Capital Budgeting Assignment On Financial Management

Question

Task: Part A Capital Budgeting
Background: (EV) GOGreen Motors is considering a new project to produce electric vehicles for the Australian domestic market and international markets. The potential growth in this market has been outlined in a report by Climateworks, which you can view by CLICKING HERE. GOGreen has identified a property/plant that was formerly used to build petrol fueled motor vehicles that could be refitted at minimal cost to manufacture the new EV's.

GOGreen is targeting Australian metrolpolitan centres for initial sales and expanding into regional centres over the next five years. International demand for EV's is being driven by China and GOGreen has been in negotiation to provide vehicles to the Chinese market in 2020.

Problem
GOGreen has made the following projections: In the first year 2,000 units will be sold, growing at 10% per annum.
The price for each unit in the first year will be AU$50,000. This price will increase each year by 5%.
Variable costs are 60% of the sales price, which will grow by 3% each year.
Fixed costs are $5 mil pa, which are expected to grow by 2% each year.
The project is for a term of 5 years. The projected growth of the EV line is expected to outgrow the plant at this time, hence the plan will be sold at the end of 5 years.
Initial investment into manufacturing equipment of $100 million;equipment may be depreciated at 20% straight-line (prime cost) method.
In 5 years, the plant will be worth 10% of its' purchase price.
Working capital $3 million.
GOGreen's required rate of return is 4.5%.
The tax rate for GOGreen is 30%.

(a) Prepare an excel spreadsheet calculating:
After-tax cash flows (in table format)
Payback period
Net present value
Profitability index

(b) You are asked to present a report on your findings regarding the upgrade proposal. Make a recommendation to Management on whether they should proceed with the project or not. Explain the criteria on which you have based your decision.

(c) It has come to your attention that variable costs are anticipated to rise by 10% per annum due to the prospective growth within the industry. Would you recommend to proceed with the project? (Show all calculations).

(d) You have been asked to provide a further evaluation regarding the alternative use of the plant for the purpose of manufacturing electric buses, however the project life will be for 10 years. Explain how financial managers may evaluate both projects that are of unequal lives.

Part B Cost of Capital
Grainwaves Ltd is an Australian firm which is publicly-listed on the ASX. The company has a long term target capital structure of 55% Ordinary Equity, 5% Preference Shares, and 40% Debt. All of the shareholders of Grainwaves are Australian residents for tax purposes. To fund a major expansion Grainwaves Ltd needs to raise a $150 million in capital from debt and equity markets.

Grainwaves Ltd’s broker advises that they can sell new 10 year corporate bonds to investors for $105 with an annual coupon of 6% and a face value of $100. Issue costs on this new debt is expected to be 1% of face value. The firm can also issue new $100 preference shares which will pay a dividend of $7.50 and have issue costs of 2%. The company also plans to issue new Ordinary Shares at an issue cost of 2.5%. The ordinary shares of Grainwaves are currently trading at $4.50 per share and will pay a dividend of $0.15 this year. Ordinary dividends in Grainwaves are predicted to grow at a constant rate of 7% pa.

Calculate how much debt Grainwaves will need to issue to maintain their target capital structure.

What will be the appropriate cost of debt for Grainwaves.
Calculate how much Preference Share equity Grainwaves will need to issue to maintain their target capital structure.
What will be the appropriate cost of Preference shares for Grainwaves? (8 marks) Calculate how much Ordinary Share equity Grainwaves will need to issue to maintain their target capital structure.
What will be the appropriate cost of Ordinary Equity shares for Grainwaves?
Calculate how the Weighted Average Cost of Capital for Grainwaves Ltd following the new capital raising.
Grainwaves Ltd has a current EBIT of $1.3 million per annum. The CFO approaches the Board and advises them that they have devised a strategy which will lower the company’s cost of capital by 0.5%. How will this change the value of the company? Support your answer using theory and calculations.

Answer

Executive Summery
Capital budgeting is one of the significant financial management tools discussed in this capital budgeting assignment that help in investor or an organization decides whether to undertake a feasible proposal or not. It insures accountability as well as measurability of the project on the basis of several factors and analysis done critically. No business shall invest in any project without critically evaluating its feasibility. Every proposal is prone to varied risks and returns, which hence, become more important to address, analyze and understand deeply. In this era of fast and competitive environment, capital budgeting provides a protective shield to face losses and therefore, allow the financial entity to survive and most importantly grow in this developing market place.

Case study
PART A of capital budgeting assignment: Capital budgeting is considered a financial commitment as well as an investment decision helpful for the organization in the long run. It adds value to the company by ensuring that the management and it takes critical and detailed analysis of the proposal with respect to its return, risks, costs and savings (Al-Dalabih, 2018). This is basically undertaken to enhance the wealth of the shareholders by increasing profitability situations within the organization through its operations. There are various metrics that are used to calculate the feasibility of the project. It includes calculating net present value, profitability index, internal rate of return, accounting rate of return, payback period, discounted payback period, etc. The most common metric used to calculate any capital budgeting decision is the method of assessing the net present value of the project. It is calculated by discounting the cash flows to consider the time value of money and then deducting the present values of the outflows from the present values of the inflows to arrive at the net present value of the project. If the NPV yields a positive result, the project is selected and vice versa. Payback period involves analyzing the time span within which the project shall be able to recover the entire money invested into the proposal as compared to its inflows generated without discounting them. The lesser the result, the better shall be the project feasibility. Profitability index mentioned in this capital budgeting assignment is calculated by dividing the present value of the inflows generated from the potential project with the present value of the outflows invested into the business (Choy, 2018).

a. The details of the organization undertaking the project are as follows:

NET PRESENT VALUE = PRESENT VALUE OF INFLOWS – PRRSENT VALUE OF OUTFLOWS.
The project generates a positive net present value and hence, it can be accepted.
PROFITABILITY INDEX = [PRESENT VALUE OF INFLOWS / PRESENT VALUE OF OUTFLOW]
Therefore, PI = 1.713
Since, the profitability index is greater than 1, the project seems feasible and sound to be accepted by the financial organization.

PAYBACK PERIOD can be calculated using the table below:

It is clear from the above table provided in the study of capital budgeting assignment that the company shall be able to recover its investment after the third year.
Using interpolation method:
(x – x’)/(x” – x’) = (y – y’)/(y” – y’)
Where,
X = PAYBACK PERIOD
X’ = year before the recovery of investment
X” = year after the recovery of investment
Y = amount of initial investment
Y’ = cumulative amount corresponding to the year x’
Y” = cumulative amount corresponding to the year x”
(x – 3)/ (4 – 3) = (103000000 – 92924882)/ (129298669 – 92924882)
Therefore, the payback period is 3.27 years

b. Considering the results of the metrics calculated as above in the capital budgeting assignment, it can be concluded that the project and the investment looks feasible for the company in the long run. It is ought to deliver a positive net present value, hence affirming to the organization of its financial stability and returns along with the time value of money being considered and taken into account. It also generates a profitability index that is greater than 1 (Fatseas & Williams, 2004). This is again an indication that the organization is again on a positive side as the project shall generate more inflows in the term of 5 years than the initial investment made. The payback period is 3.27 years. It is also adequate time duration for any financial entity to be able to recover its investment made before the initiation of the project. Overall, it can be concluded that the organization can accept the proposal (Goldmann, 2016).

c. If the variable costs rise within the industry by 10%, the results would be able as follows:

Considering the above analysis, it can be clearly stated that the organization shall face lesser stable and adequate results than the base case, but then also the top management may accept the proposal as it yields better metrics results.

d. When the other project to be considered shall have a different time duration than one calculated as above, it shall become imperative for the organization to consider the time value of money so that discounting is done and results produced can be compared easily to arrive at a conclusion of either accepting or rejecting any one of them from amongst the two (Johnson, 2017).

PART B of capital budgeting assignment
Cost of capital is a very significant concept in financial management. It is very crucial in determining whether or not to accept any potential proposal available before the eyes of the organization. It is basically in simple terms, sacrifice made by the investors of the organization to acquire potential and reasonable returns from the operations of the organization. This is the investor’s point of view. From the business organization’s point of view, it is the price that the entity pays for in exchange of the capital invested or provided by them. Hence, it is essential to calculate the weighted average cost of capital (WACC) well before in advance to know which proposal yields lower cost to the company in generating capital through funds via equity, bonds, preference stock or any other long term debt. It is useful in determining the validity of many capital budgeting decisions and hence, it is extremely crucial in realizing the efficiency and effectiveness of sound decision making activity of the management of the organization (Jones, 2017). An organization can chose from various sources to meet its finance requirements. It then needs to critically analyze the costs of raising such funds from each source to calculate and reach an optimum one. This shall help in enhancing the financial performance of the entity by decreasing costs and increase in profits thereby. It also allows the investors to be fully aware of the expected income and the associated risks inherent in the weighted average cost of capital in the organization. It is helpful in making the capital structure of the organization more stable, optimal and balanced. Such composition shall be the best possible combination of the sources of funds.

The case given in this capital budgeting assignment is about an organization named Grainwaves. It currently maintains their capital structure at 55% equity, 5% Preference Stock and 40% long term debt. With the advancement in technology and the desire to grow, they wish to undertake an expansion project. This shall allow the company to raise funds of about $ 150 million for the same. If the organization wishes to maintain the same capital structure, it shall raise funds amounting to $ 60 million as debt for its expansion strategy (Linden & Freeman, 2017). Currently the organization faces three alternatives in combination to maintain its current capital structure ratio. These are as follows-

Selling bonds in the open market there in interest rate of 6% per annum and flotation cost that will be incurred at the rate of 1% of the face value of the bonds. These bonds are priced at $105 each.
The organization can also issue preference shares that is currently raised at 2% flotation costs having a face value of $100 and paying an annual dividend of $ 7.50 per share (Jefferson, 2017).
It can also issue ordinary shares paying dividends of $0.15 per share and having a growth rate of 7% per annum.

a. The cost of bonds shall be calculated as follows:
\ Floatation costs = [amount to be raised as bonds/ (1 – floatation costs)]*Floatation costs
= [60 Mn / (1-0.01)] * 0.01
= 0.6060 Mn
Therefore cost of issuing bonds shall be [(0.6060/60) * 100] that is equal to 1.01%

b. If the organization wishes to maintain the same capital structure, it shall raise funds amounting to $ 7.5 million as debt for its expansion strategy.

c. The cost of preference share shall be calculated as follows:
Cost of preference capital (%) = {Dividend to be paid next year/ [current market price * (1-floatation costs)]} + Growth rate
= {7.5/ [100*(1-0.02)]}*100
= 7.65%

d. If the organization wishes to maintain the same capital structure, it shall raise funds amounting to $ 82.5 million as equity for its expansion strategy (Timothy, 2004).

e. The cost of equity share shall be calculated as follows:
Cost of equity share capital (%) =
{Dividend to be paid next year/ [current market price * (1-floatation costs)]} + Growth rate
= {{0.1605/ [4.50*(1-0.025)]}*100} + 7
= 10.66%

f. The weighted average cost of capital of the financial corporation can be calculate as follows:

Therefore, the weighted average cost of capital is [(9.9744/150) * 100] which is equal to 6.65%

g. If the EBIT of the company is $ 1.3 Mn each year, the current value of the company shall be (1.3 Mn / 6.65%). This results in $ 19.55 Mn.

h. If the WACC of the financial entity declines by 0.5% to 6.64%, then the new value of the company shall be (1.3 Mn / 6.15%). This results in $ 21.14 Mn.

Hence, the value of the company shall increase by $ 1.59 Mn if the WACC declines by 0.5%. It can be therefore concluded that the weighted average cost of capital has an inverse relationship with the value of the financial organization. If the rate of cost of capital increases, the value of the company shall decrease and inversely, if the rate of cost of capital decreases like in the given case under capital budgeting assignment, the value of the organization is likely to increase (Heminway, 2017).

Reference List
Al-Dalabih, F. A. (2018). The Impact of the Use of Accounting Information Systems on the Quality of Financial Data. International Business Research, 11(5), 143-158.

Choy, Y. K. (2018). Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, 3(1), 145. doi:https://doi.org/10.1016/j.ecolecon.2017.08.005

Fatseas, V., & Williams, J. (2004). Management Accounting for costs and control. Australia: Learning materials Centre.

Goldmann, K. (2016). Financial Liquidity and Profitability Management in Practice of Polish Business. Financial Environment and Business Development, 4(3), 103-112.

Heminway, J. (2017). Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, 1-35.

Jefferson, M. (2017). Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland . capital budgeting assignment Technological Forecasting and Social Change, 353-354.

Johnson, R. (2017). The Best Strategies for Investing. In the News, 21-31.

Jones, P. (2017). Statistical Sampling and Risk Analysis in Auditing. NY: Routledge.

Linden, B., & Freeman, R. (2017). Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), 353-379. Retrieved from https://doi.org/10.1017/beq.2017.1

Timothy, G. (2004). Managing interest rate risk in a rising rate environment. RMA Journal, Risk Management Association (RMA), 3(1), 29-41.