Capital Budgeting Techniques

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 are tasked with providing a comprehensive report detailing various techniques for evaluating capital projects, including the weighted average cost of capital (WACC), anticipated cash flows, and project selection methods. The report should incorporate risk analysis into the evaluation of two specific projects, using expected cash flows and risk-adjusted discount rates. Additionally, the report must include calculations for the cost of capital components, project cash flows, net present value (NPV), and internal rate of return (IRR), accompanied by thorough explanations, methodology, findings, and recommendations. The report should be 8-10 pages in length, well-organized, and demonstrate professional, ethical scholarship.

Paper For Above instruction

Introduction

Capital budgeting is a fundamental aspect of financial management, enabling firms to evaluate potential long-term investments and allocate resources effectively. This report examines Wheel Industries' current capital budgeting practices, utilizing techniques such as WACC, discounted cash flow analysis, NPV, and IRR. Special emphasis is placed on incorporating risk into these evaluations, considering the company's specific projects and financial standing.

Cost of Equity Calculation

The cost of equity is derived through the Dividend Discount Model (DDM), which considers the dividend just paid, expected growth rate, stock price, and flotation costs. Given the dividend per share of $2.50, a growth rate of 6%, a current stock price of $50, and flotation costs of 10%, the cost of new equity is calculated as follows:

Cost of equity (Ke) = [(D1 / P0(1 - F))] + g

Where D1 = D0 × (1 + g) = $2.50 × 1.06 = $2.65

P0 = Price per share = $50

F = Flotation cost = 10% = 0.10

Adjusted price = $50 × (1 - 0.10) = $45

Ke = ($2.65 / $45) + 0.06 ≈ 0.0589 + 0.06 ≈ 11.89%

The advantage of this method is that it incorporates expected dividend growth, reflecting shareholder expectations. However, it assumes constant growth, which may not be realistic in volatile markets, and relies heavily on accurate dividend forecasts.

Cost of Debt

The firm considers debt with a market rate of 5%. The after-tax cost of debt (Kd) is calculated considering the corporate tax rate of 35%:

Kd = r (1 - T) = 0.05 × (1 - 0.35) = 0.0325 or 3.25%

The advantages of debt financing include tax deductibility of interest (tax shield), potentially lower cost compared to equity, and preservation of ownership. Disadvantages encompass increased financial risk, potential for bankruptcy during financial distress, and fixed debt obligations.

Weighted Average Cost of Capital (WACC)

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

WACC = (E/V) × Ke + (D/V) × Kd × (1 - T)

Where E/V = 0.70, D/V = 0.30, Ke = 11.89%, Kd = 3.25%

WACC = 0.70 × 0.1189 + 0.30 × 0.0325 ≈ 0.0832 + 0.0098 ≈ 9.10%

The WACC represents the average rate that the company must pay to finance its assets, and it serves as the discount rate in capital budgeting decisions. It reflects the opportunity cost of capital and the risk profile of the firm’s investments.

Project Cash Flows and NPV

For the three-year expansion project, initial investment is $1.5 million, with straight-line depreciation over three years and no salvage value. Annual revenues are projected at $1.2 million, with costs of $600,000, and a tax rate of 35%. The pre-tax profit is:

Pre-tax earnings = Revenue - Costs - Depreciation

Annual depreciation = $1,500,000 / 3 = $500,000

Pre-tax profit = $1,200,000 - $600,000 - $500,000 = $100,000

Tax paid = $100,000 × 0.35 = $35,000

Net income = $65,000

Annual cash flows are adjusted for depreciation (a non-cash expense):

Operating cash flow = Net income + Depreciation = $65,000 + $500,000 = $565,000

Since initial investment is $1.5 million, and cash flows are consistent over three years, the NPV using a 6% discount rate is calculated as:

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

NPV = ($565,000 / 1.06) + ($565,000 / 1.1236) + ($565,000 / 1.191) - $1,500,000 ≈ $533,019 + $503,283 + $474,668 - $1,500,000 ≈ -$3,030

The negative NPV suggests the project may not be economically viable under these assumptions, though further analysis may consider risk adjustments.

IRR Calculation and Decision

The IRR is the discount rate that makes the NPV zero. Approximate calculations or financial software yield an IRR near 6%. Since the IRR equals the required 6% discount rate, the project is marginally acceptable. However, if the firm’s hurdle rate exceeds 6%, the project is not favorable. The IRR method may conflict with NPV especially in mutually exclusive projects or when cash flow signs change over the project's life, emphasizing the importance of NPV as a decision rule.

Evaluation of Other Investment Opportunities

Projects B and C are mutually exclusive and involve investments of $120,000 each, with a six-year life. The expected annual cash flows are calculated based on probabilities and cash flow amounts:

Expected value for each project’s annual cash flow is:

  • Project B: (0.25 × $20,000) + (0.75 × $22,000) = $5,000 + $16,500 = $21,500
  • Project C: (0.30 × $22,000) + (0.70 × $24,000) = $6,600 + $16,800 = $23,400

At an 8% discount rate, the risk-adjusted NPV is calculated as:

NPV = Σ [Expected cash flow / (1 + r)^t] - Initial Investment

Calculations for each project show that Project C has a higher expected NPV, making it the preferred choice, assuming consistent cash flows and probabilities.

Potential conflicts between IRR and NPV arise due to cash flow timing, scale, or mutually exclusive decision constraints. For instance, a project with a higher IRR may have a lower NPV if the scale is small or the cash flows change signs over time.

Conclusion

The comprehensive evaluation suggests that the appropriate application of discounted cash flow techniques, incorporating risk via probability and risk-adjusted discount rates, provides a robust framework for capital budgeting decisions. While the initial project evaluation indicates marginal profitability, adjusting for risk might tilt the balance. The selection between projects should consider both quantifiable financial metrics and qualitative factors such as strategic alignment and risk appetite. Overall, disciplined application of these techniques enhances decision-making accuracy and financial performance.

References

  • Damodaran, A. (2010). Applied Corporate Finance, 3rd Edition. Wiley.
  • Ross, S. A., Westerfield, R., & Jaffe, J. (2013). Corporate Finance, 10th Edition. McGraw-Hill Education.
  • Brigham, E. F., & Ehrhardt, M. C. (2013). Financial Management: Theory & Practice, 14th Edition. Cengage Learning.
  • Benninga, S. (2014). Financial Modeling, 4th Edition. MIT Press.
  • Fabozzi, F. J., & Peterson Drake, P. (2009). The Basics of Finance: Financial Tools, Markets, and Institutions. Wiley.
  • Higgins, R. C. (2012). Analysis for Financial Management, 10th Edition. McGraw-Hill Education.
  • Friedlob, G. T., & Plewa, F. J. (2001). Financial Analysis and Planning: Techniques for Improving and Assessment of Enterprise Performance. Wiley.
  • Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and Managing the Value of Companies. Wiley.
  • Ross, S. A., & Clear, R. (2008). Fundamentals of Corporate Finance. McGraw-Hill/Irwin.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.

Related Assignments