Capital Budgeting Techniques

Capital Budgeting Techniques

Capital budgeting is the concept that financial analysts employ in determining the investment decisions that are worth undertaking. Therefore, capital budgeting has a set of concepts and procedures that analysts use in affirming the value of different financial undertakings within the company (Baker & English, 2011). Notable capital budgeting techniques include the weighted average cost of capital for the firm, the anticipated cash flows for the projects, and the methods used in project selection. Capital budgeting techniques are only applicable in the case of long investments that a company is set to undertake. Through the capital budgeting techniques, a company can determine which investments will be relevant and profitable for it. This paper provides an application of various capital budgeting techniques to the long-term investment options of Wheels Industries through the evaluation of the procedures that they have to undertake.

Methodology

The case study of Wheels Industries requires the application of multiple capital budgeting techniques to determine the best investment options that the company needs to pursue. The main methods used in the case of Wheels Industries are the weighted average cost of capital for the firm, the anticipated cash flows for the projects, and the methods used for project selection (Baker & English, 2011). The specific calculations undertaken under the methodology include new equity and after-tax cost of debt. Other calculations include the weighted average cost of capital, cash flow after tax, net present value, internal rate return, and the evaluation of cash flows using risk adjusted discounted rates (Baker & English, 2011). The methodology utilized in the paper is formulae that guide the calculation of the selected capital budgeting techniques that are applicable to the case of Wheels Industry.

Findings

Company Investment Summary

The duration of the project is three years

The initial investment accounts for $1.5 million

The project uses the straight-line depreciation method

The project has no salvage value

The project will generate additional revenues of $1.2 million per year before tax

The project has additional annual costs of $600,000.

The Marginal Tax rate is 35%.

Part A

The new equity of the company is the concept of finance that enables the investors to determine the returns that a firm will earn from a project (Baker & English, 2011). The formula of calculating the new equity of a firm is the cost of equity = dividends per share / current market value of the stock + growth rate of dividends.

Owing to the flotation cost, the actual sale value of the shares is set to be 90% of $50 that equates to $45. Therefore, the value of the dividends per share in the calculation is $45.

Cost of equity = $2.50 * (1 + 0.06) / $45 + 0.06

Cost of equity = $2.65 / $45 + 0.06 = 11.89%

Advantages. The use of equity assures the company of having a regular base of income generation as the investors do not have the privileges of withdrawing their investments. The investors only have the role to play in making a transfer of shares to other potential investors without affecting the capital base of the firm. Second, equity enables Wheels Industries not to lay obligations on the management of the organization to pay a fixed proportion of dividends (Baker & English, 2011). The business environment and performance of the company play the role of making sure that it offers dividends to the target clients based on its cash flow. Raising the operating capital for the company enables the firm to identify its finance leverage ratio. In other words, the organization can determine the proportion of profits and debts that exists in its capital base. There are minimal costs that the company incurs while raising the capital, which it needs to run its operations. The only cost that the organization has to incur in raising the capital through equity is the flotation costs (Baker & English, 2011). In the case of Wheels Industries, the flotation cost is 10%, meaning that the company will receive a total value of $45 per share that an investor buys. Furthermore, the firm does not have the obligation to repay the investors the initial investment that they make in the company.

Disadvantages. On the other hand, there is an additional expense with which a company or firm has to part while floating for the equity finance. First, the flotation costs tag along with fixed costs that the company has to bear. The fixed costs include the underwriting fees, the commission of the broker, and the banking costs (Baker & English, 2011). In comparison to debt, raising capital through equity can be expensive for the firm in the end. The equity finance is a high risk that an investor has to take since there is a high probability of incurring losses in the dividends that the investor is set to earn. As such, the rate of dividends for which the investor will ask is relatively higher than the rate of repaying the debt. Finally, raising capital through equity is a recipe for the dilution of the proportion of ownership of the original shareholders in the company (Baker & English, 2011).

Part B

After-tax cost of debt = interest rate of debt * (100% – tax).

After-tax cost of debt = 5% * (100% – 35%).

After-tax cost of debt = 5% * 65%.

Therefore, the after-tax of debt = 3.25%.

Advantages of the after-tax cost of debt. Raising the capital through debt has no influence on the proportion and value of ownership that the investor has in the company. As such, the value and influence of the investor are maintained. Second, the repayment value that the company has to pay to the investors is predetermined. The firm only needs to pay the amount of value and the interests that accrue within the repayment period. Therefore, the organization has no obligation to finance the additional costs that emanate from the profitability of the firm. The lender to the company has no obligation to claim additional financial rewards to the company if the latter has settled its debt in full (Albrecht, 2007). Thus, the profitability levels of the company are pertinent in entrenching the needed growth within the firm without clinging to the dividend needs. The lender to the company has no control or say in the operations of the organization during the period of taking and repaying the loan. Third, one will benefit from the tax incentives that one is set to receive. The taxes that one has to pay exclude the interest rate that the company has to pay. The tax relief enables the firm to have relief in the financial obligations that it has while repaying the loan. Finally, raising capital through debt enables the organization to determine the time during which it has to repay the loan. From the operations of the company, it can identify the proportion of the revenue that it has to set aside to repay the loan to the lenders (Albrecht, 2007).

Disadvantages of after-tax cost of debt. The main disadvantage associated with taking debt is the lack of flexibility in the repayment of the loan. The loan repayment period is fixed and the company has to ensure that it meets its financial obligations within the agreed time with the lender. Failure to repay the loan within the set time could lead to the lender auctioning the assets of the business, hence becoming detrimental to the growth of the firm (Albrecht, 2007). There are issues that a business may develop while having to update the debts that it has on its loan books, thus making it harder to maintain the financial statement of the company. The level of debts that an organization owes influences the reputation of the company. A firm with a high level of debts is at the risk of not satisfying investors. High-risk business makes potential investors avoid from investing their capital in the business (Albrecht, 2007).

Part C

WACC = rd (1 – Tc) * (D / v) + Re * (E / v)

WACC= [(1,500,000 / 1,500,000 + 600,000) * 0.30] + [(600,000 / 1,500,000 + 600,000) * 0.70 * 1- 0.35)] * 0.12

= 0.0408

= 4.08%

WACC is used in the capital budgeting process as it enables an investor and the company to determine the valuation that a firm has to make regarding a proposed investment (Albrecht, 2007).

Part D

Cash flow after-tax determination takes into account the sum of amortization, net income, and depreciation quantities. To determine the depreciation, the straight-line depreciation method is used. The method takes into account the even assets costs throughout the life of the project in question. This method is appropriate and applicable when the economic benefits resulting from the business assets are expected to be achieved equally over the time period that proves useful. In addition, the straight-line depreciation method is convenient to be applied in situations when there are no reliable estimates that can be drawn based on the pattern of the economic benefits expected to be driven over the assets useful time.

Therefore, the depreciation = (Initial Investment Salvage Value) / Life of the Asset.

Depreciation = 1500000 / 3 = 500000.

Thus, the cash flow per year = (Revenue Cost Depreciation) * (1 Tax Rate) + Depreciation.

The cash flow = (1200000 600000 – 500000) * (1 – 0.35) + 500000 = 565000.

Part E

The calculation of the net present value (NPV) of the project explains the difference between the present value of a cash flow amount and the present value of cash outflow. The NPV formula helps to identify the present value of an investment while considering the discounted sum of all cash flows received from the project. In this situation, the initial investment, which is the current value, has no discount while the expected return, which is the additionally generated revenue, has to be discounted (Baker & Powell, 2005). As such, this formula is used to project profitability used in the corporate valuation and budgeting when there is a need to assess a potential of the project to have a return on investments which will be made. It incorporates the compounding of discounts and rates determined by the level of risks involved throughout the planned duration of the project (Baker & Powell, 2005).

Revenue generation:

Year 1 = $1.2 million

Tax = 0.35*1.2million = $0.42

Net = $0.78

Year 2 = $2.4million

Tax = 0.35 * $2.4million = $0.84

Net = $1.56

Year 3 = $3.6million

Tax = 0.35 * $3.6 million = $1.26 million

Net = 2.34 million

Total additional cost for the 3 years = 600,000 * 3

= $1800,000 = $1.8 million

The net present value uses = Expected revenue / (1 + discount) ^ time initial revenue

{0.78 / (1 + 0.06) ^ 1} + {1.56 / (1 + 0.06) ^ 2} + {2.34 / (1 + 0.06) ^ 3} – Total cost – Initial revenue

{0.74 + 1.39 + 1.96} – 1.8 – 1.5

= $0.79 million.

As a result, the project is not feasible and thus should not be undertaken. The sole aim of all business investments is to generate the profit. The project is going to demand an investment capital which speculated generated revenue is a depreciation of almost a half. Therefore, there will be no profit but the high risk.

Part F

The internal rate of return (IRR) is among many other formulas that can be used to calculate a projects feasibility (Baker & Powell, 2005). It should be used together with certain parameters like the net present value since it can be misleading if used exclusively. Based on the quantity of the initial investment that the company should make, the projects feasibility of profitability could be low in terms of IRR calculation and high in terms of the NPV. It implies that in the event that the organization slowly receives returns on the project, there could be a massive and a great deal of revenue generated in the long run at the end of the speculated period.

The formula for calculating the IRR value is similar to that of NPV except that NPV is equated to zero.

Calculating IRR

NPV = {PERIOD CASH FLOW / (1 + R) ^ t} – initial investment

NPV = 0

Making R, the subject

R^3 = {(Period of cash flow / 1.5) – 1}100^3

R = 1397.05%

According to the obtained results, the project is feasible and can be undertaken. It is contradictory because IRR is highly increased while the NPV is greatly depreciated. However, as mentioned earlier, IRR can be misleading; hence, it has to be used together with other evaluation parameters.

Part G

For investment B;

NPV / Depreciation per annum = {(cost – Residual value) / Useful life}

= $120,000 / 6

= $20,000

Rate = {$20000 / $120,000} * 100 = 16%

Project value = Cash flow – depreciation

= {(25 / 100) * $20,000} + {(50 / 100) * $32,000} + {(25 / 100) * $ 40,000} – $20,000

= $6,000

For investment C;

NPV / Depreciation per annum = {(cost – Residual value) / Useful life}

= $120,000 / 6

= $20,000

Rate = {$20000 / $120,000} * 100 = 16%

Project value = Cash flow – depreciation

{(3 / 10) * $22,000} + {(5 / 10) * $40,000} + {(2 / 10)*$ 50,000} – $20,000

= $16,600

The NPV and the IRR for the two companies are in correlation, implying that the risks involved are high. The time for the realization of the projected values is too long, thus resulting in low interest rates. There is also no contradiction between the values of the NPV and the IRR as per the parameters involved.

Part H

Adjusted NPV for investment B;

NPV = {Cash flow / (1 + 0.08^t)} – $20,000

= {26000 / (1.08) ^6} – $20,000

= $16,384 – $20,000

= – $3,616

Adjusted NPV for investment C;

NPV= {Cash flow/ (1+0.08^t)} – $20,000

= {36,600/ (1.08) ^6}-$20,000

= $23,064-$20,000

= $3064

According to the percentage risk adjustment analysis of the two investments above, one can realize that the risk involved in the investment B is lower as compared to that of the investment C, which is twice higher. This difference results from the difference in the initial cash flows even though time and discount are the same.

Recommendations

Besides capital budgeting techniques, companies should consider incorporating evaluation models. The determination of the worth of the firm, its integrity, and place in the market significantly contribute to the identification of the future prospects of the organization (Keown, 2004). Investors are usually attracted to companies that have a good record of performance, hence being able to attract more and more investors. However, an increased number of investors results in the spread of the risks in the speculation of future profits and prospects.

In the evaluation process, techniques such as the net present value, internal rate of return, and the straight-line depreciation methods should be used coherently. Application of only one single technique is detrimental to final findings and recommendations concerning the steps the organization should take. Independent, single-chosen evaluation formula could result in misleading outcomes, thus enhancing risks that are not feasible. As such, all these parameters should be applied together with other control factors (Keown, 2004).

In determining the probability of the risks and future investments, the companys personnel should not only concentrate on the capital issues but also consider other factors such as the nature of the human resource, leadership qualities, and the entire workers fraternity. These factors are worth evaluation because they are also pertinent to the growth, sustainability, and high performance of the companys (Keown, 2004).

Conclusion

Capital budgeting techniques and procedures have proven to be applicable to the long investments that a company decides to undertake. Through the capital budgeting techniques, a firm can determine the feasibility and the profitability of the relevant projects. The paper has addressed certain applications of various capital budgeting techniques to the long term investment options of Wheels Industries. It has also focused on the procedures deemed best for the evaluation of the measures that the organization needs to undertake. As a result, all the techniques mentioned in the paper should be used together and not independently to ensure the best outcome. They all have advantages and disadvantages; therefore, their application should be backed up by some other guiding parameters.

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