The cost of capital is crucial for any company. It is the cost of funds that a company possesses both equity and debt. It is necessary for the evaluation of new projects that a company initiates. Also, it is associated with the minimum return that is expected by investors in case they support a project. This paper explains the concept of MECE, interprets the project’s net present value (NVP), and analyzes the process of the relevant cost of capital calculation. Moreover, it presents the calculation of the cost of capital for the given project and reveals relevant factors in determining the project’s cost of capital.
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The Concept of MECE
MECE is an abbreviation for the term “Mutually Exclusive and Completely Exhaustive.” It usually means the way information is organized. MECE presupposes the organization of information such as ideas, topics, or solutions into the so-called MECE “buckets.” This framework is popular with business consultants because it allows them to decompose the issues of concern and bucket them thus empowering the process of problem-solving. The first component of this concept, which is “mutually exclusive,” is expected to reduce the complexity of an issue through avoiding overlaps. Because MECE is a list, the points of this list should exclude each other, or be distinct. The second component, “completely exhaustive,” means that all the relevant aspects of the issue are considered. In the context of the list, it involves “exhaustion” of the field of interest through including everything that belongs to it.
Explanation of an NVP
The net present value (NPV) is the sum of the discounted cash flows minus the original investment.
- t– the time of the cash flow,
- i– the discount rate, i.e. the return that could be earned per unit of time on investment with similar risk,
- N– is the total number of periods,
- R– the original investment (with a minus),
- R– the net cash flow i.e. cash inflow – cash outflow, at time t.
NPV of $5 mill for a project means that the sum
is equal to $5 mill.
Calculation of the Relevant Cost of Capital
Calculation of the cost of capital is an integral component of project development. Every project makes economic sense in case its net present value exceeds the planned amount of financing. Therefore, before project budgeting, a company should evaluate the level of project risk related to common business operations. The relevant cost of capital is calculated with the use of formula, which is a blend of debt and equity costs acquired by a company for funding its operations. The formula itself consists of some separate calculations that determine debt, preferred stock, and common stock. The cost of capital is critical for investment decisions of a company and the involvement of outside investors (Schlegel 240).
Calculation of the Relevant Cash Flow for the Project
Every project has its peculiarities in calculations of the relevant cash flow. This concept can be explained as incoming and outgoing streams of money for a company. Cash flow comprises two elements, inflow and outflow. Inflow includes money that a company earns while outflow includes the money that is spent. To calculate the cash flow, it is necessary to compare inflow and outflow for a certain period, a month, a quarter, or a year. In the case of this project, cash inflow may include saving cost on the salary of employees due to their shortage but preserving their wage rate. At the same time, it is possible to hire the same number of workers who agree to fulfill the same range of functions for a lower payment. Cash outflow in the project comprises expenses to support the new technology, amortization expenses, and tax in case the income is obtained. Net cash flow is included in the NVP calculation with the consideration of discounting.
Calculations for Year 1 are as follows:
20% of E1: 0.2 · 6 · 106 = 1.2 · 106 company has to pay to transferred personnel, while it could pay 25% cheaper, i.e. company costs on transferred personnel are
0.25 · 1.2 · 106 = 0.3 · 106
E1 · (0.2 · 0.25) = 0.05 · E1 = 0.05 · 6 · 106 = 0.3 · 106
Therefore, the profit on a salary of reduction personnel for the Year 1 will $
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P1 = E1 · (1 – 0,05) = 0.95 · E1 = 0.95 · 6 · 106 = 5,7 · 106
In Year 2
E2 = E1 + 200 · 60 · 103 = 18 · 106
P2 = 0,95 · E2 = 0,95 ·18 · 106 = 17,1 · 106
In Year 3
E3 = E2 + 400 · 60 · 103 = 42 · 106
P3 = 0,95 · E3 = 0,95 · 42 · 106 = 39,9 · 106
In Year 4, Year 5, Year 6…
Et = 700 · 60 · 103 = 42 · 106
Pt = 0,95 · Et = 0,95 · 42 · 106 = 39,9 · 106
P1, P2, P3, … – cash inflow in Year 1, Year 2, Year 3, …
- The investment is to be depreciated according to the country’s relevant tax code in a straight line for 25 years.
The depreciation costs per year will $
D = (180 · 106) / 25 = 7.2 · 106
- The company pays 25% corporate tax.
If there is positive income, the net cash flow will be on 25% less.
- The new technology has a yearly maintenance cost of 5% of the initial investment.
The cost of new technology maintenance per year will $
M = 0.05 · 180 · 106 = 9 · 106
In the Year 1 cash inflow P1 = 5.7 · 106, and cash outflow D + M = 16.2 · 106
Therefore, the net cash flow for Year 1 in $
R1 = P1 – (D + M) = – 10.5 · 106
Since it is negative, the 25% corporate tax is zero.
For Year 2 cash inflow P2 = 17.1 * 106, and cash outflow D + M = 16.2 * 106
Since P2 – (D + M) > 0 , the net cash flow will be on 25% less
R2 = 0.75 · (P2 – (D + M) = 0.75 · 0.9 · 106 = 0.675 · 106
Analogously in the next Years.
The central bank in the country has a guideline inflation rate of 2% for the foreseeable future.
The discount rate i=0.02
The NVP for each Year N can be calculated on the formula
The investment is considered to be risky, but as a similar investment was made 5 years ago with similar technology they have a good track record of the performance.
The cash flow and NVP for years 1-5 are presented in Table 1.
Table 1. Cash flow and NVP for years 1-5.
|Year 1||Year 2||Year 3||Year 4||Year 5|
|Number of freed||100||300||700||700||700|
|E||6 000 000||18 000 000||42 000 000||42 000 000||42 000 000|
|P (cash inflow)||5 700 000||17 100 000||39 900 000||39 900 000||39 900 000|
|Depreciation||7 200 000||7 200 000||7 200 000||7 200 000||7 200 000|
|5% maint new techn||9 000 000||9 000 000||9 000 000||9 000 000||9 000 000|
|Cash outflow||16 200 000||16 200 000||16 200 000||16 200 000||16 200 000|
|Cash flow||-10 500 000||900 000||23 700 000||23 700 000||23 700 000|
|25% corporate tax||no||225 000||5 925 000||5 925 000||5 925 000|
|R||-10 500 000||675 000||17 775 000||17 775 000||17 775 000|
|tax rate i=0.02|
|Rt / (1+i)t||-10 294 118||648 789||16 749 779||16 421 352||16 099 365|
|NVP||-190 294 118||-189 645 329||-172 895 549||-156 474 197||-140 374 832|
On the whole, it can be concluded that NVP will be positive in year 15 of project implementation. The detailed data are provided in the excel file that is attached.
Relevant Factors in Determining the Project’s Cost of Capital
The cost of capital for the project is generally determined by a complex of factors. These are the factors that can be controlled by a company and those that are uncontrollable. Thus, the controllable factors are capital structure policy adopted by a company, dividend policy, and investment policy. The uncontrollable ones are the level of interest rates and tax rates. Consequently, it is important to focus on the controllable ones to ensure the success of the project. Thus, it is necessary to take care of the capital structure and avoid the increase in the cost of debt. The dividend policy of a company should be thoughtful with strict control over the payout ratio. Finally, investment policy should be grounded on careful decisions with risk consideration.
Summarizing, it should be said that capital issues demand much attention since they determine the company’s income. When planning a project and deciding on its budget, it is necessary to consider all types of costs and provide proper calculations. Thus, the most important calculations for a project that helps to assess its economic sense are the cost of capital and the cash flow. Another crucial calculation is the net present value, which is the difference between the current value of cash inflows and the current value of cash outflows for a definite period and is used in capital budgeting.
Schlegel, Dennis. Cost-of-Capital in Managerial Finance: An Examination of Practices in the German Real Economy Sector. Springer, 2015.