Two Capital Investment Options
The two capital investment options that I chose for the RANK Group was either opening a venue in Sydney or Melbourne. At the moment, they only have a few venues in the UK and Spain. Through my comparison of Entain in Step 3, they had a much broader network of venues across the world which was reflected positively in their financial statements. Therefore, by opening up another venue, will not only promote their brand, but could also help bring in revenue. The option is between these two cities are those are Australia’s busiest and most popular cities and therefore would attract the most customers. After a life span of 10 years, the firm will sell them off to a hotel chain and then the RANK Group can use that money to span their network and increase their venues Australia-wide. The estimated cash flows for each year were predicted as the initial start-up costs of getting gambling licences and permits can be expensive and therefore I put a negative cash flow for the first few years. This is also because there is annual fees that the firm will need to pay to continue to have a gambling licence. However, the negative cash flow gradually gets less as the firm makes more revenue each year and therefore closes the gap slowly, year by year.
| Mecca Venue - Sydney | Mecca Venue - Melbourne |
Original Cost | $-12 million | $-10 million |
Estimated Life Value | 10 years | 10 years |
Residual Value | $20 million | $ 17 million |
Discount Rate | 8% | 8% |
Estimated Future Cash Flows | ||
Year 0 | $-12 million | $-10 million |
Year 1 | $-8 million | $-6 million |
Year 2 | $-4 million | $-2 million |
Year 3 | $-1 million | $1 million |
Year 4 | $2 million | $4 million |
Year 5 | $4 million | $6 million |
Year 6 | $6 million | $8 million |
Year 7 | $8 million | $10 million |
Year 8 | $10 million | $12 million |
Year 9 | $12 million | $14 million |
Year 10 | $34 million | $33 million |
Recommendation
| Option 1 - Sydney | Option 2 - Melbourne | Recommendation |
Payback Period (PP) | 7 years and 6 months | 5 years, and 10.5 months | Option 2 |
Net Present Value (NPV) | $16.16 million | $30.20 million | Option 2 |
Internal Rate of Return (IRR) | 15.8% | 24.6% | Option 2 |
After using all three methods of capital budgeting, the recommended option is building a Mecca venue in Melbourne, option two. The payback period is smaller for option two. This means that the initial investment of $10 million will be paid back in 5 years and 10.5 months. Therefore, the shorter the payback period, the more optimum. However, both options do have a payback period less than the 10-year acceptable period.
The net present value was higher for option two, building a Mecca Venue in Melbourne. The NPV came to $30.2 million which is the value that is created from the investment over the 10-year period, with a residual value of $17 million. However, a positive NPV is also created with option one, the Mecca Venue in Sydney. Over 10 years, this capital investment created a NPV of $16.16 million. If a negative NPV was created, the investment would be rejected as it would be making a loss for the firm. However, since both options make a positive NPV for the RANK Group, they would potentially build both, if they have the available funds.
The last method of capital budgeting, IRR, is higher for option two as it is 24.6% which is three times more than the required return of 8%. Although, option one also has an IRR above 8% but not as high as option two. This means that if the WACC was 24.6%, the NPV would be zero, meaning the cash flow discounted at 24.6% each year, would equal the initial investment at the end of the 10-year period.
Overall, option two is the acceptable capital investment as the PP is lowest, NPV and IRR are the highest. However, if the RANK Group have sufficient funds or available sources of cash, they could use both capital investments as they both have a PP within the 10-year acceptable period, a positive NPV and an IRR above the required rate of return of 8%.
Strengths and Weaknesses
A strength of using the payback period, it focuses on the liquidity of a firm as it is only concerned with cash flow and how the capital investment will return the cash to the firm. It is also a simple calculation meaning that firms can work it out relatively quickly and easily. Although, a weakness is that this calculation does not consider the value of money as the value of a certain amount in year one will be worth less in a few years time. There is also no specific limit or time frame, it is purely subjective to the firm. For example, what one firm deems acceptable, may not be for another firm. This calculation does not have the flexibility to consider economic downturns or deficits. If one occurs, it will limit the cash flow for the firm and therefore will change the payback period and render the initial calculation invalid. The last weakness with payback period is that it does not consider the cash flow after the initial investment is paid back. The future cash flow needs to be considered as it determines whether the capital investment will be profitable or not for the firm.
Strengths of the NPV is that it considers the value after removing the cost of the initial capital investment. This means it provides an accurate prediction of where the investment should be in regard to cash flow levels, profitability and whether this investment will add value to the firm. If it is negative, this means that the cash flow through the accepted period has not covered the initial investment cost. Therefore, directly indicates whether the investment will increase or decrease the wealth of the firm. Another strength is that is adjusts for the time-value of money through the use of the discount rate, unlike the payback period method.
A weakness of the NPV method is that the WACC could vary over the 10-year period. Although the calculation is done with an 8% WACC now, in 5 year’s time, the firm may re-evaluate it and consider it to be 10% instead. Therefore, the original calculation that has been done, only considers the current WACC.
Strengths of the IRR method is similar to the NPV, where it takes into account the time-value of money and understands that the value of money decreases over the years, which is why there is a discount rate. It also considers all cash flow for the whole 10-year period. A weakness of the IRR method is that it is unreliable when the cash flow fluctuates too much. If it drastically decreases one year and then increases the next, the IRR would be unreliable depiction due to the greater variation in cash flows.
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