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Topic:

Capital Budgeting Funding Sources

Essay Instructions:

Module 4 – Background mATERIAL

CAPITAL BUDGETING WITH FUNDING SOURCES

Required Reading

Many of you are eager to start off with the formulas for capital budgeting, so this link is a good place to review the main formulas:

McCracken, M.E. (2005) Capital budgeting, retrieved from:http://teachmefinance(dot)com/capitalbudgeting.html

Here is an example of net present value using Microsoft Excel:

Microsoft Office Online, NPV, Retrieved from https://support(dot)office(dot)microsoft(dot)com/en-US/article/NPV-function-5c52df05-07cb-48e0-a006-97225eb960bc?ui=en-US&rs=en-US&ad=US

Here is another example of net present value:

Anthes, G. (2003) ROI guide: Net present value, Retrieved fromhttp://www(dot)computerworld(dot)com/article/2581461/it-management/roi-guide--net-present-value.html

Here are some examples of how to compute internal rate of return using Microsoft Excel:

Microsoft Office Online, (n.d.) IRR, retrieved from: https://support(dot)office(dot)microsoft(dot)com/en-US/Article/IRR-function-64925eaa-9988-495b-b290-3ad0c163c1bc?ui=en-US&rs=en-US&ad=US

Advanced Excel Business Center, (2008), Internal rate of return, retrieved fromhttp://www(dot)advanced-excel(dot)com/internal_rate_of_return.html

For an example of the profitability index, see:

Investopedia (n.d.). How do you use the profitability index rule when scoping out a project? Retrieved from http://www(dot)investopedia(dot)com/ask/answers/020615/how-do-you-use-profitability-index-rule-when-scoping-out-project.asp

To gain a deeper understanding of capital budgeting beyond just the formulas, carefully review the following links:

Summary of Capital Budgeting. (n.d.) Summary of Capital Budgeting, Retrieved from:
http://www(dot)studyfinance(dot)com/lessons/capbudget/index.mv

Lefley, F. (1997). Modified internal rate of return: Will it replace IRR?. Management Accounting, 75(1), 64-65. Retrieved from http://www(dot)highbeam(dot)com/doc/1G1-19035236.html

Please review the following PowerPoint presentations:

Capital Budgeting

Return on Investment

Payback

American Superconductor switch ; Westboro company plans to raise money through a stock offering, Andi Esposito. Telegram & Gazette. Worcester, Mass.: Aug 26, 2003. pg. E. Retrieved from Proquest.

Harvey, C. (2002). How do CFOs make capital structure and budgeting decisions, from: Journal of Applied Corporate Finance, 15(1), 8-23.

Aswath Damodaran. 1. The Debt-Equity Trade Off: Stern School of Business, from Capital Structure Decision.

Optional Reading

Gotthilf, D. L. (1997). Long-term borrowing techniques. Treasurer's and Controller's Desk Book,American Management Association.

Kuhlemeyer, G. (2010). Findamentals of Financial Management, Pearson Education (read Chapter 13: Capital Budgeting Techniques)l.

Capital Budgeting - Lecture 5 Listed in the Presentations.

Damodaran, A. (n.d.). Finding the Right Financing Mix: The Capital Structure Decision, Stern School of Business. Retrieved from http://pages(dot)stern(dot)nyu(dot)edu/~adamodar/pdfiles/ovhds/ch8.pdf

 

 

 

 

 

 

 

Module 4 – Case ASSIGNMENT

CAPITAL BUDGETING WITH FUNDING SOURCES

Case Assignment

This case assignment has two separate parts.

Part I: Capital Budgeting Practice Problems

a. Consider the project with the following expected cash flows:

Year 

Cash flow

0

-$400,000

1

$100,000

2

$120,000

3

$850,000
  • If the discount rate is 0%, what is the project's net present value?
  • If the discount rate is 2%, what is the project's net present value?
  • If the discount rate is 6%, what is the project's net present value?
  • If the discount rate is 11%, what is the project's net present value?
  • With a cost of capital of 5%, what is this project's modified internal rate of return?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. Connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[ Look at the graph you draw and write a short paragraph stating what the graph 'shows’]

b. Consider a project with the expected cash flows:

Year 

Cash flow

0

-$815,000

1

$141,000

2

$320,000

3

$440,000
  • What is this project's internal rate of return?
  • If the discount rate is 1%, what is this project's net present value?
  • If the discount rate is 4%, what is this project's net present value?
  • If the discount rate is 10%, what is this project's net present value?
  • If the discount rate is 18%, what is this project's net present value?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. Connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[ Observe the graph and write a short paragraph stating what the graph 'shows’]

c. Read the background materials. Then write a one-to-two page paper answering the following question:

Which method do you think is the better one for making capital budgeting decisions - IRR or NPV?

Part 2: Equity and Debt

Read the article below available in ProQuest:

American Superconductor switch ; Westboro company plans to raise money through a stock offering, Andi Esposito. Telegram & Gazette. Worcester, Mass.: Aug 26, 2003. pg. E.1

Abstract (Article Summary)

"AMSC's management and board of directors believe the decision to forgo a secured debt financing and to adopt an equity financing strategy under current market conditions is in the best interests of our shareholders," said Gregory J. Yurek, chief executive officer of AMSC. The 265-employee company has operations in Westboro and Devens and in Wisconsin.

Finally, the Northeast blackout "shined a lot of light on the problems we have been talking about as a company for three to four years," Mr. Yurek said. AMSC products, such as a system installed this year in the aging Connecticut grid and high temperature superconductor power cables and other devices bought by China for its grid, are designed to improve the cost, efficiency and reliability of systems that generate, deliver and use electric power. "We are a company with products out there solving problems today," he said.

After reading the background materials and doing your research, apply what you learned from the background materials and write a two to three page paper answering the following questions:

What are the advantages and disadvantages for AMSC to forgo their debt financing and take on equity financing? Do you agree with their decision? How can a company's cost of equity be determined? Is there a tax deduction from the use of debt financing? Please explain.

Explain your answers thoroughly. Be sure to support your opinions on these assignment questions with references to the background materials or to other articles in your paper.

Assignment Expectations

This assignment consists of a quantitative section (Part 1) and an essay section (Part 2) below. Upload both sections 

Essay Sample Content Preview:

Finance mod 4 cases: capital budgeting funding sources
Name
Course
Instructor
Date
If the discount rate is 0%, what is the project's net present value?
Year 
Cash flow
PVIF @ 0%
PV
0
($400,000)
1
($400,000)
1
$100,000
1
$100,000
2
$120,000
1
$120,000
3
$850,000
1
$850,000
NPV
$670,000
If the discount rate is 2%, what is the project's net present value?
Year 
Cash flow
PVIF @ 2%
0
($400,000)
1
($400,000)
1
$100,000
0.9804
$98,040
2
$120,000
0.9612
$115,344
3
$850,000
0.9423
$800,955
NPV
$614,339
If the discount rate is 6%, what is the project's net present value?
Year 
Cash flow
PVIF @ 6%
0
($400,000)
1
($400,000)
1
$100,000
0.9434
$94,340
2
$120,000
0.89
$106,800
3
$850,000
0.8396
$713,660
NPV
$514,800
If the discount rate is 11%, what is the project's net present value?
Year 
Cash flow
PVIF @ 11%
0
($400,000)
1
($400,000)
1
$100,000
0.9009
$90,090
2
$120,000
0.8116
$97,392
3
$850,000
0.7312
$621,520
NPV
$409,002
MIRR when the cost of capital is 5%,
In this case the cost of capital is the finance rate at 5% and the reinvestment rate is arbitrary also assumed to be 5%. The MIRR using the excel functions is (value-range, 5%, 5%) = 40%.
Graphical representation
As the required rate of return increases, the net present value declines indicating that the NPV will eventually be equal to zero. This is the cutoff point where the management makes decisions not to invest in a project likely to have negative cash flows. This is the internal rate of return (IRR), which indicates the level at which the cash inflows is equal to the cash outflows at $ 400,000. This IRR is likely to be in the mid 40%, and decisions are made by looking at the hurdle rate and the IRR together. In the MIRR approach it is assumed projects are reinvested at the cost of capital compared to the IRR where reinvestment at the IRR (Investopedia.com, n.d.). The MIRR is lower than the IRR and provides a realistic evaluation of a project compared to the IRR that is too optimistic.
b] Project with cash flows
Year
Cash flow
0
($815,000)
1
$141,000
2
$320,000
3
$440,000

Internal rate of return=4.42%
NPV at 1%, 4%, 10% and 18%
Rate
NPV
1%
65,358
4%
7,593
10%
-91,777
18%
-197,892


The graphical representation of NPV at different discount rates shows that the IRR ranges from 4% to 5%, indicating that the calculated IRR rate at 4.42 % is correct. The company should hence not reinvest in the three year project if the cost of capital is more than 4.42%.
C] Capital budgeting decisions- NPV vs. IRR
In investment appraisal, the internal rate of return (IRR), and the net present value (NPV) are the most used techniques to evaluate projects. The NPV is better since the IRR is not applicable in all cases, especially when there are multiple IRRs. This is especially when projects have unconventio...
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