Corporate Finance

TABLE OF CONTENT

Sr. No. Topics Page No.

1 Abstract

Overview of the company 2

2 What does NPV? 3

3 Project Appraisal 4

4 Estimation of theme park project's WACC 5

5 Calculation of the NPV 7

6 Critical Financial Issue 9

7 Critical Non-financial Issue 11

8 Real option in capital budgeting Project 13

9 Conclusion 14

10 Appendix 15

11 References 16

Abstract:

In this report Wonderland company is consider as a diversification of its activities by investing in the theme park business through the construction of a theme park, therefore company has to need some financial calculation whether this project is profitable for the company of not, Wonderland done some financial calculation through NPV calculation of the whole project. In this report emphasis on total revenue of the project, total expenditure of the company, capital allowances, tax liability of the company, calculation of NPV, decision making, sensitivity etc. In this report also indicates that why should company undertake this project or why should not company undertake this project and relevant advice to management. Wonderland also spent £40,000 on market research for theme park investment and also wants to evaluation of project.

What Does Net Present Value (NPV)?

Net Present Value means difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of project or an investment. NPV analysis is sensitive to the reliability of future cash inflows that project will yield. NPV determine two variables: the expected future cash flows and the expected opportunity cost. (Brealey, 1988: 88)

A Net Present Value includes all cash flows including initial cash flows such as the cost of purchasing machinery, asset, whereas a present value does not. NPV compares the value of a pound today to the value of that same pound in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

In sum:

If the net present value is Then the project is

Positive Acceptable because of rate of return greater than the required rate of return

Zero Acceptable, because of rate of return equal to the required rate of return.

Negative Not acceptable, because of rate of return less than the required rate of return

The equation for NPV when there is conventional initial investment:

Where:

CF = Cash inflows COF = Cash outflow (initial) K = cost of capital

n = number of years or time

The equation for NPV when there is non-conventional cash flows

If projects with positive NPVs are accepted; or if necessary, whichever with the highest NPVs are selected? In the case of interacting projects, there are additional issues have to be borne in mind in the terms of whichever is best. For the Contingent projects are those projects which have to be carried out together or not at all. In the case of mutually exclusive projects are also contingent projects, where, from a set of projects, only one project can be chosen out of more than one.

Project Appraisal - NPV Method

For the capital budgeting projects, Net Present Value (NPV) technique is one of the most widely used method.

Key Assumptions:

i. The project has been analysed for a period of five years.

ii. Total insurance cost of the company £3 million, of which £2 million per year is due directly to the theme park project and it increase 6% per annum.

iii. Working capital of £60 million will be required from the beginning of the project and is expected to increase year in line with the inflation factor of the revenue 6%.

iv. Company has been spent £40,000 as sunk cost and not taken into the calculation of NPV because the expenses have already incurred and are irreversible outflows. These sunk costs do not affect the decision to accept or reject the project and hence they should be ignored.

v. The non-current asset has an after tax realise value £100 million after five years of the project.

vi. Saving in advertisement expenses amount £3 million are assumed as incremental cash flows and are expected to remain constant over the next five years.

vii. Discounted rate to be used the Wonderland's project's cost of capital adjusted for h risk level. Wonderland diversifying into a different types of business form the its restaurant business, the theme park project's expected risk and return would be different from the group's risk and return. So, NPV has been calculated on the basis of project's weighted average cost of capital (WACC).

WACC is the weighted average cost of capital. WACC basically the cost incurred when you use your capital as an investment. if you have been taken bank loan as a financial source, than the cost is the interest rate. if it's from owner equity than the cost is the investor's expected return on investment.

Estimation of Theme Park Project's WACC

WACC Calculation

Evaluating of the theme park project at risk and for the expected rate of the return or discounted rate, the financial figure of Alice Ltd., the closest competitor of the theme park is taken into consideration. We are certain that the risk characteristic of both are vey similar to each other. We can, therefore, use their financial figure as a road map for the evaluation of the theme