Introduction

The
objective of this report is to prove which of the projects between Aspire and
Wolf will result in the increase of the company’s market share.  Project Aspire has the potential to expand
the current product range and appeal to both existing and potential
customers.  On the other hand, Project Wolf
has the potential to focusing the company in a totally new direction by luring a
totally different type of customer.  The
second part of the report looks at the debt and equity financing methods.

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As
affirmed by Wengarter (1977), ”capital rationing is a
pinnacle in the corporate finance literature due to the importance of
investment decision to firms and the potential contribution that analysis can
make to the quality of decision in practice”. 
Lorie and Savage (1955) posted that, ”the forecasting correctly of
cashflows expected to result from the specified investment proposals in one of
the problems in rationing of capital, as well as the liquid resources that will
be available for investment.  Ye and
Tiong (2000) affirmed that, ”strategic capital investment decisions are key to
a business firm, hence careful consideration is expected”.  In addition, financial, political and market
risks need to be considered when evaluating a potential project.  This report therefore will reflect results
for three different methods of evaluation and look at the pros and cons of each
approach.  Qualitative factors will form
part of the recommendation and conclusion of this report.

Computations
of NPV, IRR and Payback

The
first steps of quantitative analysis will be to calculate the NPV, IRR and
payback methods for both projects and compare, contrast the merits of each
outcome, and figure out the meaning of the outcome.

The
calculations are included in the Appendix 1 attached to this report.  The table below reflects the results of the
three methods stated above for Project Aspire and Project Wolf:

 

                                                NPV                                IRR                            Payback

Project Aspire                      $371,985                           15.56%                        3.63 years

Project Wolf                        $379,422                             16.98%                        3.07 years

NPV interpretation and Analysis

Based
on the NPV results, both projects should be accepted as they have positive
values.  As suggested by Ross,
Westerfield and Jordan (2017), pg. 269 ”an investment should be accepted, if
the net present value is positive and rejected if the present value is negative”.
However, the company’s dilemma is that it only has capability, to select one
project. 

”The
NPV is one of the methods used to evaluate the profitability of a proposed
investment and is the preferred approach in principle”, as acknowledged by
Ross, Westerfield and Jordan (2017) pg. 271. 
A project has a positive NPV of cash inflows, compared to initial cash
outflow.  A positive NPV creates value
for its owner, as its market value exceeds its costs, hence it is desirable.
This method however, has a higher forecasting risk, if the forecasted cashflows
are incorrect the whole assumptions and subsequent decision becomes inaccurate.
As reported by Ross, Westerfield and Jordan (2017) pg. 321-322, ”to minimize
this risk there is need to further analysis the results”.  When a positive NPV is resultant, there is
need to interrogate this result further by asking questions that include, what
is it about this project that could have resulted in a positive value. Identification
of something specific to the source of value is needed. 

Questions
that need to be answered include, “Are we certain that our new product will be
significantly better than the competitors”? 
Can we truly manufacture at lower cost and distribute more
effectively?  Will we be able to gain
control of the market? As reported by Ross, Westerfield and Jordan (2017) pg.
322, ”reaction of competition to projects that show significant value must be
closely examined”. ”If we can’t articulate some sound economic basis of
thinking ahead of time that we have found something special, then the
conclusion that our project has a positive NPV should be perceived with
suspicion,” as noted by Ross, Westerfield and Jordan (2017) pg. 322.  Jovanovic, Â (1999), states that further analysis
of investment decision-making under uncertainty and risk by making use of
breakeven analysis, sensitivity analysis, theory of games and decision making
theory.  These methods were beyond this
paper.  

Based
on the calculation the NPV for Project Wolf was higher compared to the Project Aspire
by 2%.  However, the constant cash
inflows of Wolf, need further cross-examining. 
Project Wolf had no stated scrap value, hence at the end of the project
there is no scrap income from the plant and machinery invested at $2.250m. 

Payback interpretation and Analysis

Both
projects will be paid up in year three, however, Project Wolf has marginally a
better payback rate than project Aspire.

As
highlighted by Ross, Westerfield and Jordan (2017) pg. 273-274, ”the results
of the payback may be misleading as the method ignores the time value of money
and does not consider cashflows beyond the payoff date”.  Ignoring cashflows beyond the payoff date may
lead to rejection of an investment which may be more profitable in the long
run.  As such this method is biased
towards higher returns on short term investments.  The issue of risk is totally ignored on projects,
evaluated using Payback method. However, this method is handy when making minor
decisions, as it is very simple to use.

Based
on what the company wants to achieve through the most viable project, this is
not a minor decision.  Hence it may be
misleading to rely solely on this outcome to decide on the best project between
the Aspire and Wolf.  Cooper, Cornick and
Redmon (2011) affirmed that, ”most firms preferred to use the less
sophisticated method of payback, however, it was primarily to evaluate small
projects”.

Internal Rate of Return
(IRR) interpretation and Analysis

Ross,
Westerfield and Jordan (2017) pg. 277-278, states that, ”IRR is an alternative
of NPW, though it is closely linked to it”. 
The rate is internal, as it depends on the cashflows of a particular
investment and not on rates offered elsewhere. 
An investment is accepted if the IRR exceeds the required return.  The IRR is the required return in an
investment that results in a zero NPV when it is used as the discount factor.

The
present value of the cashflows over the entire useful life of the investment
proposals are considered.   However this
method assumes that the cash received from a proposal during its useful life
will be re-invested at the internal rate of return.  However, this may not always be reasonable
due to changing economic conditions, as well as the evaluation methods used to
decide IRR rate.

Both
projects are forecasted to result in IRR above the expected return of 10%.  Project Wolf as per the results seem to be
better than project Aspire.

Qualitative factors and
other factors to consider

Communication
and human resource play a big part in the success of the selected project as
highlighted by Pons (2008).  The firm’s
culture may either promote or derail the chosen project.  There is need to assess if the human resource
is qualified enough to effectively manage and supervise the progress of the
chosen project.  The other benefits of
the project are not clear from the scenario e.g. whether any of the two
projects would result in reduction of costs such that some staff are laid
off.  In such instances management would
need to come with strategies to boost the morale of those that will be
remaining. 

There
is need to establish if the Regulators allow the production of such a product e.g.  It’s impact to the environment and
community.  A stakeholder analysis may
need to be carried out, and ensure that proper engagements have been effected
with the right stakeholders. The issue of the competitor should be analysed and
proper strategies put in place to defend the success of the project.

Conclusion

Based
on the quantitative analysis above, I propose project Wolf as it has a higher
NPV. As implied by Ross, Westerfield and Jordan (2017) pg284, ”for two
exclusive investments, the best project cannot be based on the highest IRR, as
our concern is creating value for shareholders, hence the project with the
higher NPV is preferred, regardless of a relative return”.  The payback method is for minor projects
hence it not suitable to be used as a measure in this instance. 

Institute, P. M. (2015) pg. 34 and Carlberg,
C. (2010) pg. 494, alluded that, ”the NPV method usually
results in better decisions than other methods when making capital investments”.

Details
of qualitative factors and market risks were not readily available hence it was
difficult to select the best project using these factors.

Two Sources of Finance

The
capital employed by the company comprise of equity and debt.  Kokemuller (2017), reported that, ”debt and
equity are two basic methods of raising finance for an either a startup company
or a growing firm”.  Equity is comprised
of private investor money obtained in exchange for a share of ownership in the
business.  Debt is about borrowing (i.e.
getting money from an outside source) and includes long-term loan that is
acquired from a financial institution. 

Debt
financing can be a great way of promoting aggressive strategic growth
especially if the interest rates are lower. 
No ownership of the business is relinquished, unlike in the equity
finance arrangement.  Repayment of the
loan and interest may stifle growth and limit future cash flows. Equity
financing does not require repayment. 
Cashflow being generated can be used to advance the growth of the
company.  Over time, profits paid to
other equity owners may exceed what was paid on a loan.  Equity financing involves a lot of statutory
obligations including costs like brokerage, underwriting fees and other issue
costs which are not present with debt financing. The process of raising funds
through equity financing normally takes longer than that of debt financing.

Way
(2017) affirmed that, ”debt financing requires lower finance costs compared to
equity financing”. Debt financing lowers a firm’s taxes due to allowable
interest deductions.  Tax rules permit
interest payments as expense deduction against revenues to arrive at taxable
income.  Dividends paid to equity holders
are not tax deductible and most come from after-tax income.  Therefore, tax savings help further to reduce
a company’s debt financing cost, which is an advantage that equity financing
lacks. A higher rate of return is required from equity share investors, since equity
share investment is a high risk investment, an investor will always expect a
higher rate of return.  

Frank
and Goyal (2009), quoting the Pecking Order Theory stated that, ”equity has
serious adverse selection whilst debt has only minor adverse selection”.  The trade-off theory stipulates that, ”the
capital structure is determined by a trade-off between the benefits of debt and
the costs of debt,” Frank and Goyal (2009). 
The last method of capital structure determination highlighted by Frank
and Goyal (2009) is the market timing theory that perceives that managers look
at current conditions in both debt and equity market and pick which ever market
will be favourable at that given time.  
Houlis (2009) argued that delays in making investment decisions maybe
meaningful when market demand is uncertain and where the interest rates are
volatile (the delay will allow interest rates to come down).

Hall
(1992) stated that, ”a study carried out for U.S. manufacturing firms during
the 1980s, revealed that changes in the financial structure of firms which
tilted the balance sheet toward debt were followed instantly by substantial
reduction in both investment and R”. 
Firms that turn to external markets for capital will raise the cost of
capital to the firm and this results in decline in investments.  Higher interest levels leaves little room for
investment expenditure.

Currently
the company’s capital structure has 53% equity and 47% debt.  The company needs to consider if it still has
the capacity to borrow and what the optimal capital structure is for the firm. Williamson
(1988) argued that, ‘financing of a project depends principally on the
characteristics of the assets”.  The use
of debt is supported by transaction-cost reasoning to finance re-deployable assets,
while non-re-deployable assets are financed by equity (discretion). 

 

Effect of selection on
AYRC’s weighted average cost of capital

The
WACC will either increase or decrease depending on the source of funding
selected.  Under normal circumstance the
equity holders expect a higher return, hence increasing the equity to the company
capital structure will result in an increase in WACC.  An analysis of this is demonstrated under
Appendix 2.  Increase of debt will
therefore bring down the WACC though gearing will increase. According to Bienfait (2006) “where there is no debt the
WACC equals the opportunity cost of capital and declines with financial
leverage because of increasing interest tax shields. However, when the debt
level becomes significant relative to the value of the firm reflecting the main
costs associated with borrowing, the costs of bankruptcy, the WACC increases
again.” 

Impact of Selection on
current and potential shareholders and lenders

The
impact of equity financing on shareholders is that the shareholders will expect
a higher return, hence management need to ensure that they make good use of the
money raised.   The shareholders also
expect a return in the form of a reasonable dividend.  The current shareholders may lose part of
control depending on the magnitude of the new injected capital.  In this instance the $2,250m is significant
in terms of value to the company.  Engagement
of current shareholders is crucial in this case.

Lenders
are keen to distribute capital to those who are eligible for such
arrangements.  If the company has a good
reputation the lenders will be excited to issue a loan to such firm and are
also willing to negotiate for lower economic lending rates.  The lenders will earn interest from AYR
Company.

Recommendation

Whilst
the increase in debt will lower the WACC, the company’s optimal capital
structure needs to be satisfied. 
Increase in debt will put so much strain on the current and future
cashflows, such that this may result in stifled strategic growth.  In terms of equity financing the company
needs to calculate whether the time it takes to raise the capital will not give
room to another competitor to introduce such a product.   If the company’s need for capital is urgent
and the assumptions are relevant debt financing will be a quicker way of
raising funding.   There will be need to
review the performance of the project during it life span, to ensure that the
company adapts to any changes in the assumptions made at the initial stages of
the project.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

1.     
Bienfait,
F. (2006) International Finance Management. 
A Note on Valuation Models: CCFs vs APV vs WACC.  Harvard
Business School.  Available at:
https://www.scribd.com/doc/209690687/APV-vs-WACC (Accessed on 1
January 2018)

 

2.     
Carlberg, C. (2010). Business
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3.     
Cooper,
W.D, Cornick, M.F, and Redmon, A (2011). 
Capital Budgeting: A 1990 Study of Fortune 500 Company Practices.  Research
gate.  Journal of Applied Business
Research Volume 8, Number 3.Available 
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4.     
Frank,
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December 2017)

 

5.     
Hall,
B.H (1992) Investment and Research and Development at the Firm Level.  Does the Source of Financing Matter?  National Bureau of Economic Research.  Working paper no.4096.  Available at: http://www.nber.org/papers/w4096.pdf (Accessed 26
December 2017)

 

6.     
Houlis,
P. (2009) ‘Quantitative Methods in Capital Budgeting and Real Options
Techniques.’  Athens information technology centre of excellence for Research and
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7.     
Institute, P. M. (2015). Business
Analysis for Practitioners. Project Management Institute. ISBN:
978-1-62825-0695. (Net-Present-Value
Definition)

 

8.      Jovanovic,
Â, Â, P. (1999) ‘Application of sensitivity analysis in investment project
evaluation under uncertainty and risk.’ International Journal of Project
Management Vol. 17, No. 4, pp. 217±222, 1999 # 1999 Elsevier Science Ltd and IPMA.
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(Accessed 24 December 2017)

 

9.     
Kokemuller,
N. (2017) The Advantages and disadvantages of Debt and Equity Finance.  Chron.  Available at: http://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html (Accessed 26
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10. 
Lorie,
J.H and Savage, L J (1955) ‘Three Problems in Rationing Capital; The Journal of Business.  The School of Business of the University of
Chicago Vol XXV111 October 1955 No.4. http://www.jstor.org/stable/2351049 (Accessed on 24
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11. 
Pons,
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12. 
Ross,
S.A.  Westerfield, R.W.and Jordan, B.D.
(2017) ‘Essentials of Corporate Finance’ Ninth Edition.  Available at: https://unicaf.vitalsource.com/#/books/9781308908311/cfi/48!/4/[email protected]:64.7 (Accessed 14
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13.  Way, J (2017).
‘The Advantages of Using Debt as Capital Structure.’ Chron

http://smallbusiness.chron.com/advantages-using-debt-capital-structure-22011.html (Accessed 26
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14. 
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15.  
Williamson,
O.E., (1988), ‘Corporate Finance and Corporate Governance.’ Wiley Online
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16. 
Ye,
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