Financial Analysis Of Two Projects – Project Aspire And Project Wolf

Objective

AYR Co. is considering two projects for investment namely Aspire and Wolf with the objective of enhancing shareholders’ wealth and also gain a higher market share. Market research has been already conducted on the two projects and based on the available information, financial analysis needs to be conducted so as to advice on the superior of the two projects. Additionally, the critical qualitative factors also need to be highlighted. The given report presents the financial analysis of the two aforesaid projects along with highlighting the qualitative factors to be considered in decision making. Also, the given report highlights the two sources of financing in the form of debt and equity along with relevant costs and impact on shareholders and lenders.

The objective of the given task is to conduct a financial analysis of two projects i.e.”Project Aspire” and “Project Wolf” based on the information provided so that the AYR Co can choose the appropriate project for investment. The various aspects related to the financial information provided pertaining to the two projects are discussed as follows.

The first key aspect is that the market research cost to the tune of $ 120,000 would be a sunk cost since it has already been incurred and the same cannot be recovered irrespective of the choice made by the company. Since this is a sunk cost, hence this would be a consideration for any of the two projects (Damodaran, 2015).

It is known that the life of the project is five years. Also, initial investment would be required in the form of plant and machinery acquisition which would result in outflow of $2,250,000. Additional investment would be in the form of working capital to the tune of $ 140,000 which would be completely recovered at the end of five year period. 

The plant and machinery would have a salvage value of $ 375,000 at the end of the useful life of project or 5 years.

Annual depreciation = (2,250,000 – 375000)/5 = $375,000

The given project is expected to lead to incremental sales for the company and the information regarding the same has been provided along with the incremental variable costs. Also, capital allowances would be provided on the capital expenditure that the company would incur on the given project. These would essentially seek to minimise the tax outflow. Another noteworthy aspect is that the tax is paid in arrears which imply that tax on the income in the first year would be paid in the second year only (Brealey, Myers and Allen, 2014).

Key aspects to consider

The incremental cash flows for the given project over the useful life is indicated in APPENDIX 1.

Using the incremental cash flows of the project, the following capital budgeting techniques would be applied in order to carry out an evaluation of the project.

It refers to the cumulative sum of the incremental cash flows that would arise during the project useful life (Parrino and Kidwell, 2014). A critical element of NPV computation is the discount rate which has been given as 10% in the given case. The NPV computation is shown below.

It is apparent that the NPV of the project has come out as $ 1,842,091.

This is defined as the discount rate which leads to a NPV value of zero (Arnold, 2015). This has been computed using excel and the relevant value has come out as follows.

From the above computation, it becomes evident that IRR of the project is 37.12%.

This is the time which is required to recoup the original investment. The original investment in this case would be in the form of capital expenditure on plant and machinery coupled with investment in incremental working capital. The following table would be useful in the computation of payback period (Northington, 2015).

Payback period = 2 + (156673/1006403) = 2.16 years

The immediate project outlay for this project would be $ 2,250,000 however, no capital allowances would be available in this case for the company. The incremental cashf lows expected to arise from the project along with incremental outflows have been mentioned in the information provided. It has been assumed that the salvage value of any assets acquired during the initial outlay is zero while the useful life of the project is 5 years.

Annual depreciation = 2250000/5 = $ 450,000

Further, there is an annual opportunity cost of $75,000 which would be considered since pursuing this project would lead to loss of rental income of $ 75,000 per annum (Berk et. al., 2013).

The incremental cash flows for the given project over the useful life are indicated in APPENDIX 1.

Using the incremental cash flows of the project, the following capital budgeting techniques would be applied in order to carry out an evaluation of the project.

It refers to the cumulative sum of the incremental cash flows that would arise during the project useful life. A critical element of NPV computation is the discount rate which has been given as 10% in the given case. The NPV computation is shown below.

Capital budgeting techniques

This is defined as the discount rate which leads to a NPV value of zero (Petty et. al., 2015). This has been computed using excel and the relevant value has come out as follows.

IRR has come out as 21.80%

This is the time which is required to recoup the original investment. The following table would be useful in the computation of payback period (Damodaran, 2015).

Payback period = 2 + (634050/768384) = 2.83 years

• It is known that for the company the investment amount of $ 2.25 is a significant amount for the company and since the company is willing to invest only in one of the two projects, hence the two projects are mutually exclusive. The evaluation of the two projects based on the capital budgeting parameters computed in the above section needs to be carried out. For this, a comparison of the various parameters is desirable. On the basis of the above computations, it makes sense that Project Aspire should be chosen over Project Wolf since on account of various capital budgeting techniques, the former is superior in comparison to the latter (Brealey, Myers and Allen, 2014).

• The justification for the above is given below.

NPV – For a feasible project, the NPV of the project should be positive. Such a project tends to create value for the shareholders unlike the projects which have negative NPV and hence destroy value. In the given case, both projects have a positive NPV which implies that both the projects are financially feasible. But, since the projects are mutually exclusive, preference would be given to Project Aspire since the NPV of this project is significantly greater than the corresponding NPV of Project Wolf (Berk et. al., 2013). 

IRR – For a feasible project, the IRR of the project must be greater than the cost of capital or discount rate. Such a project would lead to NPV being positive and thereby make an incremental contribution towards shareholders’ wealth. Since cost of capital for both the projects is 10%, hence it is apparent that prima facie both the projects are feasible owing to IRR exceeding 10%. However, if a selection has to be made between these two projects, then project Aspire would be considered superior since the underlying IRR is greater than the IRR for the other project (Northington, 2015).

Payback Period – For a feasible project, the payback period should be lower than the useful life of the project which in this case is 5 years. It is noteworthy that the payback period of both the projects is lesser than three years which implies that both the projects are financially feasible. However, since the company is able to invest only one of the two projects, thus, the favourable choice would be Project Aspire since the initial investment can be covered in a quicker time as compared to the other project (Petty et. al., 2013).

• However, it is imperative that the decision should not be based only on the quantitative parameters and the qualitative parameters should also be considered.  These are highlighted as follows (Damodaran, 2015).
• One of the key aspects is the scope of the two projects. It is known that Project Aspire would cater to the existing customer base only and would expand the current product range only. Thus, this project aims to cater to a larger share of the current customer base and aim to derive higher sales from the current customers. On the other hand, Project Wolf would take the company in new direction and attract a new set of customers which the company does not currently cater to. As a result, from a strategic perspective the project Wolf makes more sense since it would provide access to new customers who can then potentially be sold the existing products of the company in the long run. Also, it would help the company to diversify which is critical in risk management. Project Wolf would lead to diversification of business model and customer base which leads to lower risk since if one division of the company is underperforming, hedging can be achieved by ensuring that the other division performs well.
• Another factor to consider is market trends and actions of competitors. With regards to five years, Project Aspire makes sense but depending on the underlying industry, long term vision and strategic planning is required. It may be possible that the industry is at crossroads and thereby the competitors are making a shift into new businesses as the current business may be declining or saturated. This is especially true for those businesses where technology acts as a disruptor and hence it is essential for firms to adapt with the market changes (Brealey, Myers and Allen, 2014).

On the basis of the above discussion, it can be inferred that on the basis of quantitative aspects, Project Aspire is far superior when compared to Project Wolf. However, in terms of qualitative aspects particularly the focus of business and consumer base, Project Wolf is superior in comparison to Project Aspire since the former tends to diversify the business of the company. However, the company needs to take a strategic decision while taking the long term strategic perspective into play considering the industry dynamics in the future and the actions of competitor. This is essential as it would allow the company to weigh the quantitative and qualitative aspects suitably since in interpretation of the latter, a large degree of subjectivity is involved (Parrino and Kidwell, 2014).

• There are two common sources of finance namely equity and debt. Equity financing refers to raising of finance by selling shares to entities. In this case, the ownership is diluted but there does not need to any repayment of the money raised or interest payment on the amount raised (Arnold, 2015). However, the equity holder would have voting rights and hence playing a role in the key business decisions. On the contrary, in case of debt financing, loan is taken from a financial institution such as bank or even individuals. In this case, there is no equity dilution but the loan amount needs to be paid back along with regular interest payment. This given rise to credit risk owing to the possibility of a default (Damodaran, 2015).

• From the above basic description of debt and equity based financing, it is apparent that in case of debt there is regular interest payment coupled with repayment of debt. However, there is no such flow to an equity investor. The equity investor would appropriate return on the investment in the form of dividend and capital appreciation which would happen when the value of the company would increase (Northington, 2015).

Quantitative Analysis

The cost of the two means of financing is based on the underlying risk associated with these. In accordance to the modern portfolio theory, risk and returns are correlated. This implies that typically when there is a higher risk involved, the investor would expect a higher return so as to act as compensation for assuming higher risk. Thus, in order to outline the relative costs of the two sources of financing, it is essential to analyse the risk associated with these financing means. Comparing the two sources of finance, it is obvious that a higher risk level is associated with equity (Brealey, Myers and Allen, 2014). This is primarily because there is no repayment of equity and even in case of liquidation, the equity-holders would not receive anything owing to being last in the preference order of deriving proceeds from liquidation. As a result, the returns can be only obtained by equity investors if the company flourishes and pays dividends along with net worth appreciation. Further, since the equity inventors tend to take risk and hence can enjoy a higher returns since there is no guaranteed returns as in case of debt (Petty et. al., 2015). 

In case of debt, the scenario is quite different. This is because lower risk is associated with the repayment in debt. This is because usually there is some collateral on which the lender would have charge and this asset can be liquidated to recover the principal and outstanding interest amount in case of default. Further, there are regular interest payments along with principal repayment which need to be given for the servicing of debt.  Besides, even in case of liquidation, the lenders would have a high priority of settling their dues from the proceeds obtained out of liquidation. As a result, there is considerably lesser chances of the lender losing money even if the company has to wind up (Arnold, 2015).

The net result of the above discussion is that there is considerably more risk in case of equity in comparison with debt and hence the cost of equity is considerably higher in comparison to that of debt.

As per the given data, it is apparent that the current WACC of the firm is 10%. Also, it is apparent that currently debt is slightly lower than equity and hence more than 50% of the financing is obtained from equity financing. The incremental financing of $ 2.25 million needs to be obtained. The various scenarios are considered below.

Qualitative Analysis

100% equity financing – Based on the discussion in the above section, it is apparent that the cost of equity is significantly higher than the corresponding cost of debt. As a result, if the selected project is funded through equity, then the capital structure would have a higher weightage of equity which would lead to higher weighted average cost or WACC for the company (Berk et. al., 2013).

100% debt financing – Based on the discussion in the above section, it is apparent that the cost of debt is significantly lower than the corresponding cost of equity. As a result, if the selected project is funded through debt only, then the capital structure would have a lower weightage of equity which would lead to lower weighted average cost or WACC for the company (Petty et. al., 2015).

On the other hand, if the financing is through the mix of debt and equity in the ratio of current capital structure, then the WACC would not be altered.

The means of finance selection would have impact on the current and potential shareholders along with lenders. This is explained below. 

Equity Financing – If the company decides to raise finance through equity issue, then there would be dilution of shareholding for the current shareholders. Also, the Earnings per Share (EPS) of the company would decline owing to an increase in the outstanding shares. This would lead to a drop in the price and hence has an adverse effect on the shareholders. Also, the overall float may increase for listed companies which can adversely impact potential gains in the future (Damodaran, 2015). Additionally, for promoters or majority shareholders, dilution of equity could lead to loss of control.  Also, the associated cost of equity is higher which tends to adversely impact the WACC and hence the viability of the projects. Equity financing is considered to be positive for lenders as this would typically imply lesser leveraging of the balance sheet which would allow the company to better service the outstanding debt (Brealey, Myers and Allen, 2014).

Debt Financing – This type of financing does not have adverse impact on shareholders as long as the debt levels are not very high thus raising questions on the solvency of the company. Debt financing would attract interest payments which would lower the EPS and hence the shares (Northington, 2015). However, the associated cost of debt is lower than equity and hence preferable from the shareholders’ perspective. From the lenders’ perspective, the debt financing is not preferred as it leads to increased leveraging of the balance sheet and hence could have an adverse impact on the ability of the company to service outstanding debts. Also, this may lead to higher default risk (Arnold, 2015).

Based on the above, it is imperative that both types of financing have implications for shareholders and lenders due to which it is imperative that a healthy mix of both should be considered for an optimum capital structure considering the industry and the environment.

Conclusion

On the basis of the above discussion, it is apparent that based on quantitative aspects, the superior project is Project Aspire. However, from a strategic perspective it is imperative to take a long term view and consider Project Wolf also owing to its ability to enhance reach to new customers. Besides, the cost of equity is significantly higher than debt but both have their respective pros and cons. As a result, it is imperative a healthy mix of the two sources of financing should be deployed owing to the key implications of capital structure on shareholders and lenders. 

References

Arnold, G. (2015) Corporate Financial Management. 3^rd ed. Sydney: Financial Times Management.   

Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V., & Finch, N. (2013) Fundamentals of corporate finance, London: Pearson Higher Education

Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Northington, S. (2015) Finance, 4^th ed. New York: Ferguson

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015). Financial Management, Principles and Applications, 6^th ed..  NSW: Pearson Education, French Forest Australia