Project evaluation
Name
Institution
Introduction
All projects need resources to operate majorly financial capital. Conversely, financial capital used in the form of cash in the project is not free. Business, States, and individuals need to forecast and evaluating how to use effectively the capital demanded in initiating besides operating a venture. Inquest of this, states devise policies that encourage economic activities; investors hunt for securities that value corporations seeking for projects with higher rewards. This project evaluation seeks to assess whether or not the company should purchase the project. The company faces the task and mandate of providing back returns to its sponsoring investors and providers. When a company decides to raise funds from more than one investor or financier, its worthy and suitable employ the WACC. According to Adair (2017), WACC is a financial concept employed to compute the average cost that a company will have to compensate its investors and financers for funding its assets or paying to its security bonds. The project evaluation will begin by calculating the cost of equity using the CAPM and evaluate the cost of debt using Book valuation; discuss the capital structure of the company using book values; also compute the company’s weighted average cost of capital (WACC); compute the Net Present Value (NPV); provide a recommendation based on the computed data; discuss why the NPV is better than the internal rate of return and payback period.
The company’s case solution
Since the company is planning on purchasing a project, it requires long-term capital resources to fund its assets. According to Pratt and Grabowski (2014), capital budgeting remains crucial essential in the view that fixed-asset investment decisions demand charts for the company’s potential path. However, the possible company’s capital structure is retained earnings, long-term debt (bond), and common stock. When estimating the company’s WACC, retained earnings, Long-term debt (bond), and common stock should be integrated as the capital structure. Using the WACC to estimate Company will aid to evaluate determine whether the component costs are regarded on a before-tax or after-tax basis.
cost of equity using capital asset pricing model(CAPM)
The CAPM model is a crucial technique necessary when dealing with risky investments. Calculating the CAPM is based on three factors: the expected market rate of return, return for the risk-free security, and an asset (Trunda, 2011).The model aids in calculating the cost of equity, which plays a significant role in a company and investor.
Risk-free rate
Market risk premium
=Beta of stock
,
FV=Face value of the bond is equal $ 75 millions,
PV is equal to the present price of bond
PMT= C= annual coupon payment = ,
t= number of periods
Substituting this values into the yield to maturity formula
The bond’s market price is arriving at 10%, which is the annual interest rate. According to Adair (2011), if the interest rate is tax-deductible, then the relevant debt cost component is the after-tax debt cost. The firm’s corporate tax rate is 35%.
Therefore, the cost debt component is 6.5%, while the debt’s market interest rate is 10%. For every capital $1 raised in debt, a 6.5 % return is expected from the investor or creditor.
The capital structure of the organization using book values
The company seeks to raise finance most efficiently and. Therefore, adopting the pecking order theory which utilizes retained earnings available, issue of debt in the form of bond and lastly equity inform of common stock. The company’s capital structure comprises retained earnings, long-term debt (bond), and common stock.
| Capital structure | |
| Long term debt | |
| Bonds | $75 million |
| Shareholders’ equity | |
| Common stock | $ 25 million |
| Retained earnings | $ 50 million |
| Total capital structure | $150 million |
The company’s WACC
When estimating the company’s WACC of a possible purchase of the project, various sources of capital are included in the computation. The sources include long term debt (bonds), common stock, and company’s retained earnings. WACC’s component cost is computed after-tax since the cash flows given out to lenders and investors are after-tax cash flows. Further, the costs should be new costs as the company’s WACC seeks future capital structure.
Therefore for every $1, the company raises from the investors, it must pay its investors almost $0.10 in return.
Net Present Value of the project
In the calculation of the NPV, the WACC value serves as the discount rate used in the calculation of the present value factor. Further, the discount rate is employed in the evaluation of business opportunities. The present value (PV) factor is employed to compute the present value of a receipt of cash on a future date based on the time value of money.
P = the present value factor,
r = interest rate,
n = the number of periods over which payments are made.
Interest rate = r = discount rate = 10.2%
| Year 1 | Year 2 | Year 3 | Year 4 | |
| Cash flows | $ 30,000 | $ 40,000 | $ 30,000 | $ 40,000 |
| Pv factors =
|
0.9074 | 0.8234 | 0.7472 | 0.6781 |
| Cash flow * Pv factor | $ 27,222 | $ 32,936 | $ 22,416 | $ 27,124 |
Recommendation
The company should not purchase the project. Every business aims to finance its debt besides generating profits from its investment. From the computed data, the Net Present Value is for the company is (negative cash flow). Since the computed NPV of the project to purchase is negative (< 0), the project is projected to result in a net loss for the company. According to Žižlavský (2014), negative cash flow implies that the company would spend more than it would generate. On the whole, and concurrence to the rule, the company should not purchase the project.
Net present value (NPV) over the internal rate of return IRR or Payback period (PBP)
Net present value approach computes the present value of the cash flows basing on the opportunity cost of capital and obtains the price which will be included to the wealth of the investors if that investment is carried out. Conversely, payback period computes a period within which the first investment of the venture is regained (Ardalan, 2012). It does not reflect the cash flows past the PBP besides ignoring the time value of the currency. Therefore, NPV provides a good prediction as it incorporates the time value of money besides taking care of all the cash flows until the completion of the project. The internal rate of return (IRR) computes a rate of return presented by the venture irrespective of the required rate of return and any other thing (Bora, 2015). It also possesses other demerits such as it does not recognize economies of scale and disregards the dollar value of the investment. Further, it cannot distinguish between two ventures with similar IRR but substantial variations between dollar returns like NPV. IRR presumes discounting and reinvestment of cash flows at a similar rate while NPV presumes a rate of lending and borrowing close to the market rates. Therefore, NPV remains a better method of the feasibility of an investment as compared to the IRR or Payback period.
Conclusion
Conclusively, depending on the WACC, CAPM and NPV analysis, the company should not purchase the project. The project will experience negative cash flow, implying that the company would spend more than it would generate. Therefore, the project would not provide back returns to its sponsoring investors and providers. As the principal financial target is to optimize shareholder’s wealth, then the company should seek to reduce its weighted average cost of capital. In practical terms, this can be attained by having an increment of debt in the capital structure, since debt is comparatively cheaper than equity.
References
Adair, T. A. (2011). Corporate finance demystified. New York: McGraw-Hill.
Pratt, S. P., & Grabowski, R. J. (2014). Cost of capital: applications and examples.
Trunda, M. (2011). Capital Asset Pricing Model.
Bora, B. (2015). Comparison between net present value and internal rate of return. IJRFM, 5(12), 61-71.
Ardalan, K. (2012). Payback period and NPV: their different cash flows. Journal of economics and finance education, 11(2), 10-16.
Žižlavský, O. (2014). Net present value approach: a method for the economic assessment of innovation projects. Procedia-Social and Behavioral Sciences, 156(26), 506-512.
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