MANCHESTER BUSINESS SCHOOL

GLOBAL MBA
ASSIGNMENT 1

MODULE:
MBSW60237 CORPORATE FINANCE
ACCELERATED
(JULY 2011)

NAME

: TAN IRENE

STUDENT NUMBER

: 8011118

ASSIGNMENT REFERENCE : CFAP/July11/1

Question 1: Explain the theoretical rationale for the NPV approach to investment
appraisal and compare the strengths and weaknesses of the NPV approach to two
other commonly used approaches.
Net present value (NPV) approach is a widely accepted and relatively reliable
methodology used in the market for investment appraisal. Let us first examine the
rationale and mechanics of the NPV rule.
In an investment appraisal, the company is evaluating the attractiveness of an
investment proposal. So what is deemed attractive? The primary assumptions in
our discussion are that the companys objective is to maximize shareholders
wealth and it operates in a perfect capital market. Hence, an attractive investment
will be one that increases shareholders wealth.
Following Fishers separation theorem, since the (efficient) capital market interest
rates and returns give the same opportunity costs that both companies and
individuals face in allocating resources over time, the company should focus on
maximizing NPV rather than considering shareholders consumption preferences
(decoupling). As long as the company accepts all projects with positive NPVs and
rejects those with negative NPVs, shareholders utility (i.e. wealth) is maximized.
This is because NPV represents the additional value/loss after covering the initial
outlay and required rate of return. As NPV takes into consideration the time value
of money (i.e. a dollar today is worth more than a dollar tomorrow), it gives an
accurate view of investment gains in todays terms. Table 1 below shows the effect
of choosing investments with different NPVs on the shareholders utility.

Table 1: Effect of NPVs on shareholders utility

NPV

Effect on shareholders utility

NPV = Present value of future investment cash inflows initial investment outlay
NPV < 0

Future cash flows generated from project are insufficient to

cover the initial outlay.

Shareholders will not be happy as they could invest the
cash themselves to get higher returns.
NPV = 0

Project breaks even - it generates exactly enough cash flows to:

(1) recover the cost of the investment and
(2) enable investors to earn their required rates of return (the
opportunity cost of capital)
Shareholders are indifferent to whether the company
accepts the project or not.

NPV > 0

Project generates more than enough cashflows to create value

for shareholders
Shareholders wealth is maximized when company
invests in positive NPV projects.

With reference to the above table, it is apparent that by accepting investments with
positive NPV will increase shareholders wealth, which is the objective of the
investment appraisal.

Two other commonly used approaches to investment appraisal are the payback
period (PP) and internal rate of return (IRR). Table 2 shows a comparison of NPV
rule against these two alternative approaches.
Table 2: Strengths and weaknesses of three key investment appraisal methods
Method

Strengths

NPV

Rule: Accept a project with positive NPV and reject those with
negative NPV.

PP

recognize time value of

money
rely solely on
forecasted cashflows &
opportunity cost of capital
can handle multiple
discount rates

Weaknesses

Rule: Accept a project if its payback period is shorter than

specified cutoff period.

easy to compute and

understand
encourage cash
generation

IRR

sensitive to discount
rates

ignore the time value of

money
ignore all cashflows
after cutoff date
choice of cutoff period
arbitrary

Rule: Accept a project if the IRR is higher than the opportunity

cost of capital.

recognize time value of

money

Rule does not hold in the

following scenarios:

lending vs borrowing
position

multiple rates of return

mutually exclusive
projects

multiple opportunity
cost of capital

NPV is by far a more reliable method as compared to PP and IRR. It takes into
consideration the time value of money, a very important economic concept that is
also applied in IRR, but unfortunately omitted in PP which assigns equal weight to
all cash flows. A variant to overcome this weakness of PP is the discounted
payback period rule, whereby discounted cashflows are used instead in the
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determination of payback period. By using present value, it allows summation of

equivalent cashflows as cashflows at different points in time are not comparable.
NPV rule relies solely on forecasted cashflows and opportunity cost of capital,
hence not tainted by managerial preferences, choice of accounting method,
profitability of existing business and other independent projects (Brealey et al,
2011). This is a more objective approach as compared to PP which uses an arbitrary
cutoff period chosen by management.
The payback rule is not without its merits. It is the easiest of the three rules to
compute and understand, as it uses the concept of profitability and breakeven point.
It is therefore a more persuasive approach in capital budgeting negotiations. NPV
and IRR are rather abstract and complex in computation, thus not be easily
apprehended. The payback rule also encourages cash generation and values early
cash flows over late cash flows since distant cash flows are uncertain. However, it
ignores all cash flows after cutoff period hence may wrongfully reject longer term
projects that will still contribute to shareholder wealth.
The IRR rule is a close relative to NPV rule and gives the same answer as long as
the NPV of project is a smooth declining function of discount rate (Brealey et al,
2011). There are nevertheless a few scenarios whereby IRR will give a misleading
conclusion.
In the event that there are changes in the direction of cashflows in a project lifeline,
there could either be multiple IRRs or even no IRR exists which will lead to
inconclusive results.
When deciding between mutually exclusive projects, IRR rule can be misleading
due to different scale or cashflow patterns. When ranking projects of different
scale, the company should look at the IRR on incremental cashflows. If the IRR on
the incremental investment is greater than the cost of capital, the bigger scale
project should be selected.

In addition, the IRR rule implicitly assumes that there is only one opportunity cost
of capital throughout the project life; however, this might not be true in reality
because the cost of capital might change over the years with fluctuations in the
economic climate. In this situation, which cost of capital should the company
compare the IRR against?
Sometimes, the cashflow pattern will determine whether the company is in a
lending or borrowing position. If the company is in a borrowing position (initial
cash inflow), it will only accept the proposal if IRR is low such that future cash
outflows will be minimized and vice versa for a lending position.
In view of the above, it is evident that NPV rule is still the most reliable method. It
is no wonder that more than 75% of companies use NPV for their investment
appraisal.

Question 2: Appraise Laurentian Bakeries expansion into the US frozen pizza

market.
Laurentian Bakeries Inc. (Laurentian) was a manufacturer of frozen baked food
products, headquartered in Montreal. It had three plants in Winnipeg, Toronto and
Montreal, producing pizzas, cakes and pies respectively. Seeing the great potential
in the North America market, management recognized the lost opportunity due to
insufficient capacity. This issue had become more pressing as a large U.S.-based
grocery chain offered an exclusive arrangement to Laurentian to supply privatelabel-brand frozen pizzas beginning in April 1996. Should Laurentian accept this
agreement, it needed to increase capacity urgently to cope with the increased
demand.
To increase capacity, Laurentian had identified four options:
Option 1 Acquisition of competitors facility in Canada
This had been rejected as the equipment would not satisfy the capacity needs nor
achieve cost savings possible with Option 4 below.
Option 2 Acquisition of a competitor in United States
This had been rejected as the capital investment required would be twice of that
under Option 4.
Option 3 Expansion of Toronto plant
This had been rejected as the capital outlay was also doubled of Option 4.
Option 4 Expansion of existing Winnipegs plant
This option was preferred as economies of scale and consistent high product
quality could be achieved.
The next step is to assess the viability of Option 4 using the Net Present Value rule.
Net Present Value (NPV)
As part of the Capital Allocation Policy, the projects NPV must be positive in
order to qualify. For this paper, we will look at the NPV calculation in three main
parts: initial investment outlay, forecasted cash flows and discount rate.

(I)

NPV C0

Initial

C1
C2
C3
C10

2
3
1 r 1 r 1 r
1 r 10

investment outlay

The list of capital expenditure required to start the expansion project is

provided in Table 1 below, aggregating $5.2 million.

(II)

Forecasted cash flows

A ten-year cash flow forecast is performed since the assets purchased for
this project have a useful life of ten years.
(a) Incremental revenue
Under the exclusive arrangement, there will be a significant increase to the
throughput as shown in Table 2, with various probabilities. To be
conservative, we will assume the worst case scenario that the customer
ordered only the guaranteed quantity.
Other assumptions made include:
Agreement with U.S.-based grocery chain would last for at least 10

years (i.e. useful life of capital assets).

Volume from 1999 onwards would be at the same level as that of

1998.
Selling price to the U.S. grocery chain is assumed to be the same

as the selling price to Canadian customers ($1.70).

Inflation rate is assumed to be at a high 5%.
Based on the above assumptions, the incremental revenue for each year is
shown in Table 2.

(b) Incremental production costs

Based on the contribution margin of pizza segment, the current unit
product cost is derived as $0.58 in 1994. At an inflation rate of 5%, unit
product cost will increase to $0.61 by 1995 and $0.64 by 1996, so on and
so forth. Similarly, inflation is factored into the other savings that resulted
from the new line. In addition, increased efficiency from the new line
reduces the plant-wide unit cost which we assume, on grounds of
prudence, that only 50% of that savings will be achieved for all 10 years.
Other costs such as the time cost and expenses of sales staff incurred to
secure the U.S. contract have been included as initial outlay (deemed
opportunity cost that might be deployed to earn other income). Annual
repairs and maintenance costs amounting to $520,000 each year will also
be incurred to upkeep the equipment. However, the value of existing land
(which we assume that there is no alternative use of the land since the
existing plant is located on that same plot of land) and fixed salaries of
administrative staff are excluded from the forecasted cash flows since they
are sunk costs and not incremental. Table 3 shows a consolidation of
incremental costs/savings.

Note that the above is computed based on the guaranteed 50% additional
volume as discussed in Section (a).
(c) Net earnings after tax
This is derived by deducting incremental production costs, capital
allowance and tax from incremental revenue. Capital allowance is based
Exhibit 6 provided and tax rate is 38% per Canada Revenue Agency
website.
(d) Working capital movements
Working capital is the net of current assets and liabilities. The incremental
working capital is arrived as a function of incremental revenue, except for
inventory which has been adjusted for the shorter inventory age (a function
of COGS). The movement in working capital is then added to the cash
flow analysis.
(III)

Discount rate
In the case of Laurentian, as the company is financed both by long-term
debt and equity, the Weighted Average Cost of Capital (WACC) is an
appropriate discount rate, with the following assumptions fulfilled:

risk of project matches overall risk of company

risk of company and its financing mix remain unchanged for the
next ten years

target debt ratio remains unchanged with the new project (this ratio
is not likely to change since the Board of Directors has established a
target capital structure of 40% debt)

To answer Knowles query, the hurdle rate represents the required rate of
return on investment, and may not necessarily be similar to the cost of
capital. It is likely that the hurdle rate would be higher than the cost of
capital such that it increases shareholders value.
To calculate the WACC, we use the following formula:

WACC rD 1 Tc

D
E
rE
V
V

(a) Cost of Equity Capital

Using Capital Asset Pricing Model (CAPM) to compute rE,

rE r f rm r f E
The risk-free (rf) is estimated to approximate the long-term Government of
Canada Bond (8.06%). The ten-year bond is selected to match the project
horizon. Market risk premium is assumed to be the difference between
Toronto stock market return (r m) and long-term government bonds (r f),
which is 6%. is equal to Laurentians stock beta (0.85) as provided.
With these variables, rE, is determined as 13.16%.
(b) Cost of Debt Capital
Corporation bonds are debt instruments which are typically riskier than
government bonds. Given that the spread between Government of Canada
bonds and "BBB-rated" corporation bonds (similar rating as Laurentian) is
2%, we deduce that the cost of debt capital will be 10.06%, i.e. 2% higher
than the government bond rate of 8.06%.

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(c) WACC
With the target capital structure of 40% debt, we assume that the weights
of the companys debt and equity are 40% (D/V) and 60% (E/V)
respectively. This is consistent with the trend noted in the Balance Sheets
where the debt-equity ratio increased from 33%:67% in 1993 to 39%:61%
in 1995. Putting all the relevant values above into the formula, WACC is
calculated to be 10.39%.
(IV)

Computation
The forecasted annual cash flows, assumed to happen at the end of each
year, are discounted using the WACC rate, thus deriving a NPV of $6.7
million. If we use the hurdle rate as the discount rate, NPV is $3.1 million.
In both scenarios, Laurentian should accept the project since it is
generating positive shareholders value. Bearing in mind that we have
adopted the worst case scenarios in the assessment, anything more than the
guaranteed volume or minimum savings will further increase the project
value. For detailed computation, please refer to spreadsheet NPV
Calculation.xls

Alternative Investment Appraisal Rules

Two other appraisal methods which are required in the Authorization for
Expenditure Form are Internal Rate of Return (IRR) and Payback Period (PP).
Using the same forecasted cash flows above, IRR is determined as 30%, which is
higher than the hurdle rate (18%) and WACC (10.39%), hence the project should
be accepted, consistent with NPV rule. Payback Period and Discounted Payback
Period (a more accurate measure) are 3.65 and 4.54 years respectively. As the cutoff period is not given, we are unable to conclude based on PP.
Other areas of consideration
To comply with the companys Capital Allocation Policy, the proposed Winnipeg
plan project (Class 2 project) needs to meet the following requirements:

support continuous improvement per Exhibit 5, the expansion project

will resolve the issue of lost sales due to insufficient capacity

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consider human resource and environment impact no employees are

affected adversely and environmental concerns had been factored into the

design of sanitary, water-regulating and refrigeration systems

provide a sufficient ROI ROI on this project is 129%!
projects more than $300,000 to be included in Strategic Plan this project

had been duly included in the Strategic Plan

projects more than $1 million, operating division has to achieve its profit
target Winnipeg plant had met its profit target for the past three years

Conclusion
Based on the above evaluation of NPV and IRR and having fulfilled all the other
policy considerations, Laurentian should accept the expansion proposal and
commence works no later than October 1995, in order to start supplying the U.S
grocery chain in April 1996. This would be a good opportunity for Laurentian to
break into the lucrative U.S. market.

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References
Brealey, R.A., Myers, S.C. and Allen, F. (2011). Principles of Corporate Finance
Global Edition. 10th edition. New York: McGraw-Hill/Irwin
Canada Revenue Agency. (2011). Corporation tax rates [online].
Available from: http://www.cra-arc.gc.ca/tx/bsnss/tpcs/crprtns/rts-eng.html
[accessed date: 4 November 2011]
Moneyterms.co.uk. (2011). Fisher separation [online].
Available from: http://moneyterms.co.uk/fisher-separation/
[accessed date: 4 November 2011]

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