Capital Budgeting and Project Evaluation

This assignment focuses on capital budgeting decisions and project evaluation. It analyzes the feasibility of several projects (H, G, K) based on their Internal Rate of Return (IRR) compared to different Weighted Average Cost of Capital (WACC) rates calculated based on various funding levels. The assignment also discusses the impact of incremental financing on project M's viability.

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STUDENT ID:
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PART A
Question 1
The requisite data for the selected company required for computation of the required ratios is
as highlighted below.
All figures in $ 000's unless stated otherwise
Particulars FY2015 FY2016 FY2017
Revenue 1144603 1226653
Cost of Goods Sold 364709 394364
Gross Profit 779894 832289
Net Profit 274402 168871
Total Assets 5602958 5602958 5574596
Total equity 2398335 2398335 2448338
Accounts Receivable 191523 206343
Accounts Payable 222990 249920
Inventory 4285 11,306
Current Asset 553586 286027
Current Liabilities 494479 661590
Total liabilities 3204623 3126258
Cash 321371 14878
Marketable Security 0 0
EPS (cents) 27.2 16.7
Closing price ($) 3.29 3.21
The corresponding ratios those are required for FY2016 and FY2017 for Vector Limited are
as indicated below.

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Question 2
Based on the above ratio analysis, the strengths and weakness of the given company needs to
be analysed as has been shown below.
Strengths of the company
The major strength of the company is the market leadership position with regards to
electricity and gas connections which it has consolidated over the last two years. In FY2016,
the company sold Vector Gas for a consideration in excess of $ 900 million which constituted
of the gas and electricity transmission business outside Auckland. The higher profit margins
coupled with ROA and ROE in FY2016 is attributed to the proceeds from the sale of this
business. It is expected that the current investment being carried out by the company in terms
of installation of smart meters would pay in rich gains to the business going forward. This is
reflected in the higher asset turnover which reflects superior ability of the company to derive
sales from the available (Arnold, 2005). Additionally, the efficiency ratios reflect that the
company has a short cash cycle where the inventory turnover and receivables turnover is
comparatively higher while the payables turnover is low. This can be attributed to the nature
of the business and ensures that the working capital is minimised (Berk et. al., 2013).
Weakness of the company

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The key area of weakness for the company is the liquidity both in the short term and long
term. This is especially true for FY2017 where there has been a deterioration of both the
liquidity and solvency ratios which going forward can enhance the going concern risk along
with credit risk associated with the company. In particular the cash ratio is very abysmal as it
covers only 2% of the current liabilities is a matter of concern. Also, the current ratio, acid
ratio along with the working capital suggests deterioration of the short term liquidity of the
company (Damodaran, 2010). However, the abysmally low amount of cash and bank
balances is on account of robust investment in the business amounting to more than $ 354
million in FY2017. Further, the company has also acquired a business in FY2017 for almost
$ 91 million. Further, post the sale of Vector Gas, the company has aggressively reduced
borrowings especially in FY2016.
Further, with regards to solvency ratios, it is apparent that in the given period, it has not
worsened. Also, even though the debt equity at about 1.28 may seem high but considering the
capital expenditure in business expansion and building enabling transmission infrastructure,
the solvency ratios should not be much of a concern as of now. However, going ahead the
company has to mindful of the fact that overleveraging of the balance sheet needs to be
avoided so as to ensure that the future expansion plans are not jeopardised (Brealey, Myers &
Allen, 2012).
Recommendation
Based on the above analysis, it is apparent that the strategic intent of the company where it
intends to focus on the Auckland market and has sold a business to deleverage the balance
sheet is a positive for the company. The short term liquidity ratios are a concern and the
company should take measures so as to improve the same especially in the form of higher
liquid assets in the form of cash or marketable security. Also, while the company is
aggressively pursuing with the expansion plans, it needs to be mindful of ensuring that the
balance sheet should not be stretched to an extent where these plans start back firing. Further,
the company should be conservative with regards to setting up infrastructure for the expected
future capacity considering the high capital expenditure involved (Bodie, Merton & Cleeton,
2009).

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PART B
Question 3
a) The objective is to compute the IRR and NPV related to the given boat proposals based on
the information provided. It is noteworthy that the amount spent on conducting the study
would be a sunk cost since the study has already been conducted and would not be taken
into consideration.
Cost implications of replacement of old ship
Annual revenue foregone = $ 7,000
Cash inflow due to disposal of current boat = $ 6,000
Loss on disposal = $ 10000 - $ 6000 = $ 4,000
The same would lead to tax savings owing to decrease in taxable income.
Captain Nemo
Initial outlay = $ 68,000
Revenue = $ 25000
The maintenance schedule has also been given.
Estimated salvage value = $ 11,000
Hence, yearly depreciation expense based on straight line = (68000-11000)/8 = $ 7,125

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NPV = -$ 3778.48
IRR = 10.1%
Titanic II
Initial outlay = $ 70,000
Revenue = 25,000
The maintenance schedule has also been given.
Estimated salvage value = $ 13,000
Hence, yearly depreciation expense based on straight line = (70000-13000)/9 = $ 6,333.33
The relevant computation of NPV and IRR is shown in the table below (Damodaran, 2010).

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NPV = -$ 1,269.22
IRR = 11.5%
b) Based on the above computations, it is apparent that the superior choice from the given
two choice seems to be Titanic II since the IRR for this ship is higher while the IRR is
lower in comparison to the other alternative i.e.Captain Nemo. However, considering the
fact that NPV for both proposed ships is negative and also the IRR is lower than the post-
tax discount rate, hence ideally the company should reject both the proposed alternatives
and instead continue with the current boat and must not avail either of the options as the
wealth of the shareholders would be adversely impacted (Bodie, Merton & Cleeton, 2009).
Question 4
a) The objective is to compute the cost of capital for the various financing ranges.
Case 1: 0 to 600,000
WACC = Respective weights * Respective post tax cost = 0.5*6.3 + 0.1*12.5 + 0.4*15.3 =
10.52% pa
Case 2: 600,000 to 1,000,000
WACC = Respective weights * Respective post tax cost = 0.5*6.3 + 0.1*12.5 + 0.4*16.4 =
10.96% pa
Case 3: 1,000,000 and above
WACC = Respective weights * Respective post tax cost = 0.5*7.8 + 0.1*12.5 + 0.4*16.4 =
11.71% pa
b) Project H is feasible as the IRR is 14.5% which is above the highest WACC of 11.71% pa.

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Project G would be feasible as the IRR is 13% which is above the highest WACC of
11.71% pa.
Project K would be feasible as the IRR is 12.8% which is above the highest WACC of
11.71% pa.
Out of the above projects, the most feasible would be H, then G and finally K based on
their respective WACC. Hence, the company would give priority to the funding
requirements of these projects (Arnold, 2005).
Total funding requirement for project H, G and K = 200,000 + 700,000 + 500,000 = $
1,400,000
Thus, incremental financing for project M would attract a cost of 11.7% which is higher
than the applicable WACC of 11.4% and hence project M would not be considered as
financially feasible (Brealey, Myers & Allen, 2012).
c) The relevant cost and opportunity diagram is indicated below.
It is apparent from the above diagram that project M would not be financially feasible since
the marginal cost of capital is greater than the IRR offered by the project. However, for the

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other projects clearly, the IRR is greater than the marginal cost of capital and hence these are
feasible (Bodie, Merton & Cleeton, 2009).
References
Arnold,G. (2005). Corporate Financial Management (3rd ed.). Sydney: Finaicial Times
Management.
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V., & Finch, N. (2013). Fundamentals
of corporate finance. London: Pearson Higher Education AU.
Bodie, Z., Merton, R. C., & Cleeton, D. L. (2009). Financial economics (2nd ed.). New
Delhi: Pearson Education India.
Brealey, R. A., Myers, S. C., & Allen, F. (2012). Principles of corporate finance (2nd ed.).
New York: McGraw-Hill Inc.,US.
Damodaran, A. (2010). Applied corporate finance: A user’s manual (3rd ed.). New York:
Wiley, John & Sons.

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Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2012).
Financial Management, Principles and Applications (6th ed.). NSW: Pearson Education,
French Forest Australia.