Sheet4Assignment 1 LASA # 2—Capital Budgeting Techniques Sheet1 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))) + gWhere,D1 = D0*(1+g)F = Flotation costKe = ((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 = 500,000Calculation of cash flows:Revenue – 1,200,000Less Cost – 600,000Less Depreciation – 500,000Profit - 100,000Less taxes (35%) 35,000Profit after taxes .

1. Sheet4Assignment 1 LASA # 2—Capital Budgeting Techniques
Sheet1
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))) +
gWhere,D1 = D0*(1+g)F = Flotation costKe =
((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

2. 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 =
500,000Calculation of cash flows:Revenue –

3. 1,200,000Less Cost – 600,000Less
Depreciation – 500,000Profit -
100,000Less taxes (35%) 35,000Profit after
taxes 65,000Add depreciation
500,000Cash flow after taxes 565,000NPV =
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 = 310,245As the
NPV is positive the project should be accepted.C) Computation
of IRR of project A:-Cash flow after taxes (per year) =
565,000Life of project = 3 yearsInitial investment =
$1,200,000IRR would be as follows:-At correct IRR, NPV of
the project is 0Let IRR of the Project15%NPV @15%(Annual
cash flow*Present value annuity [email protected]%,3 year) -
Initial investment cost(565000*2.28)-120000088200Let IRR of
the Project20%NPV @10%(Annual cash flow*Present value
annuity [email protected]%,3 year) - Initial investment
cost(565000*2.11)-1200000-7850Computaion of IRR:-NPV
@15%88200NPV @20%-7850IRR15%+(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)

4. Computation of NPV and IRR of investment B and C:-
Investment BInitial investment = $120,000Life of investment =
6 YearsProbable cash flows =
(0.25*20000)+(0.5*32000)+(0.25*40000)Probable cash flows =
$31,000 Per yearNPV = Present value of cash flows - Cash
outlay = 31,000 x PVIFA 9.3%,3 years - 120,000 =
31,000 x 4.45 – 120,000 = $17,950As the NPV is positive
the project should be accepted.IRR would be as follows:-At
correct IRR, NPV of the project is 0Let IRR of the
Project15%NPV @15%(Annual cash flow*Present value annuity
[email protected]%,6 year) - Initial investment
cost(31000*3.79)-120000-2510Let IRR of the Project10%NPV
@10%(Annual cash flow*Present value annuity
[email protected]%,6 year) - Initial investment
cost(31000*4.36)-12000015160Computaion of IRR:-NPV
@10%15160NPV @15%-2510IRR10%+(5%/(15160-(-
2510))*15160)14.29%Investment CInitial investment =
$120,000Life of investment = 6 YearsProbable cash flows =
(0.3*22000)+(0.5*40000)+(0.2*50000)Probable cash flows =
$36,600 Per yearNPV = Present value of cash flows - Cash
outlay = 36,000 x PVIFA 9.3%,3 years - 120,000 =
36,000 x 4.45 – 120,000 = $40,200As the NPV is positive
the project should be accepted.IRR would be as follows:-At
correct IRR, NPV of the project is 0Let IRR of the
Project15%NPV @15%(Annual cash flow*Present value annuity

5. [email protected]%,6 year) - Initial investment
cost(36000*3.79)-12000016440Let IRR of the Project20%NPV
@10%(Annual cash flow*Present value annuity
[email protected]%,6 year) - Initial investment
cost(36000*3.33)-120000-120Computaion of IRR:-NPV
@15%16440NPV @20%-120IRR15%+(5%/(16440-(-
120))*16440)19.96%Investment C have higher IRR and NPV as
compared to investment B and therefore it must be selected.
Sheet2YOU CAN USE THIS DATA ON WORD FILE
ALSOSteps 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,

6. = 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

7. 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

8. 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.
Sheet3