Strategic Financial Management: Capital Budgeting Techniques and Financing Sources

This report provides an analysis of capital budgeting techniques for two investment projects, along with an evaluation of financing sources. The projects, Project Aspire and Project Wolf, are assessed using net present value (NPV), internal rate of return (IRR), and payback period. The report also considers qualitative factors and discusses the pros and cons of debt and equity financing.

STRATEGIC FINANCIAL
MANAGEMENT
STUDENT ID
[Pick the date]

TABLE OF CONTENTS
Introduction 1
Capital Budgeting Techniques 2
Project Aspire 2
Project Wolf 4
Detailed Analysis 6
Finance Sources – Debt & Equity 8
Conclusion 11
REFERENCES 12
APPENDIX 1 14
1

Introduction
Based on the given facts, there are two investment proposals for the company (AYR Co) so
as to enhance the value of the company. These two projects are named project Wolf and
project Aspire. market research for both these projects has already been conducted by the
company and based on the information available capital budgeting analysis needs to be
performed based on which the company can take a decision with regards to choosing a
superior project. it is imperative to note that the superior project would not be selected only
on the basis of quantitative parameters but qualitative parameters would also be considered.
the aim of the given report is to present an analysis of the given projects using the various
Tools and techniques of capital budgeting along with relevant qualitative aspects. Alongside,
the report food also focus on the various means of Financing that may be availed with
emphasis on the respective merits and demerits.
Capital Budgeting Techniques
for the application of appropriate capital budgeting techniques, the vital first step is to
estimate the post-tax incremental cash flows that are expected to arise from each of these
projects over the respective useful lives.
Project Aspire
A pivotal information with regards to the project is that the company has spent $120,000 on
market research which would be categorised as sunk cost as irrespective of the project
decision this particular cost cannot be recovered by the company. Since this cost is labelled
as sunk cost and it would not be considered as part of the incremental cash flows arising from
the project (Damodaran, 2015).
Taking into consideration the relevant information available, it is evident that the useful life
for the project is five years. The initial capital expenditure for the project is expected to be
$2.25 million which would be incurred primarily for plant and machinery acquisition.
Besides, there would be requirement of incremental working capital to the tune of $140,000.
This incremental working capital used for the project would be fully recovered at the end of
the project. The plant and machinery purchased at the start of the project are expected to have
a salvage value of $375,000 at the end of 5 years.
The annual depreciation expense needs to be computed despite being a non-cash expense as
it leads to lowering of pre-tax income and hence acts as a tax shield.
2

On the basis of the market research conducted, it can be concluded that the project which
generate incremental sales for which incremental variable cost would also be undertaken and
the precise estimates are available for the same. On account of the capital expenditure that
the company would undertake for the project, it would obtain tax benefits in the form of
capital allowances which would provide tax shield and thereby lower the tax outflow on any
incremental profit that are generated from the project. A noteworthy feature about the project
is that the tax payment would occur in arrears which imply that the tax on Profit generated in
a given year would be paid the next year.
The incremental cash flow generated from the project are highlighted in Appendix 1. The
following capital budgeting techniques would be applied taking into consideration the
incremental cash flows expected to be generated from the project as shown below.
Net Present Value (NPV)
NPV is defined as the total sum of present value of the incremental cash flows that are
expected to be generated from a given project during the useful life (Parrino and Kidwell,
2014). A relevant input required for computation of NPV is discount rate which is important
considering the fact that NPV takes the time value of money into consideration. The discount
rate for the given project is given as 10%. The NPV computation is summarised in the
tabular manner as shown below.
3

Based on the computation conducted above it is apparent that the NPV for the given project is
$ 1,842,091.
Internal Rate of Return (IRR)
The discount rate which leads to the NPV value of zero is known as IRR (Arnold, 2015). The
IRR computation has been carried out in the table shown below.
The computation carried out below clearly highlights the IRR as 37.12%
Payback Period
The payback period is defined as the necessary time which is required for recovery of the
initial investment. In the context of the given project the initial investment would comprise of
capital expenditure in the form of plant and machinery along with working capital which is
necessary for production of final goods. The payback period computation is summarised
through the use of the following table (Northington, 2015).
Project Wolf
Based on the information obtained from the market research, it is apparent that the initial
investment for the given project would amount to $ 2.25 million. However, for this project no
capital allowances are available. For this project, any assets that have resulted in the initial
4

outlay have zero salvage value at the end of five years. The first objective is to estimate post-
tax incremental cashflows on the basis of the information provided.
Further, for the project under consideration, an opportunity cost would be incurred on an
annual basis since the company would have to lose the rental income it is currently earning as
the premises would be used by the company for the project (Berk et. al., 2013).
The incremental cash flow generated from the project are highlighted in Appendix 1. The
following capital budgeting techniques would be applied taking into consideration the
incremental cash flows expected to be generated from the project as shown below.
Net Present Value (NPV)
NPV is defined as the total sum of present value of the incremental cash flows that are
expected to be generated from a given project during the useful life (Parrino and Kidwell,
2014). A relevant input required for computation of NPV is discount rate which is important
considering the fact that NPV takes the time value of money into consideration. The discount
rate for the given project is given as 10%. The NPV computation is summarised in the
tabular manner as shown below.
Internal Rate of Return (IRR)
The discount rate which leads to the NPV value of zero is known as IRR (Arnold, 2015). The
IRR computation has been carried out in the table shown below.
5

The computation carried out below clearly highlights the IRR as 21.80%
.Payback Period
The payback period is defined as the necessary time which is required for recovery of the
initial investment. The payback period computation is summarised through the use of the
following table (Lasher, 2017).
Detailed Analysis
(i) For each of the two projects under consideration, the initial investment is the same and
since the company can fund only one of the two projects, the given situation makes the
projects as mutually exclusive. Under the given situation, the superior project ought to be
selected based on the result of the application of the various capital budgeting techniques.
These computations lead to the conclusion that the superior project is Aspire instead of
Wolf as all the capital budgeting techniques seem to favour the former over the latter
(Brealey, Myers and Allen, 2014).
(ii) A detailed explanation of the superiority of the various key parameters is offered
below.
NPV – With regards to NPV, the feasibility of the project is linked to the positive value of
NPV. A project with positive NPV is expected to increase the firm value and thereby prove
6

beneficial for the shareholders. For the projects under evaluation, the NPV is positive and
therefore each of the projects is financially viable. However, owing to the requirement of
choosing the superior project, Aspire would be the preferred bet since a higher NPV is
registered for this project as compared to Wolf (Kane and Marcus, 2013).
IRR – The underlying requirement for a financially feasible project is that the cost of capital
must be lower than the corresponding IRR. This would ensure wealth creation for the
shareholders. In the case of both the projects under consideration, the respective IRR is
higher than 10% which implies that feasibility is evident for the two projects. But since the
company can implement only one project, hence Aspire would be a preferred bet as its IRR
value tends to be greater than Wolf (Northington, 2015).
Payback Period – The financial feasibility of a project is established when the computed
payback period tends to be lesser than the project life. Considering for that the project life for
the two projects is five years and the respective payback periods are smaller, it is apparent
that the two projects have been successful is establishing their financial feasibility. But since
the company can implement only one project, hence Aspire would be a preferred bet as the
payback period for the same is lesser than payback period for Wolf (Gitman, Juchaou, and
Flanagan, 2017).
(iii) On the part of the company, it is critical that the investment decision must give
appropriate weight to the qualitative parameters associated with the evaluation. These are
highlighted below (Graham and Smart,2012).
1) Project scope is one of the key aspects that ought to be considered. Under Aspire, the main
focus of the company would be the existing customers as the company would launch new
products which are related to the current product offerings. Thus, the value generation
from this project would be on the basis of higher revenue generation from each customer
rather than targeting new customers. The scope of Wolf is quite different considering that
it would target new customers since a new business would be started whose target segment
would be separate. Hence, from strategic significance, Wold project would have a edge as
it would open immense cross sale opportunities along with ensuring business
diversification which is considered a healthy risk management practice. Hence,
implementation of Wolf project would ensure that there is a natural hedge to any downside
in the existing business. Therefore, from a strategic perspective, the superior project would
be Wolf and not Aspire.
7

2) Yet another crucial aspect is the strategy adopted by the competitor coupled with evolving
market trends. Strategic planning typically requires decisions that are driven by long term
vision and responding to structural changes in the market in a proactive manner. The
future of the current business 5-7 years down the line ought to be considered along with
the possible strategy of the peers before deciding whether business diversification is
required or not. Businesses where technology tends to play a critical role are prime
examples of such businesses (Brealey, Myers and Allen, 2014).
Based on the discussion carried out above, it seems that on account of qualitative aspects, the
superior choice would be Wolf considering that it would result in business diversification and
aid in risk management. However, on account of the qualitative aspects, Aspire scores over
Wolf. As a result, it is imperative that the relevant decision makers must accord relevant
significance to both the aspects and take a decision based on the respective weights and
priority given to the two factors (Ehrhardt and Brigham, 2016).
Finance Sources – Debt & Equity
(i) Two most prominent financing options available to businesses are debt and equity. In case
of debt based financing, there is raising of debt which needs to be repaid besides making
interest payments periodically (Damodaran, 2015). In case of equity based financing, the
finance is sharing by the issuance of equity shares or by selling ownership of the
underlying business. As consideration is provided in the form of ownership, hence the
money raised through this means need not be repaid and no interest is levied (Arnold,
2015). The obvious issue with regards to equity based financing is that promoters may
lose control. With the issue of debt also risk is associated in the form of potential credit
default and hence for each of the two financing sources there are potential pros and cons
(Christensen et. al., 2013).
(ii) From the perspective of a lender, interest payments would provide the returns as this
is the extra money received over and above the principal repayment. The returns
realisation for equity investors differs significantly as return may be in the form of
dividend receipt or appreciation of capital
8

This is quite different from investors of equity where the returns tend to be realised as two
main modes i.e. receipt of dividend and capital appreciation of the share value owing to
increase in the firm value. A key difference is that there is no assurance of dividend payment
unlike interest payments which are assured (Northington, 2015).
The cost of financing associated to each means is linked to the underlying risk associated
with each of the two sources. In accordance to the portfolio theory, for investments having a
higher risk, the issuers typically tend to provide higher returns as an incentive to find
interested investors. For equity investors, the underlying risk is higher as the amount
provided is not returned and also there is no assurance for any capital appreciation or
dividend payment from the company. In case of failure of business, liquidation proceeds are
also not received by equity investors as they are last on the priority list (Brealey, Myers and
Allen, 2014). The higher risk implies that equity investors would desire a higher return than
corresponding debt investors as the latter tend to assume lower risk than the former (Brigham
and Houston, 2014).
In case of lenders, the repayment of debt is usually guaranteed owing to the existence of a
collateral which may be liquidated for recovery of debt if the company fails to relay the same.
Also, in liquidation cases also, the priority given to lenders is higher than equity investors
which imply greater chances for recovery of outstanding debt repayments and interest
payments outstanding. The lenders also have the option to recall debt in case of breach of any
debt covenant (Ehrhardt and Brigham, 2016).
Based on the above discussion, it can be concluded that risk for equity investors is
considerably higher than corresponding debt providers and hence the former expect a higher
returns than the latter.
(iii) It is apparent that the WACC for the given firm is 10%. Further, the current capital
structure preferred by the company comprises primarily of equity with less contribution
from debt.. In order to raise the incremental fund requirement, the company has the
following choices.
.
Equity financing (100%) – In this case, no debt funding is used and finance cost is higher
considering the equity is more expensive than debt owing to higher risk associated. The
9

viability of the chosen project would undergo an adverse impact owing to higher WACC.
Based on the above, this financing means is not appropriate choice (Berk et. al., 2013).
Debt financing (100%) – In this financing choice, the obvious advantage would be lower cost
but there would be quite high interest payment that would have to be regularly paid. Also, the
balance sheet may become overleveraged and hence this option ought to be avoided (Murray
and Goyal, 2008).
Considering the above choices, it makes sense for the company to opt for the mix of debt and
equity in the same proportion which it exists currently which would yield a WACC of 10%
for the project.
(iv) Various stakeholders would be impacted by the financing choice exhibited by the
company as has been highlighted below.
Equity Financing – In this, there would be dilution of equity shares for the existing
shareholders. Besides, higher shares outstanding could lead to lower EPS especially as there
may be a time lag in generation of incremental earnings on account of the project. Further, if
the project related earnings are not realised then the shareholders wealth would be adversely
impacted (Lasher, 2017). Excessive dilution could lead to loss of control by the promoters
thereby having adverse impact on the realisation of long term goals for the business. Also, a
higher WACC would lead to incremental risk for the project. Equity financing would be
considered as positive for the debtors of the company as it would leave to lower financial risk
and encourage overall deleveraging of the balance sheet thereby reducing the risk of default
(Brealey, Myers and Allen, 2014).
Debt Financing – There is regular payment of debt which would lower the profits and hence
adversely impact the EPS and potentially the share price especially if the incremental
earnings expected from the project are not realised as per expectations (Christensen et. al.,
2013). The issuance of debt would lower the WACC and hence would serve the interests of
the shareholders if the balance sheet is not over-leveraged. The taking of extra debt would be
negative for the lenders as the ability of the company to service the debt of existing lenders
may suffer owing to incremental interest commitments and repayments to be made (Kane and
Marcus, 2013).
10

The above discussion clearly brings forth the futility of excessive reliance on any one means
of financing and instead opting for a healthy mix of the two sources taking into considering
the current balance sheet strength and debt servicing ability of the company
Conclusion
On account of the analysis conducted in previous sections, it is apparent that capital
budgeting techniques tend to favour the Aspire project but the qualitative parameters tend to
favour Wolf project. The final decision needs to be taken by providing the requisite
weightage to both factors considering the current & future priority. In the context of raising
finance, both debt and equity have their advantages and limitations and thereby it is best for
the stakeholders as a whole that a healthy mix of the two is preferred for project funding.
11

REFERENCES
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times
Management.
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2013) Fundamentals
of corporate finance, London: Pearson Higher Education
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill Inc.
Brigham, E. F. and Houston, J. F., (2014). .Fundamentals of Financial Management, 4th ed.
Boston: Cengage Learning.
Christensen, M, Drew, M, Blanchi, R . and Ross, S. (2013), Fundamentals of Corporate
Finance, 6th ed., New York: McGraw Hill
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Ehrhardt, M. C. and Brigham, E. F. (2016) Corporate Finance: A Focused Approach. 6th ed.
London: South- Western College Publisher
Gitman, L.J., Juchaou, R., and Flanagan, J. (2017).Principles of Managerial Finance, 3rd ed.
NSW: Pearson Australia
Graham, J. and Smart, S. (2012), Introduction to corporate finance, 5th ed., Sydney: South-
Western Cengage Learning
Kane, B.Z. and Marcus, A.J. (2013) Essentials of Investment, 9th ed, Singapore: McGraw-Hill
International
Lasher, W. R., (2017) Practical Financial Management 5th ed. London: South- Western
College Publisher.
Murray F. and Goyal, V.K. (2008), Tradeoff and pecking order theories of debt, Handbook of
Corporate Finance: empirical corporate finance, Volume 2, No.1 , pp. 135‐202
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
12

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H.
(2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson
Education, French Forest Australia
13

APPENDIX 1
Project Aspire Cashflows
Project Wolf Cashflows
14