Section A 1: Average weighted cost of capital (WACC)
The capital structure is important while choosing the ideal investment plan. The cost of capital must factor in the different cost burdens in different financing capital structures provided by the company. Each firm experiences a different cost of financing either through debt or shareholder's assets, and thus they have to set the minimum acceptable rate for each project.
A firm set the hurdle rate that must be met by all the projects initiated in the different division within the company. Setting the minimum hurdle ensures that the proposed project achieves the minimum profitability index (Caselli & Negri, 2018). Typically, the issue arises when the firm has to decide on a project that presents a different risk level than the firm's already existing investments. The inclusion of some cost component in the project with a significantly different interest rate is expected to level its return to the firm-wide acceptable rate. Investment in various divisions within the firm must benchmark the firm-wide average cost of capital to calculate the expected cash flow. The firm provides the cutoff rate or the minimum acceptable interest rate for any proposed investment in each division. Therefore, although the risk may present a relatively low-risk level and a more favorable interest rate than other projects undertaken by the firm, it has to be standardized to average the cost provided that is considered the firm-wide acceptable level. The fact that the critical interest rate must be placed at the highest level acceptable in the firm's division necessitates the introduction of some cost component when evaluating projects with significantly different risk levels.
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For this project, the discounting rate of 11% would be too low for other relatively high-risk investment projects undertaken by Snack Box, considering that both the maximum allowable payback and discounted payback are relatively high at 3 and 3.5 years, respectively. Worth noting, with a firm having the option of funding its investment through either debt or equity assets, the cost associated with each alternative must be considered. Therefore, either the cost of debt or equity financing should be included as a cost component when evaluating the weighted average cost of capital. Other factors that may be considered part of the cost component in accounting for the cost of capital in an investment project include; inflation, market fluctuation, and corporate taxes.
Section A 2: Principle for Cash Flow Estimation
Typically, the conventional cash flow statement does not reflect capital expenditure transactions as part of its operation but is categorized under cash flow from financing activities. The objective of separating the cash expenditure in long-term capital projects with the operating transactions is to ensure that its cash outflow from its primary operations is distinguished. Unlike the regular cash flow, free cash flow concept emphasizes the amount of cash that the firm is left with at the end of each year, irrespective of originating from regular or financing activities (Fuhrmann, 2020). Worth noting, when evaluating the company's financial performance cash flow statement, I combine it with information on investment activity to ensure that the operations achieve the expected efficiency.
Section B: Evaluate the investment criteria
Payback Period Method
The payback period of 2.6 years is significantly favorable compared to that offered by the company's acceptable level. The estimated payback period estimated at 2.6 years is within the company acceptable range of 3.0 years. However, it is important to investigate the factors that may impact the project life-cycle as a factor that may contribute to an earlier onset of the project may contribute to technological obsolescence of the Snack Box's innovation.
The suitability of the payback method is popular when comparing the suitability of projects with different periods.
Advantage of the Payback method
The method is considered favorable as it involves easy calculations.
It reflects the expected liquidity as it factors both the cash inflows and outflows.
Recognize the time value of money: cash received earlier has more value than cash received at a later date.
The method helps identify the project that is at risk for the shortest amount of time.
Disadvantages of Pay Back method
The method does not provide the total profitability of the projects as it does not account for the cash generated past the considered time
Unlike other methods such as the discounted method, payback does not account for the time value of money.
The method does not factor the non-current asset's life in its calculation and does not recognize the net cash inflows after the payback period.
The payback period is a capital budgeting method help evaluate the cash flow generated from a certain project that will have covered the initial cost incurred in undertaking the project. As in this project, an estimated 2.6 years is when the proposed project will take for the Franchise to recover the entire amount spent on the investment. Worth noting the extra cash flow generated after the payback period is not considered. The payback period method does not consider the amount of cash flow that may be generated after the estimated period.
Net present method
In this particular project the NPV is estimated at $124,106.98 > 0. Therefore, the investment should be accepted. Different limitations and benefits are associated with using the Net present method when evaluating a capital project's suitability. The net present value is calculated by determining the value of the discounted cash flow from the discounted cash inflows from the project. The NPV method recognizes the time value of money. Worth noting the NPV alone is not an adequate measure of the project's suitability as the opportunity cost foregone in financing the project must be discounted at the chosen discounted rate.
Benefits of using Net present value
The method considers the time value of money; cash received now has more value than money received in the future.
The method accounts for all expected cash flow throughout the project.
Early net cash flow is accorded more priority than the cash generated in later timings.
The disadvantage of using the net present value method
Sometimes the method may face difficulties determining the cost of the capital.
Estimating the cash flow's exact value, particularly in the later years throughout the project, maybe wrong.
The net present value fails to account for a possible change in capital cost as the project may be running.
Internal rate of return
The suitability of the project using this project is determined when the IRR is greater than zero. With the opportunity cost of financing, the project being less than the IRR and NPV is greater than zero, the project is considered profitable for investment. In this case, the IRR is estimated at 28.79%. The IRR is greater than the base interest of 11%, pointing to the need to accept the investment. For an investment to be acceptable based on IRR, the return percentage should be greater than the firm acceptable minimum.
The internal rate of return method is not without limitations and benefits.
Advantage of using Internal rate of return
The method takes into account the time value for money
The method enables comparison with other projects as it provides the exact discounted flow rate.
Disadvantages of internal rate of return
The method is considered a bit complicated to use and may not be well understood by individuals with no accounting knowledge.
Choosing the most appropriate discount rate may be time-consuming, considering the method relies more on guesswork.
Conclusion
Overall, the net present value, internal rate of return, and payback period method of evaluating the project indicate that the project is favorable and should be considered for investments. When the company is considering investing in any project, the key consideration is to have a project that provides returns that outweigh the cost incurred in undertaking the investment ( Stowell, 2018) . typically, the minimum is to select a project that provides a return that is at least equal to the project's cost.
Worth noting that capital investment is expected to significantly impact the future liquidity of a firm, and thus it becomes critical to undertake a keen evaluation before setting on a given project. Despite the different alternatives used to weigh the cost of capital in different projects undertaken by a firm, it is important to recognize that they do not sufficiently address the problems related to monitoring the projects' performance in the future. The accounting method of evaluating the suitability of capital projects is limited because they fail to recognize the importance of some qualitative information in determining the viability of given investments.
One of the important qualitative considerations not captured by the different accounting methods is whether the project is aligned to the organization's overall objective ( Glantz, 2014) . Another important consideration is the short-term and long-term expected impact on the organization's employees. Also, it is important to conduct a critical evaluation of the possible expectation that the project may have on the different firm stakeholders. Therefore, although the different accounting methods of evaluating a project's suitability are important tools in decision-making, their application should not be in isolation of qualitative information.
References
Caselli S. & Negri G. (2018). Private equity and venture capital in Europe (Second Edition). https://www.sciencedirect.com/book/9780128122549/private-equity-and-venture-capital-in-europe
Fuhrmann R. (2020). Cash Flow Statement: Analyzing Cash flow from investing activities. What is cash flow from investing activities? https://www.investopedia.com/articles/investing/112513/cash-flow-statement-analyzing-cash-flow-investing-activities.asp
Glantz M. (2014). Multi-Asset Risk modelling. https://www.sciencedirect.com/book/9780124016903/multi-asset-risk-modeling
Stowell P. (2018). Investment banks, Hedge Funds, and Private Equity (third edition). https://www.sciencedirect.com/book/9780128047231/investment-banks-hedge-funds-and-private-equity
