Assignment 1 Lasa 2 Capital Budgeting Techniques As A 304063

Assignment 1 Lasa 2capital Budgeting Techniquesas A Financial Cons

Evaluate the procedures involved in long-term investment opportunities for Wheel Industries, including calculating the weighted average cost of capital (WACC), anticipated cash flows, project selection methods, and risk considerations for two projects. Provide detailed methodology, findings, and recommendations in an 8-10 page report, including analysis of a specific expansion project (Project A), computations of the cost of new equity and debt, WACC, project cash flows, NPV, IRR, and evaluation of the projects using risk-adjusted discount rates.

Paper For Above instruction

Introduction

Capital budgeting is a crucial process for firms to evaluate long-term investments that can significantly impact their financial health and strategic positioning. Effective evaluation involves multiple techniques, including the calculation of the weighted average cost of capital (WACC), analysis of cash flows, and risk assessment. This paper provides a comprehensive assessment of Wheel Industries' proposed expansion project (Project A), alongside the evaluation of two other potential investments, incorporating core financial concepts and methodologies to support investment decision-making.

Calculating the Cost of Equity

The cost of equity for Wheel Industries is derived using the Dividend Discount Model (DDM), considering the recent dividend payment, growth rate, stock price, and flotation costs. The dividend paid was $2.50, with an expected growth rate of 6%. The current stock price is $50, and flotation costs are 10%. The formula for the cost of new equity (re) is:

re = [(D1) / (P0 * (1 - F))] + g

Where D1 is the dividend next year, P0 is the current stock price, F is flotation costs, and g is growth rate. Calculating D1: D1 = $2.50 (1 + 0.06) = $2.65. Then, re = [$2.65 / ($50 0.90)] + 0.06 = [$2.65 / $45] + 0.06 ≈ 0.0589 + 0.06 = 0.1189 or 11.89%.

Advantages and disadvantages include that equity financing doesn't require fixed interest payments, reducing financial risk, but it may dilute ownership and control, and the cost of equity can be higher than debt.

Calculating the Cost of Debt

The firm is considering using debt at a market rate of 5%. After-tax cost of debt depends on tax shields, calculated as:

After-tax cost of debt = Market rate (1 - Tax rate) = 0.05 (1 - 0.35) = 0.05 * 0.65 = 0.0325 or 3.25%. This approach provides a tax advantage since interest payments are tax-deductible.

Advantages of debt include lower cost compared to equity, tax benefits, and increased leverage. Disadvantages involve increased financial risk and potential bankruptcy costs.

Calculating WACC

The firm's target capital structure is 30% debt and 70% equity. The WACC is computed as:

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

Where E/V=0.70, D/V=0.30, Re=11.89%, Rd=3.25%. Plugging in values:

WACC = 0.70 0.1189 + 0.30 0.0325 (1 - 0.35) = 0.0832 + 0.0317 0.65 ≈ 0.0832 + 0.0206 = 0.1038 or 10.38%. This WACC will serve as the discount rate for project evaluation.

Calculating Cash Flows for Project A

The initial investment is $1.5 million, with annual revenues of $1.2 million and costs of $600,000 before tax. Straight-line depreciation over three years with no salvage value results in annual depreciation of $1.5 million / 3 = $500,000.

EBIT (Earnings Before Interest and Taxes) each year:

EBIT = Revenue - Costs - Depreciation = $1.2 million - $600,000 - $500,000 = $100,000

Tax impacts:

Tax = EBIT Tax rate = $100,000 0.35 = $35,000

Net operating profit after tax (NOPAT):

NOPAT = EBIT - Tax = $100,000 - $35,000 = $65,000

Adding back depreciation (a non-cash expense):

Annual cash flow = NOPAT + Depreciation = $65,000 + $500,000 = $565,000

Thus, each year's after-tax cash flow is approximately $565,000.

NPV Calculation at 6% Discount Rate

Using these cash flows, the NPV is computed as:

NPV = Σ (Cash flow / (1 + r)^t) - Initial Investment

NPV = ($565,000 / 1.06) + ($565,000 / 1.06^2) + ($565,000 / 1.06^3) - $1,500,000

Calculating:

Year 1: $565,000 / 1.06 ≈ $533,962

Year 2: $565,000 / 1.1236 ≈ $503,170

Year 3: $565,000 / 1.1910 ≈ $473,736

Total Present Value of cash flows: approximately $1,510,868

NPV ≈ $1,510,868 - $1,500,000 = $10,868

Since the NPV is positive, the project is economically acceptable under the 6% discount rate.

Internal Rate of Return (IRR)

IRR is the discount rate that makes the NPV zero. Given the cash flows, IRR calculations through financial calculator or software yield an IRR of approximately 6.5%. Since IRR exceeds the company's WACC of 10.38%, the project is financially viable.

Conflict Between NPV and IRR

Typically, NPV and IRR agree on the decision to accept or reject a project when cash flows are conventional. However, conflicts can occur when projects have non-standard cash flows or multiple IRRs. In this case, both metrics indicate acceptance, aligning decision-making.

Incorporating Risk: Expected Values and Risk-Adjusted Discount Rate

Wheel Industries faces alternative investments (Projects B and C), with probabilities assigned to their cash flows. Expected values are calculated as:

Expected Cash Flow = Σ (Probability * Cash Flow)

For Project B:

  • Expected CF = 0.25 $20,000 + 0.50 $32,000 + 0.25 * $40,000 = $5,000 + $16,000 + $10,000 = $31,000

For Project C:

  • Expected CF = 0.30 $22,000 + 0.50 $40,000 + 0.20 * $50,000 = $6,600 + $20,000 + $10,000 = $36,600

Using an 8% risk-adjusted discount rate, the risk-adjusted NPVs are calculated by discounting the expected cash flows over six years at 8%. The decision criterion is to select projects with positive risk-adjusted NPVs.

Conclusion

Analysis indicates that Project A, with a positive NPV and IRR exceeding the company's WACC, is a favorable investment. The expected values for Projects B and C suggest that Project C offers a higher risk-adjusted return. However, if risk considerations are paramount, Project B's lower expected cash flow and risk profile might influence the decision. Ultimately, combining quantitative analysis with strategic considerations guides optimal investment choices.

References

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