CAPITAL BUDGETING WITH FUNDING SOURCES

Health Behavior

Part I: Capital Budgeting Practice Problems
a. Consider the project with the following expected cash flows:
year Cash flow PV@0% PV@4% PV@8% PV@10%
0 -400,000

($400,000.00
) ($400,000.00)

($400,000.00
) ($400,000.00)
1 100,000 $100,000.00 $96,153.85 $92,592.59 $90,909.09
2 120,000 $120,000.00 $110,946.75 $102,880.66 $99,173.55
3 850,000 $850,000.00 $755,646.90 $674,757.40 $638,617.58
  NPV = $670,000.00 $562,747.50 $470,230.66 $428,700.23
  IRR = 46% 40% 35% 32%
Discount
Rate NPV
0% $670,000.00
2% $562,747.50
6% $470,230.66
11% $428,700.23

00.040.080.1

Discount Rate

0
50000
100000
150000
200000
250000
300000

NPV

NPV Chart

The graph does not intersect the horizontal axis at any point. This is because the discount rates given in
this situation are all positive. From the graph, it is also evident that decrease in NPV, leads to increase in
the discount rates. The relationship is inversely proportional.
b. Consider a project with the expected cash flows:
year Cash flow PV@0% PV@4% PV@8% PV@12%
0 -815,000

($815,000.00
) ($815,000.00)

($815,000.00
) ($815,000.00)
1 141,000 $141,000.00 $135,576.92 $130,555.56 $125,892.86

CAPITAL BUDGETING WITH FUNDING SOURCES 3

2 320,000 $320,000.00 $295,857.99 $274,348.42 $255,102.04
3 440,000 $440,000.00 $391,158.40 $349,286.19 $313,183.31
  NPV = $86,000.00 $7,593.31 ($60,809.84) ($120,821.79)
  IRR = 4% 0% -3% -7%
Discount
Rate NPV
1% $86,000.00
4% $7,593.31
10% ($60,809.84)
18%

($120,821.79
)

1%4%10%18%

Discount rate

(‘$150,000.00)
(‘$100,000.00)
(‘$50,000.00)
$0.00
$50,000.00
$100,000.00

NPV

NPV Chart

The NPV graph cuts the horizontal axis at 5%. This is because the discount rates given in this
situation are both positive and negative. From the graph, it is also evident that decrease in NPV, leads to
increase in the discount rates. The relationship is inversely proportional.
c. Which method do you think is the better one for making capital budgeting decisions –
IRR or NPV?
Different approaches are used in capital budgeting to evaluate viability of a project.
However, this approach has advantages and disadvantages (McCracken, 2005). With all factors
and variables kept constant, net present value (NPV) and internal rate of return (IRR) are used to
evaluate project results lead to same findings. However, there are some situations where, NPV is
normally more convenient that IRR. The limitation and the advantage of the IRR technique is
that it used one discount rate to evaluate all projects. The use of discount rates makes matters
simple and in some projects, it causes problems for IRR. Without modification of the variable,

CAPITAL BUDGETING WITH FUNDING SOURCES 4
IRR does not cater for changing discount rates hence it is not effective when it comes to long-
term projects with varying discount rates (Perrin, 2008).
Moreover, for project with high mixtures of negative and positive cash flows, IRR is found to
be ineffective. In this situation, using NPV is advantageous because it can handle multiple
discount rates comfortably. Also, in cases where the discount rate is not known, IRR is not
effective and causes problem to users. However, to consider IRR as valid, it has to be compared
to the discount rate. In this case, the project is considered feasible when the IRR is greater than
discount rate and not feasible when it is less than the discount rate. Therefore, when the discount
rates are unknown, or cannot be applied to a specified project for whatever reason then, IRR is of
little benefit. For such like situation, NPV is considered valuable in that when the result is above
zero, the project is feasible, hence a worthwhile investment (Perrin, 2008).
The reason why IRR is continuously being used in capital budgeting is because of its simple
nature whereas NPV is complex and requires the discount rates to be assumed to payments be
assumed at each stage concerning the possibility of receiving payments. IRR technique
simplifies investments to one unit that management can use to determine the economic viability
of a project. IRR is a simple technique, however, when a project has long-term multiple cash-
flows at different stages with varying discount rates, IRR is not the option, but NPV is deemed to
be of much help (Perrin, 2008).
Part 2: Equity and Debt

Equity financing
In equity financing, owners get working capital from investors in exchange of ownership
of part of the firm. The investors are normally rich people, family members or venture capital
firms, and it is through this that Gregory Yurek is opting for as the only source of capital for
AMSC. The good thing about equity financing is that at the end of the day, the firm has no
obligations of paying the investors neither there is time limit for paying back the investors, nor
when the firm goes broke, it owes nothing to anyone. Therefore when a firm has more equity, it
attracts more investors because it is a sign of its success (Carpenter & Petersen, 2002).
The major drawback is that the owner loses part of benefits of ownership to investors
which lead to loss of control of the firm by its directors and invested capital must be used in a
productive way. Also, where there are dividends paid, they are not tax deductible (Yunda &
ICCSNA, 2010).
Debt financing
In debt financing, owners borrow working capital in form of (notes, bonds, and bills)
from lenders where there is an agreement of interest rate and payback time. The lenders can be
bank or individual making it the best way to finance a company. It is beneficial though it tax
deductible dividends, thus the loans are classified as firm’s expenses hence deducted from the
income taxes of the business. Moreover, despite the amount of loans borrowed, the owners of the
firm is not affected in any way, the only issue being paying the obligations at agreed time and at
agreed interest (Yunda & ICCSNA, 2010).

CAPITAL BUDGETING WITH FUNDING SOURCES 5
As a result, the loans can work against the owners when they cannot pay the debts in time
and accumulates more debt, therefore putting the collateral equipment at risk of being lost A lot
of debt also taint the image of the firm and each loan taken, affects the credit of rating of the
company (Carpenter & Petersen, 2002).
Cost of Capital
Cost of capital is the cost of the funds of company, the cost of dent is the market interest
the company is needed to pay on its loans and is dependent of the firm’s tax rate, premium, and
interest rates (Carpenter & Petersen, 2002). The cost of equity is the firms required rate of return
that is included in both price appreciation and dividend yield. Cost of equity is measured by
dividend discount model and Capital Asset Pricing Model. CAPM shows the relationship
between expected return and expected risks and is used to price risky securities where risk and
value of money are key factors. On the other hand, Dividend discount modeling is the procedure
used to value price of stock using predicted dividends and recapturing their value (Yunda &
ICCSNA, 2010).
Conclusion
It will be a good idea for the AMSC’s management to forgo the debt financing for equity
financing because its assets will never be seized when venture becomes unproductive and it will
owe nobody in case it goes bankrupt. Moreover, the firm will likely to be successful because the
investors will work for its success because it is where their wealth lies. However, the investors
will be involved in the decision, making process of the firm and be part of running the firm.
Therefore, when the AMSC’s management opts for this option then it means it will lose some of
its roles to the investors and the decisions they will make will depend on the investors.
Therefore, it will be advisable for the firm to come up with the trade-off theory for the sake of
capital structure. The company should therefore adopt a 2:1 debt to equity ratio because it will
ensure that the bought shares do not exceed the set ratio and it will enjoy more tax deductions in
the future and reduce many claims. Also, the company should use the CAPM model because
AMSC is not an equity financing firm and the fact that it is used in common types of
investments, it is the best valuation model for the company.

CAPITAL BUDGETING WITH FUNDING SOURCES 6

References

Carpenter, R. E., & Petersen, B. C. (February 01, 2002). Capital Market Imperfections, High-
Tech Investment, and New Equity Financing. The Economic Journal, 112, 477.)
McCracken, M.E. (2005) Capital budgeting, retrieved from:
http://teachmefinance.com/capitalbudgeting.html
Perrin, R. (2008). Real world project management: Beyond conventional wisdom, best practices,
and project methodologies. Hoboken, N.J: John Wiley & Sons.
Yunda, L., & 2010 Second International Conference on Communication Systems, Networks and
Applications (ICCSNA). (June 01, 2010). The effect of the property structure on the
company’s debt financing. 2, 132-135.