This report evaluates a proposed investment in a new intercom system for Adelaide Manufacturing Company Ltd. The weighted average cost of capital (WACC) of 8.20% was calculated using the company's capital structure and used to evaluate the project. The net present value (NPV) of -$4038 and internal rate of return (IRR) of less than the WACC indicate the project should be rejected. The payback period is also longer than the company's maximum of 4 years. Based on the negative NPV, the recommendation is that the company should not purchase the new intercom system.
Understand the nature and importance of investment decisions.
Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment evaluation.
Explain the methods of calculating net present value (NPV) and internal rate of return (IRR).
Show the implications of net present value (NPV) and internal rate of return (IRR).
Describe the non-DCF evaluation criteria: payback and accounting rate of return and discuss the reasons for their popularity in practice and their pitfalls.
Illustrate the computation of the discounted payback.
Describe the merits and demerits of the DCF and Non-DCF investment criteria.
Compare and contract NPV and IRR and emphasise the superiority of NPV rule.
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
Understand the nature and importance of investment decisions.
Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment evaluation.
Explain the methods of calculating net present value (NPV) and internal rate of return (IRR).
Show the implications of net present value (NPV) and internal rate of return (IRR).
Describe the non-DCF evaluation criteria: payback and accounting rate of return and discuss the reasons for their popularity in practice and their pitfalls.
Illustrate the computation of the discounted payback.
Describe the merits and demerits of the DCF and Non-DCF investment criteria.
Compare and contract NPV and IRR and emphasise the superiority of NPV rule.
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
Project Analysis And Valuation - Introduction To Project Analysis And ValuationASAD ALI
Valuation analysis is used to evaluate the potential merits of an investment or to objectively assess the value of a business or asset. Valuation analysis is one of the core duties of a fundamental investor, as valuations (along with cash flows) are typically the most important drivers of asset prices over the long term.
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.
An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments.
What are the objectives of Capital budgeting?
Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.
The following are the two methods:
A) Traditional Method
1. Pay back period method
2. Improvement of traditional approach
3. Rate of Return Method or Accounting Method
B) Time adjusted method or discount methods
4. Net Present Value method
5. Internal Rate of Return Method
6. Profitability Index Method
It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds.
Examples of capital projects include land, buildings, equipment and other major fixed asset items.
This presentation provides an insight into techniques which can help business undertake financially viable projects using Capital Budgeting tools like Net Present Value, Internal Rate of Return and Discounted Pay-back Period.
Though the scope of this presentation involves:-
- Mutually exclusive projects,
- Indivisible Projects, and
- Equal duration projects
More research work is being undertaken for projects of different duration.
Moreover, I'll share more about calculation of Weighted Average cost of capital, ROI and Risk-adjusted ROI in the upcoming presentations.
If you wish to add comments or need to ask questions, please feel free.
1RUNNING HEAD Genesis Energy Capital Plan Report2Genesi.docxeugeniadean34240
1
RUNNING HEAD: Genesis Energy Capital Plan Report
2
Genesis Energy Capital Plan Report
Genesis Energy Capital Plan Report
Module 5 Assignment 2
Argosy University Online
Katrina Caver
The decision on capital outlays is among the most significant a firm has to make. A decision to build a new plant or expand into a foreign market may influence the performance of the firm over the next ten years. The capital budgeting decision includes the planning of expenditures for a project with a life of at least one year and usually considerably longer. Capital budgeting assists with the decision making of how a firm should invest its capital.
Different capital budgeting alternatives that are used includes the payback period, which calculates the amount of time it will take before the cumulative net cash flows are equal to the initial cost of the investment (Argosy Online University, 2012); accounting rate of return (return on investment, An indicator of profitability that is measured by dividing the accounting net income by the amount invested (AccountingCoach, 2004-2015)); discounted payback period(examines the time that is required to cover the investment of the project considering the present value of all the cash inflows); net present value(measures the present value of all the cash inflow from the project and compare the same with the initial investment); profitability index(measures the present value of cash inflows at the required rate of cash inflows at the rate of return that is required to for the initial cash outflow for the investment. However, if the present value of cash inflows is positive, then the project is accepted; if the project is negative, then the project is not accepted.
Upon evaluating the capital budget, the outcomes include cost of debt at eight percent, cost of equity at ten percent, short-term interest rate at eight percent, long-term interest rate at nine percent, and long-term equity interest rate at ten percent. Operating projections for a project is utilized to establish a forecast for cash flows that would underpin calculations of net present value, internal rates of return, payback period, and other investment metrics. The purpose of forecasting cash flows is to capture the incremental effect of a proposed project. Each project’s cash flow forecasts does not include depreciation expenses and cost that would be incurred regardless of whether a given project was undertaken or not. High, medium, and low risks categories for each division were associated with a corresponding discount rate set by the capital budgeting committee in consultation with the corporate treasurer.
The weighted average cost of capital is another method to evaluate proposed projects and capital budgeting. By computing a weighted average, the company can decide the interest for every dollar that is invested. Cost of capital assist with the determination of the minimum rate of return a company is expected to make from the project. Wei.
Project Analysis And Valuation - Introduction To Project Analysis And ValuationASAD ALI
Valuation analysis is used to evaluate the potential merits of an investment or to objectively assess the value of a business or asset. Valuation analysis is one of the core duties of a fundamental investor, as valuations (along with cash flows) are typically the most important drivers of asset prices over the long term.
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.
An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments.
What are the objectives of Capital budgeting?
Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.
The following are the two methods:
A) Traditional Method
1. Pay back period method
2. Improvement of traditional approach
3. Rate of Return Method or Accounting Method
B) Time adjusted method or discount methods
4. Net Present Value method
5. Internal Rate of Return Method
6. Profitability Index Method
It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds.
Examples of capital projects include land, buildings, equipment and other major fixed asset items.
This presentation provides an insight into techniques which can help business undertake financially viable projects using Capital Budgeting tools like Net Present Value, Internal Rate of Return and Discounted Pay-back Period.
Though the scope of this presentation involves:-
- Mutually exclusive projects,
- Indivisible Projects, and
- Equal duration projects
More research work is being undertaken for projects of different duration.
Moreover, I'll share more about calculation of Weighted Average cost of capital, ROI and Risk-adjusted ROI in the upcoming presentations.
If you wish to add comments or need to ask questions, please feel free.
1RUNNING HEAD Genesis Energy Capital Plan Report2Genesi.docxeugeniadean34240
1
RUNNING HEAD: Genesis Energy Capital Plan Report
2
Genesis Energy Capital Plan Report
Genesis Energy Capital Plan Report
Module 5 Assignment 2
Argosy University Online
Katrina Caver
The decision on capital outlays is among the most significant a firm has to make. A decision to build a new plant or expand into a foreign market may influence the performance of the firm over the next ten years. The capital budgeting decision includes the planning of expenditures for a project with a life of at least one year and usually considerably longer. Capital budgeting assists with the decision making of how a firm should invest its capital.
Different capital budgeting alternatives that are used includes the payback period, which calculates the amount of time it will take before the cumulative net cash flows are equal to the initial cost of the investment (Argosy Online University, 2012); accounting rate of return (return on investment, An indicator of profitability that is measured by dividing the accounting net income by the amount invested (AccountingCoach, 2004-2015)); discounted payback period(examines the time that is required to cover the investment of the project considering the present value of all the cash inflows); net present value(measures the present value of all the cash inflow from the project and compare the same with the initial investment); profitability index(measures the present value of cash inflows at the required rate of cash inflows at the rate of return that is required to for the initial cash outflow for the investment. However, if the present value of cash inflows is positive, then the project is accepted; if the project is negative, then the project is not accepted.
Upon evaluating the capital budget, the outcomes include cost of debt at eight percent, cost of equity at ten percent, short-term interest rate at eight percent, long-term interest rate at nine percent, and long-term equity interest rate at ten percent. Operating projections for a project is utilized to establish a forecast for cash flows that would underpin calculations of net present value, internal rates of return, payback period, and other investment metrics. The purpose of forecasting cash flows is to capture the incremental effect of a proposed project. Each project’s cash flow forecasts does not include depreciation expenses and cost that would be incurred regardless of whether a given project was undertaken or not. High, medium, and low risks categories for each division were associated with a corresponding discount rate set by the capital budgeting committee in consultation with the corporate treasurer.
The weighted average cost of capital is another method to evaluate proposed projects and capital budgeting. By computing a weighted average, the company can decide the interest for every dollar that is invested. Cost of capital assist with the determination of the minimum rate of return a company is expected to make from the project. Wei.
AgendaComprehending risk when modeling investment (project) de.docxgalerussel59292
Agenda
Comprehending risk when modeling investment (project) decisions
Standalone Risk
Market Risk
1
1
Project Risk
Standalone Risk: Risk based on uncertainty of a projects cash flows
Sensitivity
Scenarios
Breakeven
Simulations
Market Risk: Risk of the project as seen by a well diversified investor
Beta
2
Sensitivity, Scenario, and Break-Even
Each allows us to look behind the NPV number to see how stable our estimates are.
Breakeven: sales required to breakeven
Accounting break-even: sales volume at which net income = 0
Cash break-even: sales volume at which operating cash flow = 0
Financial break-even: sales volume at which net present value = 0
Sensitivity: how sensitive a particular NPV calculation is to changes in an input variable holding all other assumptions are held constant
Scenario: examine impact on NPV given a confluence of factors
When working with spreadsheets, try to build your model so that you can adjust variables in a single cell and have the NPV calculations update accordingly.
3
3
Monte Carlo Simulation
A more sophisticated variation of the scenario analysis is Monte Carlo simulation.
In a Monte Carlo simulation, analysts specify a range or a distribution of potential outcomes for each of the model’s assumptions.
Pick a probability distribution for each input variable (units, price, variable costs, etc).
The computer program will pick a random value from each input variable, calculate the NPV and store the result. This is a trial.
Repeat the process many times, saving the input variables and the output (NPV).
End result: Probability distribution of NPV based on sample of simulated values.
4
Example
5
6
When a firm with both debt and equity invests in an asset similar to its existing assets (business), the WACC is the appropriate discount rate to use in NPV calculations.
In conglomerates, the WACC reflects the return that the firm must earn on average across all its assets to satisfy investors, but using the WACC to discount cash flows of a particular investment leads to mistakes.
Any project’s cost of capital depends on the use to which the capital is being put—not the source.
Therefore, it depends on the risk of the project and not the risk of the company.
When a firm invests in an asset that is different from its existing assets, it should look for pure-play firms to find the right discount rate.
6
Finding the Right Discount Rate
6
You are a financial analyst at General Electric and are preparing a cost of equity estimate for a project analysis using NPV:
CAPM = Risk Free Rate + Beta * Market Risk Premium
9.5% = 3.0% + 1.1 * 5.9%
Lines of Business
Financial Services
Power Generation
Aviation
Transportation
Health Care
Consumer Goods
When evaluating a new power generation investment for GE, which cost of capital should be used?
Capital Budgeting & Project Risk
7
Beta
1.8
0.6
1.2
1.3
0.8
1.1
7
17
Capital Budgeti.
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 .
PART IComplete the following program exercises. When you hav.docxherbertwilson5999
PART I:
Complete the following program exercises. When you have completed the following exercises, compress the program folder and submit the .zip file. These are all separate exercise, so you will have a separate file for each exercise.
Exercises from 5.1
Determine the output displayed when the button is clicked
Problem One:
Private Sub btnConvert_Click(…) Handles btnConvert.Click
‘Convert Celsius to Fahrenheit
Dim temp As Double = 95
txtOutput,Text = CStr (CtoF (temp) )
End Sub
Function CtoF (ByVal t As Double) As Double
Return ( (9 / 5) * t) + 32
End Function
Problem Two:
Private Sub btnDisplay_Click(…) Handles btnDisplay.Click
‘Rule of 72
Dim p As Double
p = CDbl (txtPopGr.Text) ‘Population growth as a percent
txtOutput.Text = “The population will double in “ &
DoubleTime(p) & “ years."
End Sub
Function DoublingTime(ByVal x As Double) As Double
‘Number of cars that can be parked
Return 100 * x
End Function
Problem Three:
Private Sub btnDisplay_Click(…) Handles btnDisplay.Click
Dim d As Date = #12/4/2011#
txtOutput.Text = MonthAbbr(d)
End Sub
Funcion MonthAbbr(ByVal d As Date) As String
Dim str As String = FormatDateTime(d, DateFormat.LongDate)
Dim n As Integer = str.IndexOf(“ “)
Return str.Substring(n + 1, 3)
End Function
Exercises from 5.2
Write a program that displays the output shown in a list box. The last two lines of the output should be displayed by one or more Sub procedures using data passed by variables from an event procedure.
Problem One:
Assume that the following is displayed.
According to a 2008 survey of college freshman taken by the Higher
Education Research Institute:
16.7 percent said they intend to major in business.
1 percent said they intend to major in computer science.
Problem Two:
Assume that the label for txtBox reads “What is your favorite number?”, and the user types 7 into txtBox before btnDisplay is clicked.
The sum of your favorite number with itself is 14.
The product of your favorite number with itself is 49.
Problem Three:
Assume that the current date is 12/31/2010, the label for txtBox reads “What is your date of birth?”, and the user enters 2/3/1984 into txtBox before btnDisplay is clicked.
You are now 26 years old.
You have lived for 9824 days.
CAPITAL BUDGETING
Financial Management
Capital Budgeting Techniques
Introduction
The value of an entity today is the present value of all its future cash flows. The cash flows here includes the assets currently held by the company as well as any better investment opportunities that might be available in future .The value is calculated by discounting these future cash flows with investors required rate of return or what we can say is the degree of uncertainty attached to those future cash flows and expected time when these will occur. The managers of the business have a goal to maximize the entity’s value which in turn w.
Capital budgeting decisions are much vital than the decisions on management of working capital as these decisions requires careful analysis of the expected costs and benefits to be derived from each capital expenditure on acquisition of land, building, equipments and for permanent additions to working capital associated with the plant expansion.
The level of investments that maximizes the present value of the firm is simultaneously determined by the interaction of supply and demand forces under conditions of uncertainty
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