Weighted Average Cost of Capital for LAD TelEQ Plc - Case Study Example

Corporate Finance Name Tutor Unit Code Date Table of Contents Introduction 2 Weighted Average Cost of Capital (WACC) for LAD TelEQ Plc 3 Capital Investment 6 Net Present Value (NPV) 7 Internal Rate of Return (IRR) 8 Profitability Index (P.I) 9 Payback Period (PB) 10 Sensitivity Analysis 11 Project Risk 13 Recommendation 15 References 16 Introduction LAD TelEQ is a UK company currently operating in the sector of Technology Hardware & Equipment. The company’s business is focused on developing wireless devices, wireless solutions for communication, smart systems, and providing components and systems that protect electronics. Its customers include individual and business consumers. In March 2016, the company approved an ambitious plan to expand its business in Wireless Smart Home Devices and the company is considering a project, named CarHome. In this paper I conduct an anlysis to determine if the project is feasible and whether the company should carry out the project. Capital budgeting techniques are used in the analysis. Weighted Average Cost of Capital (WACC) for LAD TelEQ Plc Firms make investment decisions with a determination to improve the company’s value over the long‐term. However, in order to invest, the firm will have to rely on funding. By and large, funds are largely sourced depending on a company’s capital structure. As such, capital structure decisions are dynamic, change over time, and depends on the state of the company. The capital structure of a company refers to the composition of the company’s capital or make-up of its capitalisation. The capital structure characterises the blend of different sources of long- term capital resources (Steven, 2006). The sources of finance, which constitute the capital structure of a company, are mainly divided into internal sources and external sources. The internal sources include retained earnings, reserves, and depreciation whereas the external sources include ordinary shares, preference shares, reserves, debentures, long-term loans, and share premium. Internal sources are usually preferred because they do not require any associated costs of borrowing and they do not increase the company’s gearing ratio (debt level). They also do not dilute the management or shareholder’s control. However, internal sources do not provide sufficient capital that may well be used to finance capital intensive investments. External sources provide sufficient capital that can sustain big investments. However, they require payment for interest or dividends and increase the company’s debt level (Steven, 2006). The choice of the source of finances influences the firm’s overall required rate of return on investment projects, which in turn affects current and future investment decisions. Therefore, the management of a company has got to take into consideration different factors as they design a discretionary capital structure of the company. These include the cost of the source, the company’s objective, and the flexibility and availability of the finance, among others. (Steven, 2006). The choice to fund investments constitutes the financing decision and is touted to affect the company’s capital structure, the costs of capital, as well as the overall cost of capital (the WACC) and so the appraisal of the firm’s investment projects. The WACC constitutes the different costs of capital for a business, mainly sourced externally. The costs are weighted based on their relative proportions of the sources of finance that make up a firm’s capital structure. Even though the WACC does not give an optimal level of borrowing, it is an important consideration in making financial decisions. Besides, the WACC gives a ground of a firm’s required rate of return for investments. LAD TelEQ Plc capital structure constitutes equity (ordinary shares) and debt (bonds). LAD TelEQ Plc Capital structure: Capital Value Proportion Ordinary shares @ 350 268,000,000 E/V = 99.2% 8.5% bonds 2,000,000 D/V = 0.8% Total 270,000,000 V = 100% The company’s WACC is arrived at by summing up the individual costs of finances weighted according to their proportions on the capital structure. 𝑊𝐴𝐶𝐶=𝐸/𝑉k𝐸+𝐷/𝑉k𝐷 Where V = E +D; E = Market value of equity; and D = Market value of debt Cost of equity; Assume the company has recently paid dividends of 3 pounds and has a constant growth rate of 5%; Cost of debt = 8.5 WACC = 99.2 * 5.1 + 0.08 * 8.5 = 5.066 Capital Investment The aim of any corporate investment decision is to boost the firm value. In whichever project that a company desires to invest in there should be a cost-benefit assessment. This is because the firms incurs initial costs through which it expects to make a return into the future. As such, costs are compared against future cash flows. A simple method to do this is to consider the time value of money through various techniques. However, first the incremental cash flows need to be determined. Incremental cash flows denote the direct result of undertaking an investment project. The incremental cash flows are important in determining the additional value realised by undertaking a particular project. The table below indicates LAD TelEQ Plc initial costs and the after-tax incremental cash flows; A final investment decision is made based on the expected net cash flows to be generated by the project in comparison to the project’s initial costs. In general, the project’s net benefits (in present value terms) exceed the initial investment, then the project is ripe for consideration due to the expected value it may add to the firm. Various techniques are used to establish if a project is worth pursuing. It is important that the time value of money is taken into account. The main techniques that are then recommended to evaluate the LAD TelEQ Plc project include; Net Present Value, Internal Rate of Return, Profitability Index, Accounting Rate of Return and Payback Period. Net Present Value (NPV) The net present value is a measure, in present day terms, the value a project is expected to add to the firm if undertaken. That is, NPV = Total Present Value – Initial Outlay. Therefore, the NPV is arrived at after taking away a project’s invested amount from total the present value of the future cash flows. If the NPV is greater than zero, this means the benefits exceed the costs, so the project is accepted but if it is less than zero, that project is shelved (Brealey et al., 2012). The NPV method is largely preferred in evaluating investment projects due to three key. First, the NPV method uses incremental cash flows emanating from the project activities such that a positive NPV indicates an additional value to the firm in present value. Second, the NPV method considers the time value of money, future cash flows are adjusted to present value terms before comparing against the initial costs of the project. Lastly, the NPV method uses the discount rate that is related to the firm’s capital structure and average cost of capital and therefore considers the business and financial risks professed by investors and lenders. The general formula applicable is; Where = the initial outlay in Year 0, CFt = the annual net cash flow in Year t (t represents the number of years in which future net cash flows extend to), r = is the firm’s required rate of return for investment projects or weighted average cost of capital (used as a discount rate). Using excel, the NPV = 56,496,634.79. The NPV > 0, the project is viable. Internal Rate of Return (IRR) The IRR is the discount rate at which the net present value of a capital projects equals to the amount of cash initially invested in the project or the rate of return on the investment. Or, the discount rate at which the NPV of a project equal to zero. The IRR uses the incremental cash flows arising from the proposed project, much like the NPV. If the computed IRR is more than the cost of capital, the project is accepted, however, if it falls below the cost of capital, the project is discarded. The IRR is also interpreted as the investment’s maximum potential rate of return as long as every cash flow from Years 1 to t are reinvested at the applicable IRR. So if the project’s IRR is higher than the company’s required rate of return on investments (r) the project is accepted as it satisfies the firm’s average cost of capital (Deegan, 2009). The applicable formula is; Where = the initial outlay in Year 0, CFt = the annual net cash flow in Year t (t represent the number of years in which future net cash flows extend to). Using excel, the IRR = 24%, which is greater than the cost of capital; therefore, the project is viable. Profitability Index (P.I) This is a ratio between the total present values of all annual cash inflows against the net investment. The PI is in the main preferred in comparing projects that have different lifespans. The PI is a benefit‐cost ratio. Therefore, if the benefits are more than the costs, the PI will be greater than 1. As such, in present value terms, the project’s benefits exceed its costs and so it will improve a firm’s value. However, if the PI is less than 1, then the project’s future cash flows in present value terms do not exceed the initial investment and therefore it cannot be accepted (Brealey et al., 2012). The applicable formula is; Using excel, the PI = 1.94. Since the PI > 1, the project is viable. Payback Period (PB) The PB is also commonly used in project evaluation. The PB method is generally straightforward, easy to understand and to apply. The payback period is the amount of time required for the invested amount to be realized based on projected annual cash inflows. If the calculated payback period falls below the uppermost tolerable payback period, that project is accepted. However, if the calculated payback period is goes beyond the maximum tolerable period, that project is disallowed. The maximum tolerable payback period is determined by the reciprocal of the cost of capital (McLaney & Atrill, 2013). The applicable formula is; The payback period for the LAD TelEQ Plc project is 3 years and 9 months. This is favourable for a project intended to last for more than 8 years. Sensitivity Analysis Sensitivity analysis is a test conducted on the NPV to determine how various project variables will respond to future variations. The exercise is conducted by changing the estimates of uncertain variables in order to find out the impact they may have on the NPV. Essentially, one project variable is varied while the other variables are held constant. Each scenario is expected to result in a different NPV estimate. This then will help to ascertain how sensitive the estimated NPV is to deviations in that one variable. The NPV range under optimistic and pessimistic scenarios permits the management to find out the project variables that need more careful monitoring and observation. The base case scenario indicates that the project is expected to generate value for the firm, given that the NPV is positive. The project is expected to result in approximately 56.5 million surge in firm value in present value terms. However, this assessment is grounded on one set of proposed cash flows. As such, the firm ought to consider the prospect of deviations in the level of sales and the various costs (software engineers’ wages, selling, general and administrative expenses, and the costs of upgrading the wireless device and developing the necessary software). First, we consider how changes to sales will impact the project’s feasibility. We assume that software engineers’ wages, selling, general and administrative expenses, and the costs of upgrading the wireless device and developing the necessary software remain the same. We also assume that the tax rate of 20 per cent will continue to apply, and the 5 per cent p.a. cost of capital is unchanged. Assume that the sales will vary by + - 30%. Though the NPV under the base case is 56,496,634.79, it can vary between 98,246,838.88 under the optimistic scenario and 14,746,430.71 under the pessimistic scenario. So NPV for the project can range by 83,500,408.16 . Secondly, we consider how changes to software engineers cost after-tax will impact the project’s feasibility. We assume that sales, selling, general and administrative expenses, and the costs of upgrading the wireless device and developing the necessary software remain the same. We also assume that the tax rate of 20 per cent will continue to apply, and the 5 per cent p.a. cost of capital is unchanged. Assume that the software engineers cost after-tax will vary by + - 30%. Though the NPV under the base case is 56,496,634.79, it can vary between 72,008,345.42 under the optimistic scenario and 40,984,924.17 under the pessimistic scenario. So NPV for the project can range by 31,023,421.25. Third, we consider how changes to selling, general and administrative expenses after-tax will impact the project’s feasibility. We assume that sales, software engineers cost, and the costs of upgrading the wireless device and developing the necessary software remain the same. We also assume that the tax rate of 20 per cent will continue to apply, and the 5 per cent p.a. cost of capital is unchanged. Assume that the selling, general and administrative expenses after-tax will vary by + - 30%. Though the NPV under the base case is 56,496,634.79, it can vary between 70,210,920.51 under the optimistic scenario and 42,782,349.08 under the pessimistic scenario. So NPV for the project can range by 27,428,571.43. Fourth, we consider how changes to costs of upgrading the wireless device and developing the necessary software after-tax will impact the project’s feasibility. We assume that sales, selling, general and administrative expenses, and the software engineering costs remain the same. We also assume that the tax rate of 20 per cent will continue to apply, and the 5 per cent p.a. cost of capital is unchanged. Assume that the software engineers cost after-tax to will vary by + - 30%. Though the NPV under the base case is 56,496,634.79, it can vary between 80,859,956.72 under the optimistic scenario and 32,133,312.87 under the pessimistic scenario. So NPV for the project can range by 48,726,643.85. Management of LAD TelEQ can conclude that changes to sales will have a greater impact on the project’s value to the firm. Project Risk Capital investment decisions are made with the future in mind. A project can be undermined by a number of risks that can vary the value that can be realised of an investment for a firm over time. When making the investment decision, a firm needs to consider project risks. Business and financial risks have an impact on a firm’s feasibility. In general, the cost of any source of capital is determined by the required rate of return to compensate for the risk of being exposed to the business. Business risk is based on the company’s investment policies which can be affected by variability to future earnings and costs. Competition, demand for product or service, cost of raw inputs and factors of production, and changes to legislation. So when this risk is influenced by an investment decision, investors will as well adjust their rate of return, which will effectively impinge on the firm’s cost of capital and ultimately, the project discount rate. Financial risk arise when a firm has debt. It is caused by increased vulnerability in returns of ordinary shares resulting to increased use of debt as well as preference share financing. A firm that has borrowed too much is exposed to regular payments of the principal and interest. This may cause financial distress which will increase the debt’s rate of return. Changes to a firm’s creditworthiness, capital structure and costs of capital will impact the WACC and therefore the NPV. Moreover, the firm applies a 5 per cent p.a. WACC to determine the NPV of the project, which can also vary into the future if the capital structure, costs of capital or conditions in the overall financial market change. These highlight how business and financial risks will impact initial estimates and cause the NPV to be quite different from expectations. Besides, there is a risk of making a bad decision due to mistakes committed in projecting the cash flows. This is called the forecasting risk. This can result in the wrong valuation of the project, for instance it can result in a positive NPV whereas the NPV is not actually positive. Forecasting risk is high when the NPV estimate is found to be very sensitive to slight variations in the projected value of some item in the project cash flow. Recommendation The overall result from the analysis is highlighted below; Method of appraisal Result Decision Net present value 56,496,634.79 > 0 Project is viable Internal rate of return 24 per cent > 5 per cent Project is viable Profitability index 1.94 > 1 Project is viable Payback period 3 years and 9 months Project is viable Given that all methods of appraisal indicate that the project is viable, LAD TelEQ PLC can proceed to execute the project. The company can finance the project from the current sources of capital. If more capital is sourced elsewhere the cost of capital will be affected. This may negatively affect the NPV, which may render the project unacceptable since it may not generate the projected value for the firm. References Atrill, P. McLaney, E. Harvey, D. and Jenner, M. Accounting: An Introduction, 4th ed. 2010, Pearson. Anthony, R.N. and Breitner, L.K. (2010). Essentials of Accounting: International, 10th Ed. Pearson. Arnold, G. (2005). 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