The Capital Structure of an Organisation Free-Sample for Students

Questions: 1.Why is it Important for Companies to Consider Ethics in their Capital Budgeting? 2.Calculate after-tax Weighted Average Cost of Capital. 3. Calculate the following: (a) Payback period (b) Discounted payback period (c) Net present value (d) Profitability index (e) Internal rate of return (f) Should this project be accepted? (g) If the required rate of return is 20%, should this project be accepted? Answers: A company has to evaluate the list of investments it wishes to undertake and uses capital budgeting techniques like NPV, IRR and payback period to decide on the best and viable investments. However, these methods assess the economic viability of the project and do not take into consideration the social and environmental costs. According to a survey, such costs can range from 5 to 20% of the total activities cost. Therefore in order to enhance a firms competitive position, it is important to incorporate environmental costs into the business strategies. There are two types of costs i.e. internal and external. Internal costs are more tangible and quantifiable like monitoring of hazardous waste, disposal, and treatment of waste water. Whereas external costs are costs imposed by the society on the company and are less quantifiable and include corporate image, environmental fines and penalties, marketable by products, natural resource damage costs etc. Most of the internal costs are consid ered in the project appraisal. And since the external costs do not affect the cash flow directly, they are hardly considered. However, it is very important o factor such costs in the investment appraisal as there is a better assessment of risks and liabilities ensuring future viability of the company. Also the stakeholders get to know about the companys financial health and environmental costs from the companys economic activities. Hence, the business should adopt policies and techniques which can incorporate the internal and external costs. Examples of such techniques are Environmental Impact Assessments, Environmental cost/benefit Analysis, Triple Bottom Line Accounting (Sookram, Kistow, 2012) Treatment of hazardous waste cost is an example of ethical consideration in capital budgeting. 2.The capital structure of the company consists of equity and short term and long term debt. The market value of equity has been considered and the book value of debt has been considered. Equity Debt Market capitalisation $29,10,000 Short term debt $2,39,275 Long term debt $2,18,586 Total $29,10,000 $4,57,861 (Medigard, 2016) Calculation of WACC Cost of Debt Interest expense = $27,407 Total debt = $4, 57,861 Cost of debt = 27407 / 457861 = 5.99% Tax rate = 30% (as seen from annual report) After tax cost of debt = 5.99% * 0.7 = 4.19% Cost of Equity We will calculate the cost of equity using the CAPM model as the company has not paid any dividends in the year 2016. Risk free rate = 2.47% (Bloomberg, 2017) Beta = 3.6 (Financial Times, 2017) Expected market returns = 3.96% (Bloomberg, 2017) Required rate of return = risk free rate + beta (market return risk free rate) = 2.47% + 3.6 (3.96 2.47) = 7.8% WACC Cost Value Weights Weighted cost Debt 4.19% $4,57,861 0.14 0.006 Equity 7.8% $29,10,000 0.86 0.068 $33,67,861 7.3% Hence the WACC for Medigard Ltd. is 7.3%. Currently the company has 7.3% as its cost of capital. In order to lower its cost of capital the company can take the following course of action: a) Increase the debt component currently the company has 86% of capital in the form of equity. The cost of equity is more than the cost of debt. Hence, in order to reduce its WACC, it can increase its debt component to facilitate financial leverage. Like if the company increases the debt to 30% which lowers the equity to 70%, the WACC would be 6.7%. b) Replace part of equity by preferred stock preference capital is less expensive than equity and hence the company can look at replacing some part of equity capital by preference capital. 3.The table of net operating cash flows for the acquisition of new cooling system by Bluegum Enterprise is presented below: Year 0 1 2 3 4 5 Cash flow from operations $20,608 $20,608 $20,608 $20,608 $20,608 Salvage value $13,200 Initial investment -$54,200 Net cash flows -$54,200 $20,608 $20,608 $20,608 $20,608 $33,808 Discount factor @15% $1 $0.870 $0.756 $0.658 $0.572 $0.497 Present value of cash flows -$54,200 $17,920 $15,583 $13,550 $11,783 $16,809 a. Payback Period Year Net cash flows Cumulative cash flows 0 -$54,200 -$54,200 1 $20,608 -$33,592 2 $20,608 -$12,984 3 $20,608 $7,624 4 $20,608 $28,232 5 $33,808 $62,040 Payback period = 2 + (12984/20608) = 2.6 years b.Discounted payback period Year Present value of cash flows Cumulative cash flows 0 -$54,200 -$54,200 1 $17,920 -$36,280 2 $15,583 -$20,697 3 $13,550 -$7,147 4 $11,783 $4,635 5 $16,809 $21,444 Discounted payback period = 3 + (7147/11783) = 3.6 years c.NPV = sum of present value of cash flows = $21,443.9 d.Profitability Index = Sum of present value of cash inflows / initial investment = 1.4 e.IRR = 30% f.Yes, the project should be accepted as the NPV is positive. Also other capital budgeting techniques give a favourable result. The IRR is more than the cost of capital, the payback period and discounted payback period is within the life of the project, the profitability index is more than 1. g.If the required rate of return is 20%, the present value of cash flows will change and will be as follows: Year 0 1 2 3 4 5 Net cash flows -$54,200 $20,608 $20,608 $20,608 $20,608 $33,808 Discount factor @20% $1 $0.833 $0.694 $0.579 $0.482 $0.402 Present value of cash flows -$54,200 $17,173 $14,311 $11,926 $9,938 $13,587 NPV = $12735.3 If the required rate of return increases to 20%, the project should still be accepted as the NPV is still positive. Reference Sookram, R., Kistow, B., (2012), Capital Budgeting and Sustainable Enterprises: Ethical Implications, the Journal of Value-Based Leadership, Vol. 5, and No.1 Financial Times, (2017), Equities: Medigard Ltd., accessed online on 16th April, 2017, available at https://markets.ft.com/data/equities/tearsheet/summary?s=MGZ:ASX Bloomberg, (2017), AS51: IND, accessed online on 16th April, 2017, available at, https://www.bloomberg.com/quote/AS51:IND Bloomberg, (2017), Australian Rates and Bonds: Government Bond Yields, accessed online on 16th April, 2017, available at, https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia Medigard, (2016), Medigard Annual Report, 2016