Evaluation of Capital Budgeting Process
This proposal is about an airline company name, royal airways. This company is a listed company in the stock exchange and now it is going to introduce a new offer for all customers which is business class service. They give the name of Project Gama and they are going to discuss all details of this project in the next committee of finance. Basically, they want to increase the profit of their company. The current economy class is very well running and people who travel with them are very much satisfied with their services and overall performance. With the increased trust of people, they think about a new service through which they provide more luxury services and more comfortable environment to the customers. The expenses of that seat must be higher than before because it includes more improved and high-level services. In this report, we are going to discuss all the costs and expenses which are face by Airline Company when they start a new project. Further new equipment, maintenance expense, refreshment costs and many other going to discuss here. First of all, we calculate the profit of new service in the current and in the upcoming year. Then measure its incremental cash flow. With this, we measure the projected rate of return in this new project. We also discuss different techniques and methods of measuring the cost of capital in details and the basic reason for using these methods and purposes. The company spends a lot of money on research of market to gather maximum information about the need and requirement of customers. Basically, the company has already good reputation ion market and having good share price which attracts more inventors and they also pay a dividend and in future, the dividend may be increased by 5% as all information is given. So all important calculation has to be done for getting better results.
Business class fare = $3100 per passenger
Economy class fare =$1500 per passenger
Marketing research cost = $250000
It is an estimation that 1200 people will come to use this service and 1100 people from economy class shift to business class to enjoy the services and environment.
Share price of company = $100 par value at 10% interest
Preferred stock = $111.10
Inflation rate = 5% from the next year
Tax rate = 25%
Equipment for the new project = $12000000 which have a life of 5 years and salvage value at the end of five years is $2000000
In economy class, they have more staff so it would be expected that 3 engineers are going to left the job but with new project two must be required in the business class.
Income statement of the current year and next year:
|Current year $||Next year $|
|Cabin crew expenses||(160000)||(168000)|
|Profit after tax||2490000||2444812|
As we see in the above statement, the profit of current year is higher than the profit of next year because of the high inflation rate. When overall prices are going to high then the profit margin is automatically going to decrease. Because a large number of expenses has to bear by the company after starting a new project. But somehow it’s just estimation that inflation rate going too high if it going low then our profit may going to increase in next upcoming years.
Now calculate the project required rate of return, for this, we consider beta = 1.2. Beta is a risk factor and if beta more than 1 then the project having high risk included. Market risk premium = 6% and risk free rate = 7%.
Required rate of return = 7 %+( 6%-7%)*1.2
=5.8% is our required rate of return when we start new business class service.
The profit which we calculated above is the accounting profit but for actual cash flow we have to determine the operating cash flow of the project,
Incremental cash flow = (7130000-1300000)*(1-0.25)+0.25(200000)
This is the actual cash flow after starting a new project of the company. It shows a very good profit and the company has to continue this project for many years.
Cost of capital:
Cost of capital is the original cost of the company which explains its equity and debts and rate of return. It helps to evaluate new projects and decide which project is beneficial for the company and which one not. The cost of capital may be calculated with the help of debt, equity and weighted average cost of capital and that measurements also useful in preparing the capital budgeting decision making. If the rate of return of the project is less than the cost of capital then it would be rejected. Normally, all financial performances and investment acceptability can be measured by analyzing discounted cash flows. Debt and preferred stock have already risk factor. Cost is normally related to yield and debt is adjustable according to tax-deductible interest. the retain earning cost is measured as current dividend plus future growth rate. Capital structure is normally help to maintain the minimum amount of cost. Debt is a least costly solution because less amount of interest may pay against any debt. But more debt may also create more risks in the company. Weighted average cost of capital is more helpful as the discount rate to consider the present value of future cash flows. It ensures the company that it at least earns up to cost of financing. When the cost of capital is high then the present earning of the firm going to decrease which show that capital structure in imbalance and having high risk factor in it. Investors require the highest return in such situations. The marginal cost of capital is high when the amount of capital increases. (universalclass.com, © Copyright 1999-2018 Universal Class™ All rights reserved.)
Cost of the capital formula is a combination of debt and equity that company needs to operations funding. Company’s investment decisions belong to new operations so the cost of capital must be increased.
The cost of capital is a combination of common stock, preferred stock, and cost of debt. The formula of cost of capital can be determined by calculating all three costs. The cost of debt can be measured according to given formula:
Cos of debt= (interest exp*(1-Tax rate)/Amount of debt- debt fee+ premium on debt-discount on debt
The cost of preferred stock calculated by:
Cost of preferred stock = interest expense/amount of preferred stock
The cost of common stock measured by:
Cost of common stock = risk free return+ (beta*(average stock return- risk free return))
Then we can measure the cost of capital on weighted average basis are:
Cost of capital = (debt fund*percentage cost)+(preferred stock* percentage cost)+Common funding*percentage cost)
Always use current market value for the measurement of common and preferred stock because their actual price may fluctuate which disturb their measurements. By using market value, we accurately measure the rate of return which may be determined by investors. It’s more preferable to use book values to calculate the rate of return at every time. Because investors want a maximum return at the end of the year. (accountingtools, November 05, 2017)
Methods of project evaluation:
For evaluating different projects, in accounting, we have different methods and techniques used in business. Some methods are going to discuss below:
- Return on investment: this method includes the project of the project against the investment and the return on investment is a measure to check the worth of the project. The greater the return on investment is creating the maximum chance to accept the project. In this approach, we are going to use three different concepts which are: return on asset, return on capital employed and return on shareholder’s equity. Different methods give different results from different directions but the aim is same to give the option of the project who gives a maximum
- Payback period: when we are going to start any project, the number of years according to net revenue which became the total cost equals revenue is known as payback period. In this method, that project is selected which have less number of years in return for all cost. Basically, it is the most simple method used to determine the selection of projects because only the number of years are a basic element in this method, the project is selected because of a quick return, but some time only this calculation is not enough for selection of the project. So this method is used in easiest and simple project decision areas.
- Net present value: in this method, we determine the number of costs and revenues according to years and then by using the cost of capital or discount rate, we determine the net present value of the project. If the NPV is greater than zero then this shows that revenues are higher than costs of all years and this project is beneficial for future, so that project would be selected who have NPV more than zero. This accounting method used was many years calculations are going to be ready and long-term project planning is going to hold on the basis of these decisions.
- The internal rate of return: this method shows the rate of discount that makes all the expected revenues of projects equals the costs of projects. In this method, we use the cost of capital as a comparison because if IRR is higher than the cost of capital then the project would be selected and id the cost of capital is higher than IRR then the project must be rejected. This a good method which normally used in companies for evaluating the projects and help in long-term decision making. (economicsdiscussion)
Conclusion and summary:
According to given data, we determine the profit of project of the company and tell different methods of evaluating the projects, no amount of shares and the total amount of equity is given by company. Cost of capital is a very useful technique that used in different companies to determine the condition of the company and check whether new investments give better solutions in critical matters. As per given information, the company has capital structure in which it has 30% debt, 10% preferred stock and 60% common equity. With this statement, we consider that company has less debt and maximum depend on its equity. A lot of shares it offers in the market and they earn maximum equity in this form. It’s a good sign because a good reputation mostly depends on the equity ratio, all those companies who have less equity not present a good image in front of the market, people don’t want to invest in these companies and they think that their dealing are depend on debts because its true. Those who are mostly depend on debt having less equity. They have to pay a high amount of interest against that debt and their shareholders and investment to receive less amount of interest and no any dividend or incentive. 60% equity show that royal company has well reputed and very famous among the people. They offer less amount of shares and give proper interest and dividends as given in question it has $4.19 amount per dividend and in upcoming years the dividend will be increased by 5% which a very attractive and good news for investors. Basically, this company provides good services to all their customers and people feel more comfort and relax while traveling in this company. They offer very economical rates for all level of people to travel from one place to another. Their ticket rates are very economic and their staff very well behaves with all customers. That way when they start new business class mostly people from who travel in the economy class shift to business class. They has a strong trust on this airline and want to travel in this airline every time just because of their services, good environment and good behavior. If to move to their capital structure, we see that they utilize less amount of debt. People consider that a company who use less debt having a good reputation in the market and having a high number of investors who invest their money in their company in the form of shares and receive proper interest and dividend because company earn a high rate of profit and distribute the profit among all employees and shareholders. so everyone is happy with the performance of the company. As in the given data, we observe that company spend a high amount on their maintenance and repair. Traveling is a basic element in the life of every person. People travel from one place to another many times and get tired. They want comfortable traveling facility so they feel relaxation and their all tired gone when they set and reached their destination. Royal airline is very popular among the people about its facilities and services; they provide comfortable seating for all customers, good food facility and also medication facility for their customers. Its staff is very well trained and having manners. Their behavior and talking style with customers is very nice. Company also gives different training sessions to its employees. Good and handsome salary packages with all incentives given to all employees so that they don’t want to go anywhere.
After all detail discussions, we consider that royal airline has to start this new project of business class as soon as possible by maintaining all necessary requirements and making all adjustments for staff and customers. People are willing to pay a little higher amount to travel in this airline and feel safe and comfortable while traveling.
The company has a good reputation in the market and offer more shares in less price to attract more investors and dividend growth rate is going to increase which more attract people to come and invest in the company and enjoy a sufficient amount to earn. The company also concern about the interest of customers and they spend too much amount in research of the market. The market trend is a very important factor in case of investing or starts any new project. If the condition of the market is strong then new investment opportunities will be held among people and people willingly invest in good companies who give a good rate of interest. For new projects, the company also does good research because if people want any facility then new facilities may attract them and they definitely come and take that opportunity. So new business class service is also the need of people according to research and trend of the market and when royal airline start this service people are willingly come and use this new service for their comfort and enjoyment. So starting this new project is the positive direction of the company and they earn more profit than before.
- accounting tools. (November 05, 2017). Cost of capital formula.
- economic discussion. (n.d.). Top 4 Methods of Project Evaluation | Firm.
- universalclass.com. (© Copyright 1999-2018 Universal Class™ All rights reserved.). Concepts of Cost of Capital in Financial Analysis.