1.
Capital budgeting utilizes various financial tools in evaluating investment options. Of important consideration in these decisions is the cost of capital, since it determines the returns that will accrue from the investment decision (Brealey, et al 2011) The cost of capital can be two fold, either the published interest rates by the financial institutions, or the average of all the sources of financing for the project, a method called the weighted average cost of capital. (Please see the attached excel workings for the company’s weighted average cost of capital)
In determining the most appropriate cost of capital for the company, it’s important to evaluate the views of the chairman as well as the chief accountant. The chairman is of the opinion that a capital cost of 7.5% is appropriate for the company, while the accountant believes that the computed weighted average cost of capital of 15% would be most the appropriate.
The weighted average cost of capital is defined as the minimum cost of capital required to create value for the firm. As earlier explained, the cost of capital determines the return that the investors should expect from an investment and therefore, in this scenario, the weighted average cost of capital appears more appropriate, since it assigns weights to the various sources and then averages these to arrive at the cost of capital. This appears more reasonable, also, since it considers all the sources of capital, unlike the proposal by the chairman that assigns an arbitrary figure to the cost of capital, without realistically and objectively determining these costs using a given criteria.
Since we have bond financing, mezzanine financing as well as ordinary share capital, it would be more appropriate to assign weights to these sources of capital and average them to arrive at a more reasonable cost, which takes into consideration all these sources of capital in arriving at the weighted average cost of capital.
2.
A summary of results for the two projects is shown below. A comprehensive computation and results of the analysis appears on the excel workbook attached. Please refer.
In arriving at these results, a number of information from the case study provided has been utilized, but also, we have omitted some of the information provided, since while it’s informative, it’s not relevant for the purpose of computation, but may be useful in more analysis of the merits of these two projects. All the information provided in the case study has been utilized, except for the below explained items that have been omitted by virtue of being irrelevant with regard to the computations and appraisal of these projects. This information is however important in making further analysis of the projects, which are not covered under the investment appraisal methods utilized under this study.
In the case study, we are informed that a quarter of the factory premises are currently vacant, meaning that there is extra capacity in terms of premises. This part of the promises is still already being paid for, meaning that there is no additional cost for the company with the new or expansionary project, and therefore, the share of the rent is in this case an irrelevant cost with regard to this investment appraisal and has therefore been omitted for the purposes of the above computations (Higgins, 1998).
Apart from the new production executive who is due to be hired for the new project at an annual salary of 80,000, the other overhead costs are already being incurred by the company even without the new or expansionary project being initiated. This means that the overheads to be allocated are actually irrelevant in that they were already being incurred and will still be paid for, whether the company initiates these projects or not and therefore have been omitted in the above computations.
The £1.25 million incurred for the research and developed also falls under this category of irrelevant costs since its already incurred and whether the company implements the project or not, this cost is incurred and therefore does not count in future decisions regarding implementation of the project and has consequently been omitted from the calculations in arriving at the results shown above.
3.
For the purpose of this question, I shall address the merits and demerits of the weighted average cost of capital that has widely been discussed in this paper. As earlier explained, the WACC is deemed one of the most appropriate methods of determining the cost of capital for appraising investment projects (Beck, J. and De Marzo, 2009). Some of the advantages of using the weighted average costs of capital include the facts that it’s simple and easy to use. Given the various components that make up the capital structure of the company as well as the assigned weights, it’s quite easy to compute this financial metric. Additionally, the same computed weighted average cost of capital rate can be used for all the projects being evaluated and therefore there is no need to compute for each of the project, which makes it an easy financial tool.
Lastly, the weighted average cost of capital, unlike the ordinary cost of capital that utilizes the cheapest cost of capital after individually calculating the costs for each of them, normally averages the costs of all the available sources of capital, and therefore arrives at the most appropriate result, since all the available sources are factored in the computation (Damodaran, Aswath 2002).
This method is not without some limitations, resulting from some of the assumptions made by this method. One of the most prominent assumptions is that all the projects undertaken are of similar risk profile, which is normally not the case, as different projects are of different risks and therefore reliance on this method with disregard to the individual projects risk profile could lead to less than optimal results (Velez-Pareja, Ignacio, and Tham Joseph, 2005)
It’s also assumed, under this method, that the sources and mix of capital for financing the competing projects is similar to that of the company, which may not be the case, and therefore, this method may be misleading to some extent if over relied on.
The chairman’s proposal that 7.5% is used as the cost of capital is a bit off the mark, since, despite that fact that mezzanine financing is the main source of financing, the other sources of finance must also be considered in determining the actual costs of capital, and therefore the 15% arrived at using the weighted average cost of capital seems to be the most appropriate (Beck, J. and De Marzo, 2009). Using the chairman’s proposal as the cost of capital has the effect of generating negative not present values in most of the instances since it does not reflect the actual costs of financing.
4.
Raising capital through an IPO has a number of advantages for a company like Kaavalan. First and foremost, an IPO is a very fast method of raising capital, which is ideal for the company since it requires capital to finance these projects immediately. Secondly, a company that raises capital through an IPO not only benefits from the large pool of resources but also benefits from the publicity that comes with the listing process and therefore we even have an increase market share.
A major disadvantage of a company going public through an IPO is that the company is now required to make many additional disclosures as per the requirements of the securities exchange act of 1934. The company is also expected to meet a host of other rules and regulations as per the securities exchange commission, which is costly to the company.
Venture capital finance
Venture capital is a source of financing where a venture capitalist invests in an owners business in consideration for an ownership stake in the business (Stein, Jeremy, 1989) One of the major advantages of this sort of arrangement is that the company is able to raise capital very fast, without having to go through strenuous steps of having collateral, or being subjected to stringent reporting responsibilities.
The main disadvantage of this form of financing is that the financing company gets a stake in the company, and therefore, there is dilution of power of the existing shareholders. The new partner may also bring in rules of operations that may be unfavourable to the existing shareholders or management of the company.
Business angels
The main advantage of a business angel is that it’s of course much a faster method of financing than most of the other options such as a bank loan. There is also the benefit of business advice from the angel especially for the new business owners. The major disadvantage of this form of business financing is that the angels are not easy to find, besides demanding a share of the profit from the business, besides also demanding to own a part of the business.
Conclusion
The aforementioned discussion summarizes the case study Kaavalan limited that is faced with the option of developing the existing business or rather developing another product. The calculations in the attached excel file indicate that the company is better off putting their money into the expansionary project as opposed to launching and producing the new product. This is evident from the fact that all the capital budgeting appraisal methods point to the fact that the expansionary project has a higher Net present value, internal rate of return as well as a shorter payback period. The project is also less sensitive to the increasing cost of capital.
References
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