NPV Practice Flashcards
Brighton manufactures and sells various types of lock. They are starting a new project. For the purposes of the initial project appraisal, it can be assumed that the locks would be manufactured in the UK.
However, the board of Brighton are considering manufacturing them overseas where labour costs and associated safety standards for employees are much lower than in the UK. The bike lock market is highly competitive with companies entering and leaving the market on a regular basis.
The director felt that Brighton should be concerned with more than just the shareholders since there are other stakeholders who also contribute to the business. However, some of the other directors felt that if shareholder wealth is maximised they had fulfilled their obligations and that the company should not be concerned about these other stakeholders.
Identify and explain two real options associated with the proposed bike lock project.
The project has a negative NPV, which signals that Brighton should reject it. The real options are as follows:
A follow-on option - investing into this competitive market now will allow Brighton to invest more in the future, perhaps when other competitors have left the market
An abandonment option - Brighton might commence the project with a view to future investment. However, if it is apparent that the sector is not going to offer future opportunities, Brighton can abandon the project at any time eg., by selling out to a rival
A timing option - Brighton could delay its investment and wait and see if competitors leave the market, making it more attractive to invest later on
A growth option - As well as manufacturing overseas, Brighton also has the opportunity to expand overseas via acquisition
A flexibility option - Manufacturing overseas would perhaps give the flexibility to access overseas markets more easily
Brighton manufactures and sells various types of lock. They are starting a new project. For the purposes of the initial project appraisal, it can be assumed that the locks would be manufactured in the UK.
However, the board of Brighton are considering manufacturing them overseas where labour costs and associated safety standards for employees are much lower than in the UK. The bike lock market is highly competitive with companies entering and leaving the market on a regular basis.
The director felt that Brighton should be concerned with more than just the shareholders since there are other stakeholders who also contribute to the business. However, some of the other directors felt that if shareholder wealth is maximised they had fulfilled their obligations and that the company should not be concerned about these other stakeholders.
Giving two examples, illustrate how conflicts may arise between the shareholders and the other stakeholders in Brighton
The overriding objective of companies is to create long-term wealth for shareholders. However, this can only be done is we consider the likely behaviour of other stakeholders. For example:
- Employees: Cutting employee benefits in pursuit of creating short-term profits could have long-term detrimental effects on shareholder wealth, for example if the company has high staff turnover which affects productivity or service levels
- Creditors - delaying payments to creditors could have repercussions for future supplies, which could reduce longer-term shareholder wealth
- Managers - If managers and employees are not motivated adequately, the costs of inefficiencies will be borne by shareholders
Brighton manufactures and sells various types of lock. They are starting a new project. For the purposes of the initial project appraisal, it can be assumed that the locks would be manufactured in the UK.
However, the board of Brighton are considering manufacturing them overseas where labour costs and associated safety standards for employees are much lower than in the UK. The bike lock market is highly competitive with companies entering and leaving the market on a regular basis.
The director felt that Brighton should be concerned with more than just the shareholders since there are other stakeholders who also contribute to the business. However, some of the other directors felt that if shareholder wealth is maximised they had fulfilled their obligations and that the company should not be concerned about these other stakeholders.
Outline the main elements of an ethical employment policy that Brighton could adopt if it were to manufacture the bike locks overseas
The directors of Brighton should develop an ethical policy in respect to using overseas manufacturers where labour is cheap and safety standards for employees may be low. This should relate to not using suppliers who make use of child labour or slave labour, or who employ people in dangerous working conditions. In relation to this, the principles of integrity, objectivity and professional behaviour are relevant.
Ignoring the effects on working capital, calculate and comment upon the sensitivity of the project to changes in sales revenue
Contribution less tax in each year
= Contribution x 0.83 (if tax is 17%)
Then apply the NPV function to the sum of the contributions less tax with the relevant NPV factor
Sensitivity is then the overall project NPV divided by the NPV relating to contribution or revenue
Expressed as a percentage
Anything below 50% is relative insensitive
Sensitivity of the decision to invest in a product to changes in selling price (following on from NPV)
Consider the revenue cash flows, deduct the tax per year to give cash flow per year
Calculate the NPV using the rate from the original NPV
Divide the original project NPV by the new NPV. The sensitivity is expressed as a percentage.
Then state that this how much the price can fall by before the decision to invest would change.
Calculate the maximum discount rate this project could bear (following an NPV)
To calculate the sensitivity to the cost of equity, an IRR is required, using the net cash flows from the initial part
Use the net cash flows from the NPV from T0-TN
Apply the IRR function =IRR(all cash flows)
Calculate the impact of a 10% increase in the material cost per unit used in the NPV calculation
A 10% increase in the material cost per unit would decrease overall revenue
Calculate this deduction and then add back the tax saved
- One line for the increase in costs
- One line for tax saved
- One line for the new cash flow
Recalculate the NPV (for this area of the question)
Deduct the new NPV from the original NPV to give the new NPV
State whether this means the NPV of the project will remain positive/negative or change.
A change from positive to negative or vice versa would demonstrate that the project is sensitive to the cost of materials.
Explain the importance of considering ESG objectives
While wealth maximisation may be the primary objective for many businesses, there is increasing recognition that objectives other than financial performance should be considered. Even where shareholders do only wish to consider their wealth, the value of a businesses is not only affected by financial performance, but by other factors that affect the risk and return of investments. These other factors are referred to as environmental, social and governance issues
- Environmental: An organisation’s activities may have an impact on the natural environment. Poor environmental behaviour can lead to fines, loss of reputation and legal claims by those affected by the poor environmental behaviour. For example, the board must therefore consider waste that is created from the manufacturing process and how this is disposed of
- Social: Social refers to the relationship the organisation has with stakeholders and society as a whole. Issues such as health and safety, workers’ rights, pay and benefits and diversity and equal opportunities must be considered. For example, if the intention is to transfer some labour from the production of another project. The production manager must therefore make sure that employees are not over-worked and that working-hour regulations are being adhered to
- Governance: Governance refers to the way an organisation is managed - for example the structure of the board of directors and how the activities of the directors are monitored by other stakeholders, such as shareholders. Poor governance can lead to significant problems, such as poor decision making, taking on too much risk or even fraud. The board should appear to be structured to effectively manage the project.
Making reference to relevant theories, explain the weaknesses of the adjusted present value methodology
The APV technique is based upon the assumptions of Modigliani and Miller with tax
This means that issues which may affect the attractiveness of debt finance are not reflected in the technique:
- Direct and indirect costs of bankruptcy
- Agency costs and covenants
- Tax exhaustion
- Perfect market assumptions eg, risk-free debt
To the extent that any of these assumptions do not hold true, the APV methodology will not take account of all the potential implications of increased debt within a firm’s capital structure
There is also a question mark over the appropriate rate at which to discount the tax shield
How do you calculate the sensitivity of sales volume? (Following from an NPV)
Take the contribution per year and work out the PV. Deduct tax from the PV.
Divide the initial NPV by the new PV less tax to give the sensitivity as a percentage.
Why may acquisitions not benefit a bidding firm?
- The price paid is too high and synergies go to the target shareholder
- Lack of fit within the existing group of companies, so cost savings and synergies are not as great as forecast
- Transaction costs - underwriting, legal fees etc - are expensive and reduce any gains made
- Talented staff in the target company may leave
- The takeover/merger may be because of management hubris rather than an increase in shareholder value
- The subsidiary is too small and does not warrant the management time required
- Conglomerate discount may exist, ie, the individual parts of the business are worth more than the group as a whole
Is it better to pay with cash or shares?
Paying in cash:
- This is more attractive to the target shareholders as the value is certain, but there may be personal tax implications
- This may cause liquidity problems for the bidding firm and so it may be necessary to increase its gearing
- Lower transaction costs will arise with a cash purchase
Paying with shares:
- There will be a dilution of ownership and any gains made will now be shared with the target shareholders
Ignoring the effects on working capital, calculate the sensitivity of the project to changes in sales revenue and indicate whether there is a sufficient margin of safety for the project to go ahead
Contribution per year less tax
Calculate the NPV for this only
Divide the initial NPV by the new NPV
The percentage offered means this is how much the sales would have to fall for the NPV to be zero
- They should consider their sales and decide whether it is likely that there will be such a significant drop
- If there are similar products on the market, the market share may be eroded to a greater extent than predicted
Sensitivity to changes in the variable costs
Variable costs per NPV, add tax, give new cash flow
ADD Taxation back at the percentage
Apply the appropriate cost of capital to the NPV, T1-TN
Divide the initial NPV by the new NPV
Comment on the sensitivity
Sensitivity to changes in the realisable value of the machinery and equipment
Maximum loss of scrap value (e.g. scrap value given in question)
(Deduct tax)
To give net cash flows
—
Multiply new cash flow by the discount factor
Although this represents a percentage change (give change) of the overall NPV, the project is insensitive to the residual value, since there would be a substantial NPV even if the value fell to zero
