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.
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…
This memo will discuss the financial condition of Sparklin Automotive Company (SAC) for the years 2005-2006. Sparklin produces spark plugs for the original equipment market (OEM) for automotive manufacturers, as well as for the automotive aftermarket. The company has recently introduced a new spark plug that offers superior performance. The content of this memo will include both a ratio analysis and other forms of financial analysis. At the conclusion of