FIN80005 – Corporate Financial Management
Candy Crash Limited – a public listed confectionery company – is deciding whether to engage in a cooperation with Costca – a large supermarket chain – by supply its confectionery in a private label for Costca every year in the next ten years.
In Part 1, to help the company make the wisest decision, the project will be evaluated by calculating its Net Present Value (NPV) and Internal Rate of Return (IRR) under 3 different scenarios: (1) normal revenue, (2) 40%-than-expected revenue (started from Year 6 with 30% probability), and (3) 30%-higher-than-expected revenue (started from Year 6 with 20% probability). After analyzing the NPV and IRR under each of the presented scenario, the expected NPV is computed and resulted in a negative figure. Thus, it is suggested that Candy Crash should not adopt this project to avoid incur losses.
In Part 2, the Semi-strong form efficiency test is carried out to determined whether Candy Crash’s security prices reflect all the publicly available information. It is also concluded that the market is semi-strong form efficient since the share price immediately drops (in day 1 and day 2) after the company announces to implement the project that poses a negative NPV.
Candy Crash Limited is a public listed company specializing in supply confectionery products. To carry out the role of a financial analyst, this report would perform careful examination to arrive at the decision about whether the company should proceed with the deal with Costca.
Particularly, the report performs calculations and show various cash flows given 3 scenarios: (1) normal scenario, when the incremental revenues being (2) 40% lower and (3) 30% higher than expected started from year Six. After that, the expected NPV would be calculated. After carefully examining the return figures, some recommendation about whether or not Candy Crash should adopt the project with Costca will be provided.
The cumulative daily abnormal returns of the company’s share price before, during, and after the announcement of adopt the project will be computed to determine whether the market is semi-strong form efficient.
- PART 1:
- Discounted Rate: Assuming that the project’s risk level is not significant, it is reasonable to use the WACC of 12.6% as the discount rate for future cash flows to derive its NPV. This WACC is computed based on the capital structure formed with 80% debt and 20% equity. Since the company does not intend to adjust its capital structure in the future, the WACC is assumed to remain unchanged over the course of the project.
- Income Tax: Candy Crash Ltd ’s tax rate is assumed at 30%.
- CASH FLOWS IN DIFFERENT SCENARIOS
- Business going as normal (Normal scenario):
Table 1. Cash flows of Normal scenario
|Cost of capital||12.60%|
Table 2. NPV, IRR, Payback period of Normal Scenario
When the business operates as expected, the project generates a positive net present value of $54,155.53. The Internal rate of return generated is also greater than the cost of capital (12.95% > 12.6%). The company is able to recover its initial outlay within 7 years. Although the positive results show that the investment is profitable in this scenario when every works as expected, the returns do not present attractive profitability. Specifically, the internal rate of return only slightly outweighs the cost of capital. Therefore, in the normal scenario, the project, despite its positive returns, does not present itself as a highly attractive investment.
- Incremental revenue being 40% lower than expected started in Year 6 (Scenario 1):
Table 3. Cash flows of Lower-than-expected revenue scenario
|Cost of capital||12.60%|
Table 4. NPV, IRR, Payback period of Lower-than-expected revenue Scenario
When the incremental revenue is 40% lower than expected from Year 6 onwards, the NPV of the project is a negative value of – $681,265. The IRR of the project in this scenario is only at 7.22%, only more than half of the cost of capital. This clearly shows that in the event of lower-than-expected revenue (40% lower), the project would pose a huge financial burden for Candy Crash Ltd as the company would have to bear a huge loss from paying a substantial cost of capital and initial outlay, fixed and variable costs,…, all of which just to generate a return that cannot recover the costs. In this scenario 1, the project must for sure be rejected.
- Incremental revenue being 30% higher than expected started in Year 6 (Scenario 2):
Table 5. Cash flows of Higher-than-expected revenue scenario
|Cost of capital||12.60%|
Table 6. NPV, IRR, Payback period of Higher-than-expected revenue Scenario
When the incremental revenue exceed the expected one by 30% from Year 6 onwards, the project brings about a highly attractive NPV of $605,721 with an IRR of 16.1%, far outweighing the cost of capital (12.6%). Provided that this is the case, the company would be able to recover its initial outlay within only 6 years of implementation. In this case, it is apparent that the project yields extremely promising returns for the company and hence is a wise investment.
- EXPECTED NET PRESENT VALUE
Table 7. Expected NPV given the 3 scenarios
Using the NPV and probability for each scenario, the expected NPV is calculated as follow:
Expected NPV = ∑ (P Scenario * NPV)
From the calculation result above, it is clear that with the normal scenario happening with 50% probability, 40%-lower-than-expected revenue happening with 30% probability, and 30%-higher-than-expected revenue happening with 20% probability, the expected NPV is a negative figure of – $56,157.58. Such negative expected net present value indicates that the net present value of this project when adjusted for uncertainty given different scenarios and probability-weighting is a negative number. This means that when investing in this project, it is most likely that the company will generate a loss. Moreover, from the above analysis, even when the business goes with normal expectation (Normal scenario), the returns generated are not highly attractive. Therefore, the NPV and IRR calculations gravitate towards to rejection of implementing this project given the negative expected Net present value.
III. PART 2:
Despite the unattractive expected NPV calculated in Part 1, Candy Crash still decides to proceed with supplying a private label confectionery for Costca. The company then announces this decision to the public with regard to the expected profits and net cash flows when implementing this project.
Using the Capital Asset Pricing Model, the daily abnormal return of Candy Crash during the event window is computed and plotted as below with the formula:
Abnormal Return = Actual Return − Expected Return
Table 8. The Daily Abnormal Returns of Candy Crash given the announcement of implementing the project with Costca.
Table 9. The Cumulative Daily Abnormal Returns of Candy Crash given the announcement of implementing the project with Costca.
The Semi-strong form efficiency tests concern with determining whether the stock prices reflect all publicly available information. To carry out the test, an examination of the Candy Crash’s security price reaction before, during, and after the announcement to implement the project with Costca will be conducted.
Looking at the cumulative daily abnormal return in Table 8, we can see that prior to Day 0 – the announcement date – the stock price was experiencing an overall upward trend. However, after the news about the project adoption has been made publicly available, the stock price immediately dropped afterwards, most evidently in Day 1 and Day 2. This pattern of cumulative daily abnormal returns aligns with the analysis in Part 1 since Part 1’s findings indicate that the project is highly likely to incur a loss for the company. This would definitely come as bad news to shareholders as they are afraid that the potential loss would affect the future share price of the company.
However, observing the stock price movement from day 3 onwards, a slightly upward trend can be noticed. Thus, the initial and immediate drop in share price in Day 1 and 2 after the news is announced can be attributed to the selling of current shareholders who are afraid that they would experience further loss due to the potential adverse impact of the newly adopted project. However, the price drop also presents itself as a potential investment opportunity for stock traders who are currently not owning Candy Crash’s stocks. They may take advantage of the price drop, believing that the decline is only temporary due to a news release, hoping that the stocks would recover to its previous state and thereby generating them profits. This might be what investors expect to happen with the share price after the analyzed event window, and also the reason why the share price started to recover.
All things considered, it can be concluded that the market is the market is semi-strong form efficient, with its pattern following what the analysis in Part 1 has clearly indicated.