Calculation of the Companies Weighted Average Cost of Capital - Assignment Example

Name: Instructor: Course: Date: Question 1: Calculation of the Companies Weighted Average Cost Of Capital WACC for Scientific Robotics Equipment Corporation; Weighted average cost of capital is the average cost of the various financing sources that exist and that are employed by a company as a part of its capital structure. These sources include the common stock, debt and preferred stock. This means that a section of each of the financing source is taken into account on the basis of the overall weight on the capital structure. In the calculation of WACC, the increase in WACC signifies an increase in the risk level. It is worth mentioning that WACC is concerned with the history of financing rather than the future financing (PPT 006). Assuming that the capital structure given will remain unchanged throughout the entire life of SREC, then WACC for scientific Robotics Equipment Corporation is determined as; WACC = W e × K e + W p × K p + W d × K d (1 - t) (PPT 006) Where W e = Weight of equity, K e is cost of equity W p =Weight of preferred stock, K p is the cost of preferred stock W d = Weight of debt, K d is the cost of equity, and t is tax WACC = 0.25 x 5.8 % + 0.15 x 9 % + 0.6 x 12 % = 10 % (tax assumed to be zero since it is not mentioned) Question 2: Calculating the Net Present Value (NPV) Of Each of the Alternative Investment The Net Present Value compares the present value of all the inflows of a project with the present value of the outflows of the same project. The decision criterion is mainly based on the outcome of the calculation with three options to choose from. That is accepting, rejecting or being indifferent. The project with the highest positive net present value is always accepted (PPT 005). NPV for Alternative One; Present Value of the Cash Inflows Present value (PV) = future value x present value interest factor Year 1: F V * PVIF 10 %, 1 = $ 260,000 x 0.9091 = $236,366 Year 2: FV * PVIF 10 %, 2 = $ 255,000 x 0.8264 = $ 210,732 Year 3: FV * PVIF 10 %, 3 = $170,000 x 0.7513 = $ 127,721 Year 4: FV * PVIF10 %, 4 = $ 130,000 x 0.6830 = $ 88,790 Year 5: FV * PVIF 10 %, 5 = $135,000 x 0.6209 = $ 83,822 Total PV of Cash Inflows $747,431 Calculating the PV of the Cash Outflows; Year 1: F V * PVIF 10 %, 1 = $ 150,000 x 0.9091 = $136,364 Year 2: FV * PVIF 10 %, 2 = $ 120,000 x 0.8264 = $ 99,174 Year 3: FV * PVIF 10 %, 3 = $ 75,000 x 0.7513 = $ 56,349 Year 4: FV * PVIF 10 %, 4 = $ 40,000 x 0.6830 = $ 27,320 Year 5: FV * PVIF 10 %, 5 = $ 40,000 x 0.6209 = $ 24,837 Total PV of Outflows $ 344,044 NPV alternative one = Present value of the cash inflows – present value of the cash outflows Thus, NPV = $ 744,326 - $ 344,044 = $ 400,282 Alternative Two; Present Value of the Cash Inflows; Present value (PV) = future value x present value interest factor (PPT 005) Year 1: F V*PVIF 10 %, 1 = $ 50,000 x 0.9091 = $ 45,455 Year 2: FV*PVIF 10 %, 2 = $ 75,000 x 0.8264 = $ 61,980 Year 3: FV*PVIF 10 %, 3 = $ 405,000 x 0.7513 = $ 304,277 Year 4: FV*PVIF 10 %, 4 = $ 490,000 x 0.6830 = $ 334,670 Year 5: FV*PVIF 10 %, 5 = $ 540,000 x 0.6209 = $ 332,182 Total PV of Cash Inflows $1,081,668 Calculating the PV of the Cash Outflows of Alternative Two Year 1: F V * PVIF 10 %, 1 = $ 75,000 x 0.9091 = $68,183 Year 2: FV * PVIF 10 %, 2 = $ 75,000 x 0.8264 = $ 61,980 Year 3: FV * PVIF 10 %, 3 = $ 95,000 x 0.7513 = $ 71,374 Year 4: FV * PVIF 10 %, 4 = $ 95,000 x 0.6830 = $ 64,885 Year 5: FV * PVIF 10 %, 5 = $ 95,000 x 0.6209 = $ 58,986 Total PV Of Outflows $325,408 NPV alternative one = Present value of the cash inflows – present value of the cash outflows (PPT 005) Thus, NPV =$ 1,078,564 - $ 325,408 = $ 753,156 Question 3 a) Payback period Payback period is the period a given project will take in order to recover the initial outlay of investment (PPT 007). Year Alternative One 0 ($ 400,000) ($ 400,000) 1 $ 260,000 ($ 140,000) 2 $ 225,000 3 $ 170,000 4 $ 130,000 5 $ 130,000 Payback period = 1 + (140,000 / 225,000) = 1.62 years Alternative Two Year Alternative one 0 ($ 500,000) ($ 500,000) 1 $ 50,000 ($ 450,000 2 $ 75,000 ($ 375,000) 3 $ 405,000 4 $ 490,000 5 $ 535,000 Payback period 2 + ($ 375,000 /$ 405,000) = 3 years b). Average Accounting Rate of Return Accounting rate of return is a ratio of the average accounting profit to average investment. AAR = average profit /average investment (PPT 007) Decision rule; the alternative that should be accepted should be the one with the highest AAR. Alternative One AAR = ($ 915,000 - $ 425,000)/$ 400,000 = 12.25 % Alternative Two AAR = ($ 1,555,000 - $ 435,000)/ $ 500,000 = 22.4% c). Profitability Index The profitability index is an appraisal technique that is determined by dividing the PV of the future cash flows by the capital outlay of cash(PPT 007) Decision Rule; PI > 1 accept project PI< 1reject the project PI = 0 in different For Alternative one = $ 747,431 / $ 400,000 = 1.87 For Alternative two = $ 1,081,668 / $ 500,000 = 2.16 Question 4: The Most Viable Investment Option That John Should Invest In Based On NPV, Payback Period and the ARR The Net Present Value for alternative one =$ 744,326 - $ 344,044 = $ 400,282 For alternative two = $ 1,078,564 - $ 325,408 = $ 753,156 The alternative with the highest net present value should be accepted. In this case, alternative two with an NPV of $ 753,156 is most viable. On the basis of payback period; The alternative with the least payback period should be prioritized. The payback for alternative one =1.62 years while that of alternative two is 3 years. Thus, alternative 1 is chosen. On the basis of accounting rate of return; The alternative with the highest Accounting Rate of Return should be accepted. The AAR for alternative one is 12.25 % while that of option two is 22.4 %. Alternative two is a more viable alternative on the basis of AAR (PPT 007). It has been noted that in overall, option two presents the most viable investment project since it meets more criterion as compared to alternative one. Therefore, John should invest in Alternative two. Question 5: Other Factors That John Must Consider Before Investing In Alternative Two Simplicity; John should consider whether the equipments will be easy to operate and cause less fatigue to the operators. He also needs to consider level of training that will be required for the use of the new machine Flexibility; he should consider whether the machine has the flexibility to adapt to different uses. Durability of the machine; there is need to consider whether the machine will be durable enough to last long for the benefits of the organization Portability; John should consider whether the equipment will be portable for easier movements. That is whether the machine can be reduced into portable sizes. Benefit; in this case John needs to consider the amount of benefits that will accrue from the use of the new equipments in terms of the greater accuracy and better results. Service; there is need that the equipments will get easier repairs and maintenance for the continued operations. Operating cost; John needs to consider the cost of operating the machine, the cost need to be at its minimum. Suppliers; before purchasing the new equipments, there is need that the suppliers are carefully considered and chosen. The reputation and the integrity of the manufacturer must be examined so that the machine acquired is of good operational and mechanical qualities. Question 6: Comments on the Thoughts of Mr. John Black If at all John is forced to propose for the implementation of an alternative for the first two years, then his integrity will be questioned given that his options and investments decisions will linger for long; either profiting the organization or resulting into losses. Therefore, Mr. Black should only advocate for the investment decisions that will give the organization more profits not only in the short run but also in the long run. Therefore, there is immense support that the decision made by John will be the best for serving the interests of the organization. Read More