The company is considering a project with an up-front cost of $10 million. This investment will significantly increase the size of the company, and therefore must be given serious consideration for its financial effects. This paper will analyze this decision in the context of the financing and make recommendations to management about the project.
The company currently has assets of $17.2 million. This investment of $10 million therefore represents a 58% increase in the size of the company, to $27.2 million. Such a dramatic investment will significantly alter the company’s capital structure, so the decisions with regards to the investment and its financing must be given careful consideration.
The first question is whether or not the company should take on the project. The up-front cost is high, but the rule of thumb for an investment decision is based on whether or not the project has a positive net present value. The net present value is the value of all cash flows associated with the project, adjusted for time value back to the present day (Investopedia, 2010). In this case, the future cash flows are not known, so the net present value calculation cannot be completed. There are steps, however, that can lead to an NPV number.
The first such step is to determine the company’s discount rate. There are a couple of different ways to determine a discount rate. The first is to use the company’s existing cost of capital. The cost of capital is essentially a weighted-average of the cost of equity and the cost of debt. The weightings are determined by the company’s current capital structure. The second method of determining a discount rate is to identify the cost of capital for this project. For example if the company chooses to finance this project entirely by debt and it knows that it can borrow at x %, then this is the cost of capital to be used as the discount rate.
For this situation, the former method is more appropriate. The company’s current capital structure is $8.3 million in liabilities and $8.9 million in shareholders’ equity. The cost of debt is not known. The cost of equity is also unknown, but would be calculated using the capital asset pricing model (CAPM). This relates the cost of equity to the cost of equity in the general market by identifying the level of firm-specific risk (Wang, 2003).
The components of the capital asset pricing model are the risk free rate of return, the market risk premium and the firm-specific risk, which is reflected in the firm’s beta. The beta derives from the level of correlation between the firm’s stock price and the broad market. It answers the question of how risky the firm is compared to the economy overall. This firm does not have a name so the beta is not known, but it can either be obtained from the Internet, or it can be calculated by running a regression analysis against the market returns. For the sake of explanation, suppose the firm’s beta is 1.15. The risk free rate at present is 0.27%, based on the one-year Treasury bond (Yahoo! Finance, 2010). The historic market risk premium is 7%. This gives us a CAPM calculation of Ra = 0.27 + (1.15)(7) = 8.32%
This would be taken as the firm’s cost of equity. If we assume that the cost of debt is around 3% today the cost of capital would be calculated as the weighted average of these figures. The weighting is 48.2% debt and 51.7% equity, so the WACC would be:
WACC = (.482)(3) + (.517)(8.32) = 5.751%
This would be used as the firm’s discount rate in the NPV calculation.
The Financing Decision
If we assume that the project has a positive net present value — and if it did not we would not be considering the project — then the next decision that must be made is with respect to financing. Debt financing is the cheapest method of financing, as debt is less risky than equity as a form of investment. The main drawback of debt is that it creates an obligation on the part of the company. The company would be committing future cash flow to debt service, meaning that it would be unable to reinvest that money back into operations. If this investment was financed entirely with debt, the new capital structure would be 67.2% debt and 32.8% equity. If this investment was financed entirely with equity, the new capital structure would be 30.5% debt and 69.5% equity.
One rule of thumb for making such a decision is to match the asset type with the financing. Therefore, an asset that is expected to have a service life of five years would be financed with a five-year bond issue, so that the cash flows from the asset can be used to cover the costs of financing. In this case, the asset life is not known, so any financing type can be used.
Internal cash is not possible because the firm likely does not have $10 million in cash if it only has $17.2 million in assets and $17.5 million in annual revenues. A debt issue will leave the firm with a significantly higher degree of leverage, increasing the firm’s risk level. In order to know if this risk level is acceptable, it is worth considering the industry norms. Canadian auto part supplier Magna carries a capital structure featuring 40.2% debt and 59.8% equity (MSN Moneycentral, 2010) so it appears that 67.2% debt is probably too high for our auto parts company.
If equity is to be used to finance this project, there are still a couple of different options, including common shares and preferred shares. In this case, there is the risk of using common shares that ownership could be diluted. This dilution can be eliminated by issue rights to the existing common shareholders, allowing them to maintain their current level of holding in the firm’s equity.
The project has a positive net present value or it would not be considered. Assuming that it makes sense on a strategic level, the company should pursue the investment. Although this project will dramatically increase the size of the company, the decision needs to be made based on rational economic criteria. Thus, if the project can be financed and will result in a positive net present value for the firm, it should be pursued.
It should also be considered that at present the company only earns $5,000 in revenue per employee. This means that the company as currently constituted is probably not viable. It needs to grow in order to pay for all of those employees, so this project is likely required for strategic reasons as well.
Because of the size of the project relative to the size of the company, it is risky. The current shareholders should be asked to finance this project, as using debt would dramatically alter the company’s capital structure and bring it far from industry norms. In order that existing shareholders finance the project, the equity should be raised through a rights issue that allows current shareholders to maintain their investment in the company as it grows.
The rights issue would raise the $10 million needed for this project. Using equity will shift the capital structure closer to that of Magna. The project should be expected to be a major contributor of revenues for our company, so it is reasonable that the equity shareholders be asked to finance the project. The rights would give existed shareholders the option to buy more equity in the firm as a discounted price. There would be no dilution of control, unlike a standard equity issue. There would be no cash flow obligations created, unlike debt or preferred shares. The project’s future cash flows would be used either to fuel further growth or to pay dividends back to the shareholders as a way of returning to them their investment.
Investopedia. (2010). Net present value — NPV. Investopedia. Retrieved October 2, 2010 from http://www.investopedia.com/terms/n/npv.asp
Wang, J. (2003). Capital asset pricing model. MIT. Retrieved October 2, 2010 from http://web.mit.edu/15.407/file/Ch11.pdf
Yahoo! Finance. (2010). Advanced bond screener. Yahoo!. Retrieved October 2, 2010 from http://reports.finance.yahoo.com/z1?b=1&so=a&sf=m&tt=1&stt=-&pr=0&cpl=-1&cpu=-1&yl=-1&yu=-1&ytl=-1&ytu=-1&mtl=6&mtu=24&rl=-1&ru=-1&cll=-1
MSN Moneycentral. (2010). Magna International financial statements. MSN Moneycentral. Retrieved October 2, 2010 from http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=MGA&lstStatement=Balance&stmtView=Ann
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