Capital Budgeting Techniques - Assignment Example

Capital budgeting techniques al affiliation Question A Cost of additional equity Cost of new equity =dividend per share for the next year/ current market price [1-flotation cost] + dividend growth rate. Current price Next year’s dividend = d1=d0[1+g] d1=2.5[1+0.06] =2.65 Growth 6% Current market price = 50 Flotation cost=10% Ke=2.65/[50(1-0.1)+6% =11.8889% Advantages of equity financing Equity as a source of finance is repaid. Any risk and subsequent liability is shared with new investors thereby giving room for risk dilution. It is also important to note that equity does not have an obligation to pay interest therefore the management of the company is at liberty of making any long-term financial decision from retained earnings (Wilkes, 1983). Equity also leads to a low debt to equity ratio which will in turn help the company in getting future long-term loans when needed. Disadvantages of equity financing The use of additional equity has a negative effect life for instance the level of control is reduced since ownership is partial. When a company makes use of big investors, it will most definitely insist on having an executive position or representatives on company’s board (Dayananda, 2002). Future earnings will therefore be shared with such investors. This would in turn exceed interest that would be payable to serve an equivalent loan if it was used to finance the project (Wilkes, 1983). Question B Cost of debt finance Cost of debt=interest rate*[1-taxt] =5%*[1-.35]=3.25% Advantages of debt financing In comparison with equity, debt financing has the following advantages. It does not dilute owner’s interest in the company because it does not have claim on equity. If the company is successful, its owners get a large portion of reward that would otherwise be shared in the event that equity financing was used to finance the same project. This is because company owners are only entitled to pre agreed interest. The planning for repayment of both principle and interest obligations are pre-determined thereby making it easy to manage. With debt financing, interest on debt is an allowed deduction for taxation purposes as opposed to dividend which is not an allowed deduction. Set procedures required to raise debt capital are minimal as compared to those required to raise additional equity. Managing debt is easy since the company do not have to mail a large number of investors, seek votes of investors before taking a decision or hold annual general meeting. Disadvantages of debt financing as compared to equity financing On the other hand, debt financing has a number of disadvantages as well. These disadvantages include: Unlike equity capital, debt has a repayment obligation than must be repaid. Interest payable to debt finance is a fixed cost. This has a negative effect on the companys break-even point. If interest costs are high, it increases the chances of insolvency during difficult financial periods. Companies that are financed by too much debt as compared to equity like high leverages find it difficult to grow due to high and constant cost of debt. Debt finance requires more cash out flow for repayment of both principal and interest, thus must always be budgeted for annually. The interest and principle repayment of most loans are content and pre determined irrespective of business cycles of the company. Some debt instruments contain restrictions on areas where they are to be invested thus restrict management from pursuing other financing options that would otherwise generate more income depending on economic trends (Bierman, 1988). Question C Weighted average cost of capital. = total equity/total finance*cost of equity +total debt/total finance*cost of debt =0.7*0.118889+0.3*3.25% =9.297% The use of weighted average cost of capital is majorly to determine the required rate of return. It helps to approximate opportunity cost of forgone alternatives projects with similar risks. It also helps to estimate required rate of return on a project outside operations of the firm and has different risk profile. Question D Wheel Industries cash flow Year operational income cost dep tax after tax profit cash flow 0 0 -1500000 0 -1500000 -[1500000 1 1200000 -600000 -500000 100000 35000 65000 65500 2 1200000 -600000 -500000 100000 35000 65000 65500 3 1200000 -600000 -500000 100000 35000 65000 65500 The procedure used to compute After-Tax Cash Flow Find incremental operating income before taxes generated by the project in question. Compute incremental amount of non-cash charges like amortization expense, depreciation expense. Add these noncash items to incremental operating income generated by the project in quest. Note that all this noncash items should only relate to the new project like the incremental cost. Use the resulting figure to calculate tax payable. Then subtract tax payable from the resulting figure to get income after tax bud before noncash items like incremental depreciation. Add back incremental noncash items to get cash flow (Bierman, 1988). Wheel Industries cash flow npv at 6% Year cash flow interest factor pv at 6% 0 -1500000 1 -1500000 1 565000 0.9434 533021 2 565000 0.89 502850 3 565000 0.8396 474374 net present value 10245 This project is economically viable. This is because it has a positive net present value. Wheel Industries cash flow npv at 6% npv at 15% Year cash flow interest factor pv at 6% interest factor pv 0 -1500000 1 -1500000 1 -1500000 1 565000 0.9434 533021 0.8695 491267.5 2 565000 0.89 502850 0.7561 427196.5 3 565000 0.8396 474374 0.6575 371487.5 net present value 10245 -210049 -10245/220293.5*.06+210049/22029.3*.15 IRR=11.51% This project is acceptable since it has an IRR that is less than weighted average cost of capital. Question G Expected value of each projects annual after tax cash flow given probability of occurrence of cash flow Project B Expected cash flow = .25*20000+.5*32000+.25*40000 =31000 Project C =.3*22000+.5*4000+.2*50000 =36600 Npv of project B Npv rate 6% Years cashf flow pvif 6% Pv pvif 15% pv 16% 0 -120000 1 -120000 1 -120000 1 31000 0.9434 29245.4 0.8696 26957.6 2 31000 0.89 27590 0.7561 23439.1 3 31000 0.8296 25717.6 0.6575 20382.5 4 31000 0.792 24552 0.5718 17725.8 5 31000 0.7473 23166.3 0.4972 15413.2 6 31000 0.7069 21913.9 0.4323 13401.3 npv 32185.2 npv -2680.5 IRR -6.69193 Npv of project C Npv rate 6 Years cashf flow pvif 6% pv pvif 15% pv 15% 0 -120000 1 -120000 1 -120000 1 36600 0.9434 34528.44 0.8696 31827.36 2 36600 0.89 32574 0.7561 27673.26 3 36600 0.8296 30363.36 0.6575 24064.5 4 36600 0.792 28987.2 0.5718 20927.88 5 36600 0.7473 27351.18 0.4972 18197.52 6 36600 0.7069 25872.54 0.4323 15822.18 npv 59676.72 npv 18512.7 IRR -17.95243% Question H Risk-adjusted NPV for project b rate 6 Years cash flow risk adjusted cash flow pvif 6% pv pvif 15% pv 15% 0 -120000 -120000 1 -120000 1 -120000 1 31000 28520 0.9434 26905.77 0.8696 24800.99 2 31000 28520 0.89 25382.8 0.7561 21563.97 3 31000 28520 0.8296 23660.19 0.6575 18751.9 4 31000 28520 0.792 22587.84 0.5718 16307.74 5 31000 28520 0.7473 21313 0.4972 14180.14 6 31000 28520 0.7069 20160.79 0.4323 12329.2 npv 20010.38 npv -12066.1 IRR -9.38549 Risk-adjusted NPV for project c risk adjusted npv of project c rate 6% Years cash flow risk adjusted cash flow pvif 6% pv pvif 15% pv 15% 0 -120000 -120000 1 -120000 1 -120000 1 36600 33672 0.9434 31766.16 0.8696 29281.17 2 36600 33672 0.89 29968.08 0.7561 25459.4 3 36600 33672 0.8296 27934.29 0.6575 22139.34 4 36600 33672 0.792 26668.22 0.5718 19253.65 5 36600 33672 0.7473 25163.09 0.4972 16741.72 6 36600 33672 0.7069 23802.74 0.4323 14556.41 npv 45302.58 npv 7431.684 IRR -4.23386 Both projects are viable; however, since they are mutually exclusive project c is accepted (Bierman, 1988). References Bierman, H., & Bierman, H. (1988). Implementing capital budgeting techniques. Cambridge, Mass: Ballinger Pub. Co. Capital budgeting valuation: Financial analysis for todays investment projects. (2013). Hoboken, N.J: Wiley. Dayananda, D. (2002). Capital budgeting: Financial appraisal of investment projects. Cambridge [u.a.: Cambridge Univ. Press. Wilkes, F. M. (1983). Capital budgeting techniques. Chichester: J. Wiley. Read More