Rhodium Company: Financial Report

Terms of references

The aim of setting of optimal capital is to use the whole amount of capital that has less cost of acquisitions. This includes debt and equity capital. The profits are measured in terms of the total assets used to conduct business operations and not just the equity of the owners themselves. Aside from NPV and IRR, there are also criteria’s that do not make use of the numerical assessment because there are other components in the success of a business that has nothing to do with the numbers of any kind at all.

Methodology

Introduction

This report only tries to provide an outline on how Rhodium estimates it cost of capital and techniques used in capital budgeting. In this report I will only depend on data provided, may increase the cost of the report to a great extent. For this the first important step is to find out the sources of capital available to the company. When the list is obtained from the company annual report, then the machine to be replaced is evaluated using the proposed replacement.

Any asset has a current value equal to the value of the future cash benefits from ownership of the asset discounted at a rate commensurate with the timing and risk of those cash benefits, i.e. weighted average cost of capital. Three assumptions have to be made

• There is a known target ratio for the financing elements, which will continue for the duration of the investment project under consideration;
• The costs of the various elements will not alter in the future from the costs calculated; and
• The investment under consideration is of similar risk to the average of the other projects undertaken by the business.

Weighted average cost of capital (WACC)

Then using the weighted average cost of capital (WACC) as the discount rate is logical. Using opportunity cost implies looking at the savings in financing cost that would arise if finance were to be rapid instead of undertaking the investment project. Alternatively, it could be seen as the additional cost of raising the necessary finance to support the project. If there is a target, repayment of finance or additional financing would be carried out in accordance with the target.

The three assumptions stated at the start of this section are all concerned with the fact that in investment project appraisal, and in any other case where we may wish to assess the cost of capital, it is the future cost that we are interested in. The third assumption, relating to risk, perhaps needs a comment. We know from a combination of intuition, casual observation of real life and from a robust theoretical proposition that the required rate of return/ cost of capital depends partly on the level of risk surrounding the cash flows of the investment project concerned. It is not appropriate, therefore, to use a WACC, based on a past involving investment projects of one risk class, as the discount rate for investments of an entirely different class. The formula of WACC uses three components:

WACC = WdKd(1-T) + WsKs,

Where:

• Wd – weight of debt in capital structure
• Kd*(1-T) – after tax component, includes cost of debt multiplied by the tax collector
• Ws – weight of equity in capital structure
• Ks – cost of equity

Method of calculating cost of debt capital: the purpose of calculating the cost of capital is to derive a discount rate to apply to investment projects that are ahead of us. The appropriate discount rate is the opportunity cost of capital.

The difference must arise either from interests’ rates having increased generally or from the capital market having changed its perceptions of the risk of default in payment of interest or principal. Thus a particular business’s cost of capital is not necessarily static over time. Assuming capital market efficiency, the cost of any element of capital is the market’s best estimate of that cost for the future.

The cost of equity: To say that equities should be valued on the basis of future dividends is not to assume that any particular investor intends to hold a particular share for ever, because the proceeds of any future disposal of the share will itself depend on expectations, as the date of disposal, of future dividends. However to find the Expected return on Rhodium capital we use Capital Asset Pricing Model. CAPM considers profitability of assets depending on the market behavior as a whole. The main assumption for CAPM is based on the investor’s decision, considering only two factors: expected return and risk. Despite the fact that this model is a simplified representation of the financial market it is used by many large investment structures (Singh and Gaur, 2004). The CAPM proposes a higher rate of risks than dividend growth model. The investor has a higher rate of risk since he invests in the form of assets. An asset or portfolio may be in the form of bonds, stocks, options, warrants, real estates and all its other forms. In this kind of model, investors were risk averse. Given two asset with the same expected return, it is expected that they rather choose the less risky one. Investors can lower their risks by holding non-diversifiable risk portfolio (Ryan and Ryan, 2002). By using the formula we will know how many risks we put in investing:

• Expected Return (Er) = R_s + β (private company) (R_m-R_s)
• β levered = β unlevered * (1 + (1 – tax rate) (Debt/Equity))
• β (private company) = β unlevered (business) * (1 + (1 – tax rate) * (Industry Average Debt/Equity))

Optimal capital

Businesses seek to keep equity finance as a relatively fixed proportion of the total finance. They also keep loan –type finance as more or less a fixed proportion with minor variations may occur from time to time to keep the cost of financing low. Most businesses maintain a stable capital structure and appear to have a target gearing ratio. It is believed that such target ratios exist because businesses, taking account of such factors as levels of interest rates, tax advantages of loan interest relative to dividends, and the stability of their operating cash flows, decide on an optimal mix of financing methods, which they then try to establish and maintain. The objective of trying to establish and maintain an optimal balance between various sources of finance, indeed raising finance from other than equities at all, is presumably to try to minimize the cost of capital.

Net present value

The disadvantage of the NPV calculation is the fact that the decision making is highly dependent on the rate of return that the calculation makes use of. The rate used is the opinion of the analyst or the researcher of the future growth rate that the company might be able to achieve. There is no such thing as sure fire way to foretell the future (Collins 2003). It is almost guaranteed on the other hand that the prediction will be proved false by a very wide margin of error. Although the reasoning behind the use of the NPV’s formula is useful for comparison, it is not immune to a fatal flaw in the design of its model’s computation. It does have the ability to clearly compare options for approval if they are good investments or not. The researcher will be able to present in numbers the exact degree of profitability that a business might have. On the other hand, all of the calculations are simply based on the rate at which the business is supposed to grow. This is the reason why the calculations can go off the true path by a very wide margin. This is also the reason why NPV is not a very good measure of an investment’s soundness or chance for success (Ryan and Ryan, 2002).

It can’t accommodate the intangible things business needs to survive and succeed. The cost of capital can make the decision makers say yes or not to the project. The higher the cost of capital is, the higher the rate of return. Inversely, the lower the cost of capital is the lower the rate of return. If there are two or more projects or investment that a decision maker has to choose from, the one with the lower cost of capital will be disregarded since they are not as profitable as the one with a higher cost of capital. They are very useful tools for comparison. They show the researcher or the businessman the potential profits and the returns in numerical terms. Although it is also far from perfect, it nevertheless provides the kind of basis for a more intelligent decision rather than relying on just feelings alone. The cost of capital also gives investors a basis for their capital allocation decisions since the rate of return can be clearly compare to each other (Collins 1994). All the other factors that they have evaluated are to be added in conjunction with the rate of return that a business has. This is slightly different with the usual ROI calculation since the cost of capital also takes into account the debt that was used by the business to operate. The rate at which the debt has to be paid is also taken into consideration with this kind of calculation. It provides a more sensitive insight as compared to the understanding that a plain ROI calculation can provide.

Sensitivity analysis

A proper project management analysis has to take account of the potential risks to a project. Sensitivity analysis is one such method to model risks. Sensitivity analysis can be carried out to estimate the effect of differing inputs, e.g. drop/increase in various factors, a change in tax rate, initial capital, Change in working capital and a change in the discount rate (Gitman, 2009).

One of the difficulties of estimating future returns in a risky situation is the complexity of the influences which may work on them. Returns are not a simple uncomplicated quantity. They are the result of various factors, i.e. the revenues less all the relevant costs, and each of this may be subject to its own special risk unrelated to that affecting the others. In order to simplify the situation somewhat, use may be made of what is known as sensitivity analysis to isolate the more important factors from the less important. All that is meant by this is that we test the various factors to see how vulnerable the overall outcome of the project is to valuations in each of its own.

One of the simplest ways of considering the risk of a project is to use sensitivity analysis. Sensitivity analysis involves using a number of possible outcomes in evaluating a project. It is probably most useful in truly uncertain decision situations. The basic procedure is to evaluate a project using a number of possible association cash flows to get a “feel” for the variability of the outcomes. One of the most common sensitivity approaches is to estimate the worst, the expected and the best outcomes associated with a project (Rao, 1989)

Findings

Weighted Average Cost of capital

From the analysis carried out in the excel file attached the company weighted average cost of capital is 9.02%. This is calculated as follows:

• Average Beta for Market = (1.21 + 2.14 + 1.19) / 3 = 1.51
• Average Debt/Assets Ratio = (30.8% + 34.9% + 28.6%) / 3 = 31.4%
• Average Tax Rate = (34.40% + 28.90% + 32.3%) / 3 = 31.9%

Using HAMADA equation:

• Beta Unlevered for Market = 1.51 / (1 + (1 – 31.9%) * 31.4% / (1 – 31.4%)) = 1.15
• Beta Levered for Rhodium = 1.15 * (1 + (1 – 32.1%) * 13% / (1 – 13%)) = 1.27

Using CAPM:

• Expected Return (Er) = 3.88% + 1.27 * 4.75% = 9.9%
• Cost of Equity (Ks) = (Er) = 3.88% + 1.27 * 4.75% = 9.9%
• Cost of Debt (Kd) = (YTM) = 4.45%
• Debt / Assets = 13%
• WACC = 13% * 4.45% * (1 – 32.1%) + (1 – 13%) * 9.9% = 9.02%

The optimal capital

The optimal capital is calculated as follows:

Where:

• Wd – Weight of debt in capital structure
• Kd – Cost of debt
• Ks – Cost of equity
• Optimal capital structure = when debt is 30% in capital structure of Rhodium.

Replacement decision

If machine A replaced with machine B it will have a negative NPV of 296,734, pay back period of 5.72 years, IRR of 31% and IRR incremental of 9.06% while if replaced by machine C will have NPV of 564,351, IRR of 59%, incremental IRR of 13.74% and Payback period of 2.51 years.

Sensitivity of NPV of the project to the cost of capital

Sensitivity analysis investigates what happens to the NPV and IRR of the project when one or more variables change. In that sense, sensitivity Analysis provides an indication of how much each variable can change before the project ceases to be viable. The Cost of Capital essentially is the discount rate at which the NPV is calculated. It is important to be aware of the limitations of any NPV analysis. The calculations involve relying on estimates which can be difficult to predict, such as sales forecasts, prices and costs, tax rates, inflation, realizable values of assets and discount rates. In addition, forecasts are mostly prepared within a limited time horizon, such as in this case 10 years. Any costs and revenues beyond this period are ignored – even though they could potentially result in a higher NPV.

Further, the strategic importance of investment must also not be overlooked. There may be the potential to lead on to further opportunities or investments and the value of these options could be estimated.

For machine A:

• An increase 1% tax rate would decrease the NPV by 13%. % Sensitivity = (NPV1 – NPV2)/ (Tax rate1 – Tax rate 2)
• An increase of 1% the Cost of Capital (WACC) would decrease the NPV by 0%. % Sensitivity = (NPV1 – NPV2)/ (WACC1 – WACC2)
• An increase of cost of saving by 150,000 would increase the NPV by 84.7%.
• An increase of cost machine by 100,000 would decrease the NPV by 10.2%.

The NPV is more sensitive to any change to cost of saving is as it changes 84.7% times, while it is less sensitive to changes in cost of machine and not sensitive at all to changes to tax rate.

For machine B:

• An increase 1% tax rate would decrease the NPV by 4%. % Sensitivity = (NPV1 – NPV2)/ (Tax rate1 – Tax rate 2)
• An increase of 2% the Cost of Capital (WACC) would decrease the NPV by 39%. % Sensitivity = (NPV1 – NPV2)/ (WACC1 – WACC2)
• An increase of cost of saving by 100,000 would increase the NPV by 64%.
• An increase of cost machine by 150,000 would decrease the NPV by 9.09%.

The NPV is more sensitive to any change to cost of saving is as it changes 64% times, while it is less sensitive to changes in tax rate.

Conclusion

To conclude, the rate of return will determine whether the investment will be accepted or not. In most companies it is the expected return from asset the management intends to manage in. the company will invest in a particular asset if it is likely to generate a return that is acceptable by the institution.

Weighted average cost of capital is one of the most tools available for managers to use in decisions making relating to long term sustainability of the firm. It is the overall process of generating, evaluating and selecting the cost of capital that will be required by an investment project. The following assumptions are usually made:

• There is a known target ratio for the financing elements, which will continue for the duration of the investment project under consideration;
• The costs of the various elements will not alter in the future from the costs calculated;
• The investment under consideration is of similar risk to the average of the other projects undertaken by the business.

Then using the weighted average cost of capital (WACC) as the discount rate is logical.

Using opportunity cost implies looking at the savings in financing cost that would arise if finance were to be rapid instead of undertaking the investment project. Alternatively, it could be seen as the additional cost of raising the necessary finance to support the project. If there is a target, repayment of finance or additional financing would be carried out in accordance with the target (Tang and Tang, 2003).

Recommendation

The company should replace machine A with Machine C as per information provided in the excel file and word attachments. As per the analysis made, the machine B is not a better investment for shareholders since it have a negative net present value which will reduce the shareholders wealth. There are many subjective factors that should be considered before the investment decision is to be made, this should include, the possibility of a competitor opening a similar facility in the area thus affecting the market share. Another factor to be considered is changes in technology of the lift chairs. If the lift chairs are likely to have picked technological innovations then, the decision to invest or not to invest will be affected. The other factor to be considered is the availability of spare parts for the lift in the market. Lastly, the political or government regulations will be considered. This is because the government regulations will cut across many factors affecting the profitability of the firm. The government is responsible for diffusing inflationary tendencies at the same time regulating monetary policy. The net present value is not a correct measure for accepting the project, further analysis needs to be carried out to incorporate, inflation and other risk factors (Pandey, 2009).

List of References

Gitman, L 2009, Principles of Managerial Finance. Addison Wesley, Boston.

Pandey I 2009, Financial management. Vikas Publishing House PVT ltd, New Delhi.

Rao, R 1989, Fundamentals of Financial Management. Macmillan Publishing Company, New York.

Ryan, P. & Ryan, G 2002, ‘Capital budgeting practices of the Fortune 1000: How have things changed?’ Journal of Business and Management. vol. 8, no. 4, pp. 355-364.

Singh, S. & Gaur, P 2004, ‘How Close are NPVI and IRR as Criteria for Project Choice in Real Life?’, Finance India. vol. 18, n0. 4, pp. 1643-1650.

Tang, S. & Tang, H 2003, ‘The variable financial indicator IRR and the constant economic indicator NPV’, The Engineering Economist. vol. 48, no. 1, pp. 69-78.