Finacial Management and Investment Opportunities - Essay Example

a) A Critical Evaluation of Techniques for the Appraisal of Long Term Investment Opportunities To perform an evaluation of Techniques for the Appraisal of Long Term Investment Opportunities author elected a recent example of the long-term investment made by governmental institution (here and after referred to as government department (A)). The objective of the investment project(s) elected is to provide modern office accommodation for department (A)'s staff in a manner which represents value for money. Investment decision involves considering a number of competing projects to decide which represents a best investment in terms of value for money. The investment decision before us is significant in that it concerns cash outflows more than cash inflows as an investment in constructing/repairment of office premises used mainly (but not solely) for the accomodaring of department (A)'s employees normally would. Therefore, as a matter of investment objectives, the study turns to somewhat outrule the relevance of Payback Period, Internal rate of return (IRR) and Overall rate of return (ORR) investment appraisal techniques and invites to focus on Life-Cycle/Whole life Cost Analysis (LCCA/WLCA), NPV, Net Benefits (NB) and Net Savings (NS), Benefit-to-cost ratio (BCR) and Savings-to-investment ratio (SIR) appraisal techniques. Term 'somewhat' in this case refers to the existence of profit-bearing or cash inflow-bearing opportunities connected with letting office space to another governmental institution (department (A)) for a rent paid yearly. 1. Expoloration of appraisal techniques. There are many methods available to calculate specific economic performance measures. Used appropriately, these methods allow the investor to analyze the economic consequences of particular decisions and fairly evaluate alternative approaches. The various economic analysis methods include: Life-Cycle Cost Analysis (LCCA) Net Benefits (NB) and Net Savings (NS) Benefit-to-cost ratio (BCR) and Savings-to-investment ratio (SIR) Internal rate of return (IRR) Overall rate of return (ORR) Discounted payback (DPB) and Simple payback (SPB) Net Benefits (NB) and Net Savings (NS) are analytical methods used to describe time-adjusted economic benefits or savings between competing alternatives. NB is used to examine how costs of competing alternatives impact investment opportunities (e.g. real estate income or factory output) measured in positive outcomes relative to a base case. The NS method is the NB method recast to fit the situation where there are no important benefits in terms of revenue, but there are reductions in future costs (savings). Benefit-to-cost ratio (BCR) and Savings-to-investment ratio (SIR) are numerical ratios whose size indicates the economic performance of an investment. For example, a BCR of 1.5 means that one can expect to realize $1.50 for every $1.00 invested in the project over and above the required (baseline) rate of return. A primary application of BCR and SIR is to set funding priorities among competing projects when there is a limited overall program budget. Internal rate of return (IRR) is a measure of the annual percentage yield on investment. The IRR is compared against the investor's minimum acceptable rate of return to determine the economic attractiveness of the investment. This often misunderstood method is primarily used in Pro forma analysis in industrial and financial circles. Overall rate of return (ORR) is the annual yield from a project over the study period, taking into account reinvestment of interim receipts. Project earnings and earnings from reinvestment are accumulated to the end of the study period and set equal to the present value of cost to compute the ORR. This method offers another means of analyzing and ranking the economic performance expectations of competing alternatives. Discounted payback (DPB) and Simple payback (SPB) measure the time required to recover investment costs. If one ignores the time value of money (assume a zero discount rate), the method is called "simple payback". If one takes into account the time value of money (assume a positive discount rate), the method is called "discounted payback". DPB is a more accurate measure of payback than SPB. As a rule, costs can be more readily quantified than benefits because they normally have currency amounts attached. We should say that benefits are difficult to account for because they often tend to have more intangibles. However, in analyses, benefits should be as important as costs and deserve to be brought to the attention of decision makers. 2. Case study. Economic situation 1. Background Information. A government department (A) owns the freehold of a 2000 m2, 1960's office block on the outskirts of the city. It lets 500 m2 to another government department (B) under a memorandum of terms. Department B continues to occupy the premises, with Department A's permission, although the current memorandum of terms has expired. Department A occupies the remainder. Enquiries of the local authority have confirmed that planning consent for conversions of the buildings for high density, high quality residential development would be granted. Department A's current accommodation is poor; a staff survey has revealed widespread dissatisfaction with its facilities. Managers are now exploring the options for providing future accommodation needs. OBJECTIVES The main aim of Department A is to provide modern office accommodation for its staff in a manner which represents value for money. OPTIONS A number of options are being considered, including relocating the activities of this branch to the Department A's head office. For this example, only two will be considered in detail. Option 1. New office block Department A moves into 1500m2 of a new city centre office block, to be completed in the near future, situated next door to a rail and bus terminus. The location is seen as one that will improve markedly over the next couple of years or so and consequently, rental values are expected to grow faster than the rate of inflation over this period. The developer would be prepared to accept a fifteen-year full repairing and insuring lease for the property, with a tenant's option to break at the end of the 10th year, without penalty. The initial rent can be agreed today at 240,000 per annum subject to upwards-only rent reviews every 5 years. Department A's consultant surveyors have confirmed that the rent and other terms generally reflect current market conditions. Option 2. Re-use existing vacant government office space Department A moves to a vacant office property currently leased to another department and surplus to their requirements. The property, known as Crown Building, comprises a 1500m2 modern city center office block. The location is similar to that of the new city centre property outlined in Option 2 above. The passing rent is lower at 200,000 as it is a second hand building with a more basic specification, but growth assumptions are similar. The existing 15 years' lease has 5 years left to run and can be renewed under the Security of Tenure provisions of the Landlord and Tenant Act. The Owning Department's agents advise that the cost of disposal or surrender will be equivalent to the rent and running costs for the remaining period of the lease. Option appraisal The Department initially performs a cost-effectiveness analysis on the three options. Table 1 shows the results of this analysis. Initial appraisal findings (table 1) The cost effectiveness analysis shows that option 2, the re-use option, provided significantly better value. CONCLUSION In this example, cost effectiveness analysis is sufficient to make an appropriate choice between investment opportunities.. Valuing its additional benefits further improves the case for developing a solution based on Option 2. This example illustrates some specific aspects of accommodation appraisals, as well as introducing benefits valuation in the appraisal process. Table1 Option 1. New city centre block1 Capital costs 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Rent paid 1782 231 226 220 215 273 266 260 254 247 2733 266 260 254 247 Removals 250 Tenant's compensation 120 Running cost Rates 128 131 135 138 141 145 149 152 156 160 164 168 172 177 181 Repair 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Utilities 85 85 85 85 85 85 85 85 85 85 85 85 85 85 85 Oppr-ty cost 295 290 286 281 277 0 0 0 0 0 0 0 0 0 0 Business costs 90 90 90 90 90 90 90 90 90 90 90 90 90 90 90 Cash outflow 796 848 841 834 828 613 610 607 605 602 632 629 627 625 8734 NPVof cash outflow5 782 805 772 739 709 507 488 469 451 434 440 424 408 393 503 Total = -8,732* *(also included: Fitting out, telecoms, removals - 250, Tenants' compensation - 120 which are the costs incurred at the base year) Option 2. Re-use of vacant governmental building In thousands of pound sterlings Capital costs 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Rent paid 198 193 188 183 179 228 222 217 211 206 228 222 217 211 206 Removals 750 Tenant's compensation 120 Running cost Rates 128 131 135 138 141 145 149 152 156 160 164 168 172 177 181 Repair 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Utilities 85 85 85 85 85 85 85 85 85 85 85 85 85 85 85 Oppr-ty cost 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Business costs 90 90 90 90 90 90 90 90 90 90 90 90 90 90 90 Cash outflow 500 498 496 494 492 543 541 538 536 534 559 NPVof cash outflow6 492 473 455 437 422 450 432 416 400 385 389 Total : -6,094* *(also included: Fitting out, telecoms, removals - 750, Tenants' compensation - 120 which are the costs incurred at the base year). Economic situation 2. Background Information and Objectives are the same. Options. Option 1. Build a new office block Department A develops a project and builds 3000m2 city centre where it will occupy 1500m2 and will let for lease 1500m2. We take the rent and leasing terms just the same as in option 1 Ex. 1 for simplicity. Costs of development of design and whole life costing planning (WLCP) will be included in capital costs and regarrded as zero costs (not disclosed separately). No specific design developments will be made. Option 2. Build a new office block Department A develops a project and builds 3000m2 city centre where it will occupy 1500m2 and will let for lease 1500m2. We take the rent and leasing terms just the same as in option 1 Ex. 1 for simplicity. Costs of development of design and whole life costing planning (WLCP) will be included into capital costs of construction but disclosed separately. Design development will include three basic features: Improved disabled access, Improved parking, Improved flooring. Valuing benefits. The differences between the option 1 and 2 in that the latter provides for additional benefits and cost savings. Realizable in the long run those time/cost savings accrue to the economic benfits of the leasee. The model is sought to demonstrate that WLCP on the design stage may insure cost saving inattainable otherwise. CONCLUSION In this example, cost effectiveness analysis is made as regards two construction projects. The first project is taken as symbol of the lack of motivation in cost optimisation. The second project includes WLC analysis implemented at design stage. This brings in three cost saving initiatives (thus limited number taken for simplicity). The calculations evidences that even during first 15 years period the initiatives developed contribute to the better value for money of the rentable area. The owner of the building alone receives 0.657 mil NPV from additional benefits. The [other] leasee also benefits from the capacities provided for. The bottom line is that the leasee is interested in renteable area with such additional benefits and will be more inclined to prolong tenant's agreement. Option 1. Capital costs 10,000 payable within a year (no discounting) Cash inflow (rent) 3,670*2 = 7340 Option 2. Capital costs 10,000 + (Rubber Flooring costs - VCT flooring cost) + Improved disabled access + Expanded Parking Area = 10,000 + 14.25 + 10 + 50 = 10,074.250 payable within a year (no discounting) Capital costs + WLCP = 10,104.25 Cash inflow (rent) 3,670*2 = 7340 COST AND BENEFIT ANALYSIS Option 2. Costs 796 848 841 834 828 613 610 607 605 602 632 629 627 625 8737 Add. Benefits Improved disabled access 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 Commut. time.(visitors)8 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30 Improved flooring 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 Net cost 746 798 791 784 778 563 560 557 555 553 582 579 577 575 823 NPV 3.5% 733 776 725 694 665 464 446 428 411 396 403 387 772 358 496 Total: -8075 To compare: ex. 1 option1 Total = -8,732. Benefits accrued (in 'real money' valuation) = 0.657 mil* The same value accrued to both leasees (owner and actual leasee) of 1500m2 of area. b) Financing Decisions. The Effect of Leverage in Firm Value Both the cost of capital approach and the APV approach make the value of a firm a function of its leverage. It follows directly, then, that there is some mix of debt and equity at which firm value is maximized. Here we consider how best to make this link. Cost of Capital and Optimal Leverage In order to understand the relationship between the cost of capital and optimal capital structure, we rely on the relationship between firm value and the cost of capital. The value of the entire firm can be estimated by discounting the expected cash flows to the firm at the firm's cost of capital. The cash flows to the firm can be estimated as cash flows after operating expenses, taxes and any capital investments needed to create future growth in both fixed assets and working capital, but before financing expenses. Cash Flow to Firm = EBIT (1-t) - (Capital Expenditures - Depreciation) - Change in Working Capital The value of the firm can then be written as: t=1 Value of Firm = CF to Firmt/(1+WACC)t t=n and is a function of the firm's cash flows and its cost of capital. If we assume that the cash flows to the firm are unaffected by the choice of financing mix and the cost of capital is reduced as a consequence of changing the financing mix, the value of the firm will increase. If the objective in choosing the financing mix for the firm is the maximization of firm value, we can accomplish it, in this case, by minimizing the cost of capital. In more general case where the cash flows to the firm are a function of the debt-equity mix, the optimal financing mix is the mix that maximizes firm value9. We now proceed to the example showing at what level the of [long-term] debt the cost of capital is the lowest and what may happen to the value of shareholders equity at the specified level of cost of capital. The Boeing's cost of capital10. The cost of capital, which is 9.79%, when the firm is unlevered, decreases as the firm initially adds debt, reaches a minimum of 9.16% at 30% debt and then starts to increase again. Cost of Equity, Debt and Capital, Boeing Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Beta 0.87 0.93 1.01 1.11 1.25 1.48 1.88 2.56 3.83 7.67 Cost of Equity 9.79% 10.14% 10.57% 11.13% 11.87% 13.15% 15.35% 19.06% 26.09% 47.18% Cost of Debt (Aftertax) 3.38% 3.58% 4.06% 4.55% 6.50% 7.00% 8.50% 10.35% 10.62% 10.83% Cost of Capital 9.79% 9.48% 9.27% 9.16% 9.72% 10.07% 11.24% 12.97% 13.72% 14.47% Firm Value and Cost of Capital The reason for minimizing the cost of capital is that it maximizes the value of the firm. To illustrate the effects of moving to the optimal on Boeing's firm value, we use the model described earlier designed to value a firm in stable growth. Firm Value = FCFF Expected year next/ (WACC - g) where g = Stable growth rate We begin by computing Boeing's current free cash flow using its current earnings before interest and taxes of $1,753 million, its tax rate of 35% and its reinvestments in working capital and net fixed assets: EBIT (1- tax rate) = $ 1,138 + Depreciation & Amortization = $ 1,517 - Capital Expenditures = $ 1,584 - Change in Working Capital = $ (105) Free Cash Flow to the Firm = $ 1,176 The market value of the firm at the time of this analysis was obtained by adding up the estimated market values of debt and equity: Market Value of Equity = $ 32,595 + Market Value of Debt = $ 8,194 = Value of the Firm $ 40,789 Based upon the current cost of capital of 9.17%, we solve for the implied growth rate. Growth rate = (Firm Value)(Cost of capital) - CF to Firm/(Firm Value + CF to Firm) = 0.611 = 6.11% Now assume that Boeing shifts to 30% Debt and a WACC of 9.16%. The firm can nowbe valued using the following parameters. Cash flow to Firm = $1,176 million WACC = 9.16% Growth rate in Cash flows to Firm = 6.11% Firm Value = $40,990 million The value of the firm11 will increase from $40,789 million to $40,990 million if the firm moves to the optimal debt ratio. Increase in firm value = $ 40,990 mil - $ 40,789 mil = $201 million With 1010.7 million shares outstanding, assuming that stockholders can evaluate the effect of this refinancing, we can calculate the increase in the stock price. Increase in stock price = Increase in shares value/Number of stocks outstanding = 201/1010.7 = $0.20 Since the current stock price is $32.25, the stock price can be expected to increase to $32.45, which translates into a 0.62% increase in the price. Annex 112. EXPLANATIONS AND ASSUMPTIONS 1. Rent is regarded at its real market value. In this example, rent is reviewed every five 5 years. This means that the real rent level is eroded by inflation between rent reviews; inflation is assumed to be 2.5%, as is the market rental growth rate (i.e. rents rise in line with inflation). For example, in year 6, actual rent (the passing rent) catches up with the market rent (the calculation is 60,000*1.025^4.5=67,052). 2. The method we use to deal with rental cash flows - convert the nominal cash flow into the real terms by deflating the rent by the rate of inflation and then discount at the appropriate discount rate. 3. Rent-free period: The tenant will enjoy a rent-free period of 6 months in year 1 (as part of the terms negotiated for the new lease). 4. Running costs inflate annually and therefore can be expressed in real terms relating to year 1. 5. Cash flows and net present value of costs. The net present value of costs is shown using the 3.5% discount rate. 6. Rental growth = 10% during the first two years, 2.5% thereafter; this is only realised at the rent reviews. For example in year 6, the calculation for the rent paid is 240,000*1.1^2*1.025^3. 7. Initial rent free period of 3 months. 8. Tenants' compensation under the Landlord and Tenants Act 1954 is based upon twice the rateable value on the assumption that there has been continued occupation of the existing premises for more than 14 years. 9. Timing of cash flows: all cash flows are to the midpoint of the year. 10. Opprtunity costs: costs of holding Crown Building vacant rent and running costs until lease expiry. Rent passing 200,000. Running costs when vacant 100,000 11. Removals: Costs of fitout/telecoms/removals to move to a new location. Costs are incurred at the basic year and are not discounted further. 12. Total Cash Outflow includes 'Dilapidations on lease expiry' paid at te amount of 250,000 at the year 15 in Option 1 and 2. Annex 2. EXPLANATIONS AND ASSUMPTIONS 1. Flooring Benefits FLOORING LIFE CYCLE COST COMPARISONS Costs Per m2. Rubber VCT Sheet Vinyl Carpet - High Grade Installation 7.9 3.15 7.9 11 7 1/2 yrs 11 20.5 25.3 37.9 15 yrs 12.6 39.5 42.6 66.3 Rubber instalation costs = 23.7 (thousands) VCT instalation costs = 9.45 (thousands) 2. Improved disabled access value is calculated assuming that additional value is attached to these benefits. 3. Reducing commuting time (visitors) assumes that it is a public building. 4. Author limeted the research to 15 years length. It is considered more appropriate for the sake of comparison since previous example is also limited to that period. Thus, present calculation might be called WLC only patrtially since it does not include salvage or disposal costs. Bibliography: Booth Rupert, Life-cycle costing. (activity-based costing examined), Management Accounting (British), June 1994 v72 n6 p10(1) Clift Mike and Bourke Kathryn,DETR STUDY ON WHOLE LIFE COSTING, February 1999 Copeland and Weston, Financial Theory and Corporate Policy, 3d edition. Deading, Massachusetts, Addison-Wesley, 1988 Fernandes Pablo, Valuation Methods and Shareholders value creation, San Diego, CA, Academic Press, 2002 Fernandes Pablo, Company Valuation methods. Most Common Errors in Valuation, WP No 99, IESE CIIF Working Paper, January 2002 FIRM VALUATION: COST OF CAPITAL AND APV APPROACHES http://pages.stern.nyu.edu/adamodar/pdfiles/valn2ed/ch15.pdf Holmes, G. & Sugden, A., (1997), Interpreting Company Reports & Accounts, 6th edition, Prentice Hall Ohlson, "A synthesis of security valuation theory and the role of dividends, cash flows and earnings", Contemporary Accounting Research, 1990, 648-676 The WBDG Cost-Effective Committee, How to Use Economic Analysis to Evaluate Facility Investment Decisions retrieved April 2005 from http://www.wbdg.org/design/use_analysis.php. http://greenbook.treasury.gov.uk/annex03.htm* *Accessed April 14 2005 Read More