Question.3058 - As a financial consultant, you have contracted with Wheel Industries to evaluate their procedures involving the evaluation of long term investment opportunities. You have agreed to provide a detailed report illustrating the use of several techniques for evaluating capital projects including the weighted average cost of capital to the firm, the anticipated cash flows for the projects, and the methods used for project selection. In addition, you have been asked to evaluate two projects, incorporating risk into the calculations. You have also agreed to provide an 8-10 page report, in good form, with detailed explanation of your methodology, findings, and recommendations. Company Information Wheel Industries is considering a three-year expansion project, Project A. The project requires an initial investment of $1.5 million. The project will use the straight-line depreciation method. The project has no salvage value. It is estimated that the project will generate additional revenues of $1.2 million per year before tax and has additional annual costs of $600,000. The Marginal Tax rate is 35%. Required: A. Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm? A. The firm is considering using debt in its capital structure. If the market rate of 5% is appropriate for debt of this kind, what is the after tax cost of debt for the company? What are the advantages and disadvantages of using this type of financing for the firm? A. The firm has decided on a capital structure consisting of 30% debt and 70% new common stock. Calculate the WACC and explain how it is used in the capital budgeting process. A. Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations. A. If the discount rate were 6 percent calculate the NPV of the project. Is this an economically acceptable project to undertake? Why or why not? A. Now calculate the IRR for the project. Is this an acceptable project? Why or why not? Is there a conflict between your answer to part C? Explain why or why not? Wheel has two other possible investment opportunities, which are mutually exclusive, and independent of Investment A above. Both investments will cost $120,000 and have a life of 6 years. The after tax cash flows are expected to be the same over the six year life for both projects, and the probabilities for each year's after tax cash flow is given in the table below. Investment B Investment C Probability After Tax Cash Flow Probability After Tax Cash Flow 0.25 $20,000 0.30 $22,000 0.50 32,000 0.50 40,000 0.25 40,000 0.20 50,000 G. What is the expected value of each project’s annual after tax cash flow? Justify your answers and identify any conflicts between the IRR and the NPV and explain why these conflicts may occur. G. Assuming that the appropriate discount rate for projects of this risk level is 8%, what is the risk-adjusted NPV for each project? Which project, if either, should be selected? Justify your conclusions.
Answer Below:
Wheel Industries is considering a three-year expansion project, Project A. The project requires an initial investment of $1.5 million. The project will use the straight-line depreciation method. The project has no salvage value. It is estimated that the project will generate additional revenues of $1.2 million per year before tax and has additional annual costs of $600,000. The Marginal Tax rate is 35%. A. The adjusted cost of equity formula shows below: r = D1/P0 (1 - f) + g R=2.5(1+6%)/(50*(1-10%))+6% = (2.65/45) +6% = 11.89% Cost of equity= 11.89% Advantages of Equity Financing: Equity capital is the most crucial long-term source of financing. Following are the advantages of it: ? Permanent Capital: It is the permanent form of capital and is available to the company till its existence. Since these are not redeemable, no cash outflow associated with its redemption. It is a permanent capital, and is available for use as long as the company goes. ? Borrowing Base: It helps the company increase its borrowing limit. Lenders generally lend in ratio to the company’s equity capital. Financial capability of the company expands with its issue. It can borrow when it needs additional funds. ? Dividend Payment Discretion: A company is not legally bound to pay dividend. Reduction or suspension is possible in difficult times. Though this is not frequent a company tries to pay dividend regularly. Disadvantages of Equity Financing: Equity capital is bundled with some disadvantages which are as follows: ? Cost: Higher floatation cost on ordinary shares as compared to debt and dividends being non tax deductible. ? Risk: Ordinary shares are riskier form of capital from investor’s point of view reasons being; uncertainty regarding dividend and capital gains. Therefore, they demand a rate of return which makes equity capital as the highest cost source of finance. ? Earnings Dilution: Dilution of ownership is associated with the issue of new ordinary shares. Shareholders’ earnings per share reduce if the profits do not increase immediately in proportion to the increase in the number of ordinary shares. ? Ownership Dilution: Dilution of ownership is associated with the issue of new ordinary shares. Dilution of ownership assumes great significance in the case of closely-held companies. The issuance of ordinary shares can change the ownership. B. the after tax cost of debt for the company = 5%*(1-35%) =3.25% After tax cost of debt= 3.25% The Advantages No loss of control- Control over ownership is intact in debt financing. The right to manage or oversee or running the business and other decision making lies with the owner only and does not passes to the lender. Simple obligations- Obligation involved is to repay the money borrowed. It is not complex. Once repaid business relationship with the lender ends. Tax advantages. The interest on loan is tax deductible for your business which implies significant tax savings for a number of small businesses. Predictable payments- With loans, the principal and interest payments owed is certain and hence planning of cashflows can be done. Many small businesses appreciate this predictability. The Disadvantages Fixed payment terms- The borrowed money must be paid back within a fixed period of time regardless of the success of the business. The installments can become cumbersome on the cashflows of the company. Cash flow problems- If too much reliance is given on debt the company can end up with cash flow problems. High risk reputation- Companies having excessive debt are in their business are viewed as risky by potential investors. This makes it difficult for your business to approach potential investors in order to raise additional capital in the future. Tougher during tough times During recession it can be especially difficult to survive on pure debt financing as the cash flow is most likely be effected during these vulnerable times, it becomes increasingly difficult to pay back your debt with any regularity. High costs - It can be difficult to grow a business that carries high loan repayment costs. It is because of the cash outflows due to loan repayment schedules. Without the ability to reinvest capital, many businesses become obsolete and fail to realize their potential. Collateral and Personal Guarantees-As security, collateral in terms of business assets and/or personally guarantee the loan before money is lent. Personally guaranteeing the loan is a risky affair. C. WACC= =11.89%*70%+3.25%*30% =9.30% The Weighted Average Cost of Capital (WACC) is the first constituent of capital budgeting. The WACC is the amount a business needs to grow on its investments every year to maintain its current overall value. Businesses can raise capital required in two ways: either by taking loans or by issuing shares and parting ownership in its business. Certain amount of return on their investment is expected by the holders of these instruments. Returns vary because debt and equity have different degrees of risk. WACC combines these different elements to provide a "break- even" point that businesses need to make based on the composition of debt and equity in capital, as well as the holders' expectation of return. It is the standard of comparison for evaluating all future projects. D. Year 0 1 2 3 Capex -1500000 Revenue 120000 0 120000 0 120000 0 Op. Cost -600000 -600000 -600000 Depreciation -500000 -500000 -500000 Op. Profit 100000 100000 100000 Taxes -35000 -35000 -35000 Net Profit 65000 65000 65000 Cash Flows -1500000 565000 565000 565000 From revenues operating costs are deducted and then depreciation expenses are deducted to arrive at operating profits from which depreciation and tax is deducted to arrive at net profit. To arrive at net cash flow, depreciation is added back because there has been no cash outflow related with depreciation. Only for tax benefits depreciation is deducted. E. Depreciation = Cost of the asset – salvage value Life of the asset = 1,500,000/ 3 = 500,000 Calculation of cash flows: Revenue – 1,200,000 Less Cost – 600,000 Less Depreciation – 500,000 Profit - 100,000 Less taxes (35%) 35,000 Profit after taxes 65,000 Add depreciation 500,000 Cash flow after taxes 565,000 NPV = Present value of cash flows - Cash outlay = 565,000 x PVIFA 6%, 3 years – 1,500,000 = 565,000 x 2.6730 – 1,500,000 = 1,510,245 – 1,500,000 = 110,245 As the NPV is positive the project should be accepted. F. IRR=-1500000+565000/(1+r) +565000/(1+r)^2 +565000/(1+r)^3 =6.37% No it is not acceptable project as the IRR is less than the WACC of 9.30%. Which is the hurdle rate. Yes there is conflict with C as the IRR is less than WACC which is regarded as the minimum required rate of return in order to accept any project. G. Investment B Investment C Probability After Tax Expecte d Value Probabilit y After Tax Expecte d Value Cash Flow Cash Flow 0.25 $20,00 0 $5,000 0.3 $22,00 0 $6,600 0.5 32000 $16,000 0.5 40000 $20,000 0.25 40000 $10,000 0.2 50000 $10,000 Total $31,000 $36,600 Expected Value 33800 While comparing two projects, the NPV and IRR may provide conflicting results. It may be so that one project has higher NPV while the other has a higher IRR. This difference could occur because of the different cash flow patterns in the two projects. When facing such a situation, the project with a higher NPV should be chosen because there is an underlying reinvestment assumption. There is an assumption that the cash flows will be reinvested at the same discount rate at which they are discounted. In the NPV calculation, the implicit assumption for reinvestment rate is 10%. In IRR, the implicit reinvestment rate assumption is of 29% or 25%. The reinvestment rate of 29% or 25% in IRR is quite unrealistic compared to NPV. This makes the NPV results superior to the IRR results. H. Risk Adjusted NPV of B= Present value of cash flows - Cash outlay = 31000 x PVIFA 8%, 6 years – 120000 =143309-120000 =23309 Risk Adjusted NPV of C= Present value of cash flows - Cash outlay = 36600 x PVIFA 8%, 6 years – 120000 =169197-120000 =49197 As the NPV of project C is higher among the two project C should be accepted.More Articles From Finance
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