12 May WHAT IS THE NPV FOR EACH PROJECT?
The Alpha Corporation Inc Case
The Alpha Corporation Inc (ACI) was established in 2010 in its present form by Alex Taylor an independent computer engineer who acquired the assets of a number of defaulted small – medium software applications developing companies operating in the South-East region in EU, following the financial crisis in the early 2008s.
Alex Taylor recognized the growing demand from small-medium sized companies for smart and easy to use software applications (hope cloud computing,) and under his direction the company aggressively sought new markets both by acquisitions as well as through its own explorations.
In this process, he secured the financing needed and raises the needed capital for to expansion by bringing in the company’s share capital reputable and wealthy organizations offered preferred stock. The company also as a policy matter used to reinvest in the operation most of its net profits, thus maintaining a manageable exposure in bank loans (debt) for its financing needs.
The Case
While ACI is not one of the giants of the industry, it is extremely well positioned relative to its own tailor made software applications and marketing capacity. The executive management of Alpha Corporation, under the direction of Alex Taylor, is often faced with new investment proposals in an effort to keep the company innovative and technologically ahead of its competitors.
However, most of the executive management members at occasions indicated some dissatisfaction with ACI’s policy to retain most of the profits at the expense of dividends as they claimed, and have expressed their concern that board members and shareholders will not be happy if the company continues replacing existing hardware and electronic machinery and equipment well before the end of their useful life.
Alex Taylor, in a recent executive managements meeting when most of the executive members joined in the criticism chorus for the short circled replacement practices in hardware machinery and equipment, brought to their attention the fact that these investments added value to the company as they have been all proven to be profitable. As a matter of fact ACI’s profitability and ROCE are constantly above industry’s average.
To this end, Alex informed the executive management members that he is considering some new investment projects for replacing a substantial number of relatively newly purchased hardware equipment. He believed it was time to do it as technology advances move faster than the useful life of the hardware machinery and equipment presently in use. He also added that modern and innovative hardware is the key element for developing up-to-date software applications that are marketable.
As in most cases in the past, he asked the financial manager Mr. Chris to initiate actions towards undergoing a thorough review of the proposals presented (see in Appendix A the proposed investment data) and to propose back to the members of the management which of the presented alternative projects would be most profitable, neither excluding to do both nor excluding the ‘do nothing’ option. He was also given the mandate to make whatever changes deemed necessary for securing the best project(s) selection for ACI.
Mr. Chris was newly hired in ACI and this is his first mandate to assess investment alternatives for ACI. Before that he worked for several years in the corporate finance department of a large auditing firm. His successful path in his previous employment along with the several executive training programs attended in reputable business schools in the region during summer vacations helped him take the job with ACI in late 2010s.
For the purpose of carrying out the mandate, Mr. Chris made a list of the senior managers in the company he believed they could assist him with their ideas on how they perceived and understands the investment assessment issue, especially after the concerns expressed during the recent executive managements meeting.
During the individual meetings held with the sole subject to assess the financial data of the proposals in question, some of the views expressed from the executive managers though, raised concerns.
For instance, H. Williams, Marketing and Sales manager said: When it comes to project investment appraisals “The payback period method” is the one I favor. And he continued saying; “if it pays back in less than 3 years that we usually replace electronic equipment and machinery we can be sure it will increase the company’s value and consequently its stock price.”
Also J. Smith, software development manager said: “We should have a policy to replace our existing equipment only upon introduction of the new product. Furthermore he added “The decision that maximizes stockholder wealth shouldn’t depend on the discount rate we use or the cost of capital”.
S. Johnson, H/R manager, expressed his views on a personal mode: “I have a son in business school who tells me I should propose the NPV approach and not accounting profits generated from a project, to determine which proposal to select and in general whether to be in favor or not to make an investment. But I’ve told him that my bonus is calculated on the basis of the net profits generated in my company and that it is my bonus that pays his tuition.
Furthermore, he raised concerns regarding the case where what two alternative investment proposals turn out to be both positive. In such outcome which one to select if your money to be invested are enough for only one?
Alex Taylor was the last to see before preparing his final proposals. Based on his views short
term consequences of investments in projects should not be the criterion of accepting or
rejecting a project. What counts most is the value added in total, he stressed. For example he said “Assume a two year project is estimated to provide an increase of $1 million in cash flow because of favorable outcomes, but carries a two-cent decline in dividend payment and/or in earning per share because of a negative impact against earnings in the first year the project is on. Would that lead you to reject a project and do nothing? He asked.
Following these meetings, the data gathered were sufficient enough to start the assessment process. In this context you are requested based on the above information to answer the following questions:
Questions
1) Given the weights of the sources of capital financing used by ACI (TABLE 1 in APPENDIX A) calculate the Company’s weighted average cost of capital. (WACC) (Hint: Assume the given capital structure remains unchanged throughout the entire period ACI is in operation)
2) Using the data of TABLE 2 in APPENDIX A, calculate:
a) What is the payback period for each project?
b) What is the NPV for each project?
3) Which of the above method(s) you would recommend the financial manager to use in forming his to go or not to go proposal for each project and why?
4) Should the financial manager Mr. Chris propose to accept/reject any of the two or both projects relying solely on the method selected to use in Q3? What are some other relevant factors to be considered prior to his decision?
5) Comment if H. Williams, the Marketing and Sales manager comments are or are not to the right direction and why.
6) Comment if J. Smith, the software development manager comments are or are not to the right direction and why.
7) Given that S. Johnson, H/R manager, is paid a bonus at the end of each year based on the contributions to corporate earnings per share made by the company (‘Accounting profits’). Would this compensation scheme affect his opinion about the investment outcomes calculated in Q2?
8) Explain if and why Alex Taylor comments are to the right or to the wrong direction.
9) Suppose that Alex asks Chris to select one of the two projects to propose a go ahead in the forthcoming man agent meeting. Which one you believe he would choose to propose and why.
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