From the calculation shown in the appendix made from the micro-soft excel. The forecast shows the Net Present value (NPV), Internal Rate of Return (IRR), and the payback period; for the project Aspire and Wolf project. The process of calculation is as follows; the primary difference between the two projects is that; the Project Aspire uses Capital cost of Allowance while the Wolf project uses the Depreciation method. The Wolf project has sizeable annual cash flows compared to the Aspire project. In our calculation, we have used the company, 10 % of Weighted Average Cost OF Capital (WACC). The values of the NPV and IRR are calculated using the financial formula of micro-soft excel and cash flow are used as the inputs.
Since the $12,000 used for research of both projects, the figure was not included in our calculation since the value is historical cost and does not affect future cash flows. The number will be irrelevant whether AYR ltd implements the Wolf or the Aspire project.
Analysis and Evaluation of the Investment Project Options.
From the calculation in the appendix, the following are the summary results for NPV, IRR and Payback period.
Project NPV IRR Payback Period
Project Aspire $128502 12.01 3.26 Years
Project Wolf $837207 22.90% 2.01 years
Recommendations
Comparing the two projects using the three metrics ARC Ltd should implement project Wolf instead of projects Aspire since it has more desirable results compared to the latter.
Justification for Choosing Project Wolf.
The most accepted method of evaluating project is the Present Net Value (NPV). The NPV is calculated by the sum of all net projects cash flows. Since the cash flows will be earned in future, the Present Value Interest Factor (PVIF) is used to find the present value of the cash flow. We used 10% as the WACC for the wolf and Aspire project.
Net Present Value (NPV)
The Net Present value is the difference between the present amount of cash inflow and the current value of cash outflows over the period. The formula for calculating the NPV is as follows.
NPV=?_(t=1)^T?c_t/?(1+r)?^t -C_0
C0= Initial investment
r= the discount rate
t= the time taken by the project
Ct=Cash flow
The project to be accepted when it can generate a positive Net Present Value (NPV), this means that the project’s present cash flow must exceed the current value of the investment. The project with positive NPV will generate profit while a project with negative NPV is bound to make a loss.
Apart from the numerous advantage of using the NPV to appraise the projects, the NPV is associated with various shortcoming which includes; the NPV relies on multiple assumptions which turn out not to be true when the project is implemented. Since the project evaluated will be executed in future the finance manager uses the appropriation from the historical cost of related projects to make the investment decision. The premise may turn out to be wrong when limited resources have already been applied. It is therefore important for the financial managers to verify the accuracy of the information before any appraisal is done.
Also, the discount rate used may not take into account the risk associated with the projects. Every smart business owner knows that the more significant the risk, the higher the return. Since the investment involves risk, the risk factor cannot be ignored or assumed in making an investment decision that require a tremendous amount of money.
The project with the highest NPV will be more beneficial to the company especially if the projects are mutually exclusive. Otherwise, if the projects are independent, the project with the highest positive NPV will be selected if at all the company can afford the capital budget. (MYERS, 2007)
From table 1 the Wolf project has the NPV of $837207 while the Aspire Project has the NPV of $128,502. Therefore, if we used the NPV as the only criteria, project Wolf will be preferred over project Aspire.
Internal Rate of return (IRR)
Internal Rate of Return (IRR) is a metric that is used in capital budgeting to the profitability of potential investment. The internal rate is a discount rate that makes the net present value NPV of all cash flow from the specific project equal to zero. The IRR use the same formula as the NPV, but the value of the investment is subtracted from the equation. The IRR calculate an investor breakeven rate of return.
IRR=?_(t=1)^T?c_t/?(1+r)?^t -C_0
C0= Initial investment
r= the discount rate
t= the time taken by the project
Ct=Cash flow
The Internal Rate of Return (IRR) is used to evaluate the attractiveness of the project or a major investment. The evaluation of the projects is as follows. The IRR of the new project should always exceed the required company rate of return, and the IRR that falls below the required rate of return should be rejected.
The Internal Rate of Return (IRR) is the method of calculation that does not consider the external factors such as inflation and the cost of capital. Only the projects that are above the assumed rate of return should be selected and this case all the proposed projects must give IRR above the WACC of 10%. Comparing the two projects although both of them have the IRR above the 10% project Wolf will be selected since it has higher IRR of 22.90 compared to the to aspire which has the IRR of 12.44%. Also If we only used IRR as criteria, project Wolf would still be most preferred among the two.
Although NPV and IRR, in this case, they have shown the same results, there some instances that the two will have different effects. The situation usually happens if the projects have different cash flow patterns. For example, if the projects have an unequal lifespan, one project may have higher cash flow in earlier years but have a short lifespan compared to project with lower cash flow in the earlier years but have a long lifespan.
When dealing with the duration of the project, the project with higher NPV should be selected since the NPV consider the external factors to the company compared to the IRR which only recognizes the internal elements.
Although the payback period does not consider the time value of money, it can be used to appraise the projects since it predicts period which projects will take to cater for all expenses. The payback period can be used to determine when the projects will make a break even and starting making profits. The shorter the payback period, the better the project
ARC Ltd should choose project wolf since it has the payback period of 2.01 years compared to the Aspire projects that take 3.26 years. The payback method is mostly preferred by the company that intends to invest in a project that takes the shortest time possible.
Other Factors for Choosing the Project
When making a considerable investment, many factors should be considered although the NPV, IRR and the payback period are used as the numeric metric other factors that are discusses below should be used to choose between the Wolf project and the Aspire projects.
Financing of the project, the company should choose a project with the favorable financing term. Although a project may have a positive NPV, it may, on the other hand, have complex terms of financing, and therefore the project should be foregone. The type of funding will be of the great importance in the discount rate that would be selected and other costs that may be associated with decision making the analysis.
The financial manager should consider the ethical issue, although the project may have a positive NPV and IRR it may be against the company principle, and it will be unethical for the management to implement projects which cannot be accepted by the society, the founders of the company, and other stakeholders.
Inflation is another factor that cannot be ignored when making the financial decision since the investment will happen in future the value of the cash flow will not only be affected by the time value of money but also the inflation. It is therefore important to include the inflation factor in the discount rate used to calculate the NPV and the IRR.
When the company wants to implement a new project, the existing products may be cannibalized by the new products. The management should be sure that the new projects will not affect the sale of the current products. If the cannibalism situation exists, it should be incorporated into the analysis.
Accuracy is the key to making any decision; if the figure used are erroneous, the company will end up making a substantial finical blander. The management and the team should consider the accuracy of the data used in the analysis since any slight mistake will lead to the selection of the wrong projects.
Before any project is implemented, the company should consider if it agrees with the objects that are outlined in the memorandum of the association. Also, the project should be in harmony with the cooperate values and the company operation. Lastly, the project should not be illegal and should be environment-friendly.
Apart from the numeric factors, the company should consider other factors that listed in this report in deciding on whether to implement a particular project.
Source of Financing
The purpose of running a business in making a profit, profit are earned through investment which involves risk. The company also requires the funds for payroll expense, sundry expense, and operating costs. For a company to make a profit, short-term fund and long term funds must be applied to meet both the long term and short term goals of the company. The time frame of the finances is used to classify the type of fund which may include; the short term finances, the medium term finances, and long term finances
The short-term finances
The short-term finances can also be referred to us the working capital, the business use this type of funds to pay rent, buy equipment and utilities. The time frame for short-term funds is 90 days.
Medium finances the are funds that are used to increase the production and revenue, the banks and the owners are the primary sources of this funds since they have the shortest return period. The purpose of the funds is to boost the company cash flow.
long term funds are used to finance projects that will give return after one year, bank loan, venture capital, and private financing are the primary sources. A company cannot be able to source long term finances from the retained earnings, and hence the other stakeholders are vital in funding long term finance.
This part will consider various sources of the finance that can be used by the company. Many factors are considered in choosing the best financing strategy of the company. Some of the sources of the funding by the company include; the retained earnings, the issuance of shares, the debt capital and the issuance of the bond. We are going to discuss each item in this section by considering their advantages and disadvantages of using each method.
Equity and Debt Finance
The best and the cheapest way of raising capital is through the issuance of shares; the company may opt to issue the preference shares or the common shares. When the company is incorporated, the proposed capitalization is assimilated in the memorandum of association. The company may decide to issue a certain percentage of the share capital. If the company has n new project that it wishes to implement, the company may release a new share to the existing members or the public. If a person has stock in the company, he/she is considered to be the member of the company because he owns an interest to the company. The company, on the other hand, agrees to pay a dividend to its members. Also, since the shares appreciate over time, the member ought to benefit from this appreciation (HARRIS ; RAVIV, 2009). The company is considered highly geared if the level of equity is higher than the debt capital.
Apart from the equity capital company may decide to use the debt capital. The company may borrow the funds from banks to finance a new project. Apart from borrowing money from the banks, the company may issue other debt instruments like bonds and notes that can be issued to existing members or the member of the public. The company then agree to refund the principal amount together with interest after the specified period. (Thomassen, 2003).
Cost of Finance
The equity method of finance is more complicated than the debt-equity since the company is not obliged to refund the principal amount although the holder of the instrument become the member of the company. The debt holder receives agreed amount of interest at a specified interval during the debt period. Also, the company is at liberty to pay the dividends or not while it is compulsory for the for the company to honor the interest obligation as agreed in the instrument (HARRIS ; RAVIV, 2009). The stakeholder invests into the company hoping that one day the company will perform well which will earn them good dividends.
Since the company cannot rely on one type of financing the financial managers uses a different type of financing. The combination of the various type of funding is done using two primary model; Capital Pricing Model CAPM and the Weighted Average Cost of Capital (WACC) model. If the company has existing projects that have positive NPV the company may opt to implement the project in the expense of giving a dividend to their holder (Thomassen, 2003).
The Effect of WACC
Since the debt finance requires payments of interest, it affects the profitability of the company; on the other hand, the equity finance does not affect the profitability of the firm since the company can decide not to pay the dividends. If the company issue new shares, the existing shareholder interest will be diluted, but their interest will remain intact if the shares are sold to the current shareholders (HARRIS ; RAVIV, 2009). The most preferred, financing is the equity method since it has the positive financial statement impact.
On the other hand, if the debt finance is used it will dilute the ownership of the shareholders but will have the positive impact on the cash flow of the company. On the contrary, it will make the make riskier. Also, the company will be required to pay periodic interest to the instrument holders. Also, the debt finance leads to company total liability to increase, and the net income decreases due to the payment of the interest to the instrument holders.
References
DeAngelo, H., ; Masulis, R. W. (2008). Optimal capital structure under corporate and personal taxation. Journal of Financial Economics, 8(1), 3-29. doi:10.1016/0304-405x(80)90019-7
Fujii, H., ; Managi, S. (2016). An evaluation of inclusive capital stock for urban planning. Ecosystem Health and Sustainability, 2(10), e01243. doi:10.1002/ehs2.1243
HARRIS, M., ; RAVIV, A. (2009). The Theory of Capital Structure. The Journal of Finance, 46(1), 297-355. doi:10.1111/j.1540-6261.1991.tb03753.x
MYERS, S. C. (2007). The Capital Structure Puzzle. The Journal of Finance, 39(3), 574-592. doi:10.1111/j.1540-6261.1984.tb03646.x
Thomassen, H. (2003). Capital Budgeting for a State. Public Budgeting Finance, 10(4), 72-86. doi:10.1111/1540-5850.00886
Appendix
Project Wolf
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cash Flows 955,000 955,000 955,000 955,000 955,000
Material Cost 14400 15480 16641 17889 19230.76
Other Expenses 18000 16650 15401 14246 13178
Foregone Rental Income 75000 75000 75000 75000 75000
Depreciation Expenses 375000 375000 375000 375000 375000
EBIT 472,600 472,870 472,958 472,865 472,592
Tax 20% 94520 94574 94592 94573 94518
Net Income 378,080 378,296 378,366 378,292 378,073
Depreciation Expenses 375000 375000 375000 375000 375000
Operating Cash flow 753,080 753,296 753,366 753,292 753,073
Salvage Value 375,000
Capital Investment -2250000
Cash Flows -2250000 753,080 753,296 753,366 753,292 1,128,073
PVIF 1 0.91 0.83 0.75 0.68 0.62
Present Value -2250000 685302.8 625235.7 565024.7 512238.4 699405.4
Year Cash Flow
0 -2250000 -2250000
1 753080 -1496920
2 753296 -743624
3 753366 9742
4 753292 763034
5 1128073 1891107
Net Present Value 837207
IRR 22.90%
Pay Back period 2.01
Project Wolf
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cash Inflows 650,000 698750 751156 807492.97 868054.94
Variable cost 27000 28823 30768 32845 35062
Capital Allowance 600,000 390,000 345,000 300,000 240
EBIT 23,000 279,928 375,388 474,648 832,753
Tax 20% 4600 55986 75078 94930 166551
Net Income 18,400 223,942 300,311 379,718 666,202
Add Back Capital allowance 600,000 390,000 345,000 300,000 240
Operating Cash Flow 618,400 613,942 645,311 679,718 666,442
Working capital -140,000 140,000
Capital Investment -2,250,000
Cash Flow -2,390,000 618,400 613,942 645,311 679,718 806,442
PVIF 1 0.91 0.83 0.75 0.68 0.62
Present Value -2390000 562744 509572 483983 462209 499994
Year Cash Flow Accumulated Cash Flow
0 -2390000 -2390000
1 618,400 -1,771,600
2 613,942 -1,157,658
3 645,311 -512,347
4 679,718 167,371
5 666,442 833,813
Net Present Value $128,502
IRR 12.01%
Payback Period 3.25
