Research Paper on "Financial Decision-Making Regarding Project"
Research Paper 5 pages (1409 words) Sources: 4
[EXCERPT] . . . .
Financial DecisionThe 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.
Financing
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 structu
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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).
CAPM
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… READ MORE
Quoted Instructions for "Financial Decision-Making Regarding Project" Assignment:
“Your automobile component company is considering taking on a project that requires $10 million in preliminary funding (in other words, the project will acquire $10 million in costs before it becomes profitable). The company currently has $8.3 million in liabilities and $17.2 in assets. The company is midsized; it brings in $17.5 million per year and has 3,500 employees. Should the company undertake this project? Justify your opinion. In principle, undertaking a project involves making financial decisions that could make or break the project. How do you plan to finance the project? There are plenty of financing options, including: common stock, preferred stock, debt (many debt options), bank loans, and internal cash. Is there one financing mix that is better than the rest? Explain your rationale. Support your work with research.
Research the Internet to find out information on current rate of return on risk-free assets, beta, required return on market, and interest rate.
Make sure to meet this criteria:
Recommended whether the company should undertake the project
Explained, with reasons, how to finance the project
Supported analysis and conclusions with relevant evidence and numerical data
5 page paper: 300 words per page, each page should have one inch margins and NO DIRECT QUOTES ARE TO BE USED. CITE ALL SOURCES. 3-4 sources are required
How to Reference "Financial Decision-Making Regarding Project" Research Paper in a Bibliography
“Financial Decision-Making Regarding Project.” A1-TermPaper.com, 2010, https://www.a1-termpaper.com/topics/essay/financial-decision-company/5746. Accessed 5 Oct 2024.
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