Jacaranda Company - Cost of Capital Assumptions and Calculations, Cost and Benefits of the Projects - Case Study Example

Project evaluation Name Institution Table of contents Executive summary………………………………………………………………………………………………………………….. 2 Introduction……………………………………………………………………………………………………………………………..3 Discussion of the options…………………………………………………………………………………………………………… 4 Cost of capital assumptions and calculations……………………………………………………………………………………... …6 Descriptions of cost and benefits of the projects…………………………………………………………………………………….. 8 Project evaluations…………………………………………………………………………………………………………………… 9 Net present value…………………………………………………………………………………………………………………… …..9 Internal rate of return………………………………………………………………………………………………………………….13 Risk evaluation………………………………………………………………………………………………………………………….17 Recommendation………………………………………………………………………………………………………………………..20 References……………………………………………………………………………………………………………………………….21 Executive summary Different projects have different costs and benefits attached to them. For the organization to make a decision in regard to accepting certain project decision; project evaluation is very crucial to ensure that the decision made will be of great impact to the organization. Investing on projects without accessing their ability to benefit the organization results to loss hence impacting smooth running of the organization. Jacaranda Company has been evaluating their projects using traditional methods which have led to project failures in the organization. The report identified and analyzed three different alternative projects which Jacaranda company opts to invest in future for the better organization performance. In the analysis alternative of purchasing automatic juice processing machine which costs $5million has been viable as it has high rate of return and high positive net present value. The alternative of purchasing customized automatic juice processing plant which cost $2million had positive net present value though lower than the automatic plant. The third alternative which was to purchase juice processing plant had a negative net present value and lowest internal rate of return of 17.55% Therefore it is the organization mandate to invest in the project to enhance its performance. Introduction Business success and growth depends mostly on efficient utilization of the resources in the organization. Capital expenditure is deemed necessary for the organization as it is very crucial element in business management. Expansion of existing equipments and plant in an organization could result to economic growth hence increased productivity in an organization. As business grow it is always necessary to invest in fixed assets to improve production volume hence proper anticipation of the project cash flows and benefits for series of years is very crucial. Different machines which have been purchased in Jacaranda Company for the last five years have been wearing out strangely. Most of the machines are wearing out before the estimated period is over and even before the payback period (Jiang & Ruan, 2010, pp. 45-76). Poor capital evaluation methods seems to have been in existence for the past ten years in the company as the review of the past project analysis and evaluation indicate that less was done to determine the project useful life as the estimates seems to have certain error. Currently the company is in need f purchasing the plant machine to be installed in the company to replace one of the critical machine which is malfunctioning as it is assessed to have brought about loss in the firm. The company aims at purchasing a machine after considering three machine alternatives to evaluate critically in determine the best alternative for the organization to choose for efficient allocation and utilization of the available funds in the organization. The aim of this report is to identify each alternative the adequacy in its ability to meet the organizations goals and objectives and also recommend on the best alternative to be preferred. Discussion of the options As a result of the increased reduction in the company market share and increased customer complaints due to poor quality of products the management has strategy of increasing its market share in the market by providing high quality customized products in the market. The management objective could be achieved by deciding to buy one of the three processing plants which will enhance its performance in the organization. Therefore three project alternatives were evaluated with regard to organizations improvement. Alternative 1: Purchase automatic fruit processing plant. Automatic fruit processing plant is a high cost plant with a very high production capacity and have a long life span if well maintained. It improves organizations performance by enhancing its productivity and reducing the cost involved in production by eliminating excess labor cost. Its implementation would reduce production cost increasing organizations profitability level. It will also enhance production of high quality products which will attract more customers’ increasing the organizations market share. Purchase of the automatic processing machine would lead to elimination of other minor parts as the machine contains all components involved in different stages of manufacturing the fruit juice. The plant has a capacity of 2000BPH-30000BPH, has PLC control and packs different sizes of fruit juice. Alternative 2: Purchase custom automated fruit processing plant. Customized automated fruit processing plant is a multi task plant which could be used in manufacturing tea, juice and water with a capacity of 1500BPH-20000BPH. it only packs bottles between 0.25-2.5L in size. Implementing Automatic plant processing machine it requires other machine which could be bought for packing large size juices. In addition to that the plant will improve production and reduce cost involved in maintaining the existing plant hence improve organizations productivity. It will also lead to reduce labor cost as number of employees in different stages of production will be reduced. Lastly custom automated fruit processing plant requires less energy therefore its implementation will save energy within the plant. Alternative 3: Normal fruit juice processing plant. Normal fruit juice processing plant is a fruit juice production line almost similar to the existing plant. It has PLC control and it is beautiful and well designed. It is the model which saves energy and it is very easy to maintain. The plant will increased production cost as the customized automated processing plant machine, though it consumes a lot of energy and it is very complicated to use. Cost of capital assumptions and calculations. (Debt/equity cost). Cost of capital is the rate of return for different investments at which the cost of equity will remain unchanged in the market and attract different fund sources (Jiang & Ruan, 2010, pp 86). Each type of financing in the organization will be considered in identifying the capital cost using the different percentage of various sources of finance in the organization as using a single finance ends up causing problems to the management. Cost of capital assumptions. Constant business risk It will be assumed that the investment to be undertaken will have no significant change to the organizational business risk. Hence the overall capital cost will have no impact with the changing investments nature in different markets. Financial risk Constant financial risk will also be assumed. The management will be assumed to be using the existing financial risk and similar combination of debt and equity capital. Constant divided policy. For easy and proper computation it is assumed that dividends are increasing annually at a constant growth rate. A growth which is as per the company’s earning capacity but not just paying dividend which is beyond the company’s capacity. Dividend payout ration is also assumed to be constant. Covering operating cost. The company’s risk of inability to cover its operating cost is assumed. Debt and equity cost calculations. Cost of capital is the amount paid to capital providers by either being taken as a charge to arrive at profit or via distribution of the profits. Cost of debt is the interest that should be paid on the debt which is the rate of return required by the debtors. Effective cost of debt capital is therefore e taken into consideration when calculating the weighted cost of capital. As interest on loans and debts are tax allowable hence it reduces the taxable profits. Therefore effective cost of debt is actual cost less tax benefits. Jacaranda company had issued 3000, 10% debentures 1000 each at par and corporate tax is 40% therefore effective cost of capital for jacaranda firm is: 10% of 3000000(3000 x$1000) =$300,000 Less 40% corporate tax = $120,000 =180,000. Equity capital comprises of the ordinary share capital and retained earnings. The equity capital cost comprises of the dividends payable plus appropriate growth in equity. Shareholders expect certain return to their investment and they also anticipate that their investment returns will grow in future. Therefore cost of equity capital equals to the dividend end of year 1 divided by market price multiplied by 100 plus percentage anticipated growth (Khan & Jain 2007, pp. 52-65). For example Jacaranda Company paid dividends worthy $1.5 per share last year and had paid dividend worthy $1 in year 1 and the current market price is $25.00. the dividends are expected to grow by 3% therefore earnings necessary for meeting the dividends are as follows: Cost of equity capital = dividends end of year 1 x 100+G Market price = 1/25*100+0.03 =7% Companies are therefore not required to pay dividends on the retained earnings hence it is observed as a source of finance therefore it involves an opportunity cost which is the cost of the dividends forgone by the shareholders. Hence the cost of ordinary shares equals to the cost of retained earnings. Descriptions of cost and benefits of the projects Cost involved in the project is very easy to define in monetary terms than benefits accrued. Cost associated with project involves the project investment cost and operating costs. Investment cost consist of planning cost which involves cost related to designing and planning for the plant location and all necessary preparation on the plant site; and cost of construction which includes labor material and installation cost. On the other hand operating cost involves maintenance cost and other operational costs incurred on the project. Benefits are very difficult to measure as they are adverse and extensive. Benefits for investing in a new project involves increase in production as the processing plant will function maximum as opposed to the old plant which ha been malfunctioning. In addition to that as the plant is automated it will lead to reduced production cost by reducing labor required in different stages when producing the juice (Siegel & Shim 2008, pp. 79). The project will also increase company performance in the organization as no product delay will be associated with the company as new plant will work effectively and efficiently in enhancing and maintaining the product quality. Lastly the organization will save time by having improved productivity. Project evaluations. Projected cash outflow and cash inflow for the 3 alternative projects. Cash outflow and cash inflows. year Project 1 Project2 Project 3. 0 $5000000 $2,000,000 $2,000,000 1 $2000000 $900,000 $950,000 2 $2200,000 $600,000 $980,000 3 $1800000 $400,000 $900,000 4 $1700000 $300,000 $600,000 5 $1500000 $220,000 $400,000 Net present value. At discounting rate of 10%. Net present value method of project evaluation involves calculations of the net present value of cash flow and cash inflows in future years are calculated. When the net present value of the projects are negative the project is determine to be unviable, when it has positive net present value the project is regarded as it is anticipated to earn more than required rate of return. Project 1. At a discount rate of 10% the project has a positive net present value so it is acceptable. Project 2 year Project2 discount factor PV. 0 $2,000,000 1 $2,000,000 1 $900,000 0.9091 $818,190 2 $600,000 0.8264 $495,840 3 $400,000 0.7513 $300,520 4 $300,000 0.6832 $204,960 5 $220,000 0.6213 $136,686             NPV $43,804 At a discounted rate of 10% the project alternative 2 has negative net present value thus it is not acceptable. year Project 3 discount factor PV. 0 $2,000,000 1 $2,000,000 1 $950,000 0.9091 $863,645 2 $980,000 0.8264 $809,872 3 $900,000 0.7513 $676,170 4 $600,000 0.6832 $409,920 5 $400,000 0.6213 $248,520             NPV ($1,008,127) At 10% discount rate project alternative 3 has positive net present value hence the project should be considered though compared to project 1; project 1 has higher Net present value. Internal rate of return Internal rate of returns the amount at which the present value of cash inflows equates with the amount of cash outflows on investment. It is calculated by using interpolation method a method which two net present values are calculated out of which one should be positive and the other positive. Internal rate of return is therefore =A+ P *(B-A) N+P A: Lower rate of return with positive net present value. B: highest rate of return with negative net present value. P: Amount of positive Net present value. N: Amount of negative NPV. Project alternative 1. year Project 1 discount factor PV. discount factor 30%   0 $5,000,000 1 $5,000,000 1 5000000 1 $2,000,000 0.9091 $1,818,200 0.769 $1,538,000 2 $2,200,000 0.8264 $1,818,080 0.592 $1,302,400 3 $1,800,000 0.7513 $1,352,340 0.455 $819,000 4 $1,700,000 0.6832 $1,161,440 0.35 $595,000 5 $1,500,000 0.6213 $931,950 0.269 $403,500                 NPV ($2,082,010)   $342,100     Internal rate of return. 33.93. Internal rate of return for project alternative 2. year Project2 discount factor PV. discount factor 4% Present value. 0 $2,000,000 1 $2,000,000 1 $2,000,000 1 $900,000 0.9091 $818,190 0.962 $865,800 2 $600,000 0.8264 $495,840 0.925 $555,000 3 $400,000 0.7513 $300,520 0.889 $355,600 4 $300,000 0.6832 $204,960 0.855 $256,500 5 $220,000 0.6213 $136,686 0.822 $180,840           ($213,740)     NPV $43,804             internal rate of return = 17.55% Internal rate of return for project alternative 3 year Project 3 discount factor PV. discount factor 20%   0 $2,000,000 1 $2,000,000 1 $2,000,000 1 $950,000 0.9091 $863,645 0.833 $719,416 2 $980,000 0.8264 $809,872 0.694 $562,051 3 $900,000 0.7513 $676,170 0.579 $391,502 4 $600,000 0.6832 $409,920 0.482 $197,581 5 $400,000 0.6213 $248,520 0.402 $99,905                 NPV ($1,008,127)   $29,544         Internal rate of return. 19.72%. Risk evaluation. Risk evaluation involves determining the priorities of risk management by establishing a quantitative or qualitative relationship which exists between the project benefits and risks involved. It involves frequency which is the probability of risk occurrence and risk severity which is extend of possible loss which could result due to risk occurrence(Chandra, 2008). The project identified will enhance the organizations productivity as well as reducing the cost involved in production of goods and services. On the other there are risks which could be associated with implementation of the project. Risk level of occurrence will depend on the project adaptability and compatibility in the organization. Some risks are evaluated and its occurrence predicted and attention should always be made on immediate risks. Risk logs are therefore used in identifying the possible risks and their impacts. Risk log. Investment projects cost a lot and are associated with many uncertainties as investment projects have unpredictable risks’. Therefore it’s necessary for the organization to evaluate the possible risks which could arise during investment. Different risks should be identified and be classified as indicated in risk log above in rating and identifying the potential impact the risk should have to the investment project. The risk associated with the investment projects involves research and development risks. R&D risk is uncertainty which occurs due to changes in R&D activities altering the research and development goals which included human resource management, information resources and research and development conditions (Ehrhardt & Brigham 2009, pp. 37). Technological risks could occur due to deficiency of new ideas and emergent of new and advanced technology. Production risk involves changes in the level of production after introduction of newer project. This involves raw material supply, productivity level and knowledge and skills of production staffs. In addition to that market risks refer to uncertainty of marketing activities and competitiveness which could impact the organization performance in the market (Ehrhardt & Brigham 2009, pp. 23-34). On the other hand management risk involves management problem especially when installing the new project as their experience is very crucial at this time. Lastly environmental risks are a risk associated with factors which impact changes in demand in the market this involves economic factors, social political factors and industrial policies. Evaluations of different risks will assist in identifying potential factors which could prohibit the achievement of the project success in the organization and alternative remedy taken as possible. Recommendation Project evaluation involves identification of the viable project in an organization. After evaluation of different alternatives, alternative 1 has higher internal rate of return of 33.93% followed by project 3 with 19.72% while project 2 has the least internal rate of return with 17.55%. On the other hand alternative 1 had the highest positive net present value at 10% discounted rate, followed by alternative 3 then alternative 2 had negative net present value. Therefore given the fact that the organization processing plant is malfunctioning an issue which has brought about organization’s poor performance and production of poor quality products, it would be necessary to implement project alternative 1 as it will improve organizations productivity hence enhancing its productivity in the market. References Chandra, P. 2008. Financial Management: New-Delhi: McGraw-Hill Ehrhardt, C. & Brigham F. 2009.Financial Management Theory and Practice: Ohio: Cengange learning. Jiang, H & Ruan, J. 2010. Investment risk assessment on high tech projects based on analytic hierarchy process and BP neural network. Journal of networks, 5(4): 393-402. Khan, M & Jain, P. 2007. Financial management: New-Delhi: McGraw-Hill. Siegel, G. & Shim, K. 2008. Financial Management: New York: Barron’s education publisher. Read More