Financial Analysis For Wonderland Confectionaries Theme Park Finance Essay - Free Essay Example

Sample details Pages: 12 Words: 3533 Downloads: 10 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? Wonderland Confectionaries Inc. owns a successful chain of Restaurants and the company is considering diversifying its activities by investing in theme park business by constructing a theme park. This report analyses the Wonderlands investment in the theme park to diversify its current business. Based on the information available from the market research undertaken by Wonderland and the investigation done on the closest theme park competitor, major investment appraisal methods were used to evaluate the above said investment. Recommendations are given based on the findings from the investment appraisal methods. Furthermore, investment appraisal method used in this analysis is compared with other major investment appraisal methods. In addition to that, financial and non-financial issues that management of Wonderland need to be aware of and suggestions on how to manage these issues are discussed. Further, a brief outline of the use of real options in project appraisal is given. Don’t waste time! Our writers will create an original "Financial Analysis For Wonderland Confectionaries Theme Park Finance Essay" essay for you Create order INTRODUCTION Wonderland Confectionaries Inc. owns a successful chain of restaurants and the company is contemplating to diversify its business activities by investing in theme park business. In order to undertake this diversification process, the company is considering constructing a theme park, which would have a mixture of family and adventurous activities. This report aims to analyse the Wonderlands investment in the theme park. Based on the information available from the market research undertaken by the company and the investigation done on a closest theme park competitor (Alice Limited), major investment appraisal methods will be used to evaluate the above said investment. Recommendations will be given based on the conclusions drawn from the investment appraisal methods used in this analysis. Furthermore, investment appraisal method used in this analysis will be compared with other major investment appraisal methods. In addition to that, financial and non-financial issues that management of Wonderland need to be aware of and suggestions on how to manage these issues will be discussed. Further, a brief outline of the use of real options in project appraisal will be given. NET PRESENT VALUE In order to calculate Net Present Value (NPV), Weighted Average Cost of Capital (WACC) needs to be calculated by using project specific approach as shown below. Main reason behind this is because WACC of the new project will represent the most accurate measure of cost of capital for the new project, which will be used as discount factor to calculate NPV. Further, Wonderlands funds can be viewed as a pool of resources. Company will withdraw money from this pool of funds to invest in the theme park project and add to the pool as new finance is raised or profits are retained. In this case, it is most appropriate to use an average cost of capital as the discount rate (BPP Learning, 2009, p.334). 3.1 Calculation of Project Specific WACC (Theme Park) In order to calculate project specific WACC, 5 steps will be followed as shown below: Step 1: Identify Pure Play Company; a company in the desired industry is identified to use their beta and relevant information. This is required to allow an insight into the risk of the industry as measured by the pure play companys data. In this case, the pure play company is ALICE LIMITED operating in Theme park industry. Step 2: De-Gear; pure play company identified has a beta, which is an equity beta that is inclusive of debt. They may very well have a different gearing level to the company concerned (pure play company; ALICE LIMITED), and effects of debt (gearing) need to be removed from their equity beta (De-Gearing) in order to obtain a debt free beta known as Asset Beta. Asset Beta = Equity Beta x Equity Equity + Debt (1-tax) Where; Equity Beta of Alice Ltd = 1.50 Equity of Alice = 500,000,000+700,000,000 = 1,200,000,000 Debt of Alice Ltd = 570,000,000 Corporate Tax = 35% Asset Beta = 1.50 x 1,200,000,000 1,200,000,000 + 570,000,000 (1- 0.35) Asset Beta = 1.146 Step 3: Re-Gear; at this stage the new asset beta will be taken to introduce it to see the effects of debt of the diversifying company (re-gearing). This can be done as follows: Equity Beta = Asset Beta x Equity + Debt (1-tax) Equity Where; Asset Beta = 1.146 Equity of Wonderland = gearing is estimated to be 80% of equity = 100,000,000 x 5 x 80% = 400,000,000 Debt of Wonderland = gearing is estimated to be 20% of debt = 100,000,000 x 5 x 80% = 100,000,000 Corporate Tax = 35 Equity Beta = 1.146 x 400,000,000 + 100,000,000 (1 0.35) 400,000,000 Equity Beta = 1.332 Step 4: CAPM; at this step, new cost of equity of Wonderland Confectionary Inc. is calculated based on the new beta, which is reflective of the risk that equity investors will now have to face. This can be seen below: Ke = Rf + B (Rm-Rf) Where; Ke = Cost of Equity Rf = Risk Free Rate (3.5%) B = Beta (1.332) Rm = Expected Market Return (12%) Ke = 0.035 + 1.332 (0.12 0.035) Ke = 0.1483 (14.83%) Step 5: WACC; It is best practice to use the Weighted Average Cost of Capital (WACC) method in appraising any investment. Tabular approach will be used to calculate WACC as shown below in the table 1: Table 1: Calculation of WACC Capital Component Market Value of Capital Component (V) Cost of Capital Component (K) Value multiplied by cost of capital component (VK) Equity 400,000,000 0.148 59,300,860 Debt 100,000,000 0.0521 5,200,000 Total (Sum) 500,000,000    64,500,860 1 Kd BD = i (1 t) = 0.08 (1 0.35) = 0.052 = 5.20% Weighted Average Cost of Capital (WACC) = ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  Ãƒ ¢Ã¢â€š ¬Ã‹Å" VK ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  Ãƒ ¢Ã¢â€š ¬Ã‹Å" V WACC = 64,500,860 500,000,000 WACC = 0.1290 (12.90%) Weighted Average Cost of Capital of 12.90% will be used as a discount factor to calculate Net Present Value. 3.2 Calculation of Net Present Value (NPV) The following major assumptions have been made in working out the NPV for the theme park project: This evaluation will ignore the market research cost of 400,000 as it is a sunk cost. Leap years will be ignored in this analysis. Insurance is required at the start of the project. As a result, out of 3,000,000 insurance costs, 2,000,000 per year is due directly to the theme park project. There will be no inflation on advertising costs. Advertising savings will be considered as cash inflows. Monetary analysis of future cash flows will be used because of different inflation rates as follows: (a). Revenue to rise by 6% from current on a compound basis. (b). Insurance costs to increase in line with consumer price, i.e. 6% per annum compounded annually. (c). Labour cost will be increased by 7% each year on compounding basis (d). Operating costs to increase by 5% per year. Theme park will be operated 7 days a week for 365 days a year and will be maintained during the night. Further, the following estimates have been made: (a). Park will attract an average of 20,000 visitors per day (for at least 5 years) and 70% of the visitors are forecast to be children and rest being adults. (b). Price of admission will be taken as 25 per adult and 15 per child. (c). Average visitor will spend 10 on food and drinks. Taking into account all the above major assumptions, total revenue per year is calculated in the following table 2 below: Table 2: Revenue Per Year Description Adults Children Total Number of visitors per day 6,000 14,000 20,000 Number of visitors per year 2,190,000 5,110,000 7,300,000 Admission Fee (@ 25 adults 15 child) 54,750,000 76,650,000 131,400,000 Food Drinks ( 10 per visitor) 21,900,000 51,100,000 73,000,000 Revenue per year (Admission and Food + Drinks) 76,650,000 127,750,000 204,400,000 From the above table it can be seen that theme park project will generate revenue of 204,400,000 per year. However, Wonderland Confectionaries Inc. expect it to rise by 6% from current on a compound bases as shown in the following table 3 below: Table 3: Net Trading Revenue Calculation Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue (6% inflation rate) 1 216,664,000 229,663,840 243,443,670 258,050,291 273,533,308 Total Revenue Per Year 216,664,000 229,663,840 243,443,670 258,050,291 273,533,308 Operating Costs Insurance 2 (2,120,000) (2,247,200) (2,382,032) (2,524,954) (2,676,451) Operating Costs 3 (17,000,000) (17,850,000) (18,742,500) (19,679,625) (20,663,606) Labour Costs 4 (37,450,000) (40,071,500) (42,876,505) (45,877,860) (49,089,311) Total Operating Costs Per Year (56,570,000) (60,168,700) (64,001,037) (68,082,439) (72,429,368) NET TRADING REVENUE 160,094,000 169,495,140 179,442,633 189,967,851 201,103,940 1 Revenue (Year 1) = 204,400,000 x (1.06)1 = 216,664,000; 2 Insurance (Year 1) = 2,000,000 x (1.06)1 = ( 2,120,000); 3 Operating Costs (Year 1) = 17,000,000 x (1.05)(1-1) = 17,000,000; 4 Labour Costs (Year 1) = 35,000,000 x (1.07)1 = ( 35,450,000) Tax payable can be calculated from the above net trading revenue for each year at a rate of 35% as shown below in the table 4: Table 4: Tax Payable Calculation Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Tax Payable 1 56,032,900 59,323,299 62,804,922 66,488,748 70,386,379 1 Tax Payable (Year 1) = 160,094,000 x 0.35 = 56,032,900 Out of the whole investment, 300 million will attract a capital allowance on straight-line basis as shown in the following table 5: Table 5: Capital Allowance Calculation Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Tax Relief 1 21,000,000 21,000,000 21,000,000 21,000,000 21,000,000 1 Tax Relief (Year 1) = 300,000,000 / 5 x 0.35 = 21,000,000 Theme park would cost a total of 500 million and could be constructed working after 1 year of investment. Half of the 500 million would be payable immediately and half in one years time without the effect of inflation due to a signed agreement. This is show in the table 6 below: Table 6: Investment Calculation Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investments (250,000,000) (250,000,000) In addition to the above, working capital of 60 million will be required from the beginning of the project and is expected to increase yearly in line with inflation factor of the revenue which is 6%. This can be seen from the table 7 below: Table 7: Calculation of the Working Capital Re-capture Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Working Capital (60,000,000) (3,600,000) (3,816,000) (4,044,960) (4,287,658) (4,544,917) Working Capital Re-capture (80,293,535) Non-current asset has an after tax realisable value between 100 million and 200 million after five years of the project. As a result, an average of 150 million will be taken as residual value as show in the table 8 below: Table 8: Calculation of Residual Value Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Residual Value 150,000,000 Due to dual use of existing advertising campaigns by company on its restaurants, theme park will save 3 million per year in advertising expenses as shown below in the table 9: Table 9: Savings on Advertising Expenses Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Inflow of Advertising Savings 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 With the help of all the above information, Net Present Value of the project can be calculated as shown below in the table 10: Table 10: Calculation of Net Present Value Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Net Trading Revenue 160,094,000 169,495,140 179,442,633 189,967,851 201,103,940 Tax Payable (56,032,900) (59,323,299) (62,804,922) (66,488,748) (70,386,379) Capital Allowance (Tax Relief) 21,000,000 21,000,000 21,000,000 21,000,000 21,000,000 Investments (250,000,000) (250,000,000) Working Capital (60,000,000) (3,600,000) (3,816,000) (4,044,960) (4,287,658) (4,544,917) Working Capital Re-capture 80,293,535 Residual Value 150,000,000 Advertising Savings 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Cash Flow (310,000,000) (125,538,900) 130,355,841 136,592,752 143,191,446 150,172,644 230,293,535 Discount Factor @ 12.90%1 1.000 0.886 0.785 0.695 0.615 0.545 0.483 Present Value 2 (310,000,000) (111,194,774) 102,268,671 94,917,399 88,133,559 81,869,308 111,203,407 NET PRESENT VALUE 3 57,197,569 1 Discount Factor is taken from the WACC amount calculated above which is 12.90%; DCF (Year 1) = 1.000 / 1.1290 = 0.886 2 Present Value (Year 1) = ( 125,538,900) x 0.866 = ( 111,194,774) 3 Net Present Value is sum of all the present values for 6 years which is 57,197,569 From the above table 10, it can be seen that theme park project has a positive net present value of 57,197,569 and as such Wonderland Confectionaries Inc. should accept the project. Positive NPV means that the project will increase the wealth of the company by the amount of the NPV at the current cost of capital. In other words, positive NPV means, if the theme park project is undertaken by Wonderland, it will offer a higher return than the return required by the company to provide satisfactory return to its sources of finance, which in turn means that the companys value will be increased and the project will contribute to shareholders wealth maximisation (BPP Learning, 2009, p.148). However, it is recommended for Wonderland to have a closer examination of the sales projections done for the project. NPV decision could be further supported by calculating the Internal Rate of Return (IRR) for the project. To calculate IRR, the following technique is used (deriving cost of redeemable debt technique): Columnar Approach. Identify the cash flows. Discount at two rates (Negative NPV = Divide 1st discount rate by 2 and Positive NPV = Multiply 1st discount rate by 2). Use the IRR formula (Entonu, 2010). Table 11: Columnar Approach to Calculate Internal Rate of Return Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Cash Flows (310,000,000) (125,538,900) 130,355,841 136,592,752 143,191,446 150,172,644 230,293,535 DCF @ 12.90% 1.000 0.886 0.785 0.695 0.615 0.545 0.483 Present Value (310,000,000) (111,194,774) 102,268,671 94,917,399 88,133,559 81,869,308 111,203,407 Net Present Value                   57,197,569 DCF @ 25.80% 1.000 0.795 0.632 0.502 0.399 0.317 0.252 Present Value (310,000,000) (99,792,448) 82,370,028 68,609,733 57,173,465 47,663,686 58,102,912 Net Present Value (95,872,625) Note: NPV at DCF (Discount Factor) @ 12.90% = 57,197,569; when NPV is positive, that means DCF used to calculate NPV is too low. As a result DCF should be multiplied by 2 (i.e. 12.90 x 2 = 25.80%) to get a negative NPV [NPV @ 25.80% DCF = ( 95,872,625)]. To calculate IRR, the following formula is used: Internal Rate of Return (IRR) = LR + NPV (+) x (HR LR) NPV (+) NPV (-) Where; LR = Lower Discount Rate HR = Higher Discount Rate NPV (+) = NPV at lower discount rate NPV (-) = NPV at lower discount rate IRR = 0.129 + 57,197,569 x (0.258 0.129) (57,197,569+ 95,872,625) IRR = 0.1772 IRR of 0.1772 (17.72%) is greater than the current weighted average cost of capital of Wonderland, which is at 9%, as such IRR agrees with NPV decision to proceed with the project. 3.3 Evaluation of Net Present Value method compared to other major methods used Net Present Value (NPV) is the difference between an investments (theme park) market value and its costs. In other words, NPV is a measure of how much value is created or added today to Wonderland Company by undertaking the theme park investment (Ross et al., 2008, p. 232). NPV appraisal method is the best method for the financial analysis of theme park project is for the following reasons (LSBF, 2009, p.34): (a). Theme park project with a positive NPV increases the wealth of the Wonderland Company and consequently increases the shareholders wealth. (b). Unlike ROCE and payback method, NPV takes into account the time value of money (a dollar today is worth more than a dollar tomorrow) and therefore the opportunity cost of capital. (c). Discount rate can be adjusted to take account of different level of risk inherent in different projects. In other words, higher discount rates can be set for riskier projects. (d). Better than payback and accounting rate of return method because NPV considers the cash flows over the whole life of the project rather than profit. (e). Superior to return on capital employed method because it focuses on relevant future cash flows. (f). Unlike internal rate of return, NPV method does not suffer the problem of multiple rates of return. FINANCIAL AND NON-FINANCIAL ISSUES There are number of financial and non-financial issues that the management of Wonderland needs to be aware as follow: (a). Financial Issues It is essential for Wonderland to include only incremental cash flows during project appraisal, which means cash flows that are dependent on the projects implementation (Arnold, 2005, pp. 82). It is important for Wonderland to include all opportunity costs and incidental effects in their investment appraisal (Arnold, 2005, pp. 83). Wonderland should ignore sunk costs such as market research cost of 400,000, as these are not part of the theme park investment project. Market research cost is already incurred whether or not decision to construct the theme park goes ahead and is there for not incremental (Arnold, 2005, pp. 84). It is fundamental that Wonderland management to include only incremental costs during project appraisal. This becomes an important issues when it comes to overhead costs such as labour, insurance and operating costs, etc, which are not directly related to any one part of the company or one project. To access the viability of the theme park project, only incremental expenses that would be incurred by going ahead with the project should be included as other general overhead costs will be incurred regardless of whether project takes place or not (Arnold, 2005, pp. 84). Even though interest on bank loan to be borrowed by Wonderland to invest in the theme park project does represent a cash outflow, this element should not be included in the cash flow calculations. The main reason is that, it will lead to double counting, as the opportunity cost of capital used to discount the cash flows already incorporates a cost of these funds (Arnold, 2005, pp. 85). Before Wonderland commits to invest in the theme park project, it is vital to ensure funding for the project is available. Further, identifying the right finance option for the particular project is essential from the different varieties of financing options available (Business link, 2010). Wonderland should consider potential risk of the theme park project. This could be done with the help of assessment of all the risks involved in the project such as delays, underlying assumptions not being reliable, sales forecast gone wrong, etc. Further, they could use sensitivity analysis to predict the impact these potential risks will have on the project (Business link, 2010). (b). Non- Financial Issues It is important for Wonderland to see how theme park project fits with the existing business of the company. Further, they should consider how this project could contribute to overall strategic objective of the company (Business link, 2010). Green Issues: It is important for Wonderland to consider the environmental impact that might be cause because of theme park project. It is vital for Wonderland to use most advance technologies to limit the damages caused to the environment because of the huge project. The main reason is that, companies who do not investment in green activities are considered now as irresponsible by the public who will in turn become customers of the theme park project. Motivation of staffs: The effect on the staff is a crucial consideration to be made when investing in new projects. Arnold (2005, p. 76) states that staffs enthusiasm and commitment will be central importance of the success of new projects. It is important for Wonderland to find ways to improve staff morale, making it easier to recruit and retain employees (Business link, 2010). Customer satisfaction: Its important for Wonderland to find ways to satisfy the prospective customers of the theme park project by conducting market surveys, market observation and market experiment, etc (Arnold, 2005, pp. 76). Government regulations: It is vital that Wonderland keep up to date with the government regulations and they should meet the requirements of current and future legislations (Business link, 2010). Competitors: Wonderland should consider actions of their major competitors such as Alice Ltd before making the investment decision (Business link, 2010). Trends: They should consider the future trends before making the investment decision to see the potentials in the theme park project. Further, it is important for Wonderland to anticipate and deal with future threats such as projecting intellectual property rights against potential competitors (Business link, 2010). It should be noted that most of the above non-financial issues could be assessed with the help of post audit techniques where by company checks on the progress of theme park project by conducting post audits shortly after the projects have begun to operate. This will allow Wonderland to indentify problems that need fixing, check the accuracy of forecasts and suggest questions that should have been asked before the project was undertaken (Brealey and Myers, 2003, pp. 313-314). REAL OPTIONS A real option is the right but not the obligation to undertake some business decisions; typically the option to make, abandon, expand, sell a capital investment (Kodukula and Papudesu, 2006, pp. 53-64). If Wonderland decided to investment in the theme park project, it should be noted that there are many options available for them through out the life of the project to make strategic changes as follows: (a). Abandonment: This is option where by Wonderland can cease the project during its life if it is not viable for them to continue the project due to several reasons such as changes to demand, economy, etc. Due to changes in circumstances, Wonderland can decide to abandon the theme park project in order to terminate loss-making projects (Brealey and Myers, 2003, p. 625). (b). Expansion: Depending on the success of the theme park project, Wonderland can decide to expand its theme park project to gain more market share in this industry (Arnold, 2005, p. 562). If there is potential for growth opportunities in the future, the option to expand can provide significant value to the company (Kodukula and Papudesu, 2006, p. 110). (c). Flexibility: During the life of the theme park project, Wonderland will have the option to change inputs and output of the theme park projects for example, changes in suppliers or different pricing methods, discounts, etc in order to generate more profit from that project to the company (Brealey and Myers, 2003, pp. 630-631). (d). Selling: Option where by company decides to sell the whole project for several reasons such as loss making projects or company received an opportunity to sell project at profit if they decides to abandon its theme park project, etc. (e). Timing: Even though theme park project is giving a positive NPV does not mean that Wonderland should go ahead with the project today. Company has the option to wait if they can delay the investment decision where creating a trade of between cash flow today and cash flow in the future. Further, if they decided to wait, they could make a more informed and in the long run more value creating decision (Arnold, 2005, p. 563). 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