City Energy Financial Analysis - Assignment Example

City Energy Financial Analysis Name: University: Course: Tutor: Date: Introduction City energy is considering outsourcing one of its internal functions. Before deciding on whether to outsource or retain the function in-house several financial and non-financial analysis should be carried out. It is important that the decision arrived at, benefits the various stakeholders of City Energy. It is however not feasible to satisfy numerous conflicting stakeholders’ interests but a reasonable balance should be sought. This balance means that the course of actions is financially beneficial, ethical and acceptable to majority of stakeholders (Boatright, 2010). Net Present Value Analysis Investment appraisal is an important step in making financial decision. The net present value (NPV) model is one of the tools used in investment appraisal and can simply be defined as the sum of the discounted cashflows less the initial investment (Chambers, 1967). This is a superior tool that takes into account the concept of time value of money. This concept appreciates the fact that a dollar today is worth more than a dollar tomorrow. This is incorporated in the NPV calculation by the discounting process; it involves the use of an appropriate discounting rate to discount cashflows to present value (Chambers, 1967). These discount rates can be calculated by adding one to the discount rate and raising it to the power of (negative) time in years. In the case of city energy, at a discount rate of 8% year three’s discount factor will be 0.7938 (1.08^-3). Discounting factors are also available directly from mathematical tables. It is important that only relevant costs are included in the NPV calculations. Irrelevant cost include; sunk costs, non-monetary costs, costs not wholly and exclusively incurred as a result of the investment decision, committed costs and unavoidable costs (Jean, 1973). These costs should be ignored and excluded from the NPV calculation. In the case of City Energy, the expenditure of $750,000 that has already been spent on an assessment exercise to identify key issues, is a sunk cost and should be ignored. The NPV model only takes into account future cash flows and hence costs that have already been incurred must be ignored. NPV: Option to Retain Function In-House The relocation cost incurred in year zero is relevant as it is incurred as a result of the financial decision. If City Energy decided to outsource this function the $100,000 incurred for relocation can be avoided. This cash flow is assumed to occur at year zero and hence it is not discounted. The rental costs are relevant costs and are included in the NPV calculation. These costs are constant and the cash flows are assumed to occur at year end. Additional and replacement costs are relevant costs and form part of the NPV calculation. $1.75 million is expected to be incurred at year zero while $0.5 million is expected to be incurred at year 2 (after 3 years). Cash inflows of $100,000 are expected to be realized as the salvage value, this is the only cash inflow in the case of City Energy. This cash inflow is assumed to be occurring at the end of the ten year period. Staffing costs and other operating costs are relevant costs. They are both expected to increase over the period at the rate of 3% and 5% respectively. The cash out flows at year one relating to staffing costs are $2 million while outflows relating to other operating costs are expected to be $0.5 million at year one. These cash flows should be inflated from year two going forward. Both depreciation and interest costs should be ignored and excluded in the investment appraisal. Depreciation is a non-cash item and therefore irrelevant. Depreciation is an accounting tool that tries to systematically match the cost of an asset to the cash flows it helps generate (Rees, 1995). Only tax allowable depreciation is relevant as it gives rise to relevant cash flows inform of tax allowances. Finance costs are taken care of by the discounting process. The discounting factor should represent the firm’s cost of finance; interest costs affects the firms cost of capital. Including the finance costs in the NPV calculations would amount to double counting and this would be misleading (Cooper, 1985) Increase in working capital requirements is a cash outflow. Working capital is required to run the day-to-day operations of a company and any movements in the level of working capital represent either cash inflows or outflows. In the case of City Energy the increase of working capital requirement by $250,000 is a cash outflow and it is assumed to be occurring at year zero. The net present value of the option to retain the electronic meter testing function in-house is estimated to cost $22,252,650.48. This has been calculated with the help of spreadsheet software (Microsoft excel). This analysis assumed nil taxation; this is probably unrealistic in the real world. The NPV suggests that the company will incur $ 22,252,650.48 to run the function for 10 years in present value terms or at today’s prices. This value should be compared with the NPV of the option or outsourcing help in making the decision on whether to outsource or not. NPV of the Option to Outsource The company has an option to outsource the electronic meter testing function. This would result to an immediate cash outflow of $5 million in redundancy costs. This is a relevant cost as it is incurred exclusively as a result of the decision to outsource. This expenditure is incurred upfront leading to a cash outflow at year zero. This cost is not discounted as it is already in present value terms (discounting factor equal to 1). Annual costs are expected to be $2.5 million in year one increasing by 4% per annum over the period. The annual increment is assumed to start in year two going forward. Both these cash flows are discounted at the required rate of return of 8% over the period of 10 years. This gives a net present value of negative $24,647,530.40. This is the cost the company would incur in outsourcing the function for a period of 10 years. However cash inflows that may be realized after freeing up current working capital and other resources has been ignored. Decision and Other Considerations Based on the above figures it is cheaper to retain the function in-house on financial grounds. However other non-financial matters need to be considered as well. For instance, retaining non-core functions in-house ties up valuable management’s time. The time freed through outsourcing may justify the higher cost incurred. However, if the management believes that a function is a source of competitive advantage it should be retained in-house. The needs of other stakeholders should also be taken into consideration. The NPV model measures the value by which the shareholders wealth increases by in real terms following an investment decision. This model is focused on the welfare of the investors/shareholders but ignores wider ethical issues. Before deciding on whether to outsource the electronic meter testing function the management should consider the effect on staff morale and their safety. It is also worthwhile to note that the NPV model is not perfect. The model assumes that the risk profile is unchanged by the investment decision and that the cost of capital remains the same over the period. The model also ignores the time taken to recoup the initial investments and disregards the payback period. If city energy is cash stripped, it should opt for a decision that does not require a lot of cash outflow in early years. Long term corporate objectives should also be considered. It may be unwise to outsource functions that are core to a company’s long-term success. If an organization has a vision of being a market leader in a certain field, outsourcing operations in that field should be avoided. The strategic significance of the electronic meter testing function should be reviewed before deciding on whether to outsource or not. Comments on the Required Rate of Return The required rate of return should be the rate that compensates an investor for risks that result from an investment. There are two types of risks; systematic and unsystematic risk. Systematic/market risk is risk that cannot be diversified away and an investor should be fully compensated for this risk. Unsystematic risk is diversifiable and investors should not expect a return to cover this risk. This risk can be eliminated by holding a well balanced portfolio (Chartered Institute of Management Accountants, 2011). The capital asset pricing model uses this view to calculate the required rate of return. A company is usually financed using several debt and equity instruments. These have different risks and different required rates of return. A weighted average cost of capital is calculated taking into consideration the proportion of the source of capital to the total capital. This weighting is important because some sources of capital are cheaper than other; it is also possible that raising a certain source of capital may upset the business and/or the financial risk of a company (Crane, 1983). If city energy was still a government business enterprise the risk profile would be different. This would impact on the company’s required rate of return in several ways. There would be no private equity capital which is a risky and expensive source of finance, the government could borrow at risk free rate and business risks such as impact of legislation would be lower. This would lower the overall required rate of return. References Top of Form Bottom of Form Boatright, R. 2010. Finance ethics critical issues in theory and practice. New Jersey: Wiley. Chambers, J. 1967. Financial management. Sydney: Law Book Co. Chartered Institute Of Management Accountants. 2011. Financial management. London: BPP Learning Media. Cooper, S. 1985. Financial management. Plymouth: Macdonald & Evans. Crane, B. 1983. Financial management. New York: Wiley. Jean, H. 1973. Finance.New York: Dryden Press. Rees, B. 1995. Financial analysis. London: Prentice Hall. Read More