NPV Analysis of a UK Rail Franchise Capital Decision

Introduction and Decision Overview

South Coast Railway is evaluating a proposal for a five-year franchise from the UK government. This proposal would involve operating a high-speed commuter rail service from 2018 to 2022. The following report examines the financials relating to this decision and the decision-making heuristic used to evaluate it.

The decision at hand is essentially a capital budgeting decision. There are several different ways to evaluate such a decision. The most common is the net present value (NPV) technique. This method relies on discounted future cash flows. The principle behind discounted cash flows is that money earned today can be reinvested, and because of that, a pound earned in the future is inherently worth less than a pound earned today. The value of future money decreases over time. The NPV method discounts those future cash flows back to present value and compares them with the initial cash outlay (Investopedia, 2016). The basic decision-making heuristic for NPV is that a project with an NPV above zero should be undertaken, as such a project increases the value of the company. It is assumed that the nature of the project in operational terms is secondary — a business exists to earn positive returns for shareholders.

Capital Budgeting Methods: NPV, IRR, and Payback Period

A similar method is internal rate of return (IRR), which also compares discounted future cash flows to the present-day outlay. The mathematics behind IRR are the same as for NPV, but the value is expressed as a rate of return. Any return above zero reflects a project that has a positive value. The reason a company should generally prefer NPV over IRR is that organisations have fixed amounts of capital available to invest and must sometimes choose between competing projects. In such cases, the option that adds the most absolute value to shareholders — not merely the highest percentage rate of return — is preferred. A high rate of return on a small investment is worth less in actual wealth terms than a lower rate of return on a larger total investment. This is why NPV is superior to IRR when the firm must choose between two positive but mutually exclusive options.

Payback period is another common method for evaluating capital budgeting projects. This approach does not account for the discounted value of future cash flows; rather, it assumes that shareholders want to recover their investment as quickly as possible, and that managers prefer early break-even as a form of risk management. The reason payback period is inferior to net present value is that it ignores all cash flows occurring after the payback point. A project whose payoff is weighted towards later years may ultimately add more value to the organisation, yet it would not be selected in a mutually exclusive comparison under the payback method. The methodology best suited for enhancing shareholder wealth remains net present value, whatever other practical benefits the alternative methods may offer (Gallo, 2014).

Several rules must be observed when making a net present value calculation. First, only the cash flows that are incremental to the decision at hand should be evaluated; cash flows relating to other decisions are excluded. Sunk costs — monies already spent and irrecoverable — are also excluded. For example, South Coast has invested £450,000 in a feasibility study. That amount does not factor into this analysis, as it is money already spent that cannot be recovered and therefore does not pertain to the current decision.

Another key input is the discount rate, which is typically the firm's cost of capital. The cost of capital is normally the weighted average of its cost of debt and its cost of equity — commonly referred to as the weighted average cost of capital (WACC). This is the rate the firm theoretically earns on its asset base, so any new project should earn more than this rate. A wildcard in this example is the impact of foreign exchange, since South Coast will be working with a German supply chain partner, creating exposure to currency risk. This is particularly relevant given the uncertainty surrounding the Brexit vote (Chan, 2016).

The market value of the firm's equity is calculated as follows:

3,200,000 × £5.56 = £17,792,000

The market value of the firm's debt is:

£7,000,000 × 1.06 = £7,420,000

The total size of the firm is therefore £25,212,000, of which equity represents 70.5% and debt represents 29.5%.

Calculating the Weighted Average Cost of Capital (WACC)

The cost of equity is typically higher than the cost of debt because equity is subordinated to debt. Debtholders are paid before net income is distributed, whereas equity holders are only paid after. As such, equity carries higher risk, and the expected return on equity must be correspondingly higher.

The cost of debt is 5%, though the effective yield is 4.717%, as derived using a bond yield calculator (Moneychimp, 2016). This figure reflects the fact that the bond is currently priced at a slight premium. Because the bond will mature at face value, its price will decline over time, resulting in an effective yield slightly below the coupon rate.

The cost of debt must also account for the tax deductibility of interest payments. Debt is deducted from income prior to calculating taxable net income, which reduces the effective cost of debt. This tax shield is incorporated as follows:

4.717% × (1 − 0.30) = 4.717% × 0.70 = 3.3019%

This figure of 3.3019% is the after-tax cost of debt used in the WACC formula.

To determine the cost of equity, the Capital Asset Pricing Model (CAPM) is used. This model holds that the expected return on a security is a function of the risk-free rate, the market risk premium, and the asset's systematic risk (beta). The current risk-free rate in the UK is 0.22% (Bloomberg, 2016). South Coast's beta is 1.07, and the historical market risk premium is 7%. The CAPM-derived cost of equity is therefore:

0.22 + 1.07 × 7 = 7.71%

The weighted average cost of capital is therefore:

(0.295 × 3.3019%) + (0.705 × 7.71%) = 6.4127%

Conclusion

South Coast should not adopt this franchise. The best decision-making method for this type of project is net present value (NPV), which focuses on discounted cash flows incremental to the project. The analysis found that the project barely breaks even on an NPV basis. As such, it is not recommended that South Coast undertake this project, as it will not add value to the firm or to its shareholders. This finding is based on the calculation of the weighted average cost of capital, which serves as the discount rate, and the identification of all incremental cash flows specifically pertaining to this project.