For the purpose
of carrying out discounted cash flow investment
appraisals, the cost of capital for the company
as a whole has to be worked out. In most cases
it is very difficult to associate a particular
project with a particular source of finance. The
accumulated funds of a company can be viewed as
a pool of resources from which an average cost
of capital can be determined and used as the discount
rate for investment appraisal purposes. This cost
of capital is known as the weighted average cost
of capital (WACC). WACC is more reliable when
the company’s capital structure changes
very slowly over time so that the marginal cost
of capital approximates WACC. Companies wish to
increase their profits in the long term and they
achieve this by investing in projects which have
a higher return than the discount rate, or in
other words projects which have a positive net
present value.
Most companies use discount rates issued by the
federal government or the borrowing rate as it
accurately gives the marginal cost of capital.
When a source of finance can be identified then
it is better to use the interest rate on the source
of finance as the discount rate. Three factors
should be considered while evaluating the discount
rate:
1. The risk associated with the new project (return
required by investors may go up or down).
2. The financial risk or cost of capital to the
whole company. The new project may require debt
finance which changes the overall risk of the
whole company.
3. Variable interest rates.
Intelichild.com
Intelichild is a recently incorporated company
with huge start up cost. They have financed all
their start up expenses of $33,750 with equity
finance. The company wishes to build a website
called Intelichild.com which will sell toys, books
and software for children. The company wishes
to create a high impact site with the latest web
technologies. This requires high marketing and
promotion expenditures as well as costly web hosting
services. The company believes that the internet
market for their products is increasing exponentially,
future prospects and finance availability is also
good. However, the company is relying too much
on the success of their Internet site by using
high quality and attractive graphics with a carefully
selected product line. Statistics for failure
have not been included.
The company has an exit strategy with an ending
valuation of $20 million. This figure is based
on the assumed market growth of Internet firms
and financial support. The current and long term
interest rates are a constant 10%. Operating expenses
are very high, $1,912,255 in 2000 and more or
less the same for the next two years. The company
has predicted a first year loss of more than a
million dollars.
The most influential aspect of Intelichild on
its finance is its Internal Rate of Return which
it expects to be 157% with only the initial equity.
I believe the risk factor and high cost of investment
dictate the use of the projected internal rate
of return as the discount rate.
Wedding Consultants
This company provides consultation services for
weddings and ceremonies. The company plans to
start as a simple proprietorship and convert to
a limited liability company at an unspecified
time in the future. Start up costs amount to $7000
principally funded by owners contributing a total
of $8000. With 0 interest expense and no long
term borrowing plans, the 10% market interest
rate does not affect project financing. The highest
cost for the company are the taxes it has to pay
which is 25.42%, other costs are not very significant.
The company expects a net profit over sales of
71.18% for 2000. I believe the company’s
discount rate should be the tax rate as it is
the most significant cost.
Salvador
This company has been manufacturing high quality
salsa and chips for three years. The company supplies
to 40 food outlets. Salvador is privately owned.
Salvador wants to expand its operation and supply
to two big grocery stores and a distributor who
wants to sell over $100,000 worth of their products
annually. The company wants to satisfy these orders
but does not have the necessary resources to do
so. Salvador plans to outsource its production
to satisfy these orders. The company projects
net earnings in excess of 10%. The company has
working capital financing problems which it will
solve by obtaining a small companies loan and
an open line of credit.
Salvador aims a very quick growth in sales but
without any investment in capital assets. Therefore
the main investment for Salvador remains confined
to financing the working capital. With an anticipated
sales growth of 700.96 % in 1996 the total debt
to assets ratio is 30.67 for Salvador and the
profit margin ratio is 43.96%. Since the main
expense is the selling general and administrative
expenses (21.27 % of sales) the discount rate
for Salvador would be 21.27 %.
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