Fama French Five-Factor Model Analysis

This assignment provides an in-depth analysis of the Fama French five-factor model, a refinement of the traditional three-factor model. The five-factor model takes into account size, value, profitability, investment, and market factors to provide a more comprehensive understanding of stock returns. The analysis explores how this model can be used to calculate Weighted Average Cost of Capital (WACC) and inform capital structure decisions. Specific recommendations are provided for the parent company, Kellogg Company, based on its age and maturity level.

Business Finance – Group Report May 12, 2019
WACC Calculation, Investment Selection and Asset Pricing Model analysis
Question 1: Find the appropriate risk-free rate and calculate the WACC of your parent company. Making an
adjustment to WACC that takes into any additional risks the parent company might confront from this investment.
Financial Extract
Additional information that we found
Ordinary share price (closing price on March 29,
2019)
$57.38 (NASDAQ)
Risk-free rate (appropriate rate on March 29, 2019)
(Rf)
2.4% (Ychart)
Beta (the most recent beta reported by the company) 0.5 (Reuters)
Corporate tax rate (tax rate as of January 1, 2018) 21% (Deloitte)
Fed Funds Rate (2019) 2.5% (FED)
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Business Finance – Group Report May 12, 2019
Preference shares price (trading at 50% below the
ordinary share price)
$28.69
Convertible preference shares price (trading at 30%
below the ordinary share price)
$40.166
Current interest rate on the property mortgage (2%
on top of the current Fed Funds rate)
4.5%
Bank overdraft current rate (3% above the Fed
Funds rate)
5.5%
Term loans current interest rate (3.25% above the
current Fed Funds rate)
5.75%
Current interest rate on equipment (chattel)
mortgage (2.25% on top of the current Fed Funds
rate)
4.75%
Current return on Kellogg Company debentures (5%
on top of risk-free rate on March 29, 2019)
7.4%
Market Return (Rm) 11.72%
Country Risk Premium (in Vietnam) 5%
Notes
1. Market Return is the annualised return as calculated from monthly returns of the last twelve months using
Market Index (Rm) where Rm,t = ln(Pt/Pt−1) (Rm,t is the market return at month t, Pt is the price at
month t and Pt-1 is the price of the previous month t-1, ln is the natural logarithm).
2. The interest rate on the property mortgage was 5.50% at the time of the loan. It has ten years remaining.
3. Term loans mature in 5 years. Term loans originally had a 6.25% interest rate.
4. The interest rate on equipment (chattel) mortgage was 5.75% at the time of the loan. It has seven years
remaining.
5. Debentures are due in 15 years.
6. Interest is paid quarterly on all Kellogg Company debt (except commercial bills)
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Business Finance – Group Report May 12, 2019
★ Market Return Calculation
We select the closing price of stocks on NASDAQ stock market for 1 year (from 30 April 2018 to 30 April
2019) (Yahoo Finance)
NASDAQ historical index
30 April $7,066.27
31 May $7,442.12
29 June $7,510.30
31 July $7,671.79
August 31 $8,109.54
28 Sep $8,046.35
31 Oct $7,035.90
30 Nov $7,330.54
31 Dec $6,635.28
31 Jan 2019 $7,281.74
28 Feb 2019 $7,532.53
29 Mar 2019 $7,729.32
30 Apr 2019 $8,095.39
Closing price from 30 April 2018 - 30 April 2019
Table 1. Closing price of stocks on NASDAQ stock market for 1 year
- Formula of Log Return to calculate monthly returns
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Business Finance – Group Report May 12, 2019
NASDAQ historical index
Monthly returns
30 April $7,066.27 5.18%
31 May $7,442.12 0.91%
29 June $7,510.30 2.13%
31 July $7,671.79 5.55%
August 31 $8,109.54 -0.78%
28 Sep $8,046.35 -13.42%
31 Oct $7,035.90 4.10%
30 Nov $7,330.54 -9.96%
31 Dec $6,635.28 9.30%
31 Jan 2019 $7,281.74 3.39%
28 Feb 2019 $7,532.53 2.58%
29 Mar 2019 $7,729.32 4.63%
30 Apr 2019 $8,095.39
Closing price from 30 April 2018 - 30 April 2019
Table 2. Monthly returns
- Formula for calculating monthly average market return
 Calculate nominal yearly market return = 0.93% * 12 =11.14%
- Effective market rate of return (take into account the monthly compounding)
 Effective rate = (1+ 11.14 %
12 ¿ ¿12
– 1 = 11.72%
Therefore, the final result of market return is 11.72%
All calculations of monthly returns and market return are performed in MS Excel.
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Business Finance – Group Report May 12, 2019
NASDAQ historical index
Monthly returns Monthly average market return Nominal yearly market rate of return Effective market rate
30 April $7,066.27 5.18% 0.93% 11.14% 11.72%
31 May $7,442.12 0.91%
29 June $7,510.30 2.13%
31 July $7,671.79 5.55%
August 31 $8,109.54 -0.78%
28 Sep $8,046.35 -13.42%
31 Oct $7,035.90 4.10%
30 Nov $7,330.54 -9.96%
31 Dec $6,635.28 9.30%
31 Jan 2019 $7,281.74 3.39%
28 Feb 2019 $7,532.53 2.58%
29 Mar 2019 $7,729.32 4.63%
30 Apr 2019 $8,095.39
Closing price from 30 April 2018 - 30 April 2019
Table 3. Market rate of return
 WACC calculation
(Interest is paid quarterly on all Kellogg Company debt)
Step 1: Calculate Market Value of each component
Liabilities
1. Bank overdraft
Market value: $55,000,000
2. Term loans mature in 5 years.
PV = Annual interest x [ 1−(1+ r)−n
r ] + Loan amount x (1+r )−n
 Historical interest rate = 6.25%
 Current interest rate = 5.75%
 Number of terms of payment: n= 5x4= 20
Annual interest = $135,500,000 x 6.25 %
4 = $2,117,187.5
PV = $2,117,187.5 x (
1−(1+ 5.75 %
4 )
−20
5.75 %
4
) + $135,500,000 x (1+ 5.75 %
4 )
−20
= $138,425,933.6
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Business Finance – Group Report May 12, 2019
3. Debentures due in 15 years
Debentures market value = PV of coupon payments + PV of face value
 Coupon rate: 10%
 Current return= 7.4% -> 7.5 %
4 = 0.0185
 Number of terms of payment: n= 15x4= 60
PV of coupon payments= ($1000 x 10 %
4 ) x 1−(1.0185)−60
0.0185 = $25 x 1−(1.0185)−60
0.0185 = $901.462
PV of face value = $ 1,000
(1.0185)60 = $332.92
=> Debentures = $901.462+ $332.92 = $1234.379967
=> Total market value of debentures = $ 500000000
$ 1000 x $1234.379967 = $617,189,983.7
4. Property mortgage
Kellogg Company records a property mortgage amount of $375,000,000 with the interest rate at 5.5%, and will be
refinanced on today at the rate of 4.5% (2% above the Fed Funds rate), paying in quarterly method, remaining up
to 10 years.
● Historical interest rate = 5.5%
● Current interest rate = 4.5%
● Number of terms of payment: n= 10x4= 40
Quarterly payment = PMT =
$ 375,000,000
1− ( 1+ 0.055
4 )
−40
0.055
4
= $12,250,990.47
Present value of property mortgage = PMT x ¿]= $12,250,990.47 x
1−(1+ 0.045
4 )
−40
0.045
4
= $392,867,856.9
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Business Finance – Group Report May 12, 2019
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Business Finance – Group Report May 12, 2019
5. Equipment mortgage
Kellogg Company records an equipment mortgage amount of $175,000,000 with the interest rate at 5.75%, and
will be refinanced on today at the rate of 4.75% (2.25% above the Fed Funds rate), paying in quarterly method,
remaining up to 7 years.
● Historical interest rate = 5.75%
● Current interest rate = 4.75%
● Number of terms of payment: n= 7x4= 28
Quarterly payment = PMT =
$ 175,000,000
1−(1+ 0.05755
4 )
−28
0.0575
4
= $7,636,182.89
Present value of equipment mortgage = PMT x ¿] = $7,636,182.89 x
1−(1+ 0.0475
4 )
−28
0.0475
4
= $180,995,408.2
Equity
 Ordinary shares = $ 365,000,000
10 x $57.38 = $2,094,370,000
 Preference shares = $ 150,000,000
10 x $ 57.38
2 = $430,350,000
 Convertible preferred shares = $ 215,0000,000
5 x ($57.38 x 70%) = $1,727,138,000
Step 2: Calculate total value of those items
- Total market value = Total market value of equity + Total market value of debt
= ($2,094,370,000.00 + $430,350,000.00 + $1,727,138,000.00) + ($55,000,000.00 + $138,425,933.60 +
$617,189,983.70 + $392,867,856.90 + $180,995,408.20)
= $5,636,337,182.40
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Business Finance – Group Report May 12, 2019
Step 3: Weight of each items
The weight of each item = Market value of one item
Total market value
Market Value Weight
Equity
Paid-up capital - ordinary shares ($10 par) $2,094,370,000.00 37.16%
$1.80 Preferences share ( $10 par) $430,350,000.00 7.64%
$1.20 Convertible preferred shares ($5.00 par) $1,727,138,000.00 30.64%
Liabilities
Bank Overdraft $55,000,000.00 0.98%
Term Loan $138,425,933.60 2.46%
10% debentures ($1000 par) $617,189,983.70 10.95%
Property Mortgage $392,867,856.90 6.97%
Equipment Mortgage $180,995,408.20 3.21%
Total $5,636,337,182.40 100.00%
Table 4. Weight of each item
Step 4: Calculate the current rate of return on equity
● Ordinary shares (CAPM model): RE = Rf + E(Rm – Rf) x β = 2.4% + (11.72% - 2.4%)x 0.5 = 7.06%
● Preference shares:
Dividend = $1.8
Price = $ 57.38
2 = $28.69
Rpreference shares = $ 1.8
$ 28.69 x 100% = 6.27%
● Convertible preferred shares:
Dividend = $1.2
Price = $57.38 x 70% = $40.166
Rconvertible preferred shares = $ 1.2
$ 40.166 x 100% = 2.98%
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Business Finance – Group Report May 12, 2019
Step 5: Calculate Effective Annual Rate
Formula
Corporate tax rate: 21%
Bank overdraft effective rate:
 Before tax: (1+ 5.5 %
4 )
4
– 1 = 5.6%
 After tax: 5.6*(1 – 0.21) = 4.42%
Term loans effective rate:
 Before tax = (1+ 5.75 %
4 )
4
– 1 =5.87%
 After tax = 5.87*(1 – 0.21) = 4.64%
Debentures effective rate:
 Before tax = (1+ 7.4 %
4 )
4
– 1 = 7.6%
 After tax = 7.6*(1 – 0.21) = 6.00%
Property mortgage effective rate:
 Before tax = (1+ 4.5 %
4 )
4
– 1 = 4.57%
 After tax = 4.57*(1 – 0.21) = 3.61%
Equipment mortgage effective rate:
 Before tax = (1+ 4.75 %
4 )
4
– 1 = 4.83%
 After tax = 4.83*(1 – 0.21) = 3.82%
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Business Finance – Group Report May 12, 2019
Step 6: Calculate weighted cost of each component
Weighted cost of each component = Weight of each component * Cost after tax
Market Value Weight Before Tax After tax Weighted Cost
Equity
Paid-up capital - ordinary shares ($10 par) $2,094,370,000.00 37.16% 7.06% 7.06% 2.62%
$1.80 Preferences share ( $10 par) $430,350,000.00 7.64% 6.27% 6.27% 0.48%
$1.20 Convertible preferred shares ($5.00 par) $1,727,138,000.00 30.64% 2.98% 2.98% 0.91%
Liabilities
Bank Overdraft $55,000,000.00 0.98% 5.60% 4.42% 0.04%
Term Loan $138,425,933.60 2.46% 5.87% 4.64% 0.11%
10% debentures ($1000 par) $617,189,983.70 10.95% 7.60% 6.00% 0.66%
Property Mortgage $392,867,856.90 6.97% 4.57% 3.61% 0.25%
Equipment Mortgage $180,995,408.20 3.21% 4.83% 3.82% 0.12%
Step 7: Calculate Weight-Average Cost of Capital (WACC)
- Weight-Average Cost of Capital is equal to the total weighted cost of each debt and equity component
 WACC = 0.04% + 0.11% + 0.66% + 0.25% + 0.12% + 2.62% + 0.48% + 0.91% = 5.20%
To illustrate the data more clearly, we have formed the below table:
Market Value Weight Before Tax After tax Weighted Cost
Equity
Paid-up capital - ordinary shares ($10 par) $2,094,370,000.00 37.16% 7.06% 7.06% 2.62%
$1.80 Preferences share ( $10 par) $430,350,000.00 7.64% 6.27% 6.27% 0.48%
$1.20 Convertible preferred shares ($5.00 par) $1,727,138,000.00 30.64% 2.98% 2.98% 0.91%
Liabilities
Bank Overdraft $55,000,000.00 0.98% 5.60% 4.42% 0.04%
Term Loan $138,425,933.60 2.46% 5.87% 4.64% 0.11%
10% debentures ($1000 par) $617,189,983.70 10.95% 7.60% 6.00% 0.66%
Property Mortgage $392,867,856.90 6.97% 4.57% 3.61% 0.25%
Equipment Mortgage $180,995,408.20 3.21% 4.83% 3.82% 0.12%
Total $5,636,337,182.40 100.00% 5.20%
Table 5. WACC calculation
Making an adjustment to this WACC that takes into any additional risks the parent company might
confront from this investment (Country Risk Premium)
According to Picardo. E, Country Risk Premium (CRP) is the additional return that investors demand to
compensate for the higher risk when companies invest in foreign countries, compared with investing in domestic
market. This higher risk of foreign countries often result from geopolitical and macroeconomics risks namely
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Business Finance – Group Report May 12, 2019
political instability, currency fluctuations, government regulations and so on. In the case of Vietnam, there are
some factors that contribute to the country risk premium.
 The first risk is about land clearance in Vietnam. In Hanoi, there are about 383 projects that are behind-
schedule because of the delay in land clearance whereas the number is 215 projects in Ho Chi Minh city
(Duong. P, 2018). Dr. Le Xuan Nghia - Former Deputy Chairman of National Financial Supervisory
Commission sees this risk as the biggest blockage for foreign investors in Viet Nam. As some projects had
been delayed for nearly a decade due to some difficulty in clearance, firms had to bear the cost of cash
flows that aren’t generated during the time plus the cost of maintaining the projects.
 Dr. Nghia also points out that currency fluctuation is the problem in Vietnam. Although exchange rate is
just a macroeconomics components which varies below 1% everyday but when considering about a
projects that last more than a decade then it becomes a real problem. The data from XE.inc shows that
throughout 10 year period, the value of 1 $USD increases from 17,785.00VND in 2009 to 23,371.73VND
in 2019. This means that the profit a company earns in Vietnam might lose its value when returning to
USA.
 Another difficulty for any corporation to invest in Vietnam is the country’s huge sovereign debt or its
national debt. The data from Parliamentary Financial Budget committee indicates that in 2017 the total
foreign debt occupied for 45.2% of the country’s GDP, in 2018, the number was 49.7% and it is expected
to be 49.9% in 2019 (RFA, 2018). The huge debt reduces Vietnam’s liabilities for international investors,
which proves to be a big risk for Kellogg. However, Fitch Ratings, one of the biggest credits rating
companies, had increased Vietnam’s ratings due to its effort to minimize the public debt in 2018 (Ha.N,
2018). Therefore, Vietnam is still a proper place to invest.
 Last but not least, an unclear point in the government’s law for foreign investment becomes a big risk. For
specific, every investment from other countries will operate under the Public- Private Partner (PPP)
module. This module means that the government and companies will collaborate in monitoring the project
since the government will set the standards and firms can follow that standard during their operation
(Tam. N, nd). PPP module seems to be the optimal way to benefit both sides but, there is one unclear point
in the standards that can causes trouble. PPP module forces the profit to stay at 14% but in case the profit
reaches 30%, will the government take the exceeded profit and in case the profit is under 14%, will the
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Business Finance – Group Report May 12, 2019
government cover the losses? The unclarity in regulations as well as 3 other issues contributes to the
country risk premium.
After listing many major risk of investing in Vietnam, there should be an effective way of calculating the exact
Country Risk Premium. In his article, Picardo.E provides 3 methods to calculate the CRP. The first one is by
comparing the sovereign debt yields between Vietnam and US market and the second way is by comparing the
volatility of equity market return of each market. However, both ways still contain many flaws which lead us to
the final method. In this method, the CRP will be measured by multiplying the difference of sovereign bond
yields between Vietnam and USA with the ratio of Vietnam’s stock market volatility and Vietnam’s bond market
volatility. The calculation will be depicted by this formula:
Country Risk Premium = (Vietnam’s Sovereign debt yields - US’ Sovereign debt yields) x
V ietnam' s Stock market Volatility
Vietnam' s Bond Market Volatility
The data from Trading Economics, Investing.Com, The Global Economy.Com and AsianBondsOnline provides
all the variables for this formula:
● Vietnam’s Sovereign debt yields = 4.8%
● US’ Sovereign debt yields = 2.47%
● Vietnam’s Stock market Volatility = 12%
● Vietnam’s Bond market Volatility = 6%
=> Vietnam’s Country Risk Premium = (4.8%-2.47%) x 12%
6 % = 4.6%
The result from the calculation is close to the number provided by NYU Stern which is 5%, so we will choose 5%
as our CRP.
According to NYU Stern (2019), country risk premium when making investment in Vietnam now stands at 5%.
Emerging market like Vietnam usually has a higher risk than developed market like the U.S, which results in
higher expected return from investors. This leads to some adjustment into the weighted average cost of capital of
the company. To reflect this risk, the Country Risk Premium is added to the Market Risk Premium when using
the CAPM model, assuming that company’s exposure to country risk premium is the same as its exposure to
systemic risk. Therefore, we adjust the CAPM model for calculating required rate of return of ordinary share by
using this formula:
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Business Finance – Group Report May 12, 2019
The rate of return on ordinary shares is adjusted as the following:
Ordinary shares: RE = Rf + E(Rm – Rf +CRP ) x β (Adjusted CAPM model)
= 2.4% + (11.72% - 2.4% + 5%)x 0.5
= 9.56%
=> Adjusted weighted cost is: 37.16% x 9.56% = 3.55%
The Market Risk Premium represents the additional returns over the risk-free rate attributed to the volatility from
the stock market. When the CRP is added, the market risk premium increases, indicating augmented expected
returns. The cost of equity will increase with the increase in risk, therefore, the WACC of the company also
increase (White 2019)
Kellogg, when investing in Vietnam, has to confront additional risks of 5%. The weighted cost of ordinary share
now increases to 3.55%, leading the WACC to rise to 6.13%
Market Value Weight Before Tax After tax Weighted Cost Adjusted with CRP
Equity
Paid-up capital - ordinary shares ($10 par) $2,094,370,000.00 37.16% 7.06% 7.06% 2.62% 3.55%
$1.80 Preferences share ( $10 par) $430,350,000.00 7.64% 6.27% 6.27% 0.48% 0.48%
$1.20 Convertible preferred shares ($5.00 par) $1,727,138,000.00 30.64% 2.98% 2.98% 0.91% 0.91%
Liabilities
Bank Overdraft $55,000,000.00 0.98% 5.60% 4.42% 0.04% 0.04%
Term Loan $138,425,933.60 2.46% 5.87% 4.64% 0.11% 0.11%
10% debentures ($1000 par) $617,189,983.70 10.95% 7.60% 6.00% 0.66% 0.66%
Property Mortgage $392,867,856.90 6.97% 4.57% 3.61% 0.25% 0.25%
Equipment Mortgage $180,995,408.20 3.21% 4.83% 3.82% 0.12% 0.12%
Total $5,636,337,182.40 100.00% 5.20% 6.13%
Table 6. Adjusted WACC
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Business Finance – Group Report May 12, 2019
Question 2: Calculating net cash flows of two projects
 Investment project 1: The Luxury
Market research 500,000.00$
Additional costs
U.S manager in Vietnam 75,000.00$ Cost of Living Adjustment 4% annual
Fish sauce (15,000 liters) each year 22,500.00$ £1.50 per liter (rise 5% a year)
Cost of equipment 850,000.00$ Depreciation using straightline method
Depreciable assets 450,000.00$
Food processing installation 50,000.00$ Included in $850,000 investment
Book value of equipment -$
Sold price 75,000.00$
Working capital 100,000.00$
Income tax rate 35.00%
Summary table Notes
Table 7. The Luxury summary table
- Depreciation cost = Cost price
Number of years = $ 450000
10 = $45000
- Incremental wage costs = Wage cost for U.S manager when working in U.S - Wage cost for U.S manager
when working in Vietnam
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Business Finance – Group Report May 12, 2019
% of Sales 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Sales Revenue 100% -$ 650,000.00$ 1,300,000.00$ 1,755,000.00$ 2,018,250.00$ 2,119,162.50$ 2,225,120.63$ 2,280,748.64$ 2,337,767.36$ 2,337,767.36$ 2,220,878.99$
Labour costs 30% -$ (195,000.00)$ (390,000.00)$ (526,500.00)$ (605,475.00)$ (635,748.75)$ (667,536.19)$ (684,224.59)$ (701,330.21)$ (701,330.21)$ (666,263.70)$
Ingredients costs 30% -$ (195,000.00)$ (390,000.00)$ (526,500.00)$ (605,475.00)$ (635,748.75)$ (667,536.19)$ (684,224.59)$ (701,330.21)$ (701,330.21)$ (666,263.70)$
Total Revenue 100% -$ 650,000.00$ 1,300,000.00$ 1,755,000.00$ 2,018,250.00$ 2,119,162.50$ 2,225,120.63$ 2,280,748.64$ 2,337,767.36$ 2,337,767.36$ 2,220,878.99$
Cost of good sold 60% -$ (390,000.00)$ (780,000.00)$ (1,053,000.00)$ (1,210,950.00)$ (1,271,497.50)$ (1,335,072.38)$ (1,368,449.18)$ (1,402,660.41)$ (1,402,660.41)$ (1,332,527.39)$
Gross Profit 40% -$ 260,000.00$ 520,000.00$ 702,000.00$ 807,300.00$ 847,665.00$ 890,048.25$ 912,299.46$ 935,106.94$ 935,106.94$ 888,351.60$
Operating Expenses
Maintenance costs 8% -$ (52,000.00)$ (104,000.00)$ (140,400.00)$ (161,460.00)$ (169,533.00)$ (178,009.65)$ (182,459.89)$ (187,021.39)$ (187,021.39)$ (177,670.32)$
Advertising costs 10% -$ (65,000.00)$ (130,000.00)$ (175,500.00)$ (201,825.00)$ (211,916.25)$ (222,512.06)$ (228,074.86)$ (233,776.74)$ (233,776.74)$ (222,087.90)$
Rent Expense -$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$
Incremental costs for U.S manager -$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$
Fish sauce -$ (22,500.00)$ (23,625.00)$ (24,806.25)$ (26,046.56)$ (27,348.89)$ (28,716.34)$ (30,152.15)$ (31,659.76)$ (33,242.75)$ (34,904.88)$
Depreciation costs -$ (45,000.00)$ (45,000.00)$ (45,000.00)$ (45,000.00)$ (45,000.00)$ (45,000.00)$ (45,000.00)$ (45,000.00)$ (45,000.00)$ (45,000.00)$
Sales of equipment 75,000.00$
Taxable income -$ 35,750.00$ 177,625.00$ 276,543.75$ 333,218.44$ 354,116.86$ 376,060.20$ 386,862.55$ 397,899.06$ 396,316.07$ 443,938.49$
Tax paid (35%) -$ (12,512.50)$ (62,168.75)$ (96,790.31)$ (116,626.45)$ (123,940.90)$ (131,621.07)$ (135,401.89)$ (139,264.67)$ (138,710.62)$ (155,378.47)$
Income after tax -$ 23,237.50$ 115,456.25$ 179,753.44$ 216,591.98$ 230,175.96$ 244,439.13$ 251,460.66$ 258,634.39$ 257,605.45$ 288,560.02$
Profit and Loss
Table 8. Pro Forma Profit and Loss statement of The Luxury
Adver
Cash flow statement 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Tax paid (35%) -$ (12,512.50)$ (62,168.75)$ (96,790.31)$ (116,626.45)$ (123,940.90)$ (131,621.07)$ (135,401.89)$ (139,264.67)$ (138,710.62)$ (155,378.47)$
Sales Revenue 100% -$ 650,000.00$ 1,300,000.00$ 1,755,000.00$ 2,018,250.00$ 2,119,162.50$ 2,225,120.63$ 2,280,748.64$ 2,337,767.36$ 2,337,767.36$ 2,220,878.99$
Labour costs 30% -$ (195,000.00)$ (390,000.00)$ (526,500.00)$ (605,475.00)$ (635,748.75)$ (667,536.19)$ (684,224.59)$ (701,330.21)$ (701,330.21)$ (666,263.70)$
Ingredients costs 30% -$ (195,000.00)$ (390,000.00)$ (526,500.00)$ (605,475.00)$ (635,748.75)$ (667,536.19)$ (684,224.59)$ (701,330.21)$ (701,330.21)$ (666,263.70)$
Maintenance costs 8.0% -$ (52,000.00)$ (104,000.00)$ (140,400.00)$ (161,460.00)$ (169,533.00)$ (178,009.65)$ (182,459.89)$ (187,021.39)$ (187,021.39)$ (177,670.32)$
Advertising costs 10% -$ (65,000.00)$ (130,000.00)$ (175,500.00)$ (201,825.00)$ (211,916.25)$ (222,512.06)$ (228,074.86)$ (233,776.74)$ (233,776.74)$ (222,087.90)$
Rent Expense -$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$ (30,000.00)$
Increment cost for U.S manager -$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$ (9,750.00)$
Fish sauce -$ (22,500.00)$ (23,625.00)$ (24,806.25)$ (26,046.56)$ (27,348.89)$ (28,716.34)$ (30,152.15)$ (31,659.76)$ (33,242.75)$ (34,904.88)$
Investment (850,000.00)$
Working capital (100,000.00)$
Sales of equipment 75,000.00$
Net cash flows (950,000.00)$ 68,237.50$ 160,456.25$ 224,753.44$ 261,591.98$ 275,175.96$ 289,439.13$ 296,460.66$ 303,634.39$ 302,605.45$ 333,560.02$
Table 9. Pro Forma Cash flow statement of The Luxury
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Business Finance – Group Report May 12, 2019
Cash flows
(950,000.00)$
68,237.50$
160,456.25$
224,753.44$
261,591.98$
275,175.96$
289,439.13$
296,460.66$
303,634.39$
302,605.45$
333,560.02$
Table 10. Net cash flows of the Luxury
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Business Finance – Group Report May 12, 2019
 Investment project 2: The Gem
Market research 500,000.00$
Additional costs
Costs of savings 30,000.00$ per annum (increase by 3%)
Speical mix of black pepper and salt 25,000.00$ Increase by 2.5% per year
Foreign manager (2 years) 72,000.00$ Increase by 5% per year With 5% annual cost-of-living allowance
Extra payment 10,000.00$
Annual travel expenses for manager 17,000.00$ Increase by 4% per year
Cost of equipment 750,000.00$
Depreciable assets 500,000.00$
Food processing installation 45,000.00$ Included in $750,000 investment
Book value of equipment -$
Sold price 5000000.00%
Working capital 40,000.00$
Income tax rate 35.00%
Summary table Notes
Table 11. Summary table of The Gem
- Depreciation costs = Cost price
Number of years = $ 500000
10 = $50000
- Incremental wage costs = Extra payment for foreign manager
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Business Finance – Group Report May 12, 2019
% of Sales 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Sales Revenue 100% -$ 625,000.00$ 1,187,500.00$ 1,721,875.00$ 1,894,062.50$ 1,988,765.63$ 2,088,203.91$ 2,150,850.02$ 2,193,867.02$ 2,215,805.69$ 2,105,015.41$
Labour costs 22% -$ (137,500.00)$ (261,250.00)$ (378,812.50)$ (416,693.75)$ (437,528.44)$ (459,404.86)$ (473,187.01)$ (482,650.75)$ (487,477.25)$ (463,103.39)$
Ingredients costs 38% -$ (237,500.00)$ (451,250.00)$ (654,312.50)$ (719,743.75)$ (755,730.94)$ (793,517.48)$ (817,323.01)$ (833,669.47)$ (842,006.16)$ (799,905.86)$
-$
Total Revenue 100% -$ 625,000.00$ 1,187,500.00$ 1,721,875.00$ 1,894,062.50$ 1,988,765.63$ 2,088,203.91$ 2,150,850.02$ 2,193,867.02$ 2,215,805.69$ 2,105,015.41$
Cost of good sold 60% -$ (375,000.00)$ (712,500.00)$ (1,033,125.00)$ (1,136,437.50)$ (1,193,259.38)$ (1,252,922.34)$ (1,290,510.01)$ (1,316,320.21)$ (1,329,483.42)$ (1,263,009.25)$
Gross Profit 40% -$ 250,000.00$ 475,000.00$ 688,750.00$ 757,625.00$ 795,506.25$ 835,281.56$ 860,340.01$ 877,546.81$ 886,322.28$ 842,006.16$
-$
Operating Expenses -$
Maintenance costs 5.5% -$ (34,375.00)$ (65,312.50)$ (94,703.13)$ (104,173.44)$ (109,382.11)$ (114,851.21)$ (118,296.75)$ (120,662.69)$ (121,869.31)$ (115,775.85)$
Advertising costs 9.5% -$ (59,375.00)$ (112,812.50)$ (163,578.13)$ (179,935.94)$ (188,932.73)$ (198,379.37)$ (204,330.75)$ (208,417.37)$ (210,501.54)$ (199,976.46)$
Rent Expense -$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$
Cost of savings -$ 30,000.00$ 30,900.00$ 31,827.00$ 32,781.81$ 33,765.26$ 34,778.22$ 35,821.57$ 36,896.22$ 38,003.10$ 39,143.20$
Mix of black pepper and salt -$ (25,000.00)$ (25,625.00)$ (26,265.63)$ (26,922.27)$ (27,595.32)$ (28,285.21)$ (28,992.34)$ (29,717.14)$ (30,460.07)$ (31,221.57)$
Increment costs for foreign manager (2 years) -$ (27,000.00)$ (27,680.00)$
Profit/Loss from Sales of Equipment -$ 50,000.00$
Depreciation costs -$ (50,000.00)$ (50,000.00)$ (50,000.00)$ (50,000.00)$ (50,000.00)$ (50,000.00)$ (50,000.00)$ (50,000.00)$ (50,000.00)$ (50,000.00)$
-$
Taxable income -$ 60,250.00$ 200,470.00$ 362,030.13$ 405,375.17$ 429,361.35$ 454,543.99$ 470,541.74$ 481,645.83$ 487,494.45$ 510,175.47$
Tax paid (35%) -$ (21,087.50)$ (70,164.50)$ (126,710.54)$ (141,881.31)$ (150,276.47)$ (159,090.40)$ (164,689.61)$ (168,576.04)$ (170,623.06)$ (178,561.42)$
Income after tax -$ 39,162.50$ 130,305.50$ 235,319.58$ 263,493.86$ 279,084.88$ 295,453.60$ 305,852.13$ 313,069.79$ 316,871.39$ 331,614.06$
Profit and Loss
Table 12. Pro Forma Profit and Loss statement of The Gem
Cash flow statement 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Tax paid (35%) (21,087.50)$ (70,164.50)$ (126,710.54)$ (141,881.31)$ (150,276.47)$ (159,090.40)$ (164,689.61)$ (168,576.04)$ (170,623.06)$ (178,561.42)$
Sales Revenue 100% 625,000.00$ 1,187,500.00$ 1,721,875.00$ 1,894,062.50$ 1,988,765.63$ 2,088,203.91$ 2,150,850.02$ 2,193,867.02$ 2,215,805.69$ 2,105,015.41$
Labour costs 22% (137,500.00)$ (261,250.00)$ (378,812.50)$ (416,693.75)$ (437,528.44)$ (459,404.86)$ (473,187.01)$ (482,650.75)$ (487,477.25)$ (463,103.39)$
Ingredients costs 38% (237,500.00)$ (451,250.00)$ (654,312.50)$ (719,743.75)$ (755,730.94)$ (793,517.48)$ (817,323.01)$ (833,669.47)$ (842,006.16)$ (799,905.86)$
Maintenance costs 5.5% (34,375.00)$ (65,312.50)$ (94,703.13)$ (104,173.44)$ (109,382.11)$ (114,851.21)$ (118,296.75)$ (120,662.69)$ (121,869.31)$ (115,775.85)$
Advertising costs 9.5% (59,375.00)$ (112,812.50)$ (163,578.13)$ (179,935.94)$ (188,932.73)$ (198,379.37)$ (204,330.75)$ (208,417.37)$ (210,501.54)$ (199,976.46)$
Rent Expense (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$ (24,000.00)$
Cost of savings 30,000.00$ 30,900.00$ 31,827.00$ 32,781.81$ 33,765.26$ 34,778.22$ 35,821.57$ 36,896.22$ 38,003.10$ 39,143.20$
Mix of black pepper and salt (25,000.00)$ (25,625.00)$ (26,265.63)$ (26,922.27)$ (27,595.32)$ (28,285.21)$ (28,992.34)$ (29,717.14)$ (30,460.07)$ (31,221.57)$
Increment costs for foreign manager (2 years) (27,000.00)$ (27,680.00)$
Profit/Loss from Sales of Equipment 50,000.00$
Investment (750,000.00)$
Working capital (40,000.00)$
Net cash flows (790,000.00)$ 89,162.50$ 180,305.50$ 285,319.58$ 313,493.86$ 329,084.88$ 345,453.60$ 355,852.13$ 363,069.79$ 366,871.39$ 381,614.06$
Table 13. Pro Forma Cash flow statement of The Gem
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Business Finance – Group Report May 12, 2019
Cash flows
(790,000.00)$
89,162.50$
180,305.50$
285,319.58$
313,493.86$
329,084.88$
345,453.60$
355,852.13$
363,069.79$
366,871.39$
381,614.06$
Table 14. Net Cash Flows of The Gem
Question 3: Calculate the Net Present Value, the Internal Rate of Return, The Effective Annual Amount (EAA)
and the Payback Period.
Adjusted WACC is the Required of Return on each investment = 6.13%
 Investment project 1: The Luxury
Payback Period
Year Cash flows Cumulative Cash flows Initial Outlay Payback Period
0 (950,000.00)$ (950,000.00)$ (950,000.00)$ 4.85
1 68,237.50$ (881,762.50)$
2 160,456.25$ (721,306.25)$
3 224,753.44$ (496,552.81)$
4 261,591.98$ (234,960.83)$
5 275,175.96$ 40,215.13$
6 289,439.13$ 329,654.26$
7 296,460.66$ 626,114.92$
8 303,634.39$ 929,749.31$
9 302,605.45$ 1,232,354.75$
10 333,560.02$ 1,565,914.77$
Project - The Luxury
Table 15. Payback Period of The Luxury
Payback period = the last period with negative cumulative cash flow (year 4) +
Cumulativenet cash flow at the end of year 4(absolute value)
Net cash flow of year5 = 4 + 234,960.83
275,175.96 = 4.85 (years)
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Business Finance – Group Report May 12, 2019
Year Cash flows Cumulative Cash flows Initial Outlay Payback Period
0 (950,000.00)$ (950,000.00)$ (950,000.00)$ 4.85
1 68,237.50$ (881,762.50)$
2 160,456.25$ (721,306.25)$
3 224,753.44$ (496,552.81)$
4 261,591.98$ (234,960.83)$
5 275,175.96$ 40,215.13$
6 289,439.13$ 329,654.26$
7 296,460.66$ 626,114.92$
8 303,634.39$ 929,749.31$
9 302,605.45$ 1,232,354.75$
10 333,560.02$ 1,565,914.77$
Project - The Luxury
Valuation Methods Rate of return
Payback Period 4.85 6.13%
Net Present Value 803,138.08$
Internal Rate of Return 19%
EAA 109,793.80$
Table 16. Internal Rate of Return, Net Present Value and Annualized Net Present Value (EAA) of The Luxury
Internal Rate of Return
Net Present Value
Annualized Net Present Value
Calculated using the formula of the present value of ordinary annuity
PV = PMT [ 1−(1+r )−n
r ]
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Business Finance – Group Report May 12, 2019
or NPV = EAA [ 1−(1+r )−n
r ]
$ 803,138.08 = EAA [ 1−(1+6.13 %)−10
6.13 % ]→ EAA =
803,138.08
[ 1−(1+6.13 % )−10
6.13 % ] = $ 109,793.80
All calculations of Payback Period, Internal Rate of Return, Net Present Value and Annualized Net Present
Value are performed in MS Excel.
 Investment project 2: The Gem
Payback period
Year Cash flows Cumulative Cash flows Initial Outlay Payback Period
0 (790,000.00)$ (790,000.00)$ (790,000.00)$ 3.75
1 89,162.50$ (700,837.50)$
2 180,305.50$ (520,532.00)$
3 285,319.58$ (235,212.42)$
4 313,493.86$ 78,281.44$
5 329,084.88$ 407,366.32$
6 345,453.60$ 752,819.91$
7 355,852.13$ 1,108,672.04$
8 363,069.79$ 1,471,741.83$
9 366,871.39$ 1,838,613.23$
10 381,614.06$ 2,220,227.28$
Project = The Gem
Table 17. Payback Period of The Gem
Payback period = the last period with negative cumulative cash flow (year 3) +
Cumulativecash flow at the end of year 3(absolute value)
Net cash flow of year 4 = 3 + 235,212.42
313,493.86 = 3.75 (years)
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Business Finance – Group Report May 12, 2019
Year Cash flows Cumulative Cash flows Initial Outlay Payback Period
0 (790,000.00)$ (790,000.00)$ (790,000.00)$ 3.75
1 89,162.50$ (700,837.50)$
2 180,305.50$ (520,532.00)$
3 285,319.58$ (235,212.42)$
4 313,493.86$ 78,281.44$
5 329,084.88$ 407,366.32$
6 345,453.60$ 752,819.91$
7 355,852.13$ 1,108,672.04$
8 363,069.79$ 1,471,741.83$
9 366,871.39$ 1,838,613.23$
10 381,614.06$ 2,220,227.28$
Project = The Gem
Valuation Methods Rate of return
Payback Period 3.75 6.13%
Net Present Value 1,311,505.14$
Internal Rate of Return 28%
EAA 179,290.64$
Table 18. Internal Rate of Return, Net Present Value and Annualized Net Present Value (EAA) of The Gem
Internal Rate of Return
Net Present Value
Annualized Net Present Value
Calculated using the formula of the present value of ordinary annuity
PV = PMT [ 1−(1+r )−n
r ]
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Business Finance – Group Report May 12, 2019
or NPV = EAA [ 1−(1+r )−n
r ]
$1,311,505.14 = EAA [ 1−(1+6.13 %)−10
6.13 % ]→ EAA =
$ 1,311,505.14
[ 1−(1+6.13 % )−10
6.13 % ] = $179,290.64
All calculations of Payback Period, Internal Rate of Return, Net Present Value and Annualized Net Present
Value are performed in MS Excel.
Question 4: Investment Selection
From the calculation of valuation methods, it is revealed that The Gem is the optimal option of investment for
Kellogg Company.
 Explanation:
 Net present value: According to Kenton (2018), net present value is the difference between the present
value of future cash outflows and the present value of future cash inflows. It is the best alternative in
capital budgeting and measuring the profitability of an investment project, as it takes into account the time
value of money and also works efficiently in the case of unknown project’s discount rate (Gallant 2018).
A positive net present value implies that the anticipated earnings generated from a project exceed the
anticipated costs. Higher net present value indicates that the investment can generate greater earning. Both
The Luxury and The Gem has positive net present value.. The Luxury project has a net present value of
£803,138.08, which is lower than The Gem project with net present value of £1,311,505.14. Hence, The
Gem can generate higher earnings.
 Payback period: According to Kagan (2019), payback period method refers to a length of time that
investment takes to generate positive cash flows which ‘pay back’ the initial investment. An investment is
attractive to investors and managers if it has shorter payback period. The Luxury has a longer payback
period (4.85 years) than The Gem (3.75 years). Therefore, The Gem is a better selection.
 Internal Rate of Return (IRR): According to Hayes (2019), the internal rate of return (the time-adjusted
rate of return) is the expected percentage of return on a firm’s capital investment projects. If IRR of a
project is greater than the benchmark rate, that project will be accepted. If IRR of a project is lower than
the benchmark rate, that project will be rejected. Projects with higher IRR are considered the best and
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Business Finance – Group Report May 12, 2019
should be undertaken. Both The Luxury and The Gem has its IRR greater than the benchmark. The
internal rate of return for The Luxury is 19%, which is lower than the internal rate of return for The Gem
(28%), hence, The Gem should be selected.
 Annualized Net Present Value (Equivalent Annual Amount): this is calculated using the annuity approach
to measure the constant cash flow generated from an investment project. Projects with a higher ANPV
should be undertaken. (Kagan 2019). The Luxury has lower Annualized Net Present Value ($109,793.80),
while The Gem has higher Annualized Net Present Value (£179,290.64). Appropriately, The Gem will be
chosen for investment.
Question 5: Asset pricing analysis and advice to the company
The relationship between risk and return has been a controversial topic for discussion and research. Investors and
investment managers seek financial models that quantify risk and translate that risk into estimates of expected
return on equity (Mullins, 1982). Below we will discuss about capital asset pricing model, country risk premium,
Fama French 3 factors and Fama French 5 factor model and their applications.
 Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAMP) represents financial markets price securities while determining expected
returns on capital investment (Mullins, 1982). CAMP assists investors to quantify risk and calculate expected
return on equity. The underlying concepts of CAPM and the associated efficient frontier can help investors
understand the relationship between expected risk and reward as they make better decisions about adding
securities to a portfolio.
The formula of CAPM
ERi = Expected return of investment
Rf = Risk-free rate (depend on time value of money)
βi = Beta of the investment (how much risk the investment will add to a portfolio)
ERm = Expected return of market
(ERm - Rf) = Market risk premium
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Business Finance – Group Report May 12, 2019
The CAPM applies the principles of Modern Portfolio Theory which is based on unrealistic assumptions about
investor behaviours, risk and return distributions and market fundamentals to indicate if a security is equally
valued (Kenton, 2019). Therefore, several errors exist in CAPM result. It is stated that the simple model is
deficient description of the movement of financial markets. Another issue is that betas are unstable through time
made difficulties in forecasting costs of equity in evaluating future cash flows from historical data (Mullins,
1982). CAPM also made mistakes in estimating future risk-free rate and expected return on the market.
 CAPM Model with Country Risk Premium (CRP)
Country Risk Premium (CRP) is the additional return or premium demanded by investors to compensate them for
the higher risk while investing overseas (Picardo, 2019). Investment in international market usually comes up
with more risk due to abundance of geopolitical and macroeconomic risk factors. CRP in developing countries are
higher than developed economies. Commentators usually apply a CRP on an asset pricing model (CAPM or other
models) to estimate investors’ required returns (Rogers, Wynn and Lun, 2018).
In ‘The Real Cost of Capital’, Ms. Spicer and Messrs Ogier & Rugman acclaimed: “…Standard financial
textbooks assume that all cash flow risks, including country risk, are dealt with by adjustment to forecast cash
flows, thus deriving true expected cash flows to which a CAPM-based cost of capital can be appropriately
applied. In practice, it is rarely the case that cash flows are adjusted for country risk, for the simple reason that it
is difficult for a manager of a particular business or investment to make an objective assessment of the probability
or impact of such risks. For this reason, in the real world many practitioners adopt the pragmatic approach of
adding a country risk premium (CRP) to a CAPM-based cost of capital in lieu of cash flow adjustment.” (Ogier,
Rugman and Spicer, 2004)
The CAPM can be adjusted with CRP to reflect the additional risk of international investing. Although, some
financial analysists argue that country risk is diversifiable, which means no additional rate should be charged
(Picardo, 2019). On the other hand, some investors agree on adjustments for possible negative events (political or
economic instability) within an economy would work well in estimating cash flows and come up with less errors
in calculation.
 Fama French 3 factor model
In 1993, Fama and French came up with the 3-factor model which was the expanse version of CAPM by adding
size risk and value risk factors to the market risk factor in CAPM. It was a significant improvement since the
CAPM; however, the 3-factor model could not interpret some anomalies nor the cross-sectional variation in
expected returns particularly related to profitability and investment (Raza, 2015).
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Business Finance – Group Report May 12, 2019
The formula of Fama French Model
Where:
● Rit is the total return of a stock or portfolio, i at time t;
● Rft is the risk free rate of return at time t;
● RMt is the total market portfolio return at time tl
● Rit - Rft is expected excess return;
● RMt - Rft is the excess return on the market portfolio (index);
● SMBt is the size premium (small minus big); and
● HMLt is the value premium (high minus low).
● β1,2,3 refer to the factor coefficients.
Fama and French quoted that investors must be able to ride out the extra short-term volatility and periodic
underperformance that could happen in a short time. On the other hand, investor with more tolerant toward long-
term investment (above 15 years) can be rewarded for losses suffered in the short term. After combining
thousands of random stock portfolio, the 3-factor model was said to interpret 95% of the return in a diversified
stock portfolio (Fama and French, 2014)
 Fama French 5 factor model
The Fama and French 5-factor model was brought up lately in 2014 in order to improve 3-factor model’s
insufficiency. Along with the original three factors, the new model adds on a factor of profitability and a factor of
investment (Fama and French, 2015). The result comes up with statistics of companies reporting higher future
earnings have higher returns in the stock market, as well as figures of internal investment and returns, suggesting
that companies directing profit towards major growth projects are likely to experience losses in the stock market
(Hayes, 2019).
This model concept proves that the value of a stock today depends on future dividends. Fama and French use the
dividend discount model to get statistics of investment and profitability (Fama and French, 2014).
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Business Finance – Group Report May 12, 2019
Formula of 5-factor Fama and Friench Model
 Conclusion
The five-factor model has yet to be proven as an improvement compared to previous models however it has left
room for further improving. Most investors still use the famous three-factor model as they prefer stick to the old
method. However, new methods seem to take some years before people start using, as industry people always
doubt, 5-factor model does come up with more accurate result. It has been proven that a five-factor model
directed at capturing the size, value, profitability, and investment patterns in average stock returns performs better
than the three-factor model in that it lessens the anomaly average returns left unexplained. Looking at the
practical work done and shown by Fama and French 5- factor model seems to be the best calculation for WACC
for investors to use the other factor models until this method proves itself in the empirical evidence.
 Advice on WACC to the parent company
WACC is a method used to reflect the capital structure of the company. Based on the research above, Fama
French five-factor model is considered to interpret the best results. As it takes into account more risk factors, this
may cause the cost of equity and the Weighted Average Cost of Capital to increase. Therefore, we advise the
company to revise their WACC using Fama French 5 factor model. This method will cover more risks confronted
pg. 28