Question

Imagine that you are the financial manager for a company in Phuket which specializes in wildlife tours. Though your company is well-known for elephant treks and guided walking tours, it has begun to lose business to other tourism companies which provide adventure-based tours using motorbikes and boats. One day, a colleague approaches you with an exciting new investment he thinks the company could make in safari trucks. He believes that the rugged terrain and breathtaking sites of the company’s preserve is perfect for the big wheels and open roof of the safari truck. He hands you a brochure of the trucks and asks your opinion. You are impressed with the potential but suggest that your colleague receive approval from the president of your company before discussing the idea any further. Later that week, the president stops by your office and asks you to conduct a financial analysis of the safari truck investment. Specifically, he would like to know whether the company will likely profit from this investment, break even, or lose money. If a profit is likely, he would like for you to authorize the capital spending of this investment. If you were the financial manager of this tourism company, would you authorize such an investment? What calculations might you use to value the potential of the safari trucks? You explore how financial managers use capital budgeting formulas to analyze investment opportunities. You also examine how each formula, though important to the capital budgeting process, is laden with pitfalls which might lead financial managers towards the wrong investment decisions.

Answer 1

If I were the financial manager of this tourism company, I would authorize the investment after conducting due financial analysis. That is, if the investment is seen to profitable, and the profitability meets the required profitability, then the investment would be authorized.

There are two stages of this analysis :

• Is the investment profitable?
• Is it profitable enough?

To do this analysis, the following steps and calculation will need to be done :

Is the investment profitable?

• Project the cash outflows - These include the initial investment in safari trucks, repairs/maintenance costs, salaries of drivers and guides, fuel, and any other expenses.
• Project the cash inflows - These include estimated cash inflows from sales, and depreciation tax shield. Depreciation is a tax-deductible expense, and the depreciation on safari trucks will reduce the tax outgo. Hence this is treated as a cash inflow
• Calculate the cost of capital for the company. The most appropriate measure for this is weighted average cost of capital (WACC). WACC = (weight of debt * cost of debt) + (weight of common stock * cost of common stock) + (weight of preferred stock * cost of preferred stock).
  • weight of debt = market value of debt / market value of (debt + common stock + preferred stock)
  • weight of common stock = market value of common stock / market value of (debt + common stock + preferred stock)
  • weight of preferred stock = market value of preferred stock / market value of (debt + common stock + preferred stock)
  • cost of debt = coupon payment / market price (in case of bonds), or effective rate of interest in case of a bank loan
  • cost of common stock = risk free rate + (beta * equity market premium), where equity market premium = market portfolio return minus risk free rate. Beta is the applicable beta for the company
  • cost of preferred stock = dividend payment / price of preferred stock
• Discount all the cash flows back to the present using the WACC as the discount rate - this will give you the Present Values (PV) of each cash flow
• Sum all the PVs to find the Net Present Value (NPV)
• If the NPV is positive, the investment is profitable and can be authorized

Is the investment profitable enough?

• Using the projected cash flows, the Internal rate of return (IRR) can be calculated using Excel/financial calculator/trail and error/intrapolation
• If the IRR > WACC, it is profitable enough. Alternative, a hurdle rate of return can be determined by the management, and investment will be authorized if IRR > hurdle rate
• Alternatively, the payback period of the investment can be calculated. Payback period is the number of years taken for the cash inflows to equal the initial investment. A maximum permissible payback period can be determined by the management and the investment will be authorized if the payback period for the investment is less than the maximum permissible payback period