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Table of Contents

Capital Budgeting Calculation ................................................................................................ 2


Analysis and Evaluation of the Investment Project Options .................................................... 2
Recommendation ..........................................................................................................................2
Justification for the Recommendation ............................................................................................3
Summary of Other Factors that Must be Considered in the Capital Budgeting Decision ....................4
Sources of Financing .............................................................................................................. 5
Description of Equity and Debt .......................................................................................................5
Cost of each Type of Financing .......................................................................................................6
Effect on the WACC ........................................................................................................................7
Effect on Current and Potential Stockholders and Lenders ..............................................................7
Reference .............................................................................................................................. 9
Appendix............................................................................................................................. 10
A Capital Budgeting Calculation-Project Aspire ............................................................................. 10
B Capital Budgeting Calculation-Project Wolf ................................................................................ 11

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Capital Budgeting Calculation

The calculations of the Net Present Value, Internal Rate of Return and Payback Period for both

Projects is shown in Appendix A for Project Aspire and Appendix B for Project Wolf. The

calculations are made directly using Microsoft Excel.

The first step in the calculation is the determination of the Annual Cash Flows. The main difference

in both projects is the fact that Project Aspire uses the Capital Cost Allowance and Project Wolf

is depreciated. The latter project also has large annual cash inflows compared to the former project.

We have discounted the annual cash flows using the current Weighted Average Cost of Capital

(WACC) of the company which is 10%. In calculating the, we made use of the Microsoft Excel

Formula IRR which automatically determines the IRR once the cash flows are entered as

parameters.

The $120,000 spent on market research was not anymore included in the analysis because this is

considered to be a sunk cost. It would not matter anymore regardless of what project AYR Co.

will undertake.

Analysis and Evaluation of the Investment Project Options

Recommendation

A summary of the results is shown below:

Payback
Project NPV IRR Period
Project Aspire $159,172 12.44% 3.25
Project Wolf $838,145 22.90% 2.01

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Based from the foregoing results of our capital budgeting analysis it would appear that Project

Wolf is more desirable than Project Aspire. It is therefore recommended that AYR Co. undertakes

Project Wolf.

A detailed discussion why we came up with this recommendation appears in the next section.

Justification for the Recommendation

Our recommendation is to go for the Project Wolf for the following reasons.

1. Project Wolf has the highest Net Present Value between the two projects. The Net Present

Value of a project is calculated by determining the net value of the projects cash flows.

Since cash flows may expand to several years in the future and we are analyzing its value

as of today determining its present value would be imperative to make meaningful analysis.

The project with the highest NPV is the project that will contribute more value to the

company especially if the projects are mutually exclusive. For projects that are independent

of each other one should chose the projects with positive NPV and the highest NPV as

possible depending on the capital budget (Bierman and Smidt, 2007).

2. Under the IRR criterion it would also appear that Project Wolf is desirable. Under the IRR

method, a project whose IRR is above the hurdle rate should be chosen. In this case, the

hurdle rate is the 10% WACC. If the IRR is above the hurdle rate it would mean that the

project would add value to the company. Although both projects have IRRs that are above

the 10% hurdle rate, Project Wolf must be chosen since it has the highest IRR among the

two projects. Our selection here also confirms what we have chosen in the first criteria

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because most often the two methods would select the same project. However, there are

instances when the project chosen by the NPV Method is different from the one chosen by

the IRR method. This situation arises when there are differences in cash flow patterns like

one project have higher cash flows in the earlier period compared to the other project or

when there are unequal lives. To resolve the discrepancy, the project with the higher NPV

must be chosen because the concept already incorporates reinvestment assumption and is

more accurate and meaningful than the other method (Bierman and Smidt, 2007).

3. The Payback Period Method also chose Project Wolf because it would only take 2.01 years

for AYR Co. to recoup its investments compared to 3.25 years in Project Aspire. The

downside for this method is that it does not consider the time value of money concept

unlike the first two method. Nonetheless, it can be used as a gauge to determine the

desirability of project especially if the company is looking for investments that have fast

turnaround times (Bierman and Smidt, 2007).

Summary of Other Factors that Must be Considered in the Capital Budgeting Decision

There are other factors that must be considered before coming up with the final decision of the

project that should be undertaken. A summary of these factors is shown below:

1. The company needs to determine the type of financing that will be used to finance the

project that will be chosen. The type of financing will have a significant role in the discount

rate that would be chosen and there might be other costs that should be incorporated in the

decision-making analysis.

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2. AYR Co. needs also to analyze the effect of the chosen project to the companys existing

products. There are instances when new products cannibalize the sales of the existing

products. If this situation is present then it must be incorporated in the analysis.

3. The company needs to verify the figures that were chosen and used in the analysis. If these

figures are erroneous then it might affect the decision that was chosen and the effects could

be disastrous on the company.

4. AYR Co. needs to also determine if the project has an effect on how the company operates.

It must determine whether the project to be taken is in lined with the corporate values,

objectives and goals of the company. It also needs to assess how the project might affect

its current operation and its impact to the environment. These things must be considered

before coming up with the final decision.

Sources of Financing
There are different types of financing available for a company. It can finance the companys project

with its own savings or retained earnings, borrow money from the bank or raise funds through the

issuance of new shares. We will be discussing these types of financing in the succeeding parts

these options.

Description of Equity and Debt

Equity Financing is simply the act of raising funds through the issuance of new shares by the

company. If the company have shares which are not yet issued to the stockholders then it can issue

them so that it can raise the funds needed to finance the chosen project. Furthermore, equity

financing is not only limited to the issuance of common equity shares but may also include the

issuance of preferred shares and share warrants. Once the shares are issued to stockholders, the

latter would have an interest in the company and becomes part-owner together with the other

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stockholders. In return of the investment, the investee company would be declaring dividends to

existing stockholders. Stockholders can also benefit from price appreciation over the years of the

equity shares that they have purchased (Helbk, Lindset and McLellan, 2010).

Debt Financing occurs when a company raises funds for working and capital requirements. The

company can directly borrow money from banks and other lending institutions. It can also raise

funds by issuing debt instruments likes bonds and notes that the public can purchase. In return of

the investment, the company would be paying the creditors or debt instrument holders of the

principal amount plus periodic interests (Helbk, Lindset and McLellan, 2010).

Cost of each Type of Financing

The cost of Equity Financing is more complex than the cost of Debt Financing. As a general rule,

once a stockholder buys a share from a company, the latter is not anymore obliged to return the

funds to the stockholder. However, the stockholder is expecting some forms of return in his/her

investment in the company. A typical investor would expect that the companys performance

would be good in the coming years and this would translate into higher dividend payments and

higher stock prices. There are different methods of determining the cost of equity like the Capital

Asset Pricing Model (CAPM). The CAPM utilizes the market return, the risk-free rate and the beta

of the company to estimate the companys cost of debt (Helbk, Lindset and McLellan, 2010).

For Debt Financing the cost incurred by the borrower like AYR Co. is the periodic interest

payment. This is the return that a lender is expecting to receive from the borrower in return for

borrowing capital. For purposes of determining the cost of debt, the interest rate is usually made

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as reference. Since interest payments are tax deductible, the real cost of debt is calculated at net of

tax.

As a general proposition, the cost of equity is generally higher than the cost of debt. Stockholders

take more risk in the company than outside lenders. For one, common stockholders only get what

is left of the company after all creditors are paid. Interest payments are required by law to be paid

regardless of the level of sales or income of the company otherwise it would be required to pay for

penalties. A company is not required by law to declare dividends every now and then and may

even opt not to declare dividends so that all earnings are plowed back to the company (Madura,

2017).

Effect on the WACC

We have already mentioned that the cost of equity is generally higher than the cost of debt. If the

company opts to finance the chosen project with Equity Financing then the WACC may increase

considerably. If this situation arises then the company would have to re-assess the suitability of

the projects given this change in the weighted average cost of capital. Conversely, if the company

would go for Debt Financing then the WACC may reduce significantly but the company would

have to consider interest payments in the calculation of the cash flows (Madura, 2017).

Effect on Current and Potential Stockholders and Lenders

Raising funds through Equity Financing does not have a direct impact on the profitability of the

company. But since the company would have to issue new shares to the public, existing

shareholders would be affected since this may result to the dilution of their interest in the company

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if they are not the one who will buy the shares to be issued. In terms of the companys financial

statements, there would be a positive cash inflow from financing activities and an increase in the

Stockholders Equity section of the Statement of Financial Position.

If funds are raised through Debt Financing then it would not dilute the ownership interest of

existing stockholders but it would have a direct impact on the companys profitability. It would

drive the companys net income because of the periodic interest payments. It would also make the

company riskier because of the higher debt balance. Borrowing money is usually attached with

covenants that must be followed under the pain of penalties and sanctions. Regardless of the

performance of the company it would still be required to pay for the period interest and the

repayment of the capital borrowed. The companys financial statements would show a positive

cash flow from financing activities, an increase in the companys total liabilities and a decrease in

the companys net income due to interest payments (Madura, 2017).

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Reference

Bierman, H. and Smidt, S. (2007). The capital budgeting decision. New York and London:

Routledge.

Helbk, 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.

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Appendix

A Capital Budgeting Calculation-Project Aspire

PROJECT ASPIRE

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5


Cash Inflows $650,000 $698,750 $751,156 $807,493 $868,055
Variable Costs $27,000 $28,823 $30,768 $32,845 $35,062
Capital Allowance $600,000 $390,000 $345,000 $300,000 $240,000
EBIT $23,000 $279,928 $375,388 $474,648 $592,993
Taxes (20%) $4,600 $55,986 $75,078 $94,930 $118,599
Net Income $18,400 $223,942 $300,311 $379,718 $474,394
Add: CCA $600,000 $390,000 $345,000 $300,000 $240,000
Operating Cash flow $618,400 $613,942 $645,311 $679,718 $714,394
Change in Net
Working Capital $(140,000) $140,000

Capital Spending $(2,250,000)

Cash Flow $(2,390,000) $618,400 $613,942 $645,311 $679,718 $854,394

Discount Factor 1.00 0.91 0.83 0.75 0.68 0.62

Present Value $(2,390,000) $562,182 $507,390 $484,831 $464,257 $530,512

ACCUMULATED CASH
YEAR CASH FLOW FLOW
- $(2,390,000) $(2,390,000)
1.00 $618,400 $(1,771,600)
2.00 $613,942 $(1,157,658)
3.00 $645,311 $(512,347)
4.00 $679,718 $167,371
5.00 $854,394 $1,021,766

NET PRESENT VALUE $159,172


IRR 12.44%
PAYBACK PERIOD 3.25 years

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B Capital Budgeting Calculation-Project Wolf

PROJECT WOLF

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5


Cash Inflows $955,000 $955,000 $955,000 $955,000 $955,000
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
Depreciation
Expenses $375,000 $375,000 $375,000 $375,000 $375,000
EBIT $472,600 $472,870 $472,958 $472,865 $472,592
Taxes (20%) $94,520 $94,574 $94,592 $94,573 $94,518
Net Income $378,080 $378,296 $378,366 $378,292 $378,073
Add: Depreciation $375,000 $375,000 $375,000 $375,000 $375,000
Operating Cash flow $753,080 $753,296 $753,366 $753,292 $753,073
Salvage Value $375,000
Capital Spending $(2,250,000)

Cash Flow $(2,250,000) $753,080 $753,296 $753,366 $753,292 $1,128,073

Discount Factor 1.00 0.91 0.83 0.75 0.68 0.62


Present Value $(2,250,000) $684,618 $622,559 $566,015 $514,508 $700,445

ACCUMULATED CASH
YEAR CASH FLOW FLOW
- $(2,250,000) $(2,250,000)
1.00 $753,080 $(1,496,920)
2.00 $753,296 $(743,624)
3.00 $753,366 $9,742
4.00 $753,292 $763,034
5.00 $1,128,073 $1,891,107

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NET PRESENT VALUE $838,145
IRR 22.90%
PAYBACK PERIOD 2.01 years

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