LASA 2 Capital Budgeting Techniques

LASA 2— Capital Budgeting Techniques

FIN401: Financial Management

I Pierre Brown have been contracted by Wheel Industries as a financial consultant to evaluate their procedures involving the evaluation of long term investment opportunities. I 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, I have been asked to evaluate two projects, incorporating risk into the calculations.

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

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%.

I will provide some the formulas to determine the cost of new equity for the firm.

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?

Current dividend * (1 + growth rate) / [Current stock price *(1 – Flotation cost)] + growth rate

current dividend = 2.50, growth rate = 6%, current stock price = 50, flotation cost = 10%

$2.50 * (1.06) / [$50 * (1-10%)] + 6%

= 11.89%

The advantage of new equity is there is no pressure to repay equity financing. Also there is no pressure to pay dividend to shareholders whether or not company has profit.

Disadvantages of new equity weakening of possession and the controlling of higher costs of equity and the reduction of financial earnings.

At the 5% market rate I will be given the formula and solution for the after tax cost of debt.

1. 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?

After Tax Cost of Debt = Pre Tax Cost of Debt *(1-Marginal Tax Rate)

Pretax = .05, marginal tax = .35

=.05*(1-.35)

= 3.25%

Some of the advantages of debt financing are cost reduction, profit retention, financial leverage, and tax savings. Some of the disadvantages of debt financing are bankruptcy and the ability to lose future flexibility.

WACC = Wd*rD*(1-T) + We*rE

1. 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.

weight of debt = .30, cost of debt = 11.89 , weight of equity = .70 , cost of equity = 3.25

WACC =.70*11.89 + .30*3.25 = 9.298

= 9.3%

The NPV method wants you to determine whether or not to accept only if the rate is positive and that is the only way the company gains value.

Depreciation = asset

1. Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations.

Asset years

= 1,500,000/ 3

= 500,000

Calculation of cash flows:

Revenue 1,200,000

Less Cost 600,000

Less Depreciation 500,000

Profit – 100,000

Less taxes (35%) 100,000 * .35 = 35,000

Profit after taxes 65,000

Add depreciation 500,000

Cash after taxes 565,000

NPV = Present value of cash flows – Cash outlay

1. 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?

= 565,000 x PVIFA 6%, 3 years – 1,200,000

= 565,000 x 2.6730 – 1,200,000

= 1,510,245 – 1,200,000

= 310,245

The NPV is positive the project should be accepted.

565,000/ (1+r) ^1 + 565,000/ (1+r)^2 + 565,000/ (1+r)^3 $120,000 = 0

1. 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?

IRR = 19.48%

The project is acceptable according to the rule of the IRR, which s stated that the capital cost is higher than the WACC which also states that NPV should be positive.

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 for each project = $120,000 The IRR of the Project B is = 14.17% whereas the IRR of Project C = 20.57%. The NPV rule states a project is good for selection as long as the NPV of the project is positive. The IRR of the projects is greater than the WACC of 9.3% which means the projects will give positive NPV.

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.

discount rate = 8%

1. 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.

NPV of Project B is

= 31,000/(1+8%)^1+31,000/(1+8%)^2+31,000/(1+8%)^3 +31,000/(1+8%)^4 +31,000/ (1+8%)^5 +31,000/(1+8%)^6 120,000

=$23,309.27

NPV of Project C

= 36,600/(1+8%)^1+ 36,600/(1+8%)^2 + 36,600/(1+8%)^3 + 36,600/(1+8%)^4 + 36,600/(1+8%)^5 + 36,600/(1+8%)^6 120000

=$49,197.49|

Since both NPVs are positive they both would be accepted so the investment with the largest amount would usually be chosen which is project c.