2. 2
TABLE OF CONTENTS
EXECUTIVE SUMMARY .......................................................................................3
WEIGHTED AVERAGE COST OF CAPITAL ........................................................4
Appropriate use of the WACC ....................................................................................... 5
PROJECT EVALUATION......................................................................................6
NET PRESENT VALUE .................................................................................................. 6
INTERNAL RATE OF RETURN .................................................................................... 7
PAYBACK PERIOD ......................................................................................................... 8
BEST PROJECT EVALUATION METHOD .........................................................10
RECOMMENDATION..........................................................................................12
APPENDICES......................................................................................................13
3. 3
EXECUTIVE SUMMARY
This report was commissioned by the Adelaide Manufacturing Company Ltd for the
purpose of examining the value of investing a new intercom system.
This was achieved by first evaluating the firm’s capital structure to determine its
weighted average cost of capital (WACC). The WACC was then used as the discount
rate to calculate the Net Present Value (NPV). The Internal Return Rate, and Payback
Period were also calculated and taken into consideration when evaluating this project.
However, the recommendation was based upon the NPV, as it is the most practical
and reliable method of evaluation.
Based on this analysis, it was recommended that the purchase of a new intercom
system would not be a valuable investment for the firm. Hence, this project should be
rejected.
4. 4
WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital (WACC) conveys the rate a company is expected
to pay its providers to be able to finance its investments. This will help determine
whether purchasing a new intercom system will be justified as a positive investment.
ADELAIDE MANUFACTURING COMPANY LTD CAPITAL STRUCTURE
COST MARKET VALUE
DEBT 2.03% (after tax) $1,335,560.05 (2.69%)
ORDINARY SHARES 8.375% $45,180,000 (91.12%)
PREFERANCE SHARES 8.31% $3,069,000 (6.19%)
Table 1: Capital Structure of Adelaide Manufacturing Company Ltd.
The WACC is 8.20%
*Please refer to Appendix for calculations of cost and market value of DEBT and
SHARES.
5. 5
Appropriate use of the WACC
It is only appropriate to use the weighted average cost of capital when calculating the
Net Present Value of a project (NPV) when the following assumptions are true:
1. The firm’s risk of existing projects, i.e. the debt cost of capital, will be equivalent
to any projects being undertaken;
2. The firm’s capital structure is the only source of capital for the firm; and,
3. No other external variables impact upon the capital structure i.e. financial
distress costs, bankruptcy, etc.
NOTE: If we were to undertake a new project with another firm, which was based in
another industry then manufacturing, we would use the other firm’s WACC in order to
determine the risk that our company would face when undertaking one of their
projects.
In the case of this particular project, assumptions one and two are relevant. As the
firm’s cost of debt capital is at a minimum, assumption number three is not valid to this
project. Therefore, the weighted average cost of capital can be used as a discount
rate to determine the NPV when installing a new intercom system. If the NPV is
positive, the Adelaide Manufacturing Company Ltd should accept the project. If the
outcome is negative in value, the company should reject the project.
6. 6
PROJECT EVALUATION
There are a number of ways to evaluate a project and to determine if a company
should accept or reject the proposal. These are the Net Present Value (NPV), the
Internal Rate of Return (IRR) and the Payback Periods. All three techniques are widely
accepted and used.
NET PRESENT VALUE
The Net Present Value is the most popular technique amongst businesses. It
showcases the sum of the present value of all positive and negative cash flows from
a project. It’s about accepting projects that will increase the value of the firm. In order
to do this, we need to establish the incremental free cash flows resulting from this
project.
Table 2: Free Cash Flows resulting from investment in proposed intercom system
7. 7
From the above information, we calculate the NPV by adding all incremental free cash
flows minus the total initial outlay of investing in the project. The NPV is calculated
using the WACC as the appropriate discount rate, which is 8.20%. The resulting NPV
is -$4038.
*Please refer to Appendix for manual calculations of Net Present Value using the
Incremental FCF.
According to the NPV decision rule, as the dollar value of benefits from this project
does not exceed the dollar value of costs, the company should reject the project.
INTERNAL RATE OF RETURN
The Internal Rate of Return (IRR) is another way to evaluate a project. It represents
the percentage of return the investment being considered. If it exceeds the cost of
capital this will result in a positive NPV which means that the project would generate
positive returns and therefore, should be accepted.
The IRR decision rule states that:
If… Then… The project should be…
IRR > WACC NPV > 0 ACCEPTED
IRR < WACC NPV < 0 REJECTED
Table 3: IRR Decision Rule
To calculate the IRR, the following formula is used:
IRR =
!"
!#
$
%
− 1
Where:
Cn = future cash flow in year n
Co = initial outlay
n = life of project in years
8. 8
HOWEVER, when there is more than one future cash flow, this formula cannot be
used. Therefore, for this project, we solved the IRR through an excel spreadsheet as
follows.
Table 4: Free Cash Flows and excel tabulated Internal Rate of Return
The required formula is =IRR(cell of Year0 cash flow: cell of Year 4 cash flow).
As all negative cash flows precede all positive future cash flows, the IRR decision rule
is applicable. As indicated in Table 4, the IRR is less than the WACC (8.20%), and the
NPV is less than zero (cf. Table 2). This is in conjunction with the IRR decision rule
shown in Table 3. Hence, the project should be rejected.
PAYBACK PERIOD
The payback period showcases the time it takes to recover the initial outlay on a
project through its cash flows. If the company can pay back the initial outlay before the
maximum payback period, the project should be accepted.
The maximum acceptable payback period set by Adelaide Manufacturing Company
Ltd. is 4 years.
YEAR CASH FLOWS
0 -23400
1 7570
2 5328.5
3 3931.08
4 6456.77
Unrecovered cost after 4th
year = - 113.65
Table 5: Unrecovered balance after subtracting yearly profits from the initial outlay
9. 9
𝑷𝒂𝒚𝑩𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 = 𝟒 +
𝟏𝟏𝟑. 𝟔𝟓
𝒄
∴ Payback Period < 4 years
As seen in Table 4, the initial outlay is not recovered within the maximum acceptable
payback period. Therefore, using the payback period evaluation method, the company
should reject the project.
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑎 +
𝑏
𝑐
a = number of whole years before initial
outlay is recovered
b = component of the initial outlay
needing to be recovered in the (a+1)th
year
c = the cash flow in the (a+1)th
year
10. 10
BEST PROJECT EVALUATION METHOD
There are three project evaluation methods common in the analysis of investment
decisions, these include the Net Present Value, the Internal Rate of Return and the
payback period. These methods take into account some or all of the three factors
considered critical in aiding companies when making positive financial decisions, listed
in Table 6 below.
CASH Used to pay costs, and increase shareholder wealth
TIME The time value of money
RISK The probability of a cash flow affects its probability
Table 6: Factors considered critical in financial capital budgeting
In order to determine the best method to evaluate a particular project, it is important
to first identify the type of project being considered, i.e. independent or mutually
exclusive or both types of projects. The advantages and disadvantages of the three
methods are discussed below.
1. Net Present Value (NPV):
This is considered to be the most reliable method because it takes all three critical
factors listed in Table 5, into account and is applicable for all types of projects. It does
this because only cash flows are included whilst calculating the NPV. The time value
of money is taken into account as all future cash flows are discounted to a present
value. And, finally, an appropriate discount rate is used when taking into account the
risk faced by the company.
The NPV is reliable as it represents the actual dollar value of the profit gained or the
loss incurred, by a company and hence its stakeholders, if a particular project is
accepted.
This is the method chosen to evaluate the purchase of the intercom system in
this report.
11. 11
2. Internal Rate of Return (IRR):
The internal rate of return takes cash flows and the time value of money into account,
similar to the NPV. It also takes into account risk to a certain extent, as the IRR itself
represents the rate of return (discount rate) required by the company in order recover
the initial capital invested in the project, i.e. an NPV of zero-dollar value. The IRR
therefore, has an inverse relationship with the NPV, for all independent projects, as
shown in Table 3.
The IRR should not be used to evaluate mutually exclusive projects as it doesn’t
account for the difference in monetary scale of projects or any future negative cash
flows. It might, therefore, misrepresent the actual costs and benefits, resulting in
decisions which are inconsistent with the NPV dollar value.
It is, therefore, the least commonly used method for project evaluation.
3. Payback Period:
The payback period is the second most-used method of project evaluation. This is
because it gives companies a quick and accurate representation of when the initial
outlay will be recovered.
The payback period, however, ignores the time-value of money, and all cash flows
received after the arbitrary maximum payback period set by management. This might
result in the rejection of positive NPV projects, which may have added value to the
firm in the long term.
12. 12
RECOMMENDATION
When deciding which project evaluation method governs the recommendation, this
intercom investment project is considered to be independent from the company’s
existing or potential projects.
In evaluating the intercom system investment, all three project evaluation methods
were considered, the outcome of which were all consistent. Despite this, the Net
Present Value was deemed the best method as it took into account all the factors
Adelaide Manufacturing Ltd. should consider before investing in this project and thus
provided a more accurate evaluation.
The analysis of the NPV from the purchase of a new intercom system by the Adelaide
Manufacturing Company Ltd resulted in a negative dollar value. An NPV of – 4038
indicates that this investment would result in a loss of wealth and value for the firm
and its shareholders. Therefore, it is recommended that the Adelaide Manufacturing
Company Ltd should not purchase the new intercom system and that this project
should be rejected.
13. 13
APPENDICES
Calculation of the Weighted Average Cost of Capital (WACC) of Adelaide
Manufacturing Ltd.
𝒓 𝑾𝑨𝑪𝑪 = 𝒓 𝑬 𝑬% + 𝒓 𝑷 𝑷% + 𝒓 𝑫 𝟏 − 𝑻 𝑪 𝑫%
Capital Structure
DEBT
Known Variables:
Face Value = 1,300,000
Maturity Period = 6 years
Semi-Annual Coupon paid at = 3.4% p.a.
Since we have, the following values, the debt-rating approach can be used to calculate
the cost of debt capital and the market value.
Debt Rating = AA = 72bp
6-year risk free rate (risk free premium) = 2.180%
Company Tax-rate = 30%
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑟W) = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑝𝑟𝑒𝑎𝑑
= 2.180 + 0.72 = 2.90 %
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑟W 1 − 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 (𝑇! )
= 2.90 1 − 0.30 = 2.03%
16. 15
𝑟x = 𝑅𝑓𝑝 + 𝛽(𝐸 {|}o − 𝑅𝑓𝑝
= 0.02525 + 1.2 0.074 − 0.02525 = 0.08375 = 8.375%
To Calculate PV:
𝑃𝑉q =
𝐷𝑖𝑣"
(1 + 𝑟x)"
𝑃𝑉q =
1.02
(1.08375)m
= 0.94
𝑃𝑉q(m) =
1.12
1.08375 n
= 0.95
𝑃𝑉q(n) =
1.23
1.08375 r
= 0.97
𝑃𝑉q(r) =
1.35
1.08375 s
= 0.98
To calculate PV of an annuity:
𝑃𝑉s =
1.02
0.08375 − 0.03
= 25.86 𝑃𝑉q(s) =
25.86
(1.08375)s
= 18.75
𝑇𝑜𝑡𝑎𝑙 𝑃𝑉 𝑎𝑡 𝑌𝑒𝑎𝑟 0 (𝑃𝑉q) = 0.94 + 0.95 + 0.97 + 0.98 + 18.75 = 22.59
To calculate Market Value
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝐸 = 𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 ×𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 (𝑃𝑉q)
𝐸 = 2000000 ×22.59 = 45180000
The market value of Ordinary shares (E) is $45,180,000
17. 16
PREFERENCE SHARES
Known Variables:
Number of shares = 300,000
Annual Dividend (DivP) = $0.85
Trading Price (PP) = $10.23
Rp =
𝐷𝑖𝑣„
𝑃„
=
0.85
10.23
= 0.831 = 8.31%
To calculate the Market Value (PV) of Preference Shares (P):
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑛𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 × 𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 𝑃„
= 300000 ×10.23 = 3069000
The Market Value of preference shares (P) is $3,069,000
18. 17
The above calculations give us the following values:
𝑟x = 8.375%
𝐸 = 45,180,000
𝑟„ = 8.310%
𝑃 = 3,069,000
𝑟W = 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥
= 2.03%
𝐷 = 1,335,560.05
In order to calculate the weighted percentage of each type of share or debt in the
capital structure:
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝐸 + 𝑃 + 𝐷 = 49,584,560.05
𝐸% =
𝐸
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
=
45180000
49584560.05
= 0.9112 = 91.12%
𝑃% =
𝐸
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
=
3069000
49584560.05
= 0.0619 = 6.19%
𝐷% =
𝐸
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
=
1335560.05
49584560.05
= 0.0269 = 2.69%
Substituting values calculated above into the original WACC equation:
𝒓 𝑾𝑨𝑪𝑪 = 𝒓 𝑬 𝑬% + 𝒓 𝑷 𝑷% + 𝒓 𝑫 𝟏 − 𝑻 𝑪 𝑫%
𝐫 𝐖𝐀𝐂𝐂 = 𝟎. 𝟎𝟖𝟑𝟕𝟓×𝟎. 𝟗𝟏𝟏𝟐 + 𝟎. 𝟎𝟖𝟑𝟏×𝟎. 𝟎𝟔𝟏𝟗 + 𝟎. 𝟎𝟐𝟎𝟑×𝟎. 𝟎𝟐𝟔𝟗 = 𝟖. 𝟐𝟎%
The weighted average cost of capital of the Adelaide Manufacturing Company is
8.20%
19. 18
Net Present Value Calculation
In order to calculate the NPV we first tabulated the Free Cash Flows of purchasing the
Intercom system (Table 2), the values were as follows:
Year 0 = -$23,400
Year 1 = $7570.00
Year 2 = $5328.50
Year 3 = $3931.08
Year 4 = $6456.77
𝑁𝑃𝑉 =
!•
(m‘’)%
"
o“m − 𝐶q
𝑁𝑃𝑉 =
7570
1.0820
+
5328.50
1.0820 n
+
3931.08
1.0820 r
+
6456.77
1.820 s
− 23400
= 6996.30 + 4551.46 + 3103.35 + 4710.93 − 23400 = −4037.97 = −$4038
The Net Present Value of the intercom investment is negative $4038.
End of Appendix
