Strategic Financial Management Case Study 

1. Critical evaluation of the use of Net Present Value method as the key analytical tool in capital investment appraisal

Businesses should undertake adequate procedures while planning to invest large amount of money to make sure that the project will generate higher value after allocating necessary resources. The investments made for longer period of time are costly and the advantages derived from it are spread over large number of years. Therefore, appropriate decision models while evaluating the cost and returns of the projected investment is crucial. The feasibility of those large investments can be effectively done by using the Net Present Value method as it undertakes all capital costs, expenses, revenues that are forming the part of an investment in its Free Cash Flow (De Marco 2018). Also, it considers the timing of every cash flow that have a large influence on the present value of overall investment. The analysis done on the basis of NPV is regarded as the intrinsic valuation and is used to determine the estimated value of business, capital project, investment security, cost reduction scenario and for other purposes involving cash flows.

Net Present Value method is often considered as a capital budgeting method by various companies as it is helpful in evaluating several projects to check whether it would be beneficial to investment large amount of money in a new project. Net Present Value is calculated by subtracting the present value of cash outflows from the present value of cash inflows of the project (Benamraoui et al. 2017). It is generally used to analyse the returns from the investment. The main purpose of using this method is to lay emphasis on maximising the wealth for shareholder and other key stakeholders of the company. This method is more effective as compared to other methods like discounted payback period method in terms of both time of value or mathematical calculations. It is regarded as the efficient method concerned with the evaluating the various physical projects where the company have a desire to invest. These projects are generally large with regard to both money and scope like construction of new building, purchase of large machinery or equipment, etc.

This method makes use of cash flows discounted at a required rate of return to undertake effective analysis. It is therefore, considered as the precise method as compared to other methods of capital budgeting. Both time and risk variables are considered in Net Present Value method. Under this method, an analysis is done after undertaking various assumptions and variables. The cash flows are forecasted and evaluated by discounting them to the present period with the help of given project information like initial cost of project, its time span, cost of capital, etc. After evaluation, if the NPV arrives positive, then the firm must invest in project otherwise not. Negative NPV indicates that the firm should not invest as the project may not provide adequate returns in future time period (Nanda and Rhodes-Kropf 2017).

In addition to this, NPV method helps the business firms to make adjustments to cope up with the working challenges posed by limited funds. A set of decision rules is framed under Net Present Value method. For instance, it is suggested that if the NPV of an independent project is more than 0 then the project must be accepted otherwise not. In case of mutually exclusive projects, the project with higher NPV must be accepted or both the projects must be rejected if both have negative NPV.

However, there are some disadvantages of using NPV method as a key analytical tool in capital investment appraisal. This method may lead to inefficient decisions as there is a risk of wrong formula inputs and ineffective assumptions. Moreover, project overall cost and estimated cash flows are affected by unforeseen and unexpected events. The calculation of profitability of projects is evaluated based on an estimated discount rate, forecasted cost and expected projected returns (Jagannath et al. 2016). This method might not be helpful in case of delays in project, unforeseen expenditure or some other issues that may arise at early or in between the project. It does not take into account all the potential risks and assumes maximum amount of cash inflows in each year of the project duration. The estimated discount rate and the accounted cash flows may not get achieved and it may lead the investors to make decision based on false calculations.

In order to meet these challenges, IRR (Internal Rate of Return) method is also used to evaluate the project for investment purposes which is based on NPV formula (Patrick and French 2016). This is different from NPV formula as it undertakes only the cash inflows from each period and do not take into account the initial investment. Proper discount rate is used in IRR formula instead of estimated discount rate like in case of NPV formula.

2. Principle uncertainties associated with the project

It is considered important to conduct analysis on negative NPV investments like it is done in case of positive NPV investments. There are times when the companies have to make decisions under high degree of uncertainty. The strategy implemented by the company for doing investment in the project has large influence on the profitability and growth of the company (Nagle and Muller 2017). Estimated cash inflows from a project are uncertain as both expenditure and income with regard to project are meant for the future period. The project being valued on the basis of NPV method may not effectively captures the flexibility offered by the project at times and thus, may generate undervalues from the project. As there are no standard guidelines followed to determine the rate of return on a project and left only to discretion of the specific company to set any such rate. This may lead to the situation of having inaccurate NPV because of inappropriate return rate (Schroeder et al. 2019).

There are uncertainties with regard to the sunk costs, hidden costs or various other types of preliminary costs that have incurred while carrying out the project. These costs are not taken into account while calculating NPV and thus, may severely impact the profitability from the project as NPV is showing inaccurate results. The project with negative NPV will lead to the fall in the overall value of the company. The main objective of the company is to provide positive and maximum return to the shareholders as they have invested funds in the company’s business. The cash flows that may result from the project are uncertain as both expenditure and income are concerned with the future purpose (Barker et al. 2017).

The chances of achieving specific scenarios are completely unknown because of various factors like insufficient historical data, diversity in the definitions of probability, lack of adequate knowledge regarding the potential states of nature, etc. As the Ridley Co. has negative NPV in an estimated project, it may not be able to provide adequate return to the shareholders in future or if it becomes successful in raising the funds at the initial stage then the investors may not invest again in this company. It is important for the company to retain the shareholders for a longer period of time for its growth and survival. There is uncertainty with regard to the decline in the overall value of the company.

However, there are various methods that are particularly designed to take uncertainty level into account like application of sensitivity analysis, rise in the discount rate, forecasting the cash flows with the help of scenario planning and probability distribution methods or the effective comparison between optimistic and pessimistic cash flows (Gaspars-Wieloch 2019). Sensitivity analysis can be applied successfully to the NPV method of project evaluation to assess how the value of NPV changes on the basis of the level of specific cash flows. Thus, it is considered as a useful tool that can be used effectively for decision making process. It helps in knowing the changes in rankings on the basis of the level of discount rate, forecasted net cash flows and the coefficient of optimism and pessimism.

3. Possible actions that could be taken by Ridley Co. to reduce the risk that the project fails to increase shareholder value.

Companies always try and look for the potential opportunities that will help them in improving the overall performance and value of their businesses. There are number of actions that could be taken by Ridley Co. in order to reduce the risk associated with the project to generate maximum value to the shareholders. These are as follows:

  • Strategic decision making: Ridley Co. has evaluated strategic decisions which are in terms of the forecasted influence on the generated earnings. It must undertake strategic decision making which is based on estimated or expected incremental worth of cash flows that are to be received in the future time period (Damodaran 2017).
  • Efficient acquisitions: Acquisition has a major influence on the value of the company. Ridley Co. may acquire any other firm like Lifeline Co. that will help it in maximizing the value of shareholders. This will lead to the creation of more value as compared to any other activity. The management of the company must estimate the present value of the cash inflows resulting from the acquisition (Greve and Man Zhang 2017). However, if the management is not sure about the returns or benefits from the mergers, then it can raise the funds by issuing shares in the market. This will help in reducing the losses for the existing shareholders of Ridley by focusing their interest of ownership in the post merger company. 
  • Rise in unit price: Rise in the price of the product after ensuring that the demand will not decline will lead to the earning of more profits and generate wealth. Although, there are many difficulties in increasing the product’s price like the price of the product charged by other competitors in the market, the value that is received by the customers and other related factors. But, the value of the company can be increased by increasing the prices at a very modest rate. Just ensure to deliver high quality products to the customers in order to make them pay better prices for the products.
  • Revenue generation: It could have undertaken various promotional and marketing activities in order to increase the sales of the company. It must adopt appropriate measures to lower down the cost of each unit of the product in order to make significant contribution towards the creation of shareholder value like add attractive features to the product that will help in differentiating the product from its competitors, offer various value added services to its customers in order to raise their satisfaction level, etc. This will lead to the sales growth and hence, will raise the shareholder value.
  • Carrying of assets: It must take forward only those assets that will help in maximising its value and also that of the shareholders. Appropriate business model could be adopted and the management of the company could have focused on higher value generating activities like designing, research and development, efficient marketing activities and outsource other low value created activities and functions that can be carried out effectively by other firms at relatively lower cost (Teece 2018).
  • Returns to shareholders: Ridley Co. should not pay dividends to the shareholders when there are various high value creating opportunities available to the business where the company can make investment and earn higher profits. The companies having large amount of cash at its disposal and very few profitable investment opportunities may make a decision to pay the money to the shareholders in the form of dividends to raise their satisfaction level and build their confidence in the company (Bordeianu and Radu 2018). This allows the shareholders to invest their money at other profitable options and reduces the potential risk of using that excess cash in making value destruction investments like overpriced acquisitions, loss making projects, etc.
  • Value relevant information: Ridley Co. could have provided its investors with the reliable and relevant information about the company’s financial performance and profitability. Complete or full disclose of its reports will help in lessen down the uncertainty level among the investors and thus further help in reducing the cost of capital and lead to the rise in the share price of the company. It must provide each and every detail with regard to the risks and assumptions taken up for different items of line at the time of presenting significant indicators of performance on which the value of company is based.

4. Main issues of Ridley using 100% debt funding to finance the project

Capital required to carry out the operations of the business can be raised in two ways, namely, by issuing shares in the market or by borrowing from the bank or public. In case of equity shares, some of the control and ownership is given to the shareholders while debt financing helps in retaining control and ownership in the company (Parsonage and Berglund 2017). However, there are various other risks which are present while using debt financing methods to raise the finance for the project. These are as follows:

  • Over-leveraging: The capital raised by borrowing funds from the public act as leverage because the amount is borrowed to earn profits and returns in the future (Ehrhardt and Brigham 2016). It will become difficult for Ridley Co. to maintain and cope up with the day to day ongoing expenses of carrying out the business operations in addition to the repayments of debt amount with regular interest payments. The interest on loan or bonds is considered as a charge against profits. Therefore, business firms are liable to make payments of interest no matter, whether it is earning profits or making any losses.
  • Collateral and slumps: There is a risk attached with the sales figure. If the business fails to generate appropriate amount of revenue then it will surely face difficulty in making huge payments of interest and principal amount on time. Also, inadequate revenue may lead to late fees, missed payments and may unfavourably impact the credit score of the company (Bonsall et al. 2017). When the company borrows to buy any capital asset, it has to keep any collateral security with them and if the company fails to pay back the money then the company will lose the asset which was kept as security with the lender.
  • Lack of funds for reinvestment purposes: Debt financing may left the company with the insufficient amount for making reinvestment back in the business to modernise or further expansion (Erickson 2018). The company is required to have enough capability to keep pace with the current commitments and expenses in order to fetch profits that can be reinvested again in to the business. Companies achieve higher growth prospects by carrying out research and development activities, adequate product development, marketing and promotional activities, etc. in order to attract and persuade customers to buy the products. Debt financing makes it complicated to engage in such activities and thus the profitability of the company falls.
  • Imposition of financing limitations in future: Raising the funds with the debt financing techniques may limit the potential of the company to borrow in the future time period. The lenders usually assess the performance of the company by looking at its financial statements and fulfilment of its debt obligations on time (Andjelic and Vesic 2017). If the position of the company does not seem good to the public or other lenders then, they may provide loans or funds to the company as this raises the risk among them whether the company would be able to pay their money back in the future or not. This will force the company to raise adequate amount of funds by issuing equity shares in the market.
  • Higher rate of interest: Normally the interest charged on bonds and debentures is high which affects the overall profitability of the firm and also this rate keep on fluctuating with the microeconomic conditions prevailing in the economy, credit rating of business, etc. which may lead to unfavourable results. To maintain the interest of investors, the company will be requiring to make competitive payments of interest.
  • High level of discipline: When the company has made a decision to use debt financing, it becomes important to maintain financial discipline to make timely payment of interest and the principle amount (Cole and Sokolyk 2018). Adequate strategy must be adopted by the management to ensure that no lender remains unpaid and no penalties will be charged from the company.
  • Limit on borrowing: Sometimes, the limits are set on the amount that can be borrowed by the company. The investors assess or verify the book value of the company’s assets, current amount of cash inflows and the credit risk in order to identify the upper limit that they are ready to invest in the company. The goodwill of the firm also gets affected by this. Thus, Ridley Co. should not consider 100% debt financing.

References for Ridley Co. Case Study 

Andjelic, S. and Vesic, T. 2017. The importance of financial analysis for business decision making. In Book of proceedings from Sixth International Scientific Conference Employment, Education and Entrepreneurship (pp. 9-25).

Barker, R., Penman, S., Linsmeier, T.J. and Cooper, S. 2017. Moving the conceptual framework forward: Accounting for uncertainty. Contemporary Accounting Research.

Benamraoui, A., Jory, S.R., Boojihawon, D.R. and Madichie, N.O. 2017. Net Present Value Analysis and the Wealth Creation Process: A Case Illustration. The Accounting Educators' Journal26.

Bonsall IV, S.B., Koharki, K., Muller III, K.A. and Sikochi, A. 2017. Credit Rating Adjustments Prior to Default and Recovery Rates.

Bordeianu, G.D. and Radu, F. 2018. Dividend Analysis. Economy Transdisciplinarity Cognition21(2), pp.32-37.

Cole, R.A. and Sokolyk, T. 2018. Debt financing, survival, and growth of start-up firms. Journal of Corporate Finance50, pp.609-625.

Damodaran, A. 2017. Measuring Investment Returns: The Mechanics of Investment Analysis. Stern School of Business.

De Marco, A. 2018. Project Feasibility. In Project Management for Facility Constructions (pp. 79-92). Springer, Cham.

Ehrhardt, M.C. and Brigham, E.F. 2016. Corporate finance: A focused approach. Cengage learning.

Erickson, K.H. 2018. Corporate Finance: A Simple Introduction. KH Erickson.

Gaspars-Wieloch, H. 2019. Project net present value estimation under uncertainty. Central European Journal of Operations Research27(1), pp.179-197.

Greve, H.R. and Man Zhang, C. 2017. Institutional logics and power sources: Merger and acquisition decisions. Academy of Management Journal60(2), pp.671-694.

Jagannathan, R., Matsa, D.A., Meier, I. and Tarhan, V. 2016. Why do firms use high discount rates?. Journal of Financial Economics120(3), pp.445-463.

Nagle, T.T. and Müller, G. 2017. The strategy and tactics of pricing: A guide to growing more profitably. Routledge.

Nanda, R. and Rhodes-Kropf, M. 2017. Financing risk and innovation. Management Science63(4), pp.901-918.

Patrick, M. and French, N. 2016. The internal rate of return (IRR): projections, benchmarks and pitfalls. Journal of Property Investment & Finance.

Parsonage, M. and Berglund, J., 2017. The Decision of Debt or Equity Financing.

Schroeder, R.G., Clark, M.W. and Cathey, J.M. 2019. Financial accounting theory and analysis: text and cases. John Wiley & Sons.

Teece, D.J. 2018. Business models and dynamic capabilities. Long Range Planning51(1), pp.40-49.

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