Superior Living Final CEO, CFO, Superior Living

Superior Living Final

CEO, CFO, Superior Living

New Production Facility Proposal and Initial Public Offering (IPO)

This report will address a few of the different strategic issues that the company faces going forward. We know that the company is proposing to build a new production facility, and there are a lot of concerns internally about that proposal. This proposal must be considered from a financial and strategic perspective. From a financial perspective, there are a number of metrics that can be used to help evaluate this project. A common metric is payback period, and I know that some on the Board want to see the payback period for this project. However, if we are taking the firm public, our investors will want to see that we are undertaking the strategies that will increase firm value. Thus, we have to base our decisions on the metrics that actually measure the impact that the project has on firm value. Payback period, because it ignores all cash flows after the payback point, does not measure the impact of the decision on firm value. Therefore we will from this point forward not be using payback period in our capital budgeting decisions.

The measures that we will use in our capital budgeting decisions are IRR, MIRR and NPV. These measures take into account all of the project's cash flows, and weigh them against the time value of money. As you know, because of interest and inflation, the value of a dollar in the future is different from the value of a dollar today. As such, we will use in our capital budgeting decisions only measures that take into account the time value of money. Internal rate of return (IRR), modified internal rate of return (MIRR) and net present value (NPV) are the metrics that comprise a discounted cash flow analysis of the project. The IRR is the rate of return that the project will earn given the discounted value of its future cash flows. The MIRR is a similar concept, but includes the idea that free cash flow from the project will be reinvested back into the business, something that is a reasonable assessment of the situation. The net present value is the value of the project in today's dollars, having discounted the future cash flows back at the company's discount (hurdle) rate.

The discount rate, which is sometimes known as the hurdle rate, is usually determined by the firm's cost of capital. The company raises capital through both debt and equity, but the cost of each of these different. Therefore, the company takes a weighted average of the cost of debt and the cost of equity in order to determine its cost of capital. Any project that the firm undertakes will need to earn more than the cost of capital. A project that does this adds value to the firm, something that shareholders look for. A positive NPV is indicative of a project that earns more on the firm's capital than the cost of that capital to the firm. Another indicator is the IRR. In this case, with an IRR of 15%, the project has a positive NPV. The project would break even on a discounted cash flow basis at the point where the IRR of the project equals its discount rate. The company's cost of capital is currently 12%, so again because the IRR is 15%, the project will add value to the company in the long-run.

For the proposed new plant, the IRR of the project is 15% and the MIRR is 18%. The NPV of the project is $41.19. What these figures mean is that the project should be undertaken. Note that these figures are produced according to accepted criteria for capital budgeting decisions, which meant that we in the finance department had to clean up some of the errors and assumptions that were included in the original figures that were circulating with respect to this project. The figures I have just presented are an accurate reflection of the value that the new production facility adds to the company.

From a financial perspective, therefore, the company should pursue the new production facility. The metrics show us that the project adds value to the firm. By adding value to the firm in advance of a potential IPO, we will also increase the amount of capital that we will be able to rise. From the perspective of a potential IPO investor, the best thing the company can do is demonstrate that it is willing and able to engage in rapid but intelligent growth.

The IPO is the other major issue that the Finance Department has been charged with evaluating. It has been asked whether the IPO should be factored into the project, and it should not be. The reason is because the cost of capital has already been calculated for the project, so even if the company adds equity in the IPO, the project should be considered on the basis of a theoretical capital structure. Besides, the form of financing for a given project is irrelevant; only the firm's weighted average cost of capital is relevant.

So for example, we have a "debt or no-debt" decision to make. This decision is independent of the decision to pursue the project. However, since we have decided to pursue the project, we do need to determine which option is better for the company. The project's initial costs are relatively high. We have $7.8 million in cash, but for the financial health of the firm we would not want to run this down. New equipment has a specific service life, and the financing mechanism should reflect that. Given that we are going to the equity markets, we should seek to maintain the current capital structure by using debt for this project. Our current debt load is low, with total debt being 28.3% of the balance sheet, and long-term debt being just 1.8%. Thus, even though taking on more debt adds risk to the company, Superior Living has a very healthy balance sheet and can easily afford to add the risk, especially knowing than an IPO can restore our capital structure. We can afford to take out debt; more debt will improve the returns to our equity investors and by taking on debt this allows us to start the project now instead of waiting for the IPO.