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Weighted Average Cost Of Capital (WACC) Add in library

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Question:

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?
 
 

Answer:

Executive Summary

This report provides analysis for investment decision in Project A and investment choice between Project B and Project C. Method of analysis includes capital budgeting. Weighted average cost of capital is calculated including debt and equity form of financing. Discounting the project A with company’s cost of capital gives positive NPV. But with WACC of project financing NPV of project A is negative. Investment choice between Project B and Project C depends on expected cash flow as both the project has same life and same investment required. Project C has higher expected cash flow than Project B which makes project C as better investment choice. Report includes detailed calculation of WACC, anticipated cash flows, NPV and IRR for project A, B and C.

Analysis for Project A

A. Equity Financing

Theoretically cost of equity is return required by stock holders of company. Formula for calculating cost of equity is
 
Recent dividend is $2.50 and dividend growth is 6%. Dividend in first year would be $2.50 * (1+0.06) = $2.65
 
Currently stock is trading at $50 and flotation cost is 10%
 
Solving above formula with all inputs gives cost of equity 11.89%
 
Advantages:
 
Equity financing doesn’t require any fixed payment obligation to equity holder. Dividend rate is not fixed and cash can be used for better opportunity in business opportunity.
 
Equity financing doesn’t require any collateral or pledge. Existing assets remain unencumbered. Assets purchase with equity financing can be used to secure long term debt.
 
Equity share holders invest for long term horizon. Company has responsibility to give returns but not responsibility or obligation to generate immediate returns. So business which can’t generate immediate return or require relative long payback period may opt for equity financing.
 
Disadvantages:
 
As equity investment doesn’t guarantee any fixed return or dividend payment, investors expect more return than debt holders for the risk associated with equity.
 
Equity share holders have rights pertaining to selection of board of directors and major business decisions. Capital raised by equity dilutes the controlling rights of business with equity shareholders.
 
Investors has right to claim on cash flow after fulfillment of all disbursement when business sold out. They have right on cash flow in proportion of their investment


B. Debt Financing

Appropriate cost of debt is 5% for wheel industries. As tax advantage on debt financing brings down the cost of debt, cost of debt after tax will be = 5% * (1-0.35) = 3.25%
 
Advantages:
 
Control: Equity financing dilutes the controlling rights of business with share holders, but debt financing doesn’t dilute any controlling rights of business.
 
Simple Obligation: Debt financing has simple obligation of repayment of principal with terms and conditions. Once debt is paid, lender doesn’t have any obligation with business.
 
Tax advantage: Interest payment on debt is recorded as expense and hence it helps to save tax. As seen, debt with cost of 5% before tax has effective rate of 3.25% due to tax advantage
 
Budgeting: As loan payment requires fixed payment, it’s easy to prepare budget in advance precisely.
 
Disadvantages:
 
Fixed Payment: For new business and startup, it’s difficult to manage fixed obligation initially as business takes time to generate returns.
 
Credit rating: High debt on balance sheet is viewed as high risk. High risk rating makes additional debt (if raised) costlier
 
Collateral: long term debt financing requires collateral as guarantee of repayment of loan. If the loan gets default assets and personal collateral may get ceased which can stops ongoing business activities.

 

C. Weighted Average Cost of Capital

Firm has decided capital structure consisting of 30% debt and 70% common stock
 
Cost of common stock is 11.89%
 
Cost of debt before tax is 5%
 
Tax rate is 35%
 
WACC = Equity Proportion * Cost of Equity + Debt Proportion * Cost of Debt * (1-tax)

 = 0.70 * 11.89 + 0.30 * 0.05 * (1-0.35)

 = 9.30%

Use of WACC

WACC is widely used for project evaluation in business

When new project has similar risk profile like existing projects of company, WACC is used to discount such projects to decide between investment options

WACC is used as discount rate to find net present value (NPV) of cash flows.

WACC is used to calculate economic value added (EAV). WACC is cost of capital for project. EAC is calculated deducting cost of capital from profit of the company

WACC is also used for valuation of stock or company. Cash flows are projected for future years and discounted with WACC to find out present value of business, firm or stock.

D. After tax cash flow

Project A

Year 0

Year 1

Year 2

Year 3

Cash inflow

       

Additional revenue after tax

 

$780,000.00

$780,000.00

$780,000.00

Depreciation tax advantage

 

$175,000.00

$175,000.00

$175,000.00

Cash outflow

       

Initial investment

$1,500,000.00

     

Additional annual cost after tax

 

$390,000.00

$390,000.00

$390,000.00

Net cash flow

-$1,500,000.00

$565,000.00

$565,000.00

$565,000.00

 

Initial outlay is $1,500,000 (Investment)

Additional revenue after tax for 3 years is $1,200,000 * (1-0.35) = $780,000

Initial investment is depreciable on straight line method for 3 years

Depreciation each year = $1,500,000/3 = $500,000

Tax advantage on depreciation = $500,000 * 0.35 = $175,000

Additional annual cost after tax for 3 years is $600,000 * (1-0.35) = $390,000

Net cash flow for year 1, year 2 and year 3 is $565,000

E. NPV

Discount rate is 6%

Project A

Year 0

Year 1

Year 2

Year 3

Net cash flow

-$1,500,000.00

$565,000.00

$565,000.00

$565,000.00

Discount factor

1

0.94339623

0.88999644

0.83961928

Discounted Cash Flow

-$1,500,000.00

$533,018.87

$502,847.99

$474,384.89

NPV

$10,251.75

     

 

Discount factor = 1/(1 + 6%)^Year

Discounting cash flows with 6 % gives NPV of $10,251.75

As NPV is positive it’s financially feasible to undertake the project

Positive NPV shows project is generating $10,251.75 cash in present value after covering cost of capital

F. IRR

IRR for project is 6.37%
 
WACC for project is 9.30%
 
As WACC > IRR, it’s not financially feasible to undertake this project
 
It’s conflicting with earlier result when discount rate was taken 6% and NPV was positive for project A
 
With cost of capital 9.30%, NPV of project A is -$228,113
 
It’s not recommended to invest in project A with WACC of 9.30%

 

Analysis for Project B and Project C

A.    Cash flows

Project B

Probability

Cash Flow

Expected Cash flow

 

0.25

$20,000.00

$5,000.00

 

0.50

$32,000.00

$16,000.00

 

0.25

$40,000.00

$10,000.00

Expected Annual Cash flow from Project B

 

$31,000.00

 

Project C

Probability

Cash Flow

Expected Cash flow

 

0.30

$22,000.00

$6,600.00

 

0.50

$40,000.00

$20,000.00

 

0.20

$50,000.00

$10,000.00

Expected Annual Cash flow from Project C

 

$36,600.00

 

For project B, expected value of cash flow considering probabilities of different cash flows is $31,000

For project C, expected value of cash flow considering probabilities of different cash flows is $36,600

 

Project B

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Net cash flow

-$120,000.00

$31,000.00

$31,000.00

$31,000.00

$31,000.00

$31,000.00

$31,000.00

Discount factor

1

0.925925926

0.85733882

0.7938322

0.7350299

0.6805832

0.6301696

Discounted Cash Flow

-$120,000.00

$28,703.70

$26,577.50

$24,608.80

$22,785.93

$21,098.08

$19,535.26

NPV

$23,309.27

           

IRR

14.17%

           

 

Project C

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Net cash flow

-$120,000.00

$36,600.00

$36,600.00

$36,600.00

$36,600.00

$36,600.00

$36,600.00

Discount factor

1

0.925925926

0.85733882

0.7938322

0.7350299

0.6805832

0.6301696

Discounted Cash Flow

-$120,000.00

$33,888.89

$31,378.60

$29,054.26

$26,902.09

$24,909.35

$23,064.21

NPV

$49,197.40

           

IRR

20.57%

           

 

B.  Conflict between IRR and NPVs

Conflict between IRR and NPV occurs when project size is different and project life is different
 
It’s not correct to compare two projects with different investment requirement on NPV basis. Project with huge investment may have greater positive NPV, though IRR would marginally greater than cost of capital, than project with small investment but better IRR.
 
For example, Project A has initial investment of $1,000,000, WACC of 8%, IRR is 9% and NPV is $50,000
 
Project B has initial investment of $200,000, WACC of 8%, IRR is 12% and NPV is $20,000
 
Though NPV of project B is smaller but it’s better investment as investment is much less than project A and IRR is better to cost of capital
 
Other conflict with investment size is:
 
It’s difficult to generate higher IRR with larger project
 
As project size increases it’s difficult to maintain IRR as high as smaller project has
 
With increasing project size, efficiency of business activities goes down compare to smaller size and cost of financing also increases
 
Problem with IRR is it doesn’t give any concrete number in absolute term. IRR can be compared to other project but for standalone project it doesn’t reflect value addition to company

 

C. Investment Decision

Discounting cash flow with 8% project B gives NPV of $23,309 and Project C gives NPV of $49,197
 
IRR of project B is 14.47% and IRR of project C is 20.57%
 
As Project C has higher NPV and higher IRR also project C should be selected for investment

 

Recommendation

Wheel industries need to raise capital for financing of project A. Current cost of capital is 6% for ongoing projects. WACC for project A is 9.30%. Discounting project A with existing cost of capital gives positive NPV while discounting project A with WACC of financing it gives negative NPV. WACC of financing for Project A would be correct discount rate than using existing cost of capital of company. As with WACC of 9.30%, NPV is negative it’s not recommended to invest in Project A

Project B and Project C both have same investment and life. But expected annual cash flow of project C is higher than Project B. Discount rate for both the project is same which makes NPV of project C higher than Project B. It’s recommended to invest in Project C between project B and Project C.

 

References

lardbucket.org,. (2015). Weighted Average Cost of Capital (WACC). Retrieved 2 June 2015, from https://2012books.lardbucket.org/books/finance-for-managers/s12-05-weighted-average-cost-of-capit.html
 
Chuluun, T., Prevost, A., & Puthenpurackal, J. (2014). Board Ties and the Cost of Corporate Debt. Financial Management, 43(3), 533-568. doi:10.1111/fima.12047
 
CORDES, J., & SHEFFRIN, S. (1983). Estimating the Tax Advantage of Corporate Debt. The Journal Of Finance, 38(1), 95-105. doi:10.1111/j.1540-6261.1983.tb03628.x
 
Finance - Zacks,. (2015). Advantages & Disadvantages of Equity Capital. Retrieved 2 June 2015, from https://finance.zacks.com/advantages-disadvantages-equity-capital-4270.html
 
Folger, J. (2014). What is the formula for calculating weighted average cost of capital (WACC)?. Investopedia. Retrieved 2 June 2015, from https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp
 
Investopedia,. (2012). Cost Of Equity - Complete Guide To Corporate Finance | Investopedia. Retrieved 2 June 2015, from https://www.investopedia.com/walkthrough/corporate-finance/5/cost-capital/cost-equity.aspx
 
com,. (2015). Capital Structure - advantage, disadvantages, cost, Advantages and disadvantages of financing options. Retrieved 2 June 2015, from https://www.referenceforbusiness.com/small/Bo-Co/Capital-Structure.html
 
Sharma, M. (2012). Determining Volatility, Cost of Equity, and Equity Valuation of Private Business for M&A. Private Equity, 15(3), 102-105. doi:10.3905/jpe.2012.15.3.102
 
Velez-Pareja, I., & Tham, J. A Note on the Weighted Average Cost of Capital WACC. SSRN Journal. doi:10.2139/ssrn.254587
 
Weber, T. (2014). On the (non-)equivalence of IRR and NPV. Journal Of Mathematical Economics, 52, 25-39. doi:10.1016/j.jmateco.2014.03.006
 
Burger, P., & Hawkesworth, I. (2013). Capital budgeting and procurement practices. OECD Journal On Budgeting, 13(1), 57-104. doi:10.1787/budget-13-5k3w580lh1q7
 
Armitage, S. (2015). Discount rates for long-term projects: the cost of capital and social discount rate compared. The European Journal Of Finance, 1-20. doi:10.1080/1351847x.2015.1029591
 
Alcaraz, V. (2014). Should Practitioners (Continue to) Use a Single Discount Rate in Large-Scale Project Valuation?. Structured Finance, 20(2), 93-102. doi:10.3905/jsf.2014.20.2.093
 
Bas, E. (2013). A robust approach to the decision rules of NPV and IRR for simple projects. Applied Mathematics And Computation, 219(11), 5901-5908. doi:10.1016/j.amc.2012.12.031
 
Goel, S. (2015). Capital Budgeting. Business Expert Press.
 
Jury, T. (2012). Cash flow analysis and forecasting. West Sussex [England]: John Wiley & Sons.
 
org,. (2015). Chapter 6 - Investment decisions - Capital budgeting. Retrieved 2 June 2015, from https://www.fao.org/docrep/w4343e/w4343e07.htm
 
Investopedia,. (2012). Capital Budgeting: Capital Budgeting Decision Tools | Investopedia. Retrieved 2 June 2015, from https://www.investopedia.com/university/capital-budgeting/decision-tools.asp
 
edu,. (2015). Chapter 14. Retrieved 2 June 2015, from https://smccd.edu/accounts/nurre/online/chtr14.html
 
com,. (2015). Capital Budgeting. Retrieved 2 June 2015, from https://www.prenhall.com/divisions/bp/app/cfl/CB/CapitalBudgeting.html
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