When businesses decide to invest in individual initiatives
A number of criteria must be taken into account. It is critical for investors to ensure that their initiatives will pay off on time and so will not result in losses. This paper analyzes the investment that North Sea Oil is set to undertake, as well as the investor reaction to a change in the capital structure for the selected project. North Sea oil would have to determine the weighted average cost of capital (WACC), which would be a good indicator of the project's estimated expenses. The WACC would be useful in evaluating the net present value which would hence reveal the profitability of the two projects thus enabling the company to choose one.
Further, a computation of the internal rate of return would be useful to evaluate the rate at which the company would generate back profits.
The rate of return ought to be higher than the cost of capital for the project to be feasible. Finally, calculating the payback period also reveals that project B would be a more appropriate investment.
Business Report
North Sea oil seeks to invest using debt, common stock and even preferred equity. In this case, the company has resolved to calculate the weighted average cost of capital, the payback period and the internal rate of return to evaluate the best project.
While only looking at the figures, it is apparent that project A would be most suitable as it seems to have higher cash flows. However, using the net present value would enable an investor to have therefore a definite way of choosing the best project. Moles, Parrino and Kidwell (2011) contends that the weighted average cost of capital estimates the cost the company would partake while investing in a particular project. In this case, the investor has to get the weighted of each source of capital and analyze using their different costs. The rate of tax is assumed since it was not given in the details.
As indicated in the appendix, the weighted average cost of capital is 16.5%. This cost of capital is essential because it helps a company to evaluate the net present value of the various projects and hence make a sound decision on the best financing option. Whenever investors are investing in a company, they are most likely interested in the cost of capital. Every investor wants to ensure that 90% of their investments are not used up repaying debt (Brigham & Ehrhardt, 2008). In this case, it is the desire of every investor to reap maximum benefits from any projects and hence would prefer one that has the lowest cost of capital. In any company, the investments can be comprised of either debt or stock. North Sea oil, in this case, has decided to use a greater fraction of common stock instead of using debt. However, investors may be wary of a company that uses stock to finance their projects (Brigham & Ehrhardt, 2008). While repaying their debtors, companies can have a tax holiday, and this means that using debt is cheaper in the long run.
The weighted average cost of capital, in this case, is applied to all the future cash flows, which would hence enable North Sea oil to evaluate their best investment project. Using the WACC to calculate the net present value, the company realizes that the NPV of project B is higher than that of Project A. Project b has a net present value of $1,591.95 while that of project A is ($1,304.94). The results hence reveal that while project A may have positive cash flows, in the beginning, it will end up making losses for the company and it is hence not worth investing in. The cost of project A is hence higher than the returns that it would generate at the end of the five years. On the other hand, project B would be profitable for the business as it has a positive net present value. In this case, project B would end up bringing in more positive cash flows for the company even after the five-year period is over. The net present value is also applicable when appraising long projects which cannot be reversible. For instance, these mentioned projects last an average of five years meaning that all the attention may be channeled to the projects and hence here is a need to choose one that would be most beneficial for the company.
This report also analyses the payback period. After calculating the net present value, there was a need to estimate the amount of time that it would take to generate back the capital used to start the project. In this case, a project that has a short payback period would be most preferred because it means that a company would easily manage to generate profits after paying for the initial capital within a certain time limit (Crosson & Needles, 2008). However, an extended payback period means that North Sea oil would spend more time trying to repay the initial cost of capital and less time aiming at generating profits and even creating more value for the shareholder (Crosson & Needles, 2008). In this case, project B has a shorter payback period while project A has a longer payback period. In fact, the payback period for Project A is three years and five months while that of project B is two years and three months. Moreover, the internal rate of return was useful to evaluate the project that would bring most returns to the company (Moles, et al., 2011). Project B has a higher rate of return of 18% while that of project A is 16%.
Conclusion
North Sea Oil would hence best positioned to choose project B, however, the capital structure of project B changes leading to the recalculation of the weighted average cost of capital. In this case, the new weighted average cost of capital would be 17.2% which is higher than the initial 16.5%. The higher weighted average cost of capital would reflect negatively to the investor because it is often associated with higher risks. In this case, the investors may seek for an additional benefit or return to invest in the company. North Sea Oil may thus end up losing on investors hence impacting negatively on the enterprise.
References
Brigham, E.F., & Ehrhardt, M.C. (2008). Financial management: Theory & practice. Mason, Ohio: Thomson Business and Economics.
Crosson, S.V., & Needles, B.E. (2008). Managerial accounting. Boston, MA: Houghton Mifflin Co.
Moles, P., Parrino, R., & Kidwell, D. S. (2011). Fundamentals of corporate finance. Hoboken, NJ: Wiley.
