The Board of AYR Co. is considering the option for the selection of the most suitable project by making the evaluation of these investment proposals using three widely used capital budgeting techniques like those of net present value, payback period and internal rate of return. It further emphasizes on the fact that not only the financial but the non-financial factors also play the major role in making such evaluation (Belton, 2017). The two project options are the Project Aspire and the project Wolf with their distinct characteristics for which our report also suggests the sources of the fund to be opted for making the investment in the selected project. While making decision on the sources of funds the major considerations kept in mind are the cost of the capital along with its overall impact on the WACC of the selected Company. Our report covers both the practical as well as the theoretical conceptual analysis of the Investment evaluation criteria. Further as it is often seen that the financial factors play major role in making such investment decision, but non-financial factors too have their own role to play in this regard, hence the detailed discussion on the same has been made too (Bromwich & Scapens, 2016).
|
Year |
Cash inflows |
Cumulative cash inflows |
|
1 |
818000 |
818000 |
|
2 |
698000 |
1516000 |
|
3 |
677997 |
2193997 |
|
4 |
667309 |
2861306 |
|
5 |
1168507 |
4029813 |
Payback period =3 years+2390000-2193997/667309*12
= 3.29 Years
|
Year |
Cash inflows |
Cumulative cash inflows |
|
1 |
818000 |
818000 |
|
2 |
698000 |
1516000 |
|
3 |
677997 |
2193997 |
|
4 |
667309 |
2861306 |
|
5 |
1168507 |
4029813 |
Pay Back Period= 3 yerars+2250000-2193997/667309
=3.08 Years
Answer to Q. No. 2
Before making any suggestion it is better to have an analytical and comparative discussion on the above calculations made so that it may assist our decision making process. The NPV of the Aspire project is more than the NPV of the Project Wolf, though both of the projects are having higher IRR when comparing the same with the overall cost of capital of the AYR company, though Project Aspire’s IRR exceeds project Wolf’s IRR (Visinescu, et al., 2017). When we see the calculation of the payback period then it is Project wolf whose payback back period is lower in comparison to the project Aspire. Hence it is being suggested to select the project Aspire and reject the project Wolf.
In above we have used three separate techniques of capital budgeting, but has made our decision based on only one technique, it is because every technique has its advantages and limitations associated with it, which have been discussed hereunder.
The mostly used techniques of the capital budgeting are undoubtedly the techniques of NPV and the IRR, but one of the most notable limitations associated with the IRR technique is that it ignores the external factors role in the determination of the appropriate discounting rate at which the future estimated cash inflows are to be discounted (Fay & Negangard, 2017). The major causes or the circumstances during which the outcome suggested by both of these techniques vary are differences in the project durations or in the cash flow estimations etc. IRR also merely an expression of the percentage at which the project shall break-even without referring to any specific absolute figure of the inflow, hence taking such percentage as a basis of our decision is not so trustworthy. NPV always gives the figure in absolute terms whether in positive or negative or even zero.
Payback period is quite illogical in the sense that it ignores the concept of the time value of money. Furthermore, though the cash flows generated post the initial payback period are significant enough, but payback period fails to recognize the same (Vieira, et al., 2017). Hence, decision on the basis of the outcome of this technique is again not recommended.
From the above comparative analysis, it is easily concluded that the Net present value technique outclasses all the other capital budgeting techniques and our recommendation is based on the outcome of this technique only.
The total capital employed by the business can be categorized as debt and equity. Here the term debt refers to the long term debt.
Long term debt providers are those who expect a fixed percentage of return on the debt provide to the company, but are not the owners of the company (Jefferson, 2017). Though in the event of liquidation they have preference over the equity holders to claim their demand on the assets of the company. The company can claim the interest tax shield on the interest paid to the long term debt providers
Equity shareholders are the owners of the company enjoying the voting rights and are responsible for making the major decision for the business. They are entitled to the share of the profit or loss earned by the company, hence can be said that they are the highest risk takers. They get the dividend in terms of the share of profit, but the same is not deductible expenses in terms of tax provision.
Hence though the debts may seem to be cheaper source of fund than equity, but there is always the risk associated with the company for being bankrupt if the debt equity ratio exceeds the optimum level (Heminway, 2017).
When we talk about the cost of the debt .we indirectly means it is the post tax cost of debt as the interest paid on such debt is considered as an allowable expenses. This is the reason why the real cost of debt comes down while calculating the after tax cost of debt (Linden & Freeman, 2017). The formula of for computing the cost of debt has been shown below
KD= I (1-tc)
Where,
KD= after tax cost of debt
I =Rate of Interest
Tc= Tax rate
Cost of equity
Cost of equity is generally being calculated using the capital asset pricing model (CAPM) or the dividend capitalization model depending on the circumstances of the case. It is the rate of return which the shareholders of the company expect in return for the funds invested by them in form of equity and the risk they bear by making such investment in the company (Sithole, et al., 2017).
CAPM makes use of historical information to calculate the cost of equity that is the reason why it is not mostly used for this calculation
E=Rf+Beta*(Rm-Rf)
Where E = Expected return from the Asset
RF= Risk-free Rate of return
Beta= Systematic Risk of the asset
Rm= Return from the market
Risk Free rate of return is the rate of return which is expected to be earned in the risk free securities like those government securities.
If the value of the beta is one then it means that the asset is as volatile as the market, if it is less than one then the degree of the volatility seems to be low in the context of the market condition and if it is greater than one then the asset is said to be highly volatile in nature (Meroño-Cerdán, et al., 2017).
One of the major limitation associated with this formula is that it is to be applied only if the company is paying dividend and at the same time it does not consider the level of risk as it is being considered in case of the application of the CAPM .
The formula to be used
E= (D1/P0)/G
Where
E= Cost of equity
D1= Dividend in next year
P0= Current market price of the share
G= growth rate of dividend
The rate of the growth of the dividend can be calculated using the following formula
G= (dt/dt-1)-1
Where,
DT= payment of dividend in T period
Dt-1= payment of dividend one year prior to t period
If the total fund required is inform of debt. Then the new capital structure of AYR co shall be
Equity = $20 million
Debt= $18+$2.25= $20.25 million
Let the after tax cost of debt be 5% and cost of equity be 7%
Hence the WACC would be
=5*$20.25/$40.25+7*$20/$40.25
=5.99%
If the entire fund is invested by means of equity. Then the new capital structure of AYR co shall be
Equity= $20million+$2.25milloion= $22.25million
Debt= $18 million
Let the after tax cost of debt be 5% and cost of equity be 7%
Hence the WACC would be
=5*$18/$40.25+7*$22.5/$40.25
=6.14%
As the WACC of AYR co is lower when making the investment by procuring the funds through debt, hence the form of financing to be chosen in the case is debt
Conclusion
On the basis of the above critical discussion and analysis it can be concluded that the while making the choice of the capital budgeting techniques it is to be kept in mind the specific merits and demerits associated with each of the techniques. Further the technique of the Net present value is always preferred than any other techniques as suggested.
Again none of the investment decisions can be made final only on the basis of financial evaluations rather the non- financial factors are also as important as the financial one. Hence they too demand equal merit.
The determination of the appropriate sources of funds is a critical judgement to be made and it is the best strategy to have the optimum balance of the equity and the debt in the capital structure of the company. As neither the total equity nor total debt funded company can best utilize its resources? Debt is cheaper but may prove to be costly if not paid. Again debts funds are not very easy to procure as it depends on the credibility of the company too.
Finally cost of equity is a major factor to be considered as at times if dividend is not paid by the company in such a case if the capital asset pricing model is used then it may make difference or even can lead to wrong decisions too.
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