STRATEGIC FINANCIAL MANAGEMENT

MBA 1 A ASSIGNMENT

PRESENTED TO:

DR. GERALD POLLIO

The NPV spreadsheets are the part of this document. NPV Analysis.xls

Sheikh Saeed

19 AUGUST 2009

LONDON SCHOOL OF COMMERCE

Table of Contents

QUESTIO 1: ............................................................................................................................................... 1 PRESENT VALUE CALCULATION ................................................................................................................. 1 Explanation: .......................................................................................................................................... 1 QUESTIO 2 ................................................................................................................................................ 3 QUESTIO 3: ............................................................................................................................................... 3 PART 1: FI A CIAL A ALYSIS..................................................................................................... 4

PV METHOD...................................................................................................................................... 4 IRR of the Differential ........................................................................................................................... 5 Discount Rate Sensitivity....................................................................................................................... 6 Why to rely on PV and IRR?............................................................................................................... 7 CONCLUSION: ............................................................................................................................................. 8 PART 2: CRITICAL ISSUES.............................................................................................................. 9

CAPITAL RATIONING................................................................................................................................... 9 Hard Capital Rationing......................................................................................................................... 9 Soft Capital Rationing:.......................................................................................................................... 9 LEASE VERSUS BUYING .............................................................................................................................. 9 Operating Lease .................................................................................................................................. 10 Financial Lease ................................................................................................................................... 10 REAL ESTATE SPECIFIC ISSUES .................................................................................................................. 10 Leasing/Renting a Real estate ............................................................................................................. 10 Purchasing a Real estate..................................................................................................................... 11 Benefit of choosing Leasing (Option 3)............................................................................................... 12 WACC AND LEVERAGE ............................................................................................................................ 13 WACC (Weighted Average Cost of Capital)........................................................................................ 13 Leverage.............................................................................................................................................. 14 The Effect of Financial Leverage ........................................................................................................ 14 INFLATION ................................................................................................................................................ 15 REFERE CES............................................................................................................................................ 16

Question 1:
Present Value Calculation
To calculate present value (PV) of any future payoffs (cash flows), we discount it by the equivalent investment rate of return offered in capital market. This rate is called discount rate or the opportunity cost of the capital. Present values of Cash Flows (after tax), of each project 1, 2 & 3 are as follow:
FIGURE 1

Explanation:
The column under projects cash flows in Figure 1 above, represent Incremental cash flow of the projects, i.e. the savings made specifically due to the of project. The only cash flows of the project are initial capital investment and residual value. (ACCA; 2006) According to the financial principles, the projects cash flows starts just after the projects initial investment (i.e. the capital investment), therefore, the present value calculation are discounted to years 0 instead of end of years which represent accounting year. The following representation explains the criteria for calculating present value of cash flows. This is illustrated in Figure 2.

FIGURE 2
Years from Project Launch 0 1 Option 1: PV of Purchase without Finance Initial Capital Investment
Relevant Benefits (Rental Savings)

PV of Purchase without Finance

Relevant Benefits (Rental Savings)

+ Residual Value

FIGURE 3

FIGURE 4

Question 2
Net Present Value (NPV) is the difference between present values of cash INFLOWS and Present values of cash OUTFLOWS of an investment or project. Or;
NPV = Present values of all Cash Flows Initial Investment Or

Where, C is the cash flow at future time t, discounted at the opportunity cost of r. relevant cost and benefits of the project must also be included in calculating PV of cash flows. The NPV for the project option 1, 2 & 3 are calculated below using Figure 1, 3 & 4.
FIGURE 5

Question 3:
The answer to the cost effectiveness of the projects of mutually exclusive nature lies in a thoughtful assessment of numerous subjective questions and a thorough objective analysis of the cash flows of the option available. In our cost analysis we are assessing three possibilities of acquiring a building for business use. The options are financing project with equity, part-financing with 30% equity and 70% through borrowing and lease renting the building. The decision to own, part-finance or lease is often driven by the cash and space needs of the business; whether the space is retail, office, industrial, mixed use, or special use; the

importance of branding, protecting, or creating trade areas; establishing franchise value; or other circumstances. Comparison of cost effectiveness of real estate projects requires evaluation of each alternative on the basis of financial outcomes as well as its advantages and disadvantages attributed due to the nature of use. The first part of our cost efficiency analysis will be based on financial examination to evaluate the cost effectiveness of project alternatives (option 1 to 3). Second part will focus on the other issues particularly associated with owning and leasing building for business use.

PART 1: Financial Analysis

The two methods of comparing project cost effectiveness are the net present value (NPV) method and the internal rate of return (IRR) method. IRR measures the profitability of the project. It is an internal rate of return in the sense that it depends only on the projects own cash flows. The opportunity cost of capital is the standard for deciding whether to accept the project. It is equal to the return offered by equivalent-risk investments in the capital market. As IRR method is considered to be less reliable for investment decision, its use in incremental cash flow analysis is somewhat recommended to further strengthen the decision based on NPV method. The IRR of the differential of mutually exclusive projects allow us to compare them with respect to inherent initial investment disparities among them. (Brealey et al; 2006)

PV METHOD
The NPV method compares the present values of the cash flows of project alternatives discounting them back at the opportunity cost (discount rate) of the firm. NPV is a measure of how much value is created or added today by undertaking an investment of long term nature. Given the goal of creating value for the stockholders, the capital budgeting process can be viewed as a search for investments with positive net present values. (Brealey et al; 2006) The NPV rule for project appraisal is that any project with positive NPV is worth investment. However in case under consideration, where most cost effective alternative is required to be indentified, the project alternative with highest NPV will be considered worth investment. When a choice has to be made between alternative projects which are mutually exclusive, it should be based on the size of the NPV either the highest NPV surplus, or the least NPV deficit, as appropriate. (Mott, 2005; page 222) NPV of each project option, as calculated in Question 2 is as follow.

FIGURE 6

The most cost effective option is leasing the building, as it returns the highest NPV of ($3,930,859.00). This means that leasing the building will incur least cash out flow (with respect to opportunity cost of the firm) during its life as compare to other two options. Purchasing (option 1) will result in total discounted cash inflows (including relevant benefits) of about $5.5 millions, However, considering the initial investment of $ 11.4 millions, projects cash inflows are about $5.9 millions less than the initial capital investment. (Figure 1) Therefore it is not worth investing under NPV analysis. Part-Financing (option 2) appears to be very close to Lease option, but in this scenario, even after an investment of $3.58 millions results in negative net cash flow of $0.56 millions. (Figure 3) However, this option will be further evaluated in IRR analysis. Leasing (option 3) shows highest cash flows from project, although a negative figure. Therefore the firm should lease the building instead of owning or part financing it. (Figure 4)

IRR of the Differential

Purpose: to evaluate whether purchase or part-finance is worth investing as compare to lease.

When analyzing two investments, one more expensive than the other, the internal rate of return on the difference in their cash flows measures the extra potential return of the more expensive investment. (Brealey et al; 2006) We know that internal rate of return is an estimate for the potential yield on an investment, however, by calculating the Incremental IRR (IRR of the differential) we evaluate whether the risk of increased capital investment is worth the potential reward. It is generally agreed that for mutually exclusive projects, if the IRR of the differential is higher than the minimum acceptable rate of return, the more expensive investment is considered the better one. (Khan & Jain, 2007). Therefore we will analyse, whether the IRR of the differential of leasing the building is higher than purchasing or part financing or not? If it is higher than, we conclude that LEASING the project is most cost efficient. The IRR of the differential method subtracts the cash flow after tax of leasing from the cash flow after tax of purchasing options, to arrive at a differential cash flow on which an internal rate of return can be calculated. This IRR is then compared to the opportunity cost of capital (discount rate) of the firm. In most cases, firms have a somewhat specific knowledge of the opportunity cost on their projects, therefore a caparison of two (opportunity cost and IRR of the differential) give insight into the project with significant disparities in initial capital investment outlays. (Benninga & Czaczkes;)

To the extent that the IRR of the differential cash flows (generated by owning the building in option 1 and 2) is greater than the yield generated by the business, the firm would select the purchase alternative. Conversely, if the yield is less than the yield that firm can achieve on its business, the firm should select the lease option. The following table shows IRR differential for all three options being considered. The highest IRR is between cash flow of option 2 minus 3, (i.e. the part finance minus lease) therefore option 3 should be selected as it will yield highest return.
FIGURE 8

IRR of the Differential

Differential Cash Flows After Tax ($)

Discounted years 0 1 2 3 4 5 6 7 8 9 IRR of the Differential 1 minus 3 -11,400,000 730,949 740,300 740,300 740,300 740,300 806,300 806,300 806,300 12,676,374 7% 2 minus 3 -3,579,000 156,383 154,975 149,820 144,237 138,191 197,643 190,551 182,871 5,902,412 9% 1 minus 2 -7,821,000 574,566 585,325 590,480 596,063 602,109 608,657 615,749 623,429 6,773,962 6%

In discount rate sensitivity curves drawn in Figure 9, point (a) on the discount rate x-axis represent the IRR of the differential of Part-Finance and Lease, point (b) represents the Purchase and Lease, point (c) represents Part-Finance and Lease.

Discount Rate Sensitivity

It is important to look at a range of discount rates because the size and timing of the cash flows of the lease and purchase option vary at different rates. Particularly, the largest inequality in size and timing usually occurs in year zero because of the size of the initial investment, and in year 9 due to the positive cash flow generated through residual value; however, year zero cash flows are not discounted at all. In lease versus purchase analysis, the only positive cash flow comes in the form of residual value at year 9. As the discount rates increase they minimize the positive effect of the residual value, and thus, flatten the curve in the purchase option (as shown in the figure.9) In our case under consideration, if the firms opportunity cost was less than 6% [point (a) in Figure 9], then the purchase option 1 would have been most cost efficient for the firm. However, as the firms opportunity cost (discount rate) is 10%, the leasing is the lowest cost option with 9% IRR of the differential (option 3- option 2). In Figure 9 point (c) represent the discount rate of 9% which is IRR differential between options 2 minus 3.

This is the reason the firms with low overhead and high margins tend to lease real estate, except when maintaining control and security are vitally important and often outweigh the financial assessments. The firms opportunity cost is 10%, which is very close to the highest IRR of the differential of leasing (i.e. 9%), the firm would likely be indifferent to leasing or owning the building. To further strengthen our decision to choose most cost effective option, we will also examine the inherent advantages and disadvantages of owing a building for business use and leasing it.
FIGURE 9

Discount Rate Sensitivity

Option (1) IRR
2,000,000

Firms opportunity Cost

a
0 0% 1% 2% 3% 4% 5% 6%

b
7% 8%

c
9% 10% 11% 12% 13% 14%

Discount Rate
15% 16% 17%

-2,000,000

PV

-4,000,000

-6,000,000

-8,000,000

Purchase Purchase with Finance Lease

-10,000,000

Why to rely on PV and IRR?

The Advantages is it will give the correct decision advice assuming a perfect capital market, and correct ranking for mutually exclusive projects. It is easy to compare the NPV of different projects and to reject projects that do not have an acceptable NPV. On the other hand, NPV as method of investment appraisal requires the decision criteria to be specified before the appraisal can be undertaken. It is very difficult to identify the correct discount rate. Both NPV and IRR are referred to as discounted cash flow methods because they factor the time value of money into the capital investment project evaluation. Both NPV and IRR are based on a series of future payments (negative cash flow), income (positive cash flow), losses (negative cash flow), or "no-gainers" (zero cash flow). NPV determines whether a project earns more or less than a desired rate of return and is good at finding out whether or not a project is going to be profitable. IRR goes one step further than NPV to determine a specific rate of return for a project. Both NPV and IRR 7

give us numbers that we can use to compare competing projects and make the best choice for business.

Conclusion:
NPV, IRR of the Differential and IRR Sensitivity analysis reveal that the most cost effective option for the firm is LEASI G THE BUILDI G.

PART 2: Critical Issues

Other issues that could influence the decision to evaluate cost effectiveness of the project under review also need to be examined. These issues need careful consideration before any project appraisal is accepted, due to their impact on financial health of the business. As it is not possible to calculate some of the critical elements used in analysis of projects cost efficiency a brief theoretical discussion is necessary. Investment appraisal is concerned with decisions about whether, when and how to spend money on capital projects. Such decisions are important ones for the companies involved because often large sums of money are committed in an irreversible decision, with no certain knowledge of the size of future benefits. (Mott, 2005)

Capital Rationing
WHY: We do not have enough information to evaluate the firms policy regarding availability of capital resources.

A firm maximizes its wealth by accepting every project that has a positive net present value. The act of placing restrictions on the amount of new investments or projects undertaken by a company is called capital rationing. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget. (Mott, 2005, Brealey 2006) There are two types of capital rationing.

Hard Capital Rationing

This arises when constraints are externally determined and the firm is unable to borrow from the outside. For example if the firm is under financial distress, tight credit conditions, firm has a new unproven product. Borrowing limits are imposed by banks particularly in relation to smaller firms and individuals.

Soft Capital Rationing:

This is due to internal, management-imposed limits on investment expenditure. Firms might decide that expansion is a trouble not worth taking fearing to lose their control in the company. The management allocates a fixed amount for each division as part of the overall corporate strategy. Earlier debt issues might prohibit the increase in the firms debt beyond a certain level.

Lease vs Buying
One way to obtain the use of an asset is to lease it. Another way is to obtain outside financing and buy it. The decision to lease or to buy the asset emphasises the importance to a comparison of alternative financing arrangements for the use of an asset. In our

assignment we are not sure if the option 2 is lease and which type of lease is meant in option 3.

Operating Lease
This form of leasing has several important characteristics. Operating leases are often relatively short-term; the life of the lease may be much shorter than the economic life of the asset. Another very important characteristic of an operating lease is that it frequently requires that the lessor maintain the asset. The lessor may also be responsible for any taxes or insurance. Most interesting feature of an operating lease is that gives the lessee the right to cancel the lease before the expiration date. (Brealey et al, 2001)

Financial Lease
With a financial lease, the lessee (not the lessor) is usually responsible for insurance, maintenance, and taxes. It is also important to note that a financial lease generally cannot be cancelled, at least not without a significant penalty. A financial lease is sometimes said to be a fully amortized or full-payout lease, whereas an operating lease is said to be partially amortized. Financial leases are often called capital leases by the accountants. (Brealey et al, 2001) Tax-Oriented Leases is in which the lessor is the owner of the leased asset for tax purposes. Such leases are also called tax leases or true leases. In contrast, a conditional sales agreement lease is not a true lease. Here, the lessee is the owner for tax purposes. Conditional sales agreement leases are really just secured loans. The financial leases we discuss in this material are all tax leases. Tax-oriented leases make the most sense when the lessee is not in a position to use tax credits or depreciation deductions that come with owning the asset. By arranging for someone else to hold title, a tax lease passes these benefits on. The lessee can benefit because the lessor may return a portion of the tax benefits to the lessee in the form of lower lease costs. (Brealey et al, 2001) Leveraged Leases is a tax-oriented lease in which the lessor borrows a substantial portion of the purchase price of the leased asset on a nonrecourse basis, meaning that if the lessee stops making the lease payments, the lessor does not have to keep making the loan payments. Instead, the lender must proceed against the lessee to recover its investment. In contrast, with a single-investor lease, if the lessor borrows to purchase the asset, the lessor remains responsible for the loan payments regardless of whether or not the lessee makes the lease payments.

Real Estate specific issues

A brief summery of advantages and disadvantages of real estates with respect to leasing and owning are described to further elaborate that in our project appraisal option leasing is most cost efficient.

Leasing/Renting a Real estate

Advantages:
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Tax Benefits: Unlike ownership, the occupancy costs of leasing are fully deductible, including that portion of rent attributable to the value of the land. Stability of Costs: The long-term occupancy costs of leasing, when viewed from the users perspective, are generally simple to estimate and typically include base rent (pure net, pure gross, or a hybrid), operating expense pass-through, amortized tenant improvements, percentage rent (retail), and the like. Although some leases may expose a user to certain capital expenditures, tenants are generally insulated from unforeseen capital costs such as the replacement of mechanical systems, structural repairs, and roof or parking lot replacement. Availability of Cash: Leasing typically requires less cash out of pocket than ownership alternatives, leaving more capital to invest in the users products and services or to establish addition allocations.

Disadvantage:
Loss of Salvage Value:

Most leases provide that any improvements made by the tenant become the property of the landlord at the end of the lease term, or the landlord may require that the tenant remove any improvements made to the premises at the tenants expense.
Cost: For a firm with a strong earnings record, ready access to capital, and the ability to take advantage of tax benefits from ownership, leasing is often the more expensive alternative. Loss of Appreciation: Leasing means the tenant does not benefit from property appreciation. Contractual Penalties: If a leased property becomes obsolete or the business occupying the space becomes unprofitable, the tenant must continue paying rent or face penalties for default.

Purchasing a Real estate

Although most businesses acquire property through the use of equity and debt financing, most owners are free to use the property as they wish.

Advantages:
Tax Advantages: An owner enjoys the benefit of interest and cost recovery deductions that reduce the annual tax liability from real estate operations. The accumulated cost recovery deductions, although taxed at the time of sale, are currently taxed at 25 percent, which is typically less than the users marginal tax rate applied to ordinary income and the user enjoys the benefit of those untaxed dollars until the property is sold. The capital gain from appreciation, while currently taxed at 15 percent, is often 87 to 133 percent less than the users ordinary income tax rate. Appreciation: An owner enjoys the benefit of capital appreciation over time.

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Debt Reduction and Equity Build-up: Assuming conventional financing, an owner enjoys debt reduction and equity build-up through amortization of the original loan amount, since both interest and principal are included in every mortgage payment.

Positive Leverage
While not guaranteed and subject to change in fluctuating financial markets or rising interest rate environments, properties acquired with borrowed funds stand to benefit from positive leverage meaning the yield to the owner on a leveraged investment is greater than the yield on an unleveraged investment.

Disadvantage:
Financial Liability: Although equity financing and investment capital may be readily available, a commitment to long-term debt financing often involves a 20 to 30 year amortization and possible loan provisions that mandate pre-payment penalties if a loan is paid off prematurely. Time Frame: The decision to purchase should be made with a holding period in mind of at least five years. Although historically commercial properties tend to appreciate in value, the costs of acquisition and disposition may offset or eliminate the benefits of appreciation over a short-term holding period. Spatial Inflexibility: Often, owned facilities do not lend themselves to the expansion or contraction of building improvements. Initial Capital Outlay: Most commercial lenders require equity at closing of 20 to 30 percent of the cost of the property acquired. This equity requirement ties up capital that could otherwise be deployed to grow the users business. Risks: There are numerous risks to ownership, including internal and external obsolescence, market risks, financing risks, and unforeseen capital requirements for repairs and maintenance.

Benefit of choosing Leasing (Option 3)

By leasing, it offers fixed-rate finance, It is an alternative to borrowing at the riskfree rate in order to buy the asset outright. (Pike, R. 2006) There are many advantages to leasing versus purchasing. With a primary consideration is cost. The cost of a lease may be more or less than the cost to purchase and may differ among the lessees. For example, if a firm has been running at a very low profit, it might not be able to enjoy the tax benefits of investment, tax credit and accelerated depreciation, which are associated with the purchase of some assets. A lessor could, however take full advantage of the tax benefits and pass them along to the lessee by means of reduced lease payments. Because the lease payments is tax deductible, the after-tax cost of leasing is the sum of the lease payment and operating expenses less the tax shield provided by the deductible expenses A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. If the firm choose to purchase without financing of the property, fixed assets appear on the balance sheet. If the firm choose to lease, they do not appear on the balance sheet.

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The leasing costs will show on the profit and loss account but no entry is made on the balance sheet because the property is not owned by the firm. The advantages of this offbalance-sheet finance is, it makes the companys financial performance look better, the return on capital employed (ROCE) ratio (Proctor, R. 2006) will increase as the asset base will be smaller. By not financing a large sum to purchase property, the business avoids increasing its gearing ratio. Atrill (2006) suggest that by leasing, it only requires a relatively small yearly payment instead of paying the entire cost of an asset. If some business is short of cash, large cash outflows can be avoided by arranging for low lease payment in the early years of the assets life. Once the asset generates positive cash flows the payments can be increased, it tends to improve your ratios of assets to liabilities. Rent is tax deductible. There is no down payment for the property. Sellers keep the taxes deductions during the leasing period. If you purchase the asset, you have to capitalize and depreciate the asset, which may mean a slower recovery of your costs. And also leasing has no need to worry about selling the property if moving to a new location since this option has more freedom. It has lower risk if the market is declining; leasing has no loss of resource incurred.

WACC and Leverage

WACC (Weighted Average Cost of Capital)
The (Weighted Average Cost of Capital) tells us that the firms overall cost of capital is a weighted average of the costs of the various components of the firms capital structure. WACC take the firms capital structure as it is. One important issue that we should have explored in our assignment is that to find what happens to the cost of capital when we vary the amount of debt financing, or the debt-equity ratio of the firm. (ACCA, 2006) A primary reason for studying the WACC is that the value of the firm is maximized when the WACC is minimized. The WACC is the discount rate appropriate for the firms overall cash flows. Since values and discount rates move in opposite directions, minimizing the WACC will maximize the value of the firms cash flows. A calculation of WACC involves all capital sources that are, common stock, preferred stock, bonds and any other long-term debt. The WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. Usually business enterprises discount the cash flows at WACC to determine the Net Present Value (NPV) of a project, using this formula:
NPV = Present Value (PV) of the Cash Flows discounted at WACC.

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The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Calculation of a weighted average cost of capital takes account of the different after-tax costs of debt and equity and of their significance in the make up of the total capital. The weightings used in the calculations should be based on the market value of the securities and not on their book or balance sheet values. (Mott, 2005)

Leverage
Leverage is most commonly used in real estate transactions; it is the amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. The leverage is also considered as the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. (McLaney, 2003) Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, the loss is magnified as compared to the situation where investment had not been leveraged. Thats why leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value. (ACCA, 2006)

The Effect of Financial Leverage

Impact of financial leverage on the payoffs to stockholders is important to be considered because financial leverage refers to the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs. Financial leverage can dramatically alter the payoffs to shareholders in the firm. However, financial leverage may not affect the overall cost of capital. If this is true, then a firms capital structure is irrelevant because changes in capital structure wont affect the value of the firm.

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Inflation
Existence of inflation and its effects on the future cash flows of projects being appraised can not be ignored. Inflation brings additional problems to project appraisals. It increases the uncertainty and makes more difficult the estimation of the future cash flows of sales revenue, operating costs and working capital requirements. It also influences the required rate of return through its effects on the nominal cost of capital. Following formula adjust nominal values of rate of return for inflation.

In the context of investment appraisals it means that two aspects of the value of money must be considered. The time value of money has already been catered for by the use of present value factors which deduct interest for the time elapsed when waiting for future cash receipts. The other aspect is the change in the value of money itself, not because of the time lapse, but because the inflationary process decreases its purchasing power. (Mott, 2005)

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http://www.reidepot.com/articles/Matthew-Chan/Lease-Options.html [Accessed by 12 Aug,2009]

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Rental property n.d, http://www.altiusdirectory.com/Realestate/rental-property.html [assessed by 17 Aug,2009]

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