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Genesis Capital Report, Case Study Example

Pages: 6

Words: 1559

Case Study

Many of the most important decisions companies will have to make relate to expanding. Whether or not to expand is an important decision, but beyond that they must correctly decide how to expand. Once the decision has been made to expand, the specific expansion, whether it is a new store, production plant, or warehouse must be correctly chosen. One reason for the extreme importance of this decision is that companies usually do not sit on large enough cash reserves to fund large expansions on their own. Usually they must either sell equity or issue bonds to pay for these types of investments. For this reason, projects usually have a rate of return higher than the weighted average cost of capital, (WACC) to be deemed worth it. WACC is the average between the cost of equity and cost of debt, weighted based on how much of their assets are financed through debt and what percentage is through equity. The number provided here is the rate an asset must return for it to pay off their creditors and equity holders. Therefore, a project that looks profitable from a basic accounting standpoint may in fact not be worth it, if its return does not meet its WACC, as the company will need to stretch other assets further to satisfy their financial needs (Investopedia).

However, WACC is not always sufficient for judging potential expansion projects. If two or more projects have returns greater than a company’s WACC the company may not be able to undertake each desired project. They may not be able to fund all of the investments, or may feel that doing so will over leverage the company or cause it to lose too much control of their operations. For this reason, other metrics that allow for better direct comparisons between two or more projects must be used. Amongst them are internal rate of return, pay-back period, and net present value. IRR is the discount rate that will give the cash flows a net present value of zero, the higher the more lucrative the project. Net present value is based on the time value of money, with a given discount rate, how much the cash flows are worth in present terms (Baker). Finally, payback period is as it sounds, the amount of time before the profits that an investment gives pay off the cash outlays to fund the project (Schmidt).

Companies should therefore judge projects with these metrics in mind. One basic criterion is that a project’s IRR should exceed the WACC, and it should do so significantly in cases where the projected cash flows face great deals of risk. However, in the aforementioned case of mutually exclusive projects, it is important to use net present value, which allows for comparison and decision between multiple projects. It is important to run this using multiple discount rates, to see how sensitive a project is to increased inflation or lower returns. Finally, one of the most important numbers for getting a good idea about a project’s viability is the economic profit it will return. This goes beyond the basic accounting profit method of revenue minus costs, and also subtracts the capital costs associated with each investment. This profit represents the funds that can be rolled over into either new projects or paid out in dividends that encourage investors to purchase equity in the company (Economic Value Added).

Genesis Corporation recently came into a similar situation. They had decided to undergo operating expansions and needed to pick between several options. There were five different types of projects that were to be undergone, with each having several different options about the size and scope that could be undertaken. Amongst these options were a new facility, three different types of equipment, and an inspection of their operations. As the company’s assets were funded largely equally through debt and equity, it can be expected that they face a standard WACC, in the range of approximately eight percent when using reasonable estimates for the costs they face on debt and equity. Although to be more sure would take knowledge of their creditworthiness and the type and quantity of investors they attract.

The first set of operating projects, the new buildings, do not come up as advisable using any of the available criteria. The first returns just seven hundred dollars of profit in its first ten years, meaning the initial investment of two thousand dollars will take multiple decades to pay back and even longer when time value of money is factored in. Neither of the other new facilities have positive net present values, even when using extremely low discount rates below what they can reasonably expect to face. None of them repays the initial investment within the first ten years that are being projected by the board. Finally, the return on all of them is significantly below the WACC. For that reason, none of them is advisable, but if at least one has to be undertaken for some reason, then Project C might be the most advisable. Its net present value is slightly lower than Project B using the ten year projections, but its cash flows are growing more positive more quickly, so over a longer term it has the best chance of reaching a zero NPV.

The new equipment investment projects are more mixed in their chances for success than the new facility is. Equipment project one features three options, automatic, manual, and naturally semi-automatic. Every one of the available options will be paid pack within the projected period, but this reveals a major flaw in payback period as a tool for evaluating projects. As money today is worth more than the same amount of money in the future, a project that only pays for its initial investment is not worth it. As the cash inflows here are not discounted, a project that barely manages to pay its own investment does not hold up even though payback period may say so. Each is projected to have an internal rate of return above zero, which is quite different from the disastrous facility options, yet neither the automatic nor the semi-automatic options are above the WACC. These low rate of returns account for the negative net present value, as their returns will fall below the necessary expense for the funds it will take to finance the projects. For that reason, neither is advisable and they should undertake an investment in the manual equipment.

Equipment type two is perhaps the one that will have the most positive outcome for the company no matter which route is chosen. Both the standard and top of the line options feature returns significantly above the company’s WACC, meaning that if both can be taken, each can be expected to be a positive for the company. However, it can be assumed that each option is a substitute for the other, meaning just one can be undertaken. The top of the line gear has a higher investment, but larger cash inflows in further years. It will take slightly longer to pay back, with a lower rate of return, but at reasonable discount rates, a larger net present value. The projects seem largely equal within the first ten years, but the higher quality equipment will likely have better cash flows after this period. As long as the maintenance costs do not increase long term, these larger cash flows can be a tiebreaker, making that project more lucrative.

The third set of equipment features no advisable options. Each has a payback period longer than the projected years and therefore necessarily a negative net present value and negative internal rate of return.  Neither should be undertaken if possible, but again if at least one is somehow necessary, they should turn towards the three man machine, which is the least bad option.

The inspections are perhaps the most straightforward decision. As the contract inspection features only cash inflows and never a cash outflow, it is extremely lucrative for the company to undertake. It features a higher net present value and a shorter payback period, as there is no initial outlay and therefore paid back immediately. The other, in house inspection is also positive, but does not hold up as well as the contract inspection, which is essentially free money for the company if they choose to undertake it.

Genesis Capital has the opportunity to make many good investments, but some that are of a risky nature, and others that project into almost certain losses. Their building expansion cannot provide value to the company, but if the new equipment can be brought into existing buildings, it can certainly add value to the company and be a worthwhile investment for them. This is best seen through analysis that focuses on net present value, which accounts for issues such as time value of money, giving an estimate of how much the project will be worth to the company. However, it is important for them to remember that projections can be off, and that projects can come up less profitable than their estimates show them likely to be.

 

Works Cited

Baker, Samuel L. “Perils of the Internal Rate of Return.” NPV and IRR. Web. 18 Mar. 2012.   <http://hspm.sph.sc.edu/courses/econ/invest/invest.html>.

“Economic Value Added.” For Balance Sheet and Financial Analysis. Web. 18 Mar. 2012.   <http://www.balancesheetwalk.com/economic-value-added.htm>.

Schmidt, Marty J. “Payback Period.” , Defined, Calculated, and Explained with Examples. Web.18 Mar. 2012. <http://www.solutionmatrix.com/payback-period.html>.

“Weighted Average Cost Of Capital – WACC.” Investopedia. Web. 18 Mar. 2012.            <http://www.investopedia.com/terms/w/wacc.asp>.

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