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International Financial Management for

Business AFE_7_IFM

Shashi Kumar
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Introduction
British firm Aromatic Chemicals plc is contemplating opening a new operation in Liverpool.
A thorough feasibility analysis is necessary because of the project's potential effect on the
company's bottom line. Cash flows, the cost of capital, a sensitivity analysis, and the effect on
profits per share are all considered in this study (Titman and Wessels, 1988). Cannibalization,
corporate overhead allocation, and inflation price adjustments are other major factors to think
about. Aromatic Chemicals plc commissioned this research to offer a thorough evaluation of
the Liverpool project and its possible effects on the company.

1. Aromatic Chemicals evaluate its capital-expenditure

proposals
The chemical manufacturing company Aromatic Chemicals employs a sophisticated
approach to evaluate potential investments. Earnings per share (EPS), payback time, net
present value, and internal rate of return (IRR) are only few of the financial metrics
considered by this approach. The company use this tactic to ensure its proposed capital
expenditures are both financially viable and likely to produce the desired long-term value.
The statistic used to assess how the planned project would affect the company's bottom line is
EPS, or earnings per share (Harris and Raviv, 1991). The time it takes for a project to
generate cash flows equivalent to its initial investment is known as the payback period. A
financial statistic known as net present value (NPV) calculates a project's value in the present
while accounting for time value of money. IRR, or internal rate of return, is a statistic that
evaluates the rate of return generated by a project over the course of its existence.

The use of this convoluted plan is acceptable due to the fact that it gives a full review of the
planned projects involving capital expenditures. The plan takes into account a variety of
financial variables, such as profitability over the short and long term, cash flow creation, and
the worth of money in relation to the passage of time. This enables Aromatic Chemicals to
identify the initiatives that are likely to generate the most long-term value for the firm as well
as the ones that will generate the most profit (Goyal and Santa-Clara, 2003). However, this
system may be reduced to the point where it is more user-friendly and requires less effort on
the user's part. One idea that might be considered is to adopt a weighted average method,
which involves assigning varying weights to each financial statistic according to the
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significance that it holds for the organisation (Akerlof, 1970). For instance, earnings per share
(EPS) and payback period may be given less weight since their primary focus is on short-
term profitability. In contrast, net present value (NPV) and internal rate of return (IRR) may
be given more weight because they assess long-term profitability and the worth of the project
over time.

2. Evaluate the Transport Division’s suggestion

There is a possibility that the proposal made by the Transport Division to increase the size of
its truck fleet by 20% has some value; nonetheless, it has to be properly assessed before being
put into action. On the bright side, there is the possibility that a rise in the number of trucks
may lead to an increase in the number of deliveries, which in turn may result in an increase in
income (Myers, 1984). This expenditure would need to go towards the purchase of more
vehicles, increased maintenance expenses, and maybe even extra workers. If the additional
money earned from the increased delivery is not enough to cover these expenditures, this
might have a detrimental impact on the company's finances. Earnings per share, payback
time, net present value, and internal rate of return are only a few of the financial metrics used
in this approach. Using this strategy, the organisation makes sure that the proposed capital
investments are both financially feasible and likely to result in the intended long-term value.
The statistic used to assess how the planned project would affect the company's bottom line is
EPS or earnings per share. The time it takes for a project to generate cash flows equivalent to
its initial investment is known as the payback period. A financial statistic known as net
present value (NPV) calculates a project's value in the present while accounting for the time
value of money. IRR, or internal rate of return, is a statistic that evaluates the rate of return
generated by a project over the course of its existence. The company could also want to take a
look at alternate solutions to satisfy the growing demand, such as creating strategic
partnerships with related companies or spending money on cutting-edge delivery technology.
Either strategy may be used by the company (Campbell et al., 2001). In the long picture, it
may make sense for the Transport Division to expand the size of its fleet of trucks, but such
choices should be preceded by a comprehensive analysis of the associated costs and benefits.
Chemical producer Aromatic Chemicals has a strict methodology to evaluate potential
investments.
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3. Evaluate the director of sales’ suggestion

It seems like the idea put out by the head of sales to provide the company's current clientele
with access to a new fragrance line is one that may be successful. It is possible for Aromatic
Chemicals to expand sales without incurring the large marketing expenditures involved with
gaining new consumers if the firm targets existing customers who are already familiar with
the company's goods and targets those customers specifically. In addition to this, the proposal
made by the sales director is in keeping with the company's objective of growing its
profitability by extending the product lines it offers. In addition to helping the business stand
out from its rivals, the introduction of a new fragrance line may also make it easier for the
firm to take a bigger portion of the market. Nevertheless, it is necessary to take into account
the potential dangers and expenses that are involved with this idea. The creation of a new
scent collection calls for a sizeable financial commitment in areas such as research and
development, the acquisition of raw ingredients, production, and marketing. The business
would have to take precautions to ensure that the potential advantages of the new scent line
are not less than the expenditures associated with creating and introducing it.

4. The assistant plant manager offer

Because the assistant plant manager was aware of the possible benefits that may be obtained
by enhancing the production process, he proposed the adjustment that he thought would be
most beneficial. He was of the opinion that if certain adjustments were made to the
procedure, the manufacturing facility would be able to enhance its efficiency and cut down
on its waste, which would ultimately result in lower production costs and higher product
quality. The recommendation made by the plant's assistant manager has value since it tackles
a significant problem that must be solved at the plant: the requirement to enhance
productivity while simultaneously cutting down on waste. If the adjustment that was
recommended was implemented at the company, there was a possibility that considerable
sums of money may be saved on the expenses of raw materials and manufacturing. In
addition, the adjustment may result in an improvement in product quality, which may lead to
increased levels of satisfaction and loyalty among customers. However, prior to putting the
suggested change into action, it would be important to determine whether or not the proposed
alteration could be implemented successfully. The manufacturing facility would need to think
about things like the price of the new machinery, the amount of time necessary for its
installation, and the possible effect it may have on the operations that are already in place. A
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comprehensive risk assessment would also have to be carried out at the factory in order to
identify possible dangers and devise solutions to eliminate or reduce them.

The analyst who works for the Treasury Staff pointed out that the existing financial
predictions of the corporation do not take into consideration the likelihood of inflation. This
indicates that the analyst feels that inflation may have an influence on the company's financial
performance and that this possibility should be accounted for in their estimates. The overall
rise in prices and the decline in the buying power of money are what economists refer to as
inflation. If inflation were to take place, it would likely result in a rise in the price of the
firm's inputs, such as its raw materials, which would lead to a decline in the profitability of
the company. If customers' buying power is lowered as a result of inflation, then there will be
less demand for the company's products, which will in turn lead to the company's capacity to
create revenue being negatively impacted (Grossman and Stiglitz, 1980). The analyst's
observation that inflation is a real concern is, in my view, something that the corporation
needs to take into consideration, as it is presented. The occurrence of inflation is a
phenomenon in economics that may have a substantial effect on companies and need to be
accounted for when making financial plans. Even if it may be impossible to correctly foresee
the effects of inflation, it is essential to at least take the possibility into consideration and
work on developing backup plans in case the worst should happen. The corporation has a
number of different options available to it to lessen the effects of inflation (Jensen and
Meckling, 1976). They may, for instance, engage in long-term contracts with their suppliers
to lock in prices, they can invest in new technologies that enhance efficiency and lower costs
and can modify their pricing strategy to reflect the higher costs of inputs.

When considering new investments, chemical producer Aromatic Chemicals takes a

methodical approach. EPS, payback time, net present value, and internal rate of return (IRR)
are only few of the financial metrics that are factored into this method's final verdict. To
guarantee that projected capital expenditures are sustainable and will provide the intended
long-term value, the corporation employs this strategy (Ross et al., 2018). The planned
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project's effect on the company's bottom line is measured in terms of earnings per share
(EPS). To sum up, the internal rate of return (IRR) is a metric that assesses the rate of return
produced by a project during its lifetime (Modigliani and Miller, 1958). On the other hand,
equity cash flows are the cash that is produced by the firm and is available to be given to its
stockholders. These cash flows are referred to as "equity cash flows." This covers both
dividends and buybacks of existing shares. Investors who are primarily interested in earning a
return on their investment in the form of dividends or capital gains should pay attention to the
cash flows generated by equity investment (Fama and Jensen, 1983). It is possible that the
senior analyst of Treasury was pointing out the difference between these two indicators in
order to emphasise how important it is to take into consideration both of them when
determining the financial health of a firm. Free cash flows are crucial for evaluating the total
cash creation of a firm and its ability to fund future expansion, whereas equity cash flows are
significant for evaluating the prospective return on investment for equity investors.

The present value of the cash flows anticipated from the investment is then discounted to
arrive at the company's market value. The following procedures can be used:
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First, you'll need to determine the yearly cash flows, taking into account both the initial
investment and the salvage value after the project's conclusion.

In the first year, we lost $300 million (on investments).

Total Operating Expenses less Revenue in Years 1-15: £299.8 Million

The salvage value after 15 years is nil.

Step 2: Apply the discount rate and the number of years to arrive at the annual discount
factor:

The formula for the discount factor is as follows: Duration in Years

The discount rate for the first year, for instance, can be determined by using the formula:

One Year Discount Factor = 1 / (1 + 12%)1 = 0.893

The discount factors for every given year can be determined in a similar fashion.

Step 3: Multiply each cash flow by the discount factor to get the present value.

Future Cash Flows Discounted at a Present Value

Cash flow in Year 1 can be discounted to its present value using the following formula:

Value of First Year's Cash Flow in Present Terms = £290.8m * 0.893% = £267.6m

Present value calculations for cash flows over multiple years are also possible.

To estimate the investment's fair market value, the fourth step is to compute the total present
value of all cash flows.

What is the Market Value of a Company?

Value in the Market = Sum of Present Values for Years 0 through 15 plus the Value in Year
15.

Value on the Market = -£300m + £267m + £267m + £... + £267m + £0

Value on the Stock Market = $2,265,000,000

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The Yield to Maturity (YTM) and the following formula are used in the case study to
determine the cost of long-term debt.

𝑟𝑑 = 𝑌𝑇𝑀𝑒= (1+YTM/2)^2-1

Using the risk-free rate, the market risk premium, and the company's beta, the CAPM may
determine the cost of equity.

Let's say the market risk premium is 7% and the risk-free rate is 3%.

Cost of equity = risk-free rate + beta * market risk premium is a common calculation used by
investors.

Under the assumption of the paper that the company has a beta of 1.2, the cost of equity
would be 3.0% plus 1.2% times 7.0%, or 11.4%.

We can now determine the price of the stock by:

𝑟𝑒 = 2.5% + 0.96(6.5%) = 11.8%

As a result, the corporation has an equity cost of 11.8%.

Finding the mix of debt and equity funding used by a corporation is a prerequisite to
determining its Weighted Average Cost of Capital (WACC). Based on the data provided, we
have:

1,500,000 Shares of Equity

Debt: £700,000

Equity plus debt equals £2,753,000.

1,500,000 divided by 2,753,000 is a proportion of 0.5456

$700,000 divided by $2,753,000 equals a debt ratio of 0.2544

The cost of equity and the cost of debt must then be determined.

Equity Cost is 11.8 per cent (question 2 CAPM model).

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Interest on Debt (5.5%, determined in Part 2)

At last, the WACC formula can be used:

Value at Risk Premium (WACC) = (1 - Tax Rate) x (Cost of Equity x Proportion of Equity) +
(Cost of Debt x Proportion of Debt)

This formula can be used:

WACC = (E / V) x (D / V) x Rd x (1 - Tc)

Equity Market Value = E.

D = debt's current market value

V=E+D

Cost of equity = Re.

Debt service rate = Rd.

Tc = Tax on Corporations

In order to obtain a WACC of 11.5%, we will assume that the present capital structure, which
includes 6.7% equity and 93.3% debt, will need to have an increase in the equity portion. The
new equity percentage that yields the target WACC can be found via trial and error.

The first step is to use the current capital structure to determine the WACC:

We use the formula: WACC = (0.067 x 0.12) + (0.933 x Rd x (1 - 0.25) = 0.09975 + 0.69975
x Rd

Getting to a WACC of 11.5 percent requires:

0.115 = x (0.12) + (1 - x) (Rd)(0.75)

the new equity proportion is x.

When we plug in x, we receive

x = 0.717
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The resulting ratio of equity to debt in the new capital structure would be 71.7% to 28.3%.

Market value of equity and debt can be determined by using the following formula:

E = 0.717 x $50,000,000 = $35,850,000 D = 0.283 x $50,000,000 = $14,150,000

Assuming a 6% cost of debt:

WACC = (E / V) x (D / V) x Rd x (1 - Tc)

11.5% = (35,850,000 / 50,000,000) x 12% + (14,150,000 / 50,000,000) x 6% x (1 - 0.25)

Getting an answer for Rd yields

Rd = 3.948%

Since the cost of equity is estimated to be 12% and the cost of debt to be 3.948%, the WACC
for the revised capital structure, consisting of 71.7% equity and 28.3% debt, WACC would be
11.5%.

In order for Robert to improve his DCF analysis, he needs to take into consideration the
following factors:

Engineering study: Robert has to revise his DCF analysis in order to incorporate all of the
expenditures that are relativity to the engineering study. He has to make an estimate of the
whole cost of the research and then deduct that amount from the cash flows of the project.

The cannibalisation of the Rotterdam plant: Allocation of expenses associated with

corporate overhead Robert has to give some thought to the possibility of transferring some of
the expenditures associated with corporate overhead to the Liverpool project (Baker and
Wurgler, 2012). Because of this, the profitability of the project will be estimated more
accurately.

Cannibalization of the Rotterdam plant: Robert needs to make some adjustments to his
DCF analysis in order to take into consideration the possibility of cannibalization of the
Rotterdam facility (Stulz, 1990). He has to make an estimate of how much revenue will be
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lost at the Rotterdam facility as a result of the Liverpool project, and then deduct that amount
from the cash flows that will be generated by the Liverpool project.

Use of excess capacity in tank cars: Utilization of Tank Cars' Extra Capacity Robert has to
take into consideration the potential cost reductions that are related to the utilisation of tank
cars' extra capacity. This will result in an increase in the cash flows generated by the project.

Whose interests are at stake: This decision will affect the interests of the shareholders,
management, workers, and consumers of Aromatic Chemicals (Shleifer and Vishny, 1997).
When doing his analysis, Robert needs to take into account how it will affect all of the
relevant parties.

Cannibalization and the interdependence of surplus capacity: Robert has to revise his
approach in order to take into consideration the cannibalization and the interdependence of
excess capacity (Bodie et al., 2014). Cannibalizing sales at the Rotterdam plant may become
an issue in the long run if the Liverpool project continues forward as planned

Alterations to the inventory: Robert has to revise his DCF analysis so that it takes into
account any alterations to the inventory. Due to the likelihood of the Liverpool project
requiring extra stock, there will be a tie-up of funds and an increase in carrying costs.

Adjustment for inflation: Robert has to make sure that his projections of cash flow taking
into account inflation. This will result in a more precise estimation of the amount of money
that can be made from the project over time.
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Calculating the increased cash flows and the resulting NPV and IRR will help us evaluate the
project's value to Aromatic Chemicals with cannibalism.

Cannibalization of the existing plant's cash flows must be estimated first. Based on the data
provided, the addition of the Liverpool unit will result in a 10% drop in sales at the existing
factory, cutting yearly operating cash flows by £1.2 million. The impact will last throughout
the project's 15-year lifespan.

We need the following data in order to determine the project's NPV (Net Present Value) and
IRR (Internal Rate of Return) using cannibalism:

This first expenditure

The money coming in and going out of the project over its duration.

Rate of discount

Let's say the projected lifespan of the project is 5 years and the first investment is $500,000.
The following are the anticipated sources of funds and expenditures:

First-year cash inflow of $50 000

$100,000 in revenue in year two

Inflow of $150,000 in the third year

Inflow of $200,000 in the fourth year

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Inflow of $150,000 in the fifth year

In addition, beginning in the second year, there will be annual cannibalism of $100,000.

A discount rate must be applied to the cash flows before the NPV and IRR can be computed.
A 10% discount rate will be used in this example.

Where CF is the cash flow, r is the discount rate, and n is the number of years into the future,
the present value (PV) of each cash flow may be determined using the following formula: PV
= CF / (1 + r)n.

The present value of each cash flow can be determined by applying this formula:

In the first year, the PV formula is: $500,000 / (1 + 0.1).^1 = $45,454.55

Present Value in Year 2 = ($100,000 - $100,000) / (1 + 0.1)^2 = $0

Value at Risk in Year 3 = ($150,000 - $100,000) / (1 + 0.1)^3 = $34,710.74

The present value in Year 4 is calculated as follows:^4 = $41,322.31

Present Value in Year 5 = ($150,000 - $100,000) / (1 + 0.1)5 = $86,145.62

The net present value (NPV) is calculated by adding up all of the cash flows and subtracting
the initial investment. Here's how to calculate the NPV:

NPV = ($45,454.55 + $0 + $34,710.74 + $41,322.31 + $86,145.62) - $500,000 = -

$302,366.78

When cannibalism is included in, the project's NPV is negative, meaning it is not profitable.
When the NPV is discounted at the internal rate of return, the result is zero. In this scenario,
the internal rate of return is around 1%. When the internal rate of return (IRR) is less than the
target rate of return, the project is unfeasible.
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Without cannibalism

The net present value (NPV) is determined by employing a discount rate to convert future
cash flows to their current value. The percentage used as the discount rate here is 10%.

The cash flows' current value must be determined first.

Present Value of Cash Flow in the First Year = $50,000 / (1+0.1)1 = $45,454.55

$75,000 x (1+0.1) = Present Value of Cash Flow in Year 2.^2 = $61,983.47

100,000 / (1+0.1) = Present Value of Year 3 Cash Flow^3 = $75,135.03

$125,000 / (1+0.1) = Present Value of Cash Flow in Year 4.^4 = $87,029.46

the present value of the cash flow in year 5 is $96,15.75 ($150,000 / (1+0.1)5

Then, we can determine the initial investment's present value by doing the following:

Investment Present Value = -$500,000 / (1+0.1)1 = -$454,545.45

By adding up the current values of the cash flows and subtracting the present value of the
initial investment, we can determine the NPV:

NPV = ($45,454.55 + $61,983.47 + $75,135.03 + $87,029.46 + $97,615.75) - $454,545.45 =

$22,678.77

With no cannibalization, the investment's NPV is $22,678.77.

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Considering the cannibalization effect, we can now determine the Liverpool project's
incremental cash flows.

A method known as sensitivity analysis is utilised to determine the effect that modifications
in a number of factors will have on the final result of a project. In the example of the
Liverpool project, sensitivity analysis may be utilised to investigate the degree to which the
project is sensitive to shifts in the discount rate, gross margin, and manufacturing throughput.
The objective of sensitivity analysis is to discover the elements that have the biggest
influence on the performance of the project and to assist the management team in making
educated decisions about how to manage these risks (Brealey et al., 2017). This may be
accomplished by comparing the results of several scenarios.

EPS measures a company's profitability per share. Net income divided by shares outstanding
determines a company's earnings per share. Earnings per share (EPS) is a key indicator
investors use to assess a company's financial health and development prospects, which can
affect the stock price. An increase in profits per share (EPS) is seen favourably by investors
since it signifies that the business is becoming more profitable. The demand for the
company's stock could rise as a result, leading to a rise in the stock price. Conversely, a
falling EPS may be interpreted as a warning sign that the business is becoming less
profitable. If fewer people want to buy shares of the corporation, the price of those shares
could fall. Investors look at a number of metrics, not simply earnings per share, to determine
a company's financial health and development potential. Other considerations include
revenue expansion, profit margins, and cash flow. No matter how sound a company's
finances are, share prices can still be significantly influenced by external factors such as
market circumstances and investor mood.

Conclusion
There are benefits and threats for Aromatic Chemicals associated with the Liverpool project.
Although the initiative may result in substantial value and growth for the organization, it also
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presents a number of risks that must be carefully examined (Kaplan and Norton, 1992).
Aromatic Chemicals can assess the project's viability and its potential impact on the
company's financial performance and long-term success by conducting thorough analysis and
evaluation of various financial metrics and factors, such as sensitivity analysis, EPS-EBIT
analysis, and capital expenditure evaluation.
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