Finance assignment: Investment appraisal mechanism of Scylace

Question

Task: Open and review your answers to Assignment 2 Element 1 – Timed Test.
You must use your own answers to Assignment 2 Element 1
A. Report Question
In this report you must use the information provided in the examination paper. You must also use the figures which you have calculated in the examination.
You will be penalised if you use figures which are not consistent with your examination answers.
You will not be further penalised in the report exercise for using figures which you have submitted as examination answers, even if your submitted answers contained errors.
Further information: Scylace plc has total assets of £312 million, including £14 million in cash, with total liabilities of £98 million.

Answer

Introduction
This finance assignment is prepared by the management consultant appointed by the grocery retail chain, Scylace plc. as it plans to explore alternatives for its expansion. The retailer stands to explore alternatives like either building a new superstore or acquiring its fellow competitor, the retailer – Helibeb plc. The purpose of the finance assignment would be to analyse both the scenarios like evaluating whether it would be feasible for the retailer to have a single superstore or two superstores at different locations. It is also going to evaluate on the acquisition analysis of Helibeb and its plausible benefits for the decision making.

The business decision would be contemplated based on the financial prowess of Scylace having assets worth £312 million, including cash resources for £14 million and liabilities worth £98 million. So considering the liquidity level of the business, kinds of option would be explored to see which alternative would suit the retailer. In this trajectory, the prowess of the investment capability of the retailer would be adjudged variably. This is done to explore whether having new superstores or acquiring its fellow competitors would be effective and profitable for the business.

Methodology to evaluate the alternatives:
In light of the available financial resources of Scylace say cash resources for £14 million, the organisation need to look for raising additional amount from the market to serve its purpose. But before that it would analyse the following methodologies discussed within the finance assignment to evaluate its investment proposals:

Net present value –
Net present value (NPV) is derived using the discounted cash inflows and outflows owing to the capital investment mechanism. It is used for capital budgeting to evaluate whether the proposed investment would yield profitability to the firm (Damodaran, 2016). NPV could be worked out using the following formula provided in the finance assignment –

Rt = Difference between cash inflow and outflow during the period t
i = Discounted rate of return
t = Number of periods

It is noteworthy to mention in the present section of finance assignment that a positive NPV is desirable to consider the investment while a negative NPV would be rejected straightaway. NPV is considered important for investment evaluation purpose as it takes into consideration the time value of money (Warren & Jones, 2018). But consideration of the discounted rate is a practical issue alongside misleading intents while dealing with alternatives having different number of years.

Internal rate of return –

Internal rate of return (IRR) is the determinant used for determining financial feasibility to find out the profitability of the potential projects. Theoretically, it is the discounted rate that equates the NPV derived of the cash inflows to zero while determining the discounted cash flow analysis (Bolton, Wang, & Yang, 2019). Both IRR and NPV follow the same formula. The IRR facility is effective for analysing the capital budgeting process to have an understanding and comparison of the plausible rates of yearly returns during the period (Dang, Li, & Yang, 2018). But IRR could be misleading at times as it comes out with multiple rates making the scenario complicated.

Payback period –

The term Payback period (PBP) outlined in the finance assignment considers the time period required by the business to recover its invested capital in the project (Fracassi, 2016). So it is the time length used by the project to attain the breakeven point. Its benefit lies in understanding the feasibility of the investment as a shorter PBP would be preferred over a longer tenure. It is simplistic to understand and determine the PBP and going by the uncertainty and dynamism of the business scenario, the investors generally prefer shorter PBP to recover their investments (Malmendier, 2018). PBP is concerned about the project’s liquidity and not its profitability, ignoring the time value of money.

Accounting rate of return –

The investigation on finance assignment illustrates that accounting rate of return (ARR) is the anticipated return on investment in context to the preliminary investment cost. It is derived by dividing the average annual post-tax profit by average investment (Atanasov & Black, 2016). The aspect of average or initial investment is used for the purpose and the one with the higher return is generally preferred over the other. The ARR mechanism is suitable to contemplate a quick decision as it is easy to determine (Chen, Filardo, He, & Zhu, 2016). Unlike NPV and IRR, ARR does not take consideration of the time value of money.

Evaluation of the proposed new superstore locations and prospective acquisition:
Investment appraisal –

To start with the investment evaluation process, the distinctive approaches of NPV, IRR, PBP, and ARR would be used for the purpose of assessing the locations of the superstores. Certain assumptions has been undertaken for the purpose of evaluation, say for the time being the evaluation has been considered for the initial 5 years. Such number of years are sufficient to understand the direction in which the business is headed to (Vishny & Zingales, 2017). So based on the initial 5 years outcome, the decision would be undertaken. The investment appraisal of the superstore locations are presented in the next section of finance assignment:

The above table mentioned in the finance assignment shows the investment feasibility of Location A of the new superstore to be considered by Scylace. In this case, there are assumptions on the cash inflow for the project as £5.16 million for the 1st year based on the profit earned by the project on setting its location there. The cash flows for the following years gets enhanced incrementally by £1 million brining the values as £6.16 million in the 2nd year, £7.16 million for the 3rd year, £8.16 million for the 4th year, and £9.16 million for the 5th year. There is also a residual value of £3 million at the end of 5th year considering the fact that the company would make the decision based on its 5 years result (Lins, Servaes, & Tamayo, 2017). Again, a discount rate of 8% is taken for the purpose keeping in mind the difficult times the businesses around are coping with due to the outbreak of the global pandemic, COVID-19.

For Location A, the initial investment to establish the superstore would cost around £30 million. As per the workings considered in the finance assignment, Scylace has an ARR of 31.27% which is fairly reasonable for the investor to consider the project as it has potentiality to yield an effective return (Bolton, Wang, & Yang, 2019). The payback period is of 4.28 years indicating the time that the retailer would take to recover its investment. The IRR is 8% which is equivalent to the discounted rate of the investment project indicating that the project has been operating at its lowest margin (Elliott & Elliott, 2015). The NPV for the Location A stands as £940,000 indicating that the investment project has potentiality to yield effective outcome in the upcoming period (Loftus, et al., 2018).

The table mentioned above within the finance assignment shows the investment proceeds of Location B earning cash inflow of £6.54 million in its 1st year which would be increased by £1.5 million incrementally in the upcoming years. So the cash inflow would be £8.04 million in the 2nd year, £9.54 million in the 3rd year, and £11.04 million in the 4th year, and £12.54 million in the 5th year. A residual value of £7 million is considered in case the business winds up within the first 5 years. In this case of finance assignment as well, the rate of discount is considered as 8% to appraise the investment.

For Location B, a cost of £45 million is considered to establish the superstore. The analysis done in finance assignment show that the particular investment would have an ARR of 25.15% having effective returns for the retailer but it is lower than that of Location A with an ARR of 31.27%. So it is seen that in terms of ARR, Location A would be preferred having a higher ARR, and higher the ARR it is better in terms of returns (Ehrhardt & Brigham, 2016). The PBP for Location B is 4.5 years while for Location A, it is 4.28 years making no such broad difference. But still, Location A would be preferred having a relatively lower PBP and shorter the PBP, it is a profitable proposition (Henderson, Peirson, Herbohn, & Howieson, 2015). The IRR for the project stands at 6% against the discounted rate of 8% showing incapability of the project to support profitability within the 5 years term. Lastly, it has a negative NPV of £1.72 million which indicates that the investment has no financial feasibility, at least within its first 5 years (Kim, Kim, & Qian, 2018).

So taking relevance of the NPV, the most important aspect of the capital budgeting process Location A would be chosen as it has a positive NPV unlike Location B with a negative NPV (Martic, 2018). Therefore, Location B would not be considered at all and Location A would be chosen for having the superstore for Scylace.

Business finance –

It can be seen in the finance assignment that Scylace plc. has cash resources for £14 million while total assets of £312 million comprising fixed assets as well that could not be liquidated easily. Such an amount would not be sufficient as to have the superstore at Location A, investment worth £30 million would be required. The retailer has only £14 million in its possession while if it uses the entire amount, it could face liquidity issue. So the retailer has to opt for external financing and that could be served by having debts rather than equities (Bazdresch, Kahn, & Whited, 2018). This is because debts are easy to acquire and cost-efficient than equities. So Scylace has alternatives like issuing redeemable bonds either for 20 or 50 years to manage its financing to have the superstore at Location A.

It is seen herein finance assignment that for a 20-year bond at a face value of £100 with a nominal interest rate of 8%, the market price of bond at £95 would have a predicted yield to redemption at 8.68%. In the alternative scenario for a face value of £100 with a nominal interest rate of 6.5% for the 50-year bond with the market price of £70, the predicted yield to redemption would be 10%. On comparison of both the alternatives done in this segment of finance assignment, it seems that for the investor lower yield would be better having lower level of risks, so the 20-year redeemable bond would be preferred over the other one (Madura, 2020). Scylace would be considering the lower yield of 8.68% 20-year bonds for raising its requisite capital to have the superstore at Location A.

Acquisition analysis –

The financial statements for Helibeb is presented above for the year ended 30th September 2019 and 2020 to contemplate the financial decision for its acquisition. The organisation is projected to earn a gross profit of £208 million and operating profit for £36.40 million in the upcoming year, 2021. The retail organisation like Scylace explored in the segments of finance assignment has active business in its core area. If Scylace take over the company, it would be able to acquire not only its business expertise, suppliers but its customers and potential markets as well (Russell, 2017). Currently, when the retail segment is coping up with COVID-19, it would be better for Scylace to acquire competent businesses like Helibeb to establish its hegemony in the market (Maynard, 2017). Therefore taking relevance of the earning potentiality, it would be effective for Scylace to bid for Helibeb for its purposeful acquisition.

It is evident in the finance assignment that UK has a competitive retail market which is subjected to severe kind of market dynamics. In such a scenario, it is appropriate for Scylace to expand its expertise in the retail segment and the scenario is favourable when there is a potential organisation like Helibeb. Scylace through this acquisition would be able to expand its store count along with the experienced sales staff, suppliers, and its brand influence in the local market. Again, the acquisition would be helpful for Scylace to establish it’s branding in the competitive market amidst big retailers like Tesco, M&S, Aldi, and others. It would serve as a unique opportunity for Scylace to expand its business horizon. The business capital would not be an issue as the retailer would seek bonds to finance its acquisition. Moreover, online sales is on rise which could be encased by acquiring the products of Helibeb.

Conclusion:

The report on finance assignment concludes that both the retailers are doing good in its market and it is the right time for Scylace to expand its business to tap the potential market as it would soon recover from the whims of COVID-19. So Scylace is striving to prepare an effective ground to expand its business. The organisation need to conduct the matter efficiently and so it took the help of investment appraisal mechanism to reach to a suitable decision. Scylace has its 1st option to come up with new superstores at two different locations, Location A and Location B. accordingly, an investment appraisal is conducted using the various means of the capital budgeting process. It is seen that in terms of payback period, both the location were apt though Location A with a relatively lower PBP is preferred.

Again, the ARR identified in the finance assignment shows that Location A with a figure of 31.27% could yield a better return than Location B with 25.15%. The IRR for Location A and Location B show the figure of 8% and 6% respectively and as per the rule, Location A with a higher IRR would be chosen. Lastly, Location A has a positive NPV while it was a negative value for Location B rejecting the proposal straightaway. So Location A would be pursued by Scylace and it needs to generate external financing to acquire the requisite financing. For this, the 20-years redeemable bonds would be used to acquire such finances. Scylace to address its growth proposition would be acquiring Helbib as well having effective earning potential in the upcoming years.

What are the recommendations for the case scenario of finance assignment?

Going through the report on finance assignment, certain recommendations are being forwarded to the Scylace management to contemplate an effective business decision, such as –

• It is not feasible for Scylace to consider investment in Location B as the capital budgeting process state it to have a negative NPV. It means that within the time frame of 5 years, the particular investment would not yield any positive return to the retailer, so it is better to keep the project of Location B aside.

• The investment project of Location A would be carried forward as it has a positive NPV, the epitome of the capital budgeting mechanism. Besides, other variables like IRR, ARR and PBP are fairly better than the Location B project tending it to be pursued for expanding the business of Scylace.

• To pursue the investment project on Location A, external financing would be required as it would not be suitable for the retailer to exhaust its cash resources for establishing the superstore. The liquidity is to be maintained by the business for meeting its sorts of obligations and avoid the bankruptcy risk.

• To source financing, Scylace would use the 20-year redeemable bond as it is low yielding than the 50-years one and have a lower yield reducing risk of the investors.

• Lastly, it can be stated in this finance assignment that it would be suitable for Scylace to acquire Helbib as the latter has earning potentiality which could be rightly exploited by the retailer in its favour.

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