Evaluate A Capital Project Using The Weighted Cost Of Capita

Evaluate a capital project using the weighted cost of capital for a firm

Your final assignment as a financial management intern involves applying knowledge related to the cost of capital and capital budgeting techniques. You will evaluate a proposed capital project by calculating the weighted average cost of capital (WACC) based on market value components and then applying capital budgeting methods such as net present value (NPV) and internal rate of return (IRR).

First, recalculate the WACC using the market value of equity, obtainable by sourcing the current stock price per share from a reliable website and multiplying it by the most recent number of shares outstanding. For this exercise, ignore preferred stock due to its likely minimal impact on overall weighting. Use the provided table to compile necessary data: company’s current stock price, number of shares outstanding, total liabilities, and market values. Calculate the total market value of the firm by summing the market value of equity and total liabilities, then determine the respective weights.

Next, compute the firm's market-value WACC by incorporating the after-tax cost of debt and the cost of equity, along with their weights. The cost components should be derived from prior phases of your project, considering current market conditions. The WACC reflects the firm’s overall cost of capital based on market values, providing a more accurate discount rate for project evaluation.

For the project evaluation, consider an initial investment of $12 million, with a 5-year productive life and an estimated salvage value of $2 million at the end of this period. The project's depreciation will be straight-line over the 5 years. It is projected to generate an annual revenue increase of $10 million and increased operating expenses of approximately $6.5 million annually. Using the depreciation schedule, calculate annual depreciation and then determine the relevant cash flows, considering taxes at the average rate calculated earlier.

Utilize the cash flow template to compute each year's net income, operating cash flow, and track salvage value in the final year. Once the relevant cash flows are established, calculate the project's NPV using the market-value WACC as the discount rate, and determine the IRR to understand the project's profitability. These calculations will guide your recommendation on whether to accept or reject the project based on whether NPV is positive and IRR exceeds the required rate of return.

In your analysis, discuss the rationale for your decision, including why NPV and IRR should generally support the same conclusion. Additionally, explore how employing a different cost of capital, such as 20%, might influence your decision and why.

Finally, evaluate the advantages and disadvantages of NPV and IRR, emphasizing situations where one may be more reliable than the other. Explain why operating cash flows are preferred over net income in capital budgeting, considering the focus on true cash movements rather than accounting accruals. Throughout your paper, cite credible academic and industry sources in APA format to support your analysis.

Paper For Above instruction

In financial management, particularly in capital budgeting, accurate evaluation of potential projects is essential for strategic decision-making. The use of the weighted average cost of capital (WACC) as a discount rate provides a comprehensive measure reflecting the average rate of return required by all sources of capital. This paper discusses the process of recalculating WACC based on market values, followed by a detailed analysis of a hypothetical capital project using NPV and IRR techniques, and concludes with a discussion of the advantages and limitations of these methods.

Calculating Market-Value WACC

The initial step in evaluating a project involves recalculating the firm's WACC based on current market values. For this purpose, the current stock price per share must be obtained from financial websites like Yahoo Finance or Google Finance. Multiplying the stock price by the number of outstanding shares yields the market value of equity. For illustration, assume a stock price of $50 and 1 million shares outstanding, resulting in a market value of $50 million for equity. Ignoring preferred stock simplifies the process because its market value contribution may be minimal.

Next, compile the company's total liabilities, say $40 million, and summate this with the equity market value to derive the total firm's market value ($90 million in this example). Assign weights to each component accordingly: weight of debt = $40 million / $90 million ≈ 44.44%, and weight of equity = $50 million / $90 million ≈ 55.56%. Then, determine the after-tax cost of debt—assumed at 4% for illustration, with a corporate tax rate of 21%—and the cost of equity, estimated using the Capital Asset Pricing Model (CAPM), such as 8% based on market data.

Applying these figures, the WACC calculation becomes as follows:

• Cost of debt (after-tax): 4% × (1 - 21%) = 3.16%
• Cost of equity: 8%
• WACC = (55.56%) × 8% + (44.44%) × 3.16% ≈ 5.55% + 1.4% = 6.95%

This WACC serves as the discount rate for the project evaluation, representing the minimum acceptable return adjusted for market risk.

Project Cash Flow Analysis

The project requires an initial investment of $12 million, with expected residual value of $2 million after five years. Straight-line depreciation allocates depreciation expense evenly over the lifespan: ($12 million - $2 million) / 5 years = $2 million annually. The annual revenue increase is projected at $10 million; operating expenses are estimated at $6.5 million, leading to an increase in operating income before depreciation of $3.5 million.

Calculating taxable income involves subtracting depreciation from operating income: $3.5 million - $2 million = $1.5 million. Applying the average tax rate of 21%, taxes amount to $0.315 million. Therefore, net income after taxes is $1.185 million, and adding back depreciation yields an operating cash flow of $3.185 million per year.

In the final year, salvage value of $2 million adds to cash flows. Summary of cash flow calculations per year demonstrates the project's profitability over its lifespan.

NPV and IRR Calculation

The NPV is computed by discounting the annual cash flows,$3.185 million for years 1 through 4, and with year 5 including the salvage value, at the market-value WACC of approximately 6.95%. A positive NPV indicates value creation, favoring project acceptance. The IRR is the discount rate at which the net present value of cash inflows equals the initial investment. Using financial calculators or spreadsheet functions like Excel’s IRR, suppose the IRR results in a rate of about 12%, exceeding the WACC, further supporting project approval.

Decision and Sensitivity Analysis

Based on the positive NPV and IRR exceeding the required rate, the recommendation is to accept the project. Had the cost of capital been increased to 20%, the discounted cash flows would be lower, potentially reducing NPV or even rendering it negative. This demonstrates the importance of precise cost of capital estimation in capital budgeting decisions.

Both NPV and IRR tend to support the same decision because they evaluate the same cash flow stream from different perspectives. However, NPV measures absolute value added, while IRR provides a relative rate of return. When conflicting signals occur, especially in projects with unconventional cash flows, NPV is generally more reliable.

Operating cash flow is utilized instead of net income because it reflects actual cash generated by operations, excluding non-cash accounting entries such as depreciation and amortization. This focus helps managers assess the true liquidity impact of the project and makes NPV and IRR more meaningful tools for investment analysis.

Conclusion

In summary, recalculating WACC from market data provides a realistic discount rate essential for capital project evaluation. Applying capital budgeting techniques like NPV and IRR assists in making informed investment decisions. While both methods have their limitations, their combined use and understanding of their respective advantages enable better financial decision-making. Operating cash flows are preferred over net income because they offer a clearer picture of actual cash generating ability. Accurate application of these tools enhances strategic financial management and investment success.

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