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Present Value and Capital Budgeting

Forward Air Corporation is one of the companies operating in the transport industry (ground and air delivery services) in North America. The company is listed in the NASDAQ (American Stock Exchange). Over the last ten years, the company has been recording positive net income, with the last five years being the most successful years for the company in terms of revenue collection since its establishment. Last year, the company recorded a net income of US$47.199 million (Forward Air Corporation, 2012). This was a 47.1 percent increase from the previous year where its net income was US$32,036 million. The company’s profit in the year 2010 increased by significant percentage of 226.8 percent compared to the net income of the year 2009 – US$9,802.

However, in the year 2009, the company had recorded one of its lowest values of net income for the previous five years. Nonetheless, it is important to note that the low performance in the year 2009 was due to the global economic crisis, which started in the year 2008 after the collapse of Lehman Brothers. Sales during the year 2009 were lower than sales in previous years. This is because there were low economic activities across the globe since many businesses were trying to recover from the crisis. Therefore, low performance in the company during the year 2009 was not due to internal factors, which the company would have controlled, but due to external factors, which the company had no control over. Apart from the years 2009 and 2010, the company has had positive net income growth since the beginning of the previous decade (Forward Air Corporation, 2012).

The company has been recording an increased growth as well during the past ten years. This has been achieved through the expansion of its areas of operations by opening additional terminals in the US and in Canada. The growth strategies employed by the company have contributed to its increased annual revenue since the beginning of the previous decade. The company’s records indicate that its shares have been performing relatively well in the NASDAQ over the last ten years apart from the year 2009. In the year 2011, the average share price of the company’s share was US$30.35. In the year 2010, the average share price was US$30.02 while in 2009, the average share price was US$28.74. In the year 2008, the average share price of the company’s shares was US$29.89 while in 2007, the average share price was US$31.21 (Forward Air Corporation, 2012).This trend indicates an almost constant trend in the movement of the company’s share prices.

Currently, the company’s shares are trading in NASDAQ at US$33.56, but the average price per share since January 2012 is approximately US$33.42 (Historical Quote of: FWRD, 2012). It is likely that by the end of this year, the company’s share price will be trading at to around US$37.0, thus closing at an average of between US$33.5 and US$34.5. This is because since January 1, 2012, the company’s shares have been recoding high prices, implying that the company’s shares are prone to wild swings up. If an investor is to purchase 100 future share of the Forward Air Corporation at the beginning of the year 2012, assuming the financial year of the company begins on March 8 of every year; such an investor is likely to gain substantially from the futures. Assume that the future price of Forward’s shares is US$33.50 and the closing price of the shares on March 8, 2013 (one-year investment in the futures) will be US$37.0, then the investor will gain US$3.5 per future share invested. Meaning, the investor will gain US$350.0 from the 100 futures. This investment is better compared to a savings account offering a 10 percent simple interest. This is because if the investor deposited US$3,350 (the amount equivalent to purchasing the 100 future options), he/she would earn US$335.0 at the end of 12 months.

Part II

Currently, the type of capital project that Forward Air Corporation is likely to undertake is to open an additional terminal in the USA, most probably in Dallas/Fort Worth International Airport, Texas. This would be to capture the growing market in the airport as the airport continues to receive large numbers of national and international cargo and passenger carriers. This would be a big project for Forward Air Corporation, thus it would require substantial amount for initial investment. This would be approximately US$100.0 million. This is around half of the cost, which Forward Air Corporation spent in order to build its Columbus central handling terminal in 1998 (Forward Air Corporation, 2012). This figure has been arrived at because the new terminal at Dallas/Fort Worth Internal Airport would be almost half the size of the Columbus terminal.

The estimated annual incremental after-tax cash flow of this investment is US$5.2 million in the first five years, and then a 20 percent annual increase within the next five years. After that, the annual incremental after-tax cash flow from the project will be constant. This implies that the payback period of the potential capital project would be approximately 12 years. Despite the high payback period, this investment is economical because it would earn the company positive incremental after-tax cash flows on annual basis.

One of the problems that Forward Air Corporation is likely to experience when estimating the cash flow that might be emanating from the initial investment and getting the project funded is investors’ relation issue. This is because the company would most probably source the investment funds from two sources: retained earnings and long-term debt. Investors are likely to object this move because if the investment funds are partially sourced from the retained earnings, it means that they are likely to receive lower earnings during the year when the project commences. This is because the company will utilize some of the money that would be distributed among the shareholders through dividends to fund the project. This would cause the DPS (dividend per share) to reduce, hence making the total income of the shareholders during that year reduce.

In addition, debt financing would mean that the company would have to pay interest for the debt. Since the debt would be a substantial amount of money, the payable interest would also be high. High amount of interest payable on annual basis implies low net income for the company, hence low income for the shareholders. This is because the interest is deducted from the gross profit as an expense. Therefore, the investors are likely to oppose the project if the funding method proposed by the company will affect their annual income.

In addition, since the project has a high payback period, the company is likely to encounter a problem of risk cost politics when estimating the cash flow that might be emanating from the project. Usually, projects with payback periods of more than ten years are considered risky. Therefore, the finance committee of the company might oppose the project due to its risky nature. Furthermore, they might require project development team to develop ways of ensuring higher incremental cash flow from the project in order to make the payback period lower (less than ten years). This is possible through the employment of the cost reduction measures. However, it is difficult to employ cost reduction measures in a new project until it reaches the growth stage. Nonetheless, the company’s finance committee should understand that long-term capital projects have high payback periods. Therefore, they should implement the project because its incremental after-tax cash flows are positive.

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