You work in the Finance division of the Essendon Manufacturing Company Ltd. The company is in the process of deciding whether or not to purchase a new die casting machine. Your company's Chief Financial Officer has asked you to prepare a report on this potential project, and to make a recommendation as to whether or not the company should proceed with the project.
The business report has been written keeping in mind the New Die Casting Machine to be purchased by Essendon Manufacturing Company Ltd. The business report begins with the brief overview of the capital structure of the company and the importance of Weighted Average Cost of Capital. The report moves to the crux of the matter – the Capital Budgeting Method used for decision making process. The method used are the Net Present Value Method, IRR Method and the Payback Period Method. The report later on moves to the importance of each capital budgeting method , Pros and cons of using these technique. After stating the importance of the techniques, the decision is taken on the basis of it. The last few pages of the project goes with the decision of buying the New Die Casting Machine is feasible or not.
Weighted Average Cost of Capital:-
Weighted Average Cost of Capital is an important financial tool for the companies and financial analyst. It helps companies make important investment decisions and compare the projects with similar risks. It is used as cost of capital by the company to evaluate the project. If the project offers less return then it WACC, then it is not feasible for the company to invest in the project. IMPORTANCE OF WEIGHTED AVERAGE COST OF CAPITAL (WACC) FOR CAPITAL BUDGETING DECISIONS: WACC is mainly used to make investment decisions for a project. While calculating Net Present Value (NPV), WACC is used as a discount rate or the hurdle rate. All free cash flows and the terminal cash flows are discounted at the WACC to get appropriate decision. Weighted Average Cost of Capital ( WACC) includes all sources of capital that is Debt, Preferred Stock and the Common Stock. The WACC thus considers all types of capital structure according to their weight in the company. Weighted Average Cost of capital uses the market value of all the funds. This helps the companies to take appropriate Investment Decision. Weighted Average Cost of Capital is used mostly as a discount rate for the projects whose cash flows which have risk almost same as that of the company’s overall risk. The WACC is calculated as the sum of the cost of each capital multiplied by the weights of each capital in the capital structure.
WACC = Wd*Rd + Wp*Rp + Ws*Rs
Wd = Weight of Debt Rd = After Tax cost of debt
Wp = Weight of Preferred Stock
RP = Cost of Preferred Stock
Ws = Weight of Common Equity
Rs = Cost of Common Equity
Capital Budgeting Techniques:-
Essendon Manufacturing Company Ltd is in the process of deciding whether or not to purchase a new die casting
machine. On behalf of the company, the report show the capital budgeting techniques:-
1. Net Present Value :-
Net Present Value (NPV) is the difference of the discounted cash inflow and the initial cash outflow. Higher NPV of the
project, the more the project is preferred . A positive NPV is viable for the project.
2. Internal Rate of Return:-
It is the discount rate at which the net present value of project is zero. A higher IRR is always preferred.
3. Payback Period:-
It measures the time in which the project recovers its initial investment of the project. The company wants to recover
the initial investment within three years of the project time. The lower the payback period, more it is preferred.
4. Discounted Payback Period:-
It is the same as the payback period, the only difference is the cash flows are discounted to its present value and then
the payback period is calculated.
All the above techniques are based on the comparison of discounted cash inflows and outflows of the project with a
substantial difference in each technique.