Murphy Stores: Capital Projects Case Study Solution
Weighted Average Cost of Capital
The calculation of WACC is given in the excel sheet. The calculation of WACC is comprised of the company’s target capital structure of 20% of debt, and 80% of equity. The cost of the company’s equity is calculated by using a CAPM, in which beta is 1.2 as given in the exhibit 1. The risk free rate is 4% while the market premium is 7.50%. The cost of equity is calculated 13% while the cost of debt after the debt is calculated,is 4%. As the company’s assumed WACC is 12%, which is higher than the calculated WACC 11%. If the company takes a higher WACC in its project then it will result in the lower NPV. Lower NPV may convert the profitable projects into unprofitable projects. Lowering the WACC might increase the profitability of the project, as the company will have to pay low cost for their project.
Key Value Drivers
Key value drivers of EAS project are that it increases the sales of the company, decreases the cost of goods sold and increases the gross profit margin of the company.The company’s overall sales growth will increase because of the decrease of shrinkage due to the EAS system.It will decrease the cost of goods sold because before the installation of EAS; the company was including the stolen goods’ amount in the cost of goods sold. As the shrink will fall; it will increase the gross margin, because EAS will increase the deferential sales and decrease the cost of goods sold, which will ultimately increase the gross margin.
In the lighting project,the overall efficiency of the stores will increase, because EAS will help in reducing the overall operating cost, electricity efficiency will increase by 30% to 40% and reduces the air conditioner usage, which will further decrease the overall expense of the company.
Higher sales will create a great impact, because it will increase the revenue as well as the margin of the company and reduce the cost of goods sold.
The calculations have been done for the shrinkage fall and each years’ shrinkage is decreasing by 3.6%, which will affect the financials of the company.
Uncertainties/ Risk:
There are many uncertainties associated with both the opportunities’ financials. If the risk free rate increases or decreases it will affect the cost of capital of the company, which will result in higher or lower NPV. If the company installs the EAS system then it would reduce the sales of the company. The reason behind it would be that the customers might get a wrong perception of the system, so the company might lose its customers. If the risk of the company will increase it will affect the company’s cost of capital, which will reduce the net worth of the company.If the market rate increases then it will increase the cost of equity, which will increase cost of capital and decrease the NPV as it proceeds.
Scenarios
On the basis of WACC, best and worst scenarios are discussed below:
Best Scenario:
If the risk free rate or beta will decrease, it will affect the WACC of the company. We are assuming that company’s cost of capital decrease to be from 8% to 11%, cash outflow to be $5126 at year 0, and cash inflows to be$9450 so, the NPV of the company will be $77311.50,which is more beneficial for the company, because it is gaining higher profits on its investment, which will ultimately maximize the net worth of the company.
Worst Scenario:
If equity, debt or beta will increase, it will increase the cost of capital. If the company’s projected cost of capital increases from 11% to 13%, it will decrease the overall net present value of discounted cash flows. It means that the company’s out flow will be higher and it will reduce the NPV of the company. Less NPV is not beneficial for the company,because the company is earning less profit, which will ultimately minimize the net worth of the company.
Recommendation
Although both the projects have positive NPV, IRR is greater than WACC and profitability index is greater than 1, so both the projects are suitable for investment.But on the basis of above analysis, when both the projects are compared, the EAS project has greater NPV, IRR and profitability index than LED light project. So, EAS project is more recommendable. The NPV of EAS project is 66841, which shows that the company will earn more than its initial investment. The profitability index of the company is 13.33, which shows that the company will earn 13 times more profit on their investment. As the Murphy has the limited capital so it is recommended that it should invest its capital in EAS project because by installing the EAS technology in their stores, the company will reduce the chance of stolen good from the stores. When the ratio of the stolen goods will reduce; the sales of the company will increase and the cost of goods will reduce, which ultimately improves the gross margins of the company. By investing in EAS project;the company will improve its profitability, would gain better results and would reduce its shrink percentage as compared to making an investment in the LED project where the company will get lower returns.............
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