CapitalBudgeting Techniques

Costof equity

Advantagesof equity as a source of finance

Equityis the amount of money contributed by the shareholders plus theretained earnings or retained losses. It is advantageous as it iscommitted to the entire investment project or business. In otherwords, equity is used to finance the business. Second, the companywill not have to incur the cost of servicing the equity like in thecase of debt where the firm has to pay interest rate every year.Third, equity finance enables the business to increase in value. Thisimplies that an increase in common stock will have an impact on theassets of the company since assets equals to liabilities pluscapital. Fourth, when a company issues equity shares, the investors,shareholders, or venture capitalists will bring contacts of prominentpeople within the business sector, experience, and skills that couldbenefit the enterprise. Lastly, equity finance increases theprofitability of the firm and its success (PetersonDrake, &amp Fabozzi, 2002).

Disadvantagesof common stock as a source of finance

Despitethe numerous advantages of having equity finance in a firm, thesource of finance comes with some disadvantages. It is costly andtime-consuming as the company focuses away from the core businessactivities and starts focusing on the investment project. Second,before investors buy the common stock of the company, the have toperform a background check of the company and determine whether thisis what they want to invest in. In the event of this, some secrets ofthe company may leak to competitors. Lastly, equity finance makesmanagement lose control of the company to the shareholders who arenow the owners of the firm (PetersonDrake, &amp Fabozzi, 2002).

Costof debt

Advantagesof debt as a source of finance

Debtis an amount borrowed by one party from another like in the case of acompany from a financial institution. Debt is an important source offinance since the interest is deductible on the returns of thecompany. Second, management’s ownership of the business will not bediluted, and they will therefore not lose control of the firm. Third,it is a cheaper source of finance since it provides a tax shield incase a company makes a loss. Lastly, it prevents a company from goingbankrupt since they will be assured that the company will continuewith the normal day-to-day activities (PetersonDrake, &amp Fabozzi, 2002).

Disadvantagesof debt in financing projects

Debtincreases the organization’s risk level since when the maturityperiod expires it must b paid together with the accumulatedinterest. Second, it has complex procedures, which must be met.Third, if the enterprise fails to pay back the debt, the financialinstitution may decide to take the assets of the business ascollateral. Third, it increases agency costs, which result in reducedprofits for the business (PetersonDrake, &amp Fabozzi, 2002).

details

Cost

Weight

Equity

11.89%

0.7

8.32

Debt

3.25%

0.3

0.98

WACC

9.30%

WACCis used in the capital budgeting process as a discount rate whencalculating the Net Present Value of the investment project (PetersonDrake, &amp Fabozzi, 2002).

ProjectA

Here,I took the earnings before tax less the annual cost to get the profitafter tax. Then I minus the tax from PAT and added depreciation toget the after-tax cash flows.

Calculationof the Net Present Value

Theproject is economically viable since the NPV is positive.

Calculationof the Internal Rate of Return

Sincethe NPV is positive, we consider a higher rate, say 48%.

Sincethe IRR is higher than the cost of capital, the investment project iseconomically viable.

Mutuallyexclusive projects

InvestmentB

Probability

After-tax cash flow

Cash flow

PVAIF,6%

PV

0.25

$ 20,000

$ 5,000

0.9434

$ 4,717

0.50

$ 32,000

$ 16,000

0.8900

$ 14,240

0.25

$ 40,000

$ 10,000

0.8396

$ 8,396.19

Io

(120,000)

NPV

-$ 92,646.81

InvestmentC

Probability

After-tax cash flow

Cash flow

PVAIF,6%

PV

0.30

$ 22,000

$ 6,600

0.9434

$ 6,226.44

0.50

$ 40,000

$ 20,000

0.8900

$ 17,800

0.20

$ 50,000

$ 10,000

0.8396

$ 8,396

Io

(120,000)

NPV

-$ 87,577.56

Conflictsbetween IRR and NPV

Whencomparing two projects, thy may have different cash flow patterns.Second, difference in the amount of initial outlay may cause someconflict. Lastly, different useful lives of the projects may alsocause conflict (PetersonDrake, &amp Fabozzi, 2002).

Risk-adjustedNPV

InvestmentB

Cash flow

PVAIF,14%

PV

$ 5,000

0.8772

$4,386

$ 16,000

0.7695

$12,312

$ 10,000

0.6750

$6,750

Io

(120,000)

NPV

-$96,552

InvestmentC

Cash flow

PVAIF,14%

PV

$ 6,600

0.8772

$5,789.52

$ 20,000

0.7695

$15,390

$ 10,000

0.6750

$6,750

Io

(120,000)

NPV

-$ 92,070.48

Sinceboth projects have a negative NPV, the company should reject them.

References

PetersonDrake, P. &amp Fabozzi, F. (2002). Capitalbudgeting.New York, NY: Wiley. Retrieved on 1 July 2016.