2016). This figure reflects the fact that the bond is priced at a slight premium at present. Given the premium, the yield on the bond will be slightly lower than the coupon rate, because the bond will lose some of its value prior to maturity, as it will mature at face value.



The cost of.....

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References


Bloomberg (2016) Rates and bonds. Bloomberg UK. Retrieved November 13, 2016 fromhttps://www.bloomberg.com/markets/rates-bonds/government-bonds/uk

Chan, S. (2016) Sterling volatility hits crisis levels as three polls show Britons back Brexit. The Telegraph. Retrieved November 13, 2016 from http://www.telegraph.co.uk/business/2016/06/06/sterling-volatility-hits-crisis-levels-as-two-polls-show-britons/

Gallo, A. (2014) A refresher on net present value. Harvard Business Review. Retrieved November 13, 2016 from https://hbr.org/2014/11/a-refresher-on-net-present-value

Investopedia (2016) Capital budgeting. Investopedia. Retrieved November 13, 2016 from http://www.investopedia.com/terms/c/capitalbudgeting.asphttp://www.investopedia.com/terms/w/wacc.asp

Investopedia (2016, 2) Weighted average cost of capital. Investopedia. Retrieved November 13, 2016 from http://www.investopedia.com/terms/w/wacc.asp

Investopedia (2016, 3) Capital asset pricing model. Investopedia. Retrieved November 13, 2016 from http://www.investopedia.com/terms/c/capm.asp

MoneyChimp (2016) Bond yield calculator. Moneychimp Retrieved November 13, 2016 from http://www.moneychimp.com/calculator/bond_yield_calculator.htm

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