Assignment 1: LASA # 2—Capital Budgeting Techniques

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Assignment 1 LASA # 2—Capital Budgeting Techniques

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Solution:-
A) Computation of WACC:-
Cost of equity (Ke) will be calculated using dividend discount model which is as under:-
Price of share (P0) = D1/(Ke-g)
Ke = (D1/(P0*(1-f))) + g
Where,
D1 = D0*(1+g)
F = Flotation cost
Ke = ((2.50*(1+6%))/(50*(1-10%))) + 6%
Ke = 11.89%
i)                    Equity financing and debt financing are two different sources of financing being used by the organizations to procure funds. Equity and debt are two different sources of financing, equity financing represents internal source of finance whereas debt financing represent external source of finance. Mixture of both is always used by the business organizations to procure funds and is most commonly known as target ratio or capital structure ratio. This ration varies from industry to industry and company and company depending upon various circumstances, equity financing can be raised only through issuing shares in market by the help of initial public offer whereas debt financing can be raise from many sources such as bonds, long term loans, money market instruments etc.
Equity Financing has following advantages:
1.                  The total cash flows generated can be used solely for investment purpose, rather than paying back the investors.
2.                  Funds can be raised in shorter time as compared to other sources of funds.
However, in equity financing, dilution of ownership easily occurs and more investors can lead to loss of Control.
Cost of debt (Kd) will be calculated as follows:-
Kd = Market rate of deb*(1-tax rate)
Kd = 5%*(1-35%)
Kd = 3.25%
Debt is a more common source of finance used by most of the organizations, the reason for the same is as follows:-
a.                   Debt is cheaper source of finance as compared to equity the reason being the cost associated with issuing the common stock like. Underwriters commission, legal expenses, various registration charges, issuing of prospectus, printing of various documents etc.
b.                  Debt financing provide leverage to the company which will increase the Earning per Share (EPS) which in turn leads to increase in market value of share, this helps organization to maximize its market capitalization.
However, if the expansion venture does not work in favour of the company, then these obligations of repayment of principal and interest may turnout to be a burden to the company.
WACC = (Ke*We) + (Kd*Wd)
WACC = (11.89%*70%) + (3.25%*30%)
WACC = 9.30%
B) Computation of NPV of project A:-
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 – 1,200,000
= 565,000 x 2.6730 – 1,200,000
= 1,510,245 – 1,200,000
= 310,245
As the NPV is positive the project should be accepted.
C) Computation of IRR of project A:-
Cash flow after taxes (per year) = 565,000
Life of project = 3 years
Initial investment = $1,200,000
IRR would be as follows:-
At correct IRR, NPV of the project is 0
Let IRR of the Project 15%
NPV @15% (Annual cash flow*Present value annuity factor@15%,3 year) - Initial investment cost
(565000*2.28)-1200000
88200
Let IRR of the Project 20%
NPV @10% (Annual cash flow*Present value annuity factor@20%,3 year) - Initial investment cost
(565000*2.11)-1200000
-7850
Computaion of IRR:-
NPV @15% 88200
NPV @20% -7850
IRR 15%+(5%/(88200-(-7850))*88200)
19.59%
As per IRR method project is acceptable, IRR of the project is 19.59% which is higher than the required rate of return i.e. 6%. If IRR is higher than minimum required rate of return than such project must be accepted as it will add value to it. Decision as per NPV method and IRR method is same and there is no conflict between both of them.
D) Computation of NPV and IRR of investment B and C:-
Investment B
Initial investment = $120,000
Life of investment = 6 Years
Probable cash flows = (0.25*20000)+(0.5*32000)+(0.25*40000)
Probable cash flows = $31,000 Per year
NPV = Present value of cash flows - Cash outlay
= 31,000 x PVIFA 9.3%,3 years - 120,000
= 31,000 x 4.45 – 120,000
= $17,950
As the NPV is positive the project should be accepted.
IRR would be as follows:-
At correct IRR, NPV of the project is 0
Let IRR of the Project 15%
NPV @15% (Annual cash flow*Present value annuity factor@15%,6 year) - Initial investment cost
(31000*3.79)-120000
-2510
Let IRR of the Project 10%
NPV @10% (Annual cash flow*Present value annuity factor@20%,6 year) - Initial investment cost
(31000*4.36)-120000
15160
Computaion of IRR:-
NPV @10% 15160
NPV @15% -2510
IRR 10%+(5%/(15160-(-2510))*15160)
14.29%
Investment C
Initial investment = $120,000
Life of investment = 6 Years
Probable cash flows = (0.3*22000)+(0.5*40000)+(0.2*50000)
Probable cash flows = $36,600 Per year
NPV = Present value of cash flows - Cash outlay
= 36,000 x PVIFA 9.3%,3 years - 120,000
= 36,000 x 4.45 – 120,000
= $40,200
As the NPV is positive the project should be accepted.
IRR would be as follows:-
At correct IRR, NPV of the project is 0
Let IRR of the Project 15%
NPV @15% (Annual cash flow*Present value annuity factor@15%,6 year) - Initial investment cost
(36000*3.79)-120000
16440
Let IRR of the Project 20%
NPV @10% (Annual cash flow*Present value annuity factor@20%,6 year) - Initial investment cost
(36000*3.33)-120000
-120
Computaion of IRR:-
NPV @15% 16440
NPV @20% -120
IRR 15%+(5%/(16440-(-120))*16440)
19.96%
Investment C have higher IRR and NPV as compared to investment B and therefore it must be selected.

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YOU CAN USE THIS DATA ON WORD FILE ALSO
Steps Used to derive Weighted Average Cost of Capital (WACC):- Step 1:- First step in computation of WACC is to find the cost of debt, cost of preference share and cost of equity and their respective weights in the capital structure. Step 2:- Computation of cost of debt is done in the following manner:- a) Write down the Coupon rate, periodicity of payment of interest, Years to maturity, current price, Face value and tax rate of the bonds issued by the UPC. b) Using the formula of rate compute the yield offered by the bonds (i.e. pre-tax cost of debt) issued by the UPC, formula for computing rate is as follows, “=rate (nper,pmt,pv,fv)”. c) After determining the rate compute the after tax rate i.e. cost of debt by using the following formula, = Pre-tax cost of debt*(1-tax rate). Step 3:- Now next step is to compute cost of preferred stock, it is very simple to compute the cost of preferred stock. First calculate the amount of preference dividend to be paid by multiplying par value of preferred stock with the percentage of dividend by the preferred stock, the divide the resultant figure by the present market value of the stock. The figure derived is the cost of preferred stock. Step 4:- Next step in the calculation is to find the cost of common stock. Now in the present case we will determine the cost of common stock by taking average of cost of common stock computed by three methods. Three methods are as follows, a) CAPM approach. b) Discounted cash flow technique. c) Bond yield plus risk premium technique. In CAPM model we will use the following formula to determine the cost of common stock, Cost of common stock = Risk free return + (Beta of stock*Market risk premium). In discounted cash flow technique we will use the following formula to determine the cost of common stock, Cost of common stock = (Expected dividend/Price of common stock) + growth rate. In Bond yield plus risk premium technique use the following formula to determine the cost of common stock, Cost of common stock = Bond yield + Risk premium. Step 5:- After determining the cost of debt, cost of preferred stock and cost of equity use the following formula to compute the weighted average cost of capital (WACC), WACC = (Weight of debt*cost of debt) + (Weight of preferred stock*cost of preferred stock) + (Weight of common stock*cost of common stock). Weight of debt, preferred stock and common stock are the total market value of these on the date of computing WACC. Challenges Involved in deriving WACC:- There are certain challenges which are faced during the calculation of WACC these are as follows, a) It is very difficult to correctly predict the risk free rate of interest. b) Measuring beta is a very typical and complex process. c) Beta is a good measure to determine the rate of return for a short period of time whereas for a long period of time it is better to rely on the fundamentals of the company. Other capital project evaluation techniques:- NPV and IRR are two capital budgeting techniques used to evaluate the projects. Usually the result provided by both of them is same but in some cases the result provided by NPV can differ from result provided by IRR. IRR depends only on the discount rates for instance say we are evaluating two projects having same discount rates, similar income flow, same time period then it would be easy to evaluate both the projects by using IRR technique but discount rates do not remain same over the period of time, it changes with time. So here using IRR technique is difficult also if some project shows both positive and negative cash flow in such case using IRR as evaluation technique is not effective. If in the project investors are planning to invest the money in every two to three years then it is not effective to use IRR technique for evaluating purpose. Quantitative factors are not the only way for evaluation of a project, Qualitative factors should also be considered such as effect on market reputation from accepting or rejecting the project, Synergy generated due to use of large resources. Reference List:- Ross, Westerfield and Jaffee, Corporate Finance Brigham Houson, Fundamentals of Financial Management.

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