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Financial Evaluation

By:   •  July 4, 2012  •  Essay  •  3,356 Words (14 Pages)  •  1,241 Views

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Executive summary

This report is about a financial appraisal for whether M&S company open 50 stores in Germany. It consists of 4 big parts: investment appraisal, sensitivity of exchange rate and cost of capital, foreign exchange risk, and organizational structure.

In the investment appraisal, it needs to consider a lot of information, such as funding, taxation, CAMP, WACC, inflation rate and exchange rate, and also give some relative assumption and prediction, like depreciation. According to using NPV, IRR and payback period, the result of these three methods are consistent. This project can be invested.

And then analyze the sensitivity of exchange rate and cost of capital in this report. The change of these two data will lead to the change of NPV from positive to negative which will affect the decision for this project. Use 2 graphs to indicate the relationship between NPV and exchange rate and cost of capital. The cost of capital increases and the NPV decrease and vice versa. And when the foreign currency appreciates, NPV will increase.

Moreover, evaluate three different exchange risk in the project, such transaction cost, translation cost and economic cost, and each risk is given relative exposure management, using forward contract, option, financing, local debt, and so on.

Lastly, analysis whether the company set up a subsidiary or a branch in Germany. Comparing with the different factors between subsidiaries and branch, and give the reasons why the company should establish a subsidiary rather than a branch.

Table of contents

1. Introduction

2. Investment appraisal

2.1Funding

2.2CAPM

2.3WACC

2.4Inflation and exchange risk

2.5Taxation

2.6 NPV and IRR

2.7 Payback period

3 Sensitivity of analysis

3.1 Cost of capital

3.2 Exchange rate

4. Foreign exchange exposure

4.1. Transaction exposure

4.2 Translation exposure

4.3 Economic exposure

5. Exposure management

5.1 Transaction management

5.1.1 Forward foreign exchange contract

5.1.2 Option

5.1.3 Financing

5.2 Translation management

5.3 Economic management

6. Organizational structure

7. Conclusion

8.Reference

9. Appendix

1. Introduction

M&S want to open 50 stores in Germany, as a foreign investment, it needs to consider a lot of uncertainty and risk. Initially, evaluate this project whether it is worth investing, and then compare with the change of the cost of capital and exchange rate, the NPV has different result. Moreover, the most uncertain factor is exchange rate for investing abroad, and analysis risk in this project from transaction exposure, translation exposure and economic exposure. Depending on different risk, using the internal and external techniques to reduce or avoid the exchange risk. Finally, a proper organizational structure can also be used to get rid of risk and improve the profit ability of this project. Assumption for this project: 20%depreciation for fixtures and fittings each year.

2. Investment appraisal

In order to make a correct decision about whether M&S should open 50 stores in Germany, I use three different investment appraisal techniques, such as NPV, IRR, and payback period.

2.1 Funding

Funding is the first procedure to start an investment abroad. In order to calculate the WACC easier, this project should borrow £221m?€250m?from bank of England for initial investment for the rental cost and also borrowed €250m from parent company as equity. The debt/equity ratio is 1:1 which indicated the good of company's profit ability.(Appendix1)

2.2 CAPM

Calculating CAPM of M&S can get the data of cost of equity, it not only can used to predict the shareholders expect the return from this company, but also can be used to calculate WACC which is important for evaluate this investment.

Rf is risk free rate, actually, no investment are risk free, therefore, government bonds are considered to be free from the risk of default. And the interest rate of government bonds is the risk free rate. Comparison with long-term government bonds, the short-term government bond will relatively more certain, because the long-term government bonds can be effected by the country's inflation, economic growth, the money supply and budget deficit. (Madura, 2008) Therefore, I choose an interest rate of government bonds in three months which is 0.62 rather than 2.46% of government bonds for five years (see appendix 2).

Beta (?) indicates the volatility of the company's security with the change of the stock exchange market. Demirag and Goddard (1994) indicates this beta of the market is always 1, and the beta for M&S's security is 0.845 which is lower than 1. It means the fluctuation of M&S's security will smaller than the change of the market. The security of M&S is less risk and more attractive to investors when stock exchange is falling.

Equity risk premium (Rm-Rf) is the excess of market returns over those associated with investing in risk free assets. In historical research, there are different data of equity risk premium used in UK. For example, in 1918-1977, the average market risk premium is 9%, while in 1951-2001, it changed in 7.2%. Arnold said, expected return on the market (Rm) changes over time, but it is normally about 8% higher than Rf. Therefore, I choose a middle data (8%) of equity risk premium for my calculation. Depend on the formula of CAPM:

Ke=0.62%+0.845(8.62%-0.62%)=0.0738=7.38%

The final result of the cost of Equity is 7.38% (see appendix 3) that means the shareholder can get 7.38% minimum return from M&S.

2.3 WACC

General speaking, each project require an individual estimate of its own risk-adjusted discount rate.( Watson & Head, 2004) In order to calculate WACC easier, I assume that the capital structure and the degree of risk of this new project are both similar to the M&S's existing investment, in this way, I just need to calculate WACC of M&S in UK as discount rate for the future cash flow of the new project. In my report, WACC calculated using market value rather than book value, because using book value can lead to the WACC being underestimated, and then the unprofitability will be accepted. (Buckley,2004)

The capital structure of a company includes debt and equity. And for M&S, the total debt (£2760.9m) (see Appendix 4) is found in balance sheet which is borrowings and other financial liabilities in current liability and non-current liability, not is the total liabilities. And the cost of debt is the total interest cost of debt divide the total debt. Fortunately, I get the interest cost of total debt directly in annual report of M&S (see Appendix 5). Therefore, I do not need to find out interest rate for each debt. And the cost of debt is 4.93%. The total equity (see Appendix 6) is the market capitalization of M&S which is £5664.7m. And the cost of equity (7.38%) is already calculated before by CAPM. Taxation can not be ignored in WACC, because the cash flow used is after tax, the discount rate should also be after tax. I use the UK taxation (28%) because this discount rate is for the future cash flow which is already remitted to UK.

Depend on formula of WACC(Appendix 7):

WACC= (2760.9/2760.9+5664.7)*4.93 %*( 1-28%) + (5564.7/2760.9+5664.7)*7.38%=6%

2.4 inflation rate and exchange rate forecast

The uncertainty of the inflation rate and exchange rate will increase the risk of investment abroad. Effective forecast of the inflation rate and exchange rate can improve the reliability of cash flow, and then use appropriate techniques to hedge.

In UK, it is not only high financial deficit and government debts, but also the rise of the fuel and food prices, the inflation rate increased 4% in 2011. Moreover, the 20% increase of the VAT which lead to the increase of consume price. And the government can get higher sales taxes to pay the government debt.

In my forecast, this situation can not be temporary, so even if the inflation rate in UK will be decreased in

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