Fundamentals of Finance and Accounting

FUNDAMENTAL OF FINANCE

Introduction
Project evaluation is one of the key management process of an entity for various reasons, the
chief being the huge investments and the resources involved, and the fact that the
organisation does not has an option to reverse the decision once taken (Berman, Knight and
Case, 2013). The aim of the following report is to guide the entity Chowkidar Plc regarding
the suitability of the two mutually project proposals before the entity. The report would shed
light on the varied aspects of the project evaluation such as the cost of capital to be used,
elaboration of the appraisal techniques for the evaluation of the projects, the potential issues
in the techniques and the recommendation for the future course of action.
Weighted Average Cost of Capital
Weighted Average Cost of Capital denotes the collective average cost of different sources of
finance in the entity that are the debt, equity shares, mezzanine financing (Ross, et. al, 2014).
In the scenario in the consideration, the management of the entity desires to maintain the
book value weights in the capital structure, and hence the book value weights have been used
for the computation of the cost of capital. The weighted average cost of capital has been
computed as follows.
In the first step, the individual cost for the individual sources of finance has been calculated,
as depicted below. The formula used for the cost of equity is the Gordon’s Growth Model.
Calculation of cost of equity
Ke (Cost of equity ) = (D *(1 + g))/ P + g
Where,
D = Dividend last paid
G = Growth Rate
P = Current market price
G = 4.55%
Ke (Cost of equity ) = ((0.14*(1 + 4.55%)) /100) + 4.55%
Ke (Cost of equity ) = 4.6964%
Ke = 4.70%

The formula for yield to maturity has been used to compute the cost of capital as listed below.
Calculation of cost of debt
Coupon per bond (C) = 4%
Coupon per bond (C) = 4.00
Face Value of Bond (FV) = 100
t = 7
Market Price (PV) = 91.5
Kd = (4 + ((100-91.50)/7))/((100+91.50)/2)
Kd = 0.054457292
Kd = 5.45%
Kd (after tax) = 4.41%
Thus, the combined cost of capital on the basis of the book value weights has been calculated
as follows.
Computation of WACC
Ratio of bonds = 0.59
Ratio of mezzanine finance = 0.4
Ratio of equity = 0.1
Cost of Equity = 4.70%
Cost of Debt = 4.41%
Cost of Mezzanine Finance = 8%
WACC = 3.93%
In contrast to this, the cost of mezzanine financing is 8% which is much higher than the
overall weighted average cost of capital which is 3.93%. In the opinion of the Chief
Accountant of the company, weighted average cost of capital is more suitable, in contrast to
the views of the Chairman of the entity. Indeed, the weighted average cost of capital is the
appropriate cost for the evaluation of the proposal of the entity. This is because, though the
project would be solely financed by the Mezzanine financing, the inclusion of more of

mezzanine financing would lead to significant impact on the overall cost of capital and the
risk profile of the entity as a whole (Brigham and Houston, 2012).
Comparative evaluation of the projects
The comparative evaluation of the projects has been carried out using the technique of the
Net Present Value Method. The reason for the choice of the said method is the superiority of
the technique over the other methods. The prime benefit of the NPV technique is that the
technique makes use of the very important concept of the time value of money. The technique
considers the varied cash flows that would arise out of a proposal in the future years
(Bierman Jr and Smidt, 2012). The said cash flows are then discounted with an appropriate
discounting rate to arrive at the present values. The present values of the cash outflows are
then compared with the present values of the cash inflows. The formula for the calculation is
expressed as follows.
NPV = ∑
i=1
n CFi
(1+ d)i = CF0 + CF1
(1+k )1 + CF 2
(1+k )2 + …. + CF3
(1+k )3
where:
k = Rate of discounting
CFi = net cash flow from year 1,
CF0 = Initial amount of the investment in thr project
n = number of years
If the net present value is calculated to be positive, the proposal should be accepted. In the
case of the mutually exclusive projects, the one with the higher Net Present Values is selected
over the others (Goyat and Nain, 2016). It must be essentially noted that a positive higher Net
Present Value is descriptive of the profits out of a project after covering the initial
investments and the expenses from the operation of the proposal.
On the comparative evaluation of the proposals, following observations are noteworthy. The
NPV of the Option 1 that is the introduction of the new product for the low key markets has
been computed to be 5903683.28. In contrast to this, the NPV of the option 2 that is the
expansion of the existing product line has been computed to be 39651249.67. Thus, as

evident the NPV of the second option is lesser than that of the Option 1. The details of the
calculations are provided in the appendix of the project report.
Explanation of the treatment of some of the significant costs in the above evaluation has been
provided as follows. The costs have been divided into three categories namely the initial
investments, the annual cash flows and the terminal cash flows. The research and
development cost has not been taken into consideration for the evaluation as the same fall in
the category of the sunk costs. The sunk costs are the ones that do not impact the cash flows
of the projects (Gὂtze, Northcott and Schuster, 2015). Irrespective of the selection of the
project, the said cost had to be incurred, and hence the same are ignored in the evaluation.
The negative impact on the revenues of the Eagle Eye’s sales has been considered as the
same is an opportunity loss. In simple words an opportunity cost is the cost of leaving one
option and accepting the other (Moran, 2015). The depreciation has been added back to arrive
at the annual cash flows as the said expenditure does not involves a cash outflow.
Comparison of the techniques
It is essential to note that the technique preferred for the evaluation of the project is the NPV
because of various factors elaborated in the previous parts. However, for the evaluation
purposes the techniques of the Internal Rate of Return and the Cash Payback Period have also
been explored. Accordingly, the IRRs of the option 1 and the option 2 has been worked out to
be 6.22 % and 33% respectively. The cash payback periods of the option 1 and the option 2 is
calculated to be 5.73 years and 2 years respectively. However, each of the technique has its
own share of the issues as listed below.
The NPV technique is complicated and requires technical expertise to perform the
calculations, estimate the cash flows based on the external market conditions. It is
additionally time consuming technique. Further, the most complex element in the technique is
the determination of a suitable discounting rate (Nurullah and Kengatharan, 2015). For
instance, as in the opinion of Chairman 8% discount rate is more suitable, and in the opinion
of the senior accountant, the WACC is more suitable. If the rate of 8% is used for the project
evaluation, the Option 2 is better than the Option 1. Thus, the choice of the discounting rate is
the most crucial aspect of the efficient operation of the NPV method.
In contrast to the above, though the IRR and the Cash Payback Periods are easier to perform
once the cash flows are determined but do not have superior results (Rὂhrich, 2014). The

cash payback periods does not considers the time value of money which is practically
impossible scenario in the real life settings where a Euro today is of more worth than the
Euro to be received tomorrow because of the ability of the interest earning (Pogue, 2010).
Additionally, the IRR does not gives the result in absolute terms (Tulvinschi, 2014). Also, the
significant issue is that a proposal can have multiple IRRs (Scott, 2012).
Recommendations and Conclusion
As per the analysis conducted in the previous parts, it is recommended to opt for the option 1,
based on the cost of capital of WACC. Some of the other factors that the management of the
entity may wish to consider are the political, economic, technological environment and the
sociological changes in relation to the demand of the products. Further, the impact on the
internal resources of the entity that are the requirement or the availability of the management
personnel, infrastructure must also be considered.

References
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Manager's Guide to Knowing What the Numbers Really Mean. Boston: Harvard Business
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Bierman Jr, H., and Smidt, S. (2012) The capital budgeting decision: economic analysis of
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Brigham, E. F., and Houston, J. F. (2012) Fundamentals of Financial Management. Boston
MA: Cengage Learning.
Goyat, S., and Nain, A. (2016) Methods of Evaluating Investment Proposals. International
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Moran, A. (2015) Managing Agile. Strategy, Implementation, Organisation and People. New
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Nurullah, M., and Kengatharan, L. (2015) Capital budgeting practices: evidence from Sri
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Scott, P. (2012) Accounting for Business: An Integrated Print and Online Solution. Oxford:
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