Intangible factors will bring about subjectivity in project evaluations as there the values and costs are only estimates and are subject to error. An intangible issue is that the market is not certain. In the forecasted that market demand will grow at 5% p.a. Although this isn’t included in the project evaluation because it’s not an incremental factor, it may affect the company’s implementation of the chosen project. For example, if market demand increases, then the sales volume would potentially increase too. Refer to Appendix 1.6.
A primary issue is agency costs within the corporation. Because managers and shareholders do not possess the same objective set, this may influence the prevailing proposal. It may be for unethical purposes – that is, to push income up or down. An inevitable issue is that in this ‘technological’ based market, new products will be produced and improved at a rapid pace; this will influence the corporation’s future market share. The reputation and customer loyalty is another intangible factor that affects the proposals. Depreciation of the equipment is not included as there is no rate given. Although depreciation is not a cash flow, the tax implication on depreciation is. However, there are no given depreciation method or rate here which may have affected the decision in accepting proposal A. Other factors may include employees performance and service that is reflected in the sales volume – their attitude towards the sale can influence the consumer’s behaviour and ultimately, affect the sales volume of the company.
On this note, the corporation also needs to consider any implementation issues including employee tasks and financing options. The corporation could also consider leasing or renting non-current assets to use rather than purchasing it. The ultimate goal is to gain returns that compensate for the risk that is encompassed when undertaking the proposal.
In summary, in accepting proposal A, the company can work to achieve its goal in increasing its total market shares and adding value to the shareholders wealth. Because all of the projects are mutually exclusive, the selection of proposal A will automatically eliminate the other two proposals put before the company. Intangible factors may also influence the net present value of the company’s proposals – but more of them are inevitable risks which the company needs to sustain in order to achieve its goal.
CASE 2
Lisa has presented to the Board two separate proposals. The installation of automated testing equipment to inspect the final products is the first proposal. The second proposal is a completely new design for the manufacturing process.
In order to analyse which proposal should be adopted using the NPV analysis, several assumptions have been made. Assumptions made include:
- The sales revenue figure will be based on last year’s sales revenue, $8 000 000.
- The Redundancy payouts will be paid in full, in year 1.
- New operation in proposal one, reduces sales returns by 50% because there is a decrease in defected products in the final inspection by 50%.
The first proposal has a Net Present Value (NPV) of $28,087,094 (Appendix 2.1). However, in order to compare these two projects, the NPV must be calculated at the same useful life as proposal two (10 years). Therefore the NPV for proposal one, with a useful like of 10 years, is $42,051,435 (Appendix 2.1 - using Table 2, 15%, 5 years). The second proposal has a NPV of $50,146,403 (Appendix 2.2).
Both proposals have a required rate of return of 15% as the cost of capital is 15%. The first proposal has a growth rate of 8% pa in sales revenue starting in year 3. While the second proposal, sales revenue is increased by 5% in year 1 by undertaking the project which remains constant in year 2, then increases by a further 8% pa in year 3 onwards. The increase in sales revenue is taxed at 30% (tax rate applicable to GM).
The projects are mutually exclusive, where only one project can be chosen and undertaken from a group of projects. When projects are mutually exclusive, the project which has the highest positive NPV is chosen. Therefore under the NPV analysis of mutually exclusive projects, proposal two would be chosen because it has a higher positive NPV ($50,146,403 vs. $42,051,435).
When the sensitivity analysis[1] is undertaken for proposal 2, changes in sales revenue is more affected then changes then scrap value (Appendix 2.3). From the sensitivity analysis, the lower the range in NPV indicates that the NPV is insensitive to changes or errors which is what the Board will prefer when deciding which proposal to undertake. A higher range in NPV indicates that the NPV is sensitive to changes or errors. Therefore proposal two has a degree of risk to changes or errors.
Overall proposal two would be chosen because it has a higher positive NPV. Choosing the project with the highest NPV will bring additional value to existing shareholders which is consistent with our objectives. The calculated NPV of $50,146,403 means they will get the required rate of return plus $50,146,403 which adds additional value to existing shareholders – they get a share of extra value.
CASE 3
East Coast Yachts has been interested in purchasing an engine company to improve the efficiency in their supply chain and to have more control over engine features. Larissa Gerhardt, the financial manager of the company decided that Ragan Engines, Inc is a possibility. Ragan Engines, Inc has experienced rapid growth because of technology that improves fuel efficiency with very little sacrifices in performance. Larissa has asked us to do some financial evaluations of the company.
Assumptions
First off, assumptions will need to be made with the information given,
- The dividend payout ratio will remain constant at 42%
- There will be a constant earnings per share of Ragan as $5.08
- The return on equity of 25% remains constant
- Nautilus Marines Engines negative earnings per share was only due to an accounting write off and the earnings per share under normal market conditions is $1.97
- The rapid growth of Ragan will only last 5 years and then slow down to the industry average
- After Ragan’s growth declines to the industry average, it will remain at the industry average
Part 1
The information given to us is that Ragan has:
Earnings per share of: $5.08
Dividend payout ratio of: 42%
Required Return 20%
Return on equity 25%
Given this, the dividend per share of Ragan can be estimated to be 2.1336 or $2.15(Appendix 3.1)
Assuming Ragan can continue its current growth rate, the value per share of the company’s stock can be estimated to be $44.42(appendix 3.2)
Part 2
However, Dan, who was asked by Larissa to do the evaluation, believes that Ragan’s rapid growth will only last 5 years and then slow down to the industry average. Additionally, Dan believes the required return the company uses is too high and that the industry average is more appropriate. Given the information about the industry average in appendix 3, Nautilus Marines Engines negative (EPS) were the result of an accounting write off and without the write off the (EPS) for the company would have been $1.97. To make this evaluation under normal market conditions, $1.97 will be used as Nautilus’s (EPS) rather than -$0.32, which brings the Industry average (EPS) up to $1.41. The industries new figures are now:
Earnings per share: $1.41
Dividend per share: $0.41
Share Price: $16.91
Return on equity 13.00%
Required Return 17.00%
(Appendix 3.4)
The growth rate of Ragan is 14.5% and the growth rate of the industry average is 9.22% respectively. (Appendix 3.5)
Under Dan’s assumptions, the new calculated stock price is estimated to be $36.90. (Appendix 3.6)
Part 3
Ragan has a price earnings ratio of 7.26 compared to the industry average of 11.99 (appendix 3.7). The price earnings ratio shows the ratio of a company’s share to its earnings per share and is often used to estimate the value of the company’s shares. Although Ragan has a higher share price than the industry average, it still has a lower earnings per share which may seem to be abnormal, however, the reasons for the lower price earnings ratio for Ragan may be because competitors are investigating methods to improve efficiency and have substantial growth opportunities while facts state rapid growth for Ragan have already occurred and are expected to decline in the next 5 years.
Part 4
If Ragan’s growth rate declines to the industry average in the next 5 years, then logically, share price would fall which is shown in previous calculations. Assuming Dan was correct in reducing the required return to the industry average (17%) then the percentage of the stock attributable to growth opportunities is the retained earnings (58%). (Appendix 3.8) This implies a future return on equity of 15.89%. (Appendix 3.9) This is lower than the original return on equity which is expected due to the decline in growth rate.
Part 5
If Carrington and Genevieve do not sell the company, there are a number of ways to increase stock value. Stock value can be increased by either increasing returns (profit) or decreasing risk. To increase returns Ragan can increase productivity, have technology improvement or take projects with a positive Net Present Value. Several methods of decreasing risk may be to increase product range, transfer the risk or even getting supplies from different companies. These strategies may not always increase stock value as improving productivity or technology may not always be possible. Increasing product range may also change the market’s view of Ragan as being specialized engine manufacturers which could be detrimental to Ragan’s name and transferring risk to other companies may also not be available.
Part 6
After careful analysis of all the information and assuming Ragan’s growth will decline to the industry average in 5 years then the estimated stock value is $36.90.Given these assumptions, Dan should purchase Ragan which has 300,000 shares totaling the estimated price to be $11,070,000. However, the P/E ratio of Ragan being lower than the industry average may be concerning and worth looking into, for fear that there are other factors contributing to the lower P/E ratio of Ragan other than the ones already mentioned.
[1] Analysis of the effect of changing one or more input variables to observe the effects on the results (Pierson, G., R., Brown, Easton, S., R., Howard, P., Business Finance, Tenth Edition, McGraw Hill, 2009)