North Sea Oil Company

The primary goal of this study was to evaluate North Sea Oil Company's ability to implement its initiatives utilizing the available financial resources. The essay focuses on the capital structure of the corporation and its ability to finance the organization's intended projects. North Sea determined that Project B was more profitable than Project A using the WACC, NPV, and IRR as assessment techniques. Investing in the project using the previous capital structure was more profitable than investing in the project using the new capital structure, which required more equity financing. Although equity financing offers various advantages over debt financing, it had an impact on the project's targeted profitability after 5 years. Nevertheless, it is profit for the company hence wealth maximization. A firm with a relatively low leverage is attractive for creditors and this will create room for future growth. Thus, the new capital structure will signal investors in a positive way.

Introduction

Capital budgeting is one of the effective financial tools used to run organizations. It is the vital link between the strategic plan and control of a firm (Bierman & Smidt, 2012). Capital budgeting allocates resources to the strategic plan of the organization and as a result, the company is in a position to meet its strategic objectives (Danielson & Scott, 2006). The fundamental objective of any organization is to make profit and create wealth for the shareholders so through capital budgeting, the organization allocates numerous large cash streams to different projects with the intention of generating future returns to the company. Capital budgeting decisions are the fundamental issues that affect the contemporary finance managers. They make decisions that can significantly affect the future of the firm. They can lead to either losses or profitability in the organization. Effective financial manager implement strong procedures and techniques in analyzing and implementing projects that will create profits for the organization. Most companies have run into absolute bankruptcy due to management inefficiencies. Such managers lack the necessary capabilities to create wealth for the shareholders using effective and efficient methods and this has been a major setback especially for the small and medium enterprises.

The capital budgeting techniques follow a definite procedure. The process begins with project definition & estimation of cash flows. At this level, the finance manager selects different projects and estimates the probable cash flows over a certain period preferably a specific number of years. The second in the process is the project analysis. The analysis stage involves determining if the company has adequate resources to invest in the project. Normally, the total cash flows of a given project should exceed the cash invested. This is also the point of selection, and the company settles for few or a single project. The third phase is project implementation and the final stage is project review. “The common capital budgeting techniques include the Net Present Value method, the Pay Back Period, and the Internal Rate of Return” (Graham, Harvey & Puri, 2015). They are few of the sophisticated methods effective in analyzing and estimating project cash flows accurately. The report shall utilize the “NPV and IRR” in analyzing the viable projects for North Sea Oil Company.

Purpose of the Report

North Oil Sea Company’s desire to invest in the two projects comes with several decisions to make. Each project has a distinct cash flow that can generate profit or loss for the company. However, this can only be established through a thorough scrutiny of each one of them using effective and sophisticated capital budgeting techniques. In this term paper, the researcher shall begin by analyzing the “Weighted Average Cost of Capital (WACC)” of the company’s capital structure. Secondly, the study shall compute the “Net Present Value (NPV)” of each project to determine the value of money in the 5-year period, and finally an evaluation of the “Internal Rate of Return (IRR)” of the proposed projects. This will be done having the capital constrain in play.

WACC Analysis

Before analyzing the WACC, the study shall begin by examining the concept of capital rationing in determining the sources of financing and the amount of financial resources required for investment. Capital rationing has received numerous definitions from different authors but its main purpose is to aid in the project selection process. Managers utilize capital rationing whenever the financial resources required to fund acceptable projects are less than the initial cost outlays for the respective projects (Graham, Harvey & Puri, 2015). In such cases, an organization is required to choose from an array of acceptable projects, those that eventually will be accepted.

Most organizations ranging from multinationals to small and medium enterprises utilize the concept of capital rationing. Chen & Deng (2011) indicates that over 64% of the fortune 500 companies apply the concept of capital rationing. Normally, they place the maximum limit of internal capital availed to projects. Further, 82% of these companies assert that executive managers do the internal rationing in comparison to other organizations, which transfer the entire process to external lenders. Decisions made through capital rationing are the most effective for the organization’s long-term financial health. Bierman & Smidt (2012) asserts that the main purpose is to maximize shareholder wealth and value through profit generating investments and favorable profits are earned if the cash flows exceed the initial project outlays. Nevertheless, a firm may not invest in all profitable ventures even when it has adequate capital. It still needs enough financial resources to cover its operations and for that reason, organizations still operate under a capital constraint. North Sea Oil Company needs to invest in two projects yet it has limited resources. The table below depicts the capital structure, the cost, and the target capital structure.

Source of Capital

Cost

Target Capital Structure

Long-Term Debt

7%

25%

Preferred Stock

19%

25%

Common Stock and Retained Earnings

20%

50%

The source of capital has an impact on the profitability of the organization. For instance, payment of interest on the long-term debt reduces the overall profitability of the organization. High debt levels make a company less appealing to potential lenders and even shareholders (Brüggen & Luft, 2011). The target capital structure is used to compute the WACC.

In this context, WACC is appropriate since the firm is considering making an investment. WACC is an appropriate tool for evaluating investment projects like in the case of North Sea Oil Company. Normally investment funds come from different sources of capital and this includes the common stock, debt, retained earnings, and preferred stock. The company has to weight its appropriate cost of capital by the proportions of various sources of capital to get its actual cost of capital (Lobe, 2008). Knowing the appropriate measures of each source and the cost of the entire capital structure aids the organization in determining the actual profits that can be obtained from a specific project. As stated above, the cost of a specific source of capital has an impact on the overall profitability of a project so the firm will be in a position to find a cost-friendly source of finance that will enhance profitability and hence maximize shareholder value. According to Brusov, Filatova, Orehova & Brusova (2011), when two projects carry similar risks, the WACC becomes the benchmark for determining if the projects will be accepted or rejected. Eskandari & Zadeh (2012) indicate that WACC is an imperative element in a firm for two primary reasons. First, the organization can undertake a variety of projects because of a lower WACC since most of the project will have a positive NPV. Secondly, the organization will have a greater value and better stock price due to a smaller number of discounted cash flows.

In the table, the computations indicate the WACC of North Sea Oil Company using the current weights and rates of capital.

Particulars

Rate

Weight

WACC

Long-Term Debt

7%

25%

1.75%

Preferred Stock

19%

25%

4.75%

Common Stock and Retained Earnings

20%

50%

10.00%

WACC/Cost of Capital

16.50%

The table indicates a WACC of 16.50%. “The debt is 1.75%, preferred stock is 4.75%, and the common stock & retained earnings is 10%.” This indicates for every dollar the company makes, it pays on average $0.165 to investors and creditors. From the table, the cost of common stock and RE is higher as compared to the other sources of capital. However, the organization has an appealing WACC.

The Net Present Value

North Oil has two projects, A and B, which can generate income for the company. The original WACC for the organization was 16.5%. The WACC was used as a discount rate for computing the NPV for project A and B as indicated in the table below.

The Net Present Value (NPV) Computation

Years

Project A

Project B

Discount

Project A

Project B

0

$ (130,000)

$ (85,000)

1.00000

$ (130,000)

$ (85,000)

1

$ 25,000

$ 40,000

0.85837

$ 21,459

$ 34,335

2

$ 35,000

$ 35,000

0.73680

$ 25,788

$ 25,788

3

$ 45,000

$ 30,000

0.63244

$ 28,460

$ 18,973

4

$ 50,000

$ 10,000

0.54287

$ 27,144

$ 5,429

5

$ 55,000

$ 5,000

0.46598

$ 25,629

$ 2,330

NPV

$ (1,520)

$ 1,855

Implement Project B

According to the table, Project A has an initial cash outlay of $130,000 whilst Project B has an initial cost outlay of $85,000. The solution indicates that after five years, Project B will generate a profit of $1,855 while Project A will have a loss of $1,520. Thus, Project B is preferred to Project A. The final computations relied on the current capital structure of North Sea Oil and the WACC of the organization.

“Internal Rate of Return (IRR)”

IRR is also one of the universally acceptable tools that measures and compares the rate of returns of investments. An attractive project or investment should depict a higher IRR than the firm’s desired rate of return. However, if the IRR of the given project falls under the company’s desired one, then the organization should abort such a venture. An investment with a higher IRR is more desirable than the one with a lower one (Bierman & Smidt, 2012). Organizations should undertake projects with IRRs that exceed the cost of capital. The table below depicts North Sea Oil Company’s IRR for Project A and Project B.

Computation for the IRR

Years

Project A

Project B

0

$ (130,000)

$ (85,000)

1

$ 25,000

$ 40,000

2

$ 35,000

$ 35,000

3

$ 45,000

$ 30,000

4

$ 50,000

$ 10,000

5

$ 55,000

$ 5,000

IRR

16.056%

17.750%

According to the table, Project A has an IRR of 16.06% while Project B is 17.75%. Therefore, Project B still meets the criteria of a viable investment so the company should implement it.

Analyzing the New WACC of North Sea Oil Company

North Sea Oil Company’s decision to undertake Project B comes with a series of decisions to be made. The company needs finances to implement the project, which can only be collected from the available sources. However, settling for a specific source of finance calls for some trade-offs on either the profitability or the investors’ perception about the organization. The company sought its finances through equity as detailed in the table below.

Calculation of WACC using the New Capital Structure

Cost

Proportion

WACC

Long-term Debt

7%

20%

1.400%

Preferred Stock

19%

20%

3.800%

Common Stock and Retained Earnings

20%

60%

12.000%

New WACC

17.200%

An increase in equity funding from 50% to 60% and a decrease in preference and debt from 25% to 20% increased the WACC from 16.5% to 17.2%. North Sea Oil Company’s decision to implement the project using equity financing has an impact on the firm’s WACC. The new WACC is 17.20%, which is 0.7% rise from the previous 16.50% and the higher the WACC, the higher the cost of capital. While the IRR remains the same, this particular equity finance affects the profitability of the Projects. Using the former capital structure, Project B, which is the most preferred, could have generated $1,855 by the end of the 5-year period but with the new capital structure, this will reduce to $807. Normally a higher WACC than the previous one does not signal good capital structure performance. The organization should implement systems that will minimize the amount of financial resources paid out to investors and creditors.

Sourcing funds for investment into various company projects can be a daunting task. An organization selects a given source of finance based on its amount of resources needed and the cost of the resource (Peirson, Brown, Easton & Howard, 2014). Although the profits are less significant, the company still maximizes wealth for the shareholders. Therefore, the new capital structure will signal investors in a positive way because the company has low leverage and the capital structure will increase value for the shareholders especially the ordinary shareholders. Nevertheless, Hillier, Grinblatt & Titman (2011) aver that though investors have high affinity for companies with low debts. Raising equity finances can affect the company as compared to raising debt finance. “Normally, the cost of equity finance is higher than the cost of debt finance because the cost of equity involves a risk premium.” Investors earn a risk premium for accepting to invest in particular stocks because of the uncertainty about market performance in future. The premium serves as an attraction and increases the shareholder value but this reduces the retained earnings for the company.

The new WACC was used to determine the profitability of the investments as depicted in the table below.

The Net Present Value (NPV) Computation

Years

Project A

Project B

Discount

Project A

Project B

0

$ (130,000)

$ (85,000)

1.00000

$ (130,000)

$ (85,000)

1

$ 25,000

$ 40,000

0.85324

$ 21,331

$ 34,130

2

$ 35,000

$ 35,000

0.72802

$ 25,481

$ 25,481

3

$ 45,000

$ 30,000

0.62118

$ 27,953

$ 18,635

4

$ 50,000

$ 10,000

0.53002

$ 26,501

$ 5,300

5

$ 55,000

$ 5,000

0.45223

$ 24,873

$ 2,261

NPV

Accept project B due to a higher NPV

$ (3,861)

$ 807

The table indicates a decrease in profitability for Project B from $1,855 to $807, which is 56% reduction. In order to attain its full capability, the company needs to explore alternative sources of finance to meet its expectations for increasing shareholder value. Focusing on one source of finance means the firm pays more for less.

The table blow shows a change in WACC after alternative sources of finances are employed in different proportions.

Calculation of WACC using the New Capital Structure

Cost

Proportion

WACC

Long-term Debt

7%

35%

2.450%

Preferred Stock

19%

20%

3.800%

Common Stock and Retained Earnings

20%

45%

9.000%

New WACC

15.250%

The table shows a change in proportions of sources of finances. When the company employs 35% of debt capital, 20% of preference, and 45% of common stock & retained earnings, the WACC will reduce from 17.2% to 15.25%, which is an indication of a healthy capital structure.

The table shows the NPV for the two projects after employing the new WACC.

The Net Present Value (NPV) Computation

Years

Project A

Project B

Discount

Project A

Project B

0

$ (130,000)

$ (85,000)

1.00000

$ (130,000)

$ (85,000)

1

$ 25,000

$ 40,000

0.86768

$ 21,692

$ 34,707

2

$ 35,000

$ 35,000

0.75287

$ 26,350

$ 26,350

3

$ 45,000

$ 30,000

0.65325

$ 29,396

$ 19,597

4

$ 50,000

$ 10,000

0.56681

$ 28,340

$ 5,668

5

$ 55,000

$ 5,000

0.49181

$ 27,049

$ 2,459

NPV

$ 2,828

$ 3,782

Accept project B due to a higher NPV or both

According to the table, Project B can generate $3,782 and Project A can generate $2,828. The company can choose either Project B due to a higher NPV or both. The two projects can generate positive cash flows using the WACC of 15.25%.

Reasons for Change in Financing

The company cannot change the entire source of capital but can source from different streams at distinct proportions to fund Project B or both. The main purpose is to increase shareholder value and this is the most effective way of shareholder wealth maximization.

Ethical Issues that Support Social Responsibility

Ethical social responsibility is a civic duty for all organizations. Companies should not only focus on enhancing profitability, their actions should focus on enhancing the well-being of the society as well. North Sea Oil Company should endeavor to implement projects that will benefit all the stakeholders in play.

Conclusion

No Need for Alternative Sources of Finance at the Moment

Equity finance is favorable because the company is not obligated to make interest charge repayments as depicted by long-term loans (Brown, Fazzari & Petersen, 2009). On the other hand, loan repayments eat back company profits and this affects shareholder returns at the end of each financial year. Furthermore, lack of financial burden means the company will have extra working capital to grow other business segments (Masulis, Pham & Zein, 2011). On the other hand, debt financing may restrict the firm’s activities preventing it from taking advantage of opportunities as they arise most of which may occur outside the core objective of the business (Brown, Fazzari & Petersen, 2009). In addition, Hillier, Grinblatt & Titman (2011) assert that a relatively low leverage is favorable for creditors and this may benefit the company in future when it is in need of debt financing (Brown, Fazzari & Petersen, 2009). Thus, the current capital structure is favorable for investors. Putting all these into consideration, if North Sea Oil Company management needs to invest effectively in the two projects, the management should employ debt and equity finance at favorable levels to minimize interest and risk premium payments while maximizing shareholder value.

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