Strategic Financial Management
Info: 5584 words (22 pages) Essay
Published: 23rd Sep 2019 in
Accounting
Strategic Financial Management
Executive Summary
The AYR Co. and its Board of Directors’ have requested useful information about two investment opportunities that are currently available to them, namely; Project Wolf and Project Aspire. To provide this information in a way that is both useful and efficient, this report uses a number of Capital budgeting techniques have been utilized to ensure confidence in the information and recommendations provided. Thinking proactively, recommendations have not only been made about which project is to be selected, instead it has also been made about what factors should be prioritized and looked for when looking at future investment opportunities. Lastly, this report takes a look at appropriate choices for sources of funds, cost of capital and the overall impact placed on the weighted average cost of capital for AYR Co.
Table of Contents
Introduction
The Aspire and Wolf projects are investment opportunities currently being evaluated by the AYR Co. and its Board of Directors. They are seeking to unearth sufficient and adequate information which will guide the selection of one project versus the next. This evidence it is assumed will be gained from assessing the Capital budgeting techniques; net present value, payback period and internal rate of return given the understanding of current budgetary constraints.
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Find out moreThough similar in some ways, each project is unique and differs in various ways. Project Wolf will seek to provide a new direction by appealing to a new group of customers, whilst project Aspire will build on the current product range and aims to appeal to both current and potential customers (Abdullah & Said, 2017).
As one would expect based on the magnitude of the decision, the Board of Directors are expecting as much details as they can get about which project is recommended and the reasons why it is recommended versus the next. They would also love to understand what factors of the decision process they can utilize in similar instances for future projects using the capital budgeting techniques. Most importantly the Board of Directors would also like advice on the sources of funds, debt or equity to be chosen for the funding of project wolf or aspire when selected (Boghossian, 2017).
Question No.1
Answer
Before going into the detailed calculation, it is better to have a brief idea on the three of the Capital Budgeting Techniques, naming Net Present Value, Internal rate of Return and Payback Period, which have been discussed below:
Net Present Value
It is the method of capital budgeting in which at first the future cash inflows to be generated in the project are estimated, thereafter this future values of cash inflows are discounted at a rate to arrive at the present value of future Cash inflows from which the present value of cash outflow, that is the value of investment proposed to be made in present is subtracted to get the Net present Value of the project. If the value derived is positive, then it is recommended to select the project otherwise not.
Internal rate of Return
It is the rate of return at which the net present value of the project is zero or in other words it is the rate at which present value of cash inflow is equal to the present value of cash inflows. The reason behind calling it the internal rate of return is because it doesn’t consider the external factors like inflation etc. while determining the rate of return (Cayon, et al., 2017).
Payback period
Under this method without taking into the time value of money in to the consideration, it tries to calculate the period which is required to recover the initial capital investment proposed to be made in a specific project. It does not consider the cash inflows generated after the payback period (Charles H, et al., 2015).
 Computation of NPV of the Project Aspire
=Present value of cash inflow Present value of cash outflow
=$818000/ (1.1) ^1+$698000/ (1.1) ^2+$677997/ (1.1) ^3+$667309/ (1.1) ^4+$653507/ (1.1) ^5+$140000/ (1.1) ^5+$375000/ (1.1) ^5$140000$2250000
=$3011487$2390000
=$621487
 Computation of NPV of the Project Wolf
= Present value of cash inflow Present value of cash outflow
=$83300/(1.1)^1+$648700/(1.1)^2+$647511/(1.1)^3+$646524/(1.1)^4+$645461/(1.1)^5$2250000$75000/(1.1)^175000/(1.1)^275000/(1.1)^375000/(1.1)^475000/(1.1)^5
=$2622238$2534309
=$87929
 Computation of internal rate of return of Project Aspire
Internal rate of return of the project is that rate at which present value of cash inflow is equal to present value of cash outflow
Froom the above,
10%=$621487, Rate 1 = 10%, NPV1
X% =$2390000
Taking discount rate 20%, Rate 2
NPV 2=$39616
IRR= Rate 1+NPV 1(Rate 2 Rate 1)/NPV1NPV2
=10%+$621487(20%10%)/$621487($39616)
=10%+$62148.7/$661103
=10%+9.40%
=19.40%
 Computation of internal rate of return of Project Wolf
From the above,
Rate 1=10%=$87929(NPV1)
Rate2 (taken 20%)
NPV = $383742
IRR= Rate 1+NPV 1(Rate 2 Rate 1)/NPV1NPV2
=10%+$87929(20%10%)/$87929($383742)
=10%+$8792.9/$471671
=10%+1.86%
=11.86%
 Payback period for the project Aspire
Total initial investment = $2390000
Year 
Cash inflows 
Cumulative cash inflows 
1 
818000 
818000 
2 
698000 
1516000 
3 
677997 
2193997 
4 
667309 
2861306 
5 
1168507 
4029813

Payback period =3 years+23900002193997/667309*12
= 3.29 Years
 Payback period for the project Wolf
Total initial investment= $22500000
Year 
Cash inflows 
Cumulative cash inflows 
1 
818000 
818000 
2 
698000 
1516000 
3 
677997 
2193997 
4 
667309 
2861306 
5 
1168507 
4029813

Pay Back Period= 3 yerars+22500002193997/667309
=3.08 Years
Question No. 2
Answer
Analysis and evaluation of investment project
 A recommendation on which project to undertake
On the basis of the above detailed calculation as we can see that the NPV of Project Aspire is greater than the project Wolf, similarly the Internal Rate of Return of Project Aspire and Project wolf both the projects are greater than the cost of capital or the weighted average cost of capital of the company, but IRR in case of Project Aspire is much higher than the IRR of Project Wolf, though using payback period we can see that the payback period of Project Aspire is higher than the project wolf, but still we would recommend the selection of the Project Aspire in the given case (Cundill, et al., 2017).
 Justification for our recommendation including an evaluation of the investment appraisal techniques used in 1 above
In this case we need to compare amongst the three capital budgeting techniques used above that which one is to be based while making our recommendation in i above.
Through the Net present value technique, it becomes possible to discount each cash flow separately, it is preferable in those cases when the project’s discount rate is also not known. Though in most of the cases both NPV and IRR are much widely used techniques, but at times they may provide different results in the scenario when there are variations found in the estimated cash inflows, cash outflows and in the duration of the project (Johan, 2018). At the same time the IRR technique doesn’t consider the impact of external factors on the discount rate being chosen. Truly speaking IRR doesn’t provide the absolute value, rather it is expressed in terms of certain percentage at which the company shall neither make profit nor loss. Hence, it makes the decisionmaking process rather complicated. At the same time NPV presents the surplus or deficit (if negative) generated from the project.
The payback period method is associated with the greatest weakness of not considering the Time value of money factor, hence it shall not be recommended to reach to a decision based on the result obtained using this technique. It even does not take into consideration the cash flows generated beyond the payback back period (Vieira, et al., 2017).
Hence in the given case from the above analysis it is quite clear that the use of Net present value techniques has much more preference over the other two techniques, hence our recommendation has been based on result obtained through NPV technique (Kang, et al., 2016).
 A summary of other factors that should be considered and information that may be needed prior to make a final decision
The following are the additional factors to be kept in mind while making final decision
 Consumer demand
 Element of uncertainty
 Innovations and inventions
 Level of income
 Corporation Tax
 The level of savings
 The accelerator effects
 The stock of capital
 The level of economic activity etc.
Question No. 3
Answer
A discussion on the two factors of financing being considered by the board of directors by the board of directors of AYR co
 A description of debt and equity
In case of any business there are basically two modes of finance available with the merits and demerits associated with each of them.
Debt financing simply means borrowing fund without sharing the ownership rather promising a fixed percentage of return in terms of interest, whereas equity means amount paid into the business by the owners of the business in exchange of a share of profit earned by the business using their funds. Whereas the business gets the tax shield on the interest paid to the borrowers, but there is no such savings generated from the dividend paid to the equity holders of the business. Raising the quantity of debt may also cause the cost of bankruptcy to the entity if it is found that the firm is overcapitalized in terms of debt financing (Kaufmann, 2017). The equity holders are the real risk takers of the business. Debt financing is considered cheaper over the equity financing due to the limited amount of the risk associated with it. Debt fund may be obtained for short term or longterm purpose depending on the requirement of the fund.
ii. An explanation on the cost of each source of finance
Cost of debt
The cost of debt is the effective rate of interest an entity pays on its debt fund. The interest paid to the debt fund holders is a taxdeductible expenditure, hence whenever the term cost of debt is used it is meant as after tax cost of debt. There is an inverse relationship between the cost of debt and the rate of tax (Wellmer, 2018). As the rate of tax increases the cost of debt decreases and viceversa. The formula used for the calculation of the cost of debt is as follows:
Kd= I(1tc)
Where,
Kd= After tax cost of debt
I =Rate of Interest
Tc= Tax rate
Cost of equity
It is the rate of return theoretically proposed to be paid to the equity shareholders of the company in exchange of the risk undertaken by them while making their investment in the entity. There are basically two formulas used while calculating the cost of equity, the first being Dividend capitalization model and capital asset pricing model (Kaufmann, 2017).
The formula used are prescribed hereunder:
Under the Capital asset pricing model, the level of risk in relation the market is considered. But is less preferred because of its use of historical information
E=Rf+Beta*(RmRf)
Where E = Expected return from the Asset
Rf= Riskfree Rate of return
Beta= Systematic Risk of the asset
Rm= Return from the market
Risk Free rate of return is the rate of return expected to be received from making the riskfree investments
Beta is the measurement of volatility that can be obtained online or may even be calculated using the regression analysis through dividing the covariance of the market return and asset by variance of the market. If the Beta is less than one means the asset is less volatile, if it is equal to one then it means that its volatility is that of equal to the market, but if it greater than market, then it means that the asset is much more volatile in relation to the market (Knechel & Salterio, 2016).
Dividend capitalization model
This approach for equity valuation can only be applied for the companies paying dividend which assumes that the dividend shall grow at a constant rate but does not consider the extent of risk as being considered by the capital asset pricing model.
The formula to be used
E=(D1/P0)/G
Where
E= Cost of equity
D1= Dividend in next year
P0= Current market price of the share
G= growth rate of dividend
Dividend for the future years can easily be obtained as generally the companies announce the dividend in far advance before the date of actual distribution of the dividend.
Current market price of the share can be obtained from the Stock exchange search.
Growth rate of dividend
If the rate of growth of the dividend is not known, then in that case it can be obtained using the following formula
G=(DTh/dt1)1
Where,
Dt= payment of dividend in T period
Dt1= payment of dividend one year prior to t period
 An analysis of the effect of the selection of the source of finance may have on AYR co.’s weighted average cost of capital (WACC).
If the entire fund is invested by means of debt then the new capital structure of AYR co shall be
Equity = $20 million
Debt= $18+$2.25= $20.25 million
Let the aftertax cost of debt be 5% and cost of equity be 7%
Hence the WACC would be
=5*$20.25/$40.25+7*$20/$40.25
=5.99%
If the entire fund is invested by means of equity then the new capital structure of AYR co shall be
Equity= $20million+$2.25milloion= $22.25million
Debt= $18 million
Let the aftertax cost of debt be 5% and cost of equity be 7%
Hence the WACC would be
=5*$18/$40.25+7*$22.5/$40.25
=6.14%
Thus, from the above calculation it is quite clear that the firm should choose the debt as a means of financing as the weighted average cost of capital shall be lower in this case.
 An Assessment of the impact of the selection of finance on the current and potential shareholders and lenders
This is described through the following points
 As in the given case the amount of debt fund shall be higher in comparison to the overall equity investment in the AYR co, hence there shall be the high risk of bearing the burden of debt for the firm, that it must mandatorily pay to those debtholders.
 The creditworthiness of the company shall be highly doubtful in which owner’s fund ids less than the borrowed funds (Pamela & Tamara, 2013).
 In future it shall be difficult to raise further funds through the means of debt financing before it repays some amount of its existing debt liabilities.
 There is huge potential of decreasing the market price of the share of the AYR Co.
 In future it shall become doubtful to pay dividend to its shareholders after meeting the interest obligations of the debt fund holders (Knechel & Salterio, 2016).
Conclusion
From the above detailed analysis, it is quite clear that capital budgeting techniques undoubtedly play a major role in choosing an appropriate investment project, but the decision cannot be or should not be finally based on the result obtained from these capital budgeting techniques. S these capital budgeting techniques are purely based on the quantitative data, but there are qualitative factors too that are major contributors or determinants of such decision making.
Hence a careful detailed discussion is required to be made for these qualitative factors too before reaching to a conclusion.
At the same time while making selection for the appropriate mode of financing due consideration should be given to the both modes of financing naming debt and equity. Because though it is correct that debt financing can provide the tax savings as the interest paid on debt is a taxdeductible expense, but there is the risk of bankruptcy too for a firm having higher amount of debt. At the same time if the firm thinks about to raise the amount of equity then the level of risk taking by such equity holders get increased and consequently they may demand higher amount of dividend. In that case they may also expect to increase the rate of dividend every year that may again indirectly affect the share price of the AYR Co. Hence a reasonable proportion of debt and equity is being suggested.
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View our servicesFinally, it is recommended to the Board of directors that they should not reach to any final decision solely based on quantitative calculations made in this report but should resort to other reports and other means of seeking valuable information in this regard. They may seek the help from the experts too.
Appendix 1
Working Note No. 1
 Statement showing the Aftertax cash inflow from the Project Aspire of AYR Co.
(Figures in $)
Particulars 
First year 
Second year 
Third Year 
Fourth Year 
Fifth Year 
Cash Inflows 
650000 
698750 
698750 
698750 
698750 
Less: Variable Expenses 
27000 
28823 
30768 
32845 
35062 
Net cash inflow before capital allowance and depreciation and Taxes 
623000 
669927 
667982 
665905 
663688 
Less: Taxes@20% 
Nil 
124600 
133985 
133596 
133181 
Net cash inflow after taxes 
623000 
545327 
533997 
532309 
530507 
Add: Depreciation tax shield@20% [See Note Below] 
75000 
75000 
75000 
75000 
75000 
Add: Capital Allowance Tax shield@20% [See Note Below] 
120000 
78000 
69000 
60000 
48000 
Net cash inflow after taxes after capital allowance tax shield and depreciation tax shield 
818000 
698327 
677997 
667309 
653507 
 Computation of Depreciation under straight method
Depreciation per annum= (Cost of the AssetScrap value) *Rate of Depreciation P.A
= ($2250000$375000) *20/100
=$375000
 Depreciation tax shield = $375000*20/100
=$75000
 Capital Allowance Tax Shield
Year I Year II Year III Year IV Year V
=$600000*20% =$390000*20% =$345000*20% =$300000*20% =$240000820%
=$120000 =$78000 =$69000 =$60000 =$48000
 Statement showing the Aftertax cash inflow from the Project Wolf of AYR Co
(Figures in $)
Particulars 
First year 
Second year 
Third Year 
Fourth Year 
Fifth Year 
Cash Inflows 
955000 
955000 
955000 
955000 
955000 
Less: Variable Expenses 

Material cost 
14400 
15050 
16179 
17392 
18697 
Other Expenses 
18000 
16650 
16650 
16650 
16650 
Net cash flow before taxes 
923000 
923300 
922171 
920958 
919653 
Less: Taxes @20% 
Nil 
184600 
184660 
184434 
184192 
Net cash inflow after taxes 
923000 
738700 
737511 
736524 
735461 

90000 
90000 
90000 
90000 
90000 
Net cash inflow after taxes after and depreciation tax shield 
833000 
648700 
647511 
646524 
645461 
 Calculation of Depreciation=$2250000*20/100
=$450000
 Depreciation Tax Shield
=$450000*20/100
=$90000
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