Capital Budgeting for a New Machine - Coursework Example

Task 4. Capital Budgeting for a New Machine What is the project’s IRR? (10 pts) To determine the IRR of the project we use the financial calculator, 22% 2. What is the project’s NPV? (15 pts) 3. Should the company accept this project and why (or why not)? (5 pts) The acceptability of this project depends upon the fact that the return for the project should be greater than the return of it. This logic holds true here. This is evident from the fact that the Net Present Value of this project is greater than zero which means that the project is in a condition to generate returns to a level that the present value of it is more than zero. Secondly, internal rate of return for a project provides a percentage of the amount of return that the cash flows will generate. It is noted that the required rate of return is 15% however; the return for this project is 22% which provides a 7% spread. These two ground are enough to take up this project. 4. Explain how depreciation will affect the present value of the project. (10 pts) Depreciation is a non cash expense and it is also tax deductible. The depreciation is first reduced from the operating income to get earnings before interest and taxes. The amount of depreciation deducted is then added back in the cash flow statements to get the operating cash flows. We know that the net present value is determined by the cash flows expected from the project therefore; this non cash expense eventually increases the cash flows of the project. Ultimately, the net present value of the cash flows will increase which is beneficial for the company. In addition to the above, a company which opts for straight line depreciation method will have equal positive cash flows every year. For example: Depreciation of $100,000 per year, with an income tax of 35%, saves $35,000 of taxes each year and that amount is accounted as a positive cash flow. This amount is also known as the depreciation tax shield. 5. Provide examples of at least one of the following as it relates to the project: (5 pts each) a. Sunk Cost b. Opportunity cost c. Erosion Sunk cost Sunk Cost is a sum of money which has already been spent and it is not recoverable. It is essential to understand because many people feel intuitively that if an investment is made then it is essential to get a return on it. This will lead to rejection of one course of action which favors the other one to actually generate smaller cash flows. One needs to understand that sunk costs are irrelevant to financial decisions. Opportunity cost is a profit that is forgone by not investing in a particular opportunity. This is particularly true when there are mutually exclusive projects and you have to choose the best out of two good projects. The profit forgone from not choosing the other project is your opportunity cost (Shim & Siegel, 2008). Erosion is the slow but sure redirection of funds from profitable sections or projects within a business to new project and areas. It is considered to be an investment in the long, money flowing in new projects, however; the short run effect is a slow erosion of company cash flows. 6. Explain how you would conduct a scenario and sensitivity analysis of the project. What would be some project-specific risks and market risks related to this project? Sensitivity analysis is a practice adopted by the finance department of a company which is taking up a new project. The cash flows are expected therefore; one needs to ensure that the estimation is true in all cases. For that, one should know which factors would reduce your actual cash flows and which will increase them. So, in this case the variables which are crucial are required rate of return, interest rate risk, discrepancy in cash flows, damage to the equipment etc. Sensitivity analysis of this project would be done against various variables. (Brigham & Ehrhardt, 2010) These may include required rate of return, interest rate risk, discrepancy in cash flows, damage to the equipment etc. Increase in the required rate of return will decrease NPV of the project and may cause the end result to be negative. Furthermore, if interest rate rises than the cost of capital will increase which will ultimately lead to lower profits. In addition to the above factors, if the cash flows are not the same as anticipated then the complete analysis would be outmoded and may result in lower or higher returns. Lastly, we have assumed that the equipment remains in running condition for the time it is with us but this is not always true. Sensitivity analysis is necessary to measure the accurate impact of the above factors on the project. Task 5: Cost of Capital (70 pts) AirJet Best Parts Inc. is now considering that the appropriate discount rate for the new machine should be the cost of capital and would like to determine it. You will assist in the process of obtaining this rate. 1. Compute the cost of debt. Assume AirJet Best Parts Inc. is considering issuing new bonds and decided to use the YTM of one of its main competitors (Boing) as a reference. Assume that the YTM for Boing’s bonds is 6.9% a. What is the after-tax cost of debt if the tax rate is 34%? (5 pts) The after tax cost of debt is calculated as: b. Explain what other methods you could have used to find the cost of debt for AirJet Best Parts Inc.(10 pts) a) Options are available to calculate cost of debt in the above case. One of them could be to add all the interest paid last year and divide the sum by debt outstanding. b) Another way is to add all weighted debt cost to get an average cost of debt for the firm. a. Explain why you should use the YTM and not the coupon rate as the required return for debt. (5 pts) Yield to maturity of a bond is comparable to the IRR received by an investor. It is a definite evaluation of future return, as it is the rate at which coupon payments can be reinvested when received is unknown. It acquaints an investor to compare the advantages and disadvantages of different investments. On the other hand, coupon payment does not report the component of required return in it. It is difficult to infer the cost-benefit equilibrium by looking at the coupon payment c) Compute the cost of common equity using the CAPM model. For beta, use the average Beta of Boing. Assume that this Beta is 1.31. Assume as well the risk free rate to be 3% and the market risk premium to be 4%. a. What is the cost of common equity? (5 pts) b. Explain the advantages and disadvantages to use the CAPM model as the method to compute the cost of common equity. Compare and contrast this method with the dividend growth model approach. (10 pts) CAPM presents a linear connection between risks linked with the return. The systematic risk concerned is taken into vision to provide its mandatory rate of return. However; these postulations do not match actual conditions. On the other hand, dividend growth model constructs on two non realistic assumptions which are dividend growth is unvarying and expected dividend growth rate is lesser than cost of equity. Consequently, it is not useful for companies which are not remunerating any dividends. Also it falls short to link risk straight to the return. In contrast, CAPM has a wider appliance. Only limitation is that the company’s share ought to be quoted on the stock exchange and anticipates detailed share price data. The drawbacks include beta is assumed to remain stable over time which is not true. It fluctuates continuously therefore; to account it as invariable could direct to faulty conclusions. d) Compute the cost of preferred equity assuming the dividend paid for preferred stock is $2.93 and the current value of the stock is $50 per share. a. What is the cost of preferred equity? (5 pts) b. Is there any other method to compute this cost? Explain. (5 pts) Yes, it can be calculated through WACC. If WACC is known and cost of debt is also known along with share of equity and debt in the firm then cost of equity can easily be calculated. e) Assuming that the market value weights of these capital sources are 30% bonds, 60% common equity and 10% preferred equity, what is the weighted cost of capital of the firm? (10 pts) f) Should the firm use this WACC for all projects? Explain and provide examples as appropriate. (10 pts) WACC takes into account the cost of debt, equity and preferred equity taken up till date. This means that if today a company is analyzing an investment opportunity, the company would relate the return of return to cost of previous debt and not solely with the cost of opportunity on hand. Therefore; it is by no means an indicator of a firm’s individual project cost. WACC is different for each project which depends on the exposure to risk taken. Investors required rate of return will defer with project’s beta therefore; taking one WACC for all would be a mistake. Each project should have its separate WACC and approval or disapproval would depend on individual analysis of the project. For example, the required rate of return for this project is 15% and the return associated with it is 22%. Although the cost of financing this project is above WACC but this project should be taken up as it provides a higher return for the company in relation to other projects which may not deliver return of similar scale. g) Recompute the net present value of the project based on the cost of capital you found. Do you still believe that your earlier recommendation for accepting or rejecting the project was adequate? Why or why not? (5 pts) Yes, I believe the decision taken precedent to this analysis was true as the WACC is below the required rate of return for the project. This project would yield generous accounting profits for the company as the spread is quite substantial. Works Cited Brigham, E. F., & Ehrhardt, M. C. (2010). Financial Management Theory and Practice. Cengage Learning. Shim, J. K., & Siegel, J. G. (2008). Financial Management. Barrons Educational Series. Read More