Cracker plc

Question 1

Cracker plc has the option to invest in a project where they convert waste into a marketable product. In order to see if the project should be embarked upon, investment appraisal is used. A cash flow has been drawn up on the attached excel worksheet using the information given, and the following assumptions have been made:

1) The previous waste disposal contract was terminated, resulting in a £60,000 cost.

2) As the contract was terminated, the £100,000 yearly cost of waste disposal is an opportunity cost and is therefore added onto the incremental cash flow statement as if Cracker plc went ahead with the project, they would be saving this money. There is £50,000 allocated to year 0 as it is stated half of the yearly payment is paid at the beginning of each year, and half at the end. Therefore the £50,000 for the beginning of year 1 is shown as year 0, and then year 1 shows £100,000, as this is the £50,000 for the end of year 1, and the £50,000 for the start of year 2, and so on.

3) The £10,000 in year 4 of the machine is the £40,000 made by selling the machine at the end of the year, minus the £30,000 cost of dismantling, cleaning and selling the machine, resulting in a profit of £10,000.

4) Sales are included at the end of the year as not stated otherwise.

5) The cost of the replacement value of material A has been calculated as twice the cost of the current book value. Materials are replaced in the year used and for cash.

6) Stock is purchased and used up before year end to keep correct levels of materials required within each year.

7) Material Zed is included as a -£10,000 opportunity cost because if the project did not go ahead the material could be used elsewhere and make an extra contribution per unit of £10. The contracted £15 per unit for the cost of material Zed is already included in additional materials, and therefore has not been added elsewhere, as this would duplicate figures.

8) Skilled labour costs are incurred at the end of the year as not otherwise stated.

9) As fixed overhead costs are an apportionment of general factory overheads, they have not been included as they would occur regardless of the project going ahead or not. £60,000 has been included as the project would cause an increase in insurance premiums.

10) Other expenses are a result of the proposed project and are assumed to be paid at the end of the years shown as not otherwise stated.

11) Tthe rental of the storage material space has been included as an opportunity cost as it is otherwise assumed that without going ahead with the project, this space would create an extra income of £20,000 in years 2 and 3.

12) Product Q is included because without the project going ahead it is assumed the production of this product would have continued. Therefore the opportunity cost of -£200,000 in years 1 through to 4 is included.

13) Depreciation is not a cash flow and is therefore not included.

14) The interest on the loan has not been included. Even though it is a cash outflow, the cost of financing is already considered in the discounting of the cash flow.

15) Unskilled labour is not included in the cash flow as it is being recorder as “idle time” and is not being used. It has therefore been assumed that unskilled labour is required regardless of if the project is invested in or not, meaning it is not a cost associated with the project.

16) The initial £400,000 of the loan is not included as the payback period of the loan is not mentioned, and therefore cannot be accounted for.

NPV, as an investment analysis tool, can be used to help accept or reject a project. If an NPV is positive the project should be accepted, and if negative, it should be rejected. As the NPV for the project has been calculated to reach the figure of £551,558.04, I would strongly advise Cracker plc to go ahead with the project, although the qualitative factors should also be considered when accepting a project.

Question 2

In making a decision regarding investment in a project, the quantitative data is crucial. However not all factors which need to be considered are numerical. Qualitative factors, which are subjective, also need to be measured by Cracker plc, in order to make the best decision possible.

The external environment can play a key role in decision making, such as the state of the economy. If a recession is occurring, expanding the business through investment may be seen as a risky option, as the demand for products are likely to decrease. Another external factor Cracker could take into consideration is legislation. They would need to be aware of any laws regarding manufacturing using corrosive waste, for example health and safety laws regarding employees, or the restrictions on usage of such materials.

Cracker plc would also need to be aware of any pressure group activity which is occurring regarding the corrosive waste, as this could cause problems in the future. They should also consider the competition of other companies, and how advance their technologies are. If, for example, another company had already produced a similar product using similar methods, Cracker plc would need to consider its success and if there is any room in the market to compete for the customer base.

Cracker plc would need to take the other materials used to make this product into consideration, for example material A. This material may be scarce or could have a bad reputation within society, meaning an alternative material would need to be found. Another external qualitative factor of the product is the customer base who would purchase the product as without them, the product would be pointless. Therefore effects on both present and future customers need to be carefully considered. They would also need to be aware of any negative or bad press they feel would be associated with their proudct. This could be done through market research before the project is invested in.

Alongside the external qualitative factors affecting an investment appraisal decision, are the internal factors. Human resources could be put under strain as changes are made to adapt the company for the new product, and therefore need to be carefully considered as a potential issue. For example, even though less units of product Q are produced when the project is conducted, no skilled employees are hired. The skilled workers who previously worked on these units would have to move departments and re-train, either on the new project, or elsewhere. They may not want their jobs to change, especially as they will be working with a corrosive waste product, which is clearly dangerous as an extra £60,000 in insurance premiums would be required due to its hazardous properties. This could result in a low staff morale, which could then lead to increased absence, lower rates of production and even a poor retention of staff, which would significantly affect the company as a whole. Therefore steps into how to keep staff motivated and interested in their work, how to deal with the new risks involved with the waste material and any machinery would need to be considered by Cracker plc, along with the cost of training staff in the new procedures.

The image of the company would be another qualitative factor which should be considered before a decision is made regarding investing in the project. Cracker plc's image with the public could be boosted by showing how they do not just ship their dangerous waste products out to another place to be dealt with, but instead that they care about the environment and are dealing with the issue themselves by actually turning it into something useful. However, this could also be a negative factor as people who live in close proximity to the factory may not want this corrosive material being used on their doorstep, especially as it is not bringing the area any benefits in the area of employing more staff.

The local community are just one of many stakeholders who the proposal could affect. By considering the affected parties Cracker plc would be making sure they knew all of the effects they were causing, and prepare for them all. For example, if the shareholders in the company do not want to the project to go ahead and Cracker plc do so, they may sell their shares, which could result in a decrease in the share price, and result in financial problems for Cracker plc. Suppliers are another stakeholder who would be affected by the project, and should be taken into consideration, such as losing good relations with the terminated waste disposal contract.

By investing in a project Cracker need to consider whether the companies objectives are fulfilled, both in the long term and short term. If the companies objectives are to continue in production for a certain number of years, or until they reach a specified profit level, then the project may not be for them, although if it is profitable immediately and popular with customers, workers, and other stakeholders, then passing the opportunity of the project up would appear to be a foolish move.

Cracker plc should be completely aware of the qualitative issues when deciding on investing in a project. By using statistical analysis of figures and focusing solely on profit, other crucial and potentially major factors could be ignored, such as the internal aspects of the company, including how all stakeholders would be affected, including the local community, shareholders, employees and customers. Also external factors such as the economy, laws and legislation, pressure groups and competition need to be looked at. The company's reputation can also be greatly affected by change, and so by taking into account each of these aspects, alongside the financial analysis, the appropriate decision can be drawn.

To what amount could the contract termination payment alter before your advice would change?

As the NPV for the proposed project is £551,558.04, Cracker plc would be advised to go ahead with the investment, as any positive NPV is suggested to be invested in, and this figure is high. In order for my advice to change with regards to the cost of terminating the waste disposal contract, the figure would have to significantly increase from £60,000 to, at least, a few hundred thousand. For example if the termination cost was raised to £300,000, which in itself is fairly excessive, then the NPV would decrease to £221,558.04. This is still a significantly high NPV, even if the qualitative factors would cause issues. Therefore in order to reject the project the cost of terminating the waste disposal contract would have to change by a largely considerable amount.

Question 3

Investment appraisal is used to look at the potential financial rewards made in comparison to the cost of investing in a particular project. There are a number of methods which can be used to measure the strength of investing in a project including the payback method, the average rate of return (ARR), Net present value (NPV) and the internal rate of return (IRR).

By looking at the net present value of the project, the future cash flow is calculated. If this figure is positive it is suggested to go ahead with the project, and to reject it if is a negative value. A merit of NPV is that is clearly shows in monetary values how much profit can be made, whilst keeping in mind the size of the investment. However, in comparison to the internal rate of return, these figures are only easily understood if the reader has some knowledge of NPV. The IRR approach shows what discount rate would be needed in order to make the NPV zero, showing what present value of a future cash flow is needed to be equal to the initial investment.

Both the net present value and the internal rate of return techniques are discounting cash flow methods. This means they take into account the time value of money, which shows how a pound today is worth more than a pound in the future. This can be seen as a merit of both approaches as they include macro economical issues such as inflation, and realise that money has a changing value. NPV incorporates a discounting factor on the cash inflows and outflows of a project, allowing for the time value of money to be considered. This discount factor allows easy adaption of the discounting rate, which can change, especially if a project is spread over a long period of time. However this discounting figure is an estimation, and therefore if this is calculated incorrectly, the NPV can be incorrectly calculated.

IRR is calculated in terms of a percentage which allows easy comparison of the profitability of investments, meaning the higher the IRR, the better the return of the projects. Therefore a merit of the IRR approach is the ease in which projects can be ranked. Managers may prefer to use this method in comparison to NPV as a percentage is often easier to communicate, especially if the people involved have little knowledge of investment appraisal techniques. NPV can seem complicated and longwinded to an inexperienced individual, where as the IRR is not.

If a number of projects are available to accept, and not mutually exclusive, NPV allows maximisation of shareholder utility. NPV is also seen as the most suitable decision criteria for projects which are mutually exclusive, meaning one project cannot be taken up if the other is. When using IRR to evaluate two mutually exclusive projects, the results can often be misleading, as the IRR does not take into account the scale of investment, where as NPV does. Neglecting the size of the investment could result in a company selecting an appealingly high IRR from a small project, ignoring the smaller IRR of a larger investment which could result in a higher net cash flow. As IRR uses a percentage and ignores the scale of the investment, ranking problems can occur and the wrong project could end up being selected. Therefore NPV is the preferred choice in ranking mutually exclusive projects.

When using NPV, non- conventional cash flows are easily dealt with. A Non- conventional cash flow is when cash inflows and outflows can occur with more than one change in signs, such as a cash outflow, followed by an inflow, and then followed by an outflow. On the other hand, when using the IRR to deal with non-conventional cash flows, multiple solutions can arise, which can be confusing and misleading, resulting in the wrong investment choice being made.

NPV is in the present value, and shows how much the future of a project is worth in terms of the value of money at this point in time. Additivity can take place, meaning if a company has the choice of grouping a number of non mutually exclusive project, the NPV's can be easily added together to get an overall figure in the current value of money, allowing the selection of the best combination. This cannot occur with IRR as the rate is a percentage.

Both Net Present Value and the internal rate of return are commonly used investment appraisal techniques, both of which take into account the time value of money. NPV appears to have more merits than IRR. Having an easily adaptable discount rate, NPV can easily be altered is needed. NPV also tends to deal with mutually exclusive projects with a more accurate approach, as IRR can result in misleading statistics. NPV also deals with non- conventional cash flows in a suitable way, and additivity can occur, allowing the optimal choice of project combinations to be selected. IRR can create multiple percentages when non-conventional cash flows occur and does not allow additivity as the figure is in percentage form. IRR is seen to have few merits in comparison to NPV. However, it is much simpler to understand for people inexperienced in investment appraisal methods. IRR is more suitable in comparing investments in similar size projects with similar inflows and outflows, as this allows a more consistent comparison. Both appraisal methods are often used closely together, and often lead to the same decisions, meaning the flaws of one method can be strengthened by the other method, resulting in a well researched investment decision. Before investing in the project though, it is strongly advised to consider any qualitative factors which may have an impact on the decision.

Bibliography

Arnold, Glenn. Corporate Financial Management, 4th Edition. London: Pearson education limited, 2008.

Bodil, Dickerson, B.J. Campsey & Eugene F. Brigham. Introduction to financial management, 4th edition. Fort Worth, Texas : Dryden Press, 1995.

Lumby, Stephen. Investment appraisal and financial decisions, 5th Edition. London: Chapman & Hall, 1994.

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