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% * (10.35) = 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 * (1tax)
= 0.70 * 11.89 + 0.30 * 0.05 * (10.35)
= 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 * (10.35) = $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 * (10.35) = $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.
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