Study on Investment Appraisal and Takeovers Finance Essay

Investment analysis is very important as it establishes cash and other resources are invested in profitable projects and identify some risk which might arise from investment and measures to eliminate the risks. Getting the right choice of a project to invest is crucial, the management need to have the skills to make the right decision which will maximise stakeholder's profit. Most of the companies have lost their reputation and even liquidated due to wrong managerial decisions on what investment to embark to, hence a proper and less risk method of investment analysis is crucial in this role. This is an academic report analysing Jebb PLC, a predator (acquirer) company proposed to takeover a target rival company. In this report, I as a senior Financial Manager in large listed company, I have analysed business investment feasibility, to assess whether it is worthwhile to make a company's investment decision. The analysis has covered reasons behind takeovers, methods and potential effects of takeovers. Also I have looked at the methods of investment appraisal, nature of gearing, risks and cost of capital.

2.0 TAKEOVERS

Jebb PLC has decided to embark into takeovers as one of its growth strategies to increase the wealth of shareholders. Takeovers can be simply defined as the purchase of one's company (the target) by another (the acquirer, bidder or predator). In takeovers basically a stronger company takes over a weaker one. The general driving force for Jebb Ltd takeover has been enhancement of shareholders' value, bringing cost saving and efficiencies. However the reasons can be analyses in length here under as follows.

2.1 Reasons behind takeover

Economies of scale This is simply reductions in the average cost of production, and hence in the unit costs, when output is increased. Oxford Dictionary of Business and Management 4th Ed. When the cost of producing a unit of good falls as its output rate increases, economies of scale exist. Michael Parkin (2003) p. 189 In this context the fixed operating costs are being spread over a larger production volume, equipments are being used efficiently with high volume of production. Economies of scale arise from specialization and division of labor that can be reaped more effectively by firm coordination rather than market coordination. Michael Parkin et al.Economics 5th ed. (2003) p. 189. Following this acquisition Jebb Plc expect cost reduction and hence achieve of economies of scale (scale effect) In the economies of scale to work out Jebb Plc would expect one of the following to happen. Negotiation of lower prices with suppliers for larger orders Combined production processes, or operation on larger but fewer sites to save operating costs Saving in administration, distribution, marketing or research and development costs.

.

Growth, Empire building and market penetration by accessing to new markets, may be achieved at a much quicker rate by buying existing operator Avoiding higher start up costs Barrier to entry in industry or country may be avoided Access to skilled workers, hence performance maximisation Brands/patents a trademark which increases company's reputation. Complementary resources Here there are mutual benefits, the predator company will provide the necessary ingredients necessary for a small company (target) success. In this situation a small company may have unique product/services but lack the managerial, engineering, knowhow and many more which requires a target company to produce and market its product/service in a profitable way. (Richard A. Brealey, et al pg. 886). Acquire technology and R&D expertise

2.2 Potential effects of takeover

The process of takeover has both positive and negative effects for both parties, i.e. predator's side and to a target company. In this case I will base on the potential effects which might arise in Jebb Plc as acquirer and few for a target company. On positive side the offer given by Jebb Plc to its target company will Increase production level, thus increase of profit margin and maximisation of shareholders wealth and dividends. This growth and shareholders increase in wealth is possible due to synergic effect, by sharing expertise, cost saving production costs per unit and increase in company's reputations, advantage in sharing technology and many more. As we have seen the aim of takeover is to maximise shareholders wealth however this is not always the case. A survey conducted shows the following are some of the factors contributing to M & A fail. Target management attitudes and culture differences Lack of post acquisition planning Lack of knowledge of the industry or target company Poor management practices in target company Little or no experience of acquisitions. (Per Cooper and Lybrand survey in Merger and Acquisition conducted in 1992) The takeover predictions might prove disaster due to hostility takeover process, whereby a predator company is forced to overpay a target company in a bidding process so as to win a bid. A simple recent example here is a takeover between Kraft a US Food Company and Cadbury a British-based confectionery company, which took place in March 2010. Initially Kraft valuing a company at £9.8bn this were rejected by Cadbury, it went up to £10.5bn still were rejected and the last deal were made at £11.5bn. The overpay has increased Kraft debt after had to borrow £7bn to finance the takeover, this can further increases Interest rate. Available at: https://news.bbc.co.uk/1/hi/8467007.stm accessed on 10 April 2010 Normally this happens when a company is losing sight in hostile takeover as a company focusing in winning. Another negative effect is time consuming in the course of takeover and a company can even step aside in concentrating in running its current business, and dealing with takeover process. Redundancies can be one of the disadvantages, as not all staff will be taken to start a new project, especially top posts as there is likelihood of having two experts in one post, one from target and the other from acquirer companies. This can be seen from my example as it has happened in Cadbury were Chairman Roger Carr, Chief Executive Todd Stitzer and Chief Financial Officer had to resign, this were followed by Kraft announcement that it planned to close the Cadbury factory at Keynsham with the loss of 400 jobs. Available at: https://news.bbc.co.uk/1/hi/business/8453433.stm Accessed on 12 April 2010. Also a company should expect increasing running costs at the beginning which will be used in business reengineering process, and staff training especially when is to do with deliver in a new technology. Most of the disasters occurring in M&A even in many mergers which seem to make economic sense are due to Management failure (as we have seen according to Per Coopers and Lybrand survey 1992) to handle the complex task of integrating two firms with different production processes, accounting methods and corporate cultures. A simple example here is the merger of three Japanese banks to form Mizuho Bank. These tree Largest Japanese banks predicted that the bank would lead the new era through cutting-edge comprehensive financial servicesA¢â‚¬A¦A¢â‚¬A¦A¢â‚¬A¦A¢â‚¬A¦.Within three months of operation after its merger IT problem occurred, due to different supplier of its computer system, the system couldn't link they then decided to connect the three different systems together using relay computers. This was disaster as some 7,000 of the bank's cash machines did not work, 60,000 accounts were debited twice for the same transaction and a lot more problems. The Economies April 27, 2002. p. 72 "Big Bold, butA¢â‚¬A¦. One of the objectives of Mizuho was to exploit economies in its IT Systems. The fiasco illustrate dramatically that it is easier to predict such merger synergies than to realize them. Motivations and involvement of staff in the whole process of takeover is of paramount important so staff can buy the idea, as the value of the most business depends on human assets(managers, skilled workers, scientists, and engineers). If these people are not happy in their new roles in the acquiring firm the best of them will leave. (Richard A. Brealey, et al pg. 884). One Portuguese bank (BCP) learned this lesson the hard way when it brought an investment management firm against the wishes of the firm's employees, when the entire workforce immediately quit and set up a rival investment management firm with a similar name. Occasionally a takeover does gains but buyers nevertheless lose because it pays too much. This happen especially in unforeseen circumstances when Predator Company underestimate the cost of renovating old plant and equipment, or it may overlook the warranties on a defective product and other costs. At the end of the day all these costs will probably fall on the buyers. I have analysed the reasons behind takeovers, and the methods by which such takeover may take place together with the potential effects of takeover, with some real life example. Jebb Plc should learn a lesson from what has happened to other companies in a takeover exercise, by making sure realistic and better informed decision is made on acquiring and disposing of assets to avoid any disaster.

3.0 METHODS OF INVESTMENT APPRAISAL

Investment can be defined as the purchase of creation of assets with the aim of making profit in future. Economists define investment as the addition to the capital stock of the economy - factories, machines offices and stock of materials, used to produce other goods and services. Alain Anderton Economics (1999) 2nd ed. Investment appraisals are conducted as an assessment tool to see whether it is worthwhile to embark into a certain investment. Economies Investment decision making is one of the most critical and key area in an organisation. The decision in opting what project a company should go for which will earn the firm more than amount employed over a period of time needs managerial skills to handle. Jebb Plc need to assess outflow and inflow of funds, the lifespan of the investment, the degree of risk attached and how much will it cost a firm to obtain funds, with the maximisation of shareholders wealth as the key business objective. The investment appraisals conducted by Jebb Plc will ensure the cash and other resources are invested in the most profitable and less risk projects. Any arising risk(s) will be considered and measures will be taken to eliminate the risk and/or reduce the impact. In order to achieve a profitable and economic sound project various methods on investment appraisal are used. These methods are categorised into two, the traditional methods includes payback period (PP) and Average Rate of Return (ARR) and the second method is discounted cash flow (DCF), this one includes the Internal rate of return(IRR) and Net Present Value (NPV)

TRADITIONAL METHODS

Payback Period (PP)

Payback period measures the length of time taken for a project to pay back /repay its initial capital cost. A company uses the method in deciding between two or more competing projects by taking the one with shortest payback period. The method is used as an initial screening method. Mathematically a PP can be calculated as: Payback Period = Initial payment / Annual cash flow The method is the most widely used worldwide than any other method according to number of literatures. The research has proved most of UK firms prefer the method. (See fig: 1, a comparative study of appraisal techniques used by 100 large UK businesses - Upchurch, 1988 p.p.337). The reasons behind this are as follows: Simple method available to compute It acts as proxy for risk Provides a crude measure for liquidity-can be useful in a business where liquidity is a problem. The problem with most of investment appraisal methods is risk in capital budgeting, as most of the data used in decision making are based on estimation. Most of the data are derived for the later year of a project further from today's value of cash flow this make it less reliable. In a payback period in this respect it tells a manager how soon the project cash inflow covers its cash outflow. The quickest the money can be recovered back the better the project to embark to and most of UK managers are rewarded after a quick return. In this case Jebb Plc need to be risk averse and will decide on the project which have lower value for PP. Despite of favourability to PP there are strong arguments against it as follows: Cash flows are regarded as pre-payback or post payback, but the latter tend to be ignored. It ignores the time value for money. This is sufficiently serious for it to be rejected as an indicator of whether a project increases the value of a company, it takes no account of the effect on business profitability, its sole concern is cash flow. Ignores the risk of future cash flow Takes no account of what is happening with interest rate

Accounting Rate of Return- ARR

Accounting Rate of return also called ROCE and ROI expresses the profit arising from a project as a percentage of the initial cost. The method look at annual accounting profit rather than cash flows. The calculation has shown differently in different textbook, however one of the most common approach is this one: ARR = (Average annual revenue / Initial capital costs) * 100 The average investment is given by: (Cost + disposal value) / 2 The rate of ARR obtained using the method is compared with a pre-determined hurdle rate and the project with greater return would be acceptable. Example if the ARR method gave ARR of 17% and the firm's hurdle rate was 13% then a project does worth. The method can also be used to compare the worth of more than one project, by opting the one with the highest rate of return.

Advantages of AAR

As we have seen with pp, the chief advantage of ARR is simplicity. The percentage value given make it easier for business planner to understand, and make it easier for manager to understand It shows investment profitability The value in % can easily be compared with hurdle rate r with the company's existing ROCE and to compare mutually exclusive project. It consider all cash flows over the life of a project (unlike PP)

Disadvantages of ARR

Despite its usefulness ARR method has got a number of criticisms as follows: Uses accounting profit (and not cash) which can be manipulated (e.g. by changing assumptions about scrap value and hence annual depreciation charges. Uses average profits therefore does not take into account the timing of profits (earlier profits may be preferred to later ones) Ignore qualitative aspects of decision. There is no definitive signal given by the ARR for managerial decision whether to invest or not. The lack of guide for managers makes it subjective rather than objective. Doesn't consider how long recover in initial investment and cost of finance may take.

DISCOUNTED CASH FLOW (DCF)

We have seen Traditional methods of investment appraisal which are PP and ARR. Now I will discuss DCF, the differences between this with the earlier methods are its consideration of the time value. These two techniques take account of all the costs and benefits (in cash terms) over the life of project and take into account the timing of the cash flows and benefits over the project life. As with the payback method, DCF analysis is based on cash flows not the accounting profit or losses. The timing of cash flows is taking into account by discounting them to a present value (PV)

Internal Rate of Return (IRR)

IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital employed. OR It can be defined as the rate of interest applying to a project at which its net present value is precisely zero. The calculation shows us the break-even financing cost. The method in some senses seems to be simplest of the technique to understand. However it is the most difficult to cope with mathematically. A number of text and surveys has shown that, practically IRR method is more popular than the NPV method. This is said may be IRR is straightforward. Decision to accept a project is made when IRR is greater than a company's cost of capital or target rate of return.

Disadvantages of IRR

Notwithstanding its popularity in the business world, IRR bring about many problems than a practitioner may think. IRR gives unrealistic rates of return, this is the main problem of IRR. So unless the calculated IRR is a reasonable rate of reinvestment of future cash flows, it should not be used as a standard for comparison to accept or reject a project. Moreover IRR method may give different rates of return. Also IRR cannot be used to rate mutually exclusive projects.

Net Present Value (NPV)

NPV is a the Investment Appraisal tool/technique, where cash inflows expected in future years are discounted back at the appropriate discount rate to their present value. NPV has also been defines as "The difference between the present value of the cash inflows and the present value of the cash outflows associated with an investment project" (McGraw-Hill Ryerson 2001). A positive NPV provides cash flows from the Capital investment which yields a return in excess of the cost of finance/capital. Jebb Plc will treat +ve NPV as an attractive project which will help in decision making. If the NPV is -ve, cash inflows from the capital investment will yield a return below the cost of finance/capital from a finance perspective, the project is unattractive. If the PVC is exactly zero, cash flows from the capital investment will yield a return exactly equal to the cost of finance/capital, the project is therefore about financially attractive. Jebb Plc will use NPV as one of investment appraisal tools to measure how much value is created or added today by undertaking an investment. In this technique Jebb Plc will accept to embark into a project if the net present value is positive and likewise rejected if it is negative. For mutually exclusive projects Jebb Plc will accept the one with the highest NPV value to maximise shareholder's wealth.

Advantage of NPV

The following are some of benefits of using NPV which will be considered by Jebb Plc as an aid in decision making. NPV recognises the time value of money reflected in the discount. This is a key concept in corporate finance. It must be recognised that £20,000 received today is worth more that £20,000 receivable at some point in time in the future because £20,000 received today could earn in the intervening period. This is known as the 'time value of money concept'. The technique takes into account the risks involved in an investment through expected cash flows and/or discount rate. NPV offers a degree of flexibility and depth, since the equation can be adjusted for inflation and can be used with other financial tools such as Scenario analysis and the Monte Carlo simulation. Take account of both amount and timing of cash flows over the whole life of the project Has a direct relationship to shareholder wealth (positive NPVs increase it, negative ones decrease it).

Disadvantages of using NPV

Despite the above advantages, NPV have a number of problems of which Jebbs Plc needs to be aware. Here are some of the problems:- NPV looks at cash flows and not at Profit and Losses. NPV is highly sensitive to discount percentage, this makes it difficult to identify an appropriate discount rate. Choice of discount rate is one of the critical factors in NPV calculation the other factor is Quality of forecast cash flows. Using a standard discount rate where all projects are discounted using a standard rate, despite their different risks, may undervalue or overvalue the project, decreasing the overall accuracy. NPV does not compare absolute levels of investment. All in all DCF method is preferable to either PP or ARR because DCF takes account of the time value of money, and thus will maximise shareholders' wealth. And NPV is the most acceptable technique compared to others.

4. GEARING

Jebbs Plc investment will only be worthwhile if the expected return on capital employed will be greater than the cost of capital. The cost of capital is the return to the providers of finance to a business. Cost of capital can also defined as "the cost of capital is the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security. This rate is determined by the returns offered on alternative securities with the same risk" Arnold, G (2008) Corporate Financial Management, Harlow: FT Prentice Hall Jebb Plc needs to make the right decision when taking a loan to finance its project by reducing a cost of capital and hence reducing gearing ratio. The gearing ratio this is the percentage of capital financed by debt and longtime finance. The higher the gearing, the higher the dependence on borrowings and long-term financing. And the lower the gearing ration the higher the level of dependence on equity finance. Before we see the potential effects of higher gearing on perceived risk and cost of capital let's see 2 schools of thought in capital structure

Theory of Capital Structure-2 School of thought

There are two schools of thought: Traditional-Traditionalist believes that capital structure is very important That business should seek to establish the optimal mix of debt and equity (optimal capital structure), where the cost of capital is minimized and the value of the business is maximized. Modernists (Modigliani and Miller-M&M) theorem - believe capital structure it is irrelevant. Capital structure-Traditionalist view It regards the cost of capital to be cheaper than equity, following a lower risk for the borrower and tax advantages for the company. This implies that the overall cost of capital can be reduced by increasing the level of borrowing (of gearing). However as the level of borrowing increases the return required by ordinary shareholders also increases to compensate for the higher level of financial risk they have to bear. At low level of borrowing the benefits of raising further debt (cheap source of finance) should outweigh the costs of doing so (increased return to shareholders and existing lenders) For highly geared companies, the costs of further increases in debt will outweigh the benefits. Capital Structure - Modigliani and Miller M&M argue that the benefits from raising debt finance are exactly offset by the increased return required by shareholders over the whole range of borrowing. Therefore the overall cost of capital remains constant at any level of gearing and there is no optimal capital structure. Capital structure is irrelevant and changes in it do not affect the value of a firm. Modigliani and Miller (1958). The following are assumptions lied behind M&M theorem. There are no taxation There are no costs involved in changing capital structure such as issue and dealing costs. There is one rate of interest that applies to both borrowers and lenders. In addition M&M assumed that the capital markets are efficient and perfect. The first assumption is the most critical and led M&M to revise their theory after criticism in 1963 to incorporate corporation tax. To conclude the link between cost of capital and gearing level is not direct and proportional. A company should look into all the associated factors like tax implications, risk, bankruptcy, agency costs, cost of serving the debt, in deciding its capital structure. In the real World at low level of borrowing the cost of capital will decline and gearing increases. Eventually at higher levels of gearing, the cost of both debt and equity will shoot up due to bankruptcy and agency costs, causing the overall cost of capital to rise also. Atrill, P (2009) 5TH ed. Financial Management for decision Makers, Harlow: FT Prentice Hall

Potential effects of higher gearing

The higher the ratio of debt to equity the riskier the company is from the ordinary shareholders point of view. Some investors might decide to withdraw their investment if the company has high gearing as it rating will go down. Agency costs involved in monitoring and controlling actions of manager to avoid company experiencing financial difficulties. Tax exhaustion: The task benefit relief will be lost. If the company has very high gearing due to lack of taxable income to offset against the tax relief and also affecting the operating income.

CONCLUSION

Capital budgeting is a crucial managerial tool. Jebb Plc is required to choose investment with attractive and sound cash flows and rates of return. Jebb Plc will use capital budget to evaluate, compare and select attractive project. The investment Appraisal techniques will also help Jebb Plc management to know whether the project under review is attractive one risky one or a safe one. In this case NPV is recommended however should be seen as a starting point in any decision making rather than the decision by itself. In choosing these techniques Jebb has to consider both financial and non financial factors. Jebb will also make the right informed decision when taking a loan to finance its project by reducing a cost of capital and hence reducing gearing ratio. This will reduce risks as borrowed fund is attached with interest which has to be paid irrespective of business performance.

REFERENCES

BBC News Online Richard Pettinger: Investment appraisal- managerial approach. Neale, B and T McElroy (2004) Business Finance a Value-Based Approach Arnold, G (2008) Corporate Financial Management, Harlow: FT Prentice Hall The Journal of Finance Vol. XLVI No. 1 March 1991 Michael Parkin et al.Economics 5th ed. (2003) Alain Anderton Economics (1999) 2nd ed

Cite this page