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Scenario 1- Capital acquisition

Assume you are a manager in the Whizz Bang Corporation Ltd (WBC), a large organisation whose business is to manufacture and wholesale spare parts for heavy transport motor vehicles. This assessment presents you with three hypothetical scenarios that you are required to respond to. You must address all three scenarios and incorporate your answers into a single cohesive report that would be suitable for submission to senior management.

Capital Acquisitions One of your team members provides you with a request seeking your approval to replace an expensive worn-out piece of equipment. As it is a replacement, very few details to support the request is provided as the staff member automatically presumes your approval. In the past, your predecessor had approved all such requests, without further information.


Required

Discuss this scenario, In particular describing what information you should require before you approve the release of capital funds for such a request, and why you would require that information.

Project Proposal You have identified a potential opportunity (or WBC, which Involves undertaking a project that will have a ten-year life. The project requires an initial purchase of equipment and furniture totalling 54,500,000, plus ancillary programming capability and machinery costing 51,500,000. The equipment and furniture will depreciate and have a salvage value of $500,000 at the end of the project's life, and the programing machinery will have nil salvage value at the end of the project's life. Depredation is calculated on a straight-line basis over five years.

Information related to the project is as follows:

• Sales will be $3,050,000. $4,000.000 and $5.000.000 respectively In each of the first three years of operation. expected to grow at 10 per cent per annum for a further four years thereafter, and then settle to a growth of per cent per annum indefinitcdy thereafter. In the event of not undertaking this project. all of this income would be lost.

• Variable costs associated with the project will be 65 per cent of sales.

• Fixed costs associated with the project will be $400,000 In the first year and expected to grow at 5 per cent per annum thereafter.

• Even though this project will not add additional expenses to head office, WBC has a policy of allocating Chead office' charge of $200,000 a year to each male project

• Research for this project and its capabifity was conducted during the previous year at a cost of $300.000. It yielded valuable information.

• The corporate tax rate is 30 per cent.

• Financiers of this type and risk In this Industry are presently requiring a rate 0112 per cent alter corporate tax.


In order to undertake this propel. WBC is considering various financing options. One option le to borrowing 35,000,060 at 7 per cent per annum. This loan will be paid off in 10 equal annual instalments.

Required


Evaluate this project, and provide a report to WBC management discussing whether or not you recommend 4 should undertake the project providing a full explanation of your recommendation. As support for your recommendation ensure your answer Includes the following: • Calculations of the NPV, IRR and the payback for the project and an analysis of the results. • Justification for the correct discount rate to be used in evaluating the project • Your assessment of the advantages and disadvantages of each methodology (NPV, IRR and payback), and which you therefore recommend is applied to evaluate this Protect • Details of any other (financial and non-financial) matters you would consider before making a recommendation In respect of this project

Project Financing WBC is currently financed using debt and equity with a targeted debt to equity ratio of one (D/E e 1). Its debt financing Is from three sources. overdraft, bank bills and debentures, with the ratio of overdraft to bank bills to debentures of 1:2:3. Its equity Is ordinary shares. These ratios represent the longterm capital structure target for WBC. The debenture pays an annual coupon of 12 per cent per annum on its $1,000 face value. The remaining term of the debenture Is six years. The debenture is currency priced $922.23. The bank bills issued by WOG are ninety-day bills, with a face value of $100,000 and are currently priced at 397,593.58. The bank overdraft rate is 1 per cent per annum above the bank bill rate. The ordinary shares sell for $8.00. The projected dividend for year one is $1.10. Dividends are expected to grow at 8 per cent per annum indefinitely.


Required

Calculate the Weighted Average Cost of Capital (WACC) for WBC. assuming a tax rate of 30 per cent. Hint this requires a calculation of the effective annual cost for each source of finance.

Scenario 1- Capital acquisition

This report can be considered as a management report as it has been described in various activities that the business manager is required to conduct during the production of goods and services. Capital financing is one of the most essential parts of business management as it helps in providing cost efficient to the source of financing for business operations. It is very important that overall benefits achieved through capital financing are exceeding the overall cost of capital. This report will discuss critical information that will be required in making capital acquisition decisions according to a given scenario. This report will also use different capital appraisal techniques for evaluating the financial viability of a particular project presented such as net present value, payback period method and internal rate of return (Peirson et.al, 2014). In addition to that theoretical aspect of this method will also be discussed in this report. At last cost of capital for a particular scenario will be calculated which is called a weighted average cost of capital. The main objective of this report is to evaluate the practical and theoretical aspects of capital financing.

In the given scenario a request of replacing a particular part of the equipment is presented. The details provided in relation to spare part and reason for replacement is very limited as the team member is assuming that the request will be approved automatically. This type of practices was very common before the predecessor was in-charge of equipment acquisition. This type of practice can be very harmful for the financial position of the company (Lengu, Syntetos and Babai, 2014). It is important that proper requisition is made in case there is a requirement for new equipment or part of the equipment. Machinery used in business organizations are very costly and it is important to conduct financial viability analysis before making any decision in relation to such equipment. Following are some of the information that should be provided by a team member before making replacement request for part of equipment-

Details of the spare part

First and foremost detailed information in relation to a spare part should be provided by the team member. This information should include details in relation to model number, nature of machinery, the procedure of machinery, the name of the manufacturer, expected cost etc. This type of information is necessary because this information will be helpful in making sure that spare part of the machinery is still available in the market. This information will also be helpful in case manager is required to make inquiries in relation to price and quality of the spare part (Hu et.al, 2018).

Scenario 2- Project proposal

The expected life of the machinery

It is already discussed to that the cost of spare parts in machinery can be very expensive, therefore it is important to evaluate whether it would be more efficient to purchase new machinery or to replace the spare part. For example, if the life of the machinery is only one year then it would not be very beneficial for the organization to purchase very costly spare part of such machinery (Gu, 2013). Instead, management of the company can purchase new machinery which would have a new life as a company has to incur this cost next year. In such scenario the expenditure incurred by the company on purchase of spare part will be of no beneficial value as the spare part will have no use in the business and resale value would not be able to cover the overall cost of the spare part (Driessen et.al, 2015). Identifying the expected life of messenger will also help in making decisions in relation to purchasing of a new spare part or second-hand spare part as second-hand spare part can be very helpful if the life of machinery is limited.

Reason of replacement

It is also important for a manager to understand the reason for which the spare part is being replaced. Understanding this reason will helpful for future references. For example, if machinery is worn out due to overloading of machinery then the manager should evaluate whether the purchase of new machinery will be a viable option or not. In addition to that the manager of the company can also evaluate whether the maintenance procedures adopted by the company have any benefits on the machinery and equipment or not (Van Houtum and Kranenburg, 2015).

Formal requisition letter

It is also important for a team member to present a formal requisition letter for making a request in relation to the purchase of spare part. It is important for management to maintain proper documentation in relation to each and every spare part required for plant and machinery. This type of documentation is very important as it helps business managers in the future. It is not essential that same business manager will continue in a particular organization for an indefinite period of time (Cordes and Hellingrath, 2014). Therefore this documentation will help the next manager to take effective and efficient decision in relation to spare part management.

A. NPV, IRR and Payback period

Scenario 3- Project financing

Statement showing net cash inflow from the proposed project-

Particular

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

Cash outflow

Furniture and equipment

4500000

Machinery

1500000

Research and development cost

300000

Principal payment

361887

387219

414325

443327

474360

507565

543095

581112

621790

665315

Total outflow

6300000

361887

387219

414325

443327

474360

507565

543095

581112

621790

665315

Cash inflow

Salvage value

500000

Cash inflow from operations (WN1)

0

117500

455333

811438

993391

1193772

990091

1160142

1257668

1360603

1469254

Total inflow

0

117500

455333

811438

993391

1693772

990091

1160142

1257668

1360603

1469254

Net inflow

-6300000

-244387

68114

397113

550064

1219412

482526

617047

676556

738813

803939

PVF@12%

1

0.893

0.797

0.712

0.636

0.567

0.507

0.452

0.404

0.361

0.322

PV of net inflow

-6300000

-218238

54287

282744

349841

691406

244641

278905

273329

266712

258868

WN 1- Statement showing net cash flow from operations  

Statement of expected profit

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

Sales

3050000

4000000

5000000

5500000

6050000

6655000

7320500

7686525

8070851

8474394

Variable cost (65% of sales)

1982500

2600000

3250000

3575000

3932500

4325750

4758325

4996241

5246053

5508356

Fixed cost

400000

420000

441000

463050

486203

510513

536038

562840

590982

620531

Allocated expense

200000

200000

200000

200000

200000

200000

200000

200000

200000

200000

Interest cost

350000

324667

297562

268559

237526

204321

168791

130775

90097

46572

Depreciation

1100000

1100000

1100000

1100000

1100000

Total cost

4032500

4644667

5288562

5606609

5956229

5240584

5663154

5889856

6127132

6375459

Net profit

-982500

-644667

-288562

-106609

93772

1414416

1657346

1796669

1943719

2098935

Tax @ 30%

424325

497204

539001

583116

629680

NPAT

-982500

-644667

-288562

-106609

93772

990091

1160142

1257668

1360603

1469254

(+) Depreciation

1100000

1100000

1100000

1100000

1100000

0

0

0

0

0

Cash inflow

117500

455333

811438

993391

1193772

990091

1160142

1257668

1360603

1469254

Statement showing NPV, IRR and Payback period

Particular

Rate/ Amount

NPV

-3817504

IRR

-2%

Payback period

-

On the basis of this calculation, it can be said that this project should not be accepted by the company as it has negative NPV and IRR. In addition to that 0 payback period shows that the company would not be able to recover the initial cost of investment during the life of the project (Gotze, Northcott and Schuster, 2016).   

It is provided in the case scenario that currently financiers are using the rate of 12% after corporate tax for the purpose of calculating net present value. It can be said that it is the correct rate after evaluating the business scenario under consideration. It is important for management to use correct and market relevant discount rate for the purpose of evaluating the present value of cash inflow and outflow. Correct discount rate helps in including the concept of time value of money in the project appraisal method which is one of the most important to the method while calculating the financial viability of a project. It is not possible that the current value of money will remain the same in future as the value of money decreases constantly due to inflation (Baum and Crosby, 2014). If the present value of cash inflows and outflows is calculated with the help of wrong discount rate then there is a probability that decisions made will have a negative impact on the overall financial performance of the company in future.

Net present value method

This is a method in which the present value of net cash inflow is calculated by subtracting the net present value of cash outflow from the net present value of cash inflow. This method helps in estimating the overall cash to be generated from a proposed project.

Advantages- the Main advantage of this method is that it is very simple to calculate and analysis of the result is also very simple. This method also considers the concept of the time value of money which is one of the most essential concepts while calculating the financial viability of a project that will be happening in future. A final advantage of this method is that it considers both of the important aspects in investment appraisal i.e. risk and cost of capital through the use of discounted rate (Aggarwal and Thakur, 2013).

Disadvantage- This method is based on various assumptions and wrong assumptions can result in a negative impact on the business organization and project. For example, the wrong estimation of a discounted rate or expected revenue can have a significant impact on the decision taken.

Payback period method

This method helps in estimating the time that will be taken by a particular project in recovering its overall initial cost.

Advantages- the Main advantage of this method is that it is very simple to calculate and can be calculated without the help of any professional. This method gives more importance to the liquidity position of a particular project what is essential for the generation of cash. This method can be very helpful in the initial screening of numerous projects.

Disadvantages- Main and primary disadvantage of this method is that it does not consider the time value of money (Ghahremani, Aghaie and Abedzadeh, 2012). This project is generally not used by business managers to evaluate the financial viability of the project due to its inconclusive results in certain cases.

The internal rate of return

This method calculates a rate of return that will be provided by a particular project and then such rate is compared with the overall cost of capital to make decisions in relation to financial viability.

Advantages- This method also considers the concept of the time value of money which is its one of while evaluating the rate of return. With the help of this method, comparison can be made with the cost of capital of the company that will help in understanding whether a search project will be financially viable in the future or not (Finnerty, 2013).

Disadvantages- Calculation of this internal rate of return where is very complex as it is based on various assumptions and wrong assumptions can lead to wrong decision making. Type of method will not be usable in identifying the financial viability of mutually exclusive projects.

Change management

It is important to evaluate whether current business processes of the organization will be able to handle the new project or not. In case current resources are not sufficient then management to should you decide whether it would be financially viable to employer new resources or not.

Market consideration

The business market is very dynamic and preference of consumers changes on a regular basis. In such a dynamic environment, it is important that business organization considers the viability of the project in the future by evaluating trends and preferences of the customer.

Legal obligations

This is a non-financial factor that should be considered as a business organization should perform within the legal framework applicable to such business organization. Therefore management should evaluate whether the new project is allowable according to the legislature is applicable.

A. Calculation of WACC

Debt to capital ratio is 1:1

Cost of debt

Debentures- rate of debenture (1-tax rate) (Frank and Shen, 2016).

= 12 (1-.30)

= 8.4%

Bank bills

{(Face value- current value) face value}* 360/90

=   .096 or 9.6%

Bank overdraft= One percent above bank bill i.e. 10.6% (1+9.6)

Overall cost of debt (Ratio of overdraft to bank bill to debenture is 1:2:3)

Therefore, cost of debt-

= {(10.6*1) + (9.6*2) + (8.4*3)}/ 6

= 9.166%

Cost of equity

= Ke = (D1 / P0) + g

Here Ke is cost of equity, D1 dividend to be paid in net year, P0 is current price of equity share and g is dividend growth rate.

= {(1.10+ 6%)/ 8} + 6%

= 6.1457%

Weighted Average Cost of Capital (WACC)

= {(Cost of equity* weight of equity) + (cost of debt* weight of debt)}/ combined weight of debt and equity (Hann, Ogneva and Ozbas, 2013).

= (9.166*1) + (6.1457*1)/ 2

= 7.6558%

Therefore WACC of WBC is 7.6558%.   

There are various sources of financing available in the market and cost associated with each of such resources different from each other. Cost of capital is totally dependent on the risk associated with such capital. For example the cost of debt, capital is lower as compared to equity capital because the risk associated in debt capital is limited. The weighted average cost of capital helps in identifying the overall cost of capital employed in a business organization.

This method can be used in the given scenario because the capital of the company is the composition of the different type of capital i.e. debt and equity. In addition to that, that capital of the company is also the composition of three different types of debt instruments i.e. overdraft bank, bank bill, and debentures. For the evaluation of any project, it is important to calculate the cost of capital to compare it with the rate of return that will be provided by such project. The rate of return of a particular project cannot be compared with each and every capital of the company separately. Therefore it is important to calculate a particular rate of return that will represent the overall cost of capital. It can be said that in the given scenario calculation of the weighted average cost of capital will be a viable option (Hou, Van Dijk and Zhang, 2012).

The weighted average cost of capital cannot be used in each and every situation and some of the limitations of this method are as follows-

  • This method should not be used when the cost of capital is changing on a constant basis as it will result in the wrong calculation of the cost of capital.
  • This method also cannot be used in situations where the market rate of capital is not available.
  • Evaluation of financial viability with the help of this method becomes very difficult when the expected internal rate of return in a particular project is not available.

Conclusion

It can be concluded that selection of an effective and efficient to the source of financing for a business organization is very important. In addition to that, it is also important to evaluate the financial viability of a particular project before integration of such project in the organization. Any new project started by the organization requires a large amount of resources and failure of the project can result in a significant negative impact on the overall performance of the organization. This report has described the various aspects of project financial management. It is important that business managers should consider all the calculations provided in this project before making any decisions in relation to the given scenario.

References 

Aggarwal, A. and Thakur, G.S.M., 2013. Techniques of performance appraisal-a review. International Journal of Engineering and Advanced Technology (IJEAT), 2(3), pp.617-621.

Baum, A.E. and Crosby, N., 2014. Property investment appraisal. John Wiley & Sons.

Cordes, A.K. and Hellingrath, B., 2014, July. Conceptual approach for integrating tactical spare parts inventory management and transport planning. In Industrial Informatics (INDIN), 2014 12th IEEE International Conference on (pp. 548-553). IEEE.

Driessen, M., Arts, J., van Houtum, G.J., Rustenburg, J.W. and Huisman, B., 2015. Maintenance spare parts planning and control: a framework for control and agenda for future research. Production Planning & Control, 26(5), pp.407-426.

Finnerty, J.D., 2013. Project financing: Asset-based financial engineering. John Wiley & Sons.

Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), pp.300-315.

Ghahremani, M., Aghaie, A. and Abedzadeh, M., 2012. Capital budgeting technique selection through four decades: with a great focus on real option. International Journal of Business and Management, 7(17), p.98.

Gotze, U., Northcott, D. and Schuster, P., 2016. INVESTMENT APPRAISAL. SPRINGER-VERLAG BERLIN AN.

Gu, J., 2013. Proactive and Efficient Spare Parts Inventory Management Policies Considering Reliability Issues.

Hann, R.N., Ogneva, M. and Ozbas, O., 2013. Corporate diversification and the cost of capital. The journal of finance, 68(5), pp.1961-1999.

Hou, K., Van Dijk, M.A. and Zhang, Y., 2012. The implied cost of capital: A new approach. Journal of Accounting and Economics, 53(3), pp.504-526.

Hu, Q., Boylan, J.E., Chen, H. and Labib, A., 2018. OR in spare parts management: A review. European Journal of Operational Research, 266(2), pp.395-414.

Lengu, D., Syntetos, A.A. and Babai, M.Z., 2014. Spare parts management: Linking distributional assumptions to demand classification. European Journal of Operational Research, 235(3), pp.624-635.

Peirson, G., Brown, R., Easton, S. and Howard, P., 2014. Business finance. McGraw-Hill Education Australia.

Van Houtum, G.J. and Kranenburg, B., 2015. Spare parts inventory control under system availability constraints (Vol. 227). Springer.

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