This report will analyze and discuss the recommendations for the new specialty spark plug project, which our company is considering undertaking. This analysis will include the basic information that is needed to evaluate the project, and also the different methods and approaches that are suitable to make such financial decisions. I will analyze the process of calculating the weighted average cost of capital, and elaborate upon its significance, as well. The calculation and interpretation of the net present value of the project will also be discussed, in addition to other decision-making techniques. Lastly, the report will discuss the various decision-making techniques, and present the final decision concluded on the basis of the analysis.
In order to make a good financial decision certain information is required. A thorough analysis would need to be conducted about the different scenarios (Smith, 2007), for instance, here we have two options: either to invest or not to invest. Complete information about the expenses and expected future cash flows need to be collected so that a logical decision can be made. In the given case we know that investment in the equipment would increase the annual production of the specialty spark plugs by 100,000. And the investment required is $3,000,000 at the present time. The investment will also change the cost per unit and bring it to $8.00. Keeping in mind the demand and supply situation in the market, we also expect to sell these parts at $2.00 per unit. Another piece of important information is the tax rate applicable to the company, which is 34%. All this information is of critical importance while making an educated financial decision of significant risks and rewards.
Weighted Average Cost of Capital
WACC is one of the most critical factors in the decision-making process, it represents the effective cost that the company incurs for the funds it uses, and it is used as the discount rate while calculating the net present value of the project’s future cash flows (Garrison, Noreen, & Brewer, 2010). WACC can be calculated by using the formula: E/V Re + D/V Rd (1-TC). It is a sophisticated calculation of average cost, on the basis of the different weights of the assets and liabilities. In the given case the WACC is calculated to be 7%.
Capital Budgeting Techniques
There are three popular capital budgeting techniques, namely IRR, Payback Period and NPV (Edwards & Hermanson, 2007). The first one is IRR, which stands for internal rate of return. IRR represents the real economic value that an investment or project delivers over its useful economic life (Phillips, 2008). The decision-making criterion is simple; if the IRR is equal to or greater than WACC, it means that the project is capable of generating higher returns than the cost incurred, and thus is profitable. Otherwise, if WACC is greater than IRR, it means that the project will not be able to recover the costs incurred and thus should not be pursued. In this method, we take the required investment and divide it with the net annual cash flow. This yields the present value factor. Once we have the present value factor, we determine the percentage over a specific period, which in our case is five years. In the given case IRR comes out to be 10%, which is greater than WACC at 7%, so the project is profitable.
The second technique is the Payback period. This technique considers the time taken to recover the invested money as the deciding factor. The management evaluates the number of periods needed to generate the money that was invested initially and decides on the basis of this information whether the project is worth investing or not. However, this is not a recommended method of decision-making as it ignores some other important variables. The Payback time is calculated by dividing the initial outlay by the annual after-tax cash flows.
The third and most popularly used technique is the Net Present Value (Smith, 2007). This takes into account most of the important factors and basis the decision on the present value of all the future cash flows. This is a simple four-step process. Firstly, all the expected cash flows are to be forecasted and put in a table. Second, the required discount rate is determined. Third, the NPV is calculated by discounting all the expected cash flows. Lastly, the decision is based on the NPV of the project, and the criterion is very simple, too. If the NPV is greater than zero it means that the project is profitable and if the VPV is smaller than zero, it means that the project will not be able to cover the incurred costs, and thus is not a suitable option. The NPV of the given project comes to $247,200, by using the mentioned steps. Since it is greater than zero the project is profitable.
Conclusion and Recommendation
IRR and NPV both indicate that this is a profitable investment and it would increase the shareholder wealth, therefore, I recommend that the required investment should be made, because it is very likely to generate high returns.
Edwards, J., & Hermanson, R. (2007). Accounting Principles: A Business Perspective. New York: Prentice Hall.
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2010). Managerial Accounting. New York: McGraw-Hill.
Phillips, L. (2008). Moving Away from Traditional Budgeting. Qfinance.
Smith, J. (2007). Handbook Of Management Accounting (4th ed.). Oxford: CIMA publication.