Introduction Theobjective of this report is to prove which of the projects between Aspire andWolf will result in the increase of the company’s market share. Project Aspire has the potential to expandthe current product range and appeal to both existing and potentialcustomers. On the other hand, Project Wolfhas the potential to focusing the company in a totally new direction by luring atotally different type of customer.
Thesecond part of the report looks at the debt and equity financing methods.Asaffirmed by Wengarter (1977), ”capital rationing is apinnacle in the corporate finance literature due to the importance ofinvestment decision to firms and the potential contribution that analysis canmake to the quality of decision in practice”. Lorie and Savage (1955) posted that, ”the forecasting correctly ofcashflows expected to result from the specified investment proposals in one ofthe problems in rationing of capital, as well as the liquid resources that willbe available for investment. Ye andTiong (2000) affirmed that, ”strategic capital investment decisions are key toa business firm, hence careful consideration is expected”.
In addition, financial, political and marketrisks need to be considered when evaluating a potential project. This report therefore will reflect resultsfor three different methods of evaluation and look at the pros and cons of eachapproach. Qualitative factors will formpart of the recommendation and conclusion of this report.Computationsof NPV, IRR and PaybackThefirst steps of quantitative analysis will be to calculate the NPV, IRR andpayback methods for both projects and compare, contrast the merits of eachoutcome, and figure out the meaning of the outcome.
Thecalculations are included in the Appendix 1 attached to this report. The table below reflects the results of thethree methods stated above for Project Aspire and Project Wolf: NPV IRR Payback Project Aspire $371,985 15.56% 3.63 years Project Wolf $379,422 16.98% 3.
07 years NPV interpretation and AnalysisBasedon the NPV results, both projects should be accepted as they have positivevalues. As suggested by Ross,Westerfield and Jordan (2017), pg. 269 ”an investment should be accepted, ifthe net present value is positive and rejected if the present value is negative”.However, the company’s dilemma is that it only has capability, to select oneproject. ”TheNPV is one of the methods used to evaluate the profitability of a proposedinvestment and is the preferred approach in principle”, as acknowledged byRoss, Westerfield and Jordan (2017) pg. 271. A project has a positive NPV of cash inflows, compared to initial cashoutflow.
A positive NPV creates valuefor its owner, as its market value exceeds its costs, hence it is desirable.This method however, has a higher forecasting risk, if the forecasted cashflowsare incorrect the whole assumptions and subsequent decision becomes inaccurate.As reported by Ross, Westerfield and Jordan (2017) pg.
321-322, ”to minimizethis risk there is need to further analysis the results”. When a positive NPV is resultant, there isneed to interrogate this result further by asking questions that include, whatis it about this project that could have resulted in a positive value. Identificationof something specific to the source of value is needed. Questionsthat need to be answered include, “Are we certain that our new product will besignificantly better than the competitors”? Can we truly manufacture at lower cost and distribute moreeffectively? Will we be able to gaincontrol of the market? As reported by Ross, Westerfield and Jordan (2017) pg.322, ”reaction of competition to projects that show significant value must beclosely examined”.
”If we can’t articulate some sound economic basis ofthinking ahead of time that we have found something special, then theconclusion that our project has a positive NPV should be perceived withsuspicion,” as noted by Ross, Westerfield and Jordan (2017) pg. 322. Jovanovic, Â (1999), states that further analysisof investment decision-making under uncertainty and risk by making use ofbreakeven analysis, sensitivity analysis, theory of games and decision makingtheory. These methods were beyond thispaper. Basedon the calculation the NPV for Project Wolf was higher compared to the Project Aspireby 2%. However, the constant cashinflows of Wolf, need further cross-examining. Project Wolf had no stated scrap value, hence at the end of the projectthere is no scrap income from the plant and machinery invested at $2.
250m. Payback interpretation and AnalysisBothprojects will be paid up in year three, however, Project Wolf has marginally abetter payback rate than project Aspire. Ashighlighted by Ross, Westerfield and Jordan (2017) pg. 273-274, ”the resultsof the payback may be misleading as the method ignores the time value of moneyand does not consider cashflows beyond the payoff date”. Ignoring cashflows beyond the payoff date maylead to rejection of an investment which may be more profitable in the longrun. As such this method is biasedtowards higher returns on short term investments. The issue of risk is totally ignored on projects,evaluated using Payback method. However, this method is handy when making minordecisions, as it is very simple to use.
Basedon what the company wants to achieve through the most viable project, this isnot a minor decision. Hence it may bemisleading to rely solely on this outcome to decide on the best project betweenthe Aspire and Wolf. Cooper, Cornick andRedmon (2011) affirmed that, ”most firms preferred to use the lesssophisticated method of payback, however, it was primarily to evaluate smallprojects”.Internal Rate of Return(IRR) interpretation and AnalysisRoss,Westerfield and Jordan (2017) pg. 277-278, states that, ”IRR is an alternativeof NPW, though it is closely linked to it”. The rate is internal, as it depends on the cashflows of a particularinvestment and not on rates offered elsewhere. An investment is accepted if the IRR exceeds the required return.
The IRR is the required return in aninvestment that results in a zero NPV when it is used as the discount factor.Thepresent value of the cashflows over the entire useful life of the investmentproposals are considered. However thismethod assumes that the cash received from a proposal during its useful lifewill be re-invested at the internal rate of return. However, this may not always be reasonabledue to changing economic conditions, as well as the evaluation methods used todecide IRR rate.Bothprojects are forecasted to result in IRR above the expected return of 10%. Project Wolf as per the results seem to bebetter than project Aspire.Qualitative factors andother factors to considerCommunicationand human resource play a big part in the success of the selected project ashighlighted by Pons (2008).
The firm’sculture may either promote or derail the chosen project. There is need to assess if the human resourceis qualified enough to effectively manage and supervise the progress of thechosen project. The other benefits ofthe project are not clear from the scenario e.
g. whether any of the twoprojects would result in reduction of costs such that some staff are laidoff. In such instances management wouldneed to come with strategies to boost the morale of those that will beremaining. Thereis need to establish if the Regulators allow the production of such a product e.
g. It’s impact to the environment andcommunity. A stakeholder analysis mayneed to be carried out, and ensure that proper engagements have been effectedwith the right stakeholders. The issue of the competitor should be analysed andproper strategies put in place to defend the success of the project.ConclusionBasedon the quantitative analysis above, I propose project Wolf as it has a higherNPV.
As implied by Ross, Westerfield and Jordan (2017) pg284, ”for twoexclusive investments, the best project cannot be based on the highest IRR, asour concern is creating value for shareholders, hence the project with thehigher NPV is preferred, regardless of a relative return”. The payback method is for minor projectshence it not suitable to be used as a measure in this instance. Institute, P. M. (2015) pg. 34 and Carlberg,C. (2010) pg. 494, alluded that, ”the NPV method usuallyresults in better decisions than other methods when making capital investments”.
Detailsof qualitative factors and market risks were not readily available hence it wasdifficult to select the best project using these factors.Two Sources of FinanceThecapital employed by the company comprise of equity and debt. Kokemuller (2017), reported that, ”debt andequity are two basic methods of raising finance for an either a startup companyor a growing firm”. Equity is comprisedof private investor money obtained in exchange for a share of ownership in thebusiness. Debt is about borrowing (i.e.getting money from an outside source) and includes long-term loan that isacquired from a financial institution.
Debtfinancing can be a great way of promoting aggressive strategic growthespecially if the interest rates are lower. No ownership of the business is relinquished, unlike in the equityfinance arrangement. Repayment of theloan and interest may stifle growth and limit future cash flows. Equityfinancing does not require repayment. Cashflow being generated can be used to advance the growth of thecompany. Over time, profits paid toother equity owners may exceed what was paid on a loan. Equity financing involves a lot of statutoryobligations including costs like brokerage, underwriting fees and other issuecosts which are not present with debt financing.
The process of raising fundsthrough equity financing normally takes longer than that of debt financing.Way(2017) affirmed that, ”debt financing requires lower finance costs compared toequity financing”. Debt financing lowers a firm’s taxes due to allowableinterest deductions. Tax rules permitinterest payments as expense deduction against revenues to arrive at taxableincome.
Dividends paid to equity holdersare not tax deductible and most come from after-tax income. Therefore, tax savings help further to reducea company’s debt financing cost, which is an advantage that equity financinglacks. A higher rate of return is required from equity share investors, since equityshare investment is a high risk investment, an investor will always expect ahigher rate of return. Frankand Goyal (2009), quoting the Pecking Order Theory stated that, ”equity hasserious adverse selection whilst debt has only minor adverse selection”. The trade-off theory stipulates that, ”thecapital structure is determined by a trade-off between the benefits of debt andthe costs of debt,” Frank and Goyal (2009).
The last method of capital structure determination highlighted by Frankand Goyal (2009) is the market timing theory that perceives that managers lookat current conditions in both debt and equity market and pick which ever marketwill be favourable at that given time. Houlis (2009) argued that delays in making investment decisions maybemeaningful when market demand is uncertain and where the interest rates arevolatile (the delay will allow interest rates to come down).Hall(1992) stated that, ”a study carried out for U.
S. manufacturing firms duringthe 1980s, revealed that changes in the financial structure of firms whichtilted the balance sheet toward debt were followed instantly by substantialreduction in both investment and R”. Firms that turn to external markets for capital will raise the cost ofcapital to the firm and this results in decline in investments. Higher interest levels leaves little room forinvestment expenditure.
Currentlythe company’s capital structure has 53% equity and 47% debt. The company needs to consider if it still hasthe capacity to borrow and what the optimal capital structure is for the firm. Williamson(1988) argued that, ‘financing of a project depends principally on thecharacteristics of the assets”.
The useof debt is supported by transaction-cost reasoning to finance re-deployable assets,while non-re-deployable assets are financed by equity (discretion). Effect of selection onAYRC’s weighted average cost of capitalTheWACC will either increase or decrease depending on the source of fundingselected. Under normal circumstance theequity holders expect a higher return, hence increasing the equity to the companycapital structure will result in an increase in WACC. An analysis of this is demonstrated underAppendix 2. Increase of debt willtherefore bring down the WACC though gearing will increase. According to Bienfait (2006) “where there is no debt theWACC equals the opportunity cost of capital and declines with financialleverage because of increasing interest tax shields. However, when the debtlevel becomes significant relative to the value of the firm reflecting the maincosts associated with borrowing, the costs of bankruptcy, the WACC increasesagain.
” Impact of Selection oncurrent and potential shareholders and lendersTheimpact of equity financing on shareholders is that the shareholders will expecta higher return, hence management need to ensure that they make good use of themoney raised. The shareholders alsoexpect a return in the form of a reasonable dividend. The current shareholders may lose part ofcontrol depending on the magnitude of the new injected capital. In this instance the $2,250m is significantin terms of value to the company. Engagementof current shareholders is crucial in this case. Lendersare keen to distribute capital to those who are eligible for sucharrangements. If the company has a goodreputation the lenders will be excited to issue a loan to such firm and arealso willing to negotiate for lower economic lending rates. The lenders will earn interest from AYRCompany.
RecommendationWhilstthe increase in debt will lower the WACC, the company’s optimal capitalstructure needs to be satisfied. Increase in debt will put so much strain on the current and futurecashflows, such that this may result in stifled strategic growth. In terms of equity financing the companyneeds to calculate whether the time it takes to raise the capital will not giveroom to another competitor to introduce such a product. If the company’s need for capital is urgentand the assumptions are relevant debt financing will be a quicker way ofraising funding. There will be need toreview the performance of the project during it life span, to ensure that thecompany adapts to any changes in the assumptions made at the initial stages ofthe project. References1. Bienfait,F. (2006) International Finance Management.
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