Determining the Right Cost of Capital

In this report an attempt is made to evaluate the proposal using the investment appraisal technique. Irrespective of the size of the project, one of the main concerns for any manager is to fully understand the parameters and the variables that are going to affect the project both quantitatively and qualitatively. In the present case scenario both the proposal promise to bring profits for the company and the initial capital outlay is quitter similar in terms of amount involved (Doherty et al. 2014). However, the real issue is finding the right cost of capital to discount the future estimated cash flows and the selection of the right method of valuation of project. This report will address all these issues objectively including comparative analysis of the two proposals. Recommendation in respect of some other factors to be considered will also be given out via deep analysis of the situation. 

Decision in respect of appropriate cost of capital is immensely important. The reason being that based on the cost of capital determined by the company the decision to go forward with a project is ascertained. If the expected return of the project is more than the cost of the capital of the company the project is confirmed. Hence, the issue of selection of the right kind of cost of capital has to be dealt with great objectivity (Boczko 2016). As per the information of the case, it is seen that Suzy is of the opinion that as the finance requirement of the company in respect of both the proposals will be met by use of finance the interest rate of the loan amount should be used for determining the cost of capital. On the other hand, Maxie is of the opinion that cost of capital should be calculated using the Weighted Average Cost of Capital method. The reason being that the expenses and the revenues that are being forecasted are based on current prices and there is substantial probability that due to the expected inflation rate of 2% the amount of the expenses and the revenues are going to increase proportionately. It is advisable that the concerns and the recommendation of Maxie are considered for the determination of the cost of capital of the proposals (Martin 2016). This is because the interest rate of the borrowed amount remains fixed but the expectation level of the shareholders keep on changing over the period of time that affects the cost of equity of the firm. Hence, the return that should be earned by the company must be more than their expectation too. It is not satisfactory to earn a return on any project that will only suffice the payment of the interest amount of the funds invested into it but also the cash flow generated must add value to the shareholders. by factoring in the expectations and thereby the cost of equity and other sources of finance the company will be able to take a prudent decision in respect of the returns that should be expected from a project so as to confirm its selection. If the decision is taken based on the cost of debt, only the problem will be that in the end due to the increased in the value of the commodities the return the shareholders will be getting will not prove to be sufficient to meet their expectations. It might even happen that due to the increase in the cost amount of the expenses the company is unable to earn sufficient returns to pay back the interest of the loan taken due to the small margin of error kept by the company during the planning stage. The weighted average cost of capital method effectively allots weights to the relevance or the amount of influence that is exercised by the various providers of the funds to the company (Reason 2016). If the influence of the equity shareholders is more in the capital structure of the company the same will be reflected in the cost of capital of the firm. The same thing goes for the condition where the influence or the amount of debt or loan funds in the capital structure of the company is significantly high. Where the weightage of the equity shareholders will be more the attainment of the desired rate of return of the company will ensure that the returns of the shareholders are adequately met by the company. In case the weightage of the debt funds is more in the capital structure of the company, if the company is able to earn the expected return then it will be capable enough to pay back the loan amount with the interest liability and in addition to this add some value to the shareholders. Hence, it is advisable that the advice of Maxie should be taken into consideration for determining the cost of capital of the proposals and the evaluation must be conducted accordingly.   

Factors Affecting the Decision-Making Process

Every project has some inherent risks and the same should be addressed by the company objectively prior to commissioning any of the proposed projects. Some of the risks or factors that might exercise their influence on the decision taken by the company are as follows:

1. The cost of capital of the company-

In case the cost of the capital of the company increases, the discounting rate will also increase. Hence, this will reduce the future estimated cash flows from the proposals. This has two aspects. If even after the increase in the cost of capital and the corresponding increase in the discounting rate the proposal is able to generate positive returns then the company should move ahead with it (Nguyen 2017).

1. The selling price of the product-

If the selling price of the commodity of the company increases with a reduction in the expense of the company then the margin of profit earned Byte Company will increase thereby increasing the profitability of the proposal. However if due to the increase in the selling price the company loses its customers then the revenue of the company will come down.

The cost of initial investment involved-

In order to create value for the stakeholders of the company it must factoring the kind of investment that is involved in the proposals. If the investment is huge then the payback period of the company will also increase and the returns expected by the stakeholders will be higher and vice versa (Vernimmen et al. 2014). The amount of risk involved in the project is directly related or proportional to the amount that has been invested in the project by the company and the various factors affecting the recovery of the invested amount. 

In order to choose between the various proposals presented before the management of the company, a proper comparison has to be drawn between the two proposals. The comparison must be based upon the data that is being collected or obtained objectively. Hence, all the information that is being made available for the comparison must be used to arrive at a result or conclusion (Kothari et al. 2015). Only by ensuring that all the relevant information is factored in for the purpose of comparison of the proposals, the effectiveness and the efficiency of the comparison can be appreciated. For the purpose of comparison the proposals detailed calculations have been done. They are as follows:

• Proposal 1 (extension of the production capacity of the current product):

Discounting Rate/ Cost of capital	6.52%
Initial Investment	£     5,00,000.00

Statement showing calculation for evaluating Proposal 1
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Net Incremental Tax Operating Cash flow		£  3,75,000.00	£ 2,50,000.00	£ 1,25,000.00	£        30,000.00
Discounting rate		0.938754785	0.881260546	0.827287554	0.776620149
Discounted Cash flow	-£     5,00,000.00	£  3,52,033.04	£ 2,20,315.14	£ 1,03,410.94	£        23,298.60
Cumulative Discounted Cash flow	-£     5,00,000.00	-£ 1,47,966.96	£    72,348.18	£ 1,75,759.12	£     1,99,057.73
Total NPV of Cash flow	£     6,99,057.73
Initial Investment	£     5,00,000.00
Net Present Value	£     1,99,057.73
Internal Rate of Return	23%
Pay Back period (years)	1.33

The calculations in respect of the proposal increasing the production capacity of the company apparently show positive signals. The net present value of the proposal is positive. This clearly indicates that in case the company employs the following proposal, value will be created for the company in terms of monetary returns. The payback period of the proposal is even less than 2 years. This means that the capital invested by the company in the proposal will be earned by it within a small period (Skilton et al. 2018). This ensures that the company is able to earn a decent amount of return after getting back the amount it had invested in the proposal earlier. The internal rate of return that is given out by the proposal at the end of its tenure boils down to around 23% that is a decent merging above the cost of capital of the company. Hence, if the company is able to pull off the proposal in its entirety and there are no unforeseen loss incurred by the company during this period (Harkins 2016).   

• The launch of new product line by the name Venus:

Equipment cost	£     5,00,000.00
Project Life (years)	5
Salvage Value of machinery (PV)	£        50,000.00
Expected Sales unit	80000
Sales growth rate	6%
Selling Price	£               10.00
Inflation rate	2%
Fall in sales for first 2 years for old product (unit)	20000
Fall in sales after 2 years for old product (unit)	10000
Selling price of old product	£                 8.00
variable cost of old product	£                 3.50
Contribution of old product	£                 4.50
Capital Allowance rate	20%
Additional Working capital requirement	10%

Comparison of Proposals

It can be clearly seen that the various information that were being considered for the appraisal of the second proposal. Some o fete most important information include the inflation rate, factoring in the loss incurred due to the fall in the sale so the old product, factoring in the savings in respect of the variable cost of the product and the additional working capital requirement of the project. After factoring in all these information, the following results were obtained (Crane and Matten 2016).

Statement showing calculation of cash flow for Proposal 2
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Sales Unit		80000	84800	89888	95281	100998
Selling price per unit		£            10.00	£           10.20	£           10.40	£               10.61	£             10.82
Sales		£  8,00,000.00	£ 8,64,960.00	£ 9,35,194.75	£   10,11,132.57	£ 10,93,236.53
Profit from sale of Equipment						£      50,000.00
Total revenue (A)		£  8,00,000.00	£ 8,64,960.00	£ 9,35,194.75	£   10,11,132.57	£ 11,43,236.53
Expenses
Loss of profit from fall in Helena’s sales		£     90,000.00	£    90,000.00	£    45,000.00	£        45,000.00	£      45,000.00
Variable cost		£  3,20,000.00	£ 3,39,200.00	£ 3,59,552.00	£     3,81,125.12	£   4,03,992.63
Rent Payable apportioned		£     40,000.00	£    40,000.00	£    40,000.00	£        40,000.00	£      40,000.00
Apportionment of administrative costs		£     60,000.00	£    60,000.00	£    60,000.00	£        60,000.00	£      60,000.00
Selling and promotional Expenses		£  1,50,000.00	£ 1,50,000.00	£ 1,50,000.00	£     1,50,000.00	£   1,50,000.00
Interest on loan		£  1,00,000.00	£ 1,00,000.00	£ 1,00,000.00	£     1,00,000.00	£   1,00,000.00
Other attributable recurring overhead		£     45,000.00	£    45,000.00	£    45,000.00	£        45,000.00	£      45,000.00
Depreciation		£     90,000.00	£    90,000.00	£    90,000.00	£        90,000.00	£      90,000.00
Store rent		£     20,000.00	£    20,000.00	£    20,000.00	£        20,000.00	£      20,000.00
Total expenses (B)		£  9,15,000.00	£ 9,34,200.00	£ 9,09,552.00	£     9,31,125.12	£   9,53,992.63
Net profit (A-B)		-£ 1,15,000.00	-£    69,240.00	£    25,642.75	£        80,007.45	£   1,89,243.90
Tax Rate				£      5,384.98	£        16,801.56	£      39,741.22
Profit After Tax		-£  1,15,000.00	-£    69,240.00	£    20,257.77	£        63,205.88	£   1,49,502.68
Add back
Depreciation		£     90,000.00	£    90,000.00	£    90,000.00	£        90,000.00	£      90,000.00
Less:
Tax savings on Capital Allowance		£     21,000.00	£    16,800.00	£    13,440.00	£        10,752.00	£        8,601.60
Additional Working capital requirement		£     80,000.00	£    86,496.00	£    93,519.48	£     1,01,113.26	£   1,09,323.65
Recovery of Working capital invested						£   4,70,452.38
Net Operating cash flow		-£  1,26,000.00	-£    82,536.00	£      3,298.30	£        41,340.63	-£   3,48,874.95

Statement showing calculation for evaluation of Proposal 2
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Net cash flow	-£     7,15,000.00	-£ 1,26,000.00	-£    82,536.00	£      3,298.30	£        41,340.63	-£   3,48,874.95
Discounting factor		0.938755	0.881261	0.827288	0.776620	0.729055881
Net discounted Cash flow	-£     7,15,000.00	-£ 1,18,283.10	-£    72,735.72	£      2,728.64	£        32,105.96	-£   2,54,349.34
Cumulative Discounted Cash flow	-£     7,15,000.00	-£ 8,33,283.10	-£ 9,06,018.82	-£ 9,03,290.18	-£     8,71,184.22	-£ 11,25,533.56
Total NPV of Cash flow	-£     4,10,533.56
Initial Investment	£     7,15,000.00
Net Present Value	-£   11,25,533.56

Calculation of Variable Costs per unit
Particulars	Gm/Units/minutes	Cost/unit/Hour	Total
Material A	10	£              0.15	£             1.50
Material B	2	£              0.12	£             0.24
Component X	1	£              0.16	£             0.16
Component Y	1	£              0.30	£             0.30
Total Material Cost per unit (A)			£             2.20
Skilled labour	20	0.06	1.2
Unskilled labour	10	0.03	0.3
Total Labour Cost per unit (B)			1.5
Other Variable cost per unit (C )			0.3
Total Variable cost per unit (A+B+C)			£             4.00

Calculation of Initial Investment
Particulars	Amount
Cost of Equipment	£     5,00,000.00
Product development expenses incurred	£     1,25,000.00
Market research expenses incurred	£        90,000.00
Total Initial Investment	£     7,15,000.00

Calculation of Capital Allowance
Years	Opening balance	Depreciation	WDV
1	£     5,00,000.00	£  1,00,000.00	£ 4,00,000.00
2	£     4,00,000.00	£     80,000.00	£ 3,20,000.00
3	£     3,20,000.00	£     64,000.00	£ 2,56,000.00
4	£     2,56,000.00	£     51,200.00	£ 2,04,800.00
5	£     2,04,800.00	£     40,960.00	£ 1,63,840.00

It is clearly visible that the proposal 2 of the company is not adding any value in terms of the monetary returns to the company. The cash flow from the proposal is negative in the first two years of the operation and thereafter it is followed up by two years of positive cash flows. However subsequently the proposals failed to earn any positive return for the company and the cash flow was negative (Le Dinh et al. 2018). The net present value in case of the second proposal is equal to (£112533). The negative net present value of the proposal suggests that the proposal is not capable of giving out positive returns to the company in the future.

After conducting the comparison, it can be clearly stated that the company should not move ahead with the second proposal because it will be unable to add value for the stakeholders of the company in the end. The difference in the net present value between the two proposals is immense and hence the decision to be made by the company becomes relatively easier and the tip should move towards the first proposal (Noorderhaven et al. 2015). 

Conclusion and recommendation:

Computation of the NPVs of the two proposals and comparison of the proposals of the company on several other parameters as if the Net Present Value that is estimated to be created by the proposals at the end of their respective tenure has been undertaken. After obtaining the results of the several analysis performed it can be prudently concluded that the company should not go ahead with the second proposal as the Net Present Value of the proposal is coming negative. There are several qualitative factors that are needed to be considered by the company in addition the quantitative results of the proposed proposals. Some of the most important aspects include that of the competition faced by the company in the industry. It is a well-known fact that in order to strive in the market the company needs to continuously improve the quality and the variety of the products offered by it to the customers. The projections regarding the proposal 1 have been made keeping in mind the present trend and assuming that the same trend will be enjoyed by the company in the future and there will be no entry of new products in the market. The assumption is not a prudent one. The reason being that due to the research and development activities that are being conducted by the competitors of the company there is always a chance that they will come up with a product that will be different from that of the products offered by the company.  In case the product offered bit eh competitors are better than that o the company, the revenue for the proposal will come down and the company may have to face a huge loss in respect of the extension they have to make for the production of their old products. On the other hand, the same quantity of money will be spent by its competitor in building a better product and improving its brand name. Hence, simply because the math suggest that proposal one is going to create value for the company it is not possible to lose funds in its respect.   

Reference

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