Posted: March 18th, 2023
The company is considering a project with an up-front cost of $10 million. This investment will significantly increase the size of the company, and therefore must be given serious consideration for its financial effects. This paper will analyze this decision in the context of the financing and make recommendations to management about the project.
The company currently has assets of $17.2 million. This investment of $10 million therefore represents a 58% increase in the size of the company, to $27.2 million. Such a dramatic investment will significantly alter the company’s capital structure, so the decisions with regards to the investment and its financing must be given careful consideration.
The first question is whether or not the company should take on the project. The up-front cost is high, but the rule of thumb for an investment decision is based on whether or not the project has a positive net present value. The net present value is the value of all cash flows associated with the project, adjusted for time value back to the present day (Investopedia, 2010). In this case, the future cash flows are not known, so the net present value calculation cannot be completed. There are steps, however, that can lead to an NPV number.
The first such step is to determine the company’s discount rate. There are a couple of different ways to determine a discount rate. The first is to use the company’s existing cost of capital. The cost of capital is essentially a weighted-average of the cost of equity and the cost of debt. The weightings are determined by the company’s current capital structure. The second method of determining a discount rate is to identify the cost of capital for this project. For example if the company chooses to finance this project entirely by debt and it knows that it can borrow at x %, then this is the cost of capital to be used as the discount rate.
For this situation, the former method is more appropriate. The company’s current capital structure is $8.3 million in liabilities and $8.9 million in shareholders’ equity. The cost of debt is not known. The cost of equity is also unknown, but would be calculated using the capital asset pricing model (CAPM). This relates the cost of equity to the cost of equity in the general market by identifying the level of firm-specific risk (Wang, 2003).
The components of the capital asset pricing model are the risk free rate of return, the market risk premium and the firm-specific risk, which is reflected in the firm’s beta. The beta derives from the level of correlation between the firm’s stock price and the broad market. It answers the question of how risky the firm is compared to the economy overall. This firm does not have a name so the beta is not known, but it can either be obtained from the Internet, or it can be calculated by running a regression analysis against the market returns. For the sake of explanation, suppose the firm’s beta is 1.15. The risk free rate at present is 0.27%, based on the one-year Treasury bond (Yahoo! Finance, 2010). The historic market risk premium is 7%. This gives us a CAPM calculation of Ra = 0.27 + (1.15)(7) = 8.32%
This would be taken as the firm’s cost of equity. If we assume that the cost of debt is around 3% today the cost of capital would be calculated as the weighted average of these figures. The weighting is 48.2% debt and 51.7% equity, so the WACC would be:
WACC = (.482)(3) + (.517)(8.32) = 5.751%
This would be used as the firm’s discount rate in the NPV calculation.
The Financing Decision
If we assume that the project has a positive net present value — and if it did not we would not be considering the project — then the next decision that must be made is with respect to financing. Debt financing is the cheapest method of financing, as debt is less risky than equity as a form of investment. The main drawback of debt is that it creates an obligation on the part of the company. The company would be committing future cash flow to debt service, meaning that it would be unable to reinvest that money back into operations. If this investment was financed entirely with debt, the new capital structure would be 67.2% debt and 32.8% equity. If this investment was financed entirely with equity, the new capital structure would be 30.5% debt and 69.5% equity.
One rule of thumb for making such a decision is to match the asset type with the financing. Therefore, an asset that is expected to have a service life of five years would be financed with a five-year bond issue, so that the cash flows from the asset can be used to cover the costs of financing. In this case, the asset life is not known, so any financing type can be used.
Internal cash is not possible because the firm likely does not have $10 million in cash if it only has $17.2 million in assets and $17.5 million in annual revenues. A debt issue will leave the firm with a significantly higher degree of leverage, increasing the firm’s risk level. In order to know if this risk level is acceptable, it is worth considering the industry norms. Canadian auto part supplier Magna carries a capital structure featuring 40.2% debt and 59.8% equity (MSN Moneycentral, 2010) so it appears that 67.2% debt is probably too high for our auto parts company.
If equity is to be used to finance this project, there are still a couple of different options, including common shares and preferred shares. In this case, there is the risk of using common shares that ownership could be diluted. This dilution can be eliminated by issue rights to the existing common shareholders, allowing them to maintain their current level of holding in the firm’s equity.
The project has a positive net present value or it would not be considered. Assuming that it makes sense on a strategic level, the company should pursue the investment. Although this project will dramatically increase the size of the company, the decision needs to be made based on rational economic criteria. Thus, if the project can be financed and will result in a positive net present value for the firm, it should be pursued.
It should also be considered that at present the company only earns $5,000 in revenue per employee. This means that the company as currently constituted is probably not viable. It needs to grow in order to pay for all of those employees, so this project is likely required for strategic reasons as well.
Because of the size of the project relative to the size of the company, it is risky. The current shareholders should be asked to finance this project, as using debt would dramatically alter the company’s capital structure and bring it far from industry norms. In order that existing shareholders finance the project, the equity should be raised through a rights issue that allows current shareholders to maintain their investment in the company as it grows.
The rights issue would raise the $10 million needed for this project. Using equity will shift the capital structure closer to that of Magna. The project should be expected to be a major contributor of revenues for our company, so it is reasonable that the equity shareholders be asked to finance the project. The rights would give existed shareholders the option to buy more equity in the firm as a discounted price. There would be no dilution of control, unlike a standard equity issue. There would be no cash flow obligations created, unlike debt or preferred shares. The project’s future cash flows would be used either to fuel further growth or to pay dividends back to the shareholders as a way of returning to them their investment.
Investopedia. (2010). Net present value — NPV. Investopedia. Retrieved October 2, 2010 from http://www.investopedia.com/terms/n/npv.asp
Wang, J. (2003). Capital asset pricing model. MIT. Retrieved October 2, 2010 from http://web.mit.edu/15.407/file/Ch11.pdf
Yahoo! Finance. (2010). Advanced bond screener. Yahoo!. Retrieved October 2, 2010 from http://reports.finance.yahoo.com/z1?b=1&so=a&sf=m&tt=1&stt=-&pr=0&cpl=-1&cpu=-1&yl=-1&yu=-1&ytl=-1&ytu=-1&mtl=6&mtu=24&rl=-1&ru=-1&cll=-1
MSN Moneycentral. (2010). Magna International financial statements. MSN Moneycentral. Retrieved October 2, 2010 from http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=MGA&lstStatement=Balance&stmtView=Ann
Are you busy and do not have time to handle your assignment? Are you scared that your paper will not make the grade? Do you have responsibilities that may hinder you from turning in your assignment on time? Are you tired and can barely handle your assignment? Are your grades inconsistent?
Whichever your reason is, it is valid! You can get professional academic help from our service at affordable rates. We have a team of professional academic writers who can handle all your assignments.
Students barely have time to read. We got you! Have your literature essay or book review written without having the hassle of reading the book. You can get your literature paper custom-written for you by our literature specialists.
Do you struggle with finance? No need to torture yourself if finance is not your cup of tea. You can order your finance paper from our academic writing service and get 100% original work from competent finance experts.
While psychology may be an interesting subject, you may lack sufficient time to handle your assignments. Don’t despair; by using our academic writing service, you can be assured of perfect grades. Moreover, your grades will be consistent.
Engineering is quite a demanding subject. Students face a lot of pressure and barely have enough time to do what they love to do. Our academic writing service got you covered! Our engineering specialists follow the paper instructions and ensure timely delivery of the paper.
In the nursing course, you may have difficulties with literature reviews, annotated bibliographies, critical essays, and other assignments. Our nursing assignment writers will offer you professional nursing paper help at low prices.
Truth be told, sociology papers can be quite exhausting. Our academic writing service relieves you of fatigue, pressure, and stress. You can relax and have peace of mind as our academic writers handle your sociology assignment.
We take pride in having some of the best business writers in the industry. Our business writers have a lot of experience in the field. They are reliable, and you can be assured of a high-grade paper. They are able to handle business papers of any subject, length, deadline, and difficulty!
We boast of having some of the most experienced statistics experts in the industry. Our statistics experts have diverse skills, expertise, and knowledge to handle any kind of assignment. They have access to all kinds of software to get your assignment done.
Writing a law essay may prove to be an insurmountable obstacle, especially when you need to know the peculiarities of the legislative framework. Take advantage of our top-notch law specialists and get superb grades and 100% satisfaction.
We have highlighted some of the most popular subjects we handle above. Those are just a tip of the iceberg. We deal in all academic disciplines since our writers are as diverse. They have been drawn from across all disciplines, and orders are assigned to those writers believed to be the best in the field. In a nutshell, there is no task we cannot handle; all you need to do is place your order with us. As long as your instructions are clear, just trust we shall deliver irrespective of the discipline.
Our essay writers are graduates with bachelor's, masters, Ph.D., and doctorate degrees in various subjects. The minimum requirement to be an essay writer with our essay writing service is to have a college degree. All our academic writers have a minimum of two years of academic writing. We have a stringent recruitment process to ensure that we get only the most competent essay writers in the industry. We also ensure that the writers are handsomely compensated for their value. The majority of our writers are native English speakers. As such, the fluency of language and grammar is impeccable.
There is a very low likelihood that you won’t like the paper.
Not at all. All papers are written from scratch. There is no way your tutor or instructor will realize that you did not write the paper yourself. In fact, we recommend using our assignment help services for consistent results.
We check all papers for plagiarism before we submit them. We use powerful plagiarism checking software such as SafeAssign, LopesWrite, and Turnitin. We also upload the plagiarism report so that you can review it. We understand that plagiarism is academic suicide. We would not take the risk of submitting plagiarized work and jeopardize your academic journey. Furthermore, we do not sell or use prewritten papers, and each paper is written from scratch.
You determine when you get the paper by setting the deadline when placing the order. All papers are delivered within the deadline. We are well aware that we operate in a time-sensitive industry. As such, we have laid out strategies to ensure that the client receives the paper on time and they never miss the deadline. We understand that papers that are submitted late have some points deducted. We do not want you to miss any points due to late submission. We work on beating deadlines by huge margins in order to ensure that you have ample time to review the paper before you submit it.
We have a privacy and confidentiality policy that guides our work. We NEVER share any customer information with third parties. Noone will ever know that you used our assignment help services. It’s only between you and us. We are bound by our policies to protect the customer’s identity and information. All your information, such as your names, phone number, email, order information, and so on, are protected. We have robust security systems that ensure that your data is protected. Hacking our systems is close to impossible, and it has never happened.
You fill all the paper instructions in the order form. Make sure you include all the helpful materials so that our academic writers can deliver the perfect paper. It will also help to eliminate unnecessary revisions.
Proceed to pay for the paper so that it can be assigned to one of our expert academic writers. The paper subject is matched with the writer’s area of specialization.
You communicate with the writer and know about the progress of the paper. The client can ask the writer for drafts of the paper. The client can upload extra material and include additional instructions from the lecturer. Receive a paper.
The paper is sent to your email and uploaded to your personal account. You also get a plagiarism report attached to your paper.
PLACE THIS ORDER OR A SIMILAR ORDER WITH US TODAY AND GET A PERFECT SCORE!!!
Place an order in 3 easy steps. Takes less than 5 mins.