Analysis of the Business Venture by Asdy Plc to Enter the UK Supermarket Market - Coursework Example

? The following report analyzes the proposed business venture by Asdy Plc to enter the UK supermarket market. The feasibility of the projectwas ascertained by using the NPV and Payback criterion appraisal techniques. Despite the project being profitable in the long run, associated risks as well as loan repayment restrictions require further planning and considerations. Contents 1. Introduction 1.1 Motivation behind report 2. Project Proposal and Appraisal Techniques 2.1 NPV 2.2 Payback Criterion 3. Key Risk and Mitigants 3.1 Loan repayments 3.2 Business Environment 3.3 Product Introduction 4. Appraisal Techniques: Advantages and Disadvantages 4.1 NPV Advantages 4.2 NPV Disadvantages 4.3 Payback Criterion Advantages 4.4 Payback Criterion Disadvantages 5. Conclusion 5.1 Strengths of the Project 5.2 Weaknesses of the Project 6. References Appendix One Growth of UK Grocery Retail Markets Appendix Two Breakdown of UK Grocery Industry 1. Introduction The grocery industry in the UK forms an integral part of the aggregate consumer spending and was valued at ?156.8 billion in 2011 (IGD, 2012), an increase of 3.8% year -on-year. The growth of this industry over the years can be seen in Appendix One. Expenditure on food and grocery items constitutes 53p in every ?1 of retail spending (IGD, 2012), underscoring the importance of this industry as a cornerstone in the consumer spending landscape of the country. All of the 88,441 UK grocery stores in UK can be divided into four broad categories: 1) Convenience Retailing 2) Traditional Retail 3) Hypermarkets, Supermarkets and Superstores 4) Online As per our business interests, it should be noted that the Supermarket and Superstores category contributes to ?111.4 billion of the total grocery industry, as shown in Appendix Two. 1.1 Motivation Asdy Plc is considering the proposal of entering the UK supermarket industry in line with their business strategy of attaining international reach. The following report is an analysis of the proposed business venture based on certain appraisal techniques and the associated risks. 2. Project Proposal 2.1 NPV NPV is an appraisal technique which gives an estimate of the profitability of the project by taking into account the difference between present values of cash outflows and cash inflows. As per initial estimates, the cost of setting up the new store to operational status will be ?20,000,000 and the company's cost of capital has been estimated at 5%. In order to bridge the financing gap between the project cost and the company's internal funds, a long term bank loan has been arranged. The following tables outlines the expected free cash flows that the company is expected to obtain from operations: Free Cash Flows Time line Years 1 - 3 Years 4 - 8 Year 8 onwards Yearly breakdown Receive ?1,000,000 for 3 years Grow @ 10% per year Grow @ 2% per year Aggregate amount ?3,000,000 ?5,105,100 ?73,205,000 Discounted to t = 0 ?56,158,034 After taking into consideration the initial outlay of ?20,000,000, the NPV of the project is ?36,158,034. This indicates that the business proposition of entering the UK grocery market is a financially viable and will lead to positive returns in the future. 2.2 Payback Criterion Payback criterion is used to calculate the time it takes for the cash inflows of the project to offset the cash outflows and provide an estimate of the time it will take to recover an investment. Provided the maximum loan term tenor granted is ten years, the payback criterion gives us a time line of 14.47 years, which translates into a minimum repayment period of 14 years and 6 months. This is conditional on the yearly free cash flows being used in their entirety to fund the loan repayment. Therefore, despite the profitability of the project, the proposed means of financing is not ideal for such a project where the returns are mainly realized in the long term. 3. Key Risks and Mitigants 3.1 Loan Repayments As mentioned above, the payback period for the loan exceeds the maximum tenor available. As a possible solution, the company can enter into a loan guarantee contract, whereby repayments are guaranteed by a third party. There will be a commission charged for this service, but provided that the company might be in need of future term loan arrangements, it is imperative that the loan repayments are made on schedule to avoid a negative impact on the company's credit history. 3.2 Interest rate Risk Following upon the risk of taking out a loan to finance the business venture, there is the possibility of interest rate risk affecting the project. Given the uncertain and volatile nature of the current financial markets, changes in interest rates can affect the mark up payments the company will have to make, inadvertently affecting the cost of capital of the company. One way to offset this risk includes taking out a call option on the interest rate. This option will effectively put an upper cap on interest rate volatility and going forward will limit the losses accruing to the company resulting from a sudden rise in interest rates. 3.3 Inflation Risk Asdy will be operating in an industry which is highly susceptible to inflation risk, or risk owing to the rise in prices of retail products. Unexpected increase in inflation can have an impact on the dynamics of the UK consumer spending and affect the future cash inflows for the company. In order to mitigate this risk, the company could invest in inflation indexed bonds which provide coupon payments that are adjusted in line with movements in the General Index of Retail Prices in the UK (UK Debt Management Office, 2012). 3.4 Business environment Before a new business venture is undertaken, the prevalent industry environment must be studied to arrive at a strategy for success. Given the developed and sophisticated nature of the UK supermarket industry, the company, being a small scale entrant, must adopt existing strategies used by other players of equal size and scale like Waitrose and M&S which have managed to create and maintain a niche for themselves under such competitive circumstances to remain competitive. US products already enjoy substantial accessibility and recognition in the UK retail markets; however, in order to carve out a loyal customer base, the company will not only have to set aside a substantial advertising budget but also present a fresh and unique product catalogue. Again the introduction of new products must be done after taking into account the tastes of the local population. 3.5 Product Introduction A supermarket's product catalogue is the most important driver in the success of the chain. The US is the largest non-EU country supplier to the UK (Julie Vasquez-Nicholson, 2011); however the access of British markets to EU suppliers can be a hurdle for foreign producers. UK markets especially enjoy the presence of specialty products like Italian cheese and Spanish citrus, which along with the duty free supply terms that the EU enjoys can create tough circumstances for US producers to dent the monopoly of these products. The company can better handle these market conditions by undertaking an overview of their product catalogue and balancing it by having a combination of products produced in the US and products from local suppliers. Specialty produced available only in the US will create a niche in the local market. 4. Appraisal Techniques: Advantages and Disadvantages 4.1 NPV Advantages Net Present Value (NPV) takes into account the time value of money. This means that future cash flows resulting from the business venture can be discounted back to see whether the costs spent on the project will be offset by future profits. Other advantages of this appraisal technique are that it takes into account the cost of capital of the company, which can include borrowed funds or freshly injected equity. 4.2 NPV Disadvantages The shortcomings in NPV calculations come from uncertainty in future cash flows. The cash flows used as inputs in calculating the net present value of a project can change significantly depending on future internal issues of the company or changing market conditions. Also the NPV calculation does not include a percentage return. 4.3 Payback Criterion Advantages This appraisal technique is usually used as an initial screening to determine the feasibility of a project based on a time line that the manager has set. It is simple to calculate and can be used to evaluate the possibility of risks that could arise in a project due to liquidity issues and uncertainty from a long payback period. There are several reasons why a manager opts for payback method. Firstly; it has simplicity to make capital budgeting decisions. Using this approach a manager doesn’t need to hire various employees from diversified background in order to evaluate the investment projects. He can evaluate the projects easily with lesser people and in shorter time. He can identify that which project is lucrative enough to investment in and which to choose the best, also the need of rigorous economic analysis curtails. It make an investment decision making simple and easily perceivable for manager as it gives a sketch to him in making capital budgeting decision, especially if a manager faces any dilemma in choosing a project out of two then he can overcome the problem immediately using the same approach. It also protects a manager from any risk related to the project because it may be possible that a manager undertakes a project that generates low income than the initial cost. For example, if an investment has a payback period of 5 years and the life span of the machine in which the money is invested is 4 years, then the manager may face a huge loss, but if he is aware about all such circumstance then he would avoid such investment, hence the method can help him decide that in which project to further invest. Therefore, it is necessary for a manger to learn this technique and avoid wasting money by undertaking any uneconomical investments (Hilton, 2009). 4.4 Payback Criterion Disadvantages Since this is a basic appraisal technique, it has a lot of shortcomings. It does not take into account the time value of money. Furthermore, it neither takes into account the timing of cash flows within the payback period nor the cash flows after the payback period, which means it will rank those projects better which provide better returns in the near future regardless of total profitability of the project. 5. Conclusion 5.1 Strengths of the Project As evidenced in the report, despite the competitiveness in the UK supermarket industry, there is potential for growth. Asdy has the potential to introduce its US products and create a niche for themselves through private labels and product differentiation. The projected cash flows indicate that the proposed business venture is profitable in the long run. 5.2 Weaknesses of the Project Given the tenor of the bank loan available and the payback period that exceeds this tenor, the company should look towards other venues for financing like generating equity through issuance of shares to secure funds for the project. It also should be noted that the payback period is dependent on free cash flows estimates. Given the uncertain nature of this business venture, these cash flow estimates can be subject to change At the same time, the company should be wary of the potentials risks present in this project and take the necessary steps to mitigate the same. References UK Grocery Retailing - Grocery sector size, structure & value factsheet - IGD.com. 2012. UK Grocery Retailing - Grocery sector size, structure & value factsheet - IGD.com. [ONLINE] Available at: http://www.igd.com/index.asp? id=1&fid=1&sid=7&tid=26&folid=0&cid=94. [Accessed 01 November 2012]. Julie Vasquez-Nicholson, 2011, United Kingdom Retail Foods, [ONLINE] Available at:http://gain.fas.usda.gov/Recent%20GAIN%20Publications/Retail %20Foods_London_United%20Kingdom_2-3-2011.pdf. [Accessed 01 November 2012]. Short and Constanzo, 1999, Super Market Banking, IIBFS Exclusive report No.19 [ONLINE] Available at: http://profesores.ie.edu/enrique_dans/TESCO/supermarket%20banking.pdf. [Accessed 01 November 2012]. Grocery Retailers in the United Kingdom . 2012, Euromonitor . [ONLINE] Available at: http://www.euromonitor.com/grocery-retailers-in-the-united- kingdom/report. [Accessed 01 November 2012]. The Waitrose difference - Our company - Waitrose.com. 2012. The Waitrose difference - Our company - Waitrose.com. [ONLINE] Available at: http://www.waitrose.com/content/waitrose/en/home/about_waitrose/our_company/the_waitrose_difference.html. [Accessed 01 November 2012]. UK Debt Management Office. 2012. UK Debt Management Office. [ONLINE] Available at: http://www.dmo.gov.uk/index.aspx?page=gilts/indexlinked. [Accessed 11 Novemeber 2012]. Hilton. (2009). Managerial Accounting 7E. Tata McGraw-Hill Education. Appendices Appendix One: Appendix Two: Read More