The Investment Detective Essay

General speaking, WACC is the rate that a company’s shareholders expect to be paid on average to finance its assets, and it is the overall required return on the firm as a whole. Therefore, company directors often use WACC to determine whether a financial decision is feasible or not. In this case, I will choose 9.38% as discount rate. The reason why I choose 9.38% as discount rate is because the estimated Debt/Equity is 26% under the assumptions by CFO Sheila Dowling, which is most close to 25% of Debt/Equity from the projected WACC schedule. There might be some flaws existing by using WACC as discount rate. As we know, the cost of debt would be raised significantly as the leverage increased. The investment will definitely increase the firm’s current debt. So, the cost of debt would not keep at 7.75%.

The NPV compares the inflow of cash against the flow of cash to make the investment. With the cash flows occurring over a period of time, NPV also takes into account the cost of capital. The cost of capital or discount rate allows the company to weigh the present value of capital today with the investment capital’s present value. Futronics Inc. investment would have an NPV of $138,642.39. The NPV of this investment would add value to Futronics Inc.’ worth.

I used WACC as the discount factor, we expect the rate of return to be higher than it, the same at least. The WACC reflects the average risk and overall capital structure of the entire firm [2]. It’s the required return and it presents how much the company pays for the capital it finances. In this case, the cost of equity is 10.33%, the cost of debt is 6.50%. I calculated WACC using those numbers and got a result of 8.49%.

The next step was to calculate the free cash flows for the eleven-year period. In order to do so, we used to following formula: FCF = EBIT(1-tax) + depreciation - change in NWC – CapEx. From here, we used to WACC of 13.89% previously calculated, in order to find the present value of each FCF.

Our WACC is almost constantly these years – around 5.50% -- via from 5.04% to 5.82%. We also use the scenario analysis for how the WACC and growth rate affect enterprise value and equity value.

WACC = (1-corporate tax rate)(Pretax rate of cost of debt)(Market value of debt/ D+E))+ After tax rate of cost of equity(market value of equity/D+E))

Net Present Value (NPV) calculates the sum of discounted future cash flows and subtracting that amount with the initial investment of the project. If the NPV of a project results in a positive number, the project should be undertaken. It is the most widely used method of capital budgeting. While discount rate used in NPV is typically the organization’s WACC, higher risk projects would not be factored in into the calculation. In this case, higher discount rate should be used. An example of this is when the project to be undertaken happens to be an international project where the country risk is high. Therefore, NPV is usually used to determine if a project will add value to the company. Another disadvantage of NPV method is that it is fairly complex compared to the other methods discussed earlier.

company’s securities, both debt and equity. The WACC is important to calculate because it is a necessary

Project Free Cash Flows (dollars in thousands) Project number: 1 2 3 4 5 6 7 8 Initial investment (2,000) (2,000) (2,000) (2,000) (2,000) (2,000) (2,000) (2,000) Year 1 $ 330 $ 1,666 $ 160 $ 280 $ 2,200 $ 1,200 $ (350) 2 330 334 200 280 900 (60) 3 330 165 350 280 300 60 4 330 395 280 90 350 5 330 432 280 70 700 6 330 440 280 1,200 7 330 442 280

For future cash flows, evaluation is done with WACC rate which consists from cost of equity and cost of debt in a weighted average. In this case, using cost of equity is not appropriate since we doesn’t know cost of debt and weights of equity and debt, it doesn’t reflect the actual rate for WACC.

WPC has used a discount rate of 15% to evaluate potential projects for the last 10 years. Many in management are correct in thinking that this rate should be evaluated on a much more frequent basis. The current rate of 15% is much too high considering the yield on treasury bonds has declined from 10% to 5% over the last ten years. In order to calculate the correct discount rate we must first determine what their equity and debt ratios are. As you can see in Exhibit1, in order to find the total value of equity we must multiply the number of total outstanding shares of stock times the market value of each share. Completing this calculation shows us that WPC has $12 billion in outstanding equity. WPC also has $2.5 billion in outstanding debt. If you add the debt and equity together we see that WPC has a total of $14.2 billion in outstanding financing. Assuming the 10 year rate of Government Bonds of 4.60% as our risk free rate and using the Capital Asset Pricing Model we find that that WPC’s return on equity is 11.2% (See Exhibit 1). As stated in the case, Worldwide Paper Company has an A bond rating so we can use the 5.78% for their return on debt. Combining all of these variables in the Weighted Average Cost of

In fully investigating all of our calculations we are fully invested in using the Net Present Value figures we calculated as a means of ranking the eight projects. In doing so we found reasons in which why the Net Present Value was our benchmark for ranking the projects and why we did not use the Payback Method. The Payback Method ignores the time value of money, requires and arbitrary cutoff point, ignores cash flows beyond the cutoff date, and is biased against long-term projects, such as research and development and new projects. When comparing the Average Accounting Return Method to the Net Present Value method we found that the Average Accounting Return Method is a worse option than using the Payback Method. The Average Accounting Return Method is not a true rate of return and the time value of money is ignored, it uses an arbitrary benchmark cutoff rate, and is based on accounting net income and book values, not cash flows and market values. Plain and simply put, the Net Present Value method is the best criterion to use when ranking these eight

All of these calculated figures can then be used to calculate the WACC which is (17% x 3.47%) + (83% x 11.2%) = 9.87% WACC. This WACC percentage can then be used to value the investment and as a comparative in valuation methods. The full calculation and numerical values are shown in Appendix 1.

While this method utilizes the concept of cash flow and uses the initial investment as the denominator, discounted cash flow is still not used, and we suspect this method is geared more towards the comfort level of OL managers, while WD managers would continue to utilize the NPV and IRR figures.

This first section of this paper will provide a brief explanation on theoretical rationale for the net present value (NPV) method of investment appraisal and then compare its strengths and weaknesses to two alternative methods of investment appraisal, those of internal rate of return (IRR) and pay-back.