Assignment 1 Lasa 2 Capital Budgeting Techniques As A Financ

Assignment 1 Lasa 2capital Budgeting Techniquesas A Financial Cons

Assignment 1: LASA # 2—Capital Budgeting Techniques 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. You have also agreed to provide an 8-10 page report, in good form, with detailed explanation of your methodology, findings, and recommendations.

Company Information 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%. Required: 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?

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? 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.

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

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?

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 are given in the table below. Investment B Investment C Probability After Tax Cash Flow Probability After Tax Cash Flow 0.25 $20,000 0.30 $22,000 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.

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.

Paper For Above instruction

The process of capital budgeting is essential for firms seeking to allocate resources efficiently for long-term investments. This comprehensive report evaluates specific techniques and methodologies such as the Weighted Average Cost of Capital (WACC), net present value (NPV), and internal rate of return (IRR). It focuses on Wheel Industries' expansion project and two other mutually exclusive projects, integrating risk assessments within financial decision-making processes.

Estimating Cost of Equity: The cost of new equity is calculated using the Dividend Discount Model (DDM), considering the dividend just paid ($2.50), expected growth (6%), current stock price ($50), and flotation costs. The formula used is:

Cost of Equity = [(Dividend / Net Price) + Growth Rate]

Where Net Price = Current Stock Price - Flotation Cost. Substituting the known values:

Net Price = $50 - (10% * $50) = $45


Cost of Equity = ($2.50 / $45) + 0.06 ≈ 0.0556 + 0.06 = 0.1156 or 11.56%

Cost of Debt: Given the market rate of 5%, the after-tax cost of debt is:

Cost of Debt (after-tax) = Market Rate  (1 - Tax Rate) = 0.05  (1 - 0.35) = 0.0325 or 3.25%

Weighted Average Cost of Capital (WACC): With a 30% debt and 70% equity structure, WACC calculation involves these component costs:

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


Where:


E = equity, D = debt, V = E + D, Re = cost of equity, Rd = cost of debt, Tc = corporate tax rate.


V = 0.7 + 0.3 = 1


WACC = (0.70  0.1156) + (0.30  0.0325) = 0.08092 + 0.00975 ≈ 0.0907 or 9.07%

Project Cash Flows & NPV Analysis: The project requires an initial investment of $1.5 million with annual revenues of $1.2 million and costs of $600,000, resulting in annual taxable income. Applying straight-line depreciation over three years ($500,000 per year), the taxable income per year approximates $1.2 million - $600,000 - $500,000 = $100,000. Tax payable is 35% of taxable income (about $35,000), and net income is approximately $65,000 annually.

Depreciation is non-cash, so adding back $500,000 gives after-tax cash flows of roughly $565,000 annually. Discounting these cash flows at 6% yields the NPV, which determines the project's economic viability:

NPV = ∑ (Cash Flow / (1 + r)^t) - Initial Investment


= ($565,000 / 1.06) + ($565,000 / 1.1236) + ($565,000 / 1.191) - $1,500,000 ≈ $1,491,000 - $1,500,000 ≈ -$9,000

Thus, at a 6% discount rate, the NPV is slightly negative, indicating marginal economic acceptability.

IRR Calculation: The IRR is the discount rate that makes the NPV zero. Given the cash flows, approximate IRR calculation suggests it to be slightly below 6%, around 5.9%. Since this is just below the discount rate, the project marginally fails the IRR criterion, indicating it's not strongly desirable based on this metric alone.

Evaluation of Alternatives (Projects B and C): The expected cash flows are derived by multiplying each possible cash flow by its probability, providing expected values: for Project B, approximately $20,000 0.25 + $22,000 0.75 ≈ $21,500; similarly for Project C. Using these, risk-adjusted NPVs are computed by discounting expected cash flows at 8%, the risk-appropriate rate. Typically, Project C, with higher expected cash flows, may show a superior risk-adjusted NPV.

Conclusion: The combination of NPV, IRR, and risk considerations indicates that while the initial project is marginally acceptable, the selection of projects with higher expected cash flows or better risk-adjusted returns would optimize value. Proper risk assessment and alignment with strategic goals are essential for sound decision-making.

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