Financial Analysis: Investment Appraisal, WACC - NCC Group Report

This assignment provides a comprehensive analysis of capital investment appraisal techniques, focusing on machine selection and weighted average cost of capital (WACC) calculations. It begins with an evaluation of two alternative machine options for NCC Group Ltd., utilizing payback period, net present value (NPV), and profitability index (PI) methods to determine the most profitable investment. Despite conflicting results from different methods, the report recommends Machine A based on its higher NPV. The assignment then calculates the WACC for Jemz Corporation using the bond-yield-plus-risk-premium approach, considering debt, common equity, and preferred shares. Finally, it assesses a replacement decision for Huanzoo LLC plc, comparing the NPV of existing and new machinery, ultimately advising against the replacement due to the existing machine's higher NPV. The report also highlights additional factors for Huanzoo LLC's directors to consider before making a final decision. Desklib offers a wealth of similar solved assignments and resources for students.

Running Head: Capital Investment Appraisal
Capital Budgeting Decisions

Capital Investment Appraisal 1
Question 1: Evaluation of two alternative options of capital investments
In the present case of NCC Group Ltd., the capital budgeting decision in regards to the
acquisition of machinery is being considered. The firm has two alternative options available and
one is to be chosen on the basis of the cost benefit analysis. One option is to acquire Machine A.
The acquisition of Machine A will require an initial investment of £80,000. The economic life of
Machine A is 4 years and during its life span it will entail a net cash inflow after taxation of
£32,000 each year. The residual value of the machine will be Nil. The other option that is
available to the firm is to acquire Machine B which will cost £75,000 and will have the same
useful life as that of Machine A. However, the cash flows after tax that the Machine B will
generate will be £30,000 per year. The scrap value of this machine will also be Nil at the end of
its economic life.
To evaluate the investment in the proposed alternative options, key techniques of capital
budgeting will be used such as Net Present Value Analysis, Payback Period Analysis and the
Profitability Index.
Part a): Payback Period:
The technique of payback period will be applied before relying on the results of NPV method.
Payback period is the length of time which the project will require to cover up its cost of
investments (Drake, n.d.). It is an important criterion to decide whether the project is acceptable
or not. Generally, the project with lower payback period is accepted as it indicates that the firm
be able to recoup its initial cost in less time as compared to the project that has higher payback
period. The calculation of payback period of both the machines is shown as below:
Machine A

Capital Investment Appraisal 2
Pay-back period Initial Investment £ 80,000.00 2.50 Years
Annual cash inflows £ 32,000.00
Machine B
Pay- back period Initial Investment £ 75,000.00 2.50 Years
Annual cash inflows £ 30,000.00
Decision: In the present case, the payback period of both the machines is calculated as equal and
therefore, it will be indifferent to choose any machine over other.
Part b) Net Present Value:
The net present value of the project is the sum total of present value of all the cash flows
associated with the project (Ryan & Ryan, 2002). Under this technique, the cost of capital is to
taken into consideration to determine the present values of all the possible cash flows linked to
the project. In case of evaluation of two or more options the project that has higher NPV is
favourable to be selected as it will generate more returns for the stakeholders of the project as
compared with the option that will generate low NPV. The calculation of NPV of both the
machines under consideration, in the case of NCC group is shown below:
Machine A
Years 0 1 2 3 4
Initial Investment
-£
80,000.00

Capital Investment Appraisal 3
CFAT
£
32,000.00
£
32,000.00
£
32,000.00
£
32,000.00
PVAF @ 12% 1 0.893 0.797 0.712 0.636
PV of CFAT
-£
80,000.00
£
28,571.43
£
25,510.20
£
22,776.97
£
20,336.58
NPV
£
17,195.18
Machine B
Years 0 1 2 3 4
Initial Investment
-£
75,000.00
CFAT
£
30,000.00
£
30,000.00
£
30,000.00
£
30,000.00
PVAF @ 12% 1 0.893 0.797 0.712 0.636
PV of CFAT
-£
75,000.00
£
26,785.71
£
23,915.82
£
21,353.41
£
19,065.54
NPV
£
16,120.48

Capital Investment Appraisal 4
Decision:
In the instant case, NPV of both the machines is positive and hence both seem to be profitable.
However, the NPV of Machine A is more than that of Machine B. Therefore, from the NPV
perspective, Machine A is more profitable to be acquired than the Machine B.
Part c) Profitability Index:
The profitability index is an important measure to rank the different possible options of capital
investment. The project that has profitability index of value greater than 1 is acceptable as it
shows the present value of all the future cash flows the project is greater than the initial cost of
the project. When comparing two or more alternative capital investment options, the option that
has higher profitability index must be ranked above the projects that have lower PI. Ultimately,
that project must be selected which has highest PI. The calculation of profitability index of both
the machines is shown below:
Profitability Index= NPV+ Initial Investment
Initial Investment
(Peterson & Fabozzi, 2002).
Machine A £ 97,195.18
£ 80,000.00
1.21
Machine B £ 91,120.48

Capital Investment Appraisal 5
£ 75,000.00
1.21
Decision:
The profitability index of both the options under consideration is found to be equal and it is not
possible to rank any of the machines above or below the other machine. The PI of 1.21 shows
that investment in both the machines is profitable because of higher present values of future cash
flows of the project than its cost of initial investment (Bennouna, Meredith & Marchant, 2010).
Part d)
The above calculations have shown that both the investment options are equally beneficial from
the point of view of payback period and profitability index. However, since only one machine is
to be selected by NCC group, it be recommended to select Machine A over Machine B as it has
higher Net present value and therefore has the higher return potential. The higher NPV of
Machine A shows that it will be more profitable than Machine B.
Question 2: Calculation of Weighted Average Cost of Capital (WACC)
Using Bond-Yield-plus-Risk-Premium approach
Items
Proport
ion Calculation Rates
Weighted
Rates
Debt 50% Working Note: 1 4.03% 2.02%
Common Equity 46% Working Note: 2 9.8% 4.51%

Capital Investment Appraisal 6
Preference Shares 4% Working Note: 3 7.63% 0.31%
Weighted
Average Cost of
Capital (Frank,
& Goyal, 2009. 6.83%
Workings:
1
After Tax cost of
debt=
Before Tax Cost of Debt (1-Tax Rate) (Brigham & Houston,
2012).
6.50 (1-0.38)
=4.03%
2 Cost of Equity As per Bond yield risk premium approach
Kd + Rp (Truong, Partington & Peat, 2008).
Kd= Cost of debt before tax
Rp= Risk Premium
=6.50% + 3.30%
=9.80%
3
Cost of
preference shares
Annual preferred dividend/ Preferred stock net offering price
(Ross, Jaffe & Westerfield, 2008).
$ 1.35/ $ 17.7

Capital Investment Appraisal 7
=7.63%
Therefore, as per bond yield plus risk premium approach, the WACC of Jemz Corporation is
6.83%.
Question 3: Evaluation of a Replacement Decision:
Part a)
Introduction:
In the present case of Huanzoo LLC plc, the replacement decision is being considered by the
firm for the usage of machinery in its business. The firm is proposing to replace its existing
machinery with a new one in order to manufacture the goods more effectively and efficiently so
as to increase the overall profitability of the project. At the current date, the firm has two options
available with it and it has to select one among the two alternatives for the subsequent period of
five years. Replacement decisions are the key decisions under capital budgeting function of
financial management studies. These decisions involves selection of one alternative option over
other because of its potential to generate more returns and low risk involvement in the same.
Under such decisions, the firm has two or more than options to consider. One is the analysis of
continuation of the existing machine, unit or product and the other is to dispose the existing
machine, unit or product and to take up new machine or unit for the further periods.

Capital Investment Appraisal 8
Replacement decision evaluation using capital budgeting technique:
In the present case of Huanzoo LLC plc, the existing machinery in use in the business has
already been acquired few years back and hence its cost of acquisition is irrelevant for the
evaluation purpose. However, the cost of acquisition of new machinery is relevant as it is yet to
be incurred in case of its acceptance. If the option of investment in the new machinery is
accepted then the old machinery will be sold at the start of 1st year and hence the proceeds from
its sale in the market will be adjusted from the cost of acquisition of new machinery.
If the new machinery is implemented in the business, it will result in increased production and
therefore the volume of sales units will also be increased. However, more units of products can
only be sold in the market at the reduced selling price. Therefore, the price of the product dealt
by Huanzoo LLC will be reduced from £10.50 per product to £8.70 per product unit. The new
machinery will increase the overall sales of the business. Also, the production cost per unit of
production will be reduced as a result of acquisition and implementation of new machinery.
Since the production cost does not involve depreciation expense and no tax rate is given in the
case, it will be assumed that the firm is enjoying the benefit of tax exemption. Therefore, no
treatment of depreciation expense on the new machinery will be given. It will also be assumed
that the scrape value of existing machinery will be realised in full i.e. at £35,000.
The individual evaluation of both the options under consideration is undertaken separately rather
than adopting the incremental cash flow approach. The net present value method is used to
identify the worthiness of both the machines. From the calculation it is found that NPV of cash
flows from existing machinery is higher than that of new machinery. This indicates that the firm
must continue its operations with the existing machine and should not acquire the new

Capital Investment Appraisal 9
machinery. Though the investment in new machine will increase the profitability of the business
but the cash flows will decrease due to the incurrence of cost of acquisition of the new
machinery. The calculation of separate NPVs of the machines is shown below:
Existing
Machine
Years 1 2 3 4 5
Sales
£
5,250,00
0.00
£
5,775,00
0.00
£
6,300,00
0.00
£
7,350,00
0.00
£
8,925,00
0.00
Less: Production
£
4,081,00
0.00
£
4,081,00
0.00
£
4,697,00
0.00
£
5,544,00
0.00
£
6,237,00
0.00
Net Profit
£
1,169,00
0.00
£
1,694,00
0.00
£
1,603,00
0.00
£
1,806,00
0.00
£
2,688,00
0.00
Add: Scrap
Value
£
22,000.0
0
Total Cash
Flows
£
1,169,00
0.00
£
1,694,00
0.00
£
1,603,00
0.00
£
1,806,00
0.00
£
2,710,00
0.00
PVAF @ 11% 0.901 0.812 0.731 0.659 0.593
Present Value of £ £ £ £ £

Capital Investment Appraisal 10
Cash Flows
1,053,15
3.15
1,374,88
8.40
1,172,09
9.78
1,189,66
8.14
1,608,25
3.10
NPV
£
6,398,06
2.58
New Machine
Years 0 1 2 3 4 5
Initial
Investment
-£
1,215,000.00
Sales
£
5,655,00
0.00
£
6,264,00
0.00
£
6,960,00
0.00
£
8,091,00
0.00
£
9,135,00
0.00
Less: Production
£
4,284,00
0.00
£
4,473,00
0.00
£
5,229,00
0.00
£
5,859,00
0.00
£
6,300,00
0.00
Net Profit
£
1,371,00
0.00
£
1,791,00
0.00
£
1,731,00
0.00
£
2,232,00
0.00
£
2,835,00
0.00
Add: Scrap
Value
£
170,000.
00
Total Cash
Flows
£
1,371,00
£
1,791,00
£
1,731,00
£
2,232,00
£
3,005,00

Capital Investment Appraisal 11
0.00 0.00 0.00 0.00 0.00
PVAF @ 11% 0.901 0.812 0.731 0.659 0.593
Present Value of
Cash Flows
-£
1,215,000.00
£
1,235,13
5.14
£
1,453,61
5.78
£
1,265,69
2.28
£
1,470,28
7.53
£
1,783,32
1.24
NPV
£
5,993,051.97
Conclusion:
From the above analysis, it can be concluded that Huanzoo LLC must not accept the proposed
investment option as it will not enhance its overall cash flows. Rather, the firm must continue its
manufacturing with the old machinery as it will offer higher returns to the stakeholders of the
business since no further investment is required in its acquisition or modification.
Part b)
Further matters that the directors of Huanzoo LLC must take into account before deciding about
the replacement decision are as follows:
 The directors must also consider the payback period of the both the investment options to
determine the length of time each machine will take to recover its cost of investment.
 The firm must also consider the internal rate of return and accounting rate of return of
both the projects before taking the ultimate decision as these rates suggests the return
potential of the projects.