Application and Effect of Capital Budgeting

Running head: CORPORATE FINANCE
Corporate Finance
Name of the Student:
Name of the University:
Author’s Note:

1CORPORATE FINANCE
Table of Contents
Project 1...........................................................................................................................................2
Intrinsic Valuation of Share Price................................................................................................2
Weighted Average Cost of Capital..............................................................................................3
Types of Risks.............................................................................................................................4
Project Financing.........................................................................................................................5
Qualitative Factors.......................................................................................................................6
Sunk and Opportunity Costs of Business....................................................................................6
Project Analysis...........................................................................................................................7
Reference.........................................................................................................................................8

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Project 1
The analysis of the Bio-Fuels Generation Incorporated (BFG) would be done based on
the fundamental metrics whereby important metrics like the intrinsic valuation of the share price,
WACC for the company and various other operating and financial risk would be determined for
the company. The management of the company in particular are finding out best possible ways in
which they cater or use the various financing methods for the purpose of financing the operations
of the company.
Question 1
Intrinsic Valuation of Share Price
The intrinsic valuation of the share price of the company would be done with the help of
the Dividend Growth Model whereby various financial metrics would be considered for the
purpose of valuation of the share price of the company. The formula that would be applied for
the purpose of calculating the share price of the company is as follows:
Intrinsic Share Price: Do1/(Re-g).
Dividend (Do): $0.75
Growth Rate: 8%
Constant Growth Rate: 3%.
The required return for determining the discount rate has ben well applied with the hep of given
CAPM Formula as shown below:
Capital Asset Pricing Model: Risk Free Rate + Beta*(Return on Market-Risk Free Rate).

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Cost of Equity
Capital Asset Pricing Model
Risk Free Rate 3%
Expected Market Return 5%
Industry Beta 1.9
Required Rate of Return 6.80%
The share price of the company has been well calculated to be around $21.91 which has been
calculated with the help of dividend discount model whereby the details are as shown below:
Dividend Discount Model
Particulars 2013 2014 2015 Terminal Value
Dividend (Do) $ 0.75
Dividend Growth Rate 8% 6% 3%
Forecasted D (1) 0.81 0.86 23.27
Discount Factor 0.94 0.88
Discounted Cash Flows 0.76 21.16
Share Price 21.91
The terminal growth rate in particular has been determined as follows:
Value: D3/(Re-g)
Value: 086*(1+3%)/(6.80%-3.00%)
Value: 23.27
Question 2
Weighted Average Cost of Capital
The Weighted Average Cost of Capital has been well determined with the help of the
various financing sources that has been deployed by the company for the purpose of financing

4CORPORATE FINANCE
the operations of the company. The Cost of Debt for the company in particular was analysed by
taking the total debt value for the company and accordingly values were determined for the
purpose of calculating the total cost of debt. The total cost incurred in respect to debt value has
been around 5.52% after taking on a post-tax basis1. The equity cost for the company has been
around 6.80%. The formula used for the purpose of calculating the WAC are as follows:
Cost of Equity:
Capital Asset Pricing Model: Risk Free Rate + Beta*(Return on Market-Risk Free Rate).
WACC: Weight of Equity*Cost of Equity + Weight of Debt*Cost of Debt.
Cost of Equity
Capital Asset Pricing Model
Risk Free Rate 3%
Expected Market Return 5%
Industry Beta 1.9
Required Rate of Return 6.80%
Cost of Debt
Line of Credit 165,320
Cost of Credit 6.00%
Long Term Debt 1,658,560
Cost of Debt 7.50%
Weight of Line Credit (%) 9.06%
Weight of Long Term Debt (%) 90.94%
Total Value of Debt 1,823,880
Pre Tax-Cost of Debt 7.36%
1 Rossi, Matteo. "The use of capital budgeting techniques: an outlook from Italy." International Journal of
Management Practice 8, no. 1 (2015): 43-56.

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Tax Rate 25.00%
Post-Tax Cost of Debt 5.52%
Total Equity Value 1,387,920
Total Value of Firm 3,211,800
Debt (%) 56.79%
Equity (%) 43.21%
WACC 6.07%
Question 3
Types of Risks
Operating Risks refers to the risks which is related to the proper implementation of the
project or activities which is related to the project. The operational risks are also related to
production and distribution problems. The risks which is related to BFG in terms of operational
risks is the production of algae which requires lot of water, nitrogen. In addition to this, there is
also concerns of environmental concerns as the production of algae emits greenhouse house.
Business risks refers to the risks that the profits of the business might be affected either
directly or indirectly due to some uncertainties. In the case of BFG, the business risks which
might arise due to strategic fault of the business in implementing the project in an effective
manner. In addition to this, the cost of production is expected to rise which would be having a
direct impact on the profits of the business and it is anticipated that the new innovation would
handle the costs of the business. The profitability of operations is depended on the effectiveness
of the innovation which is undertaken by the management.

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Financial risks refer to the risks which is related to the ability of the management to
manage the debts and finances of the business and also generate appropriate level of profits from
the perspective of long run operations. The major risk which is associated with the business of
BFG is related to raising proper funds for financing the activities related to the project. If proper
sources are not selected than the business would be having a liquidity crisis situation in the
business.
Question 4
Project Financing
Financing of the project can be done with the help of various methods and techniques that
would be involving issuing equity shares which is he first option available with the company. On
the other hand, the other best option available is issuing of debt by the company that would be
helping the company take advantage of low cost debt financing and reduce the WACC for the
company2. However, in this case the cost of equity that the company has to bar would be based
on the cumulative dividends that the company would be paying which is around 6%. While, on
the other hand, the cost of debt for the company would be around 7% p.a payable monthly. In
this case the loan financing would be a costly option for the company as the yield or cost is
higher and the financial risk would also increase with loan financing for the company.
Question 5
Qualitative Factors
2 Sari, Irem Ucal, and Cengiz Kahraman. "Interval type-2 fuzzy capital budgeting." International Journal of Fuzzy
Systems 17, no. 4 (2015): 635-646.

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The management of the company needs to consider qualitative factors which might also
have its influence on a success of a project. Some of the Qualitative factors which needs to be
considered by the management of BFG in taking decisions are listed below:
 Inflation: One of the main factors which has an impact on the cost of raw materials is the
inflationary pressure which automatically increases the costs of operations of the
business. If the inflationary rate is high than the profitability of the business would be
directly impacted3.
 Environmental Factors: The use of algae to produce fuels requires lot of water, nitrogen
and other components which would be emitting greenhouses gases which is harmful for
the atmosphere.
 Legal Legislations: The new project would be requiring clearance from the government
or regulating bodies so that the project does not attract any penalty or fines of any nature.
Question 6
Sunk and Opportunity Costs of Business
The business would be undertaking development costs which would form part of the sunk
costs of the business and therefore appropriate planning needs to be done so that the project is
successful and the management is able to cover the initial expenses of the project. In case, an
alternative option in terms of the project arises than the same would be forming part of
opportunity costs of the business. It is under these circumstances that the management needs to
decide which project would be more viable from a long run perspective.
3 Su, Shu-Hui, Hsiu-Ling Lee, Jung-Ju Chou, Jen-Yin Yeh, and Minh Hang Vu Thi. "Application and effects of
capital budgeting among the manufacturing companies in Vietnam." International Journal of Organizational
Innovation (Online) 10, no. 4 (2018): 111-120.

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Question 7
Project Analysis
The analysis of the project in particular has been due with the help of key capital
budgeting tools like NPV, IRR and Payback Period. The NPV of the project has been around
$163,392, while the Internal Rate of Return has been around 19%. The NPV Value generated
from the project is on a positive side stating that the project would be creating a positive wealth
for the finance providers. The IRR shows the return of the project I percentage terms and the
Payback Period which shows the time taken by the company in recovering there initial
investment has been around 4.76 Years for the company4.
4 Zhang, Guochang. "Fundamental (versus Market) Risk and Capital Budgeting Decisions: Distinguishing between
the Investment Hurdle Rate and the Cost of Capital." Available at SSRN 3019270 (2017).

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Particulars 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Construction Costs
Building (15,00,000)
Equipments (5,00,000)
Land Costs (4,00,000)
Working Capital Investment (30,000)
Revenues 14,00,000 18,00,000 23,00,000 23,00,000 23,00,000 23,00,000 23,00,000 23,00,000 23,00,000 23,00,000
Less: Cost of Goods Sold (4,20,000) (5,40,000) (6,90,000) (6,90,000) (6,90,000) (6,90,000) (6,90,000) (6,90,000) (6,90,000) (6,90,000)
Less: Marketing Costs (1,42,800) (1,83,600) (2,34,600) (2,34,600) (2,34,600) (2,34,600) (2,34,600) (2,34,600) (2,34,600) (2,34,600)
Less: Fixed Operating Costs (5,75,000) (5,75,000) (5,75,000) (5,75,000) (5,75,000) (5,75,000) (5,75,000) (5,75,000) (5,75,000) (5,75,000)
Less: Depreciation
Building Depreciation (1,20,000) (1,20,000) (1,20,000) (1,20,000) (1,20,000) (1,20,000) (1,20,000) (1,20,000) (1,20,000) (1,20,000)
Equipment Depreciation (50,000) (50,000) (50,000) (50,000) (50,000) (50,000) (50,000) (50,000) (50,000) (50,000)
Salvage Value
Building 2,50,000
Land 4,00,000
Ccash Flows Before Tax (24,30,000) 92,200 3,31,400 6,30,400 6,30,400 6,30,400 6,30,400 6,30,400 6,30,400 6,30,400 12,80,400
Taxation@ 25% (23,050) (82,850) (1,57,600) (1,57,600) (1,57,600) (1,57,600) (1,57,600) (1,57,600) (1,57,600) (3,20,100)
Cash Flow After Tax (24,30,000) 69,150 2,48,550 4,72,800 4,72,800 4,72,800 4,72,800 4,72,800 4,72,800 4,72,800 9,60,300
Add: Depreciation
Building 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000
Equipment 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Working Capital Investment 30,000
Free Cash Flows (24,30,000) 2,39,150 4,18,550 6,42,800 6,42,800 6,42,800 6,42,800 6,42,800 6,42,800 6,42,800 11,60,300
Discount Factor @ 17% 1.00 0.85 0.73 0.62 0.53 0.46 0.39 0.33 0.28 0.24 0.21
Discounted Cash Flows -24,30,000 2,04,402 3,05,756 4,01,345 3,43,030 2,93,188 2,50,588 2,14,178 1,83,058 1,56,460 2,41,386
Net Present Value 1,63,392
Internal Rate of Return 19%
Payback Period
Cash Flows (24,30,000) 2,39,150 4,18,550 6,42,800 6,42,800 6,42,800 6,42,800 6,42,800 6,42,800 6,42,800 11,60,300
Amount Recovered (21,90,850) (17,72,300) (11,29,500) (4,86,700) 1,56,100 7,98,900 14,41,700 20,84,500 27,27,300 38,87,600
Payback in Years 1 2 3 4 0.76
Payback Period 4.76
Capital Budgeting Analysis

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References
Rossi, Matteo. "The use of capital budgeting techniques: an outlook from Italy." International
Journal of Management Practice 8, no. 1 (2015): 43-56.
Sari, Irem Ucal, and Cengiz Kahraman. "Interval type-2 fuzzy capital budgeting." International
Journal of Fuzzy Systems 17, no. 4 (2015): 635-646.
Su, Shu-Hui, Hsiu-Ling Lee, Jung-Ju Chou, Jen-Yin Yeh, and Minh Hang Vu Thi. "Application
and effects of capital budgeting among the manufacturing companies in Vietnam." International
Journal of Organizational Innovation (Online) 10, no. 4 (2018): 111-120.
Zhang, Guochang. "Fundamental (versus Market) Risk and Capital Budgeting Decisions:
Distinguishing between the Investment Hurdle Rate and the Cost of Capital." Available at SSRN
3019270 (2017).