A Letter to the CFO, VP Strategic Planning, Regarding Construction Project Financials

For the purpose of calculating the net present value of the project, an appropriate cost of capital has to be calculated at which free cash flows of the project should be discounted. Since the project will be solely financed by selling new shares, cost of equity will be used as the discount rate. Beta for the company can be assumed to be equal to average of the betas of the competitors of the company. This average beta value comes out to be 1.2. Risk free rate is 0.17% while risk premium has been estimated to be 6%. Thus by putting these values in CAPM formula, we can find the cost of equity for the company which is 7.39%.

b) The decision to invest in projects increases the shareholders value of the company. This is consistent with the growth and from the NPV criteria, positive NPV of projects increases the shareholder's value.

At the new WACC of 19%, the home appliance and agricultural machinery projects are valued based on their inherent levels of risk. The beta of the industry average home appliance project is 0.95, whereas the beta for the industry average agricultural machine project is calculated as 0.88. CAPM was then employed to find the cost of capital of each project. The cost of capital for the home appliance and agricultural machinery projects were found to be 10.4% and 9.92%, respectively (Appendix B). This analysis allows Star Company to allocate funds to projects that create returns greater than the industry cost of capital for each specific project.

The project team can also use the technique of calculating the rate of return using the investment value of the project wherein the increase in the rate of return indicates for the growth of the organization.

Now we want to examine the analysis business report concerning the cost of capital that has been increased at 28% in accordance with the Net Present Value which is $500,000 the question being would still be worth it to make the investment to the company (Needles, 2010). While at the same time the internal rate of return is still at 21% which is lower than the 25% in the expenditures. In reflection of these calculations the investment would not

Southwest traditionally uses a 5% premium over the weighted average cost of capital as a discount rate for long-term projects. This makes certain that the project will only have a positive net present value and be worth the investment if it gives investors a premium for the additional risk they must take on. The expected return on the project of 14.5% gives a 5.9% premium over the calculated

4. We estimated the project net present value to be -$19,125,000 without tweaking any of the financial assumptions in the capital request form. So to make the net present value positive we would have to change something. We first started by adding 10% to the utilization for every year. This alone didn’t make a huge difference so we had to additionally lower the hourly wage to $18.19/hr. This gave us a net present value of about $35,000. This seems unreasonable or at the very least unfair to lower each worker’s hourly wage while increasing the workload. The second way we tried to get the net present value positive was by just decreasing the hourly wage of each employee from $20/hr to $16.02/hr. This gave us a net present value of about $33,000. This seems like a more reasonable solution, but it is dangerous because it could cause workers to quit. Therefore we wouldn’t recommend this project. Both solutions that lead to a positive net present value are too extreme and risky. Also this only leads to a positive net present value, not an extremely profitable one. This project shouldn’t be undertaken.

Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.

The Modified Internal Rate of Return is an underused measure for selection of projects that a company can choose because it is more effective at dealing effectively with periodic free cash flows that develop from the time that an asset is purchased through its life to the point where it is sold, ranking projects and variable rates of return through the project life. The Internal Rate of Return is an inefficient model to make decisions with because it lack the ability to account for the periodic free cash flows, proper ranking and variable returns from certain projects.

The question that transcends the project is whether equity investors be sufficiently rewarded to justify there financing interests. The answer to this question is dependent

The present value of the net incremental cash flows, totaling $5,740K, is added to the present value of the Capital Cost Allowance (CCA) tax shield, provided by the Plant and Equipment of $599K, to arrive at the project’s NPV of $6,339K. (Please refer to Exhibit 4 and 5 for assumptions and detailed NPV calculations.) This high positive NPV means that the project will add a significant amount of value to FMI. In addition, using the incremental cash flows (excluding CCA) generated by the NPV calculation, we calculated the project’s IRR to be 28%. This means that the project will generate a higher rate of return than the company’s cost of capital of 10.05%. This is also a positive indication that the company should undertake the project.

5. The project is assumed to end in year 4. Do you think that this is realistic? Can you estimate the value of the project’s operating cash flows beyond year 4? State any assumptions you made.

For expansion via capital projects we must look at accounting costs, marketing research, and how to raise financial capital. The best way to get the cash flow for financing this capital project is to use any profit that we made prior and reinvest into the company through this capital project. If there was no profit or the profit wasn’t large enough to fund the project, we must look at alternative ways to fund the project. This could be through a capital investment firm or a financing corporation that we would either have to give up equity of the company to or pay interest on the money borrowed. After determining how the project is going to be funded, then we need to analyze what kind of return can we estimate getting from this particular capital project. For this issue we can perform an internal rate of return or a net present value on the earnings that we think we can get from this project. This will provide us with the information needed to determine if the project should be done or if we should look to

Due to the impact of globalization companies now spend quality time in analyzing the investments before they arrive at any conclusions. Not doing so, might end up losing their identity or liquidating their current assets. The concept of capital

In this study Hatfield, Horvath, and Webster (1998) investigated the importance of payback, average rate of return, IRR, and NPV capital budgeting techniques for the performance and value measures of firms. They found that firms analyzing all projects have higher share prices on average. They also found, in contrast to the theory of finance, that the NPV technique is not maximizing the value of the firm. Their results indicated that it is best not to rely on any single capital