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Capital Structure

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To obtain the cost of capital for the firm, the following calculation is done.

           

 

Percentage of capital

Rate of Return

Product

Stocks

 

60%

 

14%

8.400%

Bonds

 

40%

 

6%

2.400%

     

Sum

 

10.800%

Therefore, the company will use 10.8% as the cost of capital, or the minimum rate of return. The company will proceed and evaluate the project using different methods which are net present value, internal rate of return and payback method.

Net Present Value Method

This method discounts inflows and outflows and ascertains the net present value by deducting discounted outflows from discounted inflows to obtain the net present cash inflows i.e. the present value method will involve the selection of rate acceptable to the management or equal to the cost of finance, and this will be used to discount inflows and outflows and the net present value will be equivalent to the present value of inflow minus the present value of outflows.  If the net present value is positive, the board should invest, and if NPV is negative, the board should not invest (Bank, Tak, & Squire, 2000).

PV (inflow) – PV (outflows) = NPV

     

 

 

 

 

 

 

 

 

     

Year

 

 

0

1

2

3

4

5

                 

Sales

     

2,000,000

2,000,000

2,000,000

2,000,000

2,000,000

Less

               

Less Manufacturing cost

800,000

800,000

800,000

800,000

800,000

Less Depreciation

 

 

600,000

600,000

600,000

600,000

600,000

Income Before tax

 

 

600,000

600,000

600,000

600,000

600,000

Less tax @ 34%

   

204000

204000

204000

204000

204000

Net income

   

396,000

396,000

396,000

396,000

396,000

Add back depreciation

 

600,000

600,000

600,000

600,000

600,000

Cash flow after tax

   

996,000

996,000

996,000

996,000

996,000

Initial investment

 

3,000,000

         

PVIF @ 11%

 

1

0.9009009

0.8116224

0.7311914

0.658731

0.5934513

Present Value of cash inflows

897297.3

808375.94

728266.62

656096.05

591077.52

Total cash inflows

           

3681113.4

Less initial cash outflow

       

3,000,000

NPV

             

681,113

                 

 

NPV is positive. Therefore, SAC should accept the project.

     

The advantage of using this method is that it recognizes the time value of money, and as such, appreciates that a pound now is more valuable than a pound tomorrow, and the two can only be compared, if they are at their present value. Secondly, it takes into account the entire inflows or returns, and as such, it is a realistic gauge of the profitability of a venture. Thirdly, it is consistent with the value of a share, in so far as a positive NPV will have the implication of increasing the value of a share. Finally, the method follows the objective of maximizing the wellbeing of an owner, because a positive NPV will increase the net worth of owners.

However, NPV method has its own limitations, since it is difficult to use. In addition, it ignores the implicit costs. Therefore, it is ideal for assessing the viability of an investment under certainty, because it ignores the element of risk.

IRR (Internal Rate of Return)

IRR is the cash flow discounted technique which follows the principle of NPV.  Usually, it is defined as the rate that endeavors to equate present value of the cash outflows of the investment into the initial cash outlay of the venture (Czaczkes & Benninga, 2000).

IRR = PV (cash inflows) = PV (cash outflows) or IRR is the cost of capital, when NPV = 0.

It is also called internal rate of return because it depends wholly on the outlay of investment and proceeds, associated with the project and not a rate determined outside the venture.

A = inflow for each period

C = Cost of investment

                                                       Acceptance Rule of IRR

IRR will accept a venture, if its IRR is higher than or equal to the minimum required rate of return. The minimum rate of return is usually the cost of finance, also known as the cut off rate or hurdle rate. IRR will be the highest rate of interest a firm would be ready to pay to finance the project using borrowed funds and without being financially worse off by paying back the loan (the principal and accrued interest) out of cash flows generated by that project.  Thus, IRR is the break-even rate of borrowing from commercial banks (Drury, 2007)

                 

Year

 

 

0

1

2

3

4

5

                 

Sales

     

2,000,000

2,000,000

2,000,000

2,000,000

2,000,000

Less

               

Less Manufacturing cost

 

800,000

800,000

800,000

800,000

800,000

Less Depreciation

 

 

600,000

600,000

600,000

600,000

600,000

Income Before tax

 

 

600,000

600,000

600,000

600,000

600,000

Less tax @ 34%

   

204000

204000

204000

204000

204000

Net income

   

396,000

396,000

396,000

396,000

396,000

Add back depreciation

 

600,000

600,000

600,000

600,000

600,000

Cash flow after tax

   

996,000

996,000

996,000

996,000

996,000

Initial investment

 

3,000,000

         

PVIF @ 11%

 

1

0.900901

0.811622

0.731191

0.658731

0.593451

Present Value of cash inflows

 

897297.3

808375.9

728266.6

656096.1

591077.5

Total cash inflows

           

3681113

Less initial cash outflow

         

3,000,000

NPV

             

681,113

                 
                 

Year

 

 

0

1

2

3

4

5

                 

Sales

     

2,000,000

2,000,000

2,000,000

2,000,000

2,000,000

Less

               

Less Manufacturing cost

 

800,000

800,000

800,000

800,000

800,000

Less Depreciation

 

 

600,000

600,000

600,000

600,000

600,000

Income Before tax

 

 

600,000

600,000

600,000

600,000

600,000

Less tax @ 34%

   

204000

204000

204000

204000

204000

Net income

   

396,000

396,000

396,000

396,000

396,000

Add back depreciation

 

600,000

600,000

600,000

600,000

600,000

Cash flow after tax

   

996,000

996,000

996,000

996,000

996,000

Initial investment

 

3,000,000

         

PVIF @ 30%

 

1

0.769231

0.591716

0.455166

0.350128

0.269329

Present Value of cash inflows

 

766153.8

589349.1

453345.5

348727.3

268251.8

Total cash inflows

           

2425827

Less initial cash outflow

         

3,000,000

NPV

             

-574,173

                 

IRR= lower discounting rate + (Higher discounting rate NPV-lower discounting rate NPV)/ (lower discounting rate NPV)* Rates difference

Therefore,

IRR

=

19.680995291

     

In this case, SAC should purchase the equipment. This is because the IRR (19.68%) is higher than the cost of capital (11%). The method of calculating internal rate of return is advantageous, since it considers the time value of money. In addition, it considers the cash flows over the entire life of the project. Unlike the NPV method, it does not use the cost of finance to discount inflows, and for this reason, it will indicate a rate of return of the interval to the project, against which various ventures can be assessed as to their viability (Needles, Cross, & Powers, 2010). However, the board of SAC may find it difficult to use IRR, since the method is expensive. It requires the trained manpower and may use computers, especially where inflows are of large magnitude.

Payback Period Method

This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how soon a venture can payback, and for this reason, PBP (or payout period or payoff) is that period, of time or duration, it will take an investment venture to generate the sufficient cash inflows to payback the cost of such investment.  This is a popular approach among the traditional financial managers because it helps them ascertain the time it will take to recover in the form of cash from operations the original cost of the venture.  This method is usually an essential preliminary screening stage of the viability of the venture, and it may yield clues to profitability, although, in principle, it will measure how fast a venture may payback, rather than how much a venture will generate in profits, and yet the main objectives of an investment are not to recoup the original cost, but to profit for the owners or investors (Ehrhardt & Brigham, 2010).

Payback = Initial investment/ Annuity

            = 3,000,000/996,000

            = 3.01years

Consequently, SAC should accept the project, since it takes 3 years only to recoup back the initial investment. In this case, the project is advantageous, and the company should immediately implement the plan.

This method is advantageous, since it compares the returns of a machine with the initial cost. This makes it easy for the company to identify profitable projects at an early stage. However, this method does not recognize the time value of the money. Consequently, a decision based on this method may be unrealistic.

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