Capital Budgeting

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Nov 24, 2024

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1 Capital Budgeting– Individual Paper Student’s Name Module Tittle Module Code Professor Date of Submission

2 Capital Budgeting – Individual Paper Calculating the Discounting Rate To find a discount rate, we need to think about how money changes over time and how risky the investment is. The weighted average cost of capital is one way to figure out a discount rate (WACC). The WACC is the average rate of return that a company must pay to its investors in order to finance its assets. Using the following formula, we can figure out WACC: WACC = (E/V * Re) + (D/V * Rd * (1-Tc)) Where, E = the value of the company's stock on the market D = the value of the company's debts on the market V = the company's total market value (E + D). Re = Cost of equity Rd = the price of debt Tc = tax rate on corporations Since Mr. Kim is an individual investor, we can assume that the cost of debt does not apply. The cost of equity can then be used as the discount rate. To figure out the cost of equity, we have to think about how risky the investment is. The beta coefficient is one way to measure risk. It shows how volatile an investment is compared to the market as a whole. Then, we can figure out the cost of equity with the help of the Capital Asset Pricing Model (CAPM).

3 CAPM = Rf + beta * (Rm - Rf) Where Rf = risk-free rate Rm = the market's expected return Beta = beta coefficient The yield on a long-term government bond is close to the risk-free rate. On March 7, 2023, a 10-year Canadian government bond had a yield of about 1.4%. The long-term average return of the stock market can be used to get an idea of what the return on the market should be. In the past, the S&P/TSX Composite Index, which is the main index for the Canadian stock market, has given an average return of about 7-8%. For the way the market is right now, we can use a conservative estimate of 6%. To figure out the beta coefficient, we need to find a publicly traded company that is similar to the ice cream store and is in the same business. Then, we can use that company's beta coefficient as a stand-in for the risk of the ice cream store. A quick search shows that a company like Nestle, which makes a lot of ice cream, has a beta coefficient of about 0.7. Using these numbers, here is how to figure out the cost of equity: CAPM = 1.4% + 0.7 * (6% - 1.4%) = 4.62% Because of this, the appropriate discount rate for this investment would be 4.62 percent. It is essential to keep in mind that the discount rate is merely an estimate, and that it is subject to fluctuate based on the performance of the investment. Yet, in order for Mr. Kim to get a decent

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4 idea of the potential return on his investment, he might utilize this formula as a reasonable starting point. Calculating NPV, IRR, and Payback Period Net Present Value (NPV) compares the discounted future cash inflows and outflows of an investment or project over a certain time. It is a method for figuring out if a project is worth doing. It is used in investment planning and capital budgeting. NPV not only checks if an investment or project is possible, but it also compares similar options to find the best one ( Žižlavský , 2014). The NPV of a project can be positive, negative, or 0. With this method, the rule for making a decision is that investors should accept or start projects with a positive net present value (NPV) and turn down investments with a negative or zero NPV. When putting investments in order, the ones with the highest NPV come first. A positive NPV means that the discounted present value of all of a project's future cash flows is positive, which makes it a good investment. Investors should go ahead with projects whose net present value (NPV) is more than zero. Taking a look at the project: NPV: You can figure out the project's net present value (NPV) by subtracting the present value of the expected cash inflows from the present value of the cash outflows. The following table shows how much money will come in over the next five years. Each year, it goes up by 10%. Year 1: $100,000 Year 2: $110,000 (100,000*110/100) Year 3: $121,000 (110,000*110/100)

5 Year 4: $133,100 (121,000*110/100) Year 5: $146,410 (133,000*110/110) Here is what happens to the outflows: Ice cream machine cost: $500,000. Marketing expenses: $10,000 (per year) Employee salary: minimum wage (40 hours per week) To figure out the NPV, we need to use the discount rate of 4.62 percent to bring the cash flows into the present. 100,000/1.0462^1+110,000/1.0462^2+121,000/1.0462^3+133,000/1.0462^4+146,410/1.0462^5 = 529,583.27 NPV=529,583.27-500,000 =29,583.27 The cream machine has a value of (500000*1-1/1.04625) = 101,070.25 Marketing expenses = 10000*5 = 50,000 = 50,000*{1-1/1.0462^5) = 10107.025 $20 an hour is the minimum wage. =40*52*20*5

6 = 208,000 NPV = 529,583.27-101,070.25-10,107.025-208,000 = $210,405.995 A positive NPV of $210,405.995 is found by doing the math. This means that buying the ice cream shop is a good investment at the price it is going for and the cash flows that are expected. IRR: The discount rate that makes the project's net present value (NPV) equal to zero is the internal rate of return (IRR). Using a method of trial and error R=6% 100,000/1.06^1+110,000/1.06^2+121,000/1.06^3+133,000/1.06^4+146,410/1.06^5 = 508,587.69 NPV=508,587.69 -500,000 =8,587.69 R=7% 100,000/1.0462^1+110,000/1.0462^2+121,000/1.0462^3+133,000/1.0462^4+146,410/1.0462^5

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7 = 494,161.62-500,000 = -5,838.38 IRR = 6% + (8,587.69*(7%-6%)/ (8,587.69+5,838.38) = 6%+8587.69/14426.07 = 6%+0.5953 = 6.5953% In this case, the project's IRR is about 6.5953 percent, which is more than the discount rate of 4.62 percent. This means that putting money into the project is a good idea. Payback Period: The payback period is how long it takes the project to get back the money that was put into it at the beginning. PP = N= (U/C) Where N is the number of times before the investment pays off. U = the amount of investment that has not been paid back at the start of the period. C = Cash flow for the last period as a whole 100000+110000+121000+133000+ 36000/146410 4+36000/146410 = 4.25 years

8 This project will pay for itself in about 4.25 years, which is less than how long the ice cream machine is expected to last (5 years). This means that it makes sense for the ice cream shop to be an investment. Summary of the Analysis Discounting Rate or Cost of Capital Gollier (2019), when it comes to capital budgeting techniques, the discounting rate or cost of capital is the interest rate that an investor uses to calculate the present value of future cash flows. This aids in determining whether the cash flows from a project or investment will be more valuable than the capital expenditure required funding it in the present. Investors can use two main approaches to calculate the discounting rate. Weighted Average Cost of Capital (WACC) is one of the major approach that investors uses to calculate their interest rate. It comprises of cost equity, cost of debt and corporate tax ( Fernandez, 2010) . This approach is only applicable when an investor gives all these three main factors. For the case of Mr. Kim, he cannot use WACC to calculate the discounting rate because we do not have the figures of cost of equity and debt. The second approach that Mr. Kim can use to calculate his discounting rate is by using Capital Asset Pricing Method (CAPM). In this method, main factors that are an investor considers are risk free rate, return on market and beta coefficients (Ross, 2017). Risk free rate is derived from long-term government bond. As at March 7, 2023, a 10-year Canadian government bond has a yield of about 1.4%. An approximation of the expected rate of return on the market can be derived from the stock market's long-term average rate of return. The primary index of the Canadian stock market, the

9 S&P/TSX Composite Index, has historically returned 8% to 12% annually. To account for the current state of the market, a 6% projection would be reasonable. Finding a comparable publicly traded company that operates in the same industry as the ice cream shop is necessary for calculating the beta coefficient. Once we know this, we can utilize the company's beta coefficient to represent the ice cream shop's exposure to risk. Searching quickly reveals that a major ice cream manufacturer like Nestle has a beta coefficient of roughly 0.7. Therefore, CAPM gives a discounting rate of 4.62%, which Mr. Kim will use to calculate his net present value of his annual cash flows and outflows. Net Present Value (NPV) According to Žižlavský (2014), in capital budgeting, calculating a project's NPV helps determine whether the money spent on the endeavor will be worth it in the end. The net present value (NPV) of an investment is calculated by subtracting the present value of cash inflows from the present value of cash outflows over a given time horizon (Lohmann & Baksh, 2013). If the NPV is positive, then it may be assumed that the expected earnings will be greater than the expected costs, and the investment will be profitable. The net present value (NPV) of an investment or project indicates whether the expected cash inflow (profit) is sufficient to cover the cost of the venture. When calculating the NPV of Mr. Kim investment project the following steps will be considered  Determining the initial capital outlay (investment) = 500,000  Determining the time to utilize (5 years).  Estimating the cash flows on each year.  Using the discounting rate to calculate the discounted cash flows (4.62%).

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10 After calculating Mr. Kim Net Present Value, there was a positive NPV of $210,405.995 this was after deducting all cash outflows from the ice cream store. A positive NPV show that this investment is feasible and Mr. Kim should invest on the ice cream store because returns economically profitable. Internal Rate of Return (IRR) In the world of finance, the internal rate of return (IRR) is a key indicator of an investment's likely profitability. When performing a discounted cash flow analysis, an internal rate of return (IRR) discount rate is used if and only if it results in a zero net present value (NPV) of all cash flows (Lohmann & Baksh, 2013) . The same formula is used for calculating NPV as is used for IRR . To calculate the IRR we use trial and error method. This method requires approximating or guessing a discounting rate that will give a negative or positive Net Present Value (NPV). We use two discounting rates a lower and higher rate but the difference between these two interest rates should one. After equating the IRR to zero, the answer should be either less or more than the actual discounting rate. Agnes Cheng et al., (2014), states that when the Internal Rate of Return is less than the actual discounting rate it means that the project is not feasible for investment while a higher internal rate of return in comparison to actual discounting rate it means that the project is feasible for investment. Mr. Kim should invest on the ice cream store because the internal rate of return is higher than the actual discounting rate (6.5953%) compared to 4.62%. The investment will be profitable and have a positive net present value. Payback Period

11 The amount of time it will take for an investment to generate an amount of cash flow that is sufficient to pay back the total amount of the investment is referred to as the Payback Period. When an investor anticipate the payback period for an investment, project, or company, investors are actually estimating the cash flow for that investment, project, or firm (Lohmann & Baksh, 2013) . The cash flow statement can then be used to determine the number of payments that must be made in order to recoup the initial investment. The payback period is calculated to show an investor how long it will take the project to return its initial capital outlay. A higher payback period compared to expect life means that the investment is not feasible while a lower payback period compared to expect life of a project shows that the investment is economically feasible (Lohmann & Baksh, 2013) . Mr. Kim Payback Period is 4.25 years, which indicates that the project is feasible to invest in meaning that the initial cost (500,000) will be attained before. the expected period is 5 years. Advice The investigation reveals that purchasing the ice cream shop at the present price and anticipating future cash flows makes the acquisition of the business a lucrative investment opportunity. Mr. Kim ought to think about making use of this investment opportunity because it has a better chance of succeeding economically. In the alternative, he could try to negotiate a lower purchase price for the shop in order to make the project more financially feasible. In addition, Mr. Kim ought to think about diversifying his investments so as to reduce the amount of risk inherent in his portfolio.

12 References Agnes Cheng, C. S., Kite, D., & Radtke, R. (1994). The applicability and usage of NPV and IRR capital budgeting techniques. Managerial Finance , 20 (7), 10-36. Fernandez, P. (2010). WACC: definition, misconceptions, and errors. Business Valuation Review , 29 (4), 138-144. Gollier, C. (1999). Time horizon and the discount rate. Lohmann, J. R., & BAKSH, S. N. (1993). The IRR, NPV and Payback period and their relative performance in common capitial budgeting decision procedures for dealing with risk. The Engineering Economist , 39 (1), 17-47. Ross, S. A. (1977). The capital asset pricing model (CAPM), short-sale restrictions and related issues. The Journal of Finance , 32 (1), 177-183. Žižlavský, O. (2014). Net present value approach: method for economic assessment of innovation projects. Procedia-Social and Behavioral Sciences , 156 , 506-512.

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