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Capital Budgeting Techniques

As a financial consultant, you have contracted with Wheel Industries to evaluate their procedures involving the evaluation of long term investment opportunities.  You have agreed to provide a detailed report illustrating the use of several techniques for evaluating capital projects including the weighted average cost of capital to the firm, the anticipated cash flows for the projects, and the methods used for project selection.  In addition, you have been asked to evaluate two projects, incorporating risk into the calculations.

You have also agreed to provide an 8-10 page report, in good form, with detailed explanation of your methodology, findings, and recommendations.

Company Information

Wheel Industries is considering a three-year expansion project, Project A.  The project requires an initial investment of $1.5 million. The project will use the straight-line depreciation method. The project has no salvage value. It is estimated that the project will generate additional revenues of $1.2 million per year before tax and has additional annual costs of $600,000.  The Marginal Tax rate is 35%.

Required:

  1. Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm?
  2. The firm is considering using debt in its capital structure. If the market rate of 5% is appropriate for debt of this kind, what is the after tax cost of debt for the company? What are the advantages and disadvantages of using this type of financing for the firm?
  3. The firm has decided on a capital structure consisting of 30% debt and 70% new common stock. Calculate the WACC and explain how it is used in the capital budgeting process.
  4. Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations.
  5. If the discount rate were 6 percent calculate the NPV of the project. Is this an economically acceptable project to undertake? Why or why not?
  6. Now calculate the IRR for the project. Is this an acceptable project? Why or why not? Is there a conflict between your answer to part C? Explain why or why not?

Wheel has two other possible investment opportunities, which are mutually exclusive, and independent of Investment A above.  Both investments will cost $120,000 and have a life of 6 years. The after tax cash flows are expected to be the same over the six year life for both projects, and the probabilities for each year's after tax cash flow is given in the table below.

Investment B

Investment C

Probability

After Tax 
Cash Flow

Probability

After Tax 
Cash Flow

0.25

$20,000

0.30

$22,000

0.50

  32,000

0.50

  40,000

0.25

  40,000

0.20

  50,000

  1. What is the expected value of each project’s annual after tax cash flow? Justify your answers and identify any conflicts between the IRR and the NPV and explain why these conflicts may occur.
  2. Assuming that the appropriate discount rate for projects of this risk level is 8%, what is the risk-adjusted NPV for each project? Which project, if either, should be selected? Justify your conclusions.

Analysis

The report provides a detailed knowledge about the application of different capital budgeting techniques, used for evaluating projects. It involves the evaluation of long term investment projects of Wheel industries, followed by the conclusion and recommendation.

Requirement A

Initial Investment ($ million)

1.5

Additional revenue before tax per year ($ million)

1.2

Additional annual cost ($)

600000

Tax rate

35%

Salvage Value

0

Depreciation expenses per year

500000

Life of the project

3 years

Calculation of new cost of equity

Dividend paid per share ($)

2.5

Growth rate

6%

Market price per share ($)

50

Flotation cost

10%

Dividend paid per share next year ($)

2.65

Ke (cost of equity)

11.89%

  • The business will earn the return and the investors can only realize their investment, if the business is performing well.
  • The capital can be used for business operations rather than utilizing it for debt financing (Porter & Norton, 2012). 
  • It helps in the growth and exploration of the organisation.

Demerits

  • The method is costly and time consuming.
  • More interference of the investors in the business (Business.qld.gov.au. 2017). 
  • Loss of power in making management decisions.

Marginal tax rate

35%

The pre-tax Cost of Debt

5%

After tax Cost of Debt

3.25%

Advantages of debt financing:

  • It allows to make the debt payments in instalments.
  • Firms can pay for new equipment, buildings and other assets required for growth of the business.
  • It does not require the surrendering of ownership or control of the business (qld.gov.au 2017).

Disadvantages:

  • Increase in the loan repayments along with the interests. Failed to do the same, can result in the acquiring of the company’s assets by the bank for recovery.
  • Over financing through debt can affect the future cash flows and growth.  
  • More debt makes the organization more risker from investor’s point of view (Ramadani & Hisrich, 2016).

Cost after tax

Weights

Weighted cost

Debt

Kd

3.25%

0.3

0.98%

Common Equity

Ke

11.89%

0.7

8.32%

WACC

9.30%

 
WACC helps in reflecting the change in cost of debt to asset ratio and assist the management in taking decisions regarding raising funds through debt or equity. In addition to this, by applying weights to these cost, company can develop an optimum capital structure for the business. It is also used as an investment tool by the analysts for evaluating and selecting investment proposals (Baker & English, 2011). 

Years

0

1

2

3

($)

($)

($)

($)

Initial Investment

-1500000

Revenue

1200000

1200000

1200000

Cost

-600000

-600000

-600000

Depreciation

-500000

-500000

-500000

Earnings before tax

100000

100000

100000

Tax provisions

35000

35000

35000

Earnings after tax

65000

65000

65000

Add: Depreciation

500000

500000

500000

Total cash flow after tax

-1500000

565000

565000

565000

Years

Cash inflow

pvf@6%

Present values

0

-1500000

1

-1500000

1

565000

0.943396226

533018.8679

2

565000

0.88999644

502847.9886

3

565000

0.839619283

474384.8949

NPV

10251.75

NPV basically shows the profitability of a project. Generally, the proposals having high and positive NPV are considered more desirable for investment purposes (Bierman & Smidt, 2012). The proposal of Wheel industries is economically acceptable because it has NPV of $10251.75, which is positive and reflects that the project will generate profits in the future.

Years

Cash inflow

0

-1500000

1

565000

2

565000

3

565000

IRR

6.37%

This project is acceptable because the IRR is 6.37% which more than the cost of capital of 6%. There is no conflict because the all the cash flows are normal and the IRR is compare to the cost of capital used for discounting the cash flows rather than with the WACC of the business.

Calculation of annual after tax cash flow

Investment B

Probability

After tax cash flow

Expected value

0.25

20000

5000

0.50

32000

16000

0.25

40000

10000

Annual after tax cash flow ($)

31000

Investment C

Probability

After tax cash flow

Expected value

0.3

22000

6600

0.5

40000

20000

0.2

50000

10000

Annual after tax cash flow ($)

36600

 
Expected annual after tax cash flow is calculated as follows:

Expected value = Sum of (probability*cash inflow after tax).

The same formula is applied for project C also. The annual cash flows for project B are $31000 and of Proposal C are $36,600. There will be no conflict between the IRR and NPV of the projects because both have same cash outflow and same years of life. Moreover, the cash inflows are also normal.

Calculation of NPV

Project B

Years

Cash flow

pvf@8%

Present values

0

-120000

1

-120000

1

31000

0.926

28703.70

2

31000

0.857

26577.50

3

31000

0.794

24608.80

4

31000

0.735

22785.93

5

31000

0.681

21098.08

6

31000

0.630

19535.26

NPV

23309.27

Project C

Years

Cash flow

pvf@8%

Present values

0

-120000

1

-120000

1

36600

0.926

33888.89

2

36600

0.857

31378.60

3

36600

0.794

29054.26

4

36600

0.735

26902.09

5

36600

0.681

24909.35

6

36600

0.630

23064.21

NPV

49197.40

Although both the projects has positive NPV but the one having high value of NPV will be accepted for the purpose of investment. Project C has NPV of $49,197.40 which is more than the NPV of proposal B that is $23309.27. So, according to the rule of Net Present Value, proposal C should be accepted (Fabozzi & Drake, 2009). 

Conclusion and Recommendation 

The above report concluded that, it is very necessary for the company to critically evaluate its investment opportunities by using appropriate capital budgeting techniques. It can also been seen from the report that Net Present Value method is the most suitable and used among the various methods. Wheel Industries has chosen project C than project B, because of its high NPV value.

References 

Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for today's investment projects (Vol. 13). (pp. 341-359). New Jersey: John Wiley & Sons. https://books.google.co.in/books?id=OzZGDgAAQBAJ&printsec=frontcover&dq=Baker,+H.+K.,+%26+English,+P.+(2011).+Capital+budgeting+valuation:+Financial+analysis+for+today%27s+investment+projects+(Vol.+13).+New+Jersey:+John+Wiley+%26+Sons.&hl=en&sa=X&ved=0ahUKEwi0weTirObZAhUTSI8KHW3SCYAQ6AEILTAB#v=onepage&q&f=false 

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. 9th ed. (pp. 53-54). New York: Routledge. https://books.google.co.in/books?id=1IPNXQmhzo8C&printsec=frontcover&dq=Bierman+Jr,+H.,+%26+Smidt,+S.+(2012).+The+capital+budgeting+decision:+economic+analysis+of+investment+projects.+9th+ed.+New+York:+Routledge.&hl=en&sa=X&ved=0ahUKEwitxI35rObZAhWCNo8KHfrSAm0Q6AEILTAB#v=onepage&q&f=false 

Business.qld.gov.au (2017). Equity finance. Business Queensland. Retrieved from https://www.business.qld.gov.au/starting-business/costs-finance-banking/funding-business/equity 

Business.qld.gov.au (2017) Debt finance. Business Queensland. Retrieved from https://www.business.qld.gov.au/starting-business/costs-finance-banking/funding-business/debt 

Fabozzi, F. J., & Drake, P. P. (2009). Finance: capital markets, financial management, and investment management (Vol. 178). (pp. 481-485). New Jersey: John Wiley & Sons. https://116.58.21.27/articles/0470407352%20Capital%20Market.pdf 

Porter, G. A., & Norton, C. L. (2007). Financial accounting: the impact on decision makers. 6th ed. (pp. 527). USA: Cengage Learning. https://books.google.co.in/books?id=Huo_Y5fcfHcC&printsec=frontcover&dq=Porter,+G.+A.,+%26+Norton,+C.+L.+(2012).+Financial+accounting:+the+impact+on+decision+makers.+10th+ed.+USA:+Cengage+Learning.&hl=en&sa=X&ved=0ahUKEwiN-YfArubZAhWHvY8KHXuNClwQ6AEILjAB#v=onepage&q&f=false 

Ramadani, V., & Hisrich, R. D. (2016). Effective Entrepreneurial Management: Strategy, Planning, Risk Management, and Organization. (pp. 117-127). Switzerland: Springer. https://books.google.co.in/books?id=vtjJDQAAQBAJ&printsec=frontcover&dq=Ramadani,+V.,+%26+Hisrich,+R.+D.+(2016).+Effective+Entrepreneurial+Management:+Strategy,+Planning,+Risk+Management,+and+Organization.+Switzerland:+Springer.&hl=en&sa=X&ved=0ahUKEwiWnJDhrubZAhWFilQKHSEUAO4Q6AEIJjAA#v=onepage&q&f=false 

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