St.

Louis Chemical: The Investment Decision

1. Prepare a presentation for William regarding the concept of WACC

The weighted average cost (WACC) is the cost of financing of a company's assets
that reflects the riskiness of the firm or the firm's assets. In other words, it is the minimum
return that a company must earn to fulfill all of its investors.
A high WACC implies that the firm is spending a lot of money to raise capital, which
indicates that the company is risky. Meanwhile, a low WACC indicates that the company
obtains capital at a low cost.
To calculate WACC, the case provides the cost of each source of capital as well as
the target capital structure. St. Louis Chemical's before-tax cost of debt is 10%, and its cost
of common equity is 16%. St. Louis Chemical's target debt and equity capital structures are
30% and 70%, respectively.

2. Calculate St. Louis Chemical's WACC (round to the nearest whole number). What
arguments should be made to convince Williams of the advantage of using long-term
debt in the firm's capital structure?

Kd = 1(1-t)
= 1(1-3)
=7
WACC = (Wd x Kd) + (Wc x Ke)
= (0.30 x 7) + (0.70 x 0.16)
= 2.1 + 11.2
= 13.3 or 13%
William must prefer long debt as part of the firm's capital structure because debt has
a lower cost than equity because the debt holder bears less risk. Debt carries less risk
because of the certainty of payment, which is greater than the payments associated with
equity. For the record, if the risk associated with debt is lower, debt providers will have a
lower but more certain return.

3. Since the used equipment will be financed with internal capital and the new
equipment with a bank loan should the same discount rate be used to evaluate each
alternative? Explain.
 The discount rate utilized to review the project reflects the project's risk level rather
than the cost of financing. Because each alternative shows up to have the same risk level as
the firm's existing assets, the cost of capital can be used to assess each alternative.

4. Explain why an accurate WACC is important to a firm's long-term success.

To evaluate investment decisions, a firm WACC is used. The asset must provide at
least the firm's cost of capital. If the return on an asset is less than the WACC, shareholders
will not obtain the required return. If a company undervalues its WACC, it may invest in
assets that do not provide the required return.
If a company overstates its WACC, it may fail to invest in assets that would provide
the required return. If the WACC is understated, the firm risks losing equity capital as
displeased investors that may withdraw their funds.
Making investment decisions based on ambiguous analyzation is an inappropriate
process that will not benefit the firm's limited resources.

5. Evaluate the strengths and weaknesses of the NPV, IRR and Cash Payback capital
expenditure budgeting methods. Prepare a recommendation for Williams regarding
the capital budgeting method or methods to use in evaluating the expansion
alternatives. Support your answer.

NPV
STRENGTHS WEAKNESSES
Uses cash flows Estimation of opportunity cost
Uses all cash flows for the project Difficulty in calculating required rate of return
Discounts the cash flows properly Optimistic projection
Good measurement of profitability Difference in size of projects

IRR
STRENGTHS WEAKNESSES
Time value of money Impractical implicit
Simplicity Assumption of reinvestment
Multiple rate of returns Mutually exclusive projects

Payback Period
STRENGTHS WEAKNESSES
Easy to understand Ignores time value of money
Quick solution Arbitrary standard
Useful for uncertainty Ignores profitability

Suggestion should contemplate the usage of evaluation methods because each

presents valuable information regarding a probable project. Preference should be presented
to the results of the NPV method because it correlates the project value which is determined
by using WACC as discount rate.

6. Calculate the NPV, IRR and Cash Payback for each alternative. For these
calculations assume a WACC of 13%. Based strictly on the results of these methods,
should either option be selected? Why? How could the analysis be improved?
Solution requires preparation of a spreadsheet.
Based on NVP, for independent projects, we must move ahead if NPV > 0, and
for the mutually exclusive projects, accept the project with the positive NPV if the NPV of one
project is greater than the NPV of the other project. If both projects have a negative net
present value, we must ignore both. Considering the current situation, we can consider two
alternatives:

 If the projects are Independents: Both projects can be accepted

 If the projects are Mutually Exclusives: We must choose the New Equipment

In terms of the IRR, the higher the rate, the more desirable the investment. However,
we should accept the project only if the IRR exceeds the cost of capital. In this case, the cost
of capital, as calculated by WACC, is equal to 13%. As a result, when considering the
presented case, we can consider two distinct perspectives:

 If the projects are independents: Both projects can be accepted

 If the projects are mutually exclusives: We should choose the Used Equipment

USED EQUIPMENT NEW EQUIPMENT

NPV IRT NPV IRT

35,002.81 14.33% 168,352.07 14.59%

USED EQUIPMENT NEW EQUIPMENT

14,824.46 38,066.22

Cash Payback Period assumes something receives evenly yearlong operating cash
flows over the course of the year while the NPV and IRR assume operating cash flows are
received at the end of the year. The Cash Payback Period for the used equipment is 3 years.
The full investment is not recovered until the project is completed. Based on the results of
the evaluation methods, the new equipment would be selected because of the higher NPV.

7. The projected cash flow benefits of both projects did not include the effects of
inflation. Future cash flows were determined using a constant selling price and
operating costs (real cash flows). The cash flows were then discounted using a WACC
that included the impact of inflation (nominal WACC). Discuss the problem with using
real cash flows and ammoniac when calculating project's NPV or IRR.
Using real future cash flows and a nominal WACC will result in an understated NPV
and IRR, or both will be downward bias. If inflation is fair, meaning it affects both revenues
and costs equally, the NPV and IRR will be understated. Seeing as revenues are typically
greater than costs, revenues will increase in money terms larger than costs.
The precise impact of combining real cash flows and a nominal discount rate can
only be calculated by subtracting the impact of inflation from the discount rate or adding the
impact of inflation to future cash flows.

8. What other issues should be considered before a final decision regarding the
expansion alternatives is made?
As we analyze the case study, I found out that there is no any information about
inflation, but the problem exists and should not be overlooked when making capital-
budgeting decisions. If we do not include inflation expectations in our capital-budgeting
analysis, the NPV calculated from the biased cash flows will be invalid.
More capital expenditure budgeting methods are required to ensure that we are
making the right decision. It is critical to recognize the limitations of traditional methods and
to experiment with methods based on real-world options to determine the best time to
implement the project. A good way to supplement the decision-making process is to use the
Profitability Index, which aids in the maximization of company value.