ABC Pty Ltd intends to form a special purpose vehicle (SPV) to be incorporated in Australia. This will involve building new water treatment facilities. ABC Pty Ltd intends to undertake the development...

FINANCIAL MANAGEMENT
PROJECT FINANCIAL MANAGEMENT AND APPRAISAL
Table of Contents
Introduction    3
1. Internal Rate of Return (IRR)    3
2. Equity IRR    3
3. Debt Service Coverage Ratio (DSCR)    4
4. Expected Rate of Return using CAPM    4
5. Weighted Average Cost of Capital (WACC)    5
6. Decision    6
Conclusion    7
References    8
Introduction
Finance is the blood of a business. Financial Management is as important as any other activity of the firm. It is the process of planning, controlling and monitoring the financial resources of a firm. In the given scenario, there is a project involving a capital investment of $8500000. 75% of the project will be financed by debt and the remaining will be financed by equity. The firm can raise debt at a rate of 12% per annum. The risk free rate for the company is 3.5% and the beta is 0.9. The market rate of return is 15%. The company expects to invest the funds in the first year. The operations of the company will after the end of 1st year. Therefore, the company will start generating revenue from the end of 1st year. The company has a variety of tools, which can be used in the current scenario. The return from the project should increase the weighted average cost of capital. There are three options available with the firm. The evaluation of all the option has been done in the later part of the assignment.
1. Internal Rate of Return (IRR)
According to the perspective of Chittenden and Derregia (2015), Internal Rate of Return is the rate at which the Net Present Value of any project is Zero. The present value of inflows is equal to the present value of outflows. If the actual return from the project is higher than the internal rate of return, the project should be accepted and vice versa. Ng and Beruvides (2015), higher the internal rate of return, better it is for the company.
In the given scenario, there are three different options available. Therefore, there will be three different internal rate of return from the options. In case of CallWater Pty Ltd, the revenue is increasing at a rate of 7% per annum. The internal rate of return for the option is 40.27%. In the second scenario, which is in case of AP Water Limited, the revenue is increasing at the rate of 10% per annum. The IRR of the second option is 43.44%, which is better than the first option. The third option is that of Nuwater Pty Ltd. IN the third option, the revenue is increasing at the rate of 5% per annum. However, this option has the highest revenue for the projects. The IRR of the option is 67.28% and is the best among the three options.
2. Equity IRR
In case of Internal Rate of Return (IRR), it is assumed that the project is financed from internal sources. Therefore, no interest and principal repayment of debt is taken into account. However, the Equity IRR is a modified approach of evaluating various options. According to the opinion of Srithongrung (2018), the interest and principal repayments are deducted from the net operating income to arrive at the cash flow available to equity shareholders. The project requires a capital investment of $8500000. 75% of the project will be financed by debt and the remaining 25% will the financed by equity. A total of $6375000 of debt will be required for the project. The debt will be repaid in equal instalment by the end of each year. An amount of $853477 will have to be repaid by the end of each year to ensure that the whole loan is repaid by the end of 20th year. The equity IRR in case of CallWater Pty Ltd is 31.86%. In case of AP water Pty Ltd, the cash revenue is increasing at a rate of 10% per year. The equity IRR of the second option is 35.99%. The third option is the Nuwater Pty Ltd, in which the revenue is rising at the rate of 5% per year. The equity IRR of the third option is 57.93%. The equity IRR of the third option is the highest as the top line is the highest among all the three option. Higher the Equity IRR, higher will be the value for shareholders. Therefore, the company should accept the proposal of Nuwater Pty Ltd to yield the best results for the organisation.
3. Debt Service Coverage Ratio (DSCR)
As per the viewpoints of Nawaiseh et al. (2017), Debt Service Coverage Ratio is the ratio of the cash available for repayment of interest, principal and lease payment to the actual amount to be paid towards interest, principal and lease rental. Better, the top line better is the debt service coverage ratio. The firms should intend to control their DSCR within acceptable limits. This will ensure solvency of the firm in the end. The firms should try to keep the external debts low to reduce the fixed payment out of the profits.
In the given scenario, the firm requires to pay an amount of $853477 for 20 years to ensure that there is no remaining debt after 20 years. Therefore, the net inflow will reduce by the amount of interest and principal repayment. IN case of Call Water Pty Ltd, the DSCR in the initial year is 3.405.However, the same ratio increases in the subsequent year due to an increase in the income. IN case of AP Water Pty Ltd, the DSCR in the initial year is 3.298. However, the same increases in the subsequent years. The top line of the company increases at the rate of 10%, whereas the repayment of loan remains the same. Therefore, there is an increase in the DSCR of the company in subsequent years. The DSCR of second option is better than that of the third option. IN case of Nuwater Pty Ltd, the DSCR in the initial years of operation is 6.291 and the same rise high towards the end of the project. The debt service coverage ratio of the third option is the best among all the three available options. This is because the top line of the third option is the highest among all the three options.
4. Expected Rate of Return using CAPM
CAPM model refers to the capital asset pricing model. It is used to calculate the expected rate of return from a project. It is a methods used to take decisions regarding adding of assets to a well-diversified portfolio. According to the perspective of Rigopoulos (2015), if the expected rate of return is higher than or equal to the required rate of return, the project is accepted and vice versa.
In the given scenario, the risk free rate is that of government bond. The ratio of the standard deviation of the firm’s return to the standard deviation of the stock market return is 0.9. The expected rate of market return of business in similar industry is 15%. The formula for computing the expected rate of return using CAPM model is Rf + b * (Rm-Rf). IN the given scenario, the expected rate of return from the project using the Capital Asset Pricing Model is 13.85%. Therefore, if the project delivers a return of more than or equal to 13.85%, the project should be accepted. On the other hand, if the return from the project is less than 13.85%, the project should be rejected.
    CAPM method of calculating expected return
    Risk free rate (Rf)
    3.50%
    Beta (b)
    0.9
    Market rate of return (Rm)
    15%
    Expected rate of return using CAPM model
    Rf + b(Rm-Rf)
     Cost of equity
    13.85%
5. Weighted Average Cost of Capital (WACC)
The funds are raised by an organisation at different rate. As per the views of Srithongrung (2018), an organisation has multiple sources for raising funds. Such sources include loan from banks, debentures, equity and others. It is the rate, which a company is expected to pay on average on all its security holders to finance its assets. It depends on the external market scenario. Managers can only decide the optimum capital structure to reduce the weighted average cost of capital along with keeping the risk within acceptable limits.
In the given scenario, the firm requires a fund of $8500000 for the new project. The firm is raising 75% of the funds through debt. The remaining 25% of the capital expenditure will be financed through equity. The rate of interest on debt is 12%. As per the capital asset pricing return, the expected rate of return or the cost of equity is 13.85%. If the return from the project is greater than 13.85%, the company should accept the option. On the other hand, if the same is less than 13.85%, the company should reject the offer.
    Computation of WACC
    Cost of debt (Kd)
    12%
    Cost of equity (Ke)
    13.85%
    Proportion of debt
    75%
    Proportion of equity
    25%
    WACC
    12.46%
6. Decision
Various tools have been used above for the purpose of evaluation of the project. IRR, equity IRR, DSCR, CAPM model and WACC have been used to find the option that is most beneficial.
    Option
    IRR
    CallWater Pty Ltd
    40.27%
    AP Water Ltd
    43.44%
    Nuwater Pty Ltd
    67.28%
From the above table, it can be observed that Internal Rate of Return of third option is the highest. From the IRR point of view, the company should enter into agreement with Nuwater Pty Ltd.
    Option
    Equity IRR
    CallWater Pty Ltd
    31.86%
    AP Water Ltd
    35.99%
    Nuwater Pty Ltd
    57.93%
From the above table, the equity IRR of CallWater Pty Ltd is 31.86%, that of AP water Ltd is 35.99% and that of Nuwater Pty Ltd is 57.93%. According to the perspective of Rossi (2015), the option with the highest equity IRR should be selected as it will lead to maximisation of shareholders wealth. Therefore, the third should be selected from the equity IRR point of view.
    Year
    CallWater Pty Ltd
    AP Water Pty Limited
    Nuwater Pty Ltd
    1
    3.405188423
    3.29827283
    6.291909
    2
    3.621875575
    3.648604473
    6.556709
    3
    3.850567297
    4.03440866
    6.829182
    4
    4.091778769
    4.459254614
    7.109158
    5
    4.34602828
    4.927069578
    7.396397
    6
    4.613834128
    5.442174676
    7.690592
    7
    4.89571097
    6.009324351
    7.991347
    8
    5.192165553
    6.633749765
    8.298177
    9
    5.50369174
    7.321206531
    8.610489
    10
    5.830764745
    8.078027223
    8.927571
    11
    6.173834479
    8.911179149
    9.248577
    12
    6.533317892
    9.828327888
    9.572511
    13
    6.909590189
    10.8379072
    9.898205
    14
    7.302974781
    11.94919594
    10.22431
    15
    7.713731823
    13.17240261
    10.54924
    16
    8.142045159
    14.51875846
    10.87122
    17
    8.588007488
    16.00061984
    11.18815
    18
    9.051603548
    17.63158079
    11.49769
    19
    9.532691068
    19.42659694
    11.79712
    20
    10.03097924
    21.40212178
    12.0834
The above table shows the value of Debt Service Coverage ratio of companies over a period of 20 years. From the above table, it can be seen that the debt service coverage ratio of all the options is increasing. However, the debt service coverage ratio of the third option is the highest from the initial years of operation. Therefore, from the point of view of debt service coverage ratio, the company should entrée into agreement with Nuwater Pty Ltd.
From all the above-mentioned parameters, it can be ascertained that Nuwater Pty Ltd is the best option available with the company. The company should enter into agreement with Nuwater Pty Ltd, as it has the best Internal Rate of Return, Equity Internal Rate of Return and the highest Debt Service Coverage Ratio.
Conclusion
According to the assignment, the ultimate goal of an organisation is the maximisation of the wealth of the shareholders. A number of tools are used in the financial management to ensure that the funds are used in the best possible manner. Such tools include payback period, internal rate of return, accounting rate of return and similar tools. Each tool in financial management has a different purpose and it is used in various situations. Time value of money is duly considered to ensure that all the figures are calculated at present value. The third option is the most viable option as it has the highest IRR, equity IRR and debt service coverage ratio. As per the Capital Asset Pricing Model, the expected rate of return from the project is 13.85%, which is the expected return from the equity. The weighted average cost of capital of the organisation is 12.46%. The debt service coverage ratio of all the option has seen an increasing trend. However, the ratio of third option is the highest. The company should enter into agreement with Nuwater Pty Ltd.
References
Chittenden, F & Derregia, M 2015 ‘Uncertainty, irreversibility and the use of ‘rules of thumb’ in capital budgeting’ The British Accounting Review, vol. 47, no. 3, pp. 225-236
Nawaiseh, ME, Al-nawaiseh, H, Attar, MD & Al-nidawy, A 2017 ‘The Use of Capital Budgeting Techniques as a Tool for Management Decisions: Evidence from Jordan’ In International Conference on Engineering, Project, and Product Management, pp. 301-309
Ng, EH & Beruvides, MG 2015 ‘Multiple internal rate of return revisited: Frequency of occurrences’ The Engineering Economist, vol. 60, no. 1, pp. 75-87
Rigopoulos, G 2015 ‘A review on Real Options utilization in Capital Budgeting practice’ International Journal of Information, Business and Management, vol. 7, no. 2, p.1
Rossi, M 2015 ‘The use of capital budgeting techniques: an outlook from Italy’ International Journal of Management Practice, vol. 8, no. 1, pp. 43-56
Srithongrung, A 2018 ‘Capital Budgeting and Management Practices: Smoothing Out Rough Spots in Government Outlays’ Public Budgeting & Finance, vol. 38, no. 1, pp. 47-71
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