Y0 Y1 Y2 Y3 Y4 TOTAL
INFLOWS
Sales 0 7,280,000 7,570,000 7,870,000 8,190,000 30,910,000
Scrap 300,000 300,000
Capital ‘Return 500,000 500,000
Total Inflow 0 7,280,000 7,570,000 7,870,000 8,990,000 31,710,000
OUTFLOWS
Capital ‘Investment 500,000 500,000
Machinery 6,000,000 6,000,000
Variable ‘Costs 3,150,000 3,310,000 3,470,000 3,650,000 13,580,000
Fixed Costs 210,000 220,500 231,525 243,101 905,126
Total Outflow 6,500,000 3,360,000 3,530,500 3,701,525 3,893,101 20,985,126
Net Change of Cash Flow (6,500,000) 3,920,000 4,039,500 4,168,475 5,096,899 10,724,874
Discount Rate @ 12% 1 0.893 0.797 0.712 0.636
Net Present Value (a) (6,500,000) 3,500,560 3,219,482 2,967,954 3,241,628 6,429,624
Discount Rate @ 20% 1 0.833 0.694 0.579 0.482
Net Present Value (b) (6,500,000) 3,265,360 2,803,413 2,413,547 2,456,705 4,439,025
The reason that net present value is considered an important value when considering a financial decision is because it takes in to account of the timing of the cash flow, it also takes all relevant information in to account and provides clear signals to investors. “NPV Is defined as the sum of the present values (PVs) of incoming and outgoing cash flows over a period of time. Incoming and outgoing cash flows can also be described as benefit and cost cash flows, respectively” (Berk and DeMarzo, 2013).” “A cash flow today is more valuable than an identical cash flow in the future” (Berk and DeMarzo, 2013) When considering if this is a suitable project to invest in, we calculate the net present value in order to see how much money Fox Plc can hope to receive at the end of the 4 years. At first we have used 12% as the cost of capital, but sometimes a low figure like this may seem a little too conservative, hence why we have increased the cost of capital up to 20% and re-evaluated the net present value. As we can see from the cash flow table above, at a conservative percentage we can expect to receive a figure of £6,429,624, which would prove to be an excellent investment in this project for Fox Plc. “If a long-term project has a positive net present value, then it is expected to produce more income than what could be gained by earning the discount rate, which means the company should go ahead with the project.” (Hamel, 2013). Though there may be doubts, and therefore by looking at the net present value at 20%, the return level is still at satisfactory value of £4,439,025. These figures are based on the fact that will be able to sell 10,000 units a year and at the price that they will sell them for.
Internal Rate of Return is used in order to calculate the rate of growth the project is expected to generate. Obviously, this is not 100% accurate to the final figure that the project actually grew as sales may decrease/increase and this is something the internal rate of return can predict at this point. As we can see in the workings above, we can expect to reach about 37.54% project growth over the course of 4 years. This figure complies with our net present value, and proves this is a project worth investing in.
Cash Flow ∑ CFi
Y0 (6,500,000) (6,500,000)
Y1 3,920,000 (2,580,000)
Y2 4,039,500 1,459,500
Y3 4,168,475
Y4 5,096,899
Pay Back Period = (Remaining Negative Number in the ∑CFi)/(The Cash that comes in the following year in the Cash Flow) ×12months =
2580000/4039500×12 = 7.66 months, rounded up to 8 months = 1 Years and 8 Months.
The payback period is used in order to discover the length of time required in order to recover the cost of the initial investment “Payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the break-even point” (Farris et al., 2010) Projects that have a longer payback period are typically not desirable for investment positions. Though sometimes this method is usually not the preferred way as the time value of money is not considered. It also ignores any benefits that occur after the payback period and, therefore, does not measure profitability. As we can see from the workings above, it should take approximately a year and 8 months in order to regather the initial investment of £6,500,000. We have rounded it up due to the fact that a specific date in the 7th month would be too complicated, therefore rounding it up to the 8th month then lets us know we should’ve started making a profit on our investment from here. This is a very desirable time period for Fox Plc, as the project length is 4 years, and they would be recovering their initial investment within a short period of time.
The primary financial objective of a listed company such as Fox Plc. is to maximize the shareholders financial wealth and to maximizing the value of the firm. This is because Fox Plc. is a listed company and therefore is owned by the shareholders. Though it’s important to note that shareholders are paid after other stakeholders have, and it is generally necessary to satisfy the interests of other stakeholders to enrich shareholders. Though, all of the shareholders can’t be involved in day-to-day control of the business, they must employ directors, who will typically be responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditure. Technically, unless the director owns 100% of a firm, they are agents acting on behalf of other owners. These types of relationships are known as principal-agent relationships, where an arrangement in which an agent acts on the behalf of a company elect management to act on their behalf. “These directors may, therefore, be viewed as agents of the shareholders (who are the principles).”(Atrill, 2011).
“Maximizing shareholder wealth is important because firms operate in a highly competitive financial market environment that offers shareholders many alternatives for investing funds” (Gitman and Zutter, 2014). Some people may assume that the directors will seek to maximize the wealth of the shareholders, though this is not the case in most situations. In many cases, there will be incredible conflicts between both parties as maybe a small number of the directors only have themselves as priorities and therefore try and get paid as much as possible, with the inclusion of perks such as expensive cars, holidays abroad and sometimes may buy wasteful pet projects in order to increase the amount of power they feel they have. This is what is referred to when agency problems are mentioned. It’s at this point when both parties’ priorities differ. “Managers might also purchase other companies to expand individual power, or spend money on wasteful pet projects, instead of working to maximize the value of corporation stock” (Boundless, 2015). “The competition for the funds provided by shareholders, and competition for directors’ jobs refereed to earlier, should ensure that the interests of the shareholders will prevails.”(Atrill, 2011). Some may argue with Atrill in this instance though as when competitive forces are weak, or when the director’s activities are hidden or often not given to the shareholders, the risk of problems will re-occur. Problems like this also re-occur when managers don’t feel like they are earning a respectable amount based on the size of a company, and may therefore spend the companies’ budget on lavish offices, expensive cars and other perks. In some of these cases, if the shareholders aren’t happy with their returns at the end of the year, and come to find that the managers have spent on themselves, this can lead to the shareholders restricting the budget that the directors can act upon, therefore increasing pressure on the manager. Though, not all managers are a part of this mind set and will try their best on achieving their long-term goal of maximizing the value of the firm, and the best way to do that would be to encourage investors to invest in them by offering higher returns than other projects might do. Without these investors and access to financial markets, firms are unlikely to survive. “Business Growth Doesn't Happen Without Investing” (Macdonald, 2014)
One way to ensure that the directors maintain the objective to maximize shareholder wealth is to offer them incentive plans. This is when a firm grants stock option to management, then when the stock price raises in the future, the directors then have an option to purchase the stock in effect at the time of the grant, and then would be able to resell them at a higher price. This would give the directors an incentive to be as efficient as possible. Another compensation scheme they could turn to if the managers weren’t interested in shares is performance plans. Performance plans include giving the managers cash bonuses and performance shares. The cash bonuses will include cash payments tied to the achievements of certain performance goals, whereas performance shares are shares of stock given to management as a result of reaching certain performance goals. This performance goals are associated with reaching a certain level of EPS (Earnings per Share) or there has been a substantial growth in the EPS. What is not advisable would be to deny the managers both incentives. Though this could lead to the directors losing the will to improve business efficiency. Therefore reducing the amount of return the shareholders should expect. “However, if managers hold none or very few of the equity shares of the company they work for, what is to stop them from working efficiently” (Media, 2009). In cases where directors are selfish in their pursuit for wealth, it can lead to companies such as Fox Plc. not having enough money to invest in other projects. Furthermore, the costs of funds will increase as businesses compete for what funds are available.
“To help ensure that managers act in ways that are consistent with the interests of shareholders and mindful of obligations to other stakeholders, firms aim to establish sound corporate governance practices.” (Gitman and Zutter, 2014) These rules are set out in the firm’s corporate governance to help monitor and control the behavior of directors. Not only does it aid the shareholders in dealing with directors, it also ensures that their firm is run in a lawful and ethical fashion, in accordance with good best practices, and subject to all corporate regulations. One of the rules highlighted in the code is disclosure, “which lies at the heart of good corporate governance” (Atrill, 2011). This highlights the fact that all decisions made by the directors must be disclosed to the shareholders. The second legislation in place to ensure that the shareholders must clearly define the rules and duties of the directors, and by law in the UK, must make decisions to ensure that shareholders wealth is the main priority. This is rule is known as accountability. It also ensures that all companies must have their financial statements independently audited in order to lend credibility to the statements prepared by the directors. The other law in place is fairness. This is a law that doesn’t enable directors to benefit from access to ‘inside’ information that is not available to shareholders.
When shareholders and the firms internal corporate governance structure is unable to keep agency problems in check, there is a huge possibility that a rival manager would try and take over the firm. This is known as the threat of a takeover and often happen because the firm’s resources are misused and the firm’s stock is generally depressed. The threat of another firm taking over and introduce their own policies, management, financing methods and operations should be enough to motivate the current managers and directors to improve performance, otherwise they’d soon lose their jobs. This is a brilliant tactic from shareholders to ensure that managers stay loyal to the shareholders and keep up an efficient rate for the firm. This is not the only threat manager’s face though, as with every major financial decision they make for the company, it has a risk to fail. Usually when managers in a large company like Fox Plc. condone decisions, and they end up failing miserably, this leads to the overall value of the company decreasing and so do the stocks, which effect the shareholders dividends. This usually ends up with people losing their jobs. “Every major change management programme puts shareholder value at risk. If it fails or even partially fails, then the value of the company may fall and keep falling. And CEOs don't usually survive such an outcome.” (Walton, 2012)
Risk is another factor that may influence the amount a director might prioritize the shareholders wealth. When a company’s shareholders are risk averse, this would mean that they would rather take less of a risk in order to get less of a return. “Investors expect to earn higher returns on riskier investments, and they will accept lower returns on relatively safe investments.” (Gitman and Zutter, 2014). Though, some directors without shares in the company wouldn’t be too concerned about investing in a project with a higher return even though the risk would be greater. This could possibly result in the firm losing money due to bad decisions and would in due course lower the share price of the firm. Then the shareholders would have to monitor the director’s future decisions to ensure that their wealth would be maximized. This is what is known as agency cost. As the simplest way to increase shareholders wealth is to take steps in increasing their firms share price, though this does not necessarily mean that the profit of the firm would increase, and if the directors have some shares of their own, then surely their intentions would be to make as much money as possible through increasing the share price. “If the firm’s stock price rises over time, managers will be rewarded by being able to purchase stock at market price in effect at the time of the grant and then to resell the shares at the prevailing higher market price.” (Gitman and Zutter, 2014). This would mean that they wouldn’t take as much of a gamble on higher risk projects and would much prefer choosing the projects that involve a shorter return but for a shorter level of risk. The majority of directors would be reluctant on taking on investments with more than a moderate of risk, as if they did they’d risk jeopardizing their position at the firm and their personal wealth.
To conclude this answer, the main primary objective of a listed company such as Fox Plc. is to maximize shareholder wealth. As I have previously mentioned, this does have its difficulties as the shareholders don’t manage the day to day proceedings in a firm. The returns the shareholders receive are effectively in the hands of the managers. The managers must comply with the corporate governance that was written up by the shareholders in order to ensure that their main objective is to maximize the shareholders wealth. Some see risk as a major difference in the directors and shareholders. Directors that don’t have shares in the company might be more lenient towards investing in projects with a little bit more risk, whereas shareholders are risk averse. This is why it’s important to try and motivate the directors to make the shareholders wealth a priority, and only invest in safer projects. To encourage the managers to perform as efficiently as possible, shares, bonuses and packages can be given as incentives depending on how happy the shareholders are with their returns. If all does not go so well, and depending on the financial health of the company, and how much dividends the shareholders have been receiving, the shareholders could threaten the current management with an external takeover if they weren’t happy with proceedings. This would mean re-arranging all of the company to ensure that the firm re-discovers it former efficient ways, and the former managers would lose their place at the firm or be moved further down the firm’s power of positions. This would mean that the value of the company would decrease due to changes, and this would be a long term effect on the company. Therefore it’s important that shareholders find the right directors to lead their firm in the right direction, and for them to be able to ensure that the directors are happy to prioritize their wealth before anything else.