McCain Food Ltd is one of the largest frozen chips producers in the world. Its first processing factory was opened in New Brunswick Canada in 1957; owned and managed by the McCain Family. The company grew rapidly and now it has become the market leader because of its continuous innovation on both variety and quality.
McCain Foods' Whittlesey plant in Cambridgeshire turns potatoes into bags of McCain chips. As a major user of energy for its production process McCain is seeking to reduce how much gas and electricity it uses and recently it wants to invest in two projects 'Wind turbine system' and 'Waste Water treatment system' at the Whittlesey plant as an alternative source of energy which will cut their production cost and will help to reduce the carbon footprint as well. The two projects together will need a capital outlay of £150 million. McCain therefore needed to evaluate the expected financial benefits of both projects before going to proceed. The company has also selected two engineering company (Omega Alternatives and Alpha Renewable) for tender and it needs to know which company is better for tender for the projects.
I have been commission by the company to study on a comprehensive investment appraisal for the two projects, financial analysis of the two selected company for tender and appropriate source of funding if needed.
Methodology, Findings & discussion
Investment Appraisal on the two projects
Given the importance of investment decisions to the viability of business, it is essential that investment proposals are all properly screened. Ensuring that the business uses appropriate methods of evaluation is an important part of this screening process.
Research shows that there are basically four methods used in practice by businesses throughout the world to evaluate investment opportunities.
Accounting Rate of Return (ARR)
Payback period (PP)
Net present value (NPV)
Internal rate of return (IRR)
( Reff: Peter Atrill and Eddie McLaney, Management Accounting for Decision Makers, 5th Edition, p-246)
Accounting Rate of return
The accounting rate of return method takes average accounting profit that the investment will generate and expresses it as a percentage of the average investment in the project, as measured in accounting terms. Thus,
ARR = (Average annual profit / average investment to earn that profit x 100)
But for the two projects we have taken the denominator as 'initial investment' rather than average investment.
ARR of 'Wind Turbine' project
ARR of 'Waste lagoon' project
28.6%
30.64%
See the appendix A.
According to the writer Peter Atril and Eddie McLaney, users of ARR should apply the following decision rules:
For any project to be acceptable it must achieve a target ARR as a minimum
Where there are competing projects that all seem capable of exceeding this minimum rate, the one with the higher or highest ARR would normally be selected. ( Reff: Peter Atrill and Eddie McLaney, Management Accounting for Decision Makers, 5th Edition, p-248)
It is clear from the table that Waste lagoon project will be more profitable because of its higher ARR.
Merits
It clearly shows the profitability of the projects.
It allows easy comparison between project
The opportunity cost of investment can be taken into account
Demerits
More complex method
It does not take into account the effects of inflation on the value of money over a time period
Payback period
The payback period is the length of time it takes for an initial investment to be rapid out of the net cash inflows from a project.
According to the writer Peter Atril and Eddie McLaney, the decision rule for using PP is:
For a project to be acceptable it would need to have a payback period shorter than a maximum payback period set by the business.
If there were two or more competing projects that were both shorter than the maximum payback period recruitment, the decision maker should select the project with the shorter payback period. ( Reff: Peter Atrill and Eddie McLaney, Management Accounting for Decision Makers, 5th Edition, p-246)
PP of 'Wind turbine' project
PP of 'Water lagoon' project
3years 6months
3years 5months
See the appendix A
The PP of Water Lagoon is 3y 5m means that the project will be able to recover its initial investment by that time from the commencement of the project whereas the other project will take one month more to recover its initial investment.
Merit
It is extremely simple
Helps prevent cash flow problem- since money will be recovered as quickly as possible.
Demerit
Cash earned after the payback method is ignored.
It does not account for the real value of money.
Net Present Value
Under the NPV net cash flows are discounted to their present value and then compared to the capital outlay required by the investment. The difference between these two amounts is referred to as NPV.
A project is accepted when the net present value is zero or positive.
NPV = (Total PV of future CF's - Initial investment)
NPV of 'Wind Turbine' Project (£ mill)
NPV of Waste Lagoon Project (£ mill)
(5.692)
0.154
See the appendix A
In case of Waste lagoon project, the NPV is positive, so we should accept the project. Investing in this project will make the business £0.154 million benefit. The gross benefits from investing in this project are worth a total of £(50+0.154)=£50.154 million today and since the business can get the benefits for just £50 million today, the investment should be made.
On the other hand, Wind Turbine project's NPV is negative that means the present value of invested amount (£100 mill) is (100 - 5.692) = £94.308 million today which will be worthless investment.
Merits
Takes into account timing of all cash flows
Takes into account the time value of money
Simple decision rule
Can be used to compare alternative projects
Demerits
Need to calculate cost of capital
May be more difficult for lay people to understand
Basic model ignores inflation
Ignores timing of cash flows within individual years
Internal Rate of Return
The IRR is the discount rate at which NPV is zero. The IRR is calculated by discounting the net cash flows using different discount rates till it gives a net present value of zero.
IRR = [positive rate + {positive NPV/ (positive NPV+ negative NPV) x range of rates}]
IRR of 'Wind turbine' project
IRR of waste lagoon project
12.78%
15.134%
See the appendix A
In case of Waste lagoon project, the NPV is positive £0.134 million at 15% discounting factor (see appendix A) implies that the rate of return that the project generates is more than 15%. But the NPV of another project is negative (see appendix A) at the same discounting factor implies that rate of return that the project generates is less than 15%.
From the table it has been seen that the IRR of Waste lagoon is 15.134% means that the returns on its investment will be 15.134% which is an increased figure more than 15%. On the other hand, the IRR of wind turbine project is 12.78% means that the returns on its investment will be 12.78% which is lower than the cost of capital (15%).
Merits
No need to decide on cost of capital
Provides margin of error when IRR is compared with hurdle rate (minimum IRR requirements for the acceptance of a project)
Demerits
Investment may have more than one IRR
Can not choose between alternative projects using IRR
Can not be used for least cost situations
It completely ignores the scale of investment.
B) Financial analysis of the two engineering companies
Financial analysis is a comprehensive analysis of-
Strategy
Competition, regulation and taxes
Past, current and projected financial performance
Fundamental evaluation in relation to stock price
Planning for the future
>Operation
>Investment
>Financing
(Reff: Financial statement Analysis by Professor SP Kothari, June 18,2004)
There are different approaches for analyzing financial analysis and Ratio Analysis is one of the popular approaches.
Ratio Analysis is a technique by which we can -
Evaluate the financial performance and stability of an entity
Types of Ratios:
Profitability Ratio
Liquidity &Efficiency Ratios
Gearing Ratios
Investment Ratios
As McCain is not going to invest in those two companies, we only need to analyse the Profitability ratio and Liquidity & efficiency ratios.
Profitability Ratios:
"Profitability ratios are connected with the effectiveness of the business in generating profit. A very popular means of assessing a business is to assess the amount of wealth generated for the amount of wealth invested." (Eddie McLaney,Business Finance 7th edition, Prentice Hall)
Return on capital investment (ROCE): "ROCE is used in finance as a measure of the returns that a company is realizing from its capital employed." ( Wikipedia definition)
ROCE = (Profit before interest and tax /Capital employed) x 100
ROCE of Omega Alternatives
ROCE of Alpha Renewable
2007
2008
2007
2008
21.32%
20.77%
39.06%
31.15%
See appendix A
In case of Omega Alternatives, the trend of ROCE has decreased by 0.55% in 2008 from 2007 which implies that their efficiency in generating revenue from resources and management's ability to control cost has decreased. On the other side, Alpha has got higher ROCE than Omega over the mentioned period and there also can be seen a rising trend of ROCE which means that Alpha's business is much effective in generating revenue from its resources and has possessed strong management ability.
Capital turnover: "Capital turnover is a measure indicating how effectively investment capital is used to produce revenues. Capital turnover is expressed as a ratio of annual sales to invested capital" (Reff: http://financial-dictionary.thefreedictionary.com/Capital+Turnover
Capital turnover = (turnover / capital employed)
Capital Turnover of Omega
Capital Turnover of Alpha
2007
2008
2007
2008
1.62 times
1.75 times
2.45 times
2.51 times
See appendix A
Capital turnover of omega 1.62 times in 2007 which implies that Omega has used its capital 1.62 times by that year to achieve its sales revenue. In case of both companies there can be seen a rising trend of capital turnover over the period but Alpha has used its employed capital 2.51 times (in 2008) which is 0.76 times higher than Omega over the same period (2008). But it is important to note that, "A high ratio is not necessarily beneficial if margins are so small that the net profit generated is unsatisfactory" (Eddie McLaney,Business Finance 7th edition, Prentice Hall) .So this measure ( capital turnover) is related to profit margin of company.
Net Profit Margin: The Net profit margin is calculated by the following formula:
Net profit margin = (PBIT / Revenue)
The ratio actually shows that what is left of sales revenue after all of the expense of running the businesses for the period has been made.( Eddie McLaney,Business Finance 7th edition, Prentice Hall, p-52)
Net profit margin of Omega
Net profit margin of Alpha
2007
2008
2007
2008
13.15%
11.88%
15.96%
15.57%
See appendix A
The net profit margin of Omega is 13.15% in 2007 which implies that the company has earned £13.15 million out of £100 million sales revenue after all of the expenses of running the business for that period. Though there is a slight decreasing trend of net profit margin of Alpha from year 2007 to 2008, it possess higher Net profit margin than that of Omega which means Alpha has been earning more profit based on its sales revenue.
Gross Profit Margin: The ratio of Gross profit and sales turnover expressed as percentage is termed as Gross profit margin.
Gross Profit Margin = (Gross Profit / Sales Turnover) x 100
Gross Profit margin of Omega
Gross Profit Margin of Alpha
2007
2008
2007
2008
15.09%
13.47%
58.63%
58.12%
See the appendix A
A slight decline of gross profit margin by 0.51% has shown in 2008 from 2007 at Alpha whereas Omega's gross profit margin has fallen by 1.62% over the same period. It can be noted that The Gross profit margin of Alpha is more than 4 times than that of Omega in the year of 2008 which implies that the amount of sales revenue remains after the expenses of making the stock available to the customer is more than 4times than Omega.
Liquidity and efficiency ratio
Liquidity ratios are used to try to asses how well the business manages its working capital. It is used to evaluate the solvency and financial stability of a business.
There are different types of liquidity ratios:
Acid Taste: The ratio of liquid assets and current liabilities is termed as Acid Test. It shows that how much a business is stable. The ratio should be 1:1.
Acid Test of Omega
Acid Test of Alpha
2007
2008
2007
2008
1.47 : 1
1.03 : 1
1.15 : 1
1.09 : 1
See the appendix
According to the minimum required value for acid test (1: 1), both of the company shows satisfactory result. It is also remarkable that a common decline trend of their (both of the company) liquid assets has seen from the year 2007 to 2008 though Alpha possesses a bit of more liquid assets than Omega in 2008.
Stock Turnover: The ratio of cost of sales and average stock is termed as Stock turnover.
Stock turnover = (Cost of sales / average stock)
Stock turnover of Omega
Stock turnover of Alpha
2007
2008
2007
2008
2.01 times
2.23 times
1.87 times
2.03 times
See the appendix A
Both the companies have shown a rising trend of stock turnover from 2007 to 2008 but Omega's stock turnover is appraisal over the mentioned period. Omega's stock had been turn 2.23 times in 2008 which is higher than Alpha.
Debtor Collection period: This is the ratio which will tell us how long, on average, following the sale on credit, trade debtors take to meet their obligation to pay. A well-managed debtor policy will lead to debtors taking as short a time as possible to pay, without damaging good customer relation.( Eddie McLaney, Business Finance 7th edition, Prentice Hall, p-54)
Debtor collection period = (Trade debtors / Credit sales) x 365 days
Debtor collection period of Omega
Debtor collection period of Alpha
2007
2008
2007
2008
81.20 days
89.63 fays
34.40 days
36.26 days
See the appendix A
It is very clear from the ratios that the lower the debtor collection period the better the outcome. The debtor collection period of Alpha is less than half of Omega over the mentioned period. For example, Alpha was able to collect it's debts by only 36.26 days in 2008 whereas Omega has taken more than double time (89.63 days) to collect the debts in the same year.
Creditor payment period: This is the ratio that will tell us how long, on average, following a purchase on credit, the business takes to meet its obligation to pay for the goods or service bought. A well managed creditor policy will lead to as much 'free' credit being taken as possible without damaging the goodwill of suppliers.
Creditor payment period = (Trade creditors / credit purchases) x 365 days
Creditor payment period of Omega
Creditor payment period of Alpha
2007
2008
2007
2008
7.5 days
8.67 days
142.34 days
133.46 days
See the appendix A
The more the creditor payment period the more the outcome of the business. Alpha has shown an incredible creditor payment period (which is 15 times of Omega) in compared to Omega in 2008 which means that alpha will be able to increase and improves its overall cash flows more frequently over the period than Omega for the longer creditor payment period.
C) Graphical representation (cost savings Vs Year of operation) of the two Projects
X- Axis> Year of operation Y- Axis > Net cash flow
From the graph it is crystal clear that the net cash flows for both of the projects show an upward trend over the five years period. In case of Wind turbine project the cost of savings increases gradually over the period. But in case of waste lagoon project, there can be seen a sudden increase on its cost savings which starts from year 2 and a slight sharp increase continues up to year 5. By increasing the year of operation up to 7, it can be predicted that the cost savings of the both project will gradually increase on the next two years and consequently McCain will be gainer.
D) Summary and Conclusion
By taking consideration of all the results of financial appraisals measure, it can be easily assumed that which project will be more viable and feasible for McCain. To reach a conclusion we need to revise the following table
Appraisal technique
Wind turbine
(Results)
Waste Lagoon
(Results)
Comments
ARR
28.6%
30.64%
Higher ARR will preferable
PP
3y 6m
3y 5m
Lower PP will preferable
NPV
(5.692)
0.154
Negative NPV of a project means worthless investing on it
IRR
12.78%
15.134%
Wind turbine does not exceed its cost of capital (12.78%<15%) which means worthless investing
From the table it can be seen that, the NPV and IRR values are not favourable to invest for the wind turbine project, though it's ARR and PP somewhat appraisal. All the above values, on the other hand, are mostly favourable for Waste lagoon Project that will be viable and feasible in terms of all values mentioned. So, I recommend the McCain Company to invest on the Waste Lagoon Project.
Again, by analyzing the financial statements of the two engineering companies, it can be summarized as follows from which we can conclude that to whom the project can be handed over as a tender.
Financial Ratios
Omega
Alpha
Comments
Profitability ratio 2007 2008 2007 2008
Capital turnover
1.62 times
1.75
times
2.45 times
2.51 times
Alpha shows higher CT
Net profit margin
13.15%
11.88%
15.96%
15.57%
Alpha earns more profit on its sales revenue than omega
Gross profit margin
15.09%
13.47%
58.63%
58.12%
Alpha shows Higher GF
ROCE
21.32%
20.77%
39.06%
39.15%
Alpha is a effective business with its effective management ability
Liquidity ratios
Acid Test
1.47: 1
1.03:1
1.15:1
1.09:1
Alpha posses more liquid assists
Stock turnover
2.01times
2.23 times
1.87 times
2.03 times
Omega's ST is higher
Debtors collection period
81.2 days
89.63 days
34.40 days
36.26 days
Lower Debtor collection period will preferable
Creditors payment period
7.5 days
8.67 days
142.34 days
133.46 days
Higher Creditor payment period will preferable
From the table, it is crystal clear that the overall profitability ratios and Liquidity ratios are mostly support for the Alpha Renewable Plc. I therefore recommend the McCain Company to hand over the tender to this company which has shown its financial stability.
If McCain wants to install the Waste water treatment system (waste Lagoon Project), by rejecting the other project what I already recommended, it will not be needed any out source of funding because McCain's current net profit is £120 million whereas the Waste lagoon project will cost only £50 million. So the most desirable Funding might be retained profit, Delay payment to creditor and tighter credit control.
Appendix A
ARR for Wind Turbine
Year
Profit (£ million)
0
(100)
1
25
2
27
3
29
4
30
5
32
ARR = {(25+27+29+30+32)/ 5}/100 x 100 = 28.6%
ARR for Waste Lagoon
Year
Profit (£ million)
0
(50)
1
13.2
2
13.4
3
15
4
17
5
18
ARR = {(13.2+13.4+15+17+18)/5}/50 x 100 = 30.64%
PP of Wind Turbine
Year
Net cash flow
Cumulative
0
(100)
(100)
1
25
75
2
27
48
3
29
19
4
30
11 (pp occurs)
5
32
43
PP = 3years + 19/30 = 3y 6m
PP of Waste Lagoon
Year
Net cash flow
Cumulative
0
(50)
(50)
1
13.2
36.8
2
13.4
23.4
3
15
8.4
4
17
8.6(pp occurs)
5
18
26.6
PP = 3y + 8.4/17= 3y 5m
NPV of wind turbine
Year
Net Cash flow £mill
15% DF
PV
£mill
0
(100)
1.000
(100)
1
25
.870
21.75
2
27
.756
20.412
3
29
.658
19.082
4
30
.572
17.16
5
32
.497
15.904
NPV= (5.692)
NPV of Waste Lagoon
Year
Net Cash flow £mill
15% DF
PV
£mill
0
(50)
1.000
(50)
1
13.2
.870
11.484
2
13.4
.756
10.1304
3
15
.658
9.87
4
17
.572
9.724
5
18
.497
8.946
NPV= 0.154
IRR of Wind Turbine
Year
Net CF
£mill
DF 10%
PV
£mill
DF 15%
PV
£mill
0
(100)
1.000
(100)
1.000
(100)
1
25
.909
22.725
.870
21.75
2
27
.826
22.302
.756
20.412
3
29
.751
21.779
.658
19.082
4
30
.683
20.49
.572
17.16
5
32
.621
19.872
.497
15.904
NPV= (5.692) NPV= 7.168
IRR= 10 + {7.68/ (5.692+7.168)} X 5 = 12.78%
IRR of Waste Lagoon
Year
Net CF
£mill
DF 15%
PV
£mill
DF 20%
PV
£mill
0
(50)
1.000
(50)
1.000
(50)
1
13.2
.870
11.484
.833
10.995
2
13.4
.756
10.1304
.694
9.299
3
15
.658
9.87
.579
8.685
4
17
.572
9.724
.482
8.194
5
18
.497
8.947
.402
7.236
NPV = .154 NPV = (5.591)
IRR = 15 + {(.154 / (.154+5.591)} X 5 = 15.134%
ROCE
OMEGA
Alpha
2007
2008
2007
2008
(212.5 / 996.6) X 100
= 21.32%
(208.2 / 1002.2) / 100
= 20.77%
(20049 / 51324) X 100
=39.06%
(22142 / 56555 ) X 100
= 39.15%
Capital Turnover
OMEGA
Alpha
2007
2008
2007
2008
1615.5 / 996.6
= 1.62 times
1752.3 / 1002.2
=1.75 times
125648 / 51324
= 2.45 times
142231 / 56555
= 2.51 times
Net Profit Margin
OMEGA
Alpha
2007
2008
2007
2008
(212.5 /1615.5) X 100
= 13.15%
(208.2 / 1752.3) X 100
= 11.88%
(20049/125648) X 100
= 15.96
(22142 / 142231) X 100
= 15.57%
Gross Profit Margin
OMEGA
Alpha
2007
2008
2007
2008
(243.7/1615.5) X100
= 15.09%
(236/1752.3)X 100
=13.47%
(73662/125648)
X 100 =58.63%
(82671/142231)X100
= 58.12%
Acid Test
OMEGA
Alpha
2007
2008
2007
2008
(1039.7- 577.9) / 313.7
= 1.47: 1
(1162.6- 679.7)/ 468.8
= 1.03 : 1
(53397 - 27825) / 22289
=1.15 : 1
(57329 - 29315)/ 25573
= 1.09 : 1
Stock Turnover
OMEGA
Alpha
2007
2008
2007
2008
1371.8 / 679.7
= 2.01 times
1516.3 / 679.7
= 2.23 times
51986/ 27825
= 1.87 times
59560/29315
= 2.03 times
Debtor Collection period
OMEGA
Alpha
2007
2008
2007
2008
(359.4/1615.5)x 365
=81.2 days
(430.4/1752.3) x 365
= 89.63 days
(11843/125648) x 365
= 34.4 days
(14128/142231)x 365
= 32.26 days
Creditor payment period
OMEGA
Alpha
2007
2008
2007
2008
(28.2/1371.8) x 365
=7.50 days
(36/1516.3) x 365
= 8.67 days
(20274/51986) x 365
= 142.34 days
(21777/ 59560) X 365
= 133.46 days
