Capital Financing and Project Appraisal Techniques

This report discusses critical information required for making capital acquisition decisions and evaluates the financial viability of a project using different capital appraisal techniques such as NPV, IRR, and Payback period. It also covers the importance of using a correct discount rate and factors to consider while accepting a project. The report concludes with the calculation of WACC for a project financing scenario. Subject: Business Finance, Course Code: 1, Course Name: NA, College/University: NA, Document Type: Report, Type of Assignment: Management Report

Business Finance
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Contents
Introduction................................................................................................................................3
Scenario 1- Capital acquisition..................................................................................................4
Scenario 2- Project proposal......................................................................................................6
A. NPV, IRR and Payback period..........................................................................................6
B. The justification for using a correct discount rate.............................................................9
C. Advantages and disadvantages of each method.................................................................9
D. Factors to consider while accepting a project..................................................................11
Scenario 3- Project financing...................................................................................................12
A. Calculation of WACC.....................................................................................................12
B. Use and limitations of WACC.........................................................................................13
Conclusion................................................................................................................................15
References................................................................................................................................16
2

Introduction
This report can be considered as a management report as it has been described in various
activities that the business manager is required to conduct during the production of goods and
services. Capital financing is one of the most essential parts of business management as it
helps in providing cost efficient to the source of financing for business operations. It is very
important that overall benefits achieved through capital financing are exceeding the overall
cost of capital. This report will discuss critical information that will be required in making
capital acquisition decisions according to a given scenario. This report will also use different
capital appraisal techniques for evaluating the financial viability of a particular project
presented such as net present value, payback period method and internal rate of return
(Peirson et.al, 2014). In addition to that theoretical aspect of this method will also be
discussed in this report. At last cost of capital for a particular scenario will be calculated
which is called a weighted average cost of capital. The main objective of this report is to
evaluate the practical and theoretical aspects of capital financing.
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Scenario 1- Capital acquisition
In the given scenario a request of replacing a particular part of the equipment is presented.
The details provided in relation to spare part and reason for replacement is very limited as the
team member is assuming that the request will be approved automatically. This type of
practices was very common before the predecessor was in-charge of equipment acquisition.
This type of practice can be very harmful for the financial position of the company (Lengu,
Syntetos and Babai, 2014). It is important that proper requisition is made in case there is a
requirement for new equipment or part of the equipment. Machinery used in business
organizations are very costly and it is important to conduct financial viability analysis before
making any decision in relation to such equipment. Following are some of the information
that should be provided by a team member before making replacement request for part of
equipment-
Details of the spare part
First and foremost detailed information in relation to a spare part should be provided by the
team member. This information should include details in relation to model number, nature of
machinery, the procedure of machinery, the name of the manufacturer, expected cost etc.
This type of information is necessary because this information will be helpful in making sure
that spare part of the machinery is still available in the market. This information will also be
helpful in case manager is required to make inquiries in relation to price and quality of the
spare part (Hu et.al, 2018).
The expected life of the machinery
It is already discussed to that the cost of spare parts in machinery can be very expensive,
therefore it is important to evaluate whether it would be more efficient to purchase new
machinery or to replace the spare part. For example, if the life of the machinery is only one
year then it would not be very beneficial for the organization to purchase very costly spare
part of such machinery (Gu, 2013). Instead, management of the company can purchase new
machinery which would have a new life as a company has to incur this cost next year. In such
scenario the expenditure incurred by the company on purchase of spare part will be of no
beneficial value as the spare part will have no use in the business and resale value would not
be able to cover the overall cost of the spare part (Driessen et.al, 2015). Identifying the
expected life of messenger will also help in making decisions in relation to purchasing of a
4

new spare part or second-hand spare part as second-hand spare part can be very helpful if the
life of machinery is limited.
Reason of replacement
It is also important for a manager to understand the reason for which the spare part is being
replaced. Understanding this reason will helpful for future references. For example, if
machinery is worn out due to overloading of machinery then the manager should evaluate
whether the purchase of new machinery will be a viable option or not. In addition to that the
manager of the company can also evaluate whether the maintenance procedures adopted by
the company have any benefits on the machinery and equipment or not (Van Houtum and
Kranenburg, 2015).
Formal requisition letter
It is also important for a team member to present a formal requisition letter for making a
request in relation to the purchase of spare part. It is important for management to maintain
proper documentation in relation to each and every spare part required for plant and
machinery. This type of documentation is very important as it helps business managers in the
future. It is not essential that same business manager will continue in a particular organization
for an indefinite period of time (Cordes and Hellingrath, 2014). Therefore this documentation
will help the next manager to take effective and efficient decision in relation to spare part
management.
5

Scenario 2- Project proposal
A. NPV, IRR and Payback period
Statement showing net cash inflow from the proposed project-
Particular
Yea
r 0
Yea
r 1
Ye
ar
2
Ye
ar
3
Ye
ar
4
Yea
r 5
Ye
ar
6
Yea
r 7
Yea
r 8
Yea
r 9
Yea
r 10
Cash outflow
Furniture and
equipment
4500
000
Machinery
1500
000
Research and
development cost
3000
00
Principal payment
361
887
387
219
414
325
443
327
474
360
507
565
543
095
581
112
621
790
665
315
Total outflow
6300
000
361
887
387
219
414
325
443
327
474
360
507
565
543
095
581
112
621
790
665
315
Cash inflow
Salvage value
500
000
Cash inflow from
operations (WN1) 0
117
500
455
333
811
438
993
391
119
377
2
990
091
116
014
2
125
766
8
136
060
3
146
925
4
Total inflow 0 117 455 811 993 169 990 116 125 136 146
6

500 333 438 391
377
2 091
014
2
766
8
060
3
925
4
Net inflow
-
6300
000
-
244
387
681
14
397
113
550
064
121
941
2
482
526
617
047
676
556
738
813
803
939
PVF@12% 1
0.8
93
0.7
97
0.7
12
0.6
36
0.56
7
0.5
07
0.45
2
0.40
4
0.36
1
0.32
2
PV of net inflow
-
6300
000
-
218
238
542
87
282
744
349
841
691
406
244
641
278
905
273
329
266
712
258
868
WN 1- Statement showing net cash flow from operations
Statement of
expected profit
Ye
ar
0
Yea
r 1
Yea
r 2
Yea
r 3
Yea
r 4
Yea
r 5
Yea
r 6
Yea
r 7
Yea
r 8
Yea
r 9
Yea
r 10
Sales
305
000
0
400
000
0
500
000
0
550
000
0
605
000
0
665
500
0
732
050
0
768
652
5
807
085
1
847
439
4
Variable cost
(65% of sales)
198
250
0
260
000
0
325
000
0
357
500
0
393
250
0
432
575
0
475
832
5
499
624
1
524
605
3
550
835
6
Fixed cost
400
000
420
000
441
000
463
050
486
203
510
513
536
038
562
840
590
982
620
531
Allocated
expense
200
000
200
000
200
000
200
000
200
000
200
000
200
000
200
000
200
000
200
000
Interest cost 350 324 297 268 237 204 168 130 900 465
7

000 667 562 559 526 321 791 775 97 72
Depreciation
110
000
0
110
000
0
110
000
0
110
000
0
110
000
0
Total cost
403
250
0
464
466
7
528
856
2
560
660
9
595
622
9
524
058
4
566
315
4
588
985
6
612
713
2
637
545
9
Net profit
-
982
500
-
644
667
-
288
562
-
106
609
937
72
141
441
6
165
734
6
179
666
9
194
371
9
209
893
5
Tax @ 30%
424
325
497
204
539
001
583
116
629
680
NPAT
-
982
500
-
644
667
-
288
562
-
106
609
937
72
990
091
116
014
2
125
766
8
136
060
3
146
925
4
(+)
Depreciation
110
000
0
110
000
0
110
000
0
110
000
0
110
000
0 0 0 0 0 0
Cash inflow
117
500
455
333
811
438
993
391
119
377
2
990
091
116
014
2
125
766
8
136
060
3
146
925
4
Statement showing NPV, IRR and Payback period
Particular
Rate/
Amount
NPV -3817504
IRR -2%
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Payback period -
On the basis of this calculation, it can be said that this project should not be accepted by the
company as it has negative NPV and IRR. In addition to that 0 payback period shows that the
company would not be able to recover the initial cost of investment during the life of the
project (Gotze, Northcott and Schuster, 2016).
B. The justification for using a correct discount rate
It is provided in the case scenario that currently financiers are using the rate of 12% after
corporate tax for the purpose of calculating net present value. It can be said that it is the
correct rate after evaluating the business scenario under consideration. It is important for
management to use correct and market relevant discount rate for the purpose of evaluating the
present value of cash inflow and outflow. Correct discount rate helps in including the concept
of time value of money in the project appraisal method which is one of the most important to
the method while calculating the financial viability of a project. It is not possible that the
current value of money will remain the same in future as the value of money decreases
constantly due to inflation (Baum and Crosby, 2014). If the present value of cash inflows and
outflows is calculated with the help of wrong discount rate then there is a probability that
decisions made will have a negative impact on the overall financial performance of the
company in future.
C. Advantages and disadvantages of each method
Net present value method
This is a method in which the present value of net cash inflow is calculated by subtracting the
net present value of cash outflow from the net present value of cash inflow. This method
helps in estimating the overall cash to be generated from a proposed project.
Advantages- the Main advantage of this method is that it is very simple to calculate and
analysis of the result is also very simple. This method also considers the concept of the time
value of money which is one of the most essential concepts while calculating the financial
viability of a project that will be happening in future. A final advantage of this method is that
it considers both of the important aspects in investment appraisal i.e. risk and cost of capital
through the use of discounted rate (Aggarwal and Thakur, 2013).
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Disadvantage- This method is based on various assumptions and wrong assumptions can
result in a negative impact on the business organization and project. For example, the wrong
estimation of a discounted rate or expected revenue can have a significant impact on the
decision taken.
Payback period method
This method helps in estimating the time that will be taken by a particular project in
recovering its overall initial cost.
Advantages- the Main advantage of this method is that it is very simple to calculate and can
be calculated without the help of any professional. This method gives more importance to the
liquidity position of a particular project what is essential for the generation of cash. This
method can be very helpful in the initial screening of numerous projects.
Disadvantages- Main and primary disadvantage of this method is that it does not consider the
time value of money (Ghahremani, Aghaie and Abedzadeh, 2012). This project is generally
not used by business managers to evaluate the financial viability of the project due to its
inconclusive results in certain cases.
The internal rate of return
This method calculates a rate of return that will be provided by a particular project and then
such rate is compared with the overall cost of capital to make decisions in relation to financial
viability.
Advantages- This method also considers the concept of the time value of money which is its
one of while evaluating the rate of return. With the help of this method, comparison can be
made with the cost of capital of the company that will help in understanding whether a search
project will be financially viable in the future or not (Finnerty, 2013).
Disadvantages- Calculation of this internal rate of return where is very complex as it is based
on various assumptions and wrong assumptions can lead to wrong decision making. Type of
method will not be usable in identifying the financial viability of mutually exclusive projects.
D. Factors to consider while accepting a project
Change management
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It is important to evaluate whether current business processes of the organization will be able
to handle the new project or not. In case current resources are not sufficient then management
to should you decide whether it would be financially viable to employer new resources or not.
Market consideration
The business market is very dynamic and preference of consumers changes on a regular
basis. In such a dynamic environment, it is important that business organization considers the
viability of the project in the future by evaluating trends and preferences of the customer.
Legal obligations
This is a non-financial factor that should be considered as a business organization should
perform within the legal framework applicable to such business organization. Therefore
management should evaluate whether the new project is allowable according to the
legislature is applicable.
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Scenario 3- Project financing
A. Calculation of WACC
Debt to capital ratio is 1:1
Cost of debt
Debentures- rate of debenture (1-tax rate) (Frank and Shen, 2016).
= 12 (1-.30)
= 8.4%
Bank bills
{(Face value- current value) face value}* 360/90
= .096 or 9.6%
Bank overdraft= One percent above bank bill i.e. 10.6% (1+9.6)
Overall cost of debt (Ratio of overdraft to bank bill to debenture is 1:2:3)
Therefore, cost of debt-
= {(10.6*1) + (9.6*2) + (8.4*3)}/ 6
= 9.166%
Cost of equity
= Ke = (D1 / P0) + g
Here Ke is cost of equity, D1 dividend to be paid in net year, P0 is current price of equity
share and g is dividend growth rate.
= {(1.10+ 6%)/ 8} + 6%
= 6.1457%
Weighted Average Cost of Capital (WACC)
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= {(Cost of equity* weight of equity) + (cost of debt* weight of debt)}/ combined weight of
debt and equity (Hann, Ogneva and Ozbas, 2013).
= (9.166*1) + (6.1457*1)/ 2
= 7.6558%
Therefore WACC of WBC is 7.6558%.
B. Use and limitations of WACC
There are various sources of financing available in the market and cost associated with each
of such resources different from each other. Cost of capital is totally dependent on the risk
associated with such capital. For example the cost of debt, capital is lower as compared to
equity capital because the risk associated in debt capital is limited. The weighted average cost
of capital helps in identifying the overall cost of capital employed in a business organization.
This method can be used in the given scenario because the capital of the company is the
composition of the different type of capital i.e. debt and equity. In addition to that, that capital
of the company is also the composition of three different types of debt instruments i.e.
overdraft bank, bank bill, and debentures. For the evaluation of any project, it is important to
calculate the cost of capital to compare it with the rate of return that will be provided by such
project. The rate of return of a particular project cannot be compared with each and every
capital of the company separately. Therefore it is important to calculate a particular rate of
return that will represent the overall cost of capital. It can be said that in the given scenario
calculation of the weighted average cost of capital will be a viable option (Hou, Van Dijk and
Zhang, 2012).
The weighted average cost of capital cannot be used in each and every situation and some of
the limitations of this method are as follows-
 This method should not be used when the cost of capital is changing on a constant
basis as it will result in the wrong calculation of the cost of capital.
 This method also cannot be used in situations where the market rate of capital is not
available.
 Evaluation of financial viability with the help of this method becomes very difficult
when the expected internal rate of return in a particular project is not available.
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Conclusion
It can be concluded that selection of an effective and efficient to the source of financing for a
business organization is very important. In addition to that, it is also important to evaluate the
financial viability of a particular project before integration of such project in the organization.
Any new project started by the organization requires a large amount of resources and failure
of the project can result in a significant negative impact on the overall performance of the
organization. This report has described the various aspects of project financial management.
It is important that business managers should consider all the calculations provided in this
project before making any decisions in relation to the given scenario.
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review. International Journal of Engineering and Advanced Technology (IJEAT), 2(3),
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spare parts inventory management and transport planning. In Industrial Informatics (INDIN),
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Driessen, M., Arts, J., van Houtum, G.J., Rustenburg, J.W. and Huisman, B., 2015.
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research. Production Planning & Control, 26(5), pp.407-426.
Finnerty, J.D., 2013. Project financing: Asset-based financial engineering. John Wiley &
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Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal
of Financial Economics, 119(2), pp.300-315.
Ghahremani, M., Aghaie, A. and Abedzadeh, M., 2012. Capital budgeting technique selection
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Hann, R.N., Ogneva, M. and Ozbas, O., 2013. Corporate diversification and the cost of
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approach. Journal of Accounting and Economics, 53(3), pp.504-526.
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Lengu, D., Syntetos, A.A. and Babai, M.Z., 2014. Spare parts management: Linking
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