About the report
The report is based on our assistance given to Wheel Industries where we have analyzed the long term investment opportunities available with the company using the techniques of capital budgeting. To facilitate better understanding for our readers, we have included all the calculations within this report while every calculation is explained comprehensively.
Project Details
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%.We have decided to appraise the project using the technique of Net Present Value(NPV) analysis, however, before we perform the necessary calculations, it is important that we ascertain the required inputs for the NPV model. However, before we calculate the other inputs required for NPV calculations, let us compile some given information:
Initial investment= $1.5 million
Project Duration= 3 Years
Additional Revenue before tax per year = $1.2 million
Additional Annual Costs = $600,000
Marginal Tax Rate = 35%
Salvage Value = $0
Depreciation expenses(Following Straight Line Method)= ($1,500,000 - 0)/3 =$500,000/ year
Estimation of Cost of Equity
Cost of equity represents the required rate of return for the equity investors and the same is calculated using dividend discount mode with following formula:
Cost of Equity = {Forecasted Dividend Per share/ (Stock Price*(1-FloatationCosts))} + Dividend growth rate
Current Dividend per share = $2.5
Growth Rate of Dividends = 6%
Stock price = $50
Floatation Costs = 10%
Forecasted dividend Per share = $2.5 X (1.06) = $2.65
Applying the inputs in the above formula, we get:
Cost of Equity= 2.65/(50-5)+ 6%
Cost of Equity= 11.89%
Advantages of Equity Financing
a) Access to large capital base and less burden
Unlike debt financing, equity funding gives access to the large amount of capital through the market investors. Therefore, whenever an entity is citing a high amount of a capital expenditure, it will probably go for equity financing. Additionally, since the equity funding do not obligate the borrowing entity to return the fund(though every corporate activity is screened meticulously by Security and Exchange Commission), it allows the entity to work with a long-term focus rather than caring about the monthly debt repayments.
b) Access to experienced managers
A wider access to capital and the corporate recognition associated with equity financing allows the entity to hire experienced managers and utilize their corporate expertise to enhance the profitability.
Disadvantages of Equity Financing
a) High cost of capital
While equity financing does provide the company with the access to large source of capital, however this comes at the expense of higher cost of capital. As discussed previously, equity investors are exposed to higher risk as the borrowing company is under no obligation to return the funds. Therefore, since the equity investors are exposed to higher risk levels, they are to be compensated with higher cost of capital.
b) Dilution of ownership
This is one of the most prominent disadvantage associated with the equity financing. Important to note, selling stock in the capital market to raise equity financing is equal to selling part ownership in the company, therefore, with the equity funding, the company also dilutes its ownership with outside investors. It is considerable that if any investor holds more than 50% of the total stock holding of the company, he ultimately becomes the controlling owner of the company and has a power to overthrow existing management.
c) Dilution of ownership
With the equity issue comes another disadvantage of dilution of profit of the company. In other words,with the additional equity issue, more shareholders become eligible to claim their share of profits in the company.
B) Cost of Debt:
Debt is the second component for the overall cost of capital of the firm. However, for the estimation purpose, it is important that we use after-tax debt rate as interest payment on debt borrowings are tax deductible. Below we have calculated the after-tax cost of debt:
After Tax cost of debt: Before tax cost of debt* (1-tax rate)
= 0.05*(1-0.35)
= 3.25%
Advantages of Debt Financing
i)Offers Tax Shield
Since the interest paid on debt borrowings is tax deductible under the accounting standards of most countries, borrowing debt allows the company to add interest expense on the income statement and thus reduce their tax bills. Tax shield is the primary advantage of debt funding.
ii) Low cost of capital
Since debt funds are always available against collateral security, borrowing company is able to arrange the funds at a comparatively lower rate than the equity capital. Company with higher cost of capital usually adjusts their capital structure by borrowing additional debt and repurchasing equity to lower the overall cost of capital.
Disadvantages of Debt Financing
i) Financial Distress
Unlike equity funding, debt funding saves the entity from ownership dilution, however, the borrowing company is under the obligation to repay the borrowed funds on the monthly basis along with the interest, irrespective of its financial institution. Hence, if the borrowing company fails to make timely payment, it may face the bankruptcy threat.
ii) Strict covenant
Every company that issues bonds or other fixed income security to raise funds, is obliged to follow the bond covenant related to timely payment of interest and principal amount, issue of dividends to equity holders, maintenance of financial ratios, et cetera. This restricts the company to use the funds with the desired flexibility as with the equity capital.
C) Calculation of WACC
Since now we have calculated the cost of equity and cost of debt, we can now calculate the WACC rate for the company using the following expression:
WACC= Weight of debt* Cost of debt(1-tax rate)+ Weight of Equity* Cost of Equity
= 0.30* 0.0325+ 0.70* 0.1189
= 0.00975+ 0.08323
= 9.30%
Important to note, the WACC rate is the hurdle rate and represents the overall cost of capital for the firm. In other words, this is the minimum return, which the investors demand in order to channelize their funds into the company. Accordingly, this is the benchmark rate of return, which guides the company as which project to undertake and which to abandon.For instance, during the NPV analysis, operating cash flows are discounted using the WACC rate, while IRR multiple is compared with WACC rate to access whether the returns of the projects are greater than the cost of capital of the firm.
D) Estimation of Cash Flows
We have used the standard method for calculation of operating cash flow using the following:
= (Sales- Costs- Depreciation)*(1-Tax Rate)+ Depreciation
Since the depreciation expense is a non cash expense, it is required to be included in the operating cash flow estimation.Important to note, since the firm follows straight line depreciation, an equal amount of depreciation is included in our calculations. The calculations related to the depreciation amount in the ‘Project Details’ section.
e) Estimating NPV at 6% discount rate
As we can see from the above table, following a discount rate of 6%, the project yields a positive NPV multiple of $10251. 75. This confirms that at the discount rate of 6%, the project is economically viable as the project with a positive NPV multiple indicate that the said project will add value for the shareholders through higher stock price in the coming future.
f) Estimating Internal Rate of Return
Evaluating the capital project using the IRR multiple is the second most prominent method. However, many a times, IRR give conflicting results. For instance, in the above table, we can see that the IRR of the project is higher than the assumed WACC rate of 6%. Therefore, the outcome of IRR multiple aligns with that of the NPV multiple, and confirms that the company can go ahead with the project without any second thought.
Important to note, in the situation of conflicting results between NPV and IRR multiple, it is highly recommended that the firm should follow NPV outcome as the same is related directly to shareholder wealth and the stock price of the company. For instance, if the project’s IRR is compared with the actual WACC rate of 9.36%, the project turns unfeasible as the IRR will then be less than the WACC rate. However, if the project still yield positive multiple at 9.36%, the company should accept the outcome of NPV analysis and disregard IRR outcome.
Evaluating two other projects
a) Estimating Cash Flows
The cash flows for these two projects are based on probabilities. Therefore, the operating cash flow has been calculated on the same basis. Below we have ascertained the cash flows for both the projects:
Project B:
= 0.25*20000+ 0.50*32000+ 0.25*40000
= $31000
Project C:
= 0.30* 22000+ 0.50*40000+ 0.20*50000
= $36600
b) Calculating Value for the Projects
Just like the previous project, we have appraised both of these projects on the basis of NPV and IRR method. The outcome of both of these methods is discussed below:
-Project B:
-Project C:
Referring to the above calculations, we can see that both the projects are highly profitable for the company and the same is validated by the outcome of the NPV and IRR multiple. As for project B, the same has NPV of $23309.17 and IRR of 14.17%. Therefore, with positive NPV multiple and IRR greater than the cost of capital of 8%, we confirm that the company can go ahead with this project. However, on the other hand, Project C offers higher NPV of $49197.40 and better IRR of 20.57%, making it more lucrative for the company to accept this project in comparison to Project C.
Conclusion
As for the project evaluation; beginning with the Project A, our appraisal, using NPV method and IRR method confirms that at 6% cost of capital, the project is viable and will add value to the shareholder wealth.Therefore,the company should go ahead with the Project A.
On the other hand, in addition to Project A, we also evaluated Project B and Project C, which were mutually exclusive project being considered by the company. Our analysis revealed that at the discount rate of 8%, both the projects are viable with a positive NPV multiple and IRR greater than the cost of capital of 8%. However, since Project C yields higher NPV multiple, we recommend that Project C should be given preference over Project B as the former project have higher potential to add value to the shareholder wealth.
References
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 June 2, 2016, from https://www.efinancemanagement.com/investment-decisions/importance-and-use-of-weighted-average-cost-of-capital-wacc
Kokemuller, N. (n.d.). The Advantages and Disadvantages of Debt and Equity Financing. Retrieved June 2, 2016, from http://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html
Kunigis, A. (n.d.). How to Finance Your Business Growth. Retrieved June 2, 2016, from http://www.thehartford.com/business-playbook/in-depth/equity-financing
NPV vs IRR. (n.d.). Retrieved June 2, 2016, from http://accountingexplained.com/managerial/capital-budgeting/npv-vs-irr
