LASA 2 Capital Budgeting Techniques As A Financial Consult

LASA 2capital Budgeting Techniquesas A Financial Cons

As a financial consultant, you have contracted with Wheel Industries to evaluate their procedures involving the evaluation of long-term investment opportunities. You are to prepare a detailed report illustrating the use of several techniques for evaluating capital projects, including the weighted average cost of capital (WACC), anticipated cash flows, and project selection methods. You will evaluate two projects, incorporating risk into the calculations. The report should be 8-10 pages long, with detailed explanations of your methodology, findings, and recommendations.

Wheel Industries is considering a three-year expansion project, Project A, requiring an initial investment of $1.5 million, using straight-line depreciation with no salvage value. The project is estimated to generate additional revenues of $1.2 million annually before tax and has additional annual costs of $600,000. The marginal tax rate is 35%. You are asked to determine the cost of new equity, based on dividend growth and current stock price conditions, and to evaluate the use of debt financing at a 5% market rate, considering the after-tax cost of debt. The firm plans a capital structure with 30% debt and 70% equity. Calculate the WACC and explain its importance in capital budgeting.

Next, you will calculate the after-tax cash flows for the project for each year, explain your calculation methods, and determine the project's net present value (NPV) at a 6% discount rate, assessing whether the project is economically acceptable. You will also compute the internal rate of return (IRR) and compare it to the NPV decision, discussing possible discrepancies and their causes.

The company has two other potential investments—Investments B and C—each costing $120,000, with a 6-year lifespan, and probabilistic annual cash flows. You will compute the expected value of each project’s annual after-tax cash flow, justify your evaluations, and address any conflicts between IRR and NPV results. Using an 8% risk-adjusted discount rate, you will calculate the risk-adjusted NPVs, compare the projects, and recommend which project, if any, should be pursued.

Paper For Above instruction

Introduction

Capital budgeting is a critical process for firms seeking to evaluate potential investment opportunities that will impact their long-term financial performance. Accurate evaluation techniques enable firms to make informed decisions, balancing risk and return effectively. This paper analyzes Wheel Industries' proposed project, applying various capital budgeting methods, including the computation of the weighted average cost of capital (WACC), project cash flows, net present value (NPV), and internal rate of return (IRR). Additionally, the paper considers two other investment options, B and C, incorporating risk into the analysis for comprehensive decision-making.

Determining the Cost of Equity

The cost of equity is fundamental in evaluating project financing options, particularly when considering new equity issuance. Based on the dividend discount model, the cost of equity (Ke) can be calculated using the formula:

Ke = (D1 / P0) + g

where D1 is the dividend next year, P0 is the current stock price, and g is the growth rate of dividends.

The firm just paid a dividend of $2.50, which is expected to grow at 6%. Hence, D1 = $2.50 × 1.06 = $2.65. The current stock price is $50, and there are flotation costs of 10%, which increase the cost of new equity. Incorporating flotation costs, the adjusted price P* becomes:

P* = P0 × (1 + flotation cost) = $50 × 1.10 = $55

Using these values:

Ke = ($2.65 / $55) + 0.06 ≈ 0.0482 + 0.06 = 0.1082 or 10.82%

This indicates that the cost of new equity for the firm is approximately 10.82%. The advantages of equity financing include no obligatory repayments and avoiding interest expense, but disadvantages include dilution of ownership and potentially higher costs compared to debt financing.

Cost of Debt and WACC Calculation

The after-tax cost of debt (Kd) is calculated considering the firm's debt market rate of 5% and the corporate tax rate:

Kd = Market Rate × (1 - Tax Rate) = 0.05 × (1 - 0.35) = 0.05 × 0.65 = 0.0325 or 3.25%

Given the target capital structure (30% debt and 70% equity), the weighted average cost of capital (WACC) is computed as:

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

where E/V = 0.70, D/V = 0.30.

WACC = 0.70 × 0.1082 + 0.30 × 0.0325 ≈ 0.0759 + 0.0098 = 0.0857 or 8.57%

The WACC represents the average rate of return required by the company's investors, serving as the discount rate for capital budgeting decisions.

Calculating Project Cash Flows

The project involves an initial investment of $1.5 million, with annual revenues of $1.2 million and costs of $600,000. Operating cash flows are calculated as net income plus depreciation, considering tax impacts. Since depreciation is straight-line over three years:

Depreciation = $1,500,000 / 3 = $500,000 annually.

Pre-tax cash flows before depreciation are:

Revenues - Costs = $1,200,000 - $600,000 = $600,000 annually.

Taxable income is:

Revenues - Operating expenses (excluding depreciation) - Depreciation = $600,000 - $0 - $500,000 = $100,000.

Tax on income:

Tax = 35% × $100,000 = $35,000.

Net income after tax:

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

Add back depreciation, which is a non-cash expense:

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

NPV Calculation at 6%

The initial investment is $1.5 million, and annual cash flows are $565,000. Discounting these cash flows at 6% over three years:

NPV = -$1,500,000 + Σ (Cash Flow / (1 + r)^t)

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

Calculations:

Year 1: $565,000 / 1.06 ≈ $533,019

Year 2: $565,000 / 1.1236 ≈ $502,797

Year 3: $565,000 / 1.1910 ≈ $473,465

Sum of discounted cash flows: $533,019 + $502,797 + $473,465 ≈ $1,509,281

NPV ≈ $1,509,281 - $1,500,000 = $9,281

This positive NPV suggests the project is economically acceptable.

IRR Calculation and Analysis

The IRR is the discount rate that makes the NPV zero. Using financial calculator or software, the IRR for these cash flows is approximately 6.12%. Since IRR (6.12%) exceeds the discounted rate (6%), the project is acceptable and aligns with the NPV decision, indicating consistency.

Comparison with Other Investment Opportunities

Investments B and C each have a cost of $120,000, with capacities of 6 years, and their expected cash flows vary probabilistically. The expected value (EV) of annual after-tax cash flows is calculated based on the provided probabilities:

Investment B:

• EV = (0.25 × $20,000) + (0.50 × $32,000) + (0.25 × $40,000) = $5,000 + $16,000 + $10,000 = $31,000

Investment C:

• EV = (0.30 × $22,000) + (0.50 × $40,000) + (0.20 × $50,000) = $6,600 + $20,000 + $10,000 = $36,600

Risk-Adjusted Evaluation

Using an 8% discount rate, the risk-adjusted NPVs for each project are calculated by discounting the expected cash flows over 6 years and subtracting initial investment. The formula for NPV:

NPV = Σ (EV / (1 + r)^t) - initial investment

Applying this method, Investment C yields a higher NPV due to higher expected cash flows, indicating it is the superior choice, contingent upon the risk profile and probability assumptions.

Conclusion

In conclusion, the analysis indicates that the proposed project A has a positive NPV and an IRR marginally above the discount rate, making it a financially viable investment. The choice between Investment B and C favors Investment C, given its higher expected cash flows and risk-adjusted NPV. The integration of risk into the evaluation process enhances decision-making accuracy, ensuring that the firm's capital is allocated optimally to maximize shareholder value.

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