About the report
The report is commissioned to ascertain the financial viability of the capital project being considered by North Sea Oil. As part of this project, we will calculate the Net Present Value(NPV) and Internal Rate of Return(IRR) of the projects under two different set of cost of capital, and will comment as how the change in capital structure will affect the shareholders accordingly. The eventual purpose here is to come up with a prudent recommendation for the company as which project will be more profitable for the company and what proportion of capital structure will be more viable for the company.
WACC Calculation
The capital budgeting process involves the discounting of incremental cash flows associated with the project. Therefore, in order to proceed with the capital budgeting analysis, we must calculate the firm’s weighted average cost of capital. Important to note, while the WACC rate is used to discount the incremental cash flows, it is also used as a benchmark rate to compare the IRR rate of the project. Below we have calculated the WACC rate for the company under the original scenario:
WACC= Weight of Debt* After-tax Cost of Debt+ Weight of Equity* Cost of Equity+ Weight of Preferred Equity* Cost of Preferred Equity
= 0.25* 0.07+ 0.50* 0.20+ 0.25*0.19
= 0.0175+ 0.10+ 0.0475
= 16.5%
Important to note, while the above WACC multiple will be used further to appraise the capital projects, we have assumed that this WACC multiple represents the average risk embedded in the firm’s capital project and the cost of long-term debt is given on an after tax basis.
In this section, we will appraise the given capital projects, i.e Project A and Project B, through NPV, IRR and Payback Period. Highlighted below is the outcome of the capital project appraisal under the above stated methods, but under the original as well as new capital structure
-Project Appraisal under existing capita structure
a)Net Present Value:
b) Internal Rate of Return:
c) Payback Period:
Referring to the above figures, we can see that compared to Project A, Project B offers positive NPV, IRR greater than the cost of capital and a lower payback period. Important to note, the outcome of NPV and other capital budgeting tools confirm that if North Sea Oil accepts Project B, it will enhance the shareholder wealth and will also be profitable for the company as the IRR of the project is greater than the cost of capital of 16.5%.
In the nutshell, given capital restrictions or not, Project A is no where viable as it yields a negative NPV multiple and IRR lower than the cost of capital of 16.5%. On the other hand,Project B yields positive NPV and IRR greater than the cost of capital of 16.5%, which confirms its viability for the company.
WACC under the new capital structure
Now, with the assumption that if the project is financed majorly with the equity funds and thus causing the change in the capital structure, the updated cost of capital is calculated below:
WACC= Weight of Debt* After-tax Cost of Debt+ Weight of Equity* Cost of Equity+ Weight of Preferred Equity* Cost of Preferred Equity
= 0.20* 0.07+ 0.60* 0.20+ 0.20*0.19
= 0.0140+ 0.12+ 0.038
= 17.2%
As we may note, the updated cost of capital is higher than the original one. The increase here is attributed to higher proportionate increase in equity capital, which happens to be an expensive source of capital compared to debt financing. Therefore, if North Sea Oil increases the proportion of equity finance from 50% to 60% while simultaneously reducing the proportion of debt and preferred equity, the weighted average cost of capital will increase from 16.5% to 17.2%.
In this section, we will now appraise Project A and Project B with updated cost of capital using the similar tools of NPV, IRR and Payback Period. Highlighted below is the outcome of the capital project appraisal under the above stated methods, but under the revised cost of capital of the firm:
-Project Appraisal under existing capital structure
a) Net Present Value
b)Internal Rate of Return
c) Payback Period
Referring to the above calculations, we can see that if the project is implemented with the higher proportion of equity financing, the NPV of both the projects is affected negatively. As for Project A, at the revised cost of capital of 17.2%, the NPV of the project is magnified pessimistically to -$3861, while the IRR of 16.06%, further confirms non-viability of the project. On the other hand,at the revised cost of capital of 7.2%, Project B is still viable with the positive NPV multiple and IRR greater than the cost of capital. However, compared to the original scenario, the profit potential is low for the shareholders because of higher cost of capital
*Payback period is not affected because of change in the weighted average cost of capital as it ignores the consideration of the time value of money. This is also one of the major limitation of using the payback period for appraising capital projects.
Conclusion and consideration of social responsibility
Post considering both the scenarios related to the weighted average cost of capital of the firm, we found that under either of the scenarios, Project B is more viable for the company with positive NPV multiple, IRR greater than the cost of capital and Payback period comparatively lower than the Project A. Henceforth, without any dilemma, we hereby concludes that North Sea Oil should invest only in Project B as this project will enhance the shareholder wealth with NPV multiple being positive.
However, we also recommend that rather than funding the project with the increased amount of equity financing, the company should choose the existing capital structure with 50% equity financing and 25% weightage to debt and preferred equity each. Important to note, it is in these proportions of capital structure, the profit potential of Project B is more than that with a revised capital structure of 60% equity and 20% weightage to debt and preferred equity.
Finally,before giving their nod to Project B, the company should also give due consideration to social responsibility and should ensure that the project does not impose any harm on the community or the society as a whole. In case the project does not promote the objective of social responsibility, the company should abandon this project too.
References
Bennet, F. (2013). Capital Structure Theory since Modigliani-Miller. Berlin School of Economics and Law.
Dayananda, D. (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University.
Importance and Use of Weighted Average Cost of Capital (WACC). (n.d.). Retrieved February 12, 2016, from http://www.efinancemanagement.com/investment-decisions/importance-and-use-of-weighted-average-cost-of-capital-wacc
Payback Period. (n.d.). Retrieved November 2, 2015, from http://accountingexplained.com/managerial/capital-budgeting/payback-period
