Expanding Deltak at John Wiley & Sons: Capital Budgeting
The textbook publishing industry is currently undergoing massive transformations. The challenge is for businesses operating in this industry to also transform their business models to align with the emerging trends. John Wiley & Sons Inc is one of the businesses operating in the publishing industry.
The present report had set out to advise the company on an investment project. It involved advising on whether to proceed with the expansion with its already launched online program development business called Deltak. Wiley bought this business back in 2012 and has been a source of revenues ever since. Deltak generated $120 million in revenues in the fiscal year ended 2016.
Both theoretical and practical aspects of investment appraisal were looked at in coming up with the report. The theoretical aspects focused on summarising the conceptual issues underpinning investment appraisal. For instance, section 1 of the report covers the significance of investment appraisal at a theoretical level without necessarily linking it with the proposed project at Wiley. Section 3 also adopts this theoretical leaning in discussing some of the weaknesses of the two investment appraisal techniques employed in section 2.
Sections 2 and 4 were the practical aspects of the report. In section 2, the student had to generate the relevant cash flows for the proposed project. This exercise involved a lot of judgment and the author had to make very complex decisions. For instance, the 2016 annual report of Wiley was studied to see the kind of investments that the company was likely to undertake. Assumptions were also made as is seen throughout the body of the report.
|Year||Net Cash After Tax|
Having come up with the relevant cash flows, the section then proceeded to compute the payback period and as well as the net present value for the project which were 4.4 years and $75.83 million respectively.
With the results from section 2 and a consideration of a number of non financial factors in section 3, section 4 concluded the report by recommending that Wiley undertakes the project. This was in view of the fact that the decision criteria in both the payback period and the NPV were met.
Every business may occasionally have the need to buy some capital asset. Accounting makes a distinction between capital and operational expenditures respectively (Atrill and McLaney, 2009, p.258). The latter refers to expenditures for the day to day running of the business. In contrast, capital expenditures involves the expenses whose benefits to the business or organization are spread over more than one financial period. For instance, investing in a new printing plant is a capital expenditure for a book publishing company.
The motives underlying capital investments vary from firm to firm depending on their respective needs (Gitman and Zutter, 2012, p.390). A company such as John Wiley & Sons (Wiley) may want to expand its operations into another geographical location like making entry into another country. Expansion of operations may also just entail coming up with a new product offering.
Another motivation for capital expenditure may be the need to replace existing assets (Gitman and Zutter, 2012, p.392). Existing assets may be replaced either because they are obsolete in the sense that technological advances have made them inadequate for the business requirements or because they assets have depreciated over a period of time. The need to obtain some other tangible benefit over an extended period of time may yet be another motivation for making capital expenditures. For instance, a publishing company may invest in an information technology (IT) infrastructure to reduce its distribution costs.
A key determinant of how a business operates is the goal or goals chosen by its managers choose (Gitman and Zutter, 2012, p.10). Book publishing companies like Wiley, just like any other profit making enterprise, often has its main goal as the maximisation of value for its owners. All the activities of a business should be geared towards this broader goal of value maximisation for the shareholders.
While easy to state, the broader goal of value maximisation for shareholders is not always easy to measure (Gitman and Zutter, 2012, p.11). Financial theory is, however, in agreement that the behaviour of a firm’s share in terms of price is the easiest why to evaluate whether mangers are succeeding in meeting this broader objective. Managers will, therefore, be succeeding in their role if they are able to increase the share price in the long run. In contrast, managers would be failing if the share price of the given firm was falling in the long run.
Talking about maximising stock price also has a problem to do with how to implement it. Some may argue that the stock price can be increased by increasing profits. For several reasons, financial theory has established that stock price can only be increased by taking actions that maximises net cash flows balanced against the attendant risks involved in generating the given cash flows. For instance, a particular course of action may be very promising in terms of generating cash flows but a firm may well be advised not to proceed with it if it carries excess risk.
Given that firms are often faced with several alternatives but with limited resources to implement those alternatives, investment appraisal helps in choosing the alternative that best maximise value for the firm. An example would be a firm with a fixed amount of money to incur a capital expenditure. Investment appraisal will help that firm to choose the most optimal alternative from among several options.
It should be noted at the outset that the project outlined here is purely fictitious although it bears some connections to what a real capital investment Wiley may undertake. It involves improving the current online program development platform (Destalk) at Wiley to make it available for even a wider market (Wiley, 2016, p.20). This choice of project is consistent with the signicance of revenues from digital business to Wiley (Wiley, 2016, p.17).
Undertaking the project will see Wiley spend $60 million which is half the amount it spent back in 2012 to acquire Deltak (Wiley, 2016, p.20). Additional annual operational costs related to this investment will include $20 million for student recruitment, $10 million for maintenance. Wiley will also have to employ two additional engineers dedicated wholly to this new investment at an annual cost of $1 million each.
In terms of revenues, the improvements will see Deltak annual revenue increase at 30% as opposed to the 18% revenue increase trajectory that this aspect of the business was already enjoying. It should be noted that Deltak generated $96.5 million revenues in fiscal year 2016(Wiley, 2016, p.34). The present calculations will assume this to have been $100 million for ease of calculations.
The $100 million revenues generated from Deltak in 2016 was expected to grow at an annual rate of 18% every other year in the absence of this proposed improvement (Wiley, 2016, p.34).
The tax rate to be used is the U.S Federal Statutory rate as reported in Wiley’s 2016 annual report which was 35 %( Wiley, 2016, p.79).
A look at Yahoo Finance at the time of compiling the report indicated that Wiley had a stock beta of 0(Yahoo Finance 1, 2016, p.1). This means that the expected return, and also the cost of equity, for Wiley stock is the same as the expected return on a risk free asset. The yield on a 10-Year treasury bond at the time of compiling the report was 1.61 %( Yahoo Finance 2, 2016, p.1). The present calculation will assume that the cost of capital for Wiley is 10% given that the 1.61% expected return on its stock is too low.
A further assumption is that all cash flows occur at the end of the year and that the project will have no salvage value at the end of the 6 years.
A key consideration in determining the relevant cash flows is the recognition that only incremental cash flows are important (Gitman and Zutter, 2012, p.430). This means that Wiley should only focus on those cash flows that will change as a result of going ahead with the proposed improvement. For instance, any costs that may have already been spent in carrying out a market research for the project will not be considered in analysing the viability of the project as it would amount to a sunk cost(Gitman and Zutter,2012,p.430).
The figure below shows a summary of the cash inflows and outflows in million ($) before tax.
|Annual operating costs||(32)|
The table below shows the net cash flows for the project in million before factoring taxes ($)
The table below shows the net cash flows for the project in million before factoring taxes ($)
|Initial investment||(60)||Tax benefit(Expense)||Net Cash after tax|
Several methods are available for evaluating a capital project. For instance, the traditional methods such as the payback period are always very intuitive and easy to understand even for those who do not have a deeper knowledge of finance. The other methods that employ discounting techniques tend to me more complicated. Both the payback period (PP) and the Net Present Value (NPV) techniques are employed in the current analysis.
When analysing an investment proposal under the PP, the decision criteria is to accept all projects that meets the firm’s cut-off payback period (Gitman & Zutter, 2012, p.250). This is often the period its takes for the firm to recover its capital investment in any given project. The present analysis assumes that Wiley will undertake any project that pays back before the end of its 5th year.
Appendix number 5 shows that the payback period for this particular project is 4.4 years which is shorter that the 5 year cut-off for Wiley.
This appraisal technique focuses on the value of the investment discounted to the present to take care of the fact that money has time value. The decision criterion when analysing independent projects like the current one is always to accept all projects with positive NPVs. Appendix number 6 shows the computation of the NPV for the project pasted from excel. The Internal Rate of Return (IRR) has also been included to show the range of discount rates through which the project will still remain viable. The table below shows the results of the computations.
|Net Present Value($ Millions)||75.83|
|Internal Rate of Return (%)||27|
The results of our calculations all shows that Wiley should go ahead with the project. The project recovers its initial capital investment in 4.4 years making it meet the assumed decision criterion of accepting all independent projects that pay back within 5 years. The project also has a positive NPV of $75.83 million at the chosen discount rate of 10%. The project will still be viable even if the discount rate was to be higher with the maximum rate being 27% as indicated by the IRR.
The Payback Period (PP) and the NPV techniques used in the previous section to analyse the proposed project are both financial measures. Like all the other common investment appraisal techniques, the two methods focus on the technical aspects of the analysis. Business decisions are, however, made on the basis of both financial/quantitative and non-financial/qualitative factors (Atrill and McLaney, 2009, p.45).This means that a project that is technically sound may as well not be desirable having regard to the underlying qualitative factors. Besides the general qualitative factors that may be ignored in technical analysis, the various investment appraisal techniques also have their unique shortcomings.
Both the payback period and the NPV techniques are susceptible to the problem of cost escalation (Gitman and Zutter, 2012, p.394). This is simply the situation where management commit to spending on a project simply because some money has already been lost in the same project. For example, Wiley may be driven to pursue the present proposal purely because a lot of money had been spent in buying rights from content providers and carrying out market research. Technical financial analysis tools such as the NPV also fail to recognise wider strategic concerns such as the environmental impacts of proceeding with a given project.
The payback method suffers from five (5) main problems. The first of these problems is the absence of an objective criterion for determining the cut-off period (Noreen, Brewer and Garrison, 2011, p.556).This problem is easily discerned from the analysis of the Wiley project in which the cut-off point was just picked using a rule of thumb. The choice of 5 years as the maximum required payback period was not made using any objective rule.
Another weakness of this method is the failure to recognise the timing of the cash flows within the payback period (Noreen, Brewer and Garrison, 2011, p.556).With its assumed cut-off period of 5 years, it would be possible for any project that had all its cash inflows occurring slightly after the fourth year but within the five year period remaining acceptable. It does not matter that one project has its cash flows occurring earlier on in the life of the project while another has its cash flows coming much later.
In addition, the technique ignores all those cash flows occurring after the chosen payback period (Noreen, Brewer and Garrison, 2011, p.557). This is particularly true in the present project where the last two years have the largest net positive cash flows. Exclusive reliance on the payback period may see these two cash flows completely ignored because they are only important to the point where the project is assumed to have recouped its initial investment.
Lastly, neither does the technique provide objective criteria for assessing the profitability of a project nor does it provide a measure for shareholder wealth maximisation (Noreen, Brewer and Garrison, 2011, p.557). These two weaknesses stem largely from the fact that the technique focuses on the speed within which the initial investment can be recouped as opposed to measuring profitability or maximising shareholder wealth.
Regarded as the most theoretically sound investment appraisal criterion, the NPV also has two main weaknesses. The first of these is that it does not provide a gauge for profitability (Gitman and Zutter, 2012, p.392). This is easily explained by the fact that any project with a positive NPV should be accepted without much focus on the extent to which the NPV is above zero. Thus, the fictional Wiley project currently under analysis would still have been acceptable even if the NPV was just $2.
Lastly, most people also see the NPV as a complicated method of analysing projects. This is again self explanatory as the concept of discounting is not obvious to most managers without a financial background.
This report had set out to advise John Wiley & Sons on an investment proposal. The project chosen was an expansion of the company’s online program development (Deltak). Wiley acquired this business in 2012 at a cost of $120 million. Deltak generated $96.5 million in revenues in fiscal year 2016.
In recommending an accept or reject decision, the underlying logic throughout the analysis is to maximise value for the shareholders of Wiley. The present analysis used both the payback period as well as the NPV in appraising the proposed improvement. Both techniques have returned a positive verdict on the project. For instance, the calculated payback period of 4.4 years as against the accepted maximum of 5 years means that Wiley should proceed with the project as evaluated under this technique. Similarly, the NPV of $75.83 million also recommends the adoption of the project.
A question may, however, be asked as to what the recommendation would have been had the two techniques given different verdicts. An answer to such a question would largely depend on which technique has returned a positive verdict. I would still have recommended the adoption of the project so long as the NPV was positive even if the Payback Period was not met. This conclusion is borne from the fact that the NPV is often considered as a superior technique to the payback period.
Factoring non financial factors may, however, change the picture even if the two technical methods of analysis recommended proceeding with the investment. One the most important non financial factors that governed the present analysis is the industry trend in the publishing industry. Companies in the text book publishing industry are increasingly shifting their business models from print to digital. Expanding the digital capacity of Deltak was, therefore, still important to a company like Wiley even if the financial factors would have indicated otherwise. The time horizon of only 6 years may not have been enough to realise the full benefits accruing from such a major business move. In addition, the learning experience from taking the move may far outweigh any immediate quantifiable financial measures.
This is done by subtracting the annual operating costs from the yearly cash inflows.
|Net Cash Flows||Cumulated Net Cash Flow|
|Net cash($M)||$ (60.00)||$ (13.00)||$ (1.46)||$ 15.20||$ 38.83||$ 71.84||$ 117.47|
|NPV at 10%||$ 75.83|
Atrill,P. and McLaney,E.,2009.Managment Accounting for Decision Makers.6th edn.Edinburgh Gate: Pearson Education.
Gitman, L.J. and Zutter, C.J., 2012.Principles of Managerial Finance.13th edn.Boston, MA: Pearson.
John Wiley & Sons Inc.,2006. Annual Report 2016.
Noreen, E.W., Brewer, P.C. and Garrison, R.H., 2011.Managerial Accounting for Managers.2nd edn.New York: McGraw-Hill Irwin.
Yahoo Finance 1.,2016. John Wiley & Sons Inc.(JW-A).[online] Available at: < https://finance.yahoo.com/quote/JW-A/?p=JW-A >[Accessed 28 August 2016].
Yahoo Finance 2., 2016.U.S Treasury Bonds Rates.[Online] Available at: <http://finance.yahoo.com/bonds > [Accessed 28 August 2016].
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