Terms of reference
The main aim of this report is to analyze and determine whether Wonderland Confectionaries Inc. should invest in the theme park. Wonderland recently spent ÂŁ400,000 to conduct market research into the theme park in order to determine its viability as an investment. The company considered all of the cash outflows and cash inflows into the investment.
Since Wonderland Confectionaries Inc. has no experience of theme park management, it is considering one of the theme parks around for clarity on the same. Wonderland’s closest theme park competitor is Alice Limited, which has already successfully established itself in the business. The research team managed to get Alice Limited’s financial structure and current risk. The details of the financial status were summarized on a balance sheet.
Summary
The Wonderland Confectionaries Inc., which owns a chain of restaurants, wants to invest in a business it has never tried before, the theme park. This report aims at determining whether it should undertake the investment or not. This would be done using the Net Present Value which is the major method employed in the analysis of Discounted cash flow (DCF).
In the results, the Net Present Value is a negative value, meaning that the theme park project is not worth investing in because it would subtract value from the company instead of adding value, which is the major objective in investing (Wideman, 2001). I would recommend that Wonderland Company should not invest in that particular project since it is not a viable investment.
Introduction
Many companies still rely on basic cash flow methods in order to make decisions on how to use their capital in the future for investments. These methods may not be enough to get a proper evaluation of the successes or failures the company may encounter when making investments in the capital. These methods also may not be able to show the real value of future investment for the company. The real value of an investment is the value that it would bring in the future after its implementation. It includes returns of capital and the payments to interest and various other repayments it would make to the debts and costs incurred during its implementation.
A better method to employ in the evaluation of the possibility for a company to make future investments is the use of the Discounted Cashflow method. The Discounted Cash Flow (DCF) method employs such tools as the Net Present Value (NPV) to calculate the real value of an investment. The Net Present Value is the sum of cash flows, both incoming and outgoing and includes the initial capital. NPV is an important tool when it comes to decision-making in the business world since it indicates how much a company will gain from investing in a certain project. When NPV is a positive value then it indicates that the project would be viable and is worth investing in.
Firms need to identify factors and possible outcomes that an investment might encounter. What is even more important is the knowledge of their impacts on future investment. There are various upsides and downsides that investments go through therefore companies need to use analysis techniques to determine what might go wrong after an investment. These analyses also help to determine the possibility for the success of the particular investment.
It is, however, unfortunate that some factors cannot be controlled or altered by the company in the event of its occurrence. Such factors include competition and variability in the macroeconomic situation. This leaves the company no choice but to watch their investment is affected by the unpredictable events in the corporate world. Despite DCF being considered an effective methodology in assessing the viability of the investment, it has its limitations. It fails to account for the extra value that the company is likely to be liable to in the course of its operation when it reacts to a situation.
Wonderland Confectionaries Inc. seeks to make an investment of its capital to construct a theme park that would have a mixture of family activities and thrills in order to exploit profit possibilities. Investments in research, such as the one conducted by Wonderland, is important as it may lead to patents that may give way for the investments.
Net Present Value
Net Present Value is calculated by finding the sum of all the present values of a particular time interval. The present value is the discounted value of either the cash inflow or outflow. The present values are discounted using the weighted average cost of capital and this rate is 9% in the case of Wonderland. The cash inflows are in form of the admission fees into the theme park and the cash obtained from the customers when purchasing drinks and food.
The cash outflows include the construction costs, the additional working capital, operation costs, labor costs and insurance. The sum of all present values, both outflows and inflows, give the NPV. When the NPV is more than zero, then the project may be viable for investment and accepted since it would add value to the company. When the value of NPV is less than zero, the investment would not add value to the company but on the contrary, subtract its value. In this case, the investment should be rejected. When the value of NPV is equal to zero, the investment would neither add nor subtract the value from the company and investing in it would not add any monetary value to the company either. The choice for investing or not is left to the company since the decision would be based on other factors which include strategic positioning or other factors which are not incorporated in the calculation.
The total cash inflows and outflows of the theme park in the respective years have been estimated and summarized in the tables below.
Table: Total cash outflows in the respective years (ÂŁ millions)
Table: Total cash inflows in the respective years (ÂŁ millions)
The Present Values are estimated using the formula: Rt/ (1 + i) t
Rt is the number of cash inflows minus the cash outflow; i, is the weighted average cost of capital and t is the year of cash flow. The individual Present Values are calculated from the cash flows and are summarized in the table below.
Table: Calculation of Present Values
Since the NPV value is a negative value, it means that the investment would not add value to the company but in the contrary, subtract its value. In this case, the investment should be rejected. If Wonderland Confectionaries Inc. decides to continue with the investment in the theme park, it would not gain monetary value but incur losses.
Financial and non-financial issues
Apart from the costs that Wonderland Confectionaries Inc. is likely to incur from the theme park investment, it is important for the company to understand that there are many other issues likely to come up during the operation of the business. These issues include both financial and non-financial. Some of these issues can be planned for before the investment but some of them cannot be handled until the investment is underway. These issues would greatly affect and influence the sustainability of the project. If these issues are not dealt with appropriately, there is a likelihood for the investment to close down and become a failure.
One of the financial issues that Wonderland should be aware of is the fact that the salaries of its employees will not be constant forever but will at a point need to increase. Every hard-working employee always anticipates a pay rise at a certain point in their career and this prompts the management to go deep in their pockets to ensure that their employees are satisfied with the salaries that the company offers. This is one of the ways to ensure that a company maintains its employees and maintains its status in the market. Raising the salaries of employees also acts as a motivation to the employees making. This, therefore, makes the increase to be more of an investment rather than a cost.
Another thing Wonderland should be aware of is the fact that it would be required to spend some substantial amount of money in motivating its employees in such activities as trips. It has been determined that employees need motivation in order to be effective in their working places. One of the ways in which management is able to make this possible is through sending and financing for trips, either abroad or within the country, for its employees. This would be an added cost for the company but it is equally a valid investment since employee motivation is necessary to get their 100% efficiency.
Another financial issue that is likely to surface during the operation of the theme park is the likelihood of a case of suing the company. This is likely to occur in the event of a dissatisfied customer or employee. An example of a case that may cause the company to be sued in the case of an accident. A theme park is a place filled with equipment that is used by people to have fun. Some of them, however, may turn risky and deadly if not well maintained. Those that are meant to give the thrills, for example, can be the most dangerous since they operate at great speeds or are positioned high above the ground. In case of an accident involving one of these pieces of equipment, it may lead to casualties. In the event of such an accident, the company is invulnerable to suing and this would cost them a fortune if not the whole investment. The Wonderland Company should be aware of this to avoid the heavy costs that would be incurred.
One non-financial issue that the management of Wonderland should be aware of is the reputation of the company. Depending on the successes or failures of the company in the implementation of the new investment, its reputation would vary. The company should ensure that the services and goods that would be rendered to its customers are of good quality and should ensure that the customers are satisfied. Customer satisfaction would ensure that the company would be highly esteemed and represented. This is important since it would determine the sustainability of the company.
Another thing that Wonderland should know is the fact that they are not the only company that has invested in the theme park business and therefore, they should be prepared to face a steep completion. The Alice Limited Company was already running and had established a customer base. For Wonderland to convince the customers to come to their theme park and not Alice Limited, it would require them to think out of the box and come up with initiatives that would give them an added advantage over the other. This would require the company to invest in good staff members that would ensure that the services that the company offers are worth spending on.
Real options in project appraisal
Methodologies may be derived from financial tools such as the Net Present Value (Madhani, 2008). Wonderland Company would have various options to adopt in project appraisal. One of them is abandonment which involves the complete exit from the business. This option is mainly adopted when the business is not proving to be viable. In this case, Wonderland may be required to choose this option since the theme park investment proves to be unprofitable. If the investment were already operational, it would have forced the management to close it down.
Another option that could be chosen by Wonderland is the option to sell the theme park investment. This would require the exiting from the business than selling it to a worthy customer. This option could be adopted either if the company thinks the investment is not returning enough cash inflows or if it is planning to change its course in terms of investments options. If it believes that investing in another venture would be more profitable, then it would sell the investment and use the money as capital for the next investment (Dixit and Robert, 1995).
Flexibility is also a real option in project appraisal for management. This is whereby a company decides whether to have a central plant or have more than one in various locations. Wonderland, for example, can decide to have the theme park and the restaurants at a specific location or locate the theme park at a completely different location. This would depend on a variety of reasons and the most important of them is the availability of customers. The theme park should be cited in an area that would be easily accessed by the people interested in it. Not all people would want to spend time in the park and this might be due to the costs to be incurred during the visits or other personal reasons (Galletti and Wong, 2004).
Another real option is expansion. This option involves the company investing further due to the level of success that it attains. Wonderland Confectionaries Inc. could decide to adopt the expansion option in its project appraisal if it experiences high profits or if the customer turnover is higher than anticipated. If the customers that visit the theme park had exceeded the capacity, then it would consider expanding the facility to accommodate more people or better still, start another theme park to meet the demand.
Conclusion
The NPV is an important tool used in the analysis of a project’s viability and gives a company a result that helps it make decisions concerning investments options. A positive value gives the company a go-ahead in the investment while a negative value is a warning of the failures to be encountered (Henderson and Mohsenzadeh, 1991). From the results of the Net Present Value obtained, it is correct to say that the investment is not viable for investment since it would subtract value from Wonderland Confectionaries Inc.
References
Galletti, A. and Carsten, W. (2004) The value of managerial flexibility in project appraisal. America: AARHUS
Dixit, A. and Robert, P. (1995) The options Approach to Capital Investment. New Jersey: Princeton University Press
Madhani, P. (2008) Project Appraisal under Uncertainty: An Option Based Approach. Hyderabad: Icfai University Press
Wideman, M. (2001) Project Management appraisal testing the effectiveness of your project’s management. Vancouver: AEW Services
Henderson, J. and Mohsenzadeh, H. (1991) Strategic Management of Information Technology Investment: An Options Perspective. New York: New York University Press