How To Evaluate Project Profitability: An Introduction To NPV, WACC, And Working Capital Financing

Introduction to Net Present Value (NPV)

Discuss about the Choosing A Source Of Finance In Business.

There are various methods to estimate the profitability of any projects. NPV (Net Present Value) is one of the most popular techniques among them. This is mainly because the technique utilizes the time value of money concept to calculate the present value of the future cash flows taking the discount rates into consideration. In addition to it, the tool offers concrete values in respect of the viability of project (Woodroof, 2011).

Net Present Value (NPV) is a comprehensive way of corporate budgeting to calculate whether a proposed project will be profitable or not. NPV calculation involves many financial topics in one formulae like after tax cash flows, time value of money, discounted rate and initial investment etc.

The projects having NPV greater than zero is a value added project for the organization. The organization should select the project with highest NPV value. For monthly compounding of NPV, the discount rate is divided by 12. It deals with the time value of money that means that the value of money is affected by time. Net Present Value of a project is the sum of discounted future cash flows of the business. Project resulting in negative NPV would be a loss. It is an important tool for long term projects as it involves the calculation of time value of money. If all the cash flows are positive, the NPV is simply the difference between the cash inflows and cash out flows. NPV compares the time value of money taking inflation into account.

Home Guardian in its two year study on its new pest control device has positive cash inflows. On calculation of monthly NPV the value will be greater than 1. So the firm should undertake the project as it will be profitable and will add value to the organization as it has the positive NPV value (Jassy, 2018).

The net present value of a project is the amount that would be added to the total worth of the company, if the project gets selected. The criteria for the decision making depends on two main factors. In case the net present value of the project is less than zero then it will incur losses. This clearly reveals that the project, which incurs negative value of NPV, is going to make a loss and will drain the cash from the business. The other side, in case NPV incurs positive value than the project will be profitable in nature and it would be advised that the company need to accept the alternative. 

Understanding the Weighted Average Cost of Capital (WACC)

The net present value of this project comes out as $5344351, which clearly shows that by making this investment company’s overall value would be increased by $5344351. The project is profitable for the company as the project will create the value of $5344351.

Year	Cash Inflow	Cash Outflow
0		5700000
1	2000000	950000
2	2000000	950000
3	2000000	950000
4	2000000	950000
5	4100000	1010000

Year	PV of Inflows	PV of Outflows
1	1785714.286	446428.6
2	1594387.755	757334.2
3	1423560.496	676191.2
4	1271036.157	603742.2
5	2326450.108	573101.1

NPV = $5,344,351

Weighted average cost of capital is the financial tool used to determine cost of capital to a firm. It is composed of debt, shares and retained earnings and is calculated at market rates.

To calculate the average cost of capital cost of each of the sources and capital structure mix is required. The cost of debt is also to be calculated, it is determined by the interest rate paid to the supplier of these sources of fund. We need to calculate cost of each component like debt, preferred shares, common equity and retained earnings along with acquisition cost.

After calculating cost of these components the cost is required to be adjusted by the tax effects of each source of fund. (Uuooidata, 2018).

Current market value of equity = (500000* 1.85 + 200000 * 4.75) = 10200000

Current Market Value of Debt = 100000000

Total Market Value of Debt and Equity = 110200000

Weight of Equity = 10200000/110200000 =0.0926= 9%

Weight of Debt =100000000 / 10200000 = 91%

Calculation for cost of equity and after-tax cost of debt.

Cost of equity can be calculated using either DDM (Dividend Discount Model) or CAPM (Capital Asset Pricing Model)

Cost of equity (DDM) = expected dividend in 1 year /current stock price + growth rateCost of equity (CAPM) = risk-free rate + beta coefficient × market risk premium

In the current example, the data is available for CAPM to calculate the cost of equity.
Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 4% + 1.4 × 12% =20.8%

Cost of debt is equal to the yield to maturity of the bonds. As per the given data yield to maturity is 15%

For the purpose of WACC, we will be needing the after-tax cost of debt, which is 11% [= 15% × (1 − 30%)].

Having all the necessary inputs, we can now calculate WACC with a formula to get an estimate of 12%.

WACC = 9% × 20.8% + 91% × 11% = 12%

Weighted average cost of capital is the expected average future fund cost and IRR is an investment analysis technique utilized by companies for deciding if the project is good enough to be undertaken. A close relationship does exist in between two factors., as together the concepts make up the decision for IRR calculations (Folger, 2018). In general, the methods shows that the project whose IRR is more than or equal to the firm’s cost of capital is required to be accepted and the project whose IRR is less than WACC should be rejected. So as the WACC of the project is 12% and the Internal rate of return is given as 15% so, the project should be selected (Accounting Explained, 2018).

Using NPV and WACC to Evaluate Project Profitability

Working capital can be defined as the blood of the company or its short term financial health as it is the cash available to the organization to perform its daily operations. It is the measure of liquidity of the organization. The positive working capital states that the organization is able to pay its short term liabilities with its current assets. Working capital is calculated as current assets minus current liabilities. It includes various components like inventories, value of raw material, accounts receivables and work in progress.

There are various sources of working capital financing available like bank overdraft facility, short term loans, equity funding, accounts receivables, factoring and trade creditor, etc. Opting for a most appropriate option for financing the business is a very crucial task. This is because there are various funding alternatives available for short-term financing. Short term financing options can come in the form of debt or investment. The criteria and implications of each and every source need thorough analysis before any financial decision.  Three key factors the company should consider in selecting different sources short term financing are (Acadoceo, 2017):

Risk is one of the crucial elements which are to be assessed while selecting a source of short-term finance. One must analyze the implications and consequences if one is not able to meet the financial commitments relating to the particular source. For instance: One will need to take into consideration about the relationship with the lenders, if the business does not meet the expectations and the company is not in the position to repay the loan amount. What would be the consequences if he or she is unable to meet the financial commitments of debt from a bank in case business struggles with certain financial criticalities? When it comes to selecting the suitable funding option, the objective should be minimization of the risk (Revision, 2018).

Flexibility is an important factor to be considered while selecting the source of short term financing as working capital is required by the business to carry out its daily operations. Any fall may cause failure for the business to pay for its ongoing operating expenses. Like, loan from traditional lender requires an extensive guarantee for the money lent. It is commonly found that traditional lenders demand owner’s property or other valuable for approving loans. While taking a loan from online lenders is easy and at less interest. It is necessary to make plan for need of working capital on continuous basis. This makes them produce more profit or current capital and can pay the loans easily (Accounting Tools, 2018; Revision, 2018).

Interest rate is also an important factor to be considered before taking any loan. There is risk of interest rate fluctuations and refinancing is involved in short term financing. If the lender denies to refinance, the business firm has to file for the liquidation or to sell off the assets. Higher interest rate may affect the profitability of the organization. Traditional lending institutions even charge a fee if borrower wishes to pay off the loan before time. Term finance has the facility of closing the loan according to borrower’s suitability. There should be very low or no repayment charges if borrower wishes to pay off the loan earlier (Zigya, 2017).

Lender should clearly specify and communicate fees and other charges. The resources, objectives and requirements are unique and the loan offer should meet these requirements. Credit parameters should meet the nature of the enterprise. The loan offer should have wide range so that optimum amount required for business could be meet. It should have timely access to funds so that we can achieve potential business opportunities. Loan amount depend upon the nature of business enterprise.  (eFinance Management, 2018; Acadoceo, 2017).

References

Acadoceo. (2017). What factors you need to consider when choosing a source of finance in business. Retrieved from Acadoceo: https://acadoceo.com/factors-to-consider-when-choosing-a-source-of-finance/

Accounting Explained. (2018). WACC. Retrieved from Accountingexplained.com: https://accountingexplained.com/capital/cost-of-capital/

Accounting Tools. (2018, April 23). The determinants of working capital. Retrieved from Accountingtools.com: https://www.accountingtools.com/articles/what-are-the-determinants-of-working-capital.html

eFinance Management. (2018). Working Capital Management Strategies / Approaches. Retrieved from Eefinancemanagement.com: https://efinancemanagement.com/working-capital-financing/working-capital-management-strategies-approaches

Folger, J. (2018). What’s the difference between weighted average cost of capital (WACC) and internal rate of return (IRR)? Retrieved from Investopedia.com: https://www.investopedia.com/ask/answers/062714/whats-difference-between-weighted-average-cost-capital-wacc-and-internal-rate-return-irr.asp

Jassy, D. (2018). What is the formula for calculating net present value (NPV) in Excel? Retrieved from Investopedia: https://www.investopedia.com/ask/answers/021115/what-formula-calculating-net-present-value-npv-excel.asp

Revision. (2018). Factors to consder whne choosing a source of finance. Retrieved from Revision.co.zw: https://www.revision.co.zw/factors-consider-choosing-source-finance/

Uuooidata. (2018). Weighted average cost of capital. Retrieved from Uuooidata.org: https://www.uuooidata.org/course/bna10003/ch4_WEIGHTED_AVERAGE_COST_OF_CAPITAL.pdf

Woodroof, E. A. (2011). How to use NPV to your Advantage. Retrieved from Buildings.com: https://www.buildings.com/article-details/articleid/11828/title/how-to-use-net-present-value-npv-to-your-advantage

Zigya. (2017). Explain the factors affecting the choice of the source of funds. Retrieved from Zigya.com: https://www.zigya.com/study/book?class=11&board=cbse&subject=Business+Studies&book=Business+Studies&chapter=Sources+of+Business+Finance&q_type=&q_topic=&q_category=&question_id=BSEN11004669