Managerial Decisions to Expanding Division
Capital budgeting is the process by which long-term projects can be evaluated before a company decides to select a project to ensure that the shareholder’s value is maximized. In expanding the line of equipment and apparel for the high-school team, the marketing department has estimated that sales would increase by $150,000 for each of the first two years, and then by $250,000 for the next three years. However, this requires manufacturing equipment for $300,000.
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Time value of money is a principle that requires a consideration of the point in time when cash flows occur since money decreases in value with time. It means that equal sums of money do not have the same value when they relate to different periods.
The Net Present Value (NPV) method can be used in evaluating this project. “The cost of capital is the expected rate of return that the market participants require to attract funds to a particular investment” (Pratt and Grabowski 3). The present value of the future cash flows is computed to compare with the present cost of the project (Cash outflow). If the NPV is positive, the project is accepted. If negative, the project is rejected. If the cost of capital is 10%, then
|Year||Cash flows in $||PV factor||PV of cash flows in $|
Given that the NPV is positive, then the project should be accepted. The PV factor is used to change the future cash flows into present value. The division can therefore be expanded by investing in the new equipment.
The weighted average cost of capital (WACC) is used for evaluating projects which have been assumed to be of the same risk and therefore could not change the overall risk of the company as a whole. The market values or current value of the capital structure is useful to maintain a true reflection of the existing capital structure of the firm.
WACC = Ke W1 + Kd W2 where
Ke is the cost of equity, Kd is the cost of debt, W1 is the proportion of Equity and W2 is the proportion of debt at market value. In this case, any debt to be borrowed can substantially change the capital structure of the firm and may also raise the financial risk of the organization (Modigliani and Miller 264). Hence, the $ 300,000 required to finance the equipment should be considered about the perceived financial risk of either using the equity or debt. The market risk may be high due to changes in market interest rates and therefore, a decision should be made on whether to opt for a floating rate debt or fixed-rate debt. This affects the decision to be made in expanding the division.
The marginal cost of capital is the weighted average cost of new investment or the cost of raising additional capital. This may be affected by the various sources of funds that the firm intends to utilize in the new projects or investments. A firm may have different targets of the capital structure which it intends to maintain in the long-term depending on the firm’s attitude to risk and its operating conditions (Kyereboah-Coleman 57). In this case, the additional capital may be raised by the issue of bonds so that one can get the tax benefit due to a reduction of interest for tax computation purposes. If the $300,000 is to be raised from additional equity, the floatation cost should also be considered before deciding to expand the division.
Kyereboah-Coleman, Anthony. “The Impact of Capital Structure on the Performance of Microfinance Institutions.” Journal of Risk Finance 8.1(2007): 56 – 71. Print.
Modigliani, Franco and Merton H. Miller. “The Cost of Capital, Corporation Finance and the Theory of Investment”. The American Economic Review 48.3 (1958): 261-280. Web.
Pratt, Shannon P. and Roger J. Grabowski. Cost of Capital: Applications and Examples. 4th edn. New Jersey: John Wiley and Sons, 2010. Print.