Businesses are always striving to implement projects that are meant to increase profitability and the wealth of the shareholders. However, in the process, a number of factors need to be taken into consideration by the management and business owners. They include, among others, the mode of funding for the project. For example, the management has to maintain an appropriate debt-to-equity ratio.
Fiera Corporation intends to implement a new project that is expected to cost $45,000. According to Graham, Smart, and Megginson (2010), the undertaking will be financed using 40 percent debt and 60 percent equity. To this end, the management aims at maintaining the organization’s current debt-to-equity ratio. The shareholders have provided their desired rate of return. The figure is set at 18.36%. On their part, bondholders expect a return rate of 10.68% (Graham et al., 2010). The annual proceedings from the undertaking are approximated to be $13,000. The figure reflects earnings before taxes for the next twenty years. It is also noted that the firm is in the 36% tax bracket.
In this paper, the author will calculate the organization’s weighted average cost of capital (WACC) and net present value (NPV). The required return on unlevered equity will also be determined. In addition, the author will determine whether or not the project should be undertaken.
Computations
Calculating Fiera Corporation’s Weighted Average Cost of Capital
The weighted average cost of capital (WACC) involves the calculation of expenditure required to develop new projects. The computation is carried out by assessing the financing options that are available to the company. Such alternatives include debt and equity. When a firm plans to embark on a new undertaking, the scheme is financed through such sources as cash, equity, and debt. Graham et al. (2010) observe that each corporation has a target capital structure. To calculate WACC, it is important to first verify the after-tax required return on the firm’s debt and equity. The next step in the computation entails multiplying the tax rates by the percentage of equity and liability in capital structure. The figures acquired are based on market value fractions. In WACC calculations, book values are not used (Graham et al., 2010). The final figure reveals the impacts of various financing options on a project’s value. The assessment is carried out using a discount rate.
The WACC for Fiera Corporation is shown below:
WACC =E/V * RE + D/VĂ— RD Ă— (1- TC),
where
RE = Cost Equity.
RD = Cost of debt.
E = Market value of the firm’s equity.
D = Market value of the firm’s debt.
V = E+D.
E/V = Percentage of financing that is equity.
D/V = Percentage of financing that is debt.
TC = Corporate tax rate.
Fiera’s WACC = 10.68(1-0.36) × 40% + 18.36 × 60% = 14%
Calculating the Traditional Net Present Value of Fiera Corporation using WACC
Net present value (NPV) is a measure of profitability. The computation is used in company budgeting to evaluate whether or not a project will be beneficial to the firm in the long run. Graham et al. (2010) note that NVP takes into consideration the compounding of the discount rate over the period within which the project is intended to last. It shows the level by which money inflow or income equals or surpasses the amount of investment capital used to finance the undertaking. A higher NVP is an indication of the fact that the project will be profitable.
To calculate NVP, the approximated cash flow and inflow of each period must be considered. In addition, the expected discount rate should also be established. Exact figures can only be known once the investment is complete (Graham et al., 2010). However, reasonable estimates can be made by reviewing levels of success of similar projects.
Calculation
NPV = Net Period Cash flow / (1+R)^T – Initial Investment, where
R = Rate of return.
T = Number of time periods.
Fiera Corporation intends to invest $45000. Expected cash flow is $13000 annually before taxes for two decades.
Tax rate is 36%.
WACC = 12%.
36/100 Ă— 13000 = 4680
13000-4680 = 8320
8320/ (1+ 0.12) = 7428.57 annually after taxes
NPV over a period of two decades = 7428.57 Ă— 20 = $148571.43
Analyzing whether or not the project should be undertaken
Fiera Corporation should carry on with the project as planned. NPV is used to measure profitability. When the rate is above the initial investment, the project will add value to the corporation (Graham et al., 2010). As such, the venture will be profitable. If the figure is below the funds used to carry out the project, the plan will generate losses. Certain undertakings do not bring value or loss to a business. Graham et al. (2010) observe that firms should not implement ventures that do not generate any benefits.
The project that Fiera Corporation intends to pursue will cost $45000. As indicated in the case, it will be financed through debt and equity. The expected cash flow is $13000 annually over a period of two decades. From the NPV calculations, the project’s expected net returns after 36% tax cut will be $7428.57 each year. Over a period of twenty years, the total revenue generated will be $148571.43. The sum is three times more than the initial money used to fund the scheme. In light of this, Fiera Corporation should carry on with the plan. The reason behind this is because the investment will be profitable in the end.
Determining the Required Return on Unlevered Equity using Modigliani and Miller’s Proposition II
The assumption made in the Modigliani and Miller (M and M) Proposition II is that there will be no taxes and bankruptcy costs. Graham et al. (2010) note that when using the M and M, a firm’s WACC should remain constant. In addition, an increase in debt in the corporation’s capital structure makes the investment process difficult. High proportions of liability lower WACC.
M and M Proposition II’s formula with taxes
Re = R0 + D/E
(R0 – RD) (1-Tc), where
Re = required return rate on equity.
R0 = unlevered cost of equity.
RD = required rate of return on loan.
D/E = debt to equity ratio.
TC = Tax rate.
Re = 27000 + 40/60
(27000 – 18000) (1-0.36)
Re = 27000 + 5760
Re = 32760
Using the Adjusted Present Value (APV) to Determine Whether or not Fiera Corporation should Undertake the Project
The Adjusted Present Value (APV) is used to assess how the worth of a venture by a levered company is similar to that of a scheme carried out by an unlevered corporation.
APV = NPV (unlevered) + NPV (financing effects)
NPVF = 0.36 tax rate (18000 debt Ă— 0.1836 debt interest) / (1-(1/(1+ 0.1836 debt cost)
= 1189.73/0.16 = 7435.81
= -7428.57 + 7435.81
APV= 7.24
The APV measures the profitability of an investment after tax deductions (Graham et al., 2010). The figure above suggests that the project is worthwhile. As a result, Fiera Corporation should execute the plan. NPV + NPVF gave a positive value. The results reveal that the project will be beneficial to the firm. If the APV was negative, then the undertaking would not be worth the investment made. The reason behind this is because it would not generate any profits for the company. Graham et al. (2010) observe that the primary purpose of an investment is to spawn revenues.
Determining Whether Fiera Corporation should Undertake the Project using the Flow-to-Equity Method
The flow-to-equity (FTE) method focuses on cash flows available to equity investors. The worth of an investment translates to the current value of levered money flow discounted at a levered cost of equity (Graham et al., 2010). The computation is an unconventional capital budgeting approach. Calculating FTE involves three steps. They include the determination of levered cash flow, discount rate for levered equity, and NPV analysis.
FTE = Net Income – Net capital expenditure – change in net working capital + new debt – debt repayment
Fiera Corporation plans to invest $45000. Before taxes, the project will generate $13000 annually. After a period of two decades, the scheme will have generated $148571.43 after taxes.
$148571.43 – $45000 = $103571
Fiera Corporation plans to fund the scheme with a higher equity value compared to debt. From the calculations, it is evident that the planned project will generate more revenue after taxes compared to the initial funds used to finance it. Consequently, the firm should undertake the project.
References
Graham, J., Smart, S., & Megginson, B. (2010). Corporate finance (3rd ed.). Mason, OH.: Cengage Learning.