INVESTMENT APPRAISAL REPORT

TO

THE DIRECTORS OF AYR CO.

Effiong James Ntia

74105131
Strategic Financial Management (AF4S31-V2)
Tutor: Nikki Petrou
02/03/2019
TABLE OF CONTENTS

TABLE OF CONTENTS................................................................................................................... ii
1.0 INTRODUCTION ................................................................................................................. 2
2.0 INVESTMENT APPRAISAL TECHNIQUES ....................................................................... 3
2.1 NET PRESENT VALUE (NPV) ...................................................................................................... 3
2.2 INTERNAL RATE OF RETURN (IRR)............................................................................................. 4
2.3 PAYBACK PERIOD ..................................................................................................................... 6
3.0 EVALUATION OF INVESTMENT OPTIONS ..................................................................... 7
3.1 OTHER FACTORS CONSIDERED IN MAKING THE INVESTMENT DECISION .................................. 7
3.1.1 RISK................................................................................................................................... 7
3.1.2 REQUIRED RETURN ........................................................................................................... 8
3.1.3 NON-FINANCIAL CONSIDERATIONS ................................................................................... 8
3.2 INVESTMENT RECOMMENDATION AND JUSTIFICATION ........................................................... 9
4.0 SOURCE OF FINANCE ........................................................................................................... 10
4.1 EQUITY FINANCING VERSUS DEBT FINANCING ....................................................................... 10
4.2 COST OF CAPITAL ................................................................................................................... 11
4.3 EFFECT OF SOURCE OF FINANCE ON WACC ............................................................................ 12
4.4 EFFECT OF SOURCE OF FINANCE ON SHAREHOLDERS AND LENDERS ...................................... 13
5.0 CONCLUSION ......................................................................................................................... 14
6.0 REFERENCES .......................................................................................................................... 15
7.0 APPENDICES ........................................................................................................................... 16
7.1 CALCULATIONS FOR PROJECT ASPIRE ..................................................................................... 16
7.2 CALCULATIONS FOR PROJECT WOLF ................................................................................. 24
7.3 CALCULATIONS TO SHOW EFFECT OF SOURCE OF FINANCE ON WACC.............................. 32
7.4 CALCULATIONS TO SHOW EFFECT OF SOURCE OF FINANCE ON CURRENT AND POTENTIAL
SHAREHOLDERS AND LENDERS .................................................................................................... 34

ii
1.0 INTRODUCTION

Every investor who dedicates time and money to any business concern does so for the primary
reason of creating value and making a reasonably high percentage of return on the initial
investment. AYR Co. has been presented with two attractive investment proposals, Project
Aspire and Project Wolf, one of which is to be selected based on the likelihood of that project
offering better return than the other. This report seeks to use some renowned investment
appraisal techniques to determine which investment would offer more value to shareholders,
and also recommend which source of finance would be preferable between debt financing and
equity financing.

In order to accurately make these recommendations, firstly, this report calculates the Net
Present Value (NPV), the Internal Rate of Return (IRR), and the Payback Period of projects
Aspire and Wolf using the available information on start-up expenditure, projected cash flow,
material costs, taxation, and other anticipated expenses. Secondly, a measure of risk assessment
is applied to the proposals to put the projected figures in the context of the likelihood of
occurrence. Based on the results from the investment appraisal calculations mentioned above,
together with some well-informed assumptions and other non-financial considerations, the
report then goes on to make a critical comparison of both projects in question, and then
determines which one offers better value to the shareholders of AYR Co. Finally, having
identified the investment of choice, the report is concluded by comparing the effects of using
either equity financing or debt financing on the Weighted Average Cost of Capital (WACC) of
the company, and the return on the equity of the shareholders with a view to making a
preferable selection.

The analysis shows that Project Aspire and Project Wolf both have positive Net Present Values,
reasonable Internal Rates of Return, and short Payback Periods within the same range as each
other. A comparison between the choice of using either equity financing or debt financing to
fund the selected project also shows that the decision is heavily dependent on the cost of debt
which is the interest rate charged by the lender even though AYR Co. has a worryingly high
debt-equity ratio. Following these analyses, my final recommendations are stated in the
concluding segment of this report.

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 2.0 INVESTMENT APPRAISAL TECHNIQUES

The remit of financial management of any business focuses primarily on three broad questions
namely; the kind of investments to make, the source of financing, and the management of daily
operations (Collier, 2003). In order to guard against making erroneous decisions which may
result in loss of funds, it is important to assess the viability of potential investments prior to
committing shareholders’ funds into any project. Investment appraisal techniques, such as net
present value (NPV), internal rate of return (IRR), and payback period, are analytic tools used
to make these viability assessments (Pike and Neale, 2009). The calculated values for NPV,
IRR and the payback period for Project Aspire and Project Wolf are shown below.

2.1 NET PRESENT VALUE (NPV)

Figure 2.1: Projected Cash Flow Statement for Project Aspire

DESCRIPTION YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6

Plant and (2,250,000)
Machinery
Working Capital (140,000)
Cash Inflow 650,000 698,750 751,156 807,493 868,055
Scrap Value 375,000
Variable Costs (27,000) (28,822.50) (30,768.02) (32,844.86) (35,061.86)
Repayment of (225,471.40)
Working Capital
(Future Value)
Net Operating 623,000 669,928 720,388 774,648 982,522
Cash Flow
Capital (600,000) (390,000) (345,000) (300,000) (240,000)
Allowance
Taxable Cash 23,000 279,928 375,388 474,648 742,522
Flow
Tax (20%) (0.00) (4,600) (55,985.60) (75,077.60) (94,929.60) (148,504.40)
Net Cash Flow 623,000 665,328 664,402 699,570 887,592 (148,504)
Discount Rate 0.10 0.10 0.10 0.10 0.10 0.10
(10%)
Discount Factor 0.90909 0.82645 0.75131 0.68301 0.62092 0.56447
Present Value (2,390,000) 566,363 549,860 499,172 477,813 551,124 (83,826)
Net Present 170,506
Value (NPV)

3
 Figure 2.2: Projected Cash Flow Statement for Project Wolf

DESCRIPTION YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6

Initial (2,250,000)
Investment
Cash Inflow 955,000 955,000 955,000 955,000 955,000
Material Costs (14,400) (15,480) (16,641) (17,889.08) (19,230.76)
Other Expenses (18,000) (16,650) (15,401.25) (14,246.16) (13,177.70)
Rental Income (82,500) (90,750) (99,825) (109,807.50) (120,788.25)
(Future Value)
Net Operating 840,100 832,120 823,133 813,057 801,803
Cash Flow
Tax (20%) (0.00) (168,020) (166,424) (164,626.60) (162,611.40) (160,360.60)
Net Cash Flow 840,100 664,100 656,709 648,430 639,192 (160,361)
Discount Rate 0.10 0.10 0.10 0.10 0.10 0.10
(10%)
Discount Factor 0.90909 0.82645 0.75131 0.68301 0.62092 0.56447
Present Value (2,250,000) 763,727 548,845 493,392 442,884 396,887 (90,519)
Net Present 305,216
Value (NPV)

The Net Present Value (NPV) of any investment is defined as the difference between the cost
of embarking on the business venture and the market value of that investment. In other words,
it is a measure of the amount of value added to, or deducted from shareholders’ stock as a result
of the investment decision with the time value of money appropriately accounted for. A positive
NPV indicates a profitable investment whereas a negative NPV points to a loss-making
decision. Generally, the higher the NPV, the more profitable the investment will be (Pike and
Neale, 2009). The NPV for Project Aspire and Project Wolf are $170,506 and $305,216
respectively as shown in the projected cash flow statements in figures 2.1 and 2.2. Detailed
calculations are shown in appendices 7.1 and 7.2.

2.2 INTERNAL RATE OF RETURN (IRR)

The Internal Rate of Return (IRR) shows the discount rate or return on the investment when
the NPV is zero. In other words, the IRR coincides with the break-even point of the investment.
In most cases, higher values of IRR indicate better investments, but this is not always the case
especially when considered in isolation of other appraisal metrics (Ross et al, 2017). The IRR
for Project Aspire and Project Wolf are 12.7% and 15.6% respectively as shown in the NPV
profiles in figures 2.3 and 2.4. Detailed calculations are shown in appendices 7.1 and 7.2.

4
Figure 2.3: Net Present Value Profile for Project Aspire

NET PRESENT VALUE PROFILE (ASPIRE)

1,200,000

1,000,000 1,001,388

800,000
IRR = 12.7%
600,000
540,914
NPV (N)

400,000

200,000 170,506

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
-131,251
-200,000

-400,000 -379,974

-600,000
Discount Rate (%)

Figure 2.4: Net Present Value Profile for Project Wolf

NET PRESENT VALUE PROFILE (WOLF)

1,200,000
1,038,170
1,000,000

800,000
634,368
600,000
IRR= 15.6%
NPV ($)

400,000 305,216

200,000
33,682
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19-192,823
20 21
-200,000

-400,000
Discount Rate (%)

5
2.3 PAYBACK PERIOD

The payback period is defined as the amount of time it takes to recover the start-up costs of the
investment based on the net cash flow projection of the project. The shorter the payback period,
the more desirable the project will be (Pike and Neale, 2009). The payback periods for
investments in Project Aspire and Project Wolf are 3.63 years and 3.14 years respectively as
shown in the schedules in figures 2.5 and 2.6. This translates to about 3 years and 8 months,
and 3 years and 2 months respectively. Detailed calculations are shown in the appendices.

Figure 2.5: Payback Period Schedule for Project Aspire

S/N DESCRIPTION YEAR DEBIT ($) CREDIT ($) BALANCE ($)

1 Start-Up Cost
2 Net Cash Flow
3 Net Cash Flow
4 Net Cash Flow
5 Net Cash Flow
6 Net Cash Flow
7 Net Cash Flow
0 (2,390,000) -2,390,000
1 623,000 -1,767,000
2 665,328 -1,101,672
3 664,402 -437,270
4 699,570 262,300
5 887,592 1,149,892
6 (148,504) 1,001,388

Figure 2.6: Payback Period Schedule for Project Wolf

S/N DESCRIPTION YEAR DEBIT ($) CREDIT ($) BALANCE ($)

1 Start-Up Cost
2 Net Cash Flow
3 Net Cash Flow
4 Net Cash Flow
5 Net Cash Flow
6 Net Cash Flow
7 Net Cash Flow
0 (2,250,000) -2,250,000
1 840,100 -1,409,900
2 664,100 -745,800
3 656,709 -89,091
4 648,430 559,339
5 639,192 1,198,531
6 (160,361) 1,038,170

One of the downsides of the use of the payback period is that, in its calculation, the time value
of money is ignored, and the analysis carried out would be the same regardless of the level of
risk. Another problem is that the choice of the threshold for cut-off is usually arbitrary and
sometimes ignores possible cash flows accruable in the future (Ross et al, 2017). This could
lead to rushed and premature decisions which may not be representative of the true desirability
of a particular choice of investment.

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3.0 EVALUATION OF INVESTMENT OPTIONS

Projects Aspire and Wolf have been appraised using discounted techniques (NPV), and non-
discounted techniques (IRR and Payback Period), but there are other factors that should be
considered before making a definitive conclusion on which investment, if any, to get involved
in. Examples of these other factors are the amount of risk involved, the required return by the
management of the company, the location of the investment, the environmental friendliness, as
well as health and safety standards.

3.1 OTHER FACTORS CONSIDERED IN MAKING THE INVESTMENT DECISION

The other factors which have been taken into account prior to the recommendation for the final
investment decision are as follows:

3.1.1 RISK

Every business decision comes with various kinds of inherent risk such as business risk, which
has to do with uncertainty of the accuracy of projected cash flows, and financial risk, which
refers to risk associated with the source of capital used to fund the investment (UNICAF/USW,
2019). Calculation of the NPV also has its own risk connected to the choice of discount rate
used in the calculations (Brookfield, 1995). In the analyses conducted so far, the Weighted
Average Cost of Capital (WACC), which is the least amount of return required to satisfy the
yearnings of the shareholders of AYR Co., has been used as the discount rate to determine the
NPV. This rate is appropriate for a low risk venture such as Project Aspire where the investment
is used to expand the current business with a focus on existing customers and possibly some
new clientele. For a higher risk venture, such as Project Wolf, which intends to use new
products to attract new customers, the risk is considerably higher.

There are two ways of provisioning for these higher risk ventures; the pure play approach
prescribes the use of discount rates that are similar to those of organizations that are solely in
the line of business of the risky investment, as opposed to the subjective approach where the
company arbitrarily apportions higher discount rates to higher risk projects (Ross et al, 2017).
Using the subjective approach, I have assigned a 50 per cent mark-up on the WACC thus
raising the discount rate 15 per cent.

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Assuming a 50:50 probability of occurrence between the 10% and 15% discount rate scenarios:

The Expected NPV for Project Wolf = P1X1 + P2X2 (UNICAF/USW, 2019)
Where P1 = Probability of 10% Outcome = 0.5
P2 = Probability of 15% Outcome = 0.5
X1 = NPV at 10% Discount Rate = $305,216 (Appendix 7.2 - ix)
X1 = NPV at 15% Discount Rate = $33,682 (Appendix 7.2 - x)

Expected NPV for Project Wolf = (0.5 × 305,216) + (0.5 × 33,682)

= 152,608 + 16,841
= $169,449

3.1.2 REQUIRED RETURN

The WACC, as previously stated, is the minimal return needed to satisfy the shareholders but
every firm goes into business to make more money and create more value for its stakeholders
therefore there would usually be a required return, set by the management of the organization,
which would be higher than the WACC in order for an investment to be deemed worthwhile.
If the IRR is higher than the required return, then the investment is seen in a positive light
whereas if the required return is higher than the IRR, the investment will be avoided (Pike and
Neale, 2009). In this case, the required return of AYR Co. has not been stated so it is difficult
to gauge it against the IRR in order to make a better informed decision.

3.1.3 NON-FINANCIAL CONSIDERATIONS

For a financial investment to be considered viable, there are many non-financial factors to be
assessed. Firstly, the location of the new venture matters; for instance, the risk involved in
investing overseas would be different from that of a new investment within the same shores.
Even within the same country, consumer peculiarities differ from region to region. Secondly,
environmental factors are also important when making business decisions in the modern world;
stakeholders want to know the kind of emissions that plants and machinery give off, the manner
in which industrial waste disposal is handled, and the general effect of daily operations on the
health and safety of the employees and customers in particular, as well as the ecosystem in
general.

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Thirdly, political factors need to be considered when making crucial decisions such as this one.
Are the shareholders politically inclined and exposed? If they are, what is the likely reception
from the political power brokers in the region of the intended investment? Is there current or
anticipated political unrest in the area? Questions like these need to be asked and satisfactorily
answered before signing off on any potential investment. Lastly, the legal requirements of the
investment destination need to be thoroughly understood in order to avoid running into legal
battles that can erode the profits of the company.

3.2 INVESTMENT RECOMMENDATION AND JUSTIFICATION

Table 3.1 below outlines the summary of the calculations from the investment appraisal
techniques discussed in this report.

Figure 3.1: Summary of Calculations from Investment Appraisal Techniques

S/N APPRAISAL TECHNIQUE PROJECT ASPIRE PROJECT WOLF

1 NPV (Before Risk Assessment) $170,506 $305,216
2 NPV (After Risk Assessment) $170,506 $169,449
3 IRR 12.7% 15.6%
4 Payback Period 3.63 Years 3.14 Years

Project Aspire has a better NPV, after provisioning for risk assessment, of $170,506 compared
to $169,449 calculated for Project Wolf; this means that the Aspire Project will offer better
value to shareholders than the other contender. However, the margin of difference between
both figures for NPV is negligible especially when the fact that there is a fifty per cent
probability of a lower discount rate is considered. On the other hand, Project Wolf has an IRR
of 15.6 % which is higher than the 12.7% determined for the other project. This means that the
Wolf Project stands a better chance of exceeding the expected return of AYR Co. than its
Aspire counterpart. Shareholders will also recoup capital investment in Project Wolf faster than
they would if their funds were sunk into Project Aspire due to the shorter Payback Period.

Following a thorough comparison of the pros and cons of each project, I recommend that the
board invests in Project Wolf because, at its worst, that investment will do just as well as Project
Aspire and, at best, it will perform way better. The differences in NPV and Payback Period
between both projects are marginal but the difference in the IRR is telling.

9
4.0 SOURCE OF FINANCE

There are two major ways of financing new businesses and projects; equity financing, which
involves selling of shares in the existing business in exchange for inflow of new capital, and
debt financing has to do with borrowing from a lender at a fixed interest rate to be paid over an
agreed period of time (Marsh, 1982). The differences between debt financing and equity
financing are listed in section 4.1.

4.1 EQUITY FINANCING VERSUS DEBT FINANCING

The table below shows the major differences between equity financing and debt financing:

Figure 4.1: Equity versus Debt

S/N DESCRIPTION EQUITY DEBT

1 Ownership A percentage is sold to the The entirety of ownership is
equity investor. retained by business owner.
2 Risk Risk is shared with equity Risk is borne solely by the
investor. business owner.
3 Profitability Profits are available for Loan repayments are deducted
reinvestment into futurefrom profits thus reducing
growth. profitability and further
reinvestment into the business.
4 Decision Making Investors will have a major Decision making is totally
stake in management influenced by the business
decisions and daily operations owner(s).
of the business.
5 Tax Dividends are not tax Interests on loan repayments
deductible. are tax deductible.
6 Interest Rates The return on equity is usually The interest rates on loans are
higher than the interest rates normally lower than the return
on loans. on equity.
7 Predictability There is usually some level of Loan repayments are
uncertainty about the potential predictable therefore planning
exit of equity partners and is easier and more dependable.
investors.
8 Examples and Venture capital firms, family Term loans, invoice financing,
Sources and friends. credit cards, lines of credit,
merchant cash advance.

Source: Bond Street (2019)

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4.2 COST OF CAPITAL

The cost of capital for any firm is made up the cost of equity and the cost of debt used in
financing the operations of the firm (Lambert et al, 2007). The cost of debt, RD, is the interest
rate charged by the lenders of capital to the company, this can also be assessed indirectly by
comparing the rates of similar debt instruments in the financial markets. The cost of equity, RE,
can be determined using two approaches depending on the information available to the analyst.
The dividend growth model approach is dependent on the growth rate of the company, g, the
share price of the firm, P, the last dividend paid, D0 and the projected dividend payable to
shareholders in the following financial year, D1 (Ross et al, 2017).

RE = (D1/P) + g (Ross et al, 2017)

Where D1 = D0 × (1 + g)

The security market line (SML) approach, on the other hand, depends on the risk-free discount
rate, Rf, which is a measure of the rate at which there is little to no risk involved in the
investment, the market risk premium, RM – Rf, which is difference in rates between a higher
risk investment and the risk-free rate, and the systematic risk of the project, β, as it relates to
the risk-free baseline.

RE = Rf + [β × (RM – Rf) (Ross et al, 2017)

Both methods have their merits; the dividend growth model is straightforward and user friendly
while the SML approach caters to companies that may not record regular growth in dividend
payouts with accommodation for risk fine-tuning. However, they both have the distinct
disadvantage of using historic information as a basis for predicting the future as well as relying
on information that may not be readily available thereby forcing the analyst to depend on the
assumptions and estimates that may not be entirely correct. Prevalent economic conditions may
fluctuate and render these estimates impracticable (Ross et al, 2017).

In the case of AYR. Co., the last paid dividend, the projected dividend for the next financial
year, the share price, the growth rate of the company, and the form’s systematic risk are
unavailable so it is difficult to determine exact values. Generally, the cost of debt is usually
lower than the cost equity.

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4.3 EFFECT OF SOURCE OF FINANCE ON WACC

As shown in figures 2.3 and 2.4, the NPV increases as the discount rate reduces. Since the
WACC is the discount rate used for a risk-free investment, it follows that a reduction in the
WACC of any firm results in an increase in cash flow which in turn increases the NPV and
profits. WACC is calculated as follows:

WACC = [(E/V) × RE] + [(D/V) × RD × (1-TC)] (Ross et al, 2017)

Where E = Market Value of the Equity of the Company

D = Market Value of the Debt of the Company

V = Total Market Value of the Company, i.e D + E
RE = Cost of Equity ; RD = Cost of Debt; TC = Rate of Corporate Tax
The decision to use either debt or equity to finance these projects will affect the debt-equity
ratio, i.e D/E. If debt is used, the debt-equity ratio increases as a result of the increase in debt
relative to the static equity capital; if equity is used, the debt-equity ratio reduces because of
the increase in equity compared to the static capital.

Rearranging the formula for WACC above to make RE the subject of the formula, and
excluding corporate tax for simplicity:

RE = RA + [(RA – RD) × (D/E)] (Ross et al, 2017)

Where RA = Required return on the overall assets of the company

To assess the effect of the source of finance, WACC was re-calculated using three scenarios
assuming a cost of debt of 8%: i) before financing ii) equity financing; and iii) debt financing.
The results show that the WACC was still about 9% using either equity or debt financing thus
proving that the source of finance has a negligible effect on WACC.

Figure 4.2: Results Showing the Effect of Source of Finance on WACC

Scenario Finance Source Debt, D ($) Equity, E ($) D/E WACC

Scenario 1 Before Project 18,000,000 20,000,000 0.9 9.31 %
Scenario 2 Debt 20,250,000 20,000,000 1.01 9.23 %
Scenario 3 Equity 18,000,000 22,250,000 0.81 9.30 %

Detailed calculations shown in Appendix 7.3

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4.4 EFFECT OF SOURCE OF FINANCE ON SHAREHOLDERS AND LENDERS

To evaluate the effect of the source of finance on shareholders, the return on equity (ROE) for
Year 1 of Project Wolf was calculated using varying interest rates as shown in figure 4.3 below.

Figure 4.3: Return on Equity at Varying Interest Rates

DESCRIPTION AMOUNT($) AMOUNT($) AMOUNT($) AMOUNT($) AMOUNT($)
Finance Source Equity Debt Debt Debt Debt
EBIT for Year 1 840,100.00 840,100.00 840,100.00 840,100.00 840,100.00
Interest Rate - 8% 9% 10 % 11 %
Interest - (67,208.00) (75,609.00) (84,010.00) (92,411.00)
Taxable Income 840,100.00 772,892.00 764,491.00 756,090.00 747,689.00
Tax (20%) (168,020.00) (154,578.40) (152,898.20) (151,218.00) (149,537.80)
Profit After Tax 672,080.00 618,313.60 611,592.80 604,872.00 598,151.20
Equity 22,250,000 20,000,000 20,000,000 20,000,000 20,000,000
Return on Equity 3.02 % 3.09 % 3.06 % 3.02 % 2.99 %

Detailed calculations shown in Appendix 7.4

Figure 4.4: Return on Equity vs Interest Rate

RETURN ON EQUITY vs INTEREST RATE

3.10
3.09
Advantage to
3.08 Debt

3.06
Return on Equity (%)

3.06
Break-even point

3.04
Debt

3.02 3.02 3.02 3.02 Equity

3.02

Advantage to
3.00 Equity
2.99

2.98
8.00 8.50 9.00 9.50 10.00 10.50 11.00 11.50
Interest Rate (%)

13
The analysis took the calculated net operating cash flow from figure 2.2 as the earnings before
interest and taxation (EBIT), assumed that taxation is payable in the same year, and ignored
the time value of money for simplicity. Starting from the assumed interest rate of 8%, the results
showed that the ROE using debt financing, i.e 3.09%, will be higher than the ROE using equity
financing, i.e 3.02%, which would be the same for all values of interest rates since equity
financing does not require any additional interest payments. However, when the interest rate
was increased, 1% at a time, the results showed that the ROE using debt financing steadily
reduced to a break-even point of 3.02%, where it became equal to the ROE for equity financing.
The corresponding interest rate at this break-even point was 10%. Further increments of the
interest rate resulted in lower ROEs than that of equity financing. This shows that debt
financing offers higher returns for shareholders than equity financing as long as the cost of debt
is below 10%; for interest rates above 10%, equity financing is preferable.

Before financing, the debt-equity ratio is 0.9 as shown in the calculations in appendix 7.3; this
is already higher than the average general risk standard of 0.4 (Ross, 2019). The choice of debt
financing will further increase this value to 1.01, this casts more doubt on the ability of AYR
Co. to meet its long term obligations thus making it unlikely for lenders to approve loans to the
company. Equity financing will reduce debt-equity ratio to 0.81 and have the opposite effect.

5.0 CONCLUSION

The analysis shows that Project Aspire and Project Wolf both have positive Net Present Values
which fall within close proximity of each other after the risk assessment of Project Wolf is
applied as a result of the appeal to a new customer base. The Payback Periods for both projects
are also within small margins of each other, only a few months apart. The deciding appraisal
tool is the Internal Rate of Return which predicts that the Wolf project will offer a return that
would be about 3 % higher than that of the Aspire project and over 5% more than the Weighted
Average Cost of Capital of the company. For this reason, and also the possibility that the
projected cash flow exceeds the conservative outlook necessitated by the risk assessment, I
therefore recommend that the board of AYR Co. invests in Project Wolf rather than Project
Aspire. Furthermore, it is my position that this project should be funded using debt financing
on the condition that the interest rate is less than or equal to 10%; if the available debt financing
options have interest rates higher than 10%, then equity financing should be used instead.

14
6.0 REFERENCES

Bond Street (2019). ‘Understanding Debt vs Equity Financing’. Available at:

https://bondstreet.com/understanding-debt-vs-equity-financing/. Accessed: February 26, 2019.

Brookfield, D. (1995). ‘Risk and Capital Budgeting: Avoiding the Pitfalls in Using NPV When
Risk Arises’. Management Decision, 33 (8), pp. 56-59.

Collier, P.M. (2003). Accounting for Managers: Interpreting Accounting Information for
Decision Making. West Sussex: Wiley.

Davies, P. (2017). Stakeholders and Organizational Purpose. University of South Wales

Lecture Notes.

Freeman, R.E. (1984). Strategic Management: A Stakeholder Approach. Boston: Pitman.

Lambert, R., Leuz, C. and Verrechia R. E. (2007). ‘Accounting Information, Disclosure, and
the Cost of Capital’. Journal of Accounting Research, 45 (2), pp. 385 – 420.

Marsh, P. (1982). ‘The Choice Between Equity and Debt: An Empirical Study’. The Journal
of Finance, 37 (1), pp. 121-144.

Pike, R. and Neale, B. (2009). Corporate Finance and Investment: Decisions and Strategies,
6th Edition. Harlow: Pearson Education Limited.

Ross, S. (2019). ‘What is a Good Debt Ratio, and What is a Bad Debt Ratio?’. Investopedia.
Available at: https://www.investopedia.com/ask/answers/021215/what-good-debt-ratio-and-
what-bad-debt-ratio.asp. (Accessed February 1, 2019)

Ross, S.A., Westerfield, R.W. and Jordan B.D. (2017). Essentials of Corporate Finance, 9th
Edition. New York: McGraw-Hill Education.

UNICAF/University of South Wales (USW), (2019). Master of Business Administration

(MBA) Lecture Notes on Strategic Financial Management.

UNICAF/USW Assessment 2 Brief (2019). Master of Business Administration (MBA) Course

on Strategic Financial Management.

15
7.0 APPENDICES

Calculations for all the investment appraisal metrics used in this report are detailed below, all
amounts are denominated in dollars unless otherwise stated. All cash flows have been
approximated to the nearest dollar.

7.1 CALCULATIONS FOR PROJECT ASPIRE

i) Cash Inflow

Cash Inflow (CI) increases at a rate of 7.5% per annum (UNICAF/USW

Assessment 2 Brief, 2019)

CI for Year 1 = 650,000 (UNICAF/USW Assessment 2 Brief, 2019)

CI for Year 2 = 650,000 + (7.5% × 650,000)

= 650,000 + 48,750 = 698,750

CI for Year 3 = 698, 750 + (7.5% × 698,750)

= 698,750 + 52,406.25 = 751,156

CI for Year 4 = 751,156 + (7.5% × 751,156)

= 751,156 + 56,336.70 = 807,493

CI for Year 5 = 807,493 + (7.5% × 807,493)

= 807,493 + 60,561.98 = 868,055

ii) Variable Costs

Variable Costs (VC) increase at a rate of 6.75% per annum (UNICAF/USW

Assessment 2 Brief, 2019)
VC for Year 1 = 27,000 (UNICAF/USW Assessment 2 Brief, 2019)

VC for Year 2 = 27,000 + (6.75% × 27,000)

= 27,000 + 1,822.50 = 28,822.50

VC for Year 3 = 28,822.50 + (6.75% × 28,822.50)

= 28,822.50 + 1,945.52 = 30,768.02

VC for Year 4 = 30,768.02 + (6.75% × 30,768.02)

= 30,768.02 + 2,076.84 = 32,844.86

VC for Year 5 = 32,844.86 + (6.75% × 32,844.86)

= 32,844.86 + 2,217.03 = 35,061.89

16
iii) Future Value of Working Capital

Future Value (FV) = Present Value (PV) × (1 + r) n

Where r = required return; and n = no. of periods (years in this case) of investment

In this case, r = WACC = 10% = 0.10; n = 5 years

PV for working capital = 140,000 (UNICAF/USW Assessment 2 Brief, 2019)

FV = 140,000 × (1 + 0.10)5
= 140,000 × 1.105
= 140,000 × 1.61051 = 225,471.40

iv) Net Operating Cash Flow

Net Operating Cash Flow = Cash Inflow + Scrap Value – Variable Costs – Future
Value of Working Capital

Scrap value of equipment = 375,000 (UNICAF/USW Assessment 2 Brief, 2019)

Using results from i, ii, and iii,

NOCF for Year 1 = 650,000 - 27,000 = 623,000

NOCF for Year 2 = 698,750 - 28,822.50 = 669,928

NOCF for Year 3 = 751,156 - 30,768.02 = 720,388

NOCF for Year 4 = 807,493 – 32,844.86 = 774,648

NOCF for Year 5 = 868,055 + 375,000 – 35,061.89 – 225,471.40 = 982,522

v) Taxable Cash Flow

Taxable Cash Flow (TCF) = Net Operating Cash Flow – Capital Allowance

TCF for Year 1 = 623,000 - 600,000 = 23,000

TCF for Year 2 = 669,928 - 390,000 = 279,928

TCF for Year 3 = 720,388 – 345,000 = 375,388

TCF for Year 4 = 774,648 – 300,000 = 474,648

TCF for Year 5 = 982,522 – 240,000 = 742,522

17
vi) Tax

In this case, tax is pegged at 20% of taxable cash flow, payable 1 year in arrears.

Tax for Year 1 = 0.00 (To be paid the following year in arrears)

Tax for Year 2 = 20% × 23,000 = 4,600

Tax for Year 3 = 20% × 279,928 = 55,985.60

Tax for Year 4 = 20% × 375,388 = 75,077.60

Tax for Year 5 = 20% × 474,648 = 94,929.60

Tax for Year 6 = 20% × 742,522 = 148,504.40

vii) Net Cash Flow

Net Cash Flow (NCF) = Net Operating Cash Flow – Tax

From iv and vi,

NCF for Year 1 = 623,000 – 0.00 = 623,000

NCF for Year 2 = 669,928 – 4,600 = 665,328

NCF for Year 3 = 720,388 – 55,985.60 = 664,402

NCF for Year 4 = 774,648 – 75,077.60 = 699,570

NCF for Year 5 = 982,522 – 94,929.60 = 887,592

NCF for Year 6 = 0.00 – 148,504.40 = -148,504

viii) Discount Factor

Discount Factor (DF) = 1___

(1 + r) n

Where r = discount rate; and n = no. of periods (years in this case) of investment

r = WACC = 10% = 0.1

DF for Year 1 = 1 ___ = 1 __ = 1_ = 0.90909

(1 + 0.1) 1 (1.1) 1 1.1

18
 DF for Year 2 = 1 ___ = 1 __ = 1_= 0.82645
(1 + 0.1) 2 (1.1) 2 1.21

DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.75131

3 3
(1 + 0.1) (1.1) 1.331

DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.68301

(1 + 0.1) 4 (1.1) 4 1.4641

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.62092

(1 + 0.1) 5 (1.1) 5 1.61051

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.56447

(1 + 0.1) 6 (1.1) 6 1.771561

ix) Present Value

Present Value (PV) = Net Cash Flow × Discount Factor

From vii and viii,

PV for Year 1 = 623,000 × 0.90909 = 566,363

PV for Year 2 = 665,328 × 0.82645 = 549,860

PV for Year 3 = 664,402 × 0.75131 = 499,172

PV for Year 4 = 699,570 × 0.68301 = 477,813

PV for Year 5 = 887,592 × 0.62092 = 551,124

PV for Year 6 = -148,504 × 0.56447 = - 83,826

x) Net Present Value

Net Present Value (NPV) = Sum of Present Values – Sum of Relevant Start-Up
Costs

∑ Present Values = 566,363 + 549,860 + 499,172 + 477,813 + 551,124 – 83,826

= 2,560,506

∑ Relevant Start-Up Costs = Cost of Plants and Machinery + Working Capital

= 2,250,000 + 140,000
= 2,390,000

NPV = 2,560,506 – 2,390,000 = 170,506

19
xi) Internal Rate of Return

NPVL
Internal Rate of Return (IRR) = (𝐿 + [{ } (𝐻 − 𝐿)]) × 100
NPVL −NPVH
(UNICAF/USW, 2019)

Where L = Lower Discount Rate = r = WACC = 10% = 0.10

H = Higher Discount Rate that still results in a positive NPV, e.g. 12% = 0.12

NPVL = Net Present Value using lower discount rate

NPVH = Net Present Value using higher discount rate

For H= 0.12, using the formulae in viii, ix, and x,

DF for Year 1 = 1 ___ = 1 __ = 1_ = 0.89286

(1 + 0.12) 1 (1.12) 1 1.12

DF for Year 2 = 1 ___ = 1 __ = 1_= 0.79719

2 2
(1 + 0.12) (1.12) 1.2544

DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.71178

(1 + 0.12) 3 (1.12) 3 1.404928

DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.63552

(1 + 0.12) 4 (1.12) 4 1.573519

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.56743

(1 + 0.12) 5 (1.12) 5 1.76234

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.50663

(1 + 0.12) 6 (1.12) 6 1.97382

PV for Year 1 = 623,000 × 0.89286 = 556,252

PV for Year 2 = 665,328 × 0.79719 = 530,393

PV for Year 3 = 664,402 × 0.71178 = 472,908

PV for Year 4 = 699,570 × 0.63552 = 444,591

PV for Year 5 = 887,592 × 0.56743 = 503,646

PV for Year 6 = -148,504 × 0.50663 = - 75,237

20
NPVH = (556,252 + 530,393 + 472,908 + 444,591 + 503,646 - 75237) – 2,390,000
= 42,553

From x, NPVL = 170,506

170,506
IRR = (0.10 + [{ } (0.12 − 0.10)]) × 100
170,506−42,553

IRR = (0.10 + [{1.33257}(0.02)]) × 100

= (0.10 + 0.02665) × 100
= 12.67 %

Confirmation of IRR using NPV Profile

At r = 0,

DF for Year 1 = 1 ___ = 1 __ = 1_ = 1

(1 + 0) 1 (1) 1 1

The DF will be 1 for all years since the denominators in the equations will always
be 1 because every number raised to the power 0 = 1

PV for Year 1 = 623,000 × 1 = 623,000

PV for Year 2 = 665,328 × 1 = 665,328

PV for Year 3 = 664,402 × 1 = 664,402

PV for Year 4 = 699,570 × 1 = 669,570

PV for Year 5 = 887,592 × 1 = 887,592

PV for Year 6 = -148,504 × 1 = - 148,504

NPVr=0 = (623,000 + 556,328 + 664,402 + 669,570 + 887,592 – 148,504) –

2,390,000 = 1,001,388

At r = 5% = 0.05,

DF for Year 1 = 1 ___ = 1 __ = 1 _ = 0.95238

(1 + 0.05) 1 (1.05) 1 1.05

DF for Year 2 = 1 ___ = 1 __ = 1 _ = 0.90703

(1 + 0.05) 2 (1.05) 2 1.1025

DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.863838

3 3
(1 + 0.05) (1.05) 1.157625

21
DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.822703
(1 + 0.05) 4 (1.05) 4 1.215506

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.783526

(1 + 0.05) 5 (1.05) 5 1.276282

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.746215

(1 + 0.05) 6 (1.05) 6 1.340096

PV for Year 1 = 623,000 × 0.95238 = 593,333

PV for Year 2 = 665,328 × 0.90703 = 603,472

PV for Year 3 = 664,402 × 0.863838 = 573,936

PV for Year 4 = 699,570 × 0.822703 = 575,538

PV for Year 5 = 887,592 × 0.783526 = 695,451

PV for Year 6 = -148,504 × 0.746215 = - 110,816

NPVr=0.05 = (593,333 + 603,472 + 573,936 + 575,538 + 695,451 – 110,816) –

2,390,000 = 540,914

At r = 15% = 0.15,

DF for Year 1 = 1 ___ = 1 __ = 1 _ = 0.86957

(1 + 0.15) 1 (1.15) 1 1.15

DF for Year 2 = 1 ___ = 1 __ = 1_= 0.75614

(1 + 0.15) 2 (1.15) 2 1.3225

DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.657516

(1 + 0.15) 3 (1.15) 3 1.520875

DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.571753

(1 + 0.15) 4 (1.15) 4 1.749006

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.49718

(1 + 0.15) 5 (1.15) 5 2.011357

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.43233

(1 + 0.15) 6 (1.15) 6 2.313061

PV for Year 1 = 623,000 × 0.86957 = 541,742

PV for Year 2 = 665,328 × 0.75614 = 503,081

22
PV for Year 3 = 664,402 × 0.657516 = 436,855

PV for Year 4 = 699,570 × 0.571753 = 399,981

PV for Year 5 = 887,592 × 0.49718 = 441,293

PV for Year 6 = -148,504 × 0.43233 = - 64,203

NPVr=0.15 = (541,742 + 503,081 + 436,855 + 399,981 + 441,293 – 64,203) –

2,390,000 = - 131,251

At r = 20% = 0.20,

DF for Year 1 = 1 ___ = 1 __ = 1_ = 0.83333

(1 + 0.20) 1 (1.20) 1 1.20

DF for Year 2 = 1 ___ = 1 __ = 1 _ = 0.69444

(1 + 0.20) 2 (1.20) 2 1.44

DF for Year 3 = 1 ___ = 1 __ = 1 = 0.578703

3 3
(1 + 0.20) (1.20) 1.728

DF for Year 4 = 1 ___ = 1 __ = 1 = 0.482253

(1 + 0.20) 4 (1.20) 4 2.0736

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.401878

(1 + 0.20) 5 (1.20) 5 2.48832

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.334898

(1 + 0.20) 6 (1.20) 6 2.985984

PV for Year 1 = 623,000 × 0.83333 = 519,165

PV for Year 2 = 665,328 × 0.69444 = 462,030

PV for Year 3 = 664,402 × 0.578703 = 384,491

PV for Year 4 = 699,570 × 0.482253 = 337,370

PV for Year 5 = 887,592 × 0.401878 = 356,704

PV for Year 6 = -148,504 × 0.334898 = - 49,734

NPVr=0.20 = (519,165 + 462,030 + 384,491 + 337,370 + 356,704 – 49,734) –

2,390,000 = - 379,974

23
 The values of discount rates were plotted against the corresponding values of NPV
in figure 2.3 to determine the IRR which is the discount rate when NPV = 0

xii) Payback Period

Payback Period = 3 years + 437,270 = 3yrs + 0.63 years = 3.63 years
699,570

7.2 CALCULATIONS FOR PROJECT WOLF

i) Material Costs

Material Costs (MC) increase at a rate of 7.5% per annum (UNICAF/USW

Assessment 2 Brief, 2019)

MC for Year 1 = 14,400 (UNICAF/USW Assessment 2 Brief, 2019)

MC for Year 2 = 14,400 + (7.5% × 14,400)

= 14,400 + 1,080 = 15,480

MC for Year 3 = 15,480 + (7.5% × 15,480)

= 15,480 + 1,161 = 16,641

MC for Year 4 = 16,641 + (7.5% × 16,641)

= 16,641 + 1,248.08 = 17,889.08

MC for Year 5 = 17,889.08 + (7.5% × 17,889.08)

= 17,889.08 + 1,341.68 = 19,230.76

ii) Other Expenses

Other Expenses (OE) decrease at a rate of 7.5% per annum (UNICAF/USW

Assessment 2 Brief, 2019)
OE for Year 1 = 18,000 (UNICAF/USW Assessment 2 Brief, 2019)

OE for Year 2 = 18,000 - (7.5% × 18,000)

= 18,000 - 1,350 = 16,650

OE for Year 3 = 16,650 - (7.5% × 16,650)

= 16,650 - 1,248.75 = 15,401.25

OE for Year 4 = 15,401.25 - (7.5% × 15,401.25)

= 15,401.25 - 1,155.09 = 14,246.16

OE for Year 5 = 14,246.16 - (7.5% × 14,246.16)

= 14,246.16 - 1,068.46 = 13,177.70

24
iii) Rental Income

The Present Value (PV) of the Rental Income (RI) is 75,000 per annum. The future
value (FV) of this RI is as follows: (UNICAF/USW Assessment 2 Brief, 2019)

FV = PV of RI × (1+r) n (UNICAF/USW Assessment 2 Brief, 2019)

r = discount rate = WACC = 10% = 0.10 ; n = no. of periods (years in this case)

FV of RI for Year 1 = 75,000 × (1 + 0.10)1

= 75,000 × 1.101
= 75,000 × 1.10 = 82,500

FV of RI for Year 2 = 75,000 × (1 + 0.10)2

= 75,000 × 1.102
= 75,000 × 1.21 = 90,750

FV of RI for Year 3 = 75,000 × (1 + 0.10)3

= 75,000 × 1.103
= 75,000 × 1.331 = 99,825

FV of RI for Year 4 = 75,000 × (1 + 0.10) 4

= 75,000 × 1.104
= 75,000 × 1.4641 = 109,807.50

FV of RI for Year 5 = 75,000 × (1 + 0.10) 5

= 75,000 × 1.105
= 75,000 × 1.61051 = 120,788.25

iv) Net Operating Cash Flow

Net Operating Cash Inflow (NOCF) = Cash Inflow – Material Costs - Other
Expenses - FV of Rental Income (UNICAF/USW, 2019)

Cash Inflow = 955,000 for all years (UNICAF/USW Assessment 2 Brief, 2019)

NOCF for Year 1 = 955,000 – 14,400 - 18,000 - 82,500 = 840,100

NOCF for Year 2 = 955,000 - 15,480 – 16,650 – 90,750 = 832,120

NOCF for Year 3 = 955,000 – 16,641 – 15,401.25 – 99,825 = 823,133

NOCF for Year 4 = 955,000 – 17,889.08 – 14,246.16 – 109,807.50 = 813,057

NOCF for Year 5 = 955,000 – 19,230.76 – 13,177.70 - 120,788.25 = 801,803

25
v) Tax

There is no capital allowance so all the net operating cash flow, tax is pegged at
20% of net operating cash flow, payable 1 year in arrears.
Tax for Year 1 = 0.00 (To be paid the following year in arrears)

Tax for Year 2 = 20% × 840,100 = 168,020

Tax for Year 3 = 20% × 832,120 = 166,424

Tax for Year 4 = 20% × 823,133 = 164,626.60

Tax for Year 5 = 20% × 813,057 = 162,611.40

Tax for Year 6 = 20% × 801,803 = 160,360.60

vi) Net Cash Flow

Net Cash Flow (NCF) = Net Operating Cash Flow – Tax

From iv and v,

NCF for Year 1 = 840,100 – 0.00 = 840,100

NCF for Year 2 = 832,120 – 168,020 = 664,100

NCF for Year 3 = 823,133 – 166,424 = 656,709

NCF for Year 4 = 813,057 – 164,626.60 = 648,430

NCF for Year 5 = 801,803 – 162,611.40 = 639,192

NCF for Year 6 = 0.00 – 160,360.60 = -160,361

vii) Discount Factor

Discount Factor (DF) = 1___

(1 + r) n
Where r = discount rate; and n = no. of periods (years in this case) of investment

r = WACC = 10% = 0.1

DF for Year 1 = 1 ___ = 1 __ = 1_ = 0.90909

(1 + 0.1) 1 (1.1) 1 1.1

DF for Year 2 = 1 ___ = 1 __ = 1_= 0.82645

(1 + 0.1) 2 (1.1) 2 1.21

26
 DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.75131
3 3
(1 + 0.1) (1.1) 1.331

DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.68301

(1 + 0.1) 4 (1.1) 4 1.4641

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.62092

(1 + 0.1) 5 (1.1) 5 1.61051

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.56447

6 6
(1 + 0.1) (1.1) 1.771561
viii) Present Value

Present Value (PV) = Net Cash Flow × Discount Factor

From vii and viii,

PV for Year 1 = 840,100 × 0.90909 = 763,727

PV for Year 2 = 664,100 × 0.82645 = 548,845

PV for Year 3 = 656,709 × 0.75131 = 493,392

PV for Year 4 = 648,430 × 0.68301 = 442,884

PV for Year 5 = 639,192 × 0.62092 = 396,887

PV for Year 6 = -160,361 × 0.56447 = - 90,519

ix) Net Present Value

Net Present Value (NPV) = Sum of Present Values – Sum of Relevant Start-Up
Costs

∑ Present Values = 763,727 + 548,845 + 493,392 + 442,884 + 396,887 – 90,519

= 2,555,216

∑ Relevant Start-Up Costs = 2,250,000

NPV = 2,555,216 – 2,250,000 = 305,216

x) Internal Rate of Return

NPVL
Internal Rate of Return (IRR) = (𝐿 + [{ } (𝐻 − 𝐿)]) × 100
NPVL −NPVH
(UNICAF/USW, 2019)

27
Where L = Lower Discount Rate = r = WACC = 10% = 0.10

H = Higher Discount Rate that still results in a positive NPV, e.g. 15% = 0.15

NPVL = Net Present Value using lower discount rate

NPVH = Net Present Value using higher discount rate

For H= 0.15, using the formulae in viii, ix, and x,

DF for Year 1 = 1 ___ = 1 __ = 1 _ = 0.86957

(1 + 0.15) 1 (1.15) 1 1.15

DF for Year 2 = 1 ___ = 1 __ = 1_= 0.75614

(1 + 0.15) 2 (1.15) 2 1.3225

DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.657516

3 3
(1 + 0.15) (1.15) 1.520875

DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.571753

(1 + 0.15) 4 (1.15) 4 1.749006

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.49718

(1 + 0.15) 5 (1.15) 5 2.011357

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.43233

(1 + 0.15) 6 (1.15) 6 2.313061

PV for Year 1 = 840,100 × 0.86957 = 730,526

PV for Year 2 = 664,100 × 0.75614 = 502,153

PV for Year 3 = 656,709 × 0.657516 = 431,797

PV for Year 4 = 648,430 × 0.571753 = 370,742

PV for Year 5 = 639,192 × 0.49718 = 317,793

PV for Year 6 = -160,361 × 0.43233 = - 69,329

NPVH = (730,526 + 502,153 + 431,797 + 370,742 + 317,793 – 69,329) – 2,250,000

= 33,682
From ix, NPVL = 305,216

305,216
IRR = (0.10 + [{ } (0.15 − 0.10)]) × 100
305,216−33,682

28
IRR = (0.10 + [{1.12404}(0.05)]) × 100
= (0.10 + 0.056202) × 100
= 15.62 %

Confirmation of IRR using NPV Profile

At r = 0,

DF for Year 1 = 1 ___ = 1 __ = 1_ = 1

(1 + 0) 1 (1) 1 1

The DF will be 1 for all years since the denominators in the equations will always
be 1 because every number raised to the power 0 = 1
PV for Year 1 = 840,100 × 1 = 840,100

PV for Year 2 = 664,100 × 1 = 664,100

PV for Year 3 = 656,709 × 1 = 656,709

PV for Year 4 = 648,430 × 1 = 648,430

PV for Year 5 = 639,192 × 1 = 639,192

PV for Year 6 = -160,361 × 1 = - 160,361

NPVr=0 = (840,100 + 664,100 + 656,709 + 648,430 + 639,192 – 160,361) –

2,250,000 = 1,038,170

At r = 5% = 0.05,

DF for Year 1 = 1 ___ = 1 __ = 1 _ = 0.95238

(1 + 0.05) 1 (1.05) 1 1.05

DF for Year 2 = 1 ___ = 1 __ = 1 _ = 0.90703

2 2
(1 + 0.05) (1.05) 1.1025

DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.863838

(1 + 0.05) 3 (1.05) 3 1.157625

DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.822703

(1 + 0.05) 4 (1.05) 4 1.215506

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.783526

(1 + 0.05) 5 (1.05) 5 1.276282

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.746215

(1 + 0.05) 6 (1.05) 6 1.340096

29
PV for Year 1 = 840,100 × 0.95238 = 800,094

PV for Year 2 = 664,100 × 0.90703 = 602,359

PV for Year 3 = 656,709 × 0.863838 = 567,290

PV for Year 4 = 648,430 × 0.822703 = 533,465

PV for Year 5 = 639,192 × 0.783526 = 500,824

PV for Year 6 = -160,361 × 0.746215 = - 119,664

NPVr=0.05 = (800,094 + 602,359 + 567,290 + 533,465 + 500,824 – 119,664) –

2,250,000 = 634,368

At r = 15% = 0.15,

DF for Year 1 = 1 ___ = 1 __ = 1 _ = 0.86957

(1 + 0.15) 1 (1.15) 1 1.15

DF for Year 2 = 1 ___ = 1 __ = 1_= 0.75614

(1 + 0.15) 2 (1.15) 2 1.3225

DF for Year 3 = 1 ___ = 1 __ = 1 _ = 0.657516

(1 + 0.15) 3 (1.15) 3 1.520875

DF for Year 4 = 1 ___ = 1 __ = 1 _ = 0.571753

(1 + 0.15) 4 (1.15) 4 1.749006

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.49718

(1 + 0.15) 5 (1.15) 5 2.011357

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.43233

(1 + 0.15) 6 (1.15) 6 2.313061

PV for Year 1 = 840,100 × 0.86957 = 730,526

PV for Year 2 = 664,100 × 0.75614 = 502,153

PV for Year 3 = 656,709 × 0.657516 = 431,797

PV for Year 4 = 648,430 × 0.571753 = 370,742

PV for Year 5 = 639,192 × 0.49718 = 317,793

PV for Year 6 = -160,361 × 0.43233 = - 69,329

30
 NPVr=0.15 = (730,526 + 502,153 + 431,797 + 370,742 + 317,793 – 69,329) –
2,250,000 = 33,682

At r = 20% = 0.20,

DF for Year 1 = 1 ___ = 1 __ = 1_ = 0.83333

(1 + 0.20) 1 (1.20) 1 1.20

DF for Year 2 = 1 ___ = 1 __ = 1 _ = 0.69444

(1 + 0.20) 2 (1.20) 2 1.44

DF for Year 3 = 1 ___ = 1 __ = 1 = 0.578703

(1 + 0.20) 3 (1.20) 3 1.728

DF for Year 4 = 1 ___ = 1 __ = 1 = 0.482253

(1 + 0.20) 4 (1.20) 4 2.0736

DF for Year 5 = 1 ___ = 1 __ = 1 _ = 0.401878

(1 + 0.20) 5 (1.20) 5 2.48832

DF for Year 6 = 1 ___ = 1 __ = 1 _ = 0.334898

(1 + 0.20) 6 (1.20) 6 2.985984

PV for Year 1 = 840,100 × 0.83333 = 700,081

PV for Year 2 = 664,100 × 0.69444 = 461,178

PV for Year 3 = 656,709 × 0.578703 = 380,039

PV for Year 4 = 648,430 × 0.482253 = 312,707

PV for Year 5 = 639,192 × 0.401878 = 256,877

PV for Year 6 = -160,361 × 0.334898 = - 53,705

NPVr=0.20 = (700,081 + 461,178 + 380,039 + 312,707 + 256,877 – 53,705) –

2,250,000 = - 192,823

The values of discount rates were plotted against the corresponding values of NPV
in figure 2.4 to determine the IRR which is the discount rate when NPV = 0

xi) Payback Period

Payback Period = 3 years + 89,091 = 3yrs + 0.14 years = 3.14 years
648,430

31
7.3 CALCULATIONS TO SHOW EFFECT OF SOURCE OF FINANCE ON WACC

i) RE = RA + [(RA – RD) × (D/E)] (Ross et al, 2017)

D = 18,000,000; E = 20,000,000 (UNICAF/USW Assessment 2 Brief, 2019)
D/E = 18,000,000 = 0.9
20,000,000
RD = 8% = 0.08 (Assumption)
RA = WACC = 10% = 0.1 (UNICAF/USW Assessment 2 Brief, 2019)
RE = 0.1 + [(0.1 – 0.08) × 0.9]
= 0.1 + [0.02 × 0.9]
= 0.1 + 0.018 = 0.118
If the chosen source of finance is equity,
D = 18,000,000 ; E = 20,000,000 + 2,250,000 = 22,250,000
D/E = 18,000,000 = 0.81
22,250,000

If the chosen source of finance is debt,

D = 18,000,000 + 2,250,000 = 20,250,000 ; E = 20,000,000
D/E = 20,250,000 = 1.01
20,000,000

At D/E = 0.81,
RE = 0.1 + [(0.1 – 0.08) × 0.81]
= 0.1 + [0.02 × 0.81]
= 0.1 + 0.0162 = 0.1162
At D/E = 1.01,
RE = 0.1 + [(0.1 – 0.08) × 1.01]
= 0.1 + [0.02 × 1.01]
= 0.1 + 0.0202 = 0.1202

Recalculating WACC using the calculated values of RE and D/E,

WACC = [(E/V) × RE] + [(D/V) × RD × (1-TC)] (Ross et al, 2017)

32
TC = 20% = 0.2 (UNICAF/USW Assessment 2 Brief, 2019)
At D/E = 0.9, RE = 0.118
V = D + E = 18,000,000 + 20,000,000 = 38,000,000

E/V = 20,000,000 = 0.53

38,000,000
D/V = 18,000,000 = 0.47
38,000,000
WACC = [0.5263 × 0.118] + [0.47 × 0.08 × (1 – 0.2)]
= [0.063] + [0.47 × 0.08 × (1 – 0.2)]
= [0.063] + [0.47 × 0.08 × 0.8]
= 0.063 + 0.0301 = 0.0931 = 9.31 %

At D/E = 0.81, RE = 0.1162

V = D + E = 18,000,000 + 22,250,000 = 40,250,000
E/V = 22,2500,000 = 0.55
40,250,000
D/V = 18,000,000 = 0.45
40,250,000
WACC = [0.55 × 0.1162] + [0.45 × 0.08 × (1 – 0.2)]
= [0.063] + [0.45 × 0.08 × (1 – 0.2)]
= [0.063] + [0.45 × 0.08 × 0.8]
= 0.063 + 0.03 = 0.093 = 9.3 %

At D/E = 1.01, RE = 0.1202

V = D + E = 20,250,000 + 20,000,000 = 40,250,000
E/V = 20,000,000 = 0.50
40,250,000
D/V = 20,250,000 = 0.503
40,250,000
WACC = [0.50 × 0.1202] + [0.503 × 0.08 × (1 – 0.2)]
= [0.0601] + [0.50 × 0.08 × (1 – 0.2)]
= [0.0601] + [0.50 × 0.08 × 0.8]
= 0.0601 + 0.0322 = 0.0923 = 9.23 %

33
7.4 CALCULATIONS TO SHOW EFFECT OF SOURCE OF FINANCE ON
CURRENT AND POTENTIAL SHAREHOLDERS AND LENDERS

i) If the source of finance is equity financing,

D = 18,000,000; E = 20,000,000 + 2,250,000 = 22,250,000

Taxable Income = EBIT = Net Operating Cash Flow = 840,100

Tax = 20% × 840,100 = 168,020

Profit After Tax = Taxable Income – Tax = 678,080
ROE = Profit After Tax = 678,080 _ = 0.0302 = 3.02 %
Equity 22,250,000

ii) If the source of finance is debt financing,

D = 20,250,000; E = 20,000,000
EBIT = Net Operating Cash Flow = 840,100
At 8% Interest Rate,
Interest = 8% × 840,100 = 67,208
Taxable Income = EBIT – Interest = 840,100 – 67,208 = 772,892
Tax = 20% × Taxable Income = 20% × 772,892 = 154,578.40
Profit After Tax = Taxable Income – Tax = 772,892 – 154,578.40 = 618,313.60
ROE = Profit After Tax = 618,313.60 = 0.0309 = 3.09 %
Equity 20,000,000

At 9% Interest Rate,
Interest = 9% × 840,100 = 75,609
Taxable Income = EBIT – Interest = 840,100 – 75,609 = 764,491
Tax = 20% × Taxable Income = 20% × 764,491 = 152,898.20
Profit After Tax = Taxable Income – Tax = 764,491 – 152,898.20 = 611,592.80
ROE = Profit After Tax = 611,592.80 = 0.0306 = 3.06 %
Equity 20,000,000

34
At 10% Interest Rate,
Interest = 10% × 840,100 = 84,010
Taxable Income = EBIT – Interest = 840,100 – 84,010 = 756,090
Tax = 20% × Taxable Income = 20% × 756,090 = 151,218.00
Profit After Tax = Taxable Income – Tax = 756,090 – 151,218.00 = 604,872.00
ROE = Profit After Tax = 604,872.00 = 0.0302 = 3.02 %
Equity 20,000,000

At 11% Interest Rate,

Interest = 11% × 840,100 = 92,411
Taxable Income = EBIT – Interest = 840,100 – 92,411 = 747,689
Tax = 20% × Taxable Income 20% × 747,689 = 149,537.80
Profit After Tax = Taxable Income – Tax = 747,689 – 149,537.80 = 598,151.20
ROE = Profit After Tax = 598,151.20 = 0.0299 = 2.99 %
Equity 20,000,000

35