UNIVERSITY OF SOUTH WALES STRATEGIC FINANCIAL MANAGEMENT
UNIVERSITY OF SOUTH WALES
STRATEGIC FINANCIAL MANAGEMENT
(AF4S31 – V2)
CAPITAL INVESTMENT APPRAISAL
Table of Contents
TOC o “1-3” h z u INTRODUCTION PAGEREF _Toc529726935 h 3CAPITAL INVESTMENT CALCULATION REPORT PAGEREF _Toc529726936 h 3Project Wolf PAGEREF _Toc529726937 h 3Project Aspire PAGEREF _Toc529726938 h 4Projects Calculation Summary PAGEREF _Toc529726939 h 5Analysis and Evaluation of the Investment Projects PAGEREF _Toc529726940 h 5Projects Calculation Summary PAGEREF _Toc529726941 h 5AYR Co. Sources of Finance PAGEREF _Toc529726942 h 7
INTRODUCTIONCapital investment appraisal is generally defined as a budget outlining exercise that simplifies the decision-making process in the organization’s choice of durable or interim investments while accommodating stakeholder concerns. Marketing campaigns, property, marketing campaigns, new products, and new equipment are some elements that undergo scrutiny in an organizations capital investment appraisal process. Risk analysis of investments is also key in this process as it would not be wise for an organization to invest in a project that is good on paper but will generate risks that could harm its prospective growth (Carmichael, 2011). There are several techniques that could be used to evaluate company investments, in this analysis net present value, internal rate of return and payback period are applied.
Net Present Value is a capital investment appraisal method that remediates defects of the accounting rate of return and payback method. The method calculates cash flow in a project lifecycle exempting time value of money. Wilkes (1977) simply stated, “The net present value (NPV) of a project is equal to the present value of the cash inflows minus the present value of the cash outflows, all discounted at the cost of capital. Cash flows are calculated as profit before deducting depreciation and amortization.” It has been noted that the relationship between NPV and discount rate is indirectly proportional, that is, a low discount rate increases the NPV of capital. The internal rate of return, also known as return of invested capital can be defined as the interest earned when the NPV of all cash flows (positive and negative) from a project or investment equal zero (Wilkes, 1977) measuring the efficiency of capital investment. Payback period is
CAPITAL INVESTMENT CALCULATION REPORTIn completing the capital investment appraisal, the annual net cash flow was calculated by adding the profit after tax to the capital allowance. Furthermore, the yearly cost increase was determined using the formula cost of project multiplied by (! + r %). The total present value was found as a summation of the year’s individual present values from the first to the fifth year. Net present value is calculated by subtracting the investment from the total present value. The internal rate of return was calculated using excels IRR function. Table 1, 2 and 3 below summarize the calculations for both projects that were computed through excel. Following the determination of cash flows, the main difference between the two projects is the fact that project wolf depreciated while project Aspie utilized capital cost. In addition, project Wolf has better cash inflows as compared to project wolf.
Project WolfPeriod/Yearly Cash Flow 0 1 2 3 4 5
Plant & Machinery ($2,250,000.00) Cash flows $955,000.00 $955,000.00 $955,000.00 $955,000.00 $955,000.00
Variable Costs ($14,400.00) ($15,480.00) ($16,641.00) ($17,889.08) ($19,230.76)
Other expenses ($18,000.00) ($16,650.00) ($15,401.25) ($14,246.16) ($13,177.69)
Rental income lost ($75,000.00) ($75,000.00) ($75,000.00) ($75,000.00) ($75,000.00)
Gross Profit $847,600.00 $847,870.00 $847,957.75 $847,864.77 $847,591.55
Capital Allowances $ – $ – $ – $ – $ –
Profit Before Tax $847,600.00 $847,870.00 $847,957.75 $847,864.77 $847,591.55
Tax $169,520.00 $169,574.00 $169,591.55 $169,572.95 $169,518.31
Profit After Tax $678,080.00 $678,296.00 $678,366.20 $678,291.82 $678,073.24
Net Cash flow $678,080.00 $678,296.00 $678,366.20 $678,291.82 $678,073.24
Total NCF ($2,250,000.00) $678,080.00 $678,296.00 $678,366.20 $678,291.82 $1,633,073.24
PV @10% ($2,250,000.00) $616,436.36 $560,575.21 $509,666.57 $463,282.44 $1,014,010.00
Total PV $3,163,970.57 NPV $913,970.57 IRR 22.83% Cumulative cash earned $678,080.00 $1,356,376.00 $2,034,742.20 $2,713,034.02 $3,391,107.25
CCF/Inve 0.3 0.6 0.9 1.21 Payback period 4 years Project AspirePeriod/Yearly Cash Flows 0 1 2 3 4 5
Plant & Machinery ($2,250,000.00) Salvage value $375,000.00
Working Capital Investment ($140,000.00) Cash flows $650,000.00 $698,750.00 $751,156.25 $807,492.97 $868,054.94
Variable Costs ($27,000.00) ($29,025.00) ($31,201.88) ($33,542.02) ($36,057.67)
Gross Profit $623,000.00 $669,725.00 $719,954.38 $773,950.95 $831,997.27
Capital Allowances ($600,000.00) ($390,000.00) ($345,000.00) ($300,000.00) ($240,000.00)
Profit Before Tax $23,000.00 $279,725.00 $374,954.38 $473,950.95 $591,997.27
Tax $4,600.00 $55,945.00 $74,990.88 $94,790.19 $118,399.45
Profit After Tax $18,400.00 $223,780.00 $299,963.50 $379,160.76 $473,597.82
Net Cash flow $618,400.00 $613,780.00 $644,963.50 $679,160.76 $713,597.82
Total NCF ($2,390,000.00) $618,400.00 $613,780.00 $644,963.50 $679,160.76 $1,088,597.82
PV @10% ($2,390,000.00) $562,181.82 $507,256.20 $484,570.62 $463,875.94 $675,933.60
Total PV $2,693,818.18 NPV $303,818.18 IRR 14.44% Cumulative cash earned $618,400.00 $1,232,180.00 $1,877,143.50 $2,556,304.26 $3,269,902.08
CCF/Inve 0.27 0.55 0.83 1.14 1.45
Payback period 5 years Analysis and Evaluation of the Investment ProjectsProjects Calculation Summary NPV IRR Payback
Project Aspire $303818.18 14.44% 5
Project Wolf $913970.57 22.83% 4
Based on the calculations and results presented above, the best project to undertake would be the project wolf due to its higher net present value and internal rate of return. The NPV and IRR represent discounted cash flow appraisal techniques, where a discount rate is applied in order to calculate the resent day equivalent of a future cash flow. Since project wolf has a positive NPV, it indicates that the project generates more cash flows as compared to project aspire. Furthermore, the internal rate of return offers great insight into the potential return of an investment opportunity and offers effective comparisons with other projects. Accordingly, project wolf’s higher IRR indicates that it is a higher yielding project as compared to project aspire. Notably, both discounted cash flow appraisal methods return the same results. However, in most cases, the NPV is considered superior to the IRR as the latter sometimes faulty due to its assumption that cash flows from the project are reinvested in its IRR. On the other hand, the NPV is preferred as it assumes cash flows from the project is reinvested at the organization’s cost of capital. It is noted that project Aspire has a high NPV value ascribed to the project’s higher revenue from the similar investment short of any capital allowance influence. The payback period solution can be overlooked as the method mainly aims attention to cashflow examinations instead of profit (Namanda, 2016).The justification for choosing project wolf as the better investment option is presented below.
Justification for Selecting Project Wolf
Due to the higher net present value of project Wolf, it presents the best choice between the two projects. The NPV is determined by calculating the net value of a project’s cash flows. Given the possibility that cash flows may roll over several years in. the future and we are examining its current value by determining the present value. Accordingly, this information is imperative in the decision-making in capital investment choices and aids to make an efficient analysis. In this light, Project Wolf’s high net present value indicates that the project has more value to offer the company
On further examination of the internal rate of return, it is clear that project wolf is the more desirable project. Based on the IRR criteria, the project with an IRR above the hurdle rate is the best choice. In the case summarized above the hurdle rate is similar to the WACC of 10% indicating that the project wolf would add value to AYR. Co.
The Payback period calculation points to project wolf as the best investment choice as it would take a shorter period to complete. While Project Wolf would take only 2.01 years, project Aspire would take almost 3.25 years. On the other hand, since this technique does not consider the time value of money it is ineffective compared to the two other methods. However, the payback method can be used to examine if the desirability of the project if the corporation was searching for investments that turnaround swiftly.
Summary of Other Factors that must be considered in the Investment Decision
It is important to consider other factors before settling on a project regardless of whether it is the most suitable project for an organization. First, AYR Co. needs to determine the type of financing that the company will utilize to finance the selected project. The type of financing selected significantly determines the discount rate that is to be selected and thus must be considered in the decision-making analysis. Second, the corporations need to examine the impact of the selected project to its existing products. Third, AYR co. needs to confirm the figures selected and utilized in the analysis as errors might affect the final decision and affect the overall success of the company. Finally, it is crucial that AYR Co. determines if the selected project has any impact on a normal day-to-day operation of the company. It is important to determine if project Wolf is in line with the mission, values, and aims of the company as well as how it affects its competitive advantage and business environment.
AYR Co needs to conduct its due diligence of risk on both projects using the weighted average cost of capital (WACC) which will assist to give a preview of the opportunity capital of the organization. In this respect, the discount rate for the present value for the project wolf should be same as the WACC, which is 10%. This assumption is taken in the calculations above. It is important to conduct a risk analysis of both projects in order to determine their risk characteristics. The company should also determine the post-tax of capital and the cost of debt. Having assumed that the given WACC is ten percent in NPV calculation, the discount rate is ignored. The salvage value and capital allowances of both projects also play a big role in the capital investment appraisal process. As it is assumed that project wolf has no salvage value or capital allowances it presents the better investment opportunity for AYR Co. Lastly, Project wolf does not require any additional working capital investment as compared to project aspire.
AYR Co. Sources of FinanceIn the current corporate environment companies rely on debt, equity or earnings retained as their main financial resources. Typically, equity financing is described as the process in which a corporation offers additional shares of common stock to investors. Consequently, the issuing of more stock decreases the initial shareholder’s percentage of business ownership. In equity financing, if a company has shares which it has not yet issued to stockholders, the company leverages this to raise money for the selected project. Equity financing can also include the issuance of preferred shares and share warrants as a way of raising capital investments. Individuals who purchase the equity offered by a company become stockholders of the company and can benefit from revenue appreciations in the future.
On the other hand, debt financing is where a firm borrows capital without giving up ownership. A corporation can directly gain capital from banks or other financial lending institutions as well as through issuing bonds and notes for public acquisition. Generally, debt financing follows string guidelines and contracts that involve the paying of interest and principals at specified periods. The failure to meet the debt obligations put a corporation is a dire situation as it may face legal consequence. Typically, in the United States financial system, interest on the debt is a deductible expense when calculating the company’s taxable income. The accumulation of debt increases a company’s future cost of borrowing as well as its business risk.
Cost of Equity and Debt Financing
The cost of equity financing is considered more complex as compared to the cost of debt financing. Overall, once a shareholder purchases a share from a firm, the latter is no longer responsible to reimburse the funds to the stockholder. Nevertheless, the shareholder is still expecting a rerun in his/her investment in the corporation on the expectation that the firm’s performance would improve In future years and translate to high dividend payments and increased stock process. Typically, the Capital Asset Pricing Model (CAMP) is used to determine the cost of equity by focusing on the market return, beta, and risk-free rate of the corporation. Accordingly, the aforementioned information is used to calculate the corporation’s cost of debt.
On the other hand, in debt financing, the borrowing company incurs the cost during the period of interest payment. Banks or financial lenders expect to receive a return from the borrower as a compensation for borrowing money. The interest rate is used as a reference about determining the cost of debt. Overall, the cost of equity financing is considered higher as opposed to the cost of debt. Notably, this is attributed to the fact that stockholders take more risk in the firm as compared to external investors. In this respect, stockholders are only reimbursed in the firm after all other creditors have been compensated.
Effect on the Weighted Average Cost of Capital (WACC)
As aforementioned, the cost of equity financing has a higher cost compared to the cost of debt financing. Accordingly, if AYR Co. decides to fund project Wolf with equity financing then the weighted average cost of capital will rise significantly. In this case, AYR Co. will have to re-evaluate the suitability of the two projects putting in mind the weighted average cost of capital. On the other hand, if AYR Co. selects debt financing, then the weighted average cost of capital would drop significantly. As such, the firm will have to consider interest payments in the calculation of cash flows.
Impact on Current and Future Stockholders/Lenders
In respect to the case of AYR Co., raising capital through equity financing would have a direct impact on the profitability of the corporation. However, since the firm has to issue new shares to the public, the current shareholders are affected through the dilution of their dividends and interest reductions. Looking at the AYR Co.’s financial statements, it is clear there is a positive cash inflow from financing activities. Furthermore, the statement of financial position shows a rise in stockholder’s equity.
Apart from raising the capital through equity financing, AYR Co. can decide to use debt financing. In this case, the company would not dilute the ownership of interest of the existing stakeholders. However, this does not say that debt financing does not come with setbacks, as the choice would have direct effects on the company’s profitability. Debt financing would push AYR Co.’s net income down due to the periodic payments that have to be met. Furthermore, the move would increase the risk associated with the company mainly due to the high debt balance. If the company’s performance is poor, AYR Co. is still obligated to pay for the period of interest as well as the full amount of capital borrowed. This significantly increases the risk associated with the company. It is of great importance that the corporation’s financial statements indicate a positive cash flow from all financing activities, a rise in the firm’s average liabilities and a drop in its net income following the payment of interest.
Overall, this paper used a numerical example, as a vehicle to show that the NPV rule of capital budgeting and the Payback Period rule of capital budgeting should not be applied to identical sets of cash flows for a given capital budgeting project. This is in contrast to the customary practice of teaching in the field of Finance. The cash flows used in the NPV rule of capital budgeting should be different from the cash flows used in the Payback Period rule of capital budgeting. This is because the NPV rule involves discounting whereby the cost of debt and equity are accounted for, however, the Payback Period rule does not involve discounting and therefore the cost of debt and equity should be accounted for in the cash flow
Ardalan, K., 2012. Payback Period and NPV: Their Different Cash Flows. Journal of Economics and Finance Education, 11(2).
Alkaraan, F. and Northcott, D., 2006. Strategic capital investment decision-making: A role for emergent analysis tools?: A study of practice in large UK manufacturing companies. The British Accounting Review, 38(2), pp.149-173.
Almeida, H., Campello, M. and Weisbach, M.S., 2004. The cash flow sensitivity of cash. The Journal of Finance, 59(4), pp.1777-1804.
Ballantine, J.A. and Stray, S., 1999. Information systems and other capital investments: evaluation practices compared. Logistics information management, 12(1/2), pp.78-93.
Carmichael, D.G., 2011. An alternative approach to capital investment appraisal. The Engineering Economist, 56(2), pp.123-139.
McMenamin, J., 2002. Financial management: an introduction. Routledge.
Namanda, M., 2016. Capital Budgeting, Net Present Value and other Business Decision Making Tools.
Wilkes, F.M., 1977. Capital budgeting techniques. Chichester: Wiley.