Finance for international business
INVESTMENT APPRAISAL REPORT
A) Background of the Case:
Introduction about Organic Food Industry:
Organic Food is the food which has been cultivated or grown with less or no pesticide and Insecticide. Different countries have different standards in defining Organic Food. However, the food which has been grown under natural conditions and which is untreated or unprocessed with artificial agents, Industrial solvents or any other food additives is termed as Organic food. People around the world are moving to more hygienic food habits and their increased awareness about the Organic food helps the industry to grow at higher pace.
Global Organic Food Market which stood at US $ 110.25 Billion in 2016 is growing at a CAGR of 16% and it expected to reach US $ 263 Billion in 2022. It is not only the awareness among the public but also rising per capita earnings & spending and increasing health concern are also reason for this growth. We also can see that there is an increased production and aggressive marketing made by the companies to promote these products.
- B) Objective of the Report:
- i) The main objective of the report is to evaluate the Fresh Farm Foods Co valuation from the shoes of Fenland Foods Plc and to comment on the investment feasibility on the project.
- ii) In case of potential investment, the possible foreign exchange impact on the project and the alternative ways to protect the investment from the forex risk.
Introduction about Fenland Foods Plc:
Fenland Foods Plc which began in 1970 in UK is one of the pioneers in Organic Food Industry. Post restricting as a limited company in 1980, the company experienced a rapid growth till 1991. Post that the company expanded by raising capital from the public and it has updated plant and machinery. It also has expanded its geographical boundaries to foster its growth.
Introduction about Fresh Farm Foods Co:
Fresh Farm Foods Co is a family run business in Ireland. The company holds a chain of organic food shops in Ireland. The family members think that the future scope lies in expansion in wider European region. However, the senior family members want to retire and they are ready to sell the entire shares to an other company by 2020.
Investigation:
Fenland’s finance director found this Fresh Farm Foods Co opportunity to be one of the best fit for Fenland Foods Plc. This will be one of the inorganic route to spread the wings of Fenland in Ireland and in a faster manner.
- C) Profit and Loss Projection of Fresh Farm Foods Co:
Optimistic Case:
Below is the P&L projection of Fresh Farm Foods Co for the year 2021 to 2025. I consider this to be one of the Optimistic case with the given data. Here I have computed the labour cost with given 8% increase. Similarly, I assume that the depreciation of the fixed assets has been considered in the fixed cost.
| Fresh Farm Foods Co – Optimistic Case | |||||
| Particulars | 2021 | 2022 | 2023 | 2024 | 2025 |
| Sales | € 870,000 | € 974,400 | € 1,091,328 | € 1,222,287 | € 1,368,962 |
| Variable cost (ex labour) | € 297,000 | € 311,850 | € 327,443 | € 343,815 | € 361,005 |
| Variable cost (labour) | € 198,000 | € 213,840 | € 230,947 | € 249,423 | € 269,377 |
| Total Variable Cost | € 495,000 | € 525,690 | € 558,390 | € 593,238 | € 630,382 |
| Fixed Cost | € 130,000 | € 136,500 | € 143,325 | € 150,491 | € 158,016 |
| Profit before tax | € 245,000 | € 312,210 | € 389,613 | € 478,559 | € 580,564 |
| Corporation Tax | € 30,625 | € 39,026 | € 48,702 | € 59,820 | € 72,570 |
| Profit after tax | € 214,375 | € 273,184 | € 340,912 | € 418,739 | € 507,993 |
| Net Margin | 25% | 28% | 31% | 34% | 37% |
| Profit Growth % | 27% | 25% | 23% | 21% | |
| EPS | € 0.39 | € 0.50 | € 0.62 | € 0.76 | € 0.92 |
As per the working, the Net margin stands at 25% in 2021 and is expected to grow to 37% by the year 2025.
Pessimistic Case:
I also thought of not miss the other side of the coin. Taking into account that there is a chance of increase in labour cost, I have assumed the increase in labour cost to be 12% and prepared the P&L projection for the years 2021 to 2025.
| Fresh Farm Foods Co – Pesimistic Case | |||||
| Particulars | 2021 | 2022 | 2023 | 2024 | 2025 |
| Sales | € 870,000 | € 974,400 | € 1,091,328 | € 1,222,287 | € 1,368,962 |
| Variable cost (ex labour) | € 297,000 | € 311,850 | € 327,443 | € 343,815 | € 361,005 |
| Variable cost (labour) | € 198,000 | € 221,760 | € 248,371 | € 278,176 | € 311,557 |
| Total Variable Cost | € 495,000 | € 533,610 | € 575,814 | € 621,990 | € 672,562 |
| Fixed Cost | € 130,000 | € 136,500 | € 143,325 | € 150,491 | € 158,016 |
| Profit before tax | € 245,000 | € 304,290 | € 372,189 | € 449,806 | € 538,384 |
| Corporation Tax | € 30,625 | € 38,036 | € 46,524 | € 56,226 | € 67,298 |
| Profit after tax | € 214,375 | € 266,254 | € 325,666 | € 393,580 | € 471,086 |
| Net Margin | 25% | 27% | 30% | 32% | 34% |
| Profit Growth % | 24% | 22% | 21% | 20% | |
| EPS | € 0.39 | € 0.48 | € 0.59 | € 0.72 | € 0.86 |
As per the pessimistic case working, the Net margin which stands at 25% in 2021, is expected to reach 34% by the year 2025 – a drop in 3% of the bottom line in four years.
- D) Valuation Methodology:
- i) Present value of the firm by using WACC as discount factor:
As a part of valuation methodology, first we like to understand the Weighted Average Cost of Capital from the point of Fenland’s capital structure. Post finding the WACC, we can use it to discount the Fresh Farms Foods Co cash flow, to arrive whether the project is feasible for investment or not.
| Fenland’s WACC | Weightage (2018) | Weightage (2019) | Cost |
| Equity Share Capital | 75% | 79% | 8.80% |
| Preference Share Capital | 7% | 6% | 5.0% |
| Loans | 18% | 15% | 7.0% |
| Weighted Average Cost of Capital | 8.3% |
Preference Cost: The committed divided % for preference shares is found to be 5%.
Loan Cost: The interest rate for loan stands at 7%
Cost of Equity: And the cost of Equity is computed using the formula
Cost of Equity =Risk free rate of return+Premium expected for Risk
= Risk free rate of return + Beta × (market rate of return – Risk free rate of return)
=0.25%+1.7*(5.3%-0.25%) = 8.8%
WACC = (Pw*Pr)+(Lw*Lr)+(Ew*Er)
= (6%*5%)+(15%*7%)+(79%*8.8%)
WACC= 8.3%
Pw – Weightage of Preference share
Pr – Rate of return on Preference share
Lw – Weightage of Loan
Lr – Rate of interest on Loan
Ew – Weightage of Equity shares
Er – Expected Rate of return on Equity shares
The Weighted Average cost of capital is the average cost of funds that has been used by the firm and it has been derived by using the above formula (Andre Farber, Roland L. Gillet and Ariana Szafarz, 2006, A General formula for the WACC).
The present value of the Fresh Farm Foods Co is found by using the WACC as a discount factor to find the maximum valuation for the firm.
| Year | Optimistic Cash Flow | Pessimistic Cash Flow |
| 1 | € 239,375.00 | € 239,375.00 |
| 2 | € 298,183.75 | € 291,253.75 |
| 3 | € 365,911.64 | € 350,665.64 |
| 4 | € 443,738.70 | € 418,580.02 |
| 5 | € 532,993.38 | € 496,085.86 |
| Discount Factor | 8.3% | 8.3% |
| Present Value | € 1,443,814 | € 1,382,833 |
The maximum valuation of the firm that can be paid by using WACC as a discount factor is € 14,43,814 and the lower value is fixed at € 13,82,833. This has been computed by discounting the future cash flows with the discounting factor of 8.3% the WACC of the acquiring firm (James A. Miles and John R. Ezzell, 2009 , The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification)
- ii) NPV:
The cash outflow has been considered as Euro 1,485,864 which has been based on the PE projection of Norfolk Foods Plc
| Year | Optimistic Cash Flow | Pessimistic Cash Flow | |
| Cash Outflow | € (1,485,864) | € (1,485,864) | |
| Cash Inflow | 1 | € 239,375 | € 239,375 |
| 2 | € 298,184 | € 291,254 | |
| 3 | € 365,912 | € 350,666 | |
| 4 | € 443,739 | € 418,580 | |
| 5 | € 532,993 | € 496,086 | |
| Discounting Factor | 8.3% | 8.3% | |
| Present Value of future cash flows | € 1,443,814 | € 1,382,833 | |
| Net Present value | € (42,050) | € (103,031) |
Here, we find that the net present value for both Optimistic case and the Pessimistic case is negative. This shows that the cash outflow of Euro 1,485,864 is higher for the investment (Note: The cash inflows are considered only for five year. If more time horizon is included, then this is likely to change). The Net present value of the firm is computed by summing up the discounted the future cash inflow with that of the present cash outflow. If the Net present value is found to be positive, then it means that the project is good enough to earn higher money than the outflow.(Stephen A Ross, 1995). If the net present value is found to be negative, then it means that the project is not good enough to be taken up.
iii) Internal Rate of Return:
The cash outflow has been considered as Euro 1,485,864 which has been based on the PE projection of Norfolk Foods Plc
| Year | Optimistic Cash Flow | Pessimistic Cash Flow | |
| Cash Outflow | € (1,485,864) | € (1,485,864) | |
| Cash Inflow | 1 | € 239,375 | € 239,375 |
| 2 | € 298,184 | € 291,254 | |
| 3 | € 365,912 | € 350,666 | |
| 4 | € 443,739 | € 418,580 | |
| 5 | € 532,993 | € 496,086 | |
| IRR | 7.34% | 5.91% |
The internal Rate of Return stands at 7.34% for optimistic case and stands at 5.91% for pessimistic case which is much lower than the WACC of 8.3%. The internal rate of return is the rate at which the net present value turns to be zero. In other words, the rate of return of the project is called as the Internal rate of return (JC Hartman, IC Schafrick – The Engineering Economist, 2004)
- iv) Payback Method:
| Cash Outflow is considered based on the PE projection of Norfolk Foods Plc | ||
| Year | Optimistic Cash Flow | Pessimistic Cash Flow |
| 1 | € 239,375 | € 239,375 |
| 2 | € 298,184 | € 291,254 |
| 3 | € 365,912 | € 350,666 |
| 4 | € 443,739 | € 418,580 |
| 5 | € 532,993 | € 496,086 |
| Total Cash Inflow | € 1,880,202 | € 1,795,960 |
| Cash Outflow based on the PE projection of Norfolk Foods Plc | ||
| € 1,485,864 | € 1,485,864 | |
| No of Months post 4 yrs | 3.12 | 4.50 |
| Payback Period | 4 Years and 4 Months | 4 Years and 5 Months |
The payback period for an investment of €1,485,864 is 4 year 4 months under optimistic scenario and 4 year 5 months in pessimistic scenario. Payback period is the number of years in which the invested money is taken back from the investment (S.Yard, 2000, Developments of Payback Method)
- v) Discounted Payback Method:
| Discounted Cash Inflows | |||
| Year | Optimistic Cash Flow | Pessimistic Cash Flow | |
| 1 | € 221,038 | € 221,038 | |
| 2 | € 254,249 | € 248,340 | |
| 3 | € 288,098 | € 276,094 | |
| 4 | € 322,611 | € 304,320 | |
| 5 | € 357,818 | € 333,040 | |
| Total Cash Inflow | € 1,443,814 | € 1,382,833 | |
| Discounting Factor – WACC | 8.3% | ||
| Cash Outflow based on the PE projection of Norfolk Foods Plc | € 1,485,864 | € 1,485,864 | |
| Discounted Payback Period | Greater than 5 years | Greater than 5 years | |
Considering an investment of € 1,485,864 and a discount rate of 8.3%, the discounted payback period stands at greater than 5 years in both optimistic case and pessimistic case. Discounted Payback period is the number of years in which the invested money is taken back from the investment after discounting the future cash flows with the discount factor (S.Yard, 2000, Developments of Payback Method).
vi)Accounting Rate of Return:
| Fresh Farn Foods Co | ||
| Year | Optimistic Cash Flow | Pessimistic Cash Flow |
| 1 | € 214,375 | € 214,375 |
| 2 | € 273,184 | € 266,254 |
| 3 | € 340,912 | € 325,666 |
| 4 | € 418,739 | € 393,580 |
| 5 | € 507,993 | € 471,086 |
| Total Profits after tax | € 1,755,202 | € 1,670,960 |
| Average Profits | € 351,040 | € 334,192 |
| Average Investment | € 1,485,864 | € 1,485,864 |
| Accounting Rate of Return | 23.6% | 22.5% |
The Accounting rate of return stands at 23.6% in the optimistic case and it is 22.5% in the pessimistic case which is fair for any investment. It considers only the accounting information and the average investment is the average amount of assets in the five years. Here, we have considered the cash outflow to buy the project as the average investment.
Supporting Working: Fresh Farm Foods Co valuation working based on PE projection of Norfolk Foods Plc:
| Year | PAT | Growth Rate | EPS |
| 2015 | € 82,000 | € 0.15 | |
| 2016 | € 101,200 | 23% | € 0.18 |
| 2017 | € 103,800 | 3% | € 0.19 |
| 2018 | € 108,000 | 4% | € 0.20 |
| 2019 | € 114,650 | 6% | € 0.21 |
| 2020 Projection | € 123,822 | 8% | € 0.23 |
Since the sale has been planned in the year 2020, the projection of PAT for 2020from the year 2019 has been made with 8% growth. The EPS for the years 2015 to 2020 has been computed by considering the number of shares to be 550,000.
The P/E multiple of Norfolk Foods Plc is 12. Considering the same P/E, Share price of Fresh Farm in 2020 is estimated. With 550,000 shares outstanding, the value of the company is estimated to be around €14.85 Lakhs.
| Based on the PE projection of Norfolk Foods Plc: | |
| Projected Per Share Price of Fresh Farm in 2020 | € 2.70 |
| Projected Valuation of Fresh Farm in 2020 | € 1,485,864 |
| Fresh Farm Foods Co – Optimistic Case | |||||
| Particulars | 2021 | 2022 | 2023 | 2024 | 2025 |
| Sales | € 870,000 | € 974,400 | € 1,091,328 | € 1,222,287 | € 1,368,962 |
| Variable cost (ex labour) | € 297,000 | € 311,850 | € 327,443 | € 343,815 | € 361,005 |
| Variable cost (labour) | € 198,000 | € 213,840 | € 230,947 | € 249,423 | € 269,377 |
| Total Variable Cost | € 495,000 | € 525,690 | € 558,390 | € 593,238 | € 630,382 |
| Fixed Cost | € 130,000 | € 136,500 | € 143,325 | € 150,491 | € 158,016 |
| Profit before tax | € 245,000 | € 312,210 | € 389,613 | € 478,559 | € 580,564 |
| Corporation Tax | € 30,625 | € 39,026 | € 48,702 | € 59,820 | € 72,570 |
| Profit after tax | € 214,375 | € 273,184 | € 340,912 | € 418,739 | € 507,993 |
| Net Margin | 25% | 28% | 31% | 34% | 37% |
| Profit Growth % | 27% | 25% | 23% | 21% | |
| EPS | € 0.39 | € 0.50 | € 0.62 | € 0.76 | € 0.92 |
| Profit after tax + Depreciation | € 239,375 | € 298,184 | € 365,912 | € 443,739 | € 532,993 |
| Fresh Farm Foods Co – Pesaimistic Case | |||||
| Particulars | 2021 | 2022 | 2023 | 2024 | 2025 |
| Sales | € 870,000 | € 974,400 | € 1,091,328 | € 1,222,287 | € 1,368,962 |
| Variable cost (ex labour) | € 297,000 | € 311,850 | € 327,443 | € 343,815 | € 361,005 |
| Variable cost (labour) | € 198,000 | € 221,760 | € 248,371 | € 278,176 | € 311,557 |
| Total Variable Cost | € 495,000 | € 533,610 | € 575,814 | € 621,990 | € 672,562 |
| Fixed Cost | € 130,000 | € 136,500 | € 143,325 | € 150,491 | € 158,016 |
| Profit before tax | € 245,000 | € 304,290 | € 372,189 | € 449,806 | € 538,384 |
| Corporation Tax | € 30,625 | € 38,036 | € 46,524 | € 56,226 | € 67,298 |
| Profit after tax | € 214,375 | € 266,254 | € 325,666 | € 393,580 | € 471,086 |
| Net Margin | 25% | 27% | 30% | 32% | 34% |
| Profit Growth % | 24% | 22% | 21% | 20% | |
| EPS | € 0.39 | € 0.48 | € 0.59 | € 0.72 | € 0.86 |
| Profit after tax + Depreciation | € 239,375 | € 291,254 | € 350,666 | € 418,580 | € 496,086 |
- E) Findings:
- The Weighted Average cost of capital for Fenland Foods Plc stands at 8.3%. This rate of capital is used the capital budgeting as a discount factor to access the feasibility of the project (Richard Pike and Bill Neale, 2006, Corporate Finance and Investments – Decision & Strategies). The weighted average cost of capital is likely to change if there is a change in the capital structure or if there is change of cost in loan, preference share or equity shares.
- The present value of the Farm Fresh Food Co stands at € 1,443,814 in the optimistic case and €1,382,833 in the pessimistic financial projection for the years 2021 to 2025. From this, we infer that the minimum about that can quoted for the project is €1,382,833 and the maximum can be € 1,443,814. The present value of the firm is likely to change if we are going to consider some periods of future cash inflow or if there is going to be change in the discount rate.
- The Net present value of the project considering the cash out flow of € 1,485,864 (which has been arrived based on the PE projection of Norfolk Foods Plc) stands at (€ 42,050) in the optimistic case scenario. It means that the project is not feasible for an investment of € 1,485,864. {Caution: We have considered only five years of future cash inflow as the projection is said only for five years. If we extent the period, then there is good chance of getting positive NPV and accepting the project). The net present value considers all the cash flows for the project (here 5 years) and the delayed cash flows are discounted with higher rate as there is more uncertainty in the cash flows.
- The Accounting Rate of Return for the project stands at 23.6% for the optimistic scenario and 22.5% for the pessimistic scenario. The Accounting Rate of Return does not considers the number of period or the cash flows, it is computed directly from the profits and from the investment
- The Internal Rate of Return using the cash outflow of € 1,485,864 stands at 7.34%. However, if we consider the present value figure of € 1,443,814, we get an IRR of 8.3% and which affirms the feasibility of the project.
- The payback period for the cash outflow of € 1,485,864 the payback period stands at 4 year 4 months. The payback period is used to compute the number of years in which the invested amount is taken back. It does not gives importance to the cash flow post the period or it does not give importance of the cash flow for the beginning or at the end.
- The discounted payback period with the discount factor of 8.3% is greater than 5 years.
- F) Viability of the Project:
From the above working,it is clear that the project is feasible for an investment of € 1,443,814 in the higher side (working based on optimistic scenario and five year projection). Thus any value less than € 1,443,814 can be considered for investment.
- G) Financing Options:
Fenland Food Plc can look for different options in financing this project or this takeover.
Option 1: Instead of going for 100% equity funding, the company can look for 50% equity funding and balance 50% through preference share capital & loan. The preference share capital and loan has to be raised in Ireland in Euro currency. This is also called as financial gearing (19. Does Capital Structure really matter? Richard Pike and Bill Neale, 2006, Corporate Finance and Investments – Decision & Strategies). This will ensure that the money earned in Euro’s will be used to pay interest for Euro loan and to pay dividend to for Euro preference shares. The dividend which is taken out of the country for the equity shares alone is exposed to the forex risk.
Option 2: The company also can pledge its assets in a bank in UK and get the money from the bank’s branch in Ireland in Euro currency to fund the 50% equity investment. And as we discussed above the balance 50% can be funded as preference capital and as a loan.
Option 3: The Fenland Food Plc can issue Eurobonds in Eurozone and the raised Euro currency can be used to finance this investment. Later, the proceedings that the company is likely to get from Fresh Farm Foods Co can be used to pay the coupon payments and the principal payments.
Option 4: If the Fenland Food Plc can estimate as what would be its dividend from the Fresh Farm Foods Co for the next n years. Then the company can enter into a forward contract with the bank for the expected cash inflows and thus it can protect itself from the forex risk.
These are some of the ways through which the company can protect its investment from the forex risk.
- H) Value Creation:
There are different methods in capital budgeting and as we say above, the NPV method is considered to be more suitable method than others. However, the limitations are we have considered the P&L projections only for five years. The discount factor is also based on the current capital structure and current cost.
The project is likely to earn higher rate if the company works on better marketing strategies, the synergy might bring in some cost control and expertise of the Fenland Food Plc might help the company to grow faster.
- I) Potential Impact of Foreign Exchange on the Project:
Whenever a company ventures into other country for buying, selling, investing, acquiring etc, there is a Foreign Exchange risk which is attached to it. There is both positive and negative to the forex risk. For example: If the mother company expects to have a cash inflow in foreign currency in future and if the home currency appreciates there is risk of lower cash flow in home currency. On the other hand, if the home currency depreciates there is higher cash flow expected in home currency. Thus the companies are likely to get impacted because of the Foreign Exchange risk.
The potential impacts of Foreign Exchange risk are
- i) The future cash inflows in home currency might be lower if the home currency appreciates.
- ii) The future cash inflows in home currency might be higher if the home currency depreciates.
iii) The future cash outflows from home currency may be higher if the home currency depreciates.
- iv) The future cash outflows from home currency may be lower if the home currency appreciates.
- v) The investments made earlier in foreign country might turn to be lower when bringing back in to the home country if the currency appreciates. On the contrary, the investments made earlier in foreign country might turn to be higher when bringing back in to the home country if the currency depreciates.
- vi) The future dividends from the foreign soil is thus likely to get affected due to these currency fluctuations.
There are different methods available to protect the company’s cash flow. Some of them are Currency Options, Hedging, Forward contract, Swapping etc. However, there is an extra cost tied to it.
- J) Conclusion:
The project has helped me in understanding different capital budgeting techniques and the application side of the same. This also has helped me understanding as how to project the profit and loss statement & cash flow for a company.
I also have learned what are all the forex risks involved in overseas acquisition. This also has helped me to find ways to mitigate the forex risk.
- K) Recommendation:
The project is feasible for an investment of € 1,443,814 (i.e.: £1,244,667 @ forex rate of 1£ = 1.16€). 50% of this investment can be infused as equity from the mother company (i.e:£ 622,334) and the balance can be infused from the ECB or as a loan taken from the European bank and backed pound by assets in Ireland.
References:
1)Sustainable Development and Business Models of Entrepreneurs in the Organic Food Industry – Albert Jolink, Eva Niestan – https://doi.org/10.1002/bse.1826
2) Internalization Theory and Corporate International Finance – Alan M. Rugman – https://doi.org/10.2307/41164920
3) Richard Pike and Bill Neale, 2006, Corporate Finance and Investments – Decision & Strategies
4) The World of Organic Agriculture – Statistics and Emerging Trends 2008
5) The Six Types of Successful Acquisitions – By Marc Goedhart, Tim Koller, and David Wessels – McKinsey & Company
6) Andre Farber, Roland L.Gillet, ArianeSzafarz, 2006, A General Formula for the Wacc
7) Ignacio Vélez-Pareja; Joseph Tham, 2009, Market value calculation and the solution of circularity between value and the weighted average cost of capital WACC
8) James A. Miles and John R. Ezzell, 1990, The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification, https://doi.org/10.2307/2330405
