Part A:
Importance of Capital Investment Decision
The university has now reached a stage where it cannot procrastinate the decision to build a new building and replace the existing one, which has now turned expensive to run and is also imposing a poor environmental performance. Therefore, it has now turned crucial for the university to replace the old building with the new one not only because the existing facility impedes the profitability position of the organization, but is also harming the environment and is thus sending a negative signal amongst the community.
Henceforth, the university should proceed with the appraisal of this capital project using a sophisticated capital budgeting technique, which we have discussed in the next section.
Capital Budgeting Technqiues
i)Net present value(NPV):
Rated as the most sophisticated capital budgeting technique, NPV is the sum of net present value of expected incremental cash flows if a project is undertaken. In other words, NPV is the present value of the expected inflows minus the initial cost of the project. Highlighted below are the pros and cons related with NPV method:
Pros:
Consider the cash flows throughout the period of the project
Incorporates the concept of time value of money
The outcome of the NPV analysis is directly related to the value of the organization
Consider the risk of future cash flows
Cons:
Requires estimation of cost of capital, which is a subjective multiple and is prone to error
Complex and expensive to use as involve a lot of research and third-party consultation expenses
Does not include any consideration for the size of the project
ii) Internal Rate of Return(IRR)
It is the discount rate that makes the present value of cash inflows equal to initial outlay for the project. Stated otherwise, IRR is the discount rate that makes the present value of cash inflows equal to the present value of cash outflows. Highlighted below are the pros and cons related to IRR method:
Pros:
Consider the cash flows throughout the period of the project
Incorporates the concept of time value of money
The outcome of the IRR analysis is directly related to the value of the organization
Consider the risk of future cash flows
Cons:
Requires estimation of cost of capital, which is a subjective multiple and is prone to error
Useless when the pattern of cash flow is uncertain and the project involves multiple cash outflow
May not give prudent results when used to compare mutually exclusive projects
May not give value-maximizing results when used to compare projcts under the restriction of capital rationing
iii) Payback Period
Cited as the most simple and widely used capital budgeting method, payback period is the amount of time it will take for the project to recover the initial cost of investment. Highlighted below are the pros and cons related to IRR method:
Pros
Simple and easy to apply and understand
Direct indicator of liquidity factors associated with the project
Cons
Ignores time value of money
Do not consider the cash flows after the payback period
Ignores risk of future cash flows
Useless measure of profitability
Other Factors
Even though the above stated capital budgeting methods give an overview of the feasibility of the capital project, but in additional to financial feasibility, the university will also need to consider other factors before the project is finally approved.
Impact on environment
Even though the existing building is yielding poor performance of the environment, however, the university will also need to ensure that the construction of the new building should not pose any harm to the environment also. Important to note, over the past decades, the community has realized the potential of green environment and develop an ill-feeling for organizations that do not invest in the environment friendly buildings and look only for cost savings.
Impact on community and Government Regulation
The university will need to make sure that the construction of the new building should not harm the community in any way. Additionally, the university should ensure that it has all the required permissions from the government for re-constructing the building.
Overall Risk
The university should ensure that it has the capacity to absorb both financial as well as non-financial risk associated with the project. Important to note, while the financial risk will be duly accounted for in the cost of capital multiple, non-financial risk associated with the project.
Part B:
Funding the project
As already discussed in the preceding section, capital projects involve a significant amount of cash flow and it thus becomes crucial for the entity to choose a right mix of financing sources for the project. However, the decision relating to project funding cannot be taken overnight as the pros and cons relating to each funding sources are required to be meticulously considered. Highlighted below are the two funding options for the Spark’s project along with the relevant pros and cons related with each of then:
a) Debt Funding
Debt funds are the amount borrowed from one party to the other with a mandatory obligation to repay the amount along with interest, which are paid regularly on the time period specified in the bond covenant.
Here, the university can raise debt funds through a financial institution or by issuing bonds.
Advantages of debt funding:
i) Tax Advantage:
Cited as one of the biggest advantage associated with debt funding is the interest deductibility and related tax advantage. Important to note, both IFRS and US GAAP allows the entities to include the interest paid on debt amount borrowed as an expense in the income statement. Accordingly, this provision results in lower net income and lower tax bills for the entity.
ii) Low cost of capital
Since debt funding is primarily based on collateralised assets and since the debtholders even get preference for payment if the company opts for liquidation, an entity is able to raise the debt funds at a comparatively lower cost of capital.
iii) No dilution of ownership
Unlike equity issue or raising capital through venture capitalists, which seeks ownership stake in the company and board representation in lieu of their investment, raising funds through debt sources do not result in dilution of ownership or the authority to interfere in the managerial decisions of the company. In lieu of funds raised, the borrower need to make timely interest payment to the lender,be it the financial institution or the bond holders.
iv) No dilution of share of profits
Another advantage of raising funds through debt sources is that since debt funding do not result in any dilution of ownership, the entity does not need to share its profit. Accordingly, earnings per share tend to remain higher and each share retains its earnings per share ratio.
-Disadvantages of debt funding:
i) Associated risk of bankruptcy
An entity raising funds through debt sources assumes the mandatory obligation to repay the borrowed amount along with timely interest payments. Hence,even at times of low financial profits or cash flow, the borrower is required to make the interest payments on time, and in the event of non-payment of debt related payments, the entity can face the bankruptcy risk which will give the lender the full entitlement over the mortgaged assets. This can further tarnish the financial standing and image of the company and will affect the future borrowing needs of the entity.
ii) Limited funding available
Since debt funds are issued against the collateralized assets, the amount of funding available to the borrower against the mortgage is limited. Most of the financial institutions offer loan amount of only 75% of the value of the mortgage assets. Therefore, debt is not a feasible option for an entity seeking a high amount of capital to fund their projects.
b) Equity Funding/Private Placement
Equity funding can be in the form of a public issue or private placement. As part of the equity funding, the entity will raise capital from the equity lenders in lieu of a share of ownership in the company, which will be granted on the proportionate basis of the amount of capital invested.
Since the university is not publicly listed, it can seek funding through private placement as part of which it can sell the stock to a group of investors, which can be private participants or endowment funds
Advantages of equity funding
i) No obligation to repay
Unlike debt funding, where the borrower is required to make timely interest and principal related payments, the entity raising capital through equity sources has no such obligation and all the risk is borne by the investor only.
ii) Significant funding available
Since the equity funding is raised through private sources, it allows the company to raise a large amount of capital compared to debt funding.
Disadvantages of equity funding:
i) High cost of capital
Since the equity investors assume a high investment and have a least preference to claim funds at the time of liquidation, they charge a high cost from the borrowing entity.
ii) Dilution of ownership
Unlike debt financing, equity investors demand a proportional ownership stake in the company in lieu of their investment. Therefore, the additional dilution may not favor the company as an excessive or unwanted outside interference in management board may delay the decision making process. In addition, additional dilution also results in lower earnings per share, which may not be favored by the prospective investors in the company.
c)Grants and Donations
Being an educational institution, the university can also fund the project through grants and donations from the government as well as other non-profit organizations.
Deciding upon the discount rate
Discount rate or WACC rate is a crucial aspect while performing the capital budgeting analysis as this financial metric is used to discount the cash flows, which are later used for performing the final analysis in method such as NPV and IRR. However, while using the WACC rate as the discount rate, managers must understand that WACC only represent the average risk of the company, and if managers are evaluating a project with risk level different than the average risk of the company, then the discount rate should be adjusted appropriately. For instance, to evaluate a project with greater than average risk, a discount rate greater than WACC should be used, vice-versa.
In addition, if the project is being set up in a risky sovereign environment or if the sales are targeted in a risky market, then the discount rate should also included country risk premium associated with that country.
Other factors
i) Sunk Costs
Sunk costs are the costs that are paid to third-party researchers or consultants as a fee for collecting pre-appraisal data, such as estimated demand for the product or project related costs. Important to note, sunk costs cannot be avoided even if the project is not undertaken and since these are expenses irrespective of the accept/reject decisions, they should not be included in the analysis.
ii) Externalities
Externalities are the effects the acceptance of a project have on firm’s other cash flows. Therefore, if with the acceptance of a project, the firm will lose any of the existing cash flows, even they should also be included in the capital budgeting analysis.
Evaluating the Project
Highlighted below is the outcome of project appraisal so performed using the NPV method and using the discount rate of 10%.
Project Appraisal
We will be appraising the project using the Net Present Value(NPV) method under the following assumptions:
The project will have a measurable life of 5 years, post which, the cost estimation will be difficult
Cash Flows will be discounted at 10%
For year 1, the present level of income(£118,386,000) will remain unchanged, and the university will have 5% additional income every year thereafter
Net Present Value
Conclusion
As we can see from the above schedule, the project yields a positive NPV multiple of £17,727,017.16 under the assumption of 5-year measurable life and a discount rate of 10%. Therefore, considering the positive NPV multiple, which confirms that the new building will create a positive value for the institution, we conclude that the university should undertake the project.
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