Capital Budgeting Calculation ................................................................................................ ................................................................................................ 2 Analysis and Evaluation of the Investment Project Options .................................................... .................................................... 2 Recommendation ..........................................................................................................................2 Justification for the Recommendation Recommendation ............................................................................................3 ................................................................. ...........................3 Summary of Other Factors that Must be Considered in the Capital Budgeting Decision ....................4
Sources of Financing ....................................................... .......................................................................................................... ....................................................... .... 5 Description of Equity and Debt ................................................... .......................................................................................................5 ....................................................5 Cost of each Type Type of Financing .......................................................................................................6 ..................................................................... ..................................6 Effect on the WACC .................................................. ....................................................................................................... ......................................................................7 .................7 Effect on Current and Potential Stockholders Stockholders and Lenders ..............................................................7 ............................ ..................................7
Reference........................................................................................................ .............................................................................................................................. ...................... 9 Appendix................................................................................. ............................................................................................................................. ............................................ 10 A Capital Budgeting Calculation-Project Calculation-Project Aspire ................................................................ ......... .................................................................... ............. 10 B Capital Budgeting Calculation-Project Wolf ................................................................................ .......................................................................... ...... 11
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Capital Budgeting Calculation The calculations of the Net Present Value, Internal Rate of Return and Payback Period for both Projects is shown in Appendix A for Project Aspire and Appendix B for Project Wolf. The calculations are made directly using Microsoft Excel.
The first step in the calculation is the determination o f the Annual Cash Flows. The main difference in both projects is the fact that Project Aspire uses the Capital Cost Allowance and Project Wolf is depreciated. The latter project also has large annual cash inflows comp ared to the former project. We have discounted the annual cash flows using the current Weighted Average Cost of Capital (WACC) of the company which is 10%. In calculating the, we made use of the Microsoft Excel Formula IRR which automatically determines the IRR once the cash flows are entered as parameters.
The $120,000 spent on market research was not anymore included in the analysis because this is considered to be a sunk cost. It would not matter anymore regardless of what project AYR Co. will undertake.
Analysis and Evaluation of the Investment Project Options Recommendation A summary of the results is shown below:
Project Project Aspire Project Wolf
NPV $159,172 $838,145
Payback IRR Period 12.44% 3.25 22.90% 2.01
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Based from the foregoing results of our capital budgeting analysis it would appear that Project Wolf is more desirable than Project Aspire. It is therefore recommended that AYR Co. undertakes Project Wolf. A detailed discussion why we came up with this recommendation appears in the next section. Justification for the Recommendation
Our recommendation is to go for the Project Wolf for the following reasons. 1. Project Wolf has the highest Net Present Value between the two projects. The Net Present Value of a project is calculated by determining the net value of the project’s cash flows.
Since cash flows may expand to several years in the future and we are analyzing its value as of today determining its present value would be imperative to make meaningful anal ysis.
The project with the highest NPV is the project that will contribute more value to the company especially if the projects are mutually exclusive. For projects that are independent of each other one should chose the projects with positive NPV and the highest NPV as possible depending on the capital budget (Bierman and Smidt, 2007).
2. Under the IRR criterion it would also appear that Project Wolf is desirable. Under the IRR method, a project whose IRR is above the hurdle rate should be chosen. In this case, the hurdle rate is the 10% WACC. If the IRR is above the hurdle rate it would mean that the project would add value to the company. Although both projects have IRRs that are above the 10% hurdle rate, Project Wolf must be chosen since it has the highest IRR among the two projects. Our selection here also confirms what we have chosen in the first criteria
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because most often the two methods would select the same project. However, there are instances when the project chosen by the NPV Method is different from the one chosen b y the IRR method. This situation arises when there are differences in cash flow patterns like one project have higher cash flows in the earlier period compared to the other project or when there are unequal lives. To resolve the discrepancy, the project with the higher NPV must be chosen because the concept already incorporates reinvestment assumption and is more accurate and meaningful than the other method (Bierman and Smidt, 2007). 3. The Payback Period Method also chose Project Wolf because it would only take 2.01 years for AYR Co. to recoup its investments compared to 3.25 years in Project Aspire. The downside for this method is that it does not consider the time value of money concept unlike the first two method. Nonetheless, it can be used as a gauge to determine the desirability of project especially if the company is looking for investments that have fast turnaround times (Bierman and Smidt, 2007). Summary of Other Factors that Must be Considered in the Capital Budgeting Decision There are other factors that must be considered before coming up with the final decision of the project that should be undertaken. A summary of these factors is shown below:
1. The company needs to determine the type of financing that will be used to finance the project that will be chosen. The type of financing will have a significant role in the discount rate that would be chosen and there might be other costs that should be incorporated in the decision-making analysis.
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2. AYR Co. needs also to analyze the effect of the chosen project to the company’s existing products. There are instances when new products cannibalize the sales of the existing products. If this situation is present then it must be incorporated in the analysis. 3. The company needs to verify the figures that were chosen and used in the analysis. If these figures are erroneous then it might affect the decision that was chosen and the effects could be disastrous on the company. 4. AYR Co. needs to also determine if the project has an effect on how the company operates. It must determine whether the project to be taken is in lined with the corporate values, objectives and goals of the company. It also needs to assess how the project might affect its current operation and its impact to the environment. These things must be considered before coming up with the final decision.
Sources of Financing There are different types of financing available for a company. It can finance the company’s project with its own savings or retained earnings, borrow money from the bank or raise funds through the issuance of new shares. We will be discussing these types of financing in the succeeding parts these options. Description of Equity and Debt Equity Financing is simply the act of raising funds through the issuance of new shares by the company. If the company have shares which are not yet issued to the stockholders then it can issue them so that it can raise the funds needed to finance the chosen project. Furthermore, equity financing is not only limited to the issuance of common equity shares but may also include the issuance of preferred shares and share warrants. Once the shares are issued to stockholders, the latter would have an interest in the company and becomes part-owner together with the other
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stockholders. In return of the investment, the investee company would be declaring dividends to existing stockholders. Stockholder’s can also benefit from price appreciation over the years of the
equity shares that they have purchased (Helbæk, Lindset and McLellan, 2010). Debt Financing occurs when a company raises funds for working and capital requirements. The company can directly borrow money from banks and other lending institutions. It can also raise funds by issuing debt instruments likes bonds and notes that the public can purchase. In return of the investment, the company would be paying the creditors’ or debt instrument holders of the
principal amount plus periodic interests (Helbæk, Lindset and McLellan, 2010).
Cost of each Type of Financing
The cost of Equity Financing is more complex than the cost of Debt Financing. As a general rule, once a stockholder buys a share from a company, the latter is not anymore obliged to return the funds to the stockholder. However, the stockholder is expecting some forms of return in his/her investment in the company. A typical investor would expect that the company’s performance
would be good in the coming years and this would translate into higher dividend payments and higher stock prices. There are different methods of determining the cost of equity like the Capital Asset Pricing Model (CAPM). The CAPM utilizes the market return, the risk-free rate and the beta of the company to estimate the company’s cost of debt (Helbæk, Lindset and McLellan, 2010).
For Debt Financing the cost incurred by the borrower like AYR Co. is the periodic interest payment. This is the return that a lender is expecting to receive from the borrower in return for borrowing capital. For purposes of determining the cost of debt, the interest rate is usually made
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as reference. Since interest payments are tax deductible, the real cost of debt is calculated at n et of tax.
As a gener al proposition, the cost of equity is generally higher than the cost of debt. Stockholder’s take more risk in the company than outside lenders. For one, common stockholders only get what is left of the company after all creditors are paid. Interest payments are required by law to be paid regardless of the level of sales or income of the company otherwise it would be required to pay for penalties. A company is not required by law to declare dividends every now and then and may even opt not to declare dividends so that all earnings are plowed back to the company (Madura, 2017).
Effect on the WACC We have already mentioned that the cost of equity is generally higher than the cost of debt. If the company opts to finance the chosen project with Equity Financing then the WACC may increase considerably. If this situation arises then the company would have to re-assess the suitability of the projects given this change in the weighted average cost of capital. Conversely, if the company would go for Debt Financing then the WACC may reduce significantly but the company would have to consider interest payments in the calculation of the cash flows (Madura, 2017).
Effect on Current and Potential Stockholders and Lenders
Raising funds through Equity Financing does not have a direct impact on the profitability of the company. But since the company would have to issue new shares to the public, existing shareholders would be affected since this may result to the dilution of their interest in the company
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if they are not the one who will buy the shares to be issued. In terms of the company’s financial
statements, there would be a positive cash inflow from financing activities and an increase in the Stockholder’s Equity section of the Statement of Financial Position.
If funds are raised through Debt Financing then it would not dilute the ownership interest of existing stockholder’s but it would have a direct impact on the company’s profitability. It would drive the company’s net income because of the periodic interest payments. It would also make the
company riskier because of the higher debt balance. Borrowing money is usually attached with covenants that must be followed under the pain of penalties and sanctions. Regardless of the performance of the company it would still be required to pay for the period interest and the repayment of the capital borrowed. The company’s financial statements would show a positive cash flow from financing activities, an increase in the company’s total liabilities and a decrease in the company’s net income due to interest payments (Madura, 2017).
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Reference
Bierman, H. and Smidt, S. (2007). The capital budgeting decision. New York and London: Routledge. Helbæk, M., Lindset, S. and McLellan, B. (2010). Corporate finance. Maidenhead, Berkshire: Open University Press/McGraw-Hill Education. Madura, J. (2017). International financial management . US: Cengage Learning Custom Publication.
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Appendix A Capital Budgeting Calculation-Project Aspire PROJECT ASPIRE Year 0 Cash Inflows Variable Costs Capital Allowance EBIT Taxes (20%) Net Income Add: CCA Operating Cash flow Change in Net Working Capital
Year 1 $650,000 $27,000 $600,000 $23,000 $4,600 $18,400 $600,000
Year 2 $698,750 $28,823 $390,000 $279,928 $55,986 $223,942 $390,000
Year 3 $751,156 $30,768 $345,000 $375,388 $75,078 $300,311 $345,000
Year 4 $807,493 $32,845 $300,000 $474,648 $94,930 $379,718 $300,000
Year 5 $868,055 $35,062 $240,000 $592,993 $118,599 $474,394 $240,000
$618,400
$613,942
$645,311
$679,718
$714,394
$(140,000)
$140,000
Capital Spending
$(2,250,000)
Cash Flow
$(2,390,000)
$618,400
$613,942
$645,311
$679,718
$854,394
1.00
0.91
0.83
0.75
0.68
0.62
$(2,390,000)
$562,182
$507,390
$484,831
$464,257
$530,512
Discount Factor Present Value
YEAR 1.00 2.00 3.00 4.00 5.00
CASH FLOW $(2,390,000) $618,400 $613,942 $645,311 $679,718 $854,394
NET PRESENT VALUE IRR PAYBACK PERIOD
ACCUMULATED CASH FLOW $(2,390,000) $(1,771,600) $(1,157,658) $(512,347) $167,371 $1,021,766
$159,172 12.44% 3.25
years
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B Capital Budgeting Calculation-Project Wolf PROJECT WOLF Year 0
Year 1 $955,000 $14,400 $18,000
Year 2 $955,000 $15,480 $16,650
Year 3 $955,000 $16,641 $15,401
Year 4 $955,000 $17,889 $14,246
Year 5 $955,000 $19,231 $13,178
Cash Inflows Material Costs Other Expenses Foregone Rental Income Depreciation Expenses EBIT Taxes (20%) Net Income Add: Depreciation
$75,000
$75,000
$75,000
$75,000
$75,000
$375,000 $472,600 $94,520 $378,080 $375,000
$375,000 $472,870 $94,574 $378,296 $375,000
$375,000 $472,958 $94,592 $378,366 $375,000
$375,000 $472,865 $94,573 $378,292 $375,000
$375,000 $472,592 $94,518 $378,073 $375,000
Operating Cash flow
$753,080
$753,296
$753,366
$753,292
$753,073
Salvage Value Capital Spending
$(2,250,000)
Cash Flow
$(2,250,000)
$753,080
$753,296
$753,366
$753,292
$1,128,073
Discount Factor Present Value
1.00 $(2,250,000)
0.91 $684,618
0.83 $622,559
0.75 $566,015
0.68 $514,508
0.62 $700,445
YEAR 1.00 2.00 3.00 4.00 5.00
$375,000
CASH FLOW $(2,250,000) $753,080 $753,296 $753,366 $753,292 $1,128,073
ACCUMULATED CASH FLOW $(2,250,000) $(1,496,920) $(743,624) $9,742 $763,034 $1,891,107
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NET PRESENT VALUE IRR PAYBACK PERIOD
$838,145 22.90% 2.01
years
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