Importance of Project Evaluation and WACC Method

The assignment highlights the significance of project evaluation in business decision-making, emphasizing the use of the WACC method to determine discount rates. It explains how WACC is calculated by weighting cost of equity and debt with market capitalization and long-term loan amounts, then applying a tax rate. The discussion also notes limitations of the WACC method, such as its reliance on stable capital structures, and concludes that prudent use of this approach can lead to informed investment decisions in business.

BUSINESS FINANCE

EXECUTIVE SUMMARY
On completion of entire project number of things are identified which are that one must use
multiple project evaluation methods to make decisions like payback period and NPV etc. This
is because all these method have some merits and demerits and due to this reaosn it is very
important to ensure that appropriate method is used to make decisions. WACC must be used in
business but it must be ensured that there will be almost stability in capital structure.

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Scenerio 1........................................................................................................................................1
Capital aquisition.........................................................................................................................1
Project evaluation............................................................................................................................1
Scenerio 3: Project financing...........................................................................................................7
Calculation of WACC..................................................................................................................7
CONCLUSION................................................................................................................................9

INTRODUCTION
In current time period most of business firms carry out number of projects in their
business. It can be observed that in order to select any project number of decisions need to be
made in the business. In this reagrd for the company project evaluation methods are applied on
cash flows and results are interpreted in proper manner. Apart from this WACC is also computed
for the project and at end conclusion section is prepared.
Scenerio 1
Capital aquisition
In business time to time it is very important to replace tools and machines so that better
effeciency can be obtained. While any machine is replaced in the business heavy amount of
capital investment need to be made in the business. In this regard information need to gathered
before final replacement of machines. Information requied will be related to sort of technology
that used to manufacture new machines in the supplier factory site (McCabe. and et.al., 2015).
More is the advanced technology used to manufacture products it will be beenficial for the firm
because it will lead to more effeciency in the operations. Second information that will be
required to make final decisions in respect to machinery is related to cost of machine that
employees intends to purchase. In case cost of purchase is very high firm may abstain from
making its purchase. This is because such kind of practice will prove costly to the company as it
need to arrange more amount of funds to make capital investment. Third information that will be
required is related to budget that is prepared for department. In case cost of machine is above
determined value in budget then in that case decision need to be taken to make adjustment in
expenses (Jones, Moura and Domingos, 2014). Hence, there are three information that needs to
taken in to account to make decisions in respect to purchase of machine. It can be said that
making capital investment is not an easy task and management need to consider number of
factors to make decisions. Hence, after considering all sorts of facts and figures that are revealed
by these three information prudent decisions can be taken in the business.
Section 2: Project evaluation
Table 1Calcualtion of enterprise value
Enterprise
Value (EV)
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Current Market Price -
Diluted Shares -
Market Capitalization -
Long Term Liabilities 5,000,000
Less: Cash & Cash
Equivalents -
Enterprise Value (in
lacks) 5,000,000
Table 2Calculation of WACC
Debt Equity
Weightage
E/(D+E) @ Enterprise
Value 0.00%
D/(D+E) @ Enterprise
Value 100.00%
Interest Rate (%) 15%
Tax Rate (@) 20%
WACC Calculation
WACC 12.00%
Table 3Inputs for calculation
Initial investment 4500000
Machinery costing 1500000
Salvage value 500000
R&D 300000
Corporate tax rate 30%
Required rate of return 12%
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Rate of interest 7%
Table 4Projection of cash flows for different years
Sales
value
Variabl
e cost
Fixed
cost
WBC
oost
Deprec
iation
Operatin
g profit
Inte
rest
Net
profit
Profit after addition
of depreciation
1
30500
00
198250
0
4000
00
2000
00
14500
00 -982500
350
000
-
1332
500 117500
2
40000
00
260000
0
4200
00
14500
00 -470000
350
000
-
8200
00 630000
3
50000
00
325000
0
4410
00
14500
00 -141000
350
000
-
4910
00 959000
4
55000
00
357500
0
4630
50
14500
00 11950
350
000
-
3380
50 1111950
5
60500
00
393250
0
4862
03
14500
00 181298
350
000
-
1687
03 1281298
6
66550
00
432575
0
5105
13
14500
00 368737
350
000
1873
7 1468737
7
73205
00
475832
5
5360
38
14500
00 576137
350
000
2261
37 1676137
8
76865
25
499624
1
5628
40
14500
00 677444
350
000
3274
44 1777444
9
80708
51
524605
3
5909
82
14500
00 783816
350
000
4338
16 1883816
1
0
84743
94
550835
6
6205
31
14500
00 895507
350
000
5455
07 1995507
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Table 5Calculation of payback period
Investment amount -6800000
Year Sales revenue
1 117500 -6682500
2 630000 -6052500
3 959000 -5093500
4 1111950 -3981550
5 1281298 -2700253
6 1468737 -1231515
7 1676137 444622
8 1777444 2222065
9 1883816 4105881
10 1995507 6101388
Table 6Calculation of ARR
Investment amount 6500000
Year
1 -1332500
2 -820000
3 -491000
4 -338050
5 -168703
6 18737
7 226137
8 327444
9 433816
10 545507
Total -1598612
Average -159861
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ARR -2%
Table 7Calculation of NPV
Investment amount -6800000
Year Cash flows
12% Discount
rate Present value
1 117500 0.8929 104911
2 630000 0.7972 502232
3 959000 0.7118 682597
4 1111950 0.6355 706664
5 1281298 0.5674 727043
6 1468737 0.5066 744108
7 1676137 0.4523 758199
8 1777444 0.4039 717880
9 1883816 0.3606 679323
10 1995507 0.3220 642500
Sum 6265456
Investment
amount 6500000
NPV -234544
Table 8Calculation of IRR
Investment amount -6800000
Year Cash flows
1 117500
2 630000
3 959000
4 1111950
5 1281298
6 1468737
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7 1676137
8 1777444
9 1883816
10 1995507
IRR 10%
Interpretation Pay back period method: This approach is revealing that investment can be covered in 6
years out of 10 years which means that project is not profitable in nature as it it difficult
to cover cost in short time period (Myers and et.al., 2014). Advantage of payback period
is that it can be applied by anyone to make decision and limitation is that present value
concept is not used in calculation. Average rate of return method: Average rate of return is -2% which indicate that on
average basis loss will be observed in case project is picked by the firm. Advantage is
that calculation approach is simple but it make use of profitability that is proven from
accounting records (Project evaluation objectives, 2017). Net present value method: It is the approach under which from aggregate value of cash
inflow amount fresh investment amount is deducted. It can be seen that value of NPV is -
234544 which is negative and project is not profitable for company. Advantage of NPV
method is that calculation make use of present value concept but demerit is that
calcualtion procss is tough. Internal rate of return: IRR rate is positive which is 10% and it is low on basis of which
it can be said that actual rate of return is low in the business. Advantage is that it reflect
real rate of return. Disadvantage is that calculation process is tough (Bonney and et.al.,
2014).
On basis of negative results it can be said that project is not viable for company.
Discount rate used in business is 12% which is computed by using WACC approach.
Only debt value was given and due to this reason long term loan, interest rate and
corporate tax rate is taken in to account cost of capital in the business. On basis of
evaluation of positive and negative sides of all methods NPV and IRR methods are
recommended to be used in the busienss. This is because in these approaches present
value concept is used and it also reflect the actual return that can be earned on the project
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(Wagner, Padhi and Zanger, 2014). Before making recommendation in respect to project
it is very important to analyze economic condition of the nation because it have huge
impact on project cash flows. In case economic condition is unstable project cash flows
may decline below expectagtion. On other hand, as part of financial aspects firm
profitabuility and internal effeciency need to be measured by using ratios. By doing so
better decisions can be made in respect to project.
Scenerio 3: Project financing
Calculation of WACC
Table 9Input sheet and cost of equity
Debt equity ratio 1
Debenture face value 1000
Coupon rate 12%
Current price of debenture 922.23
Term of debenture 6
90 Days bill face value 100000
Current price of debenture 97533.58
Debt rate 13.00%
Share price 8
Dividend rate 1.1
Dividend growth rate 6%
Corporate tax rate 30%
D1 1.1
P1 8
G 6%
Cost of equity 19.7500%
Table 10Calcualtion of enterprise value
Enterprise Value (EV)
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Current Market Price 8
Diluted Shares 12,625
Market Capitalization 101,000
Long Term Liabilities 101,000
Less: Cash & Cash Equivalents -
Enterprise Value 202,000
Table 11Calculation of WACC
Debt Equity
Weightage
E/(D+E) @ Enterprise
Value 50.00%
D/(D+E) @ Enterprise
Value 50.00%
Interest Rate (%) 12%
Tax Rate (@) 30%
WACC Calculation
WACC 14.1%
It can be seen from above table that weighted average cost of capital is 14.1% which can be
considered high from business point of view. In order to compute weighted average cost of
capital cost of equity and debt are multuplied to market capitalization and long term loan amount
and from multiplied value tax rate is deducted. It can be said that weighted average cost of
capital is the right approach to compute discount rate for the project. It can be used in project
evaluation because under this for WACC some inputs need to be taken like cost of equity and
cost of debt as well as corporate tax rate. As per accounting standards, weigthed average cost of
capital is the one of the important approach and by using same in proper manner cost of capital
can be computed. In accounting domain in order to compute fair value of asset usually weigthed
average discount rate approach is used by the firms (Salling and Pryn, 2015). Hence, in order to
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compute value of project in today time period by considering cash flows use of discount rate is
justified from this point of view. There is limitation of WACC and one of them is that capital
structure of the firm often get changed and never remain same and due to this reason whatever
seem good for the firm in single time period may not necessarily prove good in other time
period. Hence, it is the major limitation of the weighted average cost of capital method. It can be
said that WACC method can be used only when there is expectation that there will be stability in
capital structure.
CONCLUSION
On basis of above discussion it is concluded that there is significent importance of project
evaluation for the firms because by using same best investment decisions can be made in the
business. It is also concluded that WACC is the one of the best method that can be used to
compute discount rate in the business. However, there are some limitations of this method and
due to this reason it is very important to use these approaches cautiously in the business so that
prudent decisions can be made in the business.
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