Financial Decision: NPV, CAPM, and Capital Structure

Introduction

The company is considering a project with an up-front cost of $10 million. This investment will significantly increase the size of the company and therefore must be given serious consideration for its financial effects. This paper analyzes the investment decision in the context of financing and makes recommendations to management about whether and how to pursue the project.

The company currently holds assets of $17.2 million. An investment of $10 million therefore represents a 58% increase in the size of the company, bringing total assets to $27.2 million. Such a dramatic investment will significantly alter the company's capital structure, so the financing decision must be given careful consideration.

Determining the Discount Rate

The threshold question is whether the company should take on the project at all. The standard rule of thumb for an investment decision is whether the project has a positive net present value (NPV) — that is, the value of all future cash flows associated with the project, discounted back to the present day. In this case, future cash flows are not yet known, so the NPV calculation cannot be completed directly. There are, however, preliminary steps that lead to an NPV figure.

The first step is to determine the company's discount rate. There are two primary methods. The first is to use the company's existing cost of capital — essentially a weighted average of the cost of equity and the cost of debt, with weightings determined by the current capital structure. The second method is to identify the cost of capital specific to this project. For example, if the company chooses to finance the project entirely with debt and knows it can borrow at rate x%, then that rate serves as the discount rate.

For this situation, the former method is more appropriate. The company's current capital structure consists of $8.3 million in liabilities and $8.9 million in shareholders' equity. The cost of debt is not known. The cost of equity is also unknown but would be calculated using the Capital Asset Pricing Model (CAPM), which relates the cost of equity to broad market returns by accounting for the firm's specific level of risk (Wang, 2003).

The components of CAPM are the risk-free rate of return, the market risk premium, and the firm-specific risk reflected in the firm's beta. Beta is derived from the correlation between the firm's stock price and the broad market — it answers the question of how risky the firm is relative to the economy overall. Because this firm's name is not known, its beta is not directly available, but it can be obtained from a financial data source or calculated by running a regression analysis against market returns.

Capital Asset Pricing Model (CAPM)

For the purpose of illustration, assume the firm's beta is 1.15. The risk-free rate is currently 0.27%, based on the one-year Treasury bond (Yahoo! Finance, 2010). The historical market risk premium is 7%. This yields the following CAPM calculation:

R_a = 0.27 + (1.15)(7) = 8.32%

This figure is taken as the firm's cost of equity. Assuming the cost of debt is approximately 3%, and given that the capital structure is 48.2% debt and 51.7% equity, the weighted average cost of capital (WACC) is:

WACC = (0.482)(3) + (0.517)(8.32) = 5.751%

The Financing Decision

This WACC would be used as the firm's discount rate in the NPV calculation.

Assuming the project has a positive net present value — as it must for the investment to warrant consideration — the next decision concerns how to finance it. Debt financing is the least expensive method, since debt is less risky than equity from an investor's perspective. The principal drawback of debt, however, is that it creates a fixed obligation: the company commits future cash flows to debt service, reducing funds available for reinvestment in operations. If this project were financed entirely with debt, the new capital structure would be 67.2% debt and 32.8% equity. If financed entirely with equity, the new structure would be 30.5% debt and 69.5% equity.

A common rule of thumb is to match the asset type with the financing instrument — for example, financing a five-year asset with a five-year bond, so that cash flows from the asset can cover financing costs. In this case, since the asset's service life is unknown, either financing type could technically be used.

Financing from internal cash is not feasible, as a firm with only $17.2 million in total assets and $17.5 million in annual revenues is unlikely to hold $10 million in liquid cash. A debt issue would substantially increase the firm's leverage and risk level. To assess whether that level of risk is acceptable, it is worth examining industry norms. Canadian auto parts supplier Magna International carries a capital structure of approximately 40.2% debt and 59.8% equity (MSN Moneycentral, 2010), which suggests that a 67.2% debt ratio would be well above the industry norm for an auto parts company.

If equity is used to finance the project, there are further options to consider, including common shares and preferred shares. Issuing common shares carries the risk of diluting existing ownership. This dilution can be avoided by issuing rights to existing common shareholders, allowing them to maintain their proportional stake in the company.