Equity Finance and Capital Budgeting

This report explores various financing techniques used by organizations to make important strategic decisions regarding raising capital or undertaking a project. It delves into equity finance concepts such as Right issue and scrip dividends, as well as feasibility techniques like Net Present Value (NPV) and Internal Rate of Return (IRR). The report also discusses the limitations of IRR and its impractical assumptions, highlighting the importance of considering mutually exclusive projects when comparing NPVs of two or more projects. By examining different companies' strategies, this report aims to understand how financiers formulate their decisions.

FINANCIAL MANAGEMENT

Table of Contents
INTRODUCTION...........................................................................................................................1
Question 1- Cost of Capital and Capital Structure:.........................................................................1
(a) Calculation of Book Value and Market Value cost of Capital (WACC) for Kadlex Plc: 2
(b) Kadlex Plc revised cost of capital after proposed changes with finance director proposal:. 3
(c) Critical analysis of integrating new capital:......................................................................3
(d) Effect of Short-termism on Agency Problem and Bankruptcy:........................................4
Question 2- Long term finance: Equity finance:..............................................................................4
(a) Right Issue: ......................................................................................................................4
(b) Scrip Dividends:...............................................................................................................9
Question 3- Investment Appraisal Techniques..............................................................................10
(a) Determination of economic feasibility of project using following investment appraisal
techniques:............................................................................................................................11
(b) Benefits and Drawbacks of various Investment Appraisal techniques:..........................15
CONCLUSION..............................................................................................................................16
REFERENCES .............................................................................................................................17

INTRODUCTION
Financial Management is the study of planning, controlling and organizing the finances
of an organisation (Allen, Hemming and Potter, 2013). This report takes capital structure, equity
finance and investment appraisal techniques into consideration of Kadlex Plc, Lexbel Plc and
Happy Meal Limited respectively. It also evaluates the benefits and drawbacks of scrip dividends
and appraisal techniques like ARR, IRR and NPV.
Question 1- Cost of Capital and Capital Structure:
Cost of Capital and Capital structure are an important concept for any organization as they help
in determining the proportion in which the debt and equity must be taken so as to derive
maximum benefit at lowest cost possible. Kadlex plc wants to review its capital structure in order
to minimise its cost of capital (WACC). The following calculations have been worked out to
achieve the same:
Step 1: Calculation of growth (g)
Years
1 21 pence
2 23 pence
3 25 pence
4 27 pence
5 28 pence
S0*(1+g)n = Sn where, g is growth, n denotes number of years, S0 denotes first dividend and Sn
denotes last dividend. [In the above table the number of years will be taken as 4 instead of 5 as
the dividend has increased 4 times between Year 1 and Year 5.]
S0*(1+g)n = Sn
=> 21*(1+g)4=28
=> (1+g)4=28/21
=> (1+g)4=1.3333
=> (1+g)= (1.333)0.25
=> g= (1)- ( 1.0757) = 0.0757 or 7.57%
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Step 2: To calculate the rate of individual sources of finance
(i) Cost of Equity (Ke ):
Ke = (Sn*[(1+g)+g])/P0 where, Ke denotes Cost of Equity, Sn denotes first dividend, g
denotes growth rate and P0 denotes current ex dividend share price.
Therefore, Ke = (28*[1+0.075)+0.075])/2.65=(28*1.15)/2.65=12.15%
(ii) Preference Share (Kp):
Kp= (j)/Pf where, Kp denotes Cost of Preference Shares, j denotes Preferential dividend
and Pf denotes current ex dividend preference share price.
Therefore, Kp= 7/75 = 9.33%
(iii) Irredeemable Bonds/Debt:
Kdir= ([j* (1-CT)])*(Po/Pn) where, Kdir denotes Cost of Debt (Irredeemable Bonds), j
denotes interest on debt, CT is Corporate tax rate, P0 is Initial Price and Pn denotes Current Price.
Kdir= ([0.10*(1-0.30)])*(100/107) = 0.0654 or 6.54%
(a) Calculation of Book Value and Market Value cost of Capital (WACC) for Kadlex Plc:
Book Value (£'000) Market Value (£'000) Proposed Value
(£'000)
Equity (Shares+Reserves)
£20,000+£5,000=£25,000
(No. of shares* Market price)
20000*£2.65= £53,000
20,000*£2.85=
£57,000
Preference
Shares
£10,000 10,000*£0.75=£7,500 10,000*£0.68=£6,800
Irredeemable
Bonds
£15,000 £15,000*£107/£100=£16,050 £15000*£107/£100=
£16,050
Total Capital £50,000 £76,550
New Bonds - - £15,000*£105/£100=
£15750
Total - - £95,600
2

WACC (for Book Value)= {[Ke*BVe]+[Kp*BVp]+[Kd*BVd]} / Total Capital where,
Ke = Cost of Equity (before changes)
BVe= Book Value of Equity
Kp = Cost of Preference shares (before changes)
BVp= Book Value of Preference Shares
Ke = Cost of Debt (before changes)
BVd= Book Value of Debt
Total Capital = Sum of book value of equity, preference and debt calculated in (a)
Thus, WACC = {[0.1215*£25,000] + [0.0933*£10,000] + [0.0654*£15,000]} / £50,000
=> 4951.5/50000= 0.099 or 9.9%
WACC (for Market Value)= {[Ke*MVe]+[Ke*MVp]+[Ke*MVd]} / Total Capital where,
Ke = Cost of Equity (before changes)
MVe= Market Value of Equity
Kp = Cost of Preference shares (before changes)
MVp= Market Value of Preference Shares
Kd = Cost of Debt (before changes)
MVd= MarketValue of Debt
Total Capital = Sum of market value of equity, preference and debt calculated in (a)
Thus, WACC = {[0.1215*£53,000] + [0.0933*£7,500] + [0.0654*£16,050]} / £76,550
=>8188.92/76550= 0.10697 or 10.70%
(b) Kadlex Plc revised cost of capital after proposed changes with finance director proposal:
Proposed Growth (g) [ increase by 20%] = 0.075*1.2=0.09 or 9%
Equity (Ke )= [(28*(1.09))+0.09]/2.85=0.1074 or 10.74%
Preference (Kp )=[(7/68)]= 0.1029 or 10.29%
Irredeemable Bonds (Kd) = [10(1-0.30)]*100/107= 0.0654 or 6.54%
New Bonds (Kd) = [0.11(1-0.30)]*100/105= 0.0733 or 7.33%
The proposed WACC:
WACC = {[0.09*£57,000] + [0.1074*£6,800] + [0.0654*£16,050] + [0.0733*£15,750] / £95,600
= 8064.47 / 95600 = 0.0844 or 8.44%
3

(c) Critical analysis of integrating new capital:
The WACC for the proposal is 8.44% while the market share WACC is 10.70%. Therefore,
Kadlex Company will be able to save a cost of capital (10.70%-8.44%=) 2.26%. This means that
by integrating the proposed capital structure into the existing capital structure of Kadlex Plc, the
minimum weighted average cost of capital can be reduced by 2.26%. As Myers explains cost of
capital can make or break a firm, once this new capital structure has been geared Kadlex can
utilize 2.26% saved costs in other areas for effective allocation of resources such as purchasing
new machinery or any other kind of investment.
(d) Effect of Short-termism on Agency Problem and Bankruptcy:
Short-termism relates to a situation where a company tends to focus on short-term
projects or objectives for earning present profits at the expense of foregoing long-term earnings
or benefits. The following example provides a clear picture of Short-termism on Agency
Problem.
If a finance finance director has 20 million to invest and they are able to:
-in Year 1 get a return of 5 million
-in Year 3 get a return of 10 million
-in Year 5 get a return of 15 million
Of course most of the finance directors will go for the 5 million return because they will
get that money at the end of the first year. Since their jobs are not guaranteed they will look for
their own interests first instead for the company interest. This phenomenon is known as 'Agency
problem' where interests of shareholders are overlooked for personal growth and expansion by a
company. The effects of this phenomenon on bankruptcy and agency problem in a company can
be devastating. Unrelentingly chasing short-term profits can create a gap between the aim of a
company and its operations, as short-termism is caused when managers tend to overuse their
equity funds, the company may not be able to provide dividends and interest payments to their
creditors thus going bankrupt.
Question 2- Long term finance: Equity finance:
(a) Right Issue:
A company may face a situation where the invested capital is not sufficient to carry out
its operational activities on a regular basis. Apart from meeting working capital requirements,
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this fresh capital may be required by the companies for the purpose of expansion and takeovers.
In case a company wants to expand its existing operations, it may adopt the method of Right
Issue. Right Issue helps a firm to raise fresh capital by inviting its existing shareholders to
purchase new shares, called right shares, offered by the company (Aubert and Grudnitski, 2011).
Under this method, existing shareholders get a right to purchase new shares at a discounted
market price on a predetermined future date. These rights act as a compensation to the current
shareholders for dilution of their shareholding value in future due to increase in equity capital.
The shareholders can exercise their right to fully subscribe new shares or sell their rights to
someone else before the date of right issue. They can also ignore these rights. Selling of rights
works in the same way as a shareholder selling a share of the company to someone else.
Lexbel PLC has decided to opt for a right issue in order to raise fresh capital worth
£180,000 to expand its existing operations. The financial director of Lexbel has suggested three
different right issue prices for this at £1.80, £1.60, £1.40. Current Market Price before rights
attached prevailed at £1.90. It has been decided by the management that the rate of return on
shareholder's fund shall remain unchanged at 20%.
Given Information:
Particulars Amount(£)
Existing Shareholder's Funds:
Ordinary shares of 50p each (given) 300000
Reserves (given) 400000
Total Shareholder's Funds 700000
In order to determine the number of shares to be issued, theoretical ex-right issue price,
expected earnings per share (EPS) and form of the issue for each right issue price, following
calculations were carried out:
1. Calculation of number of shares to be issued:
Number of shares to be issued = [Cash to be raised by Lexbel PLC/ Right issue price suggested
by Board]
(i) if right issue price is £1.80:
Number of existing shares of Lexbel PLC (given) = £300,000/0.5 = 600,000 shares
Cash raised by Lexbel (given) = £180,000
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Therefore, number of shares to be issued = £180,000/£1.80 = 100,000 shares
(ii) if right issue price is £1.60:
Number of existing shares of Lexbel PLC (given) = £300,000/0.5 = 600,000 shares
Cash raised by Lexbel (given) = £180,000
Therefore, number of shares to be issued = £180,000/£1.60 = 112,500 shares
(iii) if right issue price is £1.40:
Number of existing shares of Lexbel PLC (given) = £300,000/0.5 = 600,000 shares
Cash raised by Lexbel (given) = £180,000
Therefore, number of shares to be issued= £180,000/£1.40 = 128571.43 or 128572
shares.
2. Calculation of theoretical ex-right price:
(a) Step 1: Calculating Return on Shareholder's Funds:
Return on Shareholder's Funds @ 20% = total capital by return on shareholder's funds* rate of
return = £700,000* 0.20 = £140,000
(b) Step 2: Value of Lexbel PLC before Rights Issue:
Value of Lexbel PLC before Rights Issue = number of existing shares*current market price (ex-
div)
Note: Current Market Price (ex-div) of share means the prevailing market price of the share
before right issue or the rights attached to the share of a company.
(i) if right issue price is £1.80:
Number of existing shares of Lexbel PLC (given) = £300,000/0.5 = 600,000 shares
Current market price (ex-div) (given) = £1.90
Therefore, value of Lexbel PLC = 600,000*£1.90 = £1,140,000
(ii) if right issue price is £1.60:
Number of existing shares of Lexbel PLC (given) = £300,000/0.5 = 600,000 shares
Current market price (ex-div) (given) = £1.90
Therefore, Value of Lexbel PLC = 600,000*£1.90 = £1,140,000
(iii) if right issue price is £1.40:
Number of existing shares of Lexbel PLC (given) = £300,000/0.5 = 600,000 shares
6

Current market price (ex-div) (given) = £1.90
Therefore, Value of Lexbel PLC = 600,000*£1.90 = £1,140,000
(c) Step 3: Value of Lexbel PLC after Rights Issue:
Value of Lexbel PLC after Rights Issue = Value of Lexbel PLC before right issue+ Cash to be
raised
(i) if right issue price is £1.80:
Value of Lexbel PLC before right issue = £1,140,000
Cash raised by Lexbel (given) = £180,000
Therefore, value of Lexbel PLC = £1,140,000+ £180,000 = £1,320,000
(ii) if right issue price is £1.60:
Value of Lexbel PLC before right issue = £1,140,000
Cash raised by Lexbel (given) = £180,000
Therefore, value of Lexbel PLC = £1,140,000+ £180,000 = £1,320,000
(iii) if right issue price is £1.40:
Value of Lexbel PLC before right issue = £1,140,000
Cash raised by Lexbel (given) = £180,000
Therefore, value of Lexbel PLC = £1,140,000+ £180,000 = £1,320,000
(d) Step 4: Theoretical Ex-Right Issue Price
Theoretical Ex-Rights price per share is the estimated market price of the share that it
will have after a right issue is carried out by the company, in theory. The actual ex-rights price
per share may be same or different from theoretical ex-right price of share.
Theoretical Ex-Rights price per share = value of Lexbel PLC after right issue/ total number of
shares
Total Number of Shares = Existing shares + New Shares
Theoretical Ex-Rights price under three given scenarios is shown below:
(i) if right issue price is £1.80:
Value of Lexbel PLC after right issue = £1,132,000
Total Number of shares = 600,000+ 100,000 = 700,000 shares
Therefore, Theoretical Ex-Rights price = £1,132,000/700,000 = £1.89
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(ii) if right issue price is £1.60:
Value of Lexbel PLC after right issue = £1,132,000
Total Number of shares = 600,000+ 112,500 = 712,500 shares
Therefore, Theoretical Ex-Rights price = £1,132,000/712,500 = £1.85
(iii) if right issue price is £1.40:
Value of Lexbel PLC after right issue = £1,132,000
Total Number of shares = 600,000+ 128572 = 728,572 shares
Therefore, Theoretical Ex-Rights price = £1,132,000 / 728,572 = £1.81
3. Calculation of Expected Earnings per share (EPS):
Expected Earnings per share (EPS) has been calculated by the given formula:
EPS = (Number of shares before rights issue*theoretical ex-right price)/Current market Price
(ex-div)
(i) if right issue price is £1.80:
Number of shares before rights issue = 600,000 shares
Theoretical ex-rights price = £1.89
Market Price= £1.9
EPS = (600,000*£1.89)/ £1.9 = £596,842.11 or £596,842
(ii) if right issue price is £1.60:
Number of shares before rights issue = 600,000 shares
Theoretical ex-rights price = £1.85
Market Price= £1.9
EPS = (600,000*£1.85)/ £1.9 = £584,210.526 or £584,211
(iii) if right issue price is £1.40:
Number of shares before rights issue = 600,000 shares
Theoretical ex-rights price = £1.81
Market Price= £1.9
EPS = (600,000*£1.81)/ £1.9 = £571,578.947 or £571,579
4. Determining form of issue for each right issue price:
Particulars Amount(£) Amount(£) Amount(£)
8

Right issue price suggested by Board
(given)
1.80 1.60 1.40
Number of existing shares of Lexbel 600000.00 600000.00 600000.00
Cash to be raised by Lexbel PLC
(given)
180000.00 180000.00 180000.00
Right issue price suggested by Board
(given)
1.80 1.60 1.40
Number of shares to be issued 100000.00 112500.00 128571.43
Ratio of allotting new shares to
existing shareholders
0.17 0.19 0.21
Issue of right shares for number of
shares held by existing shareholders
Issue of 1 for 6
right shares
held
Issue of 9 for 48
right shares held
Issue of 3 for 14
right shares held
Number of rights needed to buy a share
Number of rights needed to buy a share =Number of shares to be issued /Number of existing
shares
(i) if right issue price is £1.80:
Number of existing shares = 600,000 shares
Number of shares to be issued = 100,000 shares
Ratio of allotting new shares to existing shareholders = 100,000 /600,000 = 1:6 or 0.1667
This means a shareholder with 6 rights shall be entitled to purchase 1 share. Thus,
Number of rights needed to buy a share= 0.17
(ii) if right issue price is £1.60:
Number of existing shares = 600,000 shares
Number of shares to be issued = 112,500 shares
Ratio of allotting new shares to existing shareholders = 112,500/600,000 = 9:48 or 0.1875
This means a shareholder with 48 rights shall be entitled to purchase 9 shares. Thus,
Number of rights needed to buy a share= 0.1875
(iii) if right issue price is £1.40:
Number of existing shares = 600,000 shares
9

Number of shares to be issued = 128,572 shares
Ratio of allotting new shares to existing shareholders = 128,572 /600,000 = 3:14 or 0.2143
This means a shareholder with 14 rights shall be entitled to purchase 3 shares. Thus,
Number of rights needed to buy a share= 0.2143
Therefore, value of one right = (£1.90-£1.80)/6= 0.467
The form of issue for each right issue price can be determined as follows:
 For right issue price of £1.80, the number of shares that would be raised by the
company would be 1,00,000 shares. Hence, on a pro-rata basis, 1 new share will be
allotted for every 6 shares held by them (Brigham and Houston, 2012).
 For right issue price of £1.60, the number shares of that would be raised by the
company would be 1,12,500 shares. Hence, on a pro-rata basis, 9 new shares will be
allotted for every 48 shares held by them.
 For right issue price of £1.40, the number shares of that would be raised by the
company would be 128571 shares (rounded-off). Hence, on a pro-rata basis, 3 new
shares will be allotted for every 14 shares held by them.
5. Interpreting the results:
It can be concluded from the above calculations that the suggested right issue price of
£1.80 generates more Earnings Per Share (EPS) for Lexbel Plc worth $596,842 than other two
suggested issue prices with 1 share allotted to every 6 shares held by a shareholder it is
recommended to assume this price for right issue.
(b) Scrip Dividends:
As mentioned by the case, it has become common for the companies to offer their
shareholders a choice between a cash dividend and an equivalent scrip dividend (Brooks and
Mukherjee, 2013). Scrip dividends are a type of dividend payment method adopted by the
companies to pay their shareholders in form of shares instead of cash. A scrip issue and a scrip
dividend are two different concepts. Scrip dividends essentially relate to payment of dividend in
kind rather than cash whereas a scrip issue is a bonus issue of shares offered to the shareholders
of the company. The advantages and disadvantages of a scrip dividend from shareholders as well
as company's point of view have been enlisted below: Advantages of Scrip Dividend:
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1. For Shareholders: Scrip dividends helps in enhancing the shareholder's value in the
company by reducing the hassle of paying commission to middlemen such as brokers or
heavy stamp duties on purchase of new shares. This also results in maximization of
wealth for the shareholders who choose payment in kind i.e. shares instead of cash
payments. Wealth maximization here means that as value of cash goes on decreasing with
time whereas the value of shares tends to increase as the company grows and goes older
with time. Scrip dividends provide flexibility to the shareholders by giving them choice
for receiving their dividends at their own convenience (Ehrmann, Fratzscher and
Rigobon, 2011).
2. For Company: Scrip dividends are a very convenient dividend payment option for the
companies. Earlier, the companies would have to pay dividends to their shareholders in
cash. This would result in a decrease in cash reserves and surplus for the company which
could have been used for other operational purposes by it. Scrip dividends provide
flexibility to the companies by reducing pressure on their cash reserves and increasing
short-term liquidity in the organization. Apart from flexibility, scrip dividends can help
organizations save tax on their part. Disadvantages of Scrip Dividend:1. For Shareholders: Unlike companies, shareholders are liable to pay tax on their dividend
earnings regardless of the form in which these earnings are received by them. Hence,
shareholders may need to save or arrange extra cash to pay off this new tax liability
which can be a tedious task for them. In some cases, they may also have to sell of their
new shareholdings to provide for tax payments. On the other hand, the new shares
received by shareholders at current market price prevailing in the stock market. If the
market conditions are not favourable, it result in decrease in value of shares for the
shareholders.
2. For Company: Scrip Dividends only offer a choice of payment to the company's
shareholders. In both cases, though, the company has to make extra efforts to arrange for
the shares and cash to meet the needs for shareholder opting for shares and cash
respectively.
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Question 3- Investment Appraisal Techniques
A company may undertake many projects and make different types of capital budgetary
decisions in its operational life (Investment Appraisal, 2018). However, scarcity of factors of
production such as capital, labour make it difficult for the organisation to undertake every project
that comes its way. Therefore, these organisations use various Investment Appraisal techniques
such as Payback Period, Accounting rate of return, Net Present Value and Internal Rate of
Return.
Happy Meal Limited is considering purchase of new machinery costing £320000 with a
salvage value charged at 10% of the cost and depreciation at 20% under reducing balance
method (Hart and Spero, 2013). The following calculations have been done using Investment
appraisal techniques:
(a) Determination of economic feasibility of project using following investment appraisal
techniques:
The Payback Period:
One of the simplest methods used by the financiers, this method provides the total
number of years it would take for the company to create enough cash inflows to break even and
reimburse the initial investment required for a given project.
Calculation of Payback Period for Happy Meal Limited
Particulars Amount(£)
Initial Investment 320000
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Cash Inflows (per annum) (given) 105000 10500
0
10500
0
105000 105000 105000
Less: Cash Outflows (per annum)
(given)
15500 15500 15500 15500 15500 15500
Net Cash Inflows1 89500 89500 89500 89500 89500 89500
Payback Period (in years)2 3.58
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1Net Cash Inflows is the difference between Cash inflows per annum (even) and Cash Outflows
(even) per annum.
2Payback Period is calculated by dividing initial investment by net cash inflows for Happy Meal.
Recommendation:
Since Payback Period is less for recouping the initial cost incurred in purchasing the
machine, it is feasible to take invest in it.
The Accounting rate of Return:
Accounting Rate of Return or ARR is an appraisal technique that analyses the relation
between the investment required to initiate a given project and the generated expected
accounting revenues (Madura, 2011).
Calculation of Accounting rate of return for Happy Meal Limited
Particulars Amount
Initial Investment (given) 320000
Particulars Year 1 Year
2
Year 3 Year 4 Year 5 Year 6
Cash Inflows (per annum) (given) 105000 10500
0
105000 105000 105000 105000
Less: Cash Outflows (per annum) 15500 15500 15500 15500 15500 15500
Net Cash Inflows 89500 89500 89500 89500 89500 89500
Less: Depreciation2 @ 20% 57600 46080 36864 29491.
20
23592.
96
18874.3
7
Net Cash Inflows after
depreciation
31900 43420 52636 60008.
80
65907.
04
70625.6
3
Average accounting profit (= Net
Cash inflows – Average
Depreciation)
54082.9
1
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Initial Investment (given) 320000
Accounting Rate of return1 16.90
1Accounting Rate of Return is calculated by dividing Average Accounting Profit by Initial
Investment for Happy Meal.
2Depreciation has been calculated in the working notes below:
Working Notes for (ii.)
Calculation for depreciation on new machine purchased by Happy Meal Limited
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Cost of new machine 320000 230400 184320 147456 117964.
80
94371.
84
Less: Salvage Value @ 10%
(given)
32000 0 0 0 0 0
Net cost of new machine 288000 230400 184320 147456 117964.
80
94371.
84
Less: Depreciation @ 20%
(given)
57600 46080 36864 29491.
2
23592.9
6
18874.
37
Carried forward balance as cost of
machinery
230400 184320 147456 117964
.8
94371.8
4
75497.
47
Average Depreciation of new
machinery3
35417.
09
3 Average depreciation has been calculated by taking an average of six years’ depreciation
values.
Recommendation:
Since ARR is high (16.9%) for purchasing the machine, it is feasible to purchase the
machinery.
The Net Present Value:
The NPV method is the most popular among the four appraisal techniques explained in
this project. It takes into account the present value of future cash flows to ascertain the economic
feasibility of a project or investment. A discount rate is taken, usually weighted average cost of
14

capital to find the discounted cash flows of the project. NPV calculation for Happy Meal Limited
has been shown below:
Cash inflow PV factor at 12%1 Disc. Cash Flow
89500 0.892 79834
89500 0.797 71331.5
89500 0.711 63634.5
89500 0.635 56832.5
89500 0.567 50746.5
89500 0.506 45287
Discounted Cash Flow 367666
Less:- Initial investment 320000
NPV 47666
1 Cost of capital of 12% provided by the case has been taken as the discount rate to calculate
NPV.
Recommendation:
Since NPV is positive if the cost of capital of 12% is taken as the discount rate, it is
recommended that Happy Meal considers purchasing the machine.
The Internal Rate of Return (IRR):
Internal Rate of Return can be defined as the point where NPV for a given project is
equal to zero. This technique helps in checking the viability of two or more projects by providing
easy comparison among them (Sharan, 2012).
Calculation of Internal Rate of Return using the above formula:
Particulars
Initial investment 320000
Lower Discount Rate (A) 12.00%
Higher Discount Rate (B) 18.00%*
NPV at 12% discount
rate1
47666
NPV at 18% discount -41439.31
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rate2
Difference in discount
rates [(B)-(A)]
6.00%
Internal Rate of Return3 15.21%
*-The higher discount rate of 18% has been assumed by using hit-and-trial method that is
higher than 16.9% calculated using ARR Method for simpler calculations.
1 and 2: Calculations for NPVs for discount rates 12% and 18% have been shown below
in the working notes. 3IRR=A+ [(lower discount rate-higher discount rate) *{Net Present Value
(a)/ (Net present Value (a)-Net Present Value (b)}] where, a denotes lower discount rate equal to
the cost of capital of Happy Meal Limited in the case given above.
Working Notes for (iv.):
Calculation of Discounted Cash Flows and NPV under IRR when discount rate is 12%:
Cash inflow PV factor at 12% Disc. Cash Flows
89500 0.89 79834.00
89500 0.80 71331.50
89500 0.71 63634.50
89500 0.64 56832.50
89500 0.57 50746.50
89500 0.51 45287.00
Discounted Cash Flows 367666
less:- Initial investment (given) 320000
Net Present Value (a) 47666
Calculation of Discounted Cash Flows and NPV under IRR when discount rate is 18%:
Cash inflow PV factor at 18% Disc. Cash Flows
89500 0.85 75847.46
89500 0.72 64277.51
89500 0.61 54472.46
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89500 0.52 46163.10
89500 0.05 4736.53
89500 0.37 33153.62
Discounted Cash Flows 278650.69
Less:- Initial investment (given) 320000
Net Present Value (b) -41349.31
Recommendation:
Since IRR is positive if the cost of capital of 12% is taken as the discount rate, it is
recommended that Happy Meal considers purchasing the machine.
(b) Benefits and Drawbacks of various Investment Appraisal techniques:
Payback Period: Benefits: Payback period method helps the manager to take quick decisions on the basis
of payback period. Project having a low payback period has lower risk. Since the given
project has a pay-back period, it can generate cash flows faster and at a lower rate of risk
which means that in short-term, the above project will be useful for the organisation.
McKinney, 2015).
 Limitations: This method ignores the time value of money. Since capital investment is
not a one-time investing activity it requires re-investment at different rate in different
time periods. Generally, projects have different cash inflows which create some
complications to calculate payback period. Hence, choosing this project only on the basis
of payback period would not be feasible.
Accounting Rate of Return: Benefits: Just like Payback Period, ARR is easy to understand and calculate than other
capital budgeting methods (Scarborough, 2016). It uses average accounting profit and
initial investment to study the economic feasibility of a project. An ARR rate of 16.9%
shows highly feasible investment opportunity for the firm as higher ARR produces more
feasibility for an investment.
 Limitations: This method ignores the time value of money. Unlike other appraisal
techniques, ARR takes profits into consideration instead of cash flows. Different
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organisations may use different variables to calculate ARR as no organisation follows
similar accounting principles and methods. Hence, choosing this project only on the basis
of ARR Method would not be feasible.
Net Present Value: Benefits: This method considers the time value of money. To ascertain investment
feasibility for the project gives future cash flows and discounts using WACC rate, a
positive NPV of $47,666. A positive NPV for the project shows it can purchase the
machinery by Happy Meal for operational efficiency. (Moutinho, 2011).
 Limitations: Determination of discount factor can be tricky in case incomplete
information is provided to ascertain cost of capital. It may mislead the results where the
size of the project is different. Hence, NPV may differ for different rates, thus, creating
confusion or delayed decisions.
Internal Rate of Return: Benefits: This method considers the time value of money. It can help in ranking projects
in an effective manner. IRR of 15.21% has been calculated by taking 12% (WACC) and
18% as lower and higher discount rates respectively. Since IRR is high it would be viable
to buy the machinery.
 Limitations: IRR assumes positive future cash flows which is impractical. Low IRR may
anticipate a low reinvestment rate and vice versa which is not a valid assumption. Since it
requires mutually exclusive projects when comparing NPVs of two or more projects, a
percentage value for a project which is not enough to judge the feasibility of the project.
(Pearson, Zhang and Zheng, 2015).
CONCLUSION
This report takes into account different financing techniques both equity and capital
budgeting that are used by the organization to make important strategic decisions regarding
raising capital or undertaking a project. Equity finance concepts such as Right issue, scrip
dividends as well as Feasibility techniques such as NPV and IRR have been studied regarding
different companies to understand how strategies are formulated and decisions are made by
financiers in those organizations.
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