Capital budgeting -case study (2024)

Capital budgeting -case study

Instructions:-

Capital Budgeting Case – From the given case information, calculate the firm’s WACC then use the WACC to calculate NPV and evaluate IRR for proposed capital budgeting projects with a capital rationing constraint. After you choose the project(s), recalculate the capital structure based on the assumption that the project(s) are implemented and determine if the new capital structure will signal the investors either positively, negatively, or not at all. Write a business report on your findings. Include an executive summary and appendices if applicable. See rubric for specific graded criteria.Click on the attached document for additional information.

Solution

Capitalbudgeting is one of the most important tasks of the finance function in anorganization, due to the central role of capital investment in the success ofan organization. This paper introducesthe various investment appraisal methods including the traditional paybackperiod, the discounted cash flow methods and the break even analysis anddiscusses their applicability in modern finance practice. A practical case issolved in different capital structure scenarios with the aim of selecting themost viable project that the company can invest in. Finally, the paperconcludes with a discussion of the findings and implications of the decisionsmade and how they signal the market and investors.

Introduction

Accordingto Higgins (1998) growth in a company is often premised on upon the investmentsthat it makes. As they seek to maximize value for shareholders through growthand financial performance, companies must manage their inputs in a way thatmaximizes their output (returns), which calls upon the decision makers tocarefully evaluate how best to invest business resources to reap maximumbenefits, a source of competitive advantage, a term referred to as capitalbudgeting. It involves the listing of all the projects that a company wants toinvest in and deciding on which ones to invest in to maximize its returns.Capital budgeting is, therefore, a critical component that informs a company’sresolve to stay competitive, sustainable, and viable as it helps in makingpivotal decisions that optimize shareholder value and corporate resources inthe longer run. There are various methods of assessing the viability of capitalprojects mostly through the comparison of cash inflows and outflows to quantifythe net gains from undertaking the project. The most common include;

Thepayback period- This is a traditional investment evaluation method thatcalculates the time taken for an investor to recoup their initial investment.It assumes that the investor’s immediate financial requirement is to recoverthe investment within a reasonable period and therefore, the project that takesthe shortest period to return the initial investment is selected.

NetPresent Value (NPV) – This is one of the most widely used methods of capitalinvestment appraisal. It discounts the expected cash inflows using the cost ofcapital and compares the net inflows with the initial cash outflows toestablish the net return on investment. A project would, therefore, be deemedfit for investment if the discounted cash inflows exceed the cash outflows, andin the event that all projects have positive net cash inflows, the one with thehighest net inflows is selected, bearing in mind the associated investmentrisks.

Thedrawbacks associated with the use of the NPV relate to the assumptions and estimatesmade in making investment decisions, which leave a lot of room for errors. Someof the factors that must rely on estimates include the initial investments,projected inflows and the cost of capital since a project may require someunforeseen expenditures during takeoff and also at the end. The method does notalso take into consideration the risks that are inherent in the projects andtherefore fall into the usual trap of over projections. Despite theseissues, Brealey and Myers (2003),presents an interesting rule that managers can in capital budgeting decisions:‘ Invest in all positive net present value projects, and reject those with anegative net present value’’. They insist that by this rule, firms will ensurethat all investment decisions maximize the value for shareholders. Since NPV isa complete measure of a project’s contribution to shareholders value, Brealeyand Myers see no need to consider alternative investment appraisal tools.

The following formula is used to calculate the net present value;

where

C_t= net cashinflow during the period t

C_o= totalinitial investment costs

r =discount rate, and

t = number of time periods

Theinternal rate of return (IRR) is another popular method of evaluatinginvestment projects. It’s the discountrate at which the project’s net present value is zero. A project is deemed tobe favorable if the internal rate of return is determined to exceed thecompany’s required rate of return. The formula for calculating the internalrate of return is similar to that of NPV, however, one would have to set theNPV at zero, and then calculate the discount rate which is the IRR. Since IRRcalculation involves trial and error, computer programs such as excel can beused as shown later in this paper. In decision making, the higher the IRR, themore desirable it is to undertake the project.

While IRRis a popular project appraisal method, it’s often misleading if used inisolation, as there are incidences where the IRR is low while NPV is very high,depending on the initial investment costs, meaning that while the company maybe seeing low returns, the value that the project adds is enormous.Additionally, IRR is not a reliable metric when evaluating projects withdifferent life spans, with short duration projects having a very high IRR butmuch less NPV while longer term projects may have a low IRR but a high NPV atcompletion. Finally, as noted above, the IRR is not an easy method, as itrelies on trial and error to compute and may, therefore, be difficult tonon-finance professionals.

Breakevenanalysis is a method that complements the above methods and is usedparticularly to test the sensitivity of various investment variables. The ideais to establish the level of sales that are required for the company togenerate a net income.

Capital budgeting in practice

Karim etal (2010) in his research on capital budgeting in large firms in Canada notedthat most firms tended to use the discounted cash flow techniques in theirevaluation of investment opportunities. Thus DCF methods especially NPV and IRRare increasingly accepted in large firms in America and other parts of theworld, with the usage of non-discounted cash flow techniques observed todecline in usage over the years. Cooper et al (2001) acknowledged that NPV andIRR are the most popular discounted cash flow method, although the paybackperiod is still in use even in fortune 500 companies in corporate America,while Ryan & Ryan (2002) identified these methods as the most popularamongst the fortune 1000. Bevery &Boyd (2004) observed that at least 75% of local authorities in New Zealand usedthe NPV and the cost-benefit analysis in project appraisal. These sentimentswere echoed by Truong et al (2006) who explained the widespread usage of theNPV and IRR as the most commonly utilized methods for capital budgeting inAustralia.

Casestudy

In thesection that follows, this paper analyses a capital budgeting case, given thevarious sources, capital structure a, costs of such capital and the initialcosts of the two projects to choose from. The question required the calculationof the firms weighted average cost of capital (WACC), calculation of the NetPresent Value (NPV) and evaluation of the firms Internal Rate of Return (IRR)for the projects and decision on which project to be undertaken. A further calculation of the capitalstructure will be done and a decision on whether the new capital structuresignals the investors either positively, negatively or not at all. To calculatethese metrics, excel formulas have been used as shown below.

Calculating the WACC

Sincethis company has three sources of capital i.e. Preferred stock, equity andlong-term debt, each with its own cost, the WACC represents the companiesaverage cost of its total capital, taking into consideration the costs andweights of each source of capital.Seeing that there is no tax element in the case study, the simple WACCwould be calculated by multiplying the weight by the cost of capital as shownbelow;

Analysis of findings and conclusions

Using thecalculated WACC, we use Microsoft Excel to calculate the NPV and IRR of bothprojects. The results indicate thatproject A has an NPV of ($1,520) while project B returns an NPV of $1,855. Thismeans that while project A appears to generate quite large cash inflows, whenwe consider the cost of capital over the period, we yield negative net presentvalue, meaning that the project will lead to reduced value for shareholders atthe end of the period. Project B, on theother hand, results in a positive net present value of $1,855 over the sameperiod. It’s therefore recommended that project B should be selected betweenthe two since it results in maximization of shareholders wealth. Project A hasan IRR of 16.06%, which is lower, that project B of 17.75%. As discussedpreviously, the higher the IRR, the more attractive is the project forinvestment as it leads to higher returns on the capital invested, whichmaximizes shareholders wealth. Using IRR, therefore, project B will be selectedwhile project A must be rejected.

Under thenew capital structure (weights), where equity capital represents 60% of thetotal capital with both long-term debt and preferred stocks accounting for 20%each, the new WACC is 17.20% which is higher than the initial one. With a higher cost of capital, thecomputation of both NPV and IRR results in lower NPV for both projects. Whilethe initial NPV for project B was $ 1,855, the new NPV given the new capitalstructure is only $807, revealing the impact of the increased cost of capitaldue to the amended capital structure.

Signaling

Thetheory of signaling dates back to the 70’s, where economists developed thecapital structure signaling theory that was based upon the asymmetricalinformation that exists between management of an organization and investors.Models of signaling are therefore based on the idea that in most cases, themanagement of an organization has inner information, which if it was let out tothe market, would affect the company’s stock prices. Since the managementcannot just announce that inside information to the public, they do so throughsending of signals. For instance, the management can change the capitalstructure in order to transfer some information relating to the profitabilityor risks involved in the firm’s decisions. According to Ross (1977), the choiceof capital structure signals external users. The quality of firms that are ableto raise debt finance tends to be better than those firms that operate mainlyon equity. Therefore, there is a negative reaction to stock prices on companiesthat announce the issue of stocks in the market. Issuing of debt is a positivesignal that the company expects to generate significant future resources to beable to offset these debts.

From thediscussion above, it follows, then that the change in capital structure in ourcase sends a negative signal to the market. The increased use of equity (60%,previous 50%), is an indicator that the company is not doing well, and is,therefore, unable to raise the required debt financing. This is corroborated bythe evaluation of the projects above, where increased use of equity financinghas increased the WACC, and therefore, reduced the NPV of the selected project,as compared to the initial capital structure which had resulted to a reducedWACC.

References

Ross A. Stephen (1977). “The determination of financial structure: The incentive -signaling approach”, The Bell Journal of Economics, vol. 8 (1), pp. 23-40

Cooper, Morgan, Redman and Smith (2001), Capitalbudgeting models: Theory Vs Practice, Business Forum, Vol.26, pp 15-19.

Brealey, R., and Myers, S. (2003). Principles ofCorporate Finance, (10th ed), New York: McGraw-Hill/Irwin, pp 102-104.

Lord Beverley R. and Boyd Jenifer R.(2004), CapitalBudgeting in New Zealand Local Authorities: An Examination of Practice, TheJournal of Contemporary Issues in Business and Government 11(1): 17-32.

Truong G., Partington G., & Peat M. (2006), Cost of Capital Estimation and Capital Budgeting Practice in Australia, University of Sydney, pp 7-13

Ryan Patricia A. & Ryan Glenn P. (2002), Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?, Journal of Business and Management, Vol.8, pp 355-364.