Business And Financial Environment Part 2 Assignment- BSM 501

BALAMURUGAN CHINNIAH, K0961097--/--/2011

Executive Summary

Every organisation in this competitive market tries to expand itself in all the possible

ways of making profit and new business. This report focuses on a business and financial

analysis of JD Wetherspoon plc (JDW). Calculations are performed using WACC and returns

for the shareholders who invest in an acquisition project in pub industry. JDW is one of the

successful pub chains in the country with its innovative strategy of acquisition of second hand

pubs and converting them into a profitable business. They diversified into coffee and

breakfast sales in 2010 due to decreasing beer sales and tough market conditions and came up

as second largest in coffee and breakfast sales. In this report, the organisation comes forward

to expand itself in the hotel industry, by acquiring model hotel developed by the author called

the B&H Hotel.

The company critically analyses various factors for feasibility and profitability with

respect to the investment in the hotel. These factors are share price, bond rates, value of the

company of the company in market and others. Financial calculations such as Net Present

Value (NPV) of B&H Hotel, Internal Rate of Return (IRR) and Weighted Average cost of

capital (WACC) and Discount Rate (DR) of J D Wetherspoon are calculated. The WACC is

calculated to find the cost of capital involved in buying the hotel. This capital is provided by

the J D Wetherspoon from its pool of fund. The average value of WACC from two different

methods was found to be 6.14% and Discount Rate was 8.62%. The NPV and IRR

calculations are performed in-order to make a decision on the investment for acquiring the

hotel. From the NPV and IRR calculations, values were found to be positive in both the

scenarios and the IRR values were lesser than the Discount Rate of JWD. Thus a decision of

rejecting the proposal of acquiring B&H Hotel was recommended. This assignment takes you

through all the above mentioned.

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Contents

1. Introduction.........................................................................................................................4

2. Investment/ Operational Plans............................................................................................5

2.1 Weighted Average Cost Of Capital (WACC).............................................................6

2.2 Discount Rate (DR).....................................................................................................6

2.3 Net Present Value (NPV)............................................................................................6

2.4 Internal Rate Of Return (IRR).....................................................................................7

3. Conclusion..........................................................................................................................8

Reference....................................................................................................................................9

Appendices...............................................................................................................................10

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1. Introduction

J D Wetherspoon Plc was founded by Tim Martin in the year 1979. It is one of the largest

and fastest growing chain of pubs in the UK. It operates around 770 eating and drinking pubs

in Wales, England and Scotland with the headquarters in Watford, United Kingdom. They

mainly run with low price and long opening hour’s strategy. The company went public in

1979, also operates the Lloyds No.1 brand. The company operates mainly in eating out and

drinking out market, which faced some issues with respect to the recession and returning

back to its state in a constant pace. The company was the first to pioneer in non-smoking

areas in the pubs even before the introduction of Health Act 2006. The company had the

highest sales record in the year 2009 with a growing of 1.2% and a pre-tax profit up by 13%,

which is £66.2 million. It also owns a chain of newer styled bars under the name Lloyds No.1

Bar. The company has policy of routinely selling their smaller/less profitable pubs and

replacing them with bigger premises, which are nearby. It also owns nearly around 16 hotels

in total with the name Wetherspoon Hotels. They have modernised/refurbished the looks of

their pubs with respect to the market changes. It has around 20,000 employees (Anon, 2000).

Figure 1: J D Wetherspoon’s Profit in 2010, sourced from FAME.

Figure 1 shows the diagrammatic representation of comparison J D Wetherspoon’s profit in

2010, with its competitor in the market.

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As the company is already into hotel and restaurant industry, it is trying to expand in

various parts of the world. This is considered as the main policy of the company, because it

had good value based model to reach the possible saturation level within the UK and entering

into new markets (foreign markets). This strategic move for the company is extended to

enhance the expansion of the company. This is done carefully by considering various factors

such as WACC (Weighted Average Cost of Capital), NPV (Net Present Value) and IRR

(Internal Rate of Return), which has concern on the profitability of the investment. The above

mentioned depends on various market factor such as share price, bond rates, value of the

company of the company in market and lot more. The organisation plans to invest in new a

project with respect to the feasibility and the profitability of the project. The company has

decided to acquire a hotel with a minimum of 20 rooms and facilities for hosting events

which can accommodate 100 guests. In recent days the pub industry has exploited the

approach of acquiring and converting a large premises into the desired pub is found to be

successful. Before investing on a project, the organisation should critically analyse various

factors such as capital for the investment, interest rates, wages, salary, amortisation, market

growth, spending mentality of the people, effects of failure/success of the project with respect

to loss and profit and also the risk involved in the new. In short most of the environmental

factors are taken into consideration. This analysis is mostly done by the mangers, who always

look at business with profitability context and this is similar to budgeting.

2. Investment/ Operational Plans

This involves various financial calculations such as WACC, ARR (Accounting Rate of

Return) or ROI (Return On Investment), IRR, NPV, and Payback. These calculations forecast

the feasibility and risk involved in the particular project. The non-discounted techniques

which are used to evaluate the capital investment appraisal are payback and ARR. These two

methods are not as effective as NPV and IRR of discounted techniques (Carreras A, 2010,p

2.5). The WACC can be calculated through two different methods namely Dividend Growth

Model (DGM) and Capital Asset Pricing model(CAPM). CAPM is more effective than the

DGM during the calculation of the WACC.

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2.1 Weighted Average Cost Of Capital (WACC)

CAPM is the Cost Appraisal Pricing Model is the most popular method. This is because it

mainly deals with the systematic risks and it derives a theoretical relation between required

return systematic risk which is considered for research analysis and testing frequently. The

CAPM method uses the β (beta) value which is more accurate than the ERP (Equity Risk

Premium), this is because the ERP leads to uncertainty at times. The CAPM links the

company’s systematic risk with the stock market. The WACC for J D Wetherspoon using

CAPM method is found to be 6.85%, whilst the value of WACC using Dividend Growth

Model (DGM) is found to be 5.44%. As the values of these are very close to each other, an

average of these two values are considered, which is 6.14%. Thus the WACC for the J D

Wetherspoon is found to be 6.14%, which is cost of capital required by the company in-order

to invest in the hotel acquisition project. The calculations of WACC with two different

methods are given in Appendix A. The advantages, disadvantages and limitations are

mentioned above should be considered when a decision is made (Carreras A, 2010, p 7.17).

2.2 Discount Rate (DR)

The discount rate is calculated with the help of WACC and the Risk Premium. The sum

of these two values gives the discount rate of J D Wetherspoon Plc. The discount rate is

found to be 8.62%.The calculations are given in Appendix B.

2.3 Net Present Value (NPV)

The NPV is nothing but the Net Present Value of the project, which helps us in appraising

the investment projects, whether to proceed it or not. The NPV uses the discounted cash flow

of the project in-order to find whether the investment on this particular project will lead to

risk or not. When the NPV is positive is it good to invest in the particular project, however

with the negative value of NPV the project is rejected (Carreras A, 2010, p 2.12). The NPV

calculations for acquiring B&H Hotel has been carried out, to take a decision to either accept

or reject the project. In-order to perform NPV calculations, the value of B&H Hotel (initial

outlay) was calculated using sustainable earnings and the P/E value and the value of B&H

Hotel is £22,660. NPV is performed in two different scenarios with different discounted cash

flow @ 10% and 5%, they are

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1. Increase in Profit before tax and interest by 3.1% (As per the Price Water House forecasted report on UK hotels for 2010 and 2011).

2. Increase in Interest Rate of Banks by 1% (As per the prediction from BBC, that there

might be an increase in the interest rate).

Let us consider the first scenario, where there is an increase of 3.1% in the profit before

tax and interest, here the value of NPV is calculated with discounted counted cash flow @

10% is found to be + 54,608.91 and @ 5% is found to be + 60,902.72 with positive values.

With these positive values of NPV, it is claimed that the project can be accepted. The second

scenario is 1% increase in the interest rate, where the NPV is also calculated with

discounted counted cash flow @ 10% is found to be + 54,062.83 and @ 5% is found to be

+ 60,293.7 with positive values. Again with these positive NPV values in the second

scenario, this project can be accepted by JDW. Thus both the scenarios are explained. The

calculations for value of B&H Hotel and NPV can be found in Appendix D.

2.4 Internal Rate Of Return (IRR)

IRR which also uses discounted factors, this determines the internal rate of return of the

company. IRR is used widely in practice than the NPV method, as it is good for long term

decision making. This is because all the non-financial managers can easily understand the

IRR when compared to NPV. This IRR completely ignores the relative size of the investor,

which is a drawback of this IRR. This is found to be an unique discount rate when the NPV is

value zero. The IRR is expressed in percentage, which makes the manager’s job easier to

compare it with another firm (Carreras A, 2010, p 3.3). The conditions for accepting and

rejecting the project are given below.

If IRR > discount rate (Accept the project).

If IRR < discount rate (Reject the project).

Considering the scenario of 3.1% increase in the profit before tax and interest (net

cash flow) with discounted cash flow @ 10% and 5%, the IRR value is found to be 4.438%.

Whilst the second scenario of 1% increase in interest rates of banks (net cash flow) with

discounted cash flow @ 10% and 5 % is 4.435%. Both these IRR values are lesser than the

discount rate 8.62% of JDW. Thus the project proposal should be rejected by considering

long term.

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3. Conclusion

J D Wetherspoon Plc being one of the successful company in the pub chain industry, it

has reached this position by innovative acquisition of second hand pubs and converting them

into a profitable business, they have also diversified into breakfast and coffee sales. The

following Table 1 shows the NPVs with respect to different scenarios which considered for

evaluating the project.

Table 1: Calculated NPVs For Different Scenarios

The below Table 2 gives the calculated IRR values with respect to the scenarios considered.

Table 2: Calculated IRR Values For Different Scenarios

From the above, the project proposal can be accepted for a short term, as the NPVs

are positive. However, the IRR values are lesser than the Discount Rate 8.62% of JDW.

From the IRR value it is clear that, this acquisition project would not favour the returns for

the shareholders who invest in this project. Hence it is recommended that the project should

be rejected by JDW, as most of the businesses look at long term feasibility and profitability

of a particular project.

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Reference:

Anon (2000), J D Wetherspoon Company History, Available at <http://www.fundinguniverse.com/company-histories/JD-Wetherspoon-plc-Company-History.html>. [Accessed on 9 January 2011].

Carreras, A. and Archbold, S. (2010), ‘Business Financial Environment II’, 2nd ed , London. Kingston Business School.

Anon (2010), JD Wetherspoon Annual Report, Available at <http://www.jdwetherspoon.co.uk/home/investors/latest> [Accessed on 10 January 2011]

Ft.com Benchmark UK Government Bonds, Available at <http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-110111> [Accessed on 13 January 2011].

Bond prices, Available at <http://www.londonstockexchange.com/exchange/prices-and-markets/retail-bonds/retail-bonds-search.html> [Accessed on 10th January 2011].

J D Wetherspoon Plc Company’s profit percentage in the indusrty, Available at < https://fame2.bvdep.com/> [Accessed on 11 January 2011]

Yahoo Finance, Share price of J D Wetherspoon Plc, Available at < http://uk.finance.yahoo.com/q?s=JDW.L> [Accessed on 10 January 2011].

Word count : 1751 (Excluding Executive Summary and Appendices)

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Appendices

Appendix A

WACC Calculation of J D Wetherspoon PLC

WACC determines the average cost of capital required by an organisation to invest in a

new project. This capital/finance provided by the company is known as the pool of the funds

concept. This pool funds can be obtained by various sources such as loans, equity, bonds and

reserves from the profit. The capital structure of the company taken mainly into consideration

when calculating the WACC (Carreras A, 2010, p 5.11). As mentioned in the main body of

this assignment WACC calculations are performed in two different methods ,

Formula of WACC = (Kd*Vd) + (Ke*Ve) / Vd + Ve.

Where Kd = Cost of Debt, Ke = Cost of Equity,

Vd = Value of Debt, Ve = Value of Equity.

Ve = Value Of Equity

= value of share price * Quantity of shares

= 4.26 * 2.783 million

= 11.85

Note: Value of the share is taken from Yahoo Finance, available at

[http://uk.finance.yahoo.com/q?s=JDW.L] and the quantity of the shares are taken from the

J D Wetherspoon Annual report, 2010.

Vd = Value of Debt

= Total Long Term Liabilities * Current Bond Market Price

= 571.7 m * 102.17/100

= 583.7 m

Note: Long term Liabilities is taken from J D Wetherspoon Annual report, 2010. And the

current bond value is taken from London Stock Exchange Available at

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[http://www.londonstockexchange.com/exchange/prices-and-markets/retail-bonds/retail-bonds-

search.html]

Kd = Cost Of Debt

= Coupon Quantity / Price

= 2.493/102.17

= 2.25%

Note: The coupon quantity is taken from Financial Times.com available at

http://markets.ft.com/markets/bonds.asp

Calculation WACC using CAPM

Ke = Cost Of Equity

Ke = rf + β (rm - rf) where rf = Risk free return

rm = Return on stock market

β = Systematic risks (within the organisation).

Calculation of WACC through CAPM,

β = 0.707

Note: The value of β is taken from FT.com available at

[http://markets.ft.com/tearsheets/performance.asp?s=JDW

%3ALSE&vsc_appId=ts&ftsite=FTCOM&searchtype=equity&searchOption=equity].

rf = 0.0475

Note: The value of rf is taken from FT.com available at

[http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-110111].

rm = 11%

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Note: The value of rm is taken from [http://www.ehow.com/about_7421877_historical-rate-return-

stock-market.html]

Ke = rf + β (rf + rm)

= 0.0475 + 0.707 (0.11 – 0.0475)

= 0.0916

= 9.16%

Calculation Of WACC using DGM

Ke = Cost of Capital

Ke = Do (1+g) /MV + g

Do = Dividend Growth

= 12p

Note: JDW didn’t pay dividend in the year 2009, however the company paid 7p as interim

dividend and 12p in the year end 2010. Hence we considered 12p.

g = Expected Growth in a year.

= 4.12%

Note: Compound Growth Rate Calculator was used to calculate the growth, which was found

to be 20.62% for five years from 2006 to 2010 (excluding 2009, as the company did not pay

any dividend to its share holders). The dividend values were taken from the Annual Report of

the JDW with respect to the corresponding year from 2006 to 2010.

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WACC = {[(Ke * Ve) + (Kd * Vd)] / (Ve + Vd)}

= {[(0.0916 * 11.85) + (0.0225 * 5.837)] / (11.92 + 5.837)}

= 0.06852

= 6.85%

MV = Market Value of the share

= 4.26p

Note: Value of the share is taken from Yahoo Finance, available at

[http://uk.finance.yahoo.com/q?s=JDW.L]

Ke = Do (1+g) /MV + g

= [0.12 (1+0.0412) / 4.26] + 0.0412

= 0.0705

= 7.05%

Average WACC: Since we have calculated two WACCs using two different method, an average of these two WACC values are considered calculating the Discount Rate.

Appendix B

Calculation Of Discount Rate for JDW

DR = Cost Of Capital + Risk Premium

= 0.0614+0.0248

= 0.0862

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WACC = {[(Ke * Ve) + (Kd * Vd)] / (Ve + Vd)}

= {[(0.0705 * 11.85) + (0.0225 * 5.837)] / (11.92 + 5.837)}

= 0.05444

= 5.44%

WACC = [WACC (CAPM) + WACC (DGM)] / 2

= [6.85 + 5.44] /2

= 6.14%

Calculation of Risk Premium

Risk Premium = Dividend per Share / Stock Price + Expected Dividend Growth

= {[12/4.284] + 0.01}

= 2.66%

Note: An assumption is made in the expected dividend growth as 1% every year. The dividend per share and the stock price are sourced from FT.com, available at [http://markets.ft.com/tearsheets/performance.asp?s=JDW

%3ALSE&vsc_appId=ts&ftsite=FTCOM&searchtype=equity&searchOption=equity]

As per the Government Treasury Records, the risk premium suggested by http://www.investopedia.com/articles/04/020404.asp is 2.3%

Average Risk Premium considered by the Author is,

Average Risk Premium = [2.66+2.3]/2

= 2.48%

Appendix C

Profit and Loss Statement Of B&H Hotel.

Note: This an assumption made by the Author

Table A-1: Profit and Loss Account Of B&H Hotel – Assumption made by Author

B&H Hotel has a capacity of 72 rooms and one conference hall facility to organize

corporate meeting. The rent of the varies flexibly from £37 to £51 and the conference hall

costs around £75 in weekdays and £80 in weekends. By assuming that rooms are booked for

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Discount Rate for JDW = 8.62%

310 days in a year, the conference halls are booked for 180 days and other income from food

and beverage. The profit and loss statement is calculated.

Appendix D

Investment Appraisal

B&H Hotel is a private hotel, which operates in hospitality and leisure industry for about 14

years. As the company is not a public limited company, average P/E value of 14.1% of the

industry is considered to perform the NPV calculations. The net profit before tax and interest

is given Table A-2,

Table A-2: Average Cash-flow from the profit and loss statement of B&H Hotels

Value of B&H Hotel = Sustainable Earnings*P/E

= 160,709*0.141

= 22,660

By considering the above value as the initial investment outlay, therefore Yo = 22,660.

Scenario 1

NPV Calculation for Increase in the Net Cash Flow @ 3.1%

As per the Price Water House report on UK hotels forecast for 2010 and 2011 found,

available at [http://www.lotus-uk.co.uk/pdf/pricewaterhouse-hospitality-and-leisure.pdf].

Forecasted a growth of 3.1%. This is the rate is considered by the Author for the project

evaluation of acquisition of B&H Hotel.

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Table A-3: NPV Calculations for B&H Hotel with 3.1% increase in the net profit @ 10% and 5% of Discounted Net Cash Flow.

The NPV for both 10% and 5% discounted net cash flow was found to be positive from the

above Table A-3. With the positive NPV values, JDW can accept this project as a good

investment to undertake in short run.

The calculation IRR for the above given NPV values as follows,

IRR = df% + [{NPV@10% / (NPVat5% - NPV@10%)}* (df@10% - df@5%) ]

= 0.10 + [{54609 / (60903 – 54609)} * (0.10-0.5)]

= .10+ (8.676*.5)

IRR = 4.438%

The above IRR value of 4.4% is < Discount Rate of JDW (8.62%)

4.438% < 8.62%

Hence we reject the project proposal for long term.

Sensitivity Analysis of B&H Hotel

Scenario 2

Assuming that the interest rate of Banks in England increases by 1%, the following NPV

calculations are performed for B&H Hotel. Prediction from BBC is available at

[http://news.bbc.co.uk/1/hi/business/8493097.stm]

NPV Calculation for Increase in the Interest Rate @ 1%

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Table A-4: NPV Calculations for B&H Hotel with 1% increase in the interest rate of banks @ 10% and 5% of Discounted Net Cash Flow.

The NPV for both 10% and 5% discounted net cash flow was found to be positive from the

above Table A-4. With the positive NPV values, JDW can accept this project as a good

investment to undertake in short run.

IRR = df% + [{NPV@10% / (NPVat5% - NPV@10%)}* (df@10% - df@5%) ]

= .10 + [{54063/ (60294 - 54063)} * .5]

= .10 + [{54063/6231} * .5]

= .10 + (8.67*0.5)

= .10 + 4.335

IRR = 4.435

The above IRR value of 4.435% is < Discount Rate of JDW (8.62%)

4.435% < 8.62%

Hence we reject the project proposal for long term.

Note: The calculations were performed in a team with the following members,

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