Case Study Data Essay Example

Capital Investment Decision 8

CAPITAL INVESTMENT DECISION USING NPV METHOD

Weighted Average Cost of Capital, WACC

Fremantle Mining Ltd uses a mixture of debt and equity to raise capital. According to Brigham and Herhardt (2009), WACC is found by weighting the cost of each specific type of capital by its proportion in the first capital structure. Calculation of WACC involves the following steps

Determination of the costs of the various sources of capital

Determination of the weights related to the various sources of capital

Multiplying the costs and the weights for each of the various sources of capital

Adding the results to arrive at the WACC

The cost of debt capital, bonds is the interest that has been paid on it. In the case of debt capital, the effective cost is taken to consideration for calculating the WACC.

The after-tax cost of debt which is the effective cost of debt = interest rate for debt * (1-taxation rate).

The current corporate tax rate in Australia is 30%

Therefore, the after-tax cost of debt capital = 7.1*(1-30%) = 4.97%

Cost of preference share capital

Case Study Data

Cost of ordinary share capital

Cost of equity = risk free rate + beta*(Market return – Risk free rate)

The risk free rate = 3.78%, beta = 1.5, market return = 8.1%

Therefore, the cost of equity = 3.78% + 1.5*(8.1 – 3.78) = 10.26%.

WACC is calculated after the cost of the specific source of financing has been determined. This calculation is performed by multiplying the specific cost of each specific type of capital by its proportion in the first capital structure and summing the weighted values. To do this the following equation is used

WACC = (wi * ki) + (wp * kp) + (ws * kr)

wi = proportion of debt

wp = proportion of preference share capital

ws = proportion of ordinary share capital

wi + wp + ws = 1

Market value of ordinary shares

Dividend in the next 1 year = $2.73

Dividend in the next 2 years = $2.73*(1+7.8%) = $2.94

Dividend in the next 3 years = $2.94*(1+7.8%) = $3.17

Dividend in the next 4 years = $3.17*(1+7.8%) = $3.42

PV of dividend in the next 1 year = $2.73*(1+10.26%)^-1 = $2.48

PV of dividend in the next 2 years = $2.94*(1+10.26%)^-2 = $2.42

PV of dividend in the next 3 years = $3.17*(1+10.26%)^-3 = $2.37

Total PV of dividends in the next 3 years = 2.48 + 2.42 + 2.37 = $7.27

Total dividends to perpetuity after the next 3 years =
Case Study Data 1

PV of this perpetuity
Case Study Data 2

Therefore, the market value of equity = $7.27 + $40.08 = $47.35

Hence the total value of ordinary shares = $47.35*10 million = $473,500,000

The table below summarises the determination of WACC

Sources of Capital

Weight*Cost

Debt (Bond)

15,000,000

Preference shares

8,800,000

Ordinary Shares

473,500,000

Total Capital

497,300,000

Net present value (NPV) of the project

NPV is the universally accepted technique of capital investment decisions (Schall, 1972). The technique recognizes that cash flows occurring at different time periods differ in value hence the technique uses discounted cash flows in its application. The NPV of the project has been arrived at by deducting the present value of cash outflows from the present value of cash inflows emanating from the project. It is assumed that the WACC of 10.26% is the minimum rate of return that Fremantle Mining Ltd must earn on gold-mining project in order to satisfy the various company investors who have made investment in the form of bonds, preference shares and ordinary shares (Weston and Brigham, 1971). The table below shows calculations and determination of present value of cash inflows from the project.

Quantity of gold

(in ounce)

(@$116 per ounce)

6,728,000

5,684,000

4,640,000

3,596,000

2,552,000

Incremental cost

(2,489,360)

(2,103,080)

(1,716,800)

(1,330,520)

(944,240)

Gross Income

4,238,640

3,580,920

2,923,200

2,265,480

1,607,760

Depreciation

— Equipment

(1,200,000)

(1,200,000)

(1,200,000)

(1,200,000)

(1,200,000)

Income before

taxation

3,038,640

2,380,920

1,723,200

1,065,480

Corporate tax

0

Income after tax

2,127,048

1,666,644

1,206,240

depreciation

1,200,000

1,200,000

1,200,000

1,200,000

1,200,000

Cash flow from

operating activities

3,327,048

2,866,644

2,406,240

1,945,836

1,607,760

Salvage value of

the mining equipment

1,700,000

Recovered additional

net working capital

5,700,000

Total Cash inflow (A)

3,327,048

2,866,644

2,406,240

1,945,836

9,007,760

PV @10.26%

Case Study Data 3

3,017,457

2,357,967

1,795,085

1,316,541

5,527,476

of Cash inflows

14,014,526

The cash inflows arising from the salvage value of the mining equipment and the recovery of additional net working capital have not been subjected to corporate taxation since they are not items of revenue nature.

The straight-line method of depreciation has been used to depreciate the equipment. This method is appropriate because the wear and tear of the equipment is not entirely dependent on the amount of gold produced. Since gold is a scarce resource, it will be abundant in the early years. However, the level of activity of the equipment will remain substantially the same despite the little gold production.

The interest expense and the repayment of the bond, which matures at the end of five years, have not been factored. This is because the bond as a source of capital for Fremantle Mining Ltd was not acquired for undertaking the gold-mining project. Therefore, these expenses cannot be charged against the revenue of this project.

Dividends paid on preference shares and on the ordinary shares have not been charged against the income from the gold-mining project. This is because dividends on preference shares is paid whether the company makes a loss or profit, hence it is irrelevant in decision making. It is assumed that Fremantle Mining Ltd is involved in other revenue generating activities. Therefore, the dividends paid cannot be charged entirely on income from gold-mining project since this capital has been applied in all investment projects of the company.

The following table shows calculations and determination of present value of cash outflows from the project.

0

Purchase of new equipment

6,000,000

Additional net working capital

5,700,000

Clean-up costs

2,900,000

Total cash outflow (A)

11,700,000

0

0

0

0

0

2,900,000

PV @10.26%

Case Study Data 4

11,700,000

0

0

0

0

0

1,613,950

Total PV of Cash outflows

13,313,950

The cost of undertaking a study on environmental impact of the project has been omitted from the analysis. This is because it is a preliminary expense which is irrelevant in decision making. The decision to undertake a gold-mining project will not be based on how much the company has expended.

It is assumed that the purchase of the new equipment will be at the start of the project. The additional net working capital will also be required at the start of the project.

From the analysis, the net present value of the project = Total PV of Cash inflows — Total PV of Cash outflows = $14,014,526 — $13,313,950 = $700,576

Decision making using NPV method

According to the NPV method the criteria is to accept those projects with positive NPVs and reject projects with negative NPVs. Brigham and Houston (2009) note that in case of mutually exclusive projects, project with a higher NPV is accepted. Therefore, Fremantle Mining Ltd should proceed with the project since the calculated NPV is positive. This shows that the company will recover the initial capital outlay for the project, meet the daily operating expenses and have a surplus for the shareholders of the company (Madura, 2006). This means that the project will add value to the wealth of the shareholders.

Reference List

Brigham, E, & Herhardt, M 2009, Financial management: Theory and practice, 13th ed., Thompson South-Western, Ohio.

Brigham, E. F, & Houston, J. F, 2009, Fundamentals of financial management, Cengage Learning, New York

Madura, J, 2006, Introduction to business, Cengage Learning, New York

Schall, L. D, 1972, Asset valuation, firm investment and firm diversification, Journal of Business, vol. 45, pp. 11-28.

Weston, J. F & Brigham, E. F 1971, Managerial finance, Winston, New York,