Managerial Finance Project budgeting – situational analysis

Managerial Finance

Project budgeting – situational analysis

Project budgeting – situational analysis

In the given scenario, the organization wants to increase its production. The weighted average capital cost has been stated to be 13%, while the debt after-cost tax is marked at 7%. The preferred stock cost and the standard equity costs are 10.5% and 15%, respectively.

The retained earnings are considered as a portion of the equity. If the weighted average cost of capital is to be calculated,

WACC = 50% of the stated 15% plus 50% of the 7%, i.e. 11%.

Now, this is more than the stated 10% margin for the project. Thus it is not the correct approach. It is necessary to take the cost opportunity under consideration as well so that the retained earning can fetch in some bank interests.

Using cost-debt only – the outcome

The primary objective that organizations have is to cut down the overall costs that are associated with a project to increase the profit margins (Gebhardt, Lee & Swaminathan, 2001). One of the primary benefits of debt is that it is deductible from the tax. The tax-exempted value of the debt can be calculated as 7%. In addition, it is possible to use retained earnings to expand even more. The organizations’ requirements for working capital are impacted by the retained earnings.

However, having specific capital rates as per the budget process cannot be as bright an option as the WACC and CAPM approaches are evaluated and are known to function efficiently in the computation of risks for the varied nature of capital being employed. These conventions are followed universally, thus helping in controlling confusion to a certain extent.

Project inherent risk

For capital projects, the risk profile varies significantly, and a practical analysis requires such considerations to be critically evaluated (Tewdwr-Jones & Phelps, 2000). For example, the beta for an organization with complete diversification can be stated as ‘1’ – like the overall market. In this context, it is necessary to keep in mind that the project risks vary should not be considered equal in comparison to the other risks of the firm. In this specific project, the high risk inherent is slowing the sales of products, in lime of the fact that the products are at the business core. In case the sales fall, the margins and business bottom lines are impacted and can trigger an imbalance inflow of cash. It turns the company’s dependency on the non-core processes to handle the foreseen growth decline and prevent the decline of product sales.

Playing field level

The use of increased leverage for adjusting the WACC is an excellent option for projects that are capitally intensive. It can alter the capital structure and modify it for better results. Also, for the same level playing field performance, it is necessary to manage the earnings of the organization along with its liquidity (Fang & Marle, 2012). In this context, sensitivity analysis can be used to develop sufficient knowledge on the situation, and based on the NPV for varying scenarios, and effective preparation can be adopted for it. Some ways include:

• Reducing WACC with increased debt in capital structure
• Earning forecast from the plant for liquidity management
• NPV analysis

If the discount rates are appropriately adjusted, the organization can enjoy great benefits in terms of project success.

Reference

Fang, C., & Marle, F. (2012). A simulation-based risk network model for decision support in project risk management. Decision Support Systems, 52(3), 635-644.

Gebhardt, W. R., Lee, C. M., & Swaminathan, B. (2001). Toward an implied cost of capital. Journal of accounting research, 39(1), 135-176.

Tewdwr-Jones, M., & Phelps, N. A. (2000). Levelling the uneven playing field: Inward investment, interregional rivalry and the planning system. Regional Studies, 34(5), 429-440.