Hypothetical Firm: Discussion of Capital Budgeting Model (Essay Sample)

Discussion of Capital Budgeting Model
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Discussion of Capital Budgeting Model
In order to grow and expand its operations, Kinder Morgan, Inc. has proposed different projects to help it achieve this goal. These projects include expansion of pipelines, acquisitions and mergers. One of these projects is Utopia project which involves construction and operation of a new pipeline. The project will be financed by joint venture with a private company known as Riverstone investment group (Otterbourg, 2014).
Capital budgeting refers to the process of determining and evaluating whether a long term project e.g. an expansion investment is worth undertaking and funding. It is used by organizations to allocate capital and other resources required by projects, analysis of the projected cash inflows of the project and making a decision whether to fund the project or not. The projects are ranked using criteria such as Net Present Value, Internal Rate of Return and Profitability Index, and the most profitable projects undertaken (Brigham, 2016).
The purpose of this paper is to evaluate Utopia project, one of the long term projects proposed by Kinder Morgan, Inc. using Excel Capital Budgeting model. The first section describes the details of Utopia project. These include the initial investment (cost of the project), projected annual cash flows for at least seven years and the discounting rate. The second section provides an explanation of development of Excel Capital Budgeting Model and determination of Net Present value, Internal Rate of Return, Modified Internal Rate of Return and Profitability Index of the project. Third section provides analysis and interpretation of results of NPV, IRR, MIRR and PI. Lastly, it provides a recommendation on whether or not the project should be accepted depending on the results of the capital budgeting criteria.
Description of proposed capital budgeting project
In order to expand and increase supply of its products Kinder Morgan has proposed Utopia project which involves the development, construction and operation of a new pipeline through Michigan and Ohio to Windsor. The project has an initial investment of approximately $500 million. The pipeline will be constructed in the state of Ohio and will cover an approximate distance of 215 miles with a 12 inch diameter. It will thereafter connect to an existing pipeline to transport ethane and propane-ethane products to Windsor. The system is designed to have an initial daily capacity of 50,000 barrels; this will be expanded to 75,000 or more barrels per day (Inkpen & Moffett, 2011).
The project will have an initial investment of approximately $500 million. It will be financed by cash flows generated through joint venture agreement between Kinder Morgan and Riverstone Investment Group in which the company reimbursed Kinder 50% of the capital costs related to the project and will also participate in funding its share of expenditures that will be incurred in future to complete the project. The revenue from the product segments is $1.9 billion whereas the number of terminals is 180. Therefore initial cash inflow is the quotient of 2016 financial year revenue and number of terminals ($19 billion / 180 terminals = $105,555,555). The project is expected to produce 80% capacity in first year, i.e. 80% of 105,555,555= $84,444,444. The cash flows are projected to grow tremendously in second and third year by 40% and a constant growth of 30% onwards. The cash inflows are as follows: $84,444,444, $118,222,222, $165,511,111, $215,164,444, $279,713,778, $363,627,911 and $472,716,284.The assumption is that first year cash flow equals revenue generated from terminals divided by number of terminals and that first year cash inflows will be at 80% (Yahoo Finance, 2016).
The discount rate for the investment is 3.26%. This rate is used to determine whether an investment will be taken or not. The internal rate of return of the project must be greater than the discount rate. The market value of equity is $47,615,460 and market value for debt equals sum of short term and long term debt ($1,769,000 and $41,251,500) which gives $43,020,500. The total market value of the company was calculated by adding value of equity and value of debt. Weight of equity was calculated by dividing market value of equity by total market value of the company. Weight of debt was calculated by dividing market value of debt by total market value of the company. Cost of equity equals to sum of risk free rate of 1.7% (a 10 year treasury constant yield rate) and expected return of the market (7.5%) multiplied by beta of assets (0.6). Cost of debt is the quotient of latest interest expense (0) and market value of debt ($43,020,500). The average tax rate for the latest two years is 47.01%. Tax used equals 1 minus 47.01% which gives 52.99%.Discount rate is therefore weighted equity multiplied by cost of equity added to weight of debt multiplied by cost of debt and effective tax rate (Yahoo Finance, 2016).
Explanation of Excel Capital Budgeting model
In order to determine whether a project is worth taking or not, the profitability must be determined. The Net Present Value, Internal Rate of Return, Modified Rate of Return and Profitability Index of Utopia project was determined using an excel capital budgeting model. The model has fields for inputs for company name, project name, and discount rate and projected cash flows. These fields are in orange as shown in Appendix 2. Kinder Morgan, Inc., Utopia Pipeline project, 3.26%, and the cash flows for the seven years are the inputs. Excel provides functions for calculating the criteria used for evaluation. After all the inputs have been keyed in: excel calculates NPV using the function =NPV (rate, value1:value7) + initial cost, IRR using =IRR(value1:value8), MIRR using the function =MIRR(value1:value8, finance rate, reinvest rate and PI using =NPV(rate, value1:value7) /-initial cost where rate is discount rate, 3.26%, value1:value7 is range of cash flows generated by the project, value1:valu8 is the range of initial cost and all the cash inflows, finance rate is the discount rate and reinvest rate is the discount rate. The outputs from the model are used to make a decision whether the project will be undertaken or not. The outputs are: NPV of $$948,287,824, IRR value of 30.73%, MIRR value of 20.20% and a PI value of $1.897(Brigham, 2016).
Explanation and Interpretation of Capital Budgeting Criteria
The values of the net present value, internal rate of return, modified rate of return and profitability index determine whether the project will be worth taking or not. Different criteria evaluate the projects using different items (Business Finance Online, n.d.).
Net Present Value: It is calculated by subtracting the initial investment (cost of the project) from the present value of the cash flows to be generated by the project in future. It is the most accurate criteria for evaluating project especially for mutually exclusive projects. It considers all the cash flows associated with the project. For projects which are independent, accept projects with positive NPV whereas for mutually exclusive projects, choose the one with the highest NPV. Utopia Pipeline project has a positive NPV hence will be profitable if undertaken. Therefore it should be accepted (Ehrhardt & Brigham 2015).
Internal Rate of Return: It is the rate at which the NPV of a project is zero. It also returns produced by the project. IRR of a project should be greater than the company’s discount rate for a project to be profitable to the company. The rate is calculated using the excel function IRR. This criterion takes into consideration all the cash flows of the project but do not evaluate correctly mutually exclusive projects. For independent projects, a project should be accepted if internal rate of return IRR is greater than the discount rate whereas for mutually exclusive ones, the project with the highest IRR which is greater than discount rate should be undertaken. Utopia pipeline project’s IRR is 48.80%. This rate is greater than the discount rate (3.26%) therefore the project should be accepted (Brigham, 2016).
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