Investment Appraisal Project

WACC=wdkd(1-T)+wpkp+wsks Where Kd = interest on debt Kp = cost of preference shares Ks = cost of shares and retained earnings. WACC is calculated by multiplying the cost of equity by the market value of the equity and cost of debt by the market value of the debt. Cost of equity can be defined as the minimum rate of return that a company must generate and offer to their investors in order to provide a return on their investment and for assuming some level of risk. If the company does not offer this risk to the investors, there is a chance that the shareholders might sell these shares in the market. Selling of the company shares can be interpreted as a negative sign for the financial outlook of the company and will put a downward impact on the market value of the company. Cost of company’s equity can be calculated through ‘Dividend Growth Model’ and ‘Capital Asset pricing model.’ The formula for dividend growth model is as follows. E = Do Ke - g Where E is the market value of the equity, Do is the recent dividend paid or the dividend projected for the next year, Ke is the cost of the equity and g is the growth rate of the dividend. The dividend growth model assumes that the dividend grows in perpetuity at a definite rate. This growth rate can be computed by observing the historical dividend pattern of the company and calculating the growth rate through simple discount rate formula. Cost of debt is actually the rate at which the present value of the interest payments and redemption amounts equals the current market value of the debt. The following formula further clarifies. Where M is the market value of the bond currently on which it is being traded in the market, i is the interest payment and kd is the rate of return required by the debt holder. From the formula it can easily be deduced that the market value of any bond is the present value of the interest payment. But the above formula is only applicable in the case of debt having maturity till perpetuity. In case tax is involved, the interest is taken after tax. Cost of debt is basically the internal rate of return. As provided in the given information, the company’s debt equity ratio is 50%, which means that 50% of its operations are financed through debt and the other half is through equity. The company has available cash balance of ?450,000 and thus, in case the company opts to purchase any of the buildings, it will have to issue bonds by acquiring more debt. Since the company anticipates that the interest rates are likely to be increased in the future, it would be prudent to raise more funds through equity in order to curtail the impact of increased finance charge on the profitability of the company. The project under consideration requires a careful estimation of all the relevant costs and revenues; a misjudgment in the forecast will cause an error in the project net present value, which might result in the acceptance of a project which is not financially viable. CALCULATION BASED ON DISCOUTNED CASHFLOW First, consider the building A which costs ?1,112,000. The following table presents the calculation of the Net Present Value (NPV) of the particular investment decision. Item Amount in ? '000 Years Now 1 2 3 4 5 6 7 8 9 10 Cost of the site (1,112) Cash in-flow
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