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Weights of Equity and Debt in the Capital Structure
Weights of equity and debt can be calculated as:
Current Market Value of equity = 5,000,000 * $16 = $80,000,000
Current Market Value of debt = 50,000,000 * $1,000 = $50,000,000,000
Hence;
Total market value of debt and equity = $80,000,000 + $50,000,000,000 = $50,080,000,000
Therefore;
Weight of equity = $80,000,000/50,080,000,000 = 0.16%
And
Weight of debt = $50,000,000,000/50,080,000,000 = 99.84% or
100% - weight of equity = 100% - 0.16% =99.84%
Weighted Average Cost of Capital (WACC)
Since Tortuga Fishing Equipment Company has both equity and debt, then weighted average cost of capital will be calculated using the formula:
WACC = r (E) x w (E) + r (D) x (1 – t) x w (D)
Where:
r (E) = cost of equity
r (D) x (1-t) = After-tax cost
w (E) = weight of equity
w (D) = weight of debt
Hence;
WACC = 4% x 0.16% + 1.386% x 99.84% = 1.39%
Net Present Value, Internal Rate of Return, and Payback Periods
The net present value (NPV) is vital as it will assist Brooks in assessing the monetary value of each project contributing to Tortuga Company, taking into account the money intended for investment. Therefore, the NPV values were calculated, and the following figures noted for each project respectively NPV = $14, 969, 835.14 for project A and B is $16, 238, 924.68. The Internal Rate of Return (IRR) is also a valuable tool for making operating and investment decisions for the Company as it gauges how well each project, performs with time ( Zhao, & Huchzermeier, 2015) . It further will help the company in assessing project A versus project B to evaluate which project should be adopted for the company. After calculations, the IRR for project A was -12.184% while that of project B was -14.586%.
The payback period is critical as it will help Brooks in giving a clear picture of the time it will take for the initial investment to be free from the risk. Therefore, the payback period for the company can be arrived at by taking the amount required to invest initially in each project divided by the amount expected from net cash flow per year ( Myers, 2015) . Therefore, the payback period for project A would be 22 years while project B would be 26 years.
Decision Rules for Tortuga
In coming up with the decision rules, it is essential to understand that the rules are founded on the cash flow principles. Furthermore, the rules should take into consideration all the increments in the cash flow attributed, in this case, to each of the project taking into account the time value of the cash invested. The rules help in adjusting the risk properly inherent with the projects ( Heaton, Polson, & Witte, 2017). Therefore, to choose between the projects, Brook’s choice should be governed by ensuring that the wealth of the shareholders is maximized given any applicable constraints.
For Brooks to properly apply the NPV decision rule, it is vital that he evaluates each of the two projects independently. He should consider the project with a positive NPV and reject the one with negative NPV. Furthermore, Brooks should check whether the projects are interdependent by taking the feasibility combination on the project that has the highest combined NPV. For Brooks to use the IRR decision rule adequately, he should consider selecting the project with a higher IRR compared to the market-based discount rate, and reject the one with a lower IRR ( Härdle, Hautsch, & Overbeck, 2017) . On the other hand, the payback rule seems to be very straight forward and easy to use. The challenge it poses is its ignorance of the time value and benefits after the payback period has elapsed. Using IRR can be misleading if the limitations are not fully understood, hence NPV analysis is recommended as a decision rule.
Strengths and Weaknesses of the Evaluation Tools
Some of the challenges that the IRR pose includes incorrect conclusions relating to the relative net worth of the projects. The IRR is very advantageous as it gives a definite rate of return for individual projects concerning the cost of initial investment. Besides the IRR, the NPV shows whether a project will add value to the company or the investors and by how much money ( Härdle, Hautsch, & Overbeck, 2017) . The weakness of this decision rule is that it makes assumptions on the company’s cost of capital. Guessing very high costs of capital can easily lead to the company avoiding numerous worthwhile investments.
References
Härdle, W. K., Hautsch, N., & Overbeck, L. (Eds.). (2017). Applied quantitative finance (Vol. 2). Springer.
Heaton, J. B., Polson, N. G., & Witte, J. H. (2017). Deep learning for finance: deep portfolios. Applied Stochastic Models in Business and Industry , 33 (1), 3-12.
Myers, S. C. (2015). Finance, theoretical and applied. Annual Review of Financial Economics , 7 , 1-34.
Zhao, L., & Huchzermeier, A. (2015). Operations–finance interface models: A literature review and framework. European Journal of Operational Research , 244 (3), 905-917.
