Strategic Financial Management: The Capital Budgeting Techniques (Case Study Sample)

STRATEGIC FINANCIAL MANAGEMENT by [Name] Course Professor’s Name Institution Location of Institution Date Strategic Financial Management Executive Summary Capital budgeting models are imperative since they enable the management to choose a suitable investment project from a list of alternatives. AYR Company intends to invest $2,250 million in two different projects, Wolf and Aspire, and since it has limited funds, one of the investments will not be undertaken. The NPV, IRR, and the payback period were taken into consideration while making the final decision. The NPV for Aspire was $184,631 compared to $541,557 generated by Wolf. The internal rate of return for Wolf is 18.6% while that of Aspire is 12.6%. The payback period for Wolf is three years and one months while that of Aspire is three years and eleven months. Therefore, the financial manager should select project Wolf since it has higher profitability as indicated by the NPV. Wolf also has the highest IRR which implies that the shareholders’ value will increase after the program is initiated. Additionally, the payback period for Wolf is lower compared to Aspire which signifies that it would take a shorter period to recover the initial amount invested. In addition to the capital budgeting techniques, some of the factors that should be reviewed by the financial manager before making the final investment decision include profitability, sustainability, size of the firm, and tangibility. Since AYR Company’s capital structure comprises of $20 million equity and $18 million in debt, the best option for financing the project would be debt. Notably, additional long-term obligations and equity into the business would lead to an increase in the WACC. Additionally, the selection of the finance source would affect the lender and the shareholders and, hence, it is necessary for the manager to consider the amount of debt and equity that is optimal for the business. Introduction Due to the financial constraints and the scarcity of resources in most companies, the managers are required to conduct project appraisal to determine the viability of multiple projects. Some of the techniques that are utilized by the management include the NPV, the payback period, and the IRR. The investment with the highest level of return should be selected after a careful review of the various alternatives for the company. The purpose of the investment appraisal is to ensure that the entities finances are utilized appropriately and that the shareholders get the highest return on investment. The paper seeks to evaluate the project that the management of AYR Company should invest in using the IRR, NPV, and the payback formulas. The report will also discuss the capital structure of the firm and the impact it has on the potential lenders and shareholders. Capital Budgeting Techniques Capital budgeting is a critical choice that the financial managers are compelled to take on behalf of an organization (Banerjee 2015, p.49). Capital budgeting enables the leaders of an institution to select the best project that would yield the highest returns. Notably, the methods that the company uses to select various investments have a direct impact on the sustainability and growth of a company (Banerjee 2015, p.49). If the management makes the wrong decision pertaining long-term project, there would be a reduction in the shareholders’ wealth. Additionally, some entities use external funding such as loans and, therefore, the repayments of the principal and interest might be forfeited if there are no returns from the investment (Banerjee 2015, p.49). The primary techniques that the financial managers utilize to appraise the long-term investments include the NPV, the IRR, and the payback period. Net Present Value (NPV) The NPV evaluates the net returns of a project after considering the initial cash investment and the incomes that are derived from the project. The NPV estimates the profitability of a project and, hence, the highest value is selected. Additionally, NPV is preferred by most managers since it includes the time value of money while estimating the projects’ financial worthiness (Jory, Benamraoui, Boojihawon, Madichie 2016, p.85). During the calculation of the NPV, there are various factors such as inflation, taxation, depreciation, and the capital expenditure must be incorporated. The increase in the price of commodities in a country should be incorporated into the project to ensure that the results are accurate. Besides, the financial managers should deduct the taxes payable over the period of the project to determine the net cash inflow. The rule of the NPV formula is to select the investment that has the highest value since it is an indication of the expected profitability in future. The formula used to calculate the NPV is indicated below. NPV=Income/(1+r) ^1+Income(1+r) ^2+Income(1+r) ^n-Initial expenditure (Jory, Benamraoui, Boojihawon, Madichie 2016, p.87) In the above formula, r represents the rate of the discounting rate used to calculate the present value while n indicates the number of years that the project will yield cash inflows. Payback Period The technique is used by the financial managers to estimate the time it would take for a project to repay the initial cash invested. The rule of the appraisal technique is that a firm should select a plan that has the shortest period. However, before making the final decision based on the payback period, the management should consider the other capital budgeting techniques such as IRR and NPV. The main difference between the NPV and the payback is that the former incorporates the changes in money value while the latter does not. The payback period would be ideal for a technological investment due to the high rate of obsolescence. The payback period for AYR Company is indicated below. Project Aspire $ (2,510,000.00) 1 After tax cash flow $ 618,400.00 $ (1,891,600.00) 2 $ 613,942.00 $ (1,277,658.00) 3 $ 645,310.59 $ (632,347.42) 4 $ 679,718.49 5 $ 1,089,394.44 The initial cost of the investment is $2,510,000. The next step is to deduct the cash inflows up to the point where the initial price is covered. As indicated in table 3, the cost will be recovered in year 4. However, since the inflows are more than the initial investment at the end of year 4, the exact number of months that it will take to cover the total expenditure in the four years. In the first three years, the total cash inflow will be $1,877,652. The initial investment of $2,510,000 is deducted from $1,877,652 to evaluate the amount that should be recovered in the fourth year, and the difference is $632,347. To determine the number of months that it would take top cover $632,347 in year 4, we divide the amount by the cash inflow as indicated below. =632,347/$679718=11 months Hence, the payback period for Aspire is three years and eleven months Wolf Initial investment $ (2,370,000.00) Year 1 cash flow $ 768,080.00 $ (1,601,920.00) Year 2 cash flow $ 768,296.00 $ (833,624.00) Year 3 cash flow $ 768,366.20 $ (65,257.80) Year 4 cash flow $ 768,291.82 Year 5 cash flow $ 768,073.24 The initial cost of the investment is $2,370,000. The next step is to deduct the cash inflows up to the point where the initial cost is covered. As indicated in table 4, the cost will be fully recovered in year 4. However, since the inflows are more than the initial investment at the end of year 4, the exact number of months that it will take to cover the total cost in the four years. In the first three years, the total cash inflow will be $2,304,742. The initial investment of $2,370,000 is deducted from $2,304,742 to evaluate the amount that should be recovered in the fourth year and the difference is $65,257. To determine the number of months that it would take top cover $65,257 in year 4, divide the amount by the cash inflow as indicated below. =65,257/$768,291=1 month Therefore, Wolf’s payback is three years and eleven month. Internal Rate of Return The model equates the cash inflow of a project to the initial cash invested (Mackevicius & Tomasevic 2010, p.116). The IRR of project Aspire is 12.6% while that of Wolf is 18.60 as indicated in table 3 and 4 in the appendices. The equation indicated below would be applied to calculate the IRR. Income/(1+r) ^1+Income(1+r) ^2+Income(1+r) ^n=Initial expenditure Whereby the discounted cashflows for the five-year period will be equivalent to the initial expenditure incurred and, therefore, the NPV would be zero. While calculating the IRR, random discounting rates are utilized to determine the exact point at which there is no profit or loss. Analysis and Evaluation Recommendation Based on the NPV estimates, the managers of the entity should undertake project “Wolf” since it has a higher NPV compared to investment Aspire. The payback period for “Aspire” is three years and eleven months and that of “Wolf” is three years and one month. Therefore, the project “Wolf” should be selected since it has a lower payback period compared to “Aspire”. Project “Wolf” has the best NPV and payback period and, hence, it is the most viable project for the financial manager of AYR Company to undertake. The IRRs for both investment options are higher than 10% since they are 18.6 and 12.6% for Wolf and Aspire respectively. Since project Wolf has an IRR of 18.6% while Aspire has an IRR of 12.6 the financial manager should select the former since it has the highest. Justification From the two projects, the financial manager should select Wolf since it has the best IRR, NPV, and payback period. The IRR of project Wolf is 18.6% while that of Aspire is 12.6% which implies that there will be mo...