Assignment 1 Las 2 Capital Budgeting Techniques As A Finance

Assignment 1 Lasa 2capital Budgeting Techniquesas A Financial Cons

Evaluate the procedures involving long-term investment opportunities at Wheel Industries, including the use of capital budgeting techniques such as net present value (NPV), internal rate of return (IRR), weighted average cost of capital (WACC), and risk analysis. Provide a comprehensive report covering the calculation of the cost of new equity, cost of debt, WACC, cash flow estimations, project evaluations, and recommendations for project acceptance based on financial criteria.

Specifically, include calculations for the cost of new equity using dividend growth models, the after-tax cost of debt at market rate, the calculation and application of WACC in capital budgeting, estimation of annual cash flows from the project, NPV at different discount rates, IRR evaluation, expected cash flows for alternative projects with probability assessments, risk-adjusted NPV calculations, and final project choices. Also, analyze advantages and disadvantages of financing methods, interpret potential conflicts between IRR and NPV, and incorporate risk considerations into project evaluation.

Paper For Above instruction

Introduction

Capital budgeting is a critical aspect of financial management that involves evaluating and selecting long-term investment projects that align with a firm’s strategic goals and financial capacity. The processes encompassing this evaluation include calculating the cost of capital, assessing potential cash flows, and applying various investment appraisal techniques such as Net Present Value (NPV) and Internal Rate of Return (IRR). This paper adopts a comprehensive approach to examining these techniques within the context of Wheel Industries’ proposed expansion project and other potential investments. It emphasizes the importance of risk analysis and the integration of different financing options to optimize the firm's capital structure.

Cost of New Equity

The cost of equity capital is a fundamental component of the WACC, representing the return required by investors to hold the company's equity. Using the dividend growth model, the cost of new equity (re) is calculated based on the current dividend, expected growth rate, stock price, and flotation costs. The dividend is given as $2.50, and it is expected to grow at 6% annually. The current stock price is $50, with a 10% flotation cost.

Re = [(Dividend per share / Net issuance price)] + Growth rate

Net issuance price = Stock price - Flotation costs

Net price = $50 - (10% of $50) = $50 - $5 = $45

Re = [($2.50 * (1 + 0.06)) / $45] + 0.06 ≈ [($2.65) / $45] + 0.06 ≈ 0.0589 + 0.06 = 0.1189 or 11.89%

Advantages of using this financing method include its simplicity and reflection of current market conditions, while disadvantages involve its sensitivity to assumptions about growth rates and market volatility.

Cost of Debt and Its Implications

The after-tax cost of debt is calculated considering the market rate of 5% and the corporate tax rate of 35%:

After-tax cost of debt, rd = Market rate (1 - Tax rate) = 0.05 (1 - 0.35) = 0.05 * 0.65 = 3.25%

Advantages of debt financing include tax deductibility of interest expenses and lower cost relative to equity. Disadvantages encompass increased financial risk, potential for bankruptcy, and restrictive covenants.

Weighted Average Cost of Capital (WACC)

Given the targeted capital structure of 30% debt and 70% equity, WACC is calculated as:

WACC = (E/V) Re + (D/V) Rd * (1 - Tax rate)

V = Total value = Equity + Debt

WACC = (0.70 11.89%) + (0.30 3.25%) = 8.323% + 0.975% = 9.298%, approximately 9.30%

This rate is utilized as the discount rate in capital budgeting to evaluate project viability, reflecting the opportunity cost of capital considering the firm's mix of financing sources.

Estimating Cash Flows

The project’s annual cash flows are determined by revenues, costs, depreciation, and taxes. The incremental revenue is $1.2 million, with costs of $600,000, resulting in pre-tax operating income of $600,000 annually.

Depreciation expense per year (straight-line over 3 years):

Depreciation = Initial Investment / Useful life = $1,500,000 / 3 = $500,000 per year

Taxable income = Operating income - Depreciation = $600,000 - $500,000 = $100,000

Tax = 35% of $100,000 = $35,000

Net income = $100,000 - $35,000 = $65,000

Cash flow = Net income + Depreciation = $65,000 + $500,000 = $565,000 per year

This method, known as the Operating Cash Flow approach, accounts for non-cash depreciation expenses.

NPV Calculation at Different Discount Rates

Using the calculated cash flows and discount rates, the NPV at 6% is computed as:

NPV = Σ (Cash flow in Year t) / (1 + discount rate)^t - Initial Investment

Plugging in the numbers:

NPV = $565,000 * [1 - (1 + 0.06)^(-3)] / 0.06 - $1,500,000

NPV ≈ $565,000 * 2.673 - $1,500,000 ≈ $1,510,245 - $1,500,000 = $10,245

A positive NPV suggests the project is economically viable at a 6% discount rate.

IRR Calculation and Project Acceptance

The IRR is found by solving for the discount rate where NPV equals zero. Using financial calculator or Excel's IRR function with cash flows:

Year 0: -$1,500,000

Years 1-3: $565,000

The IRR approximates to about 6.5%. Since IRR exceeds the WACC of 9.30%, the project appears attractive, but typically, the IRR should be compared directly to the discount rate; in this case, because IRR is lower than the WACC, the project would be deemed not acceptable. Clarification may require re-calculating or considering the project’s, benchmarks.

Evaluation of Other Projects

Projects B and C each costing $120,000 with 6-year horizons, similar cash flow structures, and probabilistic cash flows are analyzed. The expected value of cash flows is derived by:

Expected cash flow = Σ (Probability * Cash flow)

For example, for Project B:

Expected cash flow = 0.25 $20,000 + 0.75 $22,000 = $5,000 + $16,500 = $21,500

Similarly for Project C:

Expected cash flow = 0.30 $22,000 + 0.70 $24,000 = $6,600 + $16,800 = $23,400

These expected values inform future risk-adjusted NPV calculations, assuming an 8% discount rate reflecting the projects’ risk profile.

Risk-Adjusted NPV and Final Decision

The risk-adjusted NPV can be calculated as:

NPV = Σ (Expected cash flows / (1 + risk-adjusted discount rate)^t) - initial investment

Using the expected cash flows and discounting over six years, the decision criteria favor the project with higher risk-adjusted NPV, provided its value is positive. Based on calculations, Project C, with higher expected cash flows, would be preferred if the NPV is positive after discounting. Selecting this project aligns with maximizing value and considers risk factors appropriately.

Conclusion

The comprehensive evaluation demonstrates that the expansion project at Wheel Industries, when discounted at an appropriate rate considering risk, yields a positive NPV at 6%, with an IRR close to the discount rate, indicating marginal acceptability. The firm’s capital structure should incorporate the cost of debt and equity optimally to minimize WACC, thereby enhancing project valuation. The selection of projects should consider expected cash flows, risk-adjusted discount rates, and the strategic fit to maximize shareholder value. Proper risk management, rigorous analysis, and strategic financing are vital to ensure long-term sustainability and profitability.

References

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  • Academic Journals, Financial Management Articles (2022-2023). Various case studies on capital budgeting techniques and risk analysis.

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