Assignment: LASA- Capital Budgeting Techniques
As a financial consultant, you have contracted with Wheel Industries to evaluate their procedures involving the evaluation of long term investment opportunities. You have agreed to provide a detailed report illustrating the use of several techniques for evaluating capital projects including the weighted average cost of capital to the firm, the anticipated cash flows for the projects, and the methods used for project selection. In addition, you have been asked to evaluate two projects, incorporating risk into the calculations.
You have also agreed to provide an 8-10 page report, in good form, with detailed explanation of your methodology, findings, and recommendations.
Company Information
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%.
Required:
A. Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm?
B. The firm is considering using debt in its capital structure. If the market rate of 5% is appropriate for debt of this kind, what is the after tax cost of debt for the company? What are the advantages and disadvantages of using this type of financing for the firm?
C. The firm has decided on a capital structure consisting of 30% debt and 70% new common stock. Calculate the WACC and explain how it is used in the capital budgeting process.
D. Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations.
E. If the discount rate were 6 percent calculate the NPV of the project. Is this an economically acceptable project to undertake? Why or why not?
F. Now calculate the IRR for the project. Is this an acceptable project? Why or why not? Is there a conflict between your answer to part C? Explain why or why not?
Wheel has two other possible investment opportunities, which are mutually exclusive, and independent of Investment A above. Both investments will cost $120,000 and have a life of 6 years. The after tax cash flows are expected to be the same over the six year life for both projects, and the probabilities for each year's after tax cash flow is given in the table below.
|
Investment B
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Investment C
|
|
Probability
|
After Tax Cash Flow
|
Probability
|
After Tax Cash Flow
|
|
0.25
|
$20,000
|
0.30
|
$22,000
|
|
0.50
|
32,000
|
0.50
|
40,000
|
|
0.25
|
40,000
|
0.20
|
50,000
|
G. What is the expected value of each project's annual after tax cash flow? Justify your answers and identify any conflicts between the IRR and the NPV and explain why these conflicts may occur.
H. Assuming that the appropriate discount rate for projects of this risk level is 8%, what is the risk-adjusted NPV for each project? Which project, if either, should be selected? Justify your conclusions.
Capital Structure
The capital structure of an organization is the combination of sources of funds such as debt, preferred stock, and common stock. The amount of debt that a firm uses to finance its assets is called leverage. A firm that carries a large amount of debt in its capital structure is said to have high leverage. A firm that does not carry any debt is said to be unlevered.
Debt Vs. Equity Financing
It is less expensive to finance a business through borrowing than through equity because:
o Lenders expect a lower rate of return than shareholders. Debt financial securities present a lower risk than shares for finance providers because they have prior claims on annual income and liquidation. In addition security is provided and covenants are incorporated into bond contracts, which reduce the risk to bondholders.
o The debt interest can be offset against pretax profits before the calculation of the corporation tax bill thereby reducing the tax to be paid.
o Issuing and transaction costs associated with raising and servicing debt are generally less than for shares.
These are a few benefits of financing with debt. However, firms tend to avoid very high leverage levels because of the risk of financial distress. This risk arises as a result of requiring to pay interest, regardless of the cash flow of the business. If the firm goes through a recession, it may find it difficult to pay bondholders, bankers, and other creditors. Doing so would most likely result in bankruptcy.
Determinants of the Optimal Capital Structure
o The Tax Deductibility of Interest: Tends to increase the use of debt in the firm's capital structure.
o Financial Risk: The increased financial risk as a result of increased use of debt tends to moderate the use of debt in the firm's capital structure.
The firm's optimal capital structure should be a balance between debt and equity. Cost advantages as a result of using cheaper debt are matched by the increase in financial risk associated with larger debt. There probably exists a range of acceptable debt-asset ratios where the overall cost of funds is low and consequently the firm value is high.