Sac Capital Structure the Sparklin Automotive Company

SAC Capital Structure

The Sparklin Automotive Company needs to make a capital investment of $3,000,000 to improve its manufacturing facilities. This investment needs to be carefully considered along two dimensions. The first of these is that the company needs to consider the investment from a capital budgeting point-of-view. The second is that the company does not want to change its capital structure as the result of this decision. The current capital structure is 60% equity and 40% debt. The company needs to utilize the best analytical tools possible for making a capital budgeting decision. There are a number of methods that are common. A net present value (NPV) calculation, an internal rate of return (IRR) calculation, and a payback period calculation are three of the most common. Each of these will be considered, although NPV is the most trusted methodology because it is most closely aligned with total shareholder value.

Key Information

There are several key pieces of information that are needed to make this decision. The first is the initial investment. This is $3,000,000. All of the cash flows associated with the decision must be considered, and the initial cost of investment is the first such cash flow to occur. No sunk costs, however, should be considered. These are costs that have already occurred. The costs that are to be included are only those that are incremental to the investment decision -- that is costs that are dependent strictly on the decision at hand. In this case, that means there are several others that also need to be included. Ongoing costs will need to be included. The revenues associated with the decision will need to be included. The salvage value of the equipment at the end of its useful life also needs to be included in the calculation.

There are other pieces of key information as well. The tax rate is something that must be included. The method of depreciation is also important. This is because the deprecation expense is something that will affect the after-tax cash flows, once the tax rate is considered. The company's cost of capital is also important, because this is something that will impact on the present value of the future cash flows.

Weighted Average Cost of Capital Calculation

The weighted average cost of capital reflects the two components of a firm's capital structure, the equity and the debt. The current capital structure is 60% equity and 40% debt. The cost of equity is 14% and the cost of debt is 6%. The WACC is simply the weighted average of these two costs:

So for SAC, this is:

(.6)(14) + (.4)(6) = 8.4+ 2.4 = 10.8%

Capital Budgeting Techniques

There are three major capital budgeting techniques. They are the net present value, the internal rate of return and the payback period. The payback period simply reflects the time it will take to earn back the initial investment. This is a crude method of capital budgeting, because it only helps management understand part of the cash flows. All cash flows that occur after the initial payback period are irrelevant in this calculation. However, payback period can reflect at least somewhat the risk associated with the project -- those projects with a long payback period are more likely to have deviations from the expected cash flows.

Internal rate of return and NPV are similar calculations. Their strength lies in the fact that they reflect the time value of money -- they reflect that future cash flows are not worth as much as present cash flows. Both calculations are structured in a similar fashion. These two calculations take the incremental cash flows from the investment decision and discount them back to the present day. Although the math is the same, the output is different with these two methods. The IRR reflects the rate of return that the project has. This needs to be higher than the company's cost of capital in order for the project to be viable. The NPV, on the other hand, must be higher than zero when all costs are included.

The net present value is the superior of these two calculations for one key reason. The net present value calculation allows the company to evaluate between mutually exclusive decisions. The NPV does this by indicating how much the different cash flows vary over the years. The project with the higher NPV is the one that should be undertaken. A higher IRR should also be undertaken, but the IRR can be higher on a shorter project. The NPV factors in the differences in the lengths of different projects much better than does the IRR calculation. For this reason, the NPV is the superior of these two formulae for making capital budgeting decisions. Both are superior to the payback period because the payback period ignores cash flows that occur beyond the initial payback period. Both NPV and IRR incorporate all future cash flows into the calculation.