Posted: June 24th, 2021
The purpose of this report is to help a financial special assistant, Linda, to analyze the financial position of Atlas Metals Company and deciding its capital budgeting and capital structure. Firstly, I explain why firm should use Net Present Value (NPV) methods for capital budgeting rather than Return on Investment (ROI) method and Payback Period method. Secondly, I calculate the Weighted Average Cost of Capital (WACC) which will be used as discount rate while calculating NPV. Then, I decide which rapid prototyping system company should invest as well as I compare the each expansion projects’ IRR with WACC to decide which projects should be invested and which should not. After deciding projects which should be accepted, I draw Investment Opportunity Schedule (IOS) and Marginal Cost of Capital (MCC) graphs to decide where the company should finance accepted projects. Why Should Atlas Metal Company Use NPV?
Atlas Metal Company use payback period and ROI for evaluating projects. Both of these methods have some drawbacks which lead to manager to give wrong decision. Firstly, the firm use payback period by simply calculating the average time when project’s cash flow exceeds the initial investment cost. This method ignores the cash flow after the payback period. In other words, there may be some negative cash flow after payback period which may incur extra costs to company. Moreover, it also ignores the time value of money which causes a miscalculation of expected future cash flows. Secondly, increasing the ROI and deciding projects according to only ROI might harm company in the long-run. If a company always accepts higher ROI projects, company’s average return will also increase which also lead higher risk. Furthermore, there is a time difference between incurring the initial cost for project and later future cash flow. Therefore, this is difficult to evaluate the project with its cost and return in the same time. Also, ROI does not consider opportunity costs of projects.
When a firm deciding invests in a project by ROI, it might miss the opportunity of allocation of the same amount to another project. If Atlas Metal Company uses NPV method rather than payback period or ROI, they will decide more accurate decision thanks to many advantages of NPV. Firstly, NPV method adjusts all expected future cash flow to time value of money. Therefore, no matter whether it is positive or negative future cash flow, NPV calculate present value of all expected future cash flow which helps the company for comparison. Also, the size difference between projects will not cause any problem if the firm uses NPV because NPV presented in net dollars amount. Thus, company can easily understand how much money is expected to earn rather than percentage. This also led to evaluate both mutually exclusive and independent projects. Calculating Weighted Average Cost of Capital
In order to calculate the WACC, I find the total amount of company’s value (Long-term debt + Short-term debt + Preferred Stock + Common Stock). Here, I also add short-term debt in total value of the firm, while generally it is not added. The reason is that Atlas Metal Company use short-term debt as a source of permanent financing. After deciding value of firm, I find weight of each component in value of company and multiply it by their cost of funding as well as by (1- Tax Rate) for long-term and short-term debts. The calculation is below; Cost of Long-Term Debt : Since the value in balance is based on book value of long-term debts, I firstly find the market value by disclosure information about bonds; Par Value: $1000, Coupon Payment : $80, Remaining Life: 10 years, YTM= %9, number of bonds: 121,326,000/1000 (Bond price= C*[1-1/(1+r)t]/r + par value/(1+r)10
Market Value of Bonds: $113,539,297
Cost of Short-Term Debt: Since short-term debts have a life of 1 year at most, the amount in balance sheet is true amount of short-term debt for year 1998 with 6% of interest. So; Market Value of Short-Term Debt: $29,010,000
Cost of Common Equity: the cost of common equity by two different ways. One of them is CAPM. However, Linda wants to calculate the cost of common equity by growth rate. In order to calculate, we need to know growth rate of dividend, last year dividend amount and stock price. At the very beginning, I calculate the dividend amounts for last 10 years by multiplying Earning per Share by dividend payout ratio (0.3). Then, I find out the average of the growth rate for last 10 years to use that rate as company’s growth rate (Table 1). The reason for finding adjusted dividend is that it is not possible for company to have negative dividend. It is expected the company’s growth rate would be 125 percent of that experienced from 1988 to 1998. So, I found growth rate as 7.799%. So, Cost of common equity: D1 /P0 + g => ($1.75/24.84)+ 0.07799 : 14.83% Moreover, the company has 8.5 million shares outstanding and the current market price is $24.84 per share. So; Market Value of Common Stock: $211,140,000
Cost of Preferred Stock: To find cost of preferred stock, we just divide dividend per share by price of this stock. So the cost of preferred stock is $12.69/100: 12.69% Market Value of Preferred Stock: $36,010,000
Which Rapid Prototyping System Should Company Invest in?
Since the System A and System B is mutually exclusive, company can invest only one of them. As, I explained earlier the correct method should be used is NPV model and to make a comparison between two projects they should have same life. However, System A has 10-year-life while System B has 15-year-life. Since they have different life, there is a need for adjustment by Equivalent Annual Annuity method. Firstly, I find each of project’s NPV with their life. Then, I use annual annuity formula to find each project’s yearly cash flow regardless of their difference in life.
Which Expansion Projects And Project Groups Should Be Accepted?
Since IRR of each project is known, I can simply compare the WACC with IRRs and accept any projects whose IRR is larger than WACC. In this case, all six projects, Los Angeles, Texas, Florida expansion projects as well as Group 1, Group 2, Group 3 projects should be accepted in normal risk scenario. Since board members do not reach a consensus, I should add 2% risk premium to company’s WACC, which becomes 13.05%. According to this new WACC, company should reject Texas project since its IRR is below the WACC. How Much Does the Firm Need and How Will the Firm Finance Projects? Since company should invest in all projects expect Texas expansion projects, the amount needed is total of projects total costs as well as System A’s initial investment cost (32 + 65 + 40 + 50 + 20 + 3 = $210 million). For financing this amount, the company can use the amount of depreciation after tax deduction. In other words, company has total of $8,249,000 depreciation and can benefit from the tax shield of that amount which is ($8,249,000 – ($8,249,000 * 0.4)): $3,299,600.After deduction, I decide that the total amount company should find is $206,700,400. After all, it is known from the case that company’s capital structure is nearly optimal. Therefore, I think that company should finance its projects just like past capital structure so I find out the weight of financial instruments and apply them to new capital needed (Table 3).
In order to decide which project should be financed with which financial instruments, I draw Investment Opportunity Schedule (IOS) and Marginal Cost of Capital (MCC) graphs (Figure 1). In order to draw the IOS, I rank each project’s IRR in Y-axis and each project’s marginal cost in X-axis. Then, I draw the MCC graph by using each financial instrument’s cost of capital and their upper limit with the help of table 3.
According to graph above, Atlas Metal Company should finance System A, Group 1 Projects, and Florida projects with the mix of any financial instruments because these projects’ IOS are above the MCC line. And, Group 2 and Los Angeles expansion projects should be financed with any mix of method except common stock while Group 3 should be financed only with the mix of long-term debt and short-term debt.
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