Capital Budgeting Strategies

10. What is the net present value (NPV) of a long-term investment project? Describe how managers use NPVs when evaluating capital budget proposals.

For the purpose of calculating the net present value of the project, an appropriate cost of capital has to be calculated at which free cash flows of the project should be discounted. Since the project will be solely financed by selling new shares, cost of equity will be used as the discount rate. Beta for the company can be assumed to be equal to average of the betas of the competitors of the company. This average beta value comes out to be 1.2. Risk free rate is 0.17% while risk premium has been estimated to be 6%. Thus by putting these values in CAPM formula, we can find the cost of equity for the company which is 7.39%.

13. What is the formula for the Present Value (PV) for a finite stream of cash flows (1 per year) that lasts for 10 years?

32) Compute the NPV for the following project. The initial cost is $5,000. The net cash flows are $1,900 for four years. The net salvage value is $1,000 when the project terminates. The cost of capital is 10%.

Since this project is a going concern, the levered terminal and present values are calculated using the weight average cost of capital (WACC) as the discount rate, which we calculate to be 16.17%.

The total cash flow for this alternative is $293,519.67, the WACC is 10.63%, and the NPV is $265,306.31. These three alternatives are able to earn returns greater than the cost of capital, what this means is value to investors because capital expenditures are finance via issuance of stock.

Net Present Value (NPV) calculates the sum of discounted future cash flows and subtracting that amount with the initial investment of the project. If the NPV of a project results in a positive number, the project should be undertaken. It is the most widely used method of capital budgeting. While discount rate used in NPV is typically the organization’s WACC, higher risk projects would not be factored in into the calculation. In this case, higher discount rate should be used. An example of this is when the project to be undertaken happens to be an international project where the country risk is high. Therefore, NPV is usually used to determine if a project will add value to the company. Another disadvantage of NPV method is that it is fairly complex compared to the other methods discussed earlier.

WPC has used a discount rate of 15% to evaluate potential projects for the last 10 years. Many in management are correct in thinking that this rate should be evaluated on a much more frequent basis. The current rate of 15% is much too high considering the yield on treasury bonds has declined from 10% to 5% over the last ten years. In order to calculate the correct discount rate we must first determine what their equity and debt ratios are. As you can see in Exhibit1, in order to find the total value of equity we must multiply the number of total outstanding shares of stock times the market value of each share. Completing this calculation shows us that WPC has $12 billion in outstanding equity. WPC also has $2.5 billion in outstanding debt. If you add the debt and equity together we see that WPC has a total of $14.2 billion in outstanding financing. Assuming the 10 year rate of Government Bonds of 4.60% as our risk free rate and using the Capital Asset Pricing Model we find that that WPC’s return on equity is 11.2% (See Exhibit 1). As stated in the case, Worldwide Paper Company has an A bond rating so we can use the 5.78% for their return on debt. Combining all of these variables in the Weighted Average Cost of

We valued the company using four different methods; Net Present Value, Internal Rate of Return, Modified Internal Rate of Return and Profitability Index. We began with the Net Present Value, or NPV, calculation. NPV values an investment’s profitability based on the projected future cash inflows and outflows of the investment, discounted back to present value using the WACC. The calculations for NPV are presented in Appendix 2. We started by separating cash inflows and outflows by each year. We used Bob Prescott’s estimates for the revenue per year and related operating costs of cost of goods sold as

Net present value (NPV) – A projects NPV equals the sum of its cash inflows and outflows, discounted at a rate that is consistent with the projects risk.

The overall method used to calculate the expected value of the net present value of the project is to first calculate the real weighted average cost of capital of the firm, use the

cent, take B if the required return is between 5.42 percent and 38.54 percent (the IRR on B), and take neither if the required return is more than 38.54 percent. Here we need to calculate the ratio of average net income to average book value to get the AAR. Average net income is: Average net income Average book value is: Average book value $12,000/2 $6,000 ($2,000 4,000 6,000)/3 $4,000

Changes in PV may arise due to risk; what are the implications on the Company? A financial manager may interpret that this change means that the Company may be viewed negatively in the eyes of an investor, as though the Company’s ventures are seen as riskier. PV calculations may help determine the value of a business an investor is thinking of acquiring (Inc, n.d.). This implication may mean that the Company in the eyes of an investor may not be worth his or her own risk. Also, the risk’s implication may unfavorably affect

From the calculations above we see that the risky nature of the company attracts high interest rates that result in lower net cash flows. If it was a stable business it would be paying a weighted cost of capital around 0.08% and this would save the shareholders over $30,000. On the other hand, it should strive to maintain its weighted cost of capital at 0.12, a higher weighted cost of 14% will see it loose over $13,000 in discounted cash flows.

This project evaluates the discounted Net Present Value which shows the estimated cash flow. The cash flow forecast is for 10 year which incorporates International complexities as well as the cost of capital.