Archer's Organic Foods Plc.
Introduction
Decision making process is a knowledge-intensive process which can be considered as an important part of having successful strategic management. It is a fact that companies must make decisions in its everyday operations; hence, in order to make sure that the decisions are made successfully, decision making process is important. In addition, it is considered as a central factor for having successful strategic management because it provides the company the assurance that each and every operations and activities made by the organizations adheres to a common goal which is set in the decision making plans.
In Archer's Organic Foods plc, progress that the company is making is recorded as basis for, among a host of other essential things, decision-making and as a benchmark for measuring the firm’s performance for the period under scrutiny. According to (1996), a financial situation analysis is one such yardstick that documents current and future financial situation in an attempt to determine a financial strategy to help achieve organizational goals. With regards to this, this paper will cover the issues concerning behavioral corporate finance. The goal is to evaluate the acquisition plan of Archer's Organic Foods plc.
Discussions
With respect to the current status of Archer's Organic Foods, which is interested in extending the range of its produce and particularly in the possibility of diversifying in to additional geographical areas, then they are aware of the existence of a number of competitors, the directors feel that there is a ready market in the UK for their established name and product.
Basically, there are two options available to Archer’s. The first (Option 1) is the freehold acquisition of a farm at a cost of £1,500,000. The second (Option 2) is the lease of another farm at an annual rental of £150,000 payable in advance for 10 years with an initial down payment of £300,000. Archer’s intend their new venture to last for at least 10 years. In addition, in order to assess the worth of the two farms they have paid surveyor’s fees of £7,500.
Aside from these factors, Archer's Organic Foods was identified the their ordinary shares have made some progress during the year. Ordinary share dividends have achieved a growth rate of 8.5% per annum over the past four years and this rate is expected to be maintained in the future.
The present market price for Archer's Organic Foods shares is:
£1 Ordinary shares £1.65 ex div
Moreover, the beta of Archer's Organic Foods plc is believed to be 1.8, the risk-free rate of return is 5% and the market risk premium is estimated to be 3.89%. That is useful in the computations of CAMP.
From the given details of Archer, it is impossible to compute CAPM. Basically, CAPM should describe the relationship between risk and expected return and that is used in the pricing of risky securities. Therefore, we may say that the CAPM is a relationship explaining how assets should be priced in the capital market. So, the logic of CAPM can be extended to price individual securities and determine the required rate of return from individual securities. Moreover, Capital Asset Pricing Model (CAPM) theory is use to study the way investors could lend and borrow at the risk-free rate of interest, how would the portfolio opportunity set be shaped and how could securities be valued in the market. So, when combining a risk-free security and risky security, a risk-free is one, which has a zero variance or standard deviation. Consequently, the covariance between the risk-free security and the risky security will be zero. The risk-free security will have the same return under all possible economic scenarios (1995).
And from our data, the risk-free benchmark is much higher than Archer’s market benchmark which reflects to the limitation of CAPM. The method of CAPM makes sense if the market benchmark is much higher than risk-free benchmark.
And since CAPM is impossible for our given information, then other financial investment appraisal should be considered. With this respect, the following information provides the financial details of Archer's Organic Foods of the two options using payback, ARR, NPV and IRR.
Investment Appraisals
a. Payback
This type of investment appraisal conforms to the length of time required to recover the cost of an investment. The results of calculations are presented in the next sections.
Option 1
Figure 1. Payback Details
Figure 2. Payback Calculation Results
Option 2
As seen in the calculation, the Simple Payback (Time) which is stated in terms of time periods are much lower in option 2 which indicates that option 2 is the best choice if simple payback calculation was considered. However, this payback method usually requires a threshold number of periods before an investment is acceptable. One of the flaws with the payback method is that it ignores the time value of money.
Apparently, the discounted payback is another payback method that recognizes the time value of money. However this calculation shows us the second major flaw with the payback method - it does not recognize cash returns in excess of the calculated payback period. For example, if the payback is 5 years, the method does not account for cash flows after year 5.
b. ARR
Basically, Accounting Rate of Return or the so-called ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest. With this regard, the calculation for Archer's Organic Foods plc is shown below.
Option 1
Option 2
With respect to these results, ARR is better in Option 1. The company may consider this result as best option however, ARR only consider profit rather than cash flows, and it does not account for the time value of money.
c. Net Present Value (NPV)
NPV usually deals with the difference between the present value of cash inflows and the present value of cash outflows. This is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. From our given data, the following calculations shows the NPV of Archer's Organic Foods plc with respect to the two options in acquisition.
Option 1
Net Present Value: $1,499,132.42
PV of Expected Cash flows: $3,006,632.42
Option 2
Net Present Value: $1,820,236.28
PV of Expected Cash flows: $3,327,736.28
For option 1, with a discount rate of 2.30% and a span of 10 years, the projected cash flows are worth $3,006,632.42 today, which is greater than the initial $1,507,500.00 paid. On the other hand, option 2 had a discount rate of 1.00% and also a span of 10 years, with projected cash flows worth $3,327,736.28 today, which is also greater than the initial $1,507,500.00 paid. Using this method, it seems that the two options are both optimal. However, Option 2 is better since its net present value is much higher compared to NPV of option 1. Basically, the accuracy of these projected figures depends on the skill and experience of the analyst, and likelihood of these cash flows materializing depends on the financial risk associated with the type of project being pursued.
d. IRR
The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. With this regard, the calculation results of IRR for Archer's Organic Foods plc is shown below.
Option 1
IRR% = 15.150
Total Invested (-outflows): -£1,507,500.00
Total Return (+inflows): £3,475,000.00
Net Cash Flow Over 10 Years: £1,967,500.00
Option 2
IRR% = 15.338
Total Invested (-outflows): -£1,507,500.00
Total Return (+inflows): £3,550,000.00
Net Cash Flow Over 10 Years: £2,042,500.00
Basically, IRR conforms to the expected rate of growth of a certain project. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. And from this results, IRR of option 2 is better as compare to option 1 since the Total Return (+inflows and expected Net Cash Flow Over 10 Years is much higher than option 1.
Evaluation of Financial Acquisition Methods
Financial evaluation is very vital to the development of a certain organization since it is the distinction whether the certain organization are growing or not (2004). Basically, it can be evaluated by simply looking at the financial statements of a certain organization. Financial statements are, according to (1994 p. 1), the ‘universally accepted tools for analysis of a business entity’. If properly understood, they let the users know how good a company looks and how well it has been doing. They are, at best, an approximation of economic reality because of the selective reporting of economic events by the accounting system, compounded by alternative accounting methods and estimates ( 2003). The purpose of financial statements is to provide users (business owners, lenders, managers, suppliers, customers, attorneys and litigants and employees and job seekers) with a set of financial data that, in summary form, fairly represents the financial strength and performance of a business ( 1994). They reveal opportunities and provide protection against financial pitfalls. Ideally, financial statements analysis provides information that is useful to present and potential investors and creditors and other users in making rational investment, credit and other similar decisions ( 2003). Further, they are comparative measurements of risk and return to make investment or credit decisions as they provide one basis for projecting future earnings and cash flows.
With this regard, it seems that Archer's Organic Foods plc should carefully evaluate their portfolios. Actually, in some cases, payback period and ARR can be better. It is a quick calculation, and is intuitive and easily understandable. It could also be a good "tiebreaker" between two projects with similar IRR's and NPV's, or between two highly risky projects with hard-to-project cashflows.
But if we reviewed the bases of IRR and NPV, they are actually better in general because they simply take more factors into account, which was already shown previously. Besides, the objective of Archer's Organic Foods plc is to make a profit, then there is no reason to stop the analysis at the point of break-even, in which we can get more complete answer with IRR/NPV. And with regards to the results in both NPV and IRR, Option 2 is the best decision that suits to the acquisition plan of Archer's Organic Foods plc.
Typically, financial measures as well as the relationships utilized in performance measurement are designed to stress outcomes with minimal or no consideration of the decision processes of the business administrator. The traditional or conventional measures of performance are based on periodic profitability indicators without the consideration to particular variables that drive these measures (2002). Performance in the past is mainly based on conventional accounting and measures based on market performance. Specifically, these measures include the evaluation on net income, return on equity/capital employed, earnings per share as well as share-price return. Benchmarking is also considered as a financial indicator ( 2003). Traditionally, benchmarking has been related to cost analysis, wherein the focus is primarily on the activities of the competitors and how much it cost them to perform such activities. These activities include the installation of new machineries, acquisition of the latest materials, hiring of employees and even non-production costs like distribution.
The information derived from accounting has several characteristics that make it a popular indicator of performance and basis for compensation schemes. For example, accounting information undergoes several audits and internal controls, thereby enhancing its reliability. As most contemporary businesses are able to track monthly as well as quarterly accounting information, linking the existing accounting system to compensation and incentive schemes is relatively easy for the management. Moreover, measuring performance based on financial indicators provides a more direct impact in comparison to other performance indicators. This in turn, results to a better and easier evaluation for the senior management ( 2003).
Actually, the financial returns may be an effective tool to measure the abilities of the executives in managing the existing assets of the company. However, this indicator does not precisely show the executive performance in aspects with late returns. In other words, financial indicators are incapable of showing how well a company performs in terms of strategic planning, product development as well as its capabilities for growth and development (2003).
Conclusion
In order for a certain business to sustain their development, they should regularly assess the value of their portfolio. Aside from this and issues concerning acquisition, stakeholders should be given importance by the company. Stakeholders, sometimes also called sponsors, or management, are extremely important to the business. Financial information are important to them because they are the ones that give political as well as resource support for the project. In addition, financial report provides information that indicates the health of the company. For example, what's the cash flow, what's on the balance sheet, debts, assets etc.
Actually, the Option 2 acquisition approach of Archer's Organic Foods plc might have more advantages compared to Option two in terms of their overall performance and strategic position of the company. Based on the given case, one of the advantages of this method of acquisition in Archer's Organic Foods plc is in terms of market growth and profit generated. With the acquired asset, Archer's Organic Foods plc has been able to diversify their products and business portfolio and meet the needs and demands of their target market. In addition, through the acquisition, the company has also been able to see their potentials in different market including the internet market. The management has also been able to grow in terms of investment and grow in terms of market shares. The company has more opportunities to provide the quality food which may lead to further success of the company.
In accordance to this, we may also argue that, financial reports give important information to the stakeholders that need to know about the business they are dealing with. Financial reports are statements that indicate the results of operations of the business, employees are interested in knowing these information so that when they will know the current stance of their company. Financial reports are statements showing the status of the business which means if it has much debts than what they own. Consumers as well would like to know which company will last for long time and will want to patronize base on their status in the economy.
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