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Part I: Capital Budgeting Practice Problems
|Year||Cash flow||Discount Rate||NPV||Cost of Capital||IRR|
The discount rate at the point of intersection is 2.7 and this is the point where there is special discount rate representing the Internal rate of return. This is the point whereby the NPV neither increase nor reduces but remain constant.
|Year||Cash flow||Rate||NPV||COST OF CAPITAL||IRR|
The point of intersection is 7.0. The net present value is constant at this point and the value represents the internal rate of return. Increasing the internal rate of return would culminate to increase income and conversely (Niu, 2008). Besides, at this point, the value of the cash inflow is equivalent to the value of cash outflow.
Regarding the most effective method of making capital budgeting decision, both NPV and IRR provide a viable capital budgeting valuation that aid in decision making and they both end with the same result. However, according to Arshad (2012) “it is considered that using the NPV to discount cash flows make more sense regarding the valuation and viability of the decisions made.” In this case, the NPV is more effective when the discount rate of the project is well known. Besides, with NPV technique, it is possible to handle multiple discount rates without any technical issues since each cash flow can be discounted separately from the other. In extreme cases, the NPV technique can be used even when the discount rate of a project is not known unlike with the IRR which demands that the discount rate of the project must be known to aid in evaluation and making of the decision.
Besides, NPV is considered better over the IRR since, with the internal rate of return, there is a utilization of one discount rate. This is more efficient mostly to projects that share the same discount unlike with NPV where a project that does not share the same discount can be evaluated to arrive at the ultimate decision. Another problem with the IRR that makes the NPV more preferred is that with IRR there is no accountability for changes which make it unreliable option for long-term projects that have different discount rates (Arshad, 2012). This is because NPV is valid for projects that have mix of positive as well as negative cash flows hence facilitating the discounting of every project cash flow separately making it the most reliable option.
In regard for AMSC to forgo their debt financing and take on equity investment is that in the business the lender does not have a claim to the equity while debt does not end the owner’s ownership interest in the firm. In any case, the lender is subject to repayment of only the agreed upon the principal of the loan plus the interest and has no direct claim to future returns. According to (Niu,2008), “interest on any given debt can be deducted on the company’s tax return hence lowering the actual cost of the loan to the organization and raising debt capital is less complicated.” This is because the company is not expected to adhere to the state and federal securities regulations and lastly the organization is not expected to send a periodic mailing to a huge number of investors and hold regular meetings with its shareholders before any actions are taken.
Regarding the disadvantages of debt compared to equity that might have led to the company opting for equity is that at some point the debt must be repaid and at some point, massive debts might result in high-interest cost hence high risk of insolvency, unlike equity which hardly leads to elevated levels of insolvency. For instance, a company having huge debts as liabilities means that cash inflow will be less that the demand for cash outflow needed to cater for the massive liabilities. The higher the liabilities especially debts, the riskier a business is regarding being unable to generate sales that can pay back what the company owes its debtors. Besides, there are no loans that do not have interest rates, despite the fact that long-term loans carry low-interest rates, the company remains obliged to repay back the loan within the stipulated period. This means that failing to repay back the debt as required would expose the business to loan default. However, this is not the case with equity since the company is at free will of using the equity funding alone of subsidizing with other sources of income that would not amount more pressure to the company and expose it to default. Debts in most cases have restrictions on the company’s activities hence making it hard for the management to have alternative financing methods, unlike equity which allows the owners to have freedom of seeking alternative financing from other institutions (Allen, 2007). In this case, a company opting to enter into debt would mean that its assets will serve as the security for the debt. In a case like that, it becomes difficult for another lending institution to provide loan products to the company keeping in mind that the lender cannot accept the assets already subjected to collateral by another bank as security for a new loan.
Lastly, with debt, the collateral of the company is the primary consideration. Without collateral, the lender might become resistant to provide credit facilities to the company. Therefore, the company will be required to provide assets as collateral to the lender which would put at risk the entire company while with equity the case is different and the risk involved with debt is not encountered in this case (http://smallbusiness.findlaw.com). Therefore, I do agree with the decision made by the CEO of the company to opt out of debts and consider equity which would reduce the risk the company is involved in. Furthermore, a firm’s cost of equity is determined by the product of the sum of the risk-free rate of return and beta or measure of risk by the difference between the market rate of return and a risk-free rate of return. Finally, the use of debt in financing is also subjected to taxation, and this is due to the interest that accrues on debt which can be tax deductible hence the actual costs of borrowing is known to be less the indicated rate of interest hence making debt financing more expensive.
Arshad, A. (2012). Net Present Value is better than Internal Rate of Return. http://journal-archieves26.webs.com/211-219.pdf
Allen, S. (2007). Debt Financing: Pros and Cons.
Niu, X. (2008). Theoretical and Practical Review of Capital Structure and its Determinants