Study with the several resources on Docsity
Earn points by helping other students or get them with a premium plan
Prepare for your exams
Study with the several resources on Docsity
Earn points to download
Earn points by helping other students or get them with a premium plan
Community
Ask the community for help and clear up your study doubts
Discover the best universities in your country according to Docsity users
Free resources
Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors
Strategic Financial Management (AF4S31-V2)
Typology: Essays (university)
1 / 20
This page cannot be seen from the preview
Don't miss anything!
Student ID: 74102202
Capital Investment Appraisal Report for AYR Co.
Page ii of 20 ABSTRACT This report analyses AYR Co.’s two project investment proposals, namely Aspire and Wolf, to determine each project’s future success. Based on provided projects information, the report advises Directors of AYR Co. on their planned capital expenditures. Based on some assumptions, the Net Present Value (NPV), Internal Rate of return (IRR) and projects’ Payback Periods were calculated. Despite the fact that both projects have equal internal rate of return, the Project Aspire has been recommended for AYR Co.’s management, due to its great cash flows compared to the Project Wolf’s. However, a number of other factors to be considered has been highlighted and financial sources criticized. Keywords : Capital budgeting, debt, Cost of Capital, Internal Rate of Return, Stock
The capital investment appraisal is part of the planning process that helps to examine the firm’s short-term and long-term investments. There is a number of methods used in this process such as Net present value (NPV), internal rate of return (IRR), Payback period, Profitability index, etc. the current report will only be limited to the first three methods. Since the report analyses AYR Co’s two projects that have the purpose of increasing the company’s market share, our analysis will focus more on projects ability to generate cash flows. Unfortunately, this analysis doesn’t cover the company’s business strategy, which is more recommended. However, some of other factors that need to be analyzed before deciding on a potential project to undertake are surfaced in this report. 1.1. Methodology As mentioned above this report uses three main methods of appraising capital investments which are: the net present value, internal rate of return and payback period. The two first methods are based on the discounted method or time value of money (Scicluna, 2018). a) Net Present Value (NPV): This technique measures the cash in-flows of an initial investment at a particular time and at a given discount rate as per the below formula: Abbreviated Source: PreMBA (2018) The higher the NPV, the more desirable is the project, hence all firms’ objective is to drive to a positive NPV. However, working under higher interest rate increases the discount rate which, in retour reduces the value of the NPV of a capital investment. b) Internal Rate of return (IRR): this is the discount rate which brings the value of NPV to zero. IRR measures the efficiency of a capital such that if the cost of capital investment is
higher than the IRR, the project is likely to be rejected (Capital Investment, 2018). Calculating the IRR is simply equating the NPV to zero as follow: Source: Finance Formula (2018) c) Payback Period: this refers to the time required to get back the initial investment. Always projects that have shorter payback periods are more preferred. In order to calculate the payback period, we have used the formula given by Irfanullah (2018) for projects with uneven cash flows: Payback Period = A +
d) Where: A: is the last period with a negative cumulative cash flow; B: is the absolute value of cumulative cash flow at the end of the period A; C: is the total cash flow during the period after A However, due to some information that could be interpreted differently or was not clear in our analysis, we made use of assumptions. 1.2. Assumptions
1.3. Structure This report is only made of two chapters: the first chapter merely introduces the three techniques used in evaluating projects and the entire work in general. The second chapter is the proper report which entails the calculation, interpretation, recommendation and analysis of different factors in project evaluation. Lastly a concluding paragraph ends this report but details of the calculations involved are annexed too.
AYR Co. is indifferent between two potential projects that aim to increase its market share. in order to recommend either Project Aspire and project Wolf, we have analyzed these project below. 2.1. Calculations and findings In all of our calculations, we have kept in mind the assumptions made in the previous chapter. Detailed calculations are available on the appendices.
This is a very effective and common technique in evaluating projects which analyses the discounted cash flows, hence the future uncertainty of cash flows is compensated. Since the cash earned in future are discounted to present time, it allows good comparison between the cash flows. When this difference (revenues minus costs) is positive, the project is accepted. For two independent projects, the one with greater NPV should be selected. In order to calculate the NPV for both projects, we used a discount rate of 10% to discount all cash flows to their present values and made a difference (Cash inflows minus cash outflows). The findings are as the below table: Project Project Aspire Project Wolf Net Present Value (NPV) 424,845 $379,
Positive Net profit value means profit, hence projects have to be accepted and compared between them and against other metrics as we will see in the internal rate of return below:
The IRR is that discount rate that occurs when a project is break even (Sham, 2018). It is used to determine the amount of return on investment that an investor can expect from a project. The decision to accept a project is based on whether its IRR is higher than the cost of financing; the bigger IRR, the more attractive is the project. In our case, the cost of capital is 10% and we are expecting greater project to exceed this financing cost. In order to calculate the internal rate of return for each project, an excel sheet with IRR formula was used for automatic calculation once the net cash flows are entered as parameters. Project Project Aspire Project Wolf IRR 17 % 17 %
Contrary to the previous method, Payback period is the simplest decision tool, which doesn’t normally take into account the time value of money. However, it commonly used “ to determine the attractiveness of a project, especially if the company is looking for investments that have fast turnaround times ” (Bierman and Smidt, 2007). By using the Irfanullah’s formula ( 2018) we have obtained the following results: Project Project Aspire Project Wolf Payback period 3 .42 3. 2.2 Interpretations and recommendations In this section, we will interpret the above findings to draw a recommendation for AYR Co. over the most desirable project to be undertaken.
Payback Period: While it will take only 3.07 years for the project Wolf to get back its initial investment, the project Aspire will need 3.42 years to pay back its investment. Although project Aspire has a bit longer payback period than Wolf, we still advise to choose project Aspire because it will generate more cash inflows within the investment period and almost in the same year than Wolf. Therefore Project Aspire is still more desirable for AYR Co. than project Wolf. 2.3 Other Factors to Consider In capital investment decisions, there is a number of other more factors that should be considered. Company culture: If undertaking a new project like Aspire can interfere with the company culture and values, for example by changing the communication style, it is advisable that the company makes careful analysis and decide accordingly. David (2018) gives an example where an automation system can change the team dynamism on a factory floor, hence managers should study the effect that a project can have on the company culture before taking any capital investment decision. In our case, AYR Co should also analyze the effects of the project Aspire on the corporate operations and culture, to see if it can fit in. Strategy and Cannibalization effect; This happens when a new product breaks the sales of another one. If this may be the case for Project Aspire over the existing products/services, AYR Co should consider the alternative. On the other hand, the project Aspire may appeal to existing customers while Project Wolf may appeals to different type of customers, which is absolutely good on the company’s strategic view point (Leonidas, 2018). If these are the cases, Wolf would be more desirable. Economy and politics In our case specifically, economic and political factors are also important to our analysis because they can affect the rates of interest and tax paid or cause inflation.
Environmental and ethical concerns While ethical concerns are to be considered in capital investment, it has been argued that the most financially attractive options often have more impact, on environment, than the more expensive options (David, 2018). This calls for managers to become environmentally conscious when choosing affordable project. Personnel If AYR Co. has skilled personnel on board or can recruit one, then it still has wider choose. Otherwise, this non-financial factor should also be assessed. Industry and competition Beyond other things we also have to analyze the industry and market competition, company hierarchy as well as economic and financial trends. 2.4. Sources of Financing In this section we discuss the two sources of finance that are being considered by the board of AYR Co. These sources are Equity and Debt, which respectively consist of issuing new shares and borrowing money from lenders. We will also try to analyze their costs and their effects on WACC and on potential stakeholders.
Intended financing sources for AYR Co. Capital employed $million % per source Equity holder funds 20 52. Long term debt 18 47. Total 38 100 Source: AF4S31 Assessment 2 Equity Financing is that process of raising the firm’s capital by selling shares. This is now an option for AYR Co., if the company still has shares that are not yet issued to stockholders, so it
better, which increase their stock prices and gives them high dividends. Apart from the fact that stockholders participate in the potential rise in earnings, they finally lose everything if the company goes bankrupt. All of these risks should be compensated by more returns, which indicate how expensive this financing is (Equity master, 2010). Additionally, no tax can be deducted from them as this is the case for debt lenders. On the other hand, while debt financing increases risks for the borrower because in case of bankrupt the lender has first claim on company assets(Equity master, 2010), it’s the cheapest. If AYR Co. decides to go for debt financing, it will be paying the lender on regular basis and the cost of debt will only be determined by interest rate. AYR Co. would also benefit from interest tax.
Although it’s not always the case, debt is likely to be a cheaper source of finance than equity, as discussed above. It’s now up to AYR Co. to decide over a preferred source of financing based on an in-depth analysis of crosscutting factors. However, whichever option the company takes will have an effect on the weighted average cost of capital (WACC) If the company chooses to go for equity financing, the cost of capital may increase due to increase in share. Contrary, debt financing may reduce the cost of capital due to this increase the portion of the cheaper source of funding (Scicluna, 2018). However, AYR Co. should first analyze the interest rate which can affect annual cash flows (Madura, 2017).
The two source of financing have effects on either the company ownership or profitability, which in return affect Stockholders and Lenders. For example, debt financing affects the company’s net income due to regular payments of interests to lenders. Although the process doesn’t affect existing stockholders’ ownership, it increases the company’s risks by increasing liabilities that include the payable borrowed capital, interests and/or penalties depending on the agreement. For the case of equity financing, the process dilutes existing stockholders ownership and their interest in the company, if they are not the ones who buy new shares.
The results of the three investment appraisal methods have allowed us to choose Project Aspire over Project Wolf because of Project Aspire’s ability to pay back its investment within the investment period, its internal rate of return which is bigger than the cost of capital investment and foremostly because of its ability to generate more cash flows than project Wolf. However, our choice for project Aspire is also sensitive to another number of factors such as the company culture, availability of skilled personnel, environmental and ethical concerns as well as the type of financing. We recommend AYR Co to undertake the project Aspire assuming that other considerations are given account. In terms of choosing a source of financing, we have analysed a number of factors that affect cash flows such as inflation, expected return on investment, management and shared ownership, financial risks, etc. Although we believe that further analysis is needed, we have recommended the company to consider debt financing over equity financing source due to the latter being more expensive than debt financing.
Net CASH FLOW
To calculate the payback period, we have used the formula given by Irfanullah (2018) which is used for uneven cash flows: Payback Period = A +
Where: A: is the last period with a negative cumulative cash flow; B: is the absolute value of cumulative cash flow at the end of the period A; C: is the total cash flow during the period after A Payback Period 3.
B. Calculations for Project Wolf PROJECT WOLF Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Capital Spending ($2,250,000) Salvage Value 0 Cash Inflows $955,000 $955,000 $955,000 $955,000 $955, Material Costs ($14,400) ($15,480) ($16,641) ($17,889) ($19,231) Other Expenses ($18,000) ($16,650) ($15,401) ($14,246) ($13,178) Foregone Rental Income ($75,000) ($75,000) ($75,000) ($75,000) ($75,000) EBIT $847,600 $847,870 $847,958 $847,865 $847, Taxes (20%) 0 $169,520 $169,574 $169,592 $169,573 169518. Net Cash flows ($2,250,000) $847,600 $678,350 $678,384 $678,273 $678,018 ($169,518) Cumulative Cash Flows ($2,250,000) ($1,402,400) ($724,050) ($45,666) $632,607 $1,310,625 $1,141, Discount Factor 1 0.91 0.83 0.75 0.68 0.62 0. Present Values - 2,250,000 771316 563030.5 508788 461225.912 420371.16 - 94930. Net Present Value (NPV) $379, Internal Rate of Return (IRR)
Student ID: 74102202
Scicluna, C. (2018). Investment Appraisal II. In: Strategic Financial Management. University of South Wales, pp. 2 – 19. Available at: https://vle- usw.unicaf.org/mod/resource/view.php?id=3642 1 [Accessed: 12 March 2018] Scicluna, C. (2018). Investment Appraisal I. In: Strategic Financial Management. University of South Wales, pp. 2 – 25. Available at: https://vle- usw.unicaf.org/mod/resource/view.php?id=36417 [Accessed: 25 March 2018] Scicluna, C. (2018). WACC. In: Strategic Financial Management. pp. 2–11. Available at: https://vle-usw.unicaf.org/mod/resource/view.php?id=36401 [Accessed: 25 March 2018] Scicluna, C. (2018). Capital Structure and Gearing. In: AF4S31 Strategic Financial Management. University of South Wales, pp. 1 – 12. Available at: https://vle- usw.unicaf.org/mod/resource/view.php?id=36404 [Accessed: 25 March 2018] Scicluna, C. (2018). Cost of Capital - Introduction to Cost of Debt. In: Strategic Financial Management. University of South Wales, pp. 6 – 7, 15. Available at: https://vle- usw.unicaf.org/mod/resource/view.php?id=36399 [Accessed: 25 March 2018] PreMBA (2018). Evaluating Cash Flows: NPV & IRR. Available online at: http://ci.columbia.edu/ci/premba_test/c0332/s5/s5_5.html [Accessed on 25 March 2018] Finance Formulas (2018). Net Present Value. Available online at: http://financeformulas.net/Net_Present_Value.html [Accessed on 25 March 2018] Capital Investment (2018). Capital Investment Appraisal / Appraisal Techniques. Available online at: http://www.capital-investment.co.uk/capital-investment-appraisal.php [Accessed on 25 March 2018] Irfanullah J. (2013). Payback Period. Available online at: https://accountingexplained.com/managerial/capital-budgeting/payback-period [Accessed on 25 March 2018] Bierman, H. and Smidt, S. (2007). The capital budgeting decision. New York and London: Routledge. Sham G. (2018). Capital Budgeting: Capital Budgeting Decision Tools. Available online at: https://www.investopedia.com/university/capital-budgeting/decision-tools.asp [Accessed on 26 March 2018]
David I. (2018). Qualitative Factors in Capital Investment Decisions. Available online at: http://smallbusiness.chron.com/qualitative-factors-capital-investment-decisions-73769.html [Accessed on 19 March 2018] Rosemary P. (2018). 6 Types of Equity Financing for Small Business. Avoid Loans and Credit Debt By Financing with Equity. Available online at https://www.thebalance.com/types-of-equity- financing-for-small-business- 393181 [Accessed on 19 March 2018] Helbæk, M., Lindset, S. and McLellan, B. (2010). Corporate finance. Maidenhead, Berkshire: Open University Press/McGraw-Hill Education. Madura, J. (2017). International financial management. US: Cengage Learning Custom Publication. Equity master (2010). Equity or Debt: Which is cheaper?. Available online at: https://www.equitymaster.com/detail.asp?date=10/13/2010&story=2&title=Equity-or-Debt- Which-is-cheaper [accessed on 20 March 2018]
