Investment Appraisal - Case of Wooden Post Ltd - Essay Example

Wooden Post Ltd. Introduction The paper deals with investment appraisal and analysis of three investment options suggested to WOOD POST LTD to triumph over the slowdown of the business, by applying managerial finance discipline to business strategy, defining problems relating to the use of accounting and financial processes within the organizational context and present justifiable solutions to the organizational issues within a behavioral context. Strategic Managerial Accounting tools and processes are used to consider organizational problems and formulate solutions to achieve organizational control and effectiveness for profitable investing and financial control of activities, with an understanding of business strategy and people within the organization and relating accounting to realistic case situations and to individuals within the world of business. Study of the case of ELITE HOTELS GROUP plc was done and the observations are indicated in the criteria for judging the adequacy of the solution. A vision of the WOODPOST LTD after consolidation is also conceived and presented at the end. The paper ends with a conclusion as also indicating the learning outcome. Discussion On strategic analysis of the market of WOOD POST LTD, the following three options are offered as viable long term strategies by a business consultancy firm of international reputation, to overcome the slow down of the business due to recent growth in United Kingdom market. These are: 1. Acquire the assets of suitable competitors to strengthen the total UK market share. 2. Invest in upgrading WOODEN POST's production capacity and distribution network in the west and east of United Kingdom. 3. Withdraw from the west United Kingdom market and close the facilities. The three options are discussed below in detail: Option 1: Acquire assets of suitable competitors to strengthen the total UK Market share. It is proposed to acquire London Counties, a close competitor. The details of the Proposal are indicated below in the following sequence. 1. The profile of the various competitors in the industry including that of London Counties. Exhibit - 1. 2. The terms of acquisition of London Counties. Exhibit-2. 3. The analysis of the proposal 4. Financial implications of the proposal. 5. The financial appraisal of the proposal. 6. Case study of Elite Group Hotels plc 7. Vision of the organization after the acquisition. 8. Recommendations. 9. Conlcusion. Exhibit 1 Fence Post Gate Post Construction Frames and timber Total of Market %by cubic vol. Company Treated Untreated Treated Treated WOODEN POST 20 25 24 10 21.2 London Counties 28 22 30 42 28.0 Welshpool plc 12 0 4 27 8.6 Glens 8 13 10 12 10.0 Essex 10 10 5 5 8.6 Other 22 30 27 4 23.6 % of Total Sales by cubic volume 47 25 20 8 100 Exhibit 2 Option 1 - Acquisition of London Counties The purchase price is expected to be in the region of 30m - 40m now (Year 0, 2001) and further cash flow effects might include: Established annual London Counties cash flows in a range from zero up to 40m, starting from Year 1 to 10 inclusive. Cost savings on amalgamation of up to 4m in both Years 1 and 2. Cost savings on supplies of 6m in Year 3 onwards. Sale of other London Counties assets (30m) and stock reduction (5m) which would be completed in Year 1. Upgrade of WOODEN POST's eastern UK facilities in Year 0 of 20m to complement the London Counties purchase. For investment purposes, the 'life' of the project is assumed to be 10 years. All the cash flows are expressed in 'real' terms (that is, after allowance for inflation). In view of the relatively risky nature of the project, the Finance Director of WOODEN POST asserted that the 'normal' hurdle rate of 8% 'real' should be increased to 10%. But this has produced some debate among members of the management team some of whom considered that the effective cost of capital was zero since existing cash resources will be used. Quite apart from all these factors, further investigations into the acquisition established that cash flows could be reduced by the following additional factors. Redundancy and relocation provisions (5m in Year 1) Other contingencies (up to 3m annually to Year 5) Research and development costs are expected to be necessary at 4m in Year 1 and 5m in Year 2. The unification of the Distribution network will incur 'one-time' costs of 3m in Year 1. The acquisition is horizontal and cross border acquisition, i.e., Companies operating in the same industry and similar level of production and from different states and has the following features. 1. Incidence of Economies of large scale production and large area of operation with valuable distribution channels through control of a major competitor. 2. Incidence of better opportunities for growth since the competition is reduced and consolidation of competitive position. 3. Market share is increased from 21.2% to 49.2%. 4. New markets can be explored because of better leverages. 5. Reduce risk due to less competition in buying raw materials and selling finished ones. 6. Strong management due to vast experiences of both the organizations. 7. Synergy can be better planned. 8. Reduction in unit costs due to Fixed Costs strategy and Marginal cost strategy. Some of the above features are discussed below in detail. Fixed costs strategy In the given situation, under option 1 WOODENPOST will stand to gain advantage of capitalizing on profit and cost structure through economy of scale, resulting primarily from better utilization of fixed costs and in advertisement etc, since certain critical mass of fixed investment is competitive, and if that critical mass of fixed investment is divided by the annual turnover, the larger company naturally has a lower cost as a percentage of sales.('The mind of the Strategist' Business Planning for competitive advantage,Kenichi Ohmae, 1984, Penguin Books Ltd P 132,133) Marginal Costing Strategy A product makes contribution towards the fixed costs and towards the profit. Contribution is simply the difference between the selling price and the variable cost. S - V = F + P Where, S= Sales units X Selling Price per unit F=Fixed costs V=Variable cost units X Variable Cost per unit Major features of the acquisition would involve the rationalization of some manufacturing and office facilities, and the probable redundancy of 100 staff. Significantly the Leicester manufacturing capacity could be more fully used with the enlarged WOODEN POST having nearly 80% of the market between South Yorkshire and Surrey. London Counties's expensive London headquarters would be closed and Wooden Post's Leicester headquarters would be the corporate centre of the enlarged organization. London Counties has been the largest supplier of timber posts since the 1940s. This family firm had taken opportunities during and after the World War II to develop strong links with councils in the London area. This has provided a stable market in fence and ur gateposts across a region within a 50-mile radius of London. The biggest source of profit growth had been in supplying timber frames for temporary housing after the war. This sector of the timber market has become technologically based because of the growth requirement for treating the timber against damp and the high precision of the cutting and drilling. The company had retained its market in timber frames but only through contracting out to a Scandavian firm. The family owning London Counties had used the success of the business to develop personal cultural and charitable activities and had neglected the need for investment. The impact of a weak management focus was becoming evident in a fall in market share. In addition, as perhaps as significantly, Dr Alan Forest had left the company and joined Welshpool Company (now Welshpool plc) as its Chief Executive. Dr. Forest had particular expertise in the timber frame market but had failed to convince the London Counties management board of the strategic value of investing in new technology and manufacturing more products in-house. Thus the problems encountered in London Counties are: 1. Funds flow towards non-profitable social activities like developing personal cultural and charitable activities. 2. Lack of investment planning and vision for progress 3. Lack of motivation to the managers for better planning for progress. Option 2: Investment in Upgrading WP's production capacity and distribution network The cash flow benefit from the project is assessed at around 15m annually starting in Year 3 at the earliest. The initial investment will be of the order of 50m spread over three years. The planned upgrade in year 0 of WOODEN POST's western UK facilities for an additional 20m must be made to facilitate this joint venture. The funds in flow in this case are 15m annually starting in Year 3 as against the option 1 financial results of upto 40m from year 0. The outflow required is 20m. Hence this proposal is not justified. Option 3: "Withdrawal' This might involve the closure and disposal of all the facilities in the west of the UK. Additional cash of 45m would be generated less closure costs of 14m both spread over a three-year period. This is prima-facie rejected proposal as WOODPOST is not planning for reduction of it's activities and growth. Guidance as to how to proceed A good financial manager plans for financial success considering the firm's strengths and weaknesses. The planning has to exploit the firm's strengths and keeping in view the firm's weaknesses. From the Exhibit 1, it can be seen that the market share by cubic volume will go up by 28% by acquiring the London counties. However, the Price earning ratio of London counties has not been indicated in the data to assess actual financial benefit out of the acquisition. The acquisition will help WOODENPOST to overcome the problem of transportation of raw material as well as finished products over long distances even on increased market share, which results increase in profitability of WOODENPOST. The valuable distribution channels of London Counties will help even in increase in Market share beyond 49.2 %( 21.2% of WOODEN POST PLUS 28% of London Counties). The breakeven point of WOODEN POST would come down as the fixed costs of WOODEN POST are recovered from a larger outturn increasing the Profitability, as variable costs only form the unit costs of the products beyond breakeven point. Since the raw materials are purchased in large scale, and with the decrease in the buyer's market, WOODENPOST will have better bargaining power for getting a competitive rate for the raw materials too. Due to consolidation, and consequent rationalization, there will be redundancy of 100 staff, which mean reduction in fixed cost and this will further bring down the fixed cost and the breakeven point of the WOODEN POST. Closing of London Counties's expensive Lanchester headquarters would also help in improving the profitability in WOODENPOST in London Counties' segment of business. Timing is reinforced by political and economic considerations; the current air of recession in the UK presents a favorable "window" for industry rationalization. This will eventually lead to buyers' market for raw materials and sellers market for finished products, having say both on fixing prices of raw materials and finished products, giving much leverage to the organization for profit planning. The Solution Having examined the features each of the three proposals let us now find the solution. Obviously, Option No.1 i.e., acquiring London Counties is suggested to help WOODEN POST Ltd to consolidate it's position in the market and achieve various benefits like economies of scale etc enumerated above, basically ensuring that the investment decision involves the firm making a cash outlay, with the aim of receiving in return future cash inflows. However, the results depend on how the strategic MAIS supports the analysis, selection and the strategic MAIS needs to support the analysis, selection and implementation and monitoring processes Criteria adopted for judging the adequacy of solution 1. Excellent Funds In-Flow: This will help the WOODPOST LTD to have a plan to bolster it's finances and further expansions... 2. Value the potential future cash flows Capitalized earnings - annual maintainable expected earnings compared to Required earnings yield Price/earning ratio - distributable earning compared to P/E ratio. Discounted cash flow - pre acquisition present values compared to post Acquisition present values. Sensitivity analysis. A process by which managers and management accountants Determine how changes in parameter values affect the financial results. Parameters include - discount rates, cash flows (initial investment, incremental Working capital, operating cost, selling prices, sales volume), tax rates, useful Lives, salvage/residual value, inflation rates. Grundy, T. (1998), pp123 3. Cost-benefit analysis: A Systematic comparison between the cost of carrying out a service or activity and the value of that service or activity quantified as far as possible, all costs and benefits (direct, indirect, financial and social) being taken into account.(Glossary of Management Techniques, H.M.Treasury) 4. Capitalization, i.e., the value of the present assets has to be evaluated, to assess whether the same is comparable to the total face value of shares and debentures. If the face value of shares and debentures is more than the market value of assets then it amounts to overcapitalization. Conversely, if the value of assets is more than the face value of shares and debentures, it amounts to undercapitalization. While overcapitalization has overestimation of the profile of the company, the undercapitalization has underestimation of the profile of the company in the market. As both the features have their own dis-advantages, these are to be avoided. 5. Project evaluation by segregation of costs and revenues, calculation of risk involved, determination of prospective return to the company with or without consideration of timing of income. The financial implications i.e., effect on unit costs has to be examined and in the evaluation.('Management Accounting in Practice', F.C.DE PAULA, Third U.K.edition Sir Isaac Pitman and Sons Ltd, London) Definition: The calculation of the return that a capital project will provide as a basis for go/no go decision or to enable a choice to be made between two or more rival projects. (A concise Encyclopedia of Management Techniques, Frank Finch, 1976- Heinemann-London) 6. Organization Control and Effectiveness: For survival in the long run, Organizational effectiveness is a pre-requisite and application of Profitability ratios is primarily a tool to judge organizational effectiveness, i.e. measurements which should inform the reviewers as to be level of success in achieving organizational objectives. A typical grouping of ratios is: Profitability Ratios - How the organization is allocating its resources in relation To income generated Liquidity Ratios - A sufficient amount of cash and other short term assets must Be available to pay the bills. Leverage Ratios - How an organization is financed - internally generated (Profits) or externally generated through loans and equity Activity Ratio - How efficient and productive is the organization Effectiveness includes: an output target to be reached, achieving a new standard of performance, or A more idealistic potential which would be possible if all constraints were removed (Lawlor, 1985). ORGANISATIONAL EFFECTIVENESS - compares present achievement With what could be done if resources were managed more effectively. Need to design a management accounting information system (MAIS) that Recognizes the objectives and the strategy "to provide financial and non -financial information to people within organizations to make better decisions and thereby achieve organizational control enhance organizational Effectiveness." (Wilson & Chua, 1993 p.17). The various management accounting techniques will help to check and ensure that the management judgments are tested and targeted results achieved. CONTROL is concerned not with correcting past mistakes, but directing future Activities. Thus management control consists, in part, of inducing people in an Organization to do things and refrain from doing others Sizer, 1979 Case Study Case study of ELITE HOTELS GROUP PLC was done and it is learnt that centralized organization structure, putting customers first, determination to be the best and developing proprietary attitude to the workforce will help the organization grow tremendously and glorifies the organization as also the participants. Further, the study generally organizations should not resort to reduction in capacity or selling of assets, as acquiring them at a later date would involve very huge funds out-flow. Vision The projected profile of WOOD POST LTD after the acquisition and consolidation would be that of a robust organization, and certainly having better cutting edge than the small players in the industry. Conclusion: The paper has given an opportunity to look into various phases of Management Accounting and finally Option 1 i.e., acquisition of London Counties is suggested to improve financial benefits using various accounting and financial techniques enumerated above. The assignment has helped me in understanding of Managerial finance and accounting. Bibliography 1... 'The mind of the Strategist' Business Planning for competitive advantage, Kenichi Ohmae, 1984 print, Penguin Books Ltd 2. 'Management Accounting in Practice', F.C.DE PAULA, Third U.K.edition, Sir Isaac Pitman & Sons Ltd. London. 3. A concise Encyclopedia of Management Techniques, Frank Finch, 1976- Heinemann-London) 4. Glossary of Management Techniques, H.M.Treasury 5. Sizer, 1979 6. Lawlor, 1985 7. Wilson & Chua, 1993 8. Grundy, T.(1998) 9. Merchant, 1998 10. Wilson & Chua, 1993 Read More