Wheel Industries - Evaluation of Capital Projects - Example

Wheel Industries – Evaluation of Capital Projects

The methodology adopted

Capital budgeting is defined as the process of deciding the projects that a company will invest in to maximize its shareholder wealth. The term ‘budgeting’ indicates that the available funds are limited compared to the number of investment proposals (Eakins, 2002, Chapter 10).

The first step in the process is to identify the cash outflows and inflows that the investment will generate. The immediate cash outflow will be towards making the investments in the project. The cash inflows will be from the net income generated from the project each year from the revenues less the associated costs. These cash flows are converted to their Net Present Value using an appropriate discount rate. The Net Present Value has to be positive (above zero) for a project to become feasible. The Internal Rate of Return is the discount rate where the cash outflow matches the present value of cash inflows or the NPV equals zero (Eakins, 2002, Chapter 10). The discount rate applied makes a big difference to the NPV and the IRR. Between two or more projects, the proposal with the higher NPV and higher IRR would be chosen for making the investment.

The discount rate is the Weighted Average Cost of Capital for the company. The capital structure of a company is typically made up of equity capital and long term debt. The debt: equity ratio varies between companies. Equity is generally the more expensive component of the capital used in a company since returns to investors have to be paid from after-tax earnings. The expectation of returns from equity investors is based on market conditions as he always has the option to move his money to a company that pays better returns. Cost of debt is comparatively more stable and is determined by the banks based on the Federal Reserve lending conditions.

The NPV method of investment appraisal has the advantage that the concept of time-value-of –money is applied to the cash flows and the decision rule is simple i.e. if the NPV is positive, accept the project and if it is negative, reject the project. The major problem with the NPV appraisal is that the future cash flows are based on estimates and therefore uncertain. The NPV calculation can be compromised by errors in cash flow projections (Eakins, 2002, Chapter10).

The IRR rate is appears easy to understand since it is easy to check if the number is higher or lower than the company’s cost of capital. The IRR calculation, however, makes some important assumptions. One major assumption is that future cash inflows can be re-invested at the rate of the IRR. If the IRR in a project is significantly higher than the cost of capital, this assumption can lead to errors. The IRR also does not differentiate between a small project and a large project in terms of size of investment (Eakins, 2002, Chapter 10).

For these reasons, companies often perform project appraisals using multiple methods. It is however important to remember that appraisal methods are tools to facilitate decision making and cannot override knowledge and understanding of the business, which must always carry greater weightage than the calculations (Eakins, 2002, Chapter 10).

• Cost of New Equity for Wheeler Industries

The calculation for the cost of new equity for Wheeler Industries is shown below.

Cost of Equity = (Next year's dividend ÷ Current stock price) + Dividend Growth Rate

Current Year Dividend

2.50

Dividend Growth Rate

6%

Next Year Dividend

2.65

Current Stock Price

50.00

Cost of Equity

11.30%

Flotation cost of new equity

10%

Cost of new equity

12.56%

The major advantage for equity financing of investments is that the money does not have to be repaid. Cash flows from the project can be used for future projects. Increasing equity leads to a lower debt: equity ratio which helps, in future, to raise loans for the company.

The major disadvantage is that equity financing is more expensive than debt financing. This is for two reasons --- dividends on equity have to be paid from post-tax earnings whereas interest on debt is from pre-tax earnings and issue of equity dilutes the owners’ control over the company and can make it a target for a hostile acquisition.

• Cost of debt for Wheeler Industries

The cost of debt is the market rate less the marginal tax rate which is 35%. For debt with a market rate of 5%, the cost of debt for Wheeler Industries is 5% x (1-35%) = 3.75%.

Debt financing is lower in cost compared to equity financing due to interest payments being made from pre-tax earnings. Debt principal and interest payments are from future earnings from the project and do not burden the cash flows from current activities. The equity control over the business is not diluted.

The major disadvantage is the threat of repossession of the assets pledged, if repayment of principal and interest is not done on time.

• Weighted Average Cost of Capital for 30% debt and 70% new equity

The calculation for the Weighted Average Cost of Capital (WACC) for a capital structure with 30% debt and 70% new equity is shown below.

WACC = (Percentage of Debt X Cost of Debt) + (Percentage of new equity x Cost of new Equity)

Percentage of debt

30%

Cost of debt

3.75%

Percentage of New Equity

70%

Cost of New Equity

12.56%

WACC

9.92%

This WACC is used in evaluating Capital Budget proposals as the hurdle rate i.e. the minimum rate of return for an investment proposal to be accepted. The Internal Rate of Return (IRR) for the project must be higher than the WACC for the company. In some companies, the hurdle rate is set higher than the WACC for a safety margin.

D, E and F) After-tax Cash Flows for Project A, the NPV and the IRR

The calculations for the after-tax cash flow for Project a and the IRR is shown below.

(in $'000)

Year 0

Year1

Year 2

Year 3

Operating Cash Flow

Revenues

1,200

1,200

1,200

Annual Costs

(600)

(600)

(600)

Depreciation

(500)

(500)

(500)

Pre-tax income

100

100

100

Tax payable @ 35%

(35)

(35)

(35)

After-tax income

65

65

65

Investment

(1,500)

Depreciation

500

500

500

Net Cash Flows

(1,500)

565

565

565

Discount rate

6.00%

NPV

9.67

IRR

6.369%

The additional revenues of $ 1,200,000 each year for 3 years from the project and the additional annual costs of $ 600,000 are shown in the table. Depreciation charges of $ 500,000 are applied in each year since this is a 3-year project and straight line depreciation method is used. There is no salvage value at the end of Year 3. The project results in pre-tax income of $ 100,000 in each of the 3 years and with the tax rate at 35 %, the after-tax income in each year is $ 65,000.

The investment in Year 0 is $ 1,500,000 which is the cash outflow. The cash inflows in Years 1 through 3 include the after-tax income of $ 65,000 and the depreciation charge of $ 500,000 since depreciation is a non-cash charge to the revenues.

At the discount rate of 6%, the Net Present Value (NPV) for the project is $ 967,000. Since the NPV is positive, this is an economically feasible project for Wheeler Industries.

The Internal Rate of Return (IRR) is the discount rate at which the NPV becomes zero. The IRR rate works out to 6.369 % as shown in the above table. Since the IRR is higher than the discount rate, this is an economically feasible project.

There is a conflict with part (C) above in these calculations. The Weighted Average Cost of Capital for the proposed capital structure of 30% debt and 70% equity for Wheeler Industries has been calculated as 9.92 %. The discount rate used for NPV calculation for Project A should have been equal to or higher than 9.92 %. With a discount rate of 9.92 %, the NPV becomes negative at ($ 84,560) which makes the project uneconomical. The IRR of 6.369 % is also below the discount rate of 9.92 %.

(in $'000)

Year 0

Year1

Year 2

Year 3

Net Cash Flows

(1,500)

565

565

565

Discount rate

9.92%

NPV

(84.56)

IRR

6.369%

Investment B

The calculations for the after-tax cash flow, NPV and IRR for Investment B are shown below.

(in $' 000)

Year 0

Year1

Year 2

Year 3

Year 4

Year 5

Year 6

Operating Cash Flow

After-tax cash flows 25% probability

20

20

20

20

20

20

After-tax cash flows 50% probability

32

32

32

32

32

32

After-tax cash flows 25% probability

40

40

40

40

40

40

Likely cash flow

31

31

31

31

31

31

Investment

(120)

Net Cash Flows

(120)

31

31

31

31

31

31

Discount rate

6.00%

NPV

30.60

IRR

14.167%

Risk adj. Discount rate

8.00%

Risk adj. NPV

21.58

The likely cash flow for Investment B has been calculated as (0.25 x 25% probability cash flow + 0.50 x 50% probability cash flow + 0.25 x 25% probability cash flow). At the 6% discount rate the NPV is $ 30,600 and the IRR is 14.167 %. When the risk adjusted discount rate of 8 % is applied, the Risk Adjusted NPV works out to $ 21,580. The NPVs and IRR are acceptable but need to be compared with the figures for Investment C to make the choice.

Investment C

The calculations for the after-tax cash flow, NPV and IRR for Investment C are shown below.

(in $' 000)

Year 0

Year1

Year 2

Year 3

Year 4

Year 5

Year 6

Operating Cash Flow

After-tax cash flows 30% probability

22

22

22

22

22

22

After-tax cash flows 50% probability

40

40

40

40

40

40

After-tax cash flows 20% probability

50

50

50

50

50

50

Likely cash flow

37

37

37

37

37

37

Investment

(120)

Net Cash Flows

(120)

37

37

37

37

37

37

Discount rate

6.00%

NPV

56.58

IRR

20.575%

Risk adj. Discount rate

8.00%

Risk adj. NPV

45.55

The likely cash flow for Investment C has been calculated as (0.30 x 30% probability cash flow + 0.50 x 50% probability cash flow + 0.20 x 20% probability cash flow). At the 6% discount rate the NPV is $ 56,580 and the IRR is 20.575 %. When the risk adjusted discount rate of 8 % is applied, the Risk Adjusted NPV works out to $ 45,550. The NPVs and IRR for Investment C are higher than for Investment B and should be the project selected.

Possible conflicts between the NPV and the IRR methods of investment appraisal

In comparing Investment B and C, there is no conflict between the NPV and the IRR methods of investment appraisal. Both the NPV and the IRR for Investment C are higher than those for Investment B. However, if we were to compare mutually exclusive projects that have different initial cash outflows, have different project lives or have major differences in patterns of cash inflows, the NPV and the IRR calculations may show a conflict with the NPV favoring one project and the IRR supporting the other project. In such cases, the NPV value is given greater weightage since it considers the total yield on the investment rather than the rate of return on the investment. The total yield adds to shareholders’ wealth, which is the objective of making capital investments in the first place.

The NPV method also assumes that future cash inflows are reinvested at the discount rate whereas the IRR assumes that they would be reinvested at the IRR rate which would generally be higher than the discount rates in projects that are likely to be feasible. Using the NPV will result in a safer decision.

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