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...

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…