Capital budgeting analysis for North Sea Oil Company projects

Capital Budgeting Case

The contemporaneous business community is characterized by numerous features of change, the sole constant being the extremely intense competition. This economic battle is fought at both national and international levels and its existence is supported by changing consumer demands or by developing politics, such as open trade agreements. Organizational leaders implement a wide series of strategies in order to respond to competitive threats. They for instance focus more on the employee and strive to satisfy him as a satisfied employee will work harder and will cost the economic entity less money. More focus is also being placed on the customer, who is no longer perceived as the force buying whatever products the company sells, but has turned into the entity to demand what products are to be manufactured.

Aside new policies of marketing and human resource, today's organizations strive to diversify their portfolio in the meaning of developing more and newer investment projects. The primary aim of this effort is that of increasing organizational profitability, but other adjacent benefits are often available, such an expansion into new markets, the creation of new products or the expansion into other sectors and industries.

Given that an economic entity has decided to pick up a new investment project, it has to be realized that its leaders are often presented with more than one alternative. The challenge relies in choosing the one which stands the most chances of success, but also the one which is best ale to serve organizational goals. Various tools can be used in the process, of the utmost importance being the net present value and the internal rate of return. This report is focused on assessing two alternatives for investment projects currently available for the North Sea Oil Company and identifying which of them is more likely to generate the expected outcomes. The desiderate will be achieved through an analysis of the weighted average cost of capital, the net present value and the internal rate of return.

2. The Situation

North Sea Oil's capital is constructed entirely on cost, rather than profits. The long-term debts account for 7%, the preferred stock is of 19% and the common stock and retained earnings account for 20%. The target capital structure propositions are as follows: 25% for long-term debt, 25% for preferred common stock and 50% for common stock and retained earnings. The organization is currently presented with an opportunity to invest in either of two project A or project B. The initial investment for the first alternative is of $130,000, with expected cash inflows for the first five years of $25,000, $35,000, $45,000, $50,000 and $55,000. Project B. requires an initial investment of $85,000, with expected cash inflows for the first five years as follows: year 1 - $40,000; year 2 -- $35,000,-year 3 -- $30,000; year 4 - $10,000 and year 5 - $5,000.

3. Analysis of Investment Projects

Net revenues for project B = $120,000 - $85,000 = $35,000

Project B. For instance uses an initial investment of $85,000 and is expected to retrieve $120,000 throughout the first five years of operations, with a net profit of $35,000. Project A on the other hand does require an initial investment of $130,000 and also pays more to creditors, but generates estimated cash inflows in the total amount of $210,000, leaving a net revenue of $80,000.

This controversial finding implies the need for additional analysis to support the leader in his process of decision making. It is as such necessary to look at two more tools of financial analysis -- the net present value and the internal rate of return. Also, foreseeing the possibility that these computations will lead to conflicting results, it is imperative to assess them in light of a capital rationing constraint. This constraint is that of achieving long-term profitability, rather than cost reductions and capital savings.

Net Present Value

The net present value of a project is identified based on the expected cash flows the respective project is expected to generate as well as the expected cash flows it is expected to require. Otherwise put, the net present value can be calculated by subtracting the value of the outflows from the project inflows. The tool is highly efficient in identifying the profitability of an assessed project and also when making a decision between several alternative investment projects. Generally speaking, and all other things being equal, the project with the highest net present value is selected to be implemented as this will generate the highest levels of profitability. Projects with negative NPV are often renounced as it is highly probable for them to generate negative cash inflows (Investopedia).

Another useful method of calculating the net present value is that of discounting it by the weighted average cost of capital. With the aid of this technique, the NPVs for the two project investment opportunities for the North Sea Oil company are as follows:

NPV for projects = present value of the cash flows discounted by the weighted average cost of capital

NPV for project A = 210,000 -- 210,000 * 1.16% = 210,000 -- 2,436 = 207,564

NPV for project B = 120,000 -- 120,000 * 0.30755 = 120,000 -- 369.06 = 119,630.94

The calculation of the net present values for the two alternatives of investment projects concludes that project A is the most profitable one, standing the most chances of retrieving the desired profitability results. The results indicate the same findings when compared against the capital rationing constraint -- the desire for long-term profitability against savings considerations.

Internal Rate of Return

The internal rate of return is often used in correlation to the net present value and it also constitutes an efficient tool assisting the decision making process relative to projects of financial investment. The internal rate of return is often understood as the growth rate a given project is expected to generate for the overall organization and similar to the net present value, the project with the highest value of the IRR is most likely to be selected. Yet, just like with the WACC and the IRR, it is necessary to correlate the findings to the imposed capital rationing constraint -- the desire for long-term profitability in this case.

IRR, or ERR, when standing for economic rate of return, is extremely useful when organizational leaders must assess the features of more than one investment projects as it offers the possibility of comparison across the entire palette of opportunities available. Investopedia explains that the internal return rate is the rate most "often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first."

The equation to calculating the internal rate of return is a complex one, based primarily on the value of the initial investment:

(Yousaf)

In the case of the first investment project, the equation to calculating the IRR would be as follows:

130 = 25 / (1 + r) 1 + 35 / (1 + r) 2 + 45 / (1 + r) 3 + 50 / (1 + r) 4 + 55 / (1 + r) 5

For project B, the equation is:

85 = 40 / (1 + r) 1 + 35 / (1 + r) 2 + 30 / (1 + r) 3 + 10 / (1 + r) 4 + 5 / (1 + r) 5

Given the complexity of these formulas, the method used is that of estimating results and verifying until a correct solution is identified. "We use linear interpolation to estimate the actual rates of return for the four investment alternatives. Linear interpolation is a trial and error method of estimating actual rates of return when such rates are different from tables or calculators" (Yousaf).

For project A, an estimated internal rate of return of 9% would lead to the following:

130 = 25 / 1.09 + 35 / 1.18 + 45 / 1.29 + 50 / 1.41 + 55 / 1.53 130 = 158.89, which is false, meaning then that the IRR for project A is larger than 9%. Considering an IRR of 11%:

130 = 25 / 1.11 + 35 / 1.23 + 45 / 1.36 + 50 / 1.51 + 55 / 1.68 130 = 149.91, which is also false, requiring the need for an even larger estimation. For an IRR of 15%:

130 = 25 / 1.15 + 35 / 1.32 + 45 / 1.52 + 50 / 1.75 + 55 / 2.01 130 = 133.79; this result is the closest one, meaning then that the estimated IRR for project investment A is of 15.5%

For project B, the estimative calculations commence at a value of the internal return rate of 10%:

85 = 40 / 1.1 + 35 / 1.21 + 30 / 1.33 + 10 / 1.46 + 5 / 1.6 85 = 97.82, which is clearly false, meaning as such that the IRR is larger. For an estimated IRR of 15%:

85 = 40 / 1.15 + 35 / 1.32 + 30 / 1.52 + 10 / 1.75 + 5 / 2.01 85 = 89.23

Based on the previous calculations, the probable internal rate of return for project B. is of 16%, 0.05% greater than the IRR of investment project A. In this light of events, the most desirable investment seems project B.

As initially foreseen, the calculations of the net present value and the internal rate of return have generated different solutions, meaning then that the final decision is based on the correlation to the capital rationing constraint. This argues that the first investment project is the most desirable one as the goal is that of long-term profitability and limited focus is being placed on costs incurred, as long as the set profitability goals are established.

4. The Selected Investment Project

The analysis of the two proposed investment projects in light of financial tools and organizational preferences has established the fact that the first project is the one to be implemented and generate the highest levels of profitability. Considering that project A is implemented, it would lead to modifications in the capital structure as follows:

long-term debt would decrease from 25% to only 20% preferred stock would also decreased from 25 to 20%, and finally common stock and retained earnings would increase from 50 to 60%

Modifications would also occur in the amount of debt and equity, meaning that the total equity would consist of 80% in the overall capital, while debt would only account for 20%. In light of these new features, it is necessary to recalculate the weighted average capital structure:

WACC for project A (selected and implemented) = 97,500 / 130,000 * 0.8 + 32,500 / 130,000 * 0.2 * 0.85 = 0.6 + 0.425 = 0.6425.

This value is significantly higher than the one initially estimated, meaning that the company pays increased sums of money to its investors. The finding will generate conflicting views from the part of the investors, based on their individual preferences. On the one hand, the investors with a low aversion to risk will see the opportunity to register great returns for their stock purchases. On the other hand, the investors with a high threshold for risk will focus on the reduced safety the organizational stocks and bonds can offer and will most likely choose not to invest. Which ever scenario selected, fact remains that the position of the North Sea Oil company after the implementation of the project is volatile.

5. Summary

The contemporaneous business community is extremely competitive, forcing entrepreneurs to develop and implement a wide series of strategic approaches that ensure their survival and success within the market and the industry. Aside human resource policies and marketing efforts, more and more managers strive to diversify their operations in order to increase the levels of profitability.

Such a situation was presented within the North Sea Oil organization, which was forced to choose between two investment projects the one that stood the most chances of offering support to organizational goals. In the process of decision making, the financial tools of weighted average costs of capital, net present value and internal rate of return were used, alongside with a capital rationing constraint. The analysis indicated that investment project most likely to lead to the desired goals is A.

References:

Yousaf, A.S., IRR, http://www.thinkanddone.com/finance/irr.html last accessed on July 9, 2009

Investopedia, 2009, http://www.investopedia.com last accessed on July 9, 2009