Analysis
The report provides a detailed knowledge about the application of different capital budgeting techniques, used for evaluating projects. It involves the evaluation of long term investment projects of Wheel industries, followed by the conclusion and recommendation.
Requirement A
|
Initial Investment ($ million) |
1.5 |
|
Additional revenue before tax per year ($ million) |
1.2 |
|
Additional annual cost ($) |
600000 |
|
Tax rate |
35% |
|
Salvage Value |
0 |
|
Depreciation expenses per year |
500000 |
|
Life of the project |
3 years |
|
Calculation of new cost of equity |
|
|
Dividend paid per share ($) |
2.5 |
|
Growth rate |
6% |
|
Market price per share ($) |
50 |
|
Flotation cost |
10% |
|
Dividend paid per share next year ($) |
2.65 |
|
Ke (cost of equity) |
11.89% |
- The business will earn the return and the investors can only realize their investment, if the business is performing well.
- The capital can be used for business operations rather than utilizing it for debt financing (Porter & Norton, 2012).
- It helps in the growth and exploration of the organisation.
Demerits
- The method is costly and time consuming.
- More interference of the investors in the business (Business.qld.gov.au. 2017).
- Loss of power in making management decisions.
|
Marginal tax rate |
35% |
|
The pre-tax Cost of Debt |
5% |
|
After tax Cost of Debt |
3.25% |
Advantages of debt financing:
- It allows to make the debt payments in instalments.
- Firms can pay for new equipment, buildings and other assets required for growth of the business.
- It does not require the surrendering of ownership or control of the business (qld.gov.au 2017).
Disadvantages:
- Increase in the loan repayments along with the interests. Failed to do the same, can result in the acquiring of the company’s assets by the bank for recovery.
- Over financing through debt can affect the future cash flows and growth.
- More debt makes the organization more risker from investor’s point of view (Ramadani & Hisrich, 2016).
|
Cost after tax |
Weights |
Weighted cost |
||
|
Debt |
Kd |
3.25% |
0.3 |
0.98% |
|
Common Equity |
Ke |
11.89% |
0.7 |
8.32% |
|
WACC |
9.30% |
WACC helps in reflecting the change in cost of debt to asset ratio and assist the management in taking decisions regarding raising funds through debt or equity. In addition to this, by applying weights to these cost, company can develop an optimum capital structure for the business. It is also used as an investment tool by the analysts for evaluating and selecting investment proposals (Baker & English, 2011).
|
Years |
0 |
1 |
2 |
3 |
|
($) |
($) |
($) |
($) |
|
|
Initial Investment |
-1500000 |
|||
|
Revenue |
1200000 |
1200000 |
1200000 |
|
|
Cost |
-600000 |
-600000 |
-600000 |
|
|
Depreciation |
-500000 |
-500000 |
-500000 |
|
|
Earnings before tax |
100000 |
100000 |
100000 |
|
|
Tax provisions |
35000 |
35000 |
35000 |
|
|
Earnings after tax |
65000 |
65000 |
65000 |
|
|
Add: Depreciation |
500000 |
500000 |
500000 |
|
|
Total cash flow after tax |
-1500000 |
565000 |
565000 |
565000 |
|
Years |
Cash inflow |
Present values |
|
|
0 |
-1500000 |
1 |
-1500000 |
|
1 |
565000 |
0.943396226 |
533018.8679 |
|
2 |
565000 |
0.88999644 |
502847.9886 |
|
3 |
565000 |
0.839619283 |
474384.8949 |
|
NPV |
10251.75 |
NPV basically shows the profitability of a project. Generally, the proposals having high and positive NPV are considered more desirable for investment purposes (Bierman & Smidt, 2012). The proposal of Wheel industries is economically acceptable because it has NPV of $10251.75, which is positive and reflects that the project will generate profits in the future.
|
Years |
Cash inflow |
|
0 |
-1500000 |
|
1 |
565000 |
|
2 |
565000 |
|
3 |
565000 |
|
IRR |
6.37% |
This project is acceptable because the IRR is 6.37% which more than the cost of capital of 6%. There is no conflict because the all the cash flows are normal and the IRR is compare to the cost of capital used for discounting the cash flows rather than with the WACC of the business.
|
Calculation of annual after tax cash flow |
||
|
Investment B |
||
|
Probability |
After tax cash flow |
Expected value |
|
0.25 |
20000 |
5000 |
|
0.50 |
32000 |
16000 |
|
0.25 |
40000 |
10000 |
|
Annual after tax cash flow ($) |
31000 |
|
Investment C |
||
|
Probability |
After tax cash flow |
Expected value |
|
0.3 |
22000 |
6600 |
|
0.5 |
40000 |
20000 |
|
0.2 |
50000 |
10000 |
|
Annual after tax cash flow ($) |
36600 |
Expected annual after tax cash flow is calculated as follows:
Expected value = Sum of (probability*cash inflow after tax).
The same formula is applied for project C also. The annual cash flows for project B are $31000 and of Proposal C are $36,600. There will be no conflict between the IRR and NPV of the projects because both have same cash outflow and same years of life. Moreover, the cash inflows are also normal.
|
Calculation of NPV |
|||
|
Project B |
|||
|
Years |
Cash flow |
Present values |
|
|
0 |
-120000 |
1 |
-120000 |
|
1 |
31000 |
0.926 |
28703.70 |
|
2 |
31000 |
0.857 |
26577.50 |
|
3 |
31000 |
0.794 |
24608.80 |
|
4 |
31000 |
0.735 |
22785.93 |
|
5 |
31000 |
0.681 |
21098.08 |
|
6 |
31000 |
0.630 |
19535.26 |
|
NPV |
23309.27 |
|
Project C |
|||
|
Years |
Cash flow |
Present values |
|
|
0 |
-120000 |
1 |
-120000 |
|
1 |
36600 |
0.926 |
33888.89 |
|
2 |
36600 |
0.857 |
31378.60 |
|
3 |
36600 |
0.794 |
29054.26 |
|
4 |
36600 |
0.735 |
26902.09 |
|
5 |
36600 |
0.681 |
24909.35 |
|
6 |
36600 |
0.630 |
23064.21 |
|
NPV |
49197.40 |
Although both the projects has positive NPV but the one having high value of NPV will be accepted for the purpose of investment. Project C has NPV of $49,197.40 which is more than the NPV of proposal B that is $23309.27. So, according to the rule of Net Present Value, proposal C should be accepted (Fabozzi & Drake, 2009).
Conclusion and Recommendation
The above report concluded that, it is very necessary for the company to critically evaluate its investment opportunities by using appropriate capital budgeting techniques. It can also been seen from the report that Net Present Value method is the most suitable and used among the various methods. Wheel Industries has chosen project C than project B, because of its high NPV value.
References
Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for today’s investment projects (Vol. 13). (pp. 341-359). New Jersey: John Wiley & Sons. https://books.google.co.in/books?id=OzZGDgAAQBAJ&printsec=frontcover&dq=Baker,+H.+K.,+%26+English,+P.+(2011).+Capital+budgeting+valuation:+Financial+analysis+for+today%27s+investment+projects+(Vol.+13).+New+Jersey:+John+Wiley+%26+Sons.&hl=en&sa=X&ved=0ahUKEwi0weTirObZAhUTSI8KHW3SCYAQ6AEILTAB#v=onepage&q&f=false
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. 9th ed. (pp. 53-54). New York: Routledge. https://books.google.co.in/books?id=1IPNXQmhzo8C&printsec=frontcover&dq=Bierman+Jr,+H.,+%26+Smidt,+S.+(2012).+The+capital+budgeting+decision:+economic+analysis+of+investment+projects.+9th+ed.+New+York:+Routledge.&hl=en&sa=X&ved=0ahUKEwitxI35rObZAhWCNo8KHfrSAm0Q6AEILTAB#v=onepage&q&f=false
Business.qld.gov.au (2017). Equity finance. Business Queensland. Retrieved from https://www.business.qld.gov.au/starting-business/costs-finance-banking/funding-business/equity
Business.qld.gov.au (2017) Debt finance. Business Queensland. Retrieved from https://www.business.qld.gov.au/starting-business/costs-finance-banking/funding-business/debt
Fabozzi, F. J., & Drake, P. P. (2009). Finance: capital markets, financial management, and investment management (Vol. 178). (pp. 481-485). New Jersey: John Wiley & Sons. https://116.58.21.27/articles/0470407352%20Capital%20Market.pdf
Porter, G. A., & Norton, C. L. (2007). Financial accounting: the impact on decision makers. 6th ed. (pp. 527). USA: Cengage Learning. https://books.google.co.in/books?id=Huo_Y5fcfHcC&printsec=frontcover&dq=Porter,+G.+A.,+%26+Norton,+C.+L.+(2012).+Financial+accounting:+the+impact+on+decision+makers.+10th+ed.+USA:+Cengage+Learning.&hl=en&sa=X&ved=0ahUKEwiN-YfArubZAhWHvY8KHXuNClwQ6AEILjAB#v=onepage&q&f=false
Ramadani, V., & Hisrich, R. D. (2016). Effective Entrepreneurial Management: Strategy, Planning, Risk Management, and Organization. (pp. 117-127). Switzerland: Springer. https://books.google.co.in/books?id=vtjJDQAAQBAJ&printsec=frontcover&dq=Ramadani,+V.,+%26+Hisrich,+R.+D.+(2016).+Effective+Entrepreneurial+Management:+Strategy,+Planning,+Risk+Management,+and+Organization.+Switzerland:+Springer.&hl=en&sa=X&ved=0ahUKEwiWnJDhrubZAhWFilQKHSEUAO4Q6AEIJjAA#v=onepage&q&f=false
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