Research Proposal on "Capital Budgeting Case"

Research Proposal 8 pages (2182 words) Sources: 1+ Style: APA

[EXCERPT] . . . .

Capital Budgeting Case

The contemporaneous business community is characterized by numerous features of change, the sole constant being the extremely intense competition. This economic battle is fought at both national and international levels and its existence is supported by changing consumer demands or by developing politics, such as open trade agreements. Organizational leaders implement a wide series of strategies in order to respond to competitive threats. They for instance focus more on the employee and strive to satisfy him as a satisfied employee will work harder and will cost the economic entity less money. More focus is also being placed on the customer, who is no longer perceived as the force buying whatever products the company sells, but has turned into the entity to demand what products are to be manufactured.

Aside new policies of marketing and human resource, today's organizations strive to diversify their portfolio in the meaning of developing more and newer investment projects. The primary aim of this effort is that of increasing organizational profitability, but other adjacent benefits are often available, such an expansion into new markets, the creation of new products or the expansion into other sectors and industries.

Given that an economic entity has decided to pick up a new investment project, it has to be realized that its leaders are often presented with more than one alternative. The challenge relies in choosing the one which stands the most chances of success, but also the one which is best ale to serve organizational goals. Various tools can be used in the process, of the utmost importance being the net present value and the internal rate of return. This report is focused on assessing two alternatives for investment projects currently available for the North Sea Oil Company and identifying which of them is more likely to generate the expected outcomes. The desiderate will be achieved through an analysis of the weighted average cost of capital, the net present value and the internal rate of return.

2. The Situation

North Sea Oil's capital is constructed entirely on cost, rather than profits. The long-term debts account for 7%, the preferred stock is of 19% and the common stock and retained earnings account for 20%. The target capital structure propositions are as follows: 25% for long-term debt, 25% for preferred common stock and 50% for common stock and retained earnings. The organization is currently presented with an opportunity to invest in either of two project A or project B. The initial investment for the first alternative is of $130,000, with expected cash inflows for the first five years of $25,000, $35,000, $45,000, $50,000 and $55,000. Project B. requires an initial investment of $85,000, with expected cash inflows for the first five years as follows: year 1 - $40,000; year 2 -- $35,000,-year 3 -- $30,000; year 4 - $10,000 and year 5 - $5,000.

3. Analysis of Investment Projects

Weighted Average Cost of Capital

The Weighted Average Cost of Capital is a crucial element in the analysis of North Sea Oil's investment alternatives for the simple reason that the organization relies heavily on both debt and equity to finance either of the projects. In this order of ideas, the WACC is used to identify the actual costs of the capital used in order to reveal if it is profitable to engage in a given investment project. Investopedia (2009) defines the weighted average cost of capital as the "calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else help equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk."

Below is the formula at the basis of the WACC calculation:

Where:

E = market value of organizational equity

V = E + D

Re = cost of equity

D = market value of organizational debt

Rd = cost of debt

Tc = corporate tax rate (Investopedia, 2009)

Considering a corporate tax of 15%, the Weighted Average Cost of Capital for North Sea Oil's two investment alternatives can be calculated as follows:

A

B

Cost

Equity 75%

$97,500

$63,750

39%

Debt 25%

$32,500

$21,250

7%

Total

$130,000

$85,000

46%

WACC for Project A = 97,500 / 130,000 * 0.39 + 32,500 / 130,000 * 0.07 * 0.85 = 0.2925 + 0.8675 = 1.16

WACC for Project B = 63,750 / 85,000 * 0.39 + 21,500 / 85,000 * 0.07 * 0.85 = 0.2925 + 0.01505 = 0.30755

Considering all things equal, the project to be selected is the one with the lowest weighted average cost of capital, as this is the one which has to pay lees for the invested foreign capital. In the situation of the North Sea Oil organization, this project is project B. yet, the fact that it pays less is also based on the fact that it uses a lower amount of money and it also generates less revenues:

Net revenue from a project = Initial Investment -- Expected Cash Inflows

Net revenues for project A = $210,000 - $130,000 = $80,000

Net revenues for project B = $120,000 - $85,000 = $35,000

Project B. For instance uses an initial investment of $85,000 and is expected to retrieve $120,000 throughout the first five years of operations, with a net profit of $35,000. Project A on the other hand does require an initial investment of $130,000 and also pays more to creditors, but generates estimated cash inflows in the total amount of $210,000, leaving a net revenue of $80,000.

This controversial finding implies the need for additional analysis to support the leader in his process of decision making. It is as such necessary to look at two more tools of financial analysis -- the net present value and the internal rate of return. Also, foreseeing the possibility that these computations will lead to conflicting results, it is imperative to assess them in light of a capital rationing constraint. This constraint is that of achieving long-term profitability, rather than cost reductions and capital savings.

Net Present Value

The net present value of a project is identified based on the expected cash flows the respective project is expected to generate as well as the expected cash flows it is expected to require. Otherwise put, the net present value can be calculated by subtracting the value of the outflows from the project inflows. The tool is highly efficient in identifying the profitability of an assessed project and also when making a decision between several alternative investment projects. Generally speaking, and all other things being equal, the project with the highest net present value is selected to be implemented as this will generate the highest levels of profitability. Projects with negative NPV are often renounced as it is highly probable for them to generate negative cash inflows (Investopedia).

Another useful method of calculating the net present value is that of discounting it by the weighted average cost of capital. With the aid of this technique, the NPVs for the two project investment opportunities for the North Sea Oil company are as follows:

NPV for projects = present value of the cash flows discounted by the weighted average cost of capital

NPV for project A = 210,000 -- 210,000 * 1.16% = 210,000 -- 2,436 = 207,564

NPV for project B = 120,000 -- 120,000 * 0.30755 = 120,000 -- 369.06 = 119,630.94

The calculation of the net present values for the two alternatives of investment projects concludes that project A is the most profitable one, standing the most chances of retrieving the desired profitability results. The results indicate the same findings when compared against the capital rationing constraint -- the desire for long-term profitability against savings considerations.

Internal Rate of Return

The internal rate of return is often used in correlation to the net present value and it also constitutes an efficient tool assisting the decision making process relative to projects of financial investment. The internal rate of return is often understood as the growth rate a given project is expected to generate for the overall organization and similar to the net present value, the project with the highest value of the IRR is most likely to be selected. Yet, just like with the WACC and the IRR, it is necessary to correlate the findings to the imposed capital rationing constraint -- the desire for long-term profitability in this case.

IRR, or ERR, when standing for economic rate of return, is extremely useful when organizational leaders must assess the features of more than one investment projects as it offers the possibility of comparison across the entire palette of opportunities available. Investopedia explains that the internal return rate is the rate most "often used in capital budgeting that makes the net present value of all cash flows from a particular project equal… READ MORE

How to Reference "Capital Budgeting Case" Research Proposal in a Bibliography

Related Research Proposals:

Capital Budgeting the Beta for Each Project Case Study

Capital Budgeting

The beta for each project at the different points of leverage is as follows:

Beta

A 0 Lev

A 20 Lev

A 50 Lev

B 0 Lev

B… read more

Case Study 3 pages (749 words) Sources: 0 Topic: Economics / Finance / Banking

---

Capital Expenditure Requests and Capital Budgeting Process Essay

Capital Budgeting

Mission of CER and capital budgeting process

Stryker has enjoyed a strong run of growth, and has taken advantage of this to gradually de-leverage its balance sheet. As… read more

Essay 4 pages (1178 words) Sources: 4 Topic: Business / Corporations / E-commerce

---

Capital Budgeting the Underlying Principles Thesis

Capital Budgeting

The underlying principles of capital budgeting are inherent in any rational business decision. The rational actor - in this case a manager or executive -- must decide whether… read more

Thesis 5 pages (1590 words) Sources: 4 Style: MLA Topic: Economics / Finance / Banking

---

Capital Budgeting Techniques Research Proposal

Capital Budgeting

De Reyck and Leus begin their article with the underlying premise that capital budgeting for research and development projects is inherently different from capital budgeting for normal projects.… read more

Research Proposal 3 pages (977 words) Sources: 1 Style: APA Topic: Economics / Finance / Banking

---

Capital Budgeting Projects Managing Public Funds Discussion Chapter

CAPITAL BUDGETING & MANAGING PUBLIC FUNDS

Capital Budgeting & Public Funds

Capital Budgeting

Capital budgeting can be a minefield of a proposition in some instances. As mentioned in Chapter 6,… read more

Discussion Chapter 2 pages (638 words) Sources: 0 Topic: Economics / Finance / Banking

---

View 100+ more related papers  >>