Evaluation of franchise investment
The franchise investment project is evaluated based on the net present value and the internal rate of returns. The available information is used to determine the NPV and IRR of Schneller Zug and Kyuko Densha. The two measures are used to assess whether each project is viable. NPV and IRR also help in choosing the better project between the two. NPV and IRR are determined using the cost of capital for Javelin Railway Co.
Determination of the cost of capital
The cost of capital is the return investors require from investment to secure funding. It is the minimum return projects must generate to be funded by the company. The cost of capital is determined by calculating the weighted cost of equity and debt.
Cost of equity
In this case, we estimate the cost of equity using the Capital Asset Pricing Model. The following formula gives the cost of equity:
Cost of equity, required return = Risk-free rate + Beta (Market return – Risk-free rate)
The beta for Javelin Railway Co is given as 0.5527. The risk-free can be obtained from the return on government bonds. In this problem, we use the return on a ten-year UK government bond. From the yield curve given, the return on a ten-year UK government bond is 2% hence, we can use 2% as the risk-free rate. We also assume that the required return on the market is 15%. As shown in the spreadsheet, the cost of equity for Javelin Railway Co is determined as 9.185%.
Cost of debt
There are two long-term debt instruments in the capital structure of Javelin Railway Co. The cost of debt is the after-tax interest rate for each debt instrument. To determine the total cost of debt, we calculate the weighted cost of debt. Eights are assigned to each instrument based on the total market value and not the book value. The after-tax cost of debt for Javelin Railway Co is 4%.
Weighted cost of capital
It is determined by calculating the weighted cost of debt and equity in the firm’s capital structure (Paramasivan and Subramanian, 2009). The market values of debt and equity are used to assign weights to each of the components. The market value of equity (total market capitalization) is £1,952.64 million while the total market value of debt is £749.67 million. The weighted cost of capital for Javelin Railway Co is therefore 8%. This is the rate that is used to determine NPV and IRR.
Determination of cash flows
Cash flows and not revenues are used in the valuation of each project. In the determination of cash flows, the £450,000 already incurred by Javelin Railway Co is excluded from the analysis. This is because it is a sunk cost hence it is irrelevant in the analysis.
The determination of cash flows expected from the two projects first involves determining the expected net income after tax. Therefore, the projected revenues and expenses are calculated for each of the years as shown in the spreadsheet. Cash flow adjustments are made to determine net cash flows from net profit after tax. The adjustments are as follows:
Depreciation
Annual depreciation expense is added back to the profit after tax. This is because is depreciation is a non-cash expense. Depreciation a provision Javelin Railway Co makes every year for the purpose of replacing the train at the end of its economic life (Moles, 2011). The salvage value is included as a cash inflow in the last year of the asset’s economic life. In this case, both trains had no salvage/terminal values.
Working capital
Capital projects involve an additional investment in working capital. The increase in working capital is included as a cash outflow at the beginning of the project (McMenamin, 2011). Therefore, it is added to the cost of purchasing the trains to determine the initial capital outflow. Working capital is recovered in the last year of the project’s economic life. Therefore, it is included as a cash inflow in the final year of the trains’ useful lives.
Net present value
NPV is the total present value of the cash flows a project generates over and above the initial cost (Khan and Jain, 2012). The determination of NPV involves discounting all the trains’ cash flows using the weighted cost of capital of Javelin Railway Co as the discount rate. For this case, the Excel NPV function is used to determine the NPV of each of the trains. Any project whose NPV is more than zero is considered viable for investment (Chandra, 2011). A project whose NPV is negative is not feasible and should be rejected. An indifferent situation arise when the NPV is zero. In such cases, the firm should consider nonfinancial factors in assessing the viability of the investments (Brigham and Ehrhardt, 2011). In the case of mutually exclusive investment options, the alternative with the greatest NPV is selected.
As shown in the Excel spreadsheet, the NPV of Schneller Zug is £8,430,414.26. This indicates that the project is viable since its NPV is positive. On the other hand, Kyuko Densha has a NPV of £14,510,746.13 indicating that it is also profitable. The NPV of Kyuko Densha is greater than that of Schneller Zug hence Kyuko Densha is a better investment. Based on this criterion, Javelin Railway Co should acquire Kyuko Densha train.
Using the NPV technique has several benefits. Firstly, it is a reliable technique since it incorporates all the cash flows expected from each of the trains right from 2017 to 2021. It also includes the element of risk and liquidity preference by discounting cash flows. Besides, the NPV method is consistent with shareholders’ wealth maximization (Helbæk, Lindest and McLellan, 2010). By considering the difference between cash outflows and inflows, NPV seeks to maximize the value of the firm. Therefore, the value of Javelin Railway Co will increase by £14,510,746.13 by the end of year 2021 if it acquires the Kyuko Densha train. It also gives an absolute value of the investment hence it is easier for the firm to decide than when using relative measures such as IRR or profitability index.
However, the determination of NPV is complex. It involves the determination of cash flows and the cost of capital. It is difficult to accurately determine the cost of capital for a firm (Damodaran, 2012). To mitigate this limitation, it is advisable to use the worst case weighted average cost of capital. This prevents the acceptance of projects that are not viable. Secondly, it may not be reliable for comparing projects with different useful lives and initial investments (Conradie and Fourie, 2011). For instance, it is unreasonable to compare two projects with initial investments of £300,000 and £5,000,000 based on the NPV.
Internal Rate of Return
The internal rate of return is the discount rate which equates the present value of cash inflows and outflows (Smart and Megginson, 2008). It gives the discount rate at which the NPV of the trains will be zero. IRR is a relative measure and expressed as a percentage. Under this method, the IRR and the company’s cost of capital to determine the viability of a project. A project with an IRR that is greater than the weighted average cost of capital is considered viable since it generates a more than the minimum required return (Shim and Siegel, 2012). If the project’s IRR is lower than the discount rate, it should be rejected since it is not viable. Where the IRR is equal to the discount rate, further analysis should be conducted before the investment decision (Berk and DeMarzo, 2007). Alternatively, nonfinancial factors should be used to assess the viability of the project. When there are two or more projects under consideration, the firm should select the project that maximizes the IRR.
The IRR for Schneller Zug is 12%. The IRR is more than 8% (WACC) indicating that the Schneller Zug train is a viable investment. The IRR for Kyuko Densha is 13%. This is more than 8% (WACC) hence the Kyuko Densha train is also a viable investment. The IRR for Kyuko Densha is more than that of Schneller Zug indicating that the Kyuko Densha train is a better investment that the Schneller Zug train. Therefore, Javelin Railway Co should acquire Kyuko Densha train.
IRR technique is beneficial since it incorporates all the cash flows generated by the trains in the analysis (Shapiro, 2010). It also incorporates the risk element in the analysis by discounting the trains’ cash flows. Besides, it is a relative measure hence it is reliable in comparing and ranking investment alternatives with different initial costs and unequal useful lives (Gallagher and Andrew, 2007).
However, IRR ignores economies of scale since it is a relative measure. If used to compare projects, an alternative with 12% IRR and a NPV of £100,000 will be selected at the expense of another with an IRR of 10% and a NPV of £250,000. Therefore, it will give a decision that does not maximize the value of the firm. Therefore, the method should not be used in choosing among mutually exclusive investment alternatives (Brigham and Houston, 2009). Besides, the rationale behind the IRR method is unreasonable. It assumes that cash inflows from the trains will be reinvested at the IRR. The IRR is sometimes so high and is rarely generated by a project. The NPV’s assumption of the reinvestment rate as the cost of capital is more reasonable.
Conclusion and recommendation
The above determinations indicate that both Kyuko Densha and Schneller Zug are viable since their NPVs are positive and their IRRs are more than 8% (WACC). Both the IRR and the NPV of Kyuko Densha are more than those of Schneller Zug train. This implies that Kyuko Densha is more viable than Schneller Zug under both criteria. If the two alternatives gave conflicting decisions, the NPV criterion would be used. The NPV is a more reliable measure than IRR due to the limitations of IRR outlined above. So long as the company has adequate funds to finance the initial cost of each investment, the NPV should be used in comparing the projects and selecting the best alternative. Therefore, Javelin Railway should acquire Kyuko Densha train.
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