Decision to use the Weighted Average Cost of Capital (WACC):
WACC is the weighted average cost of capital. If the project is financed by debt and equity, then it is appropriate to use WACC. If it was financed by only debt or equity, then other methods should have been considered. It is assumed here that the project is finances by both debt and equity. However, there are some risks involved in using WACC, such as:
1.The discount factor is a very sensitive figure, and even a slight change or error in its calculation can lead to huge changes in the NPV of the project. Such huge changes may even turn an investment decision into a rejection one, thus completely presenting the picture upside down.
2.Estimating Sales revenue, variable costs and fixed cost is very hard. In this project, they all seem to be at a constant level for eight years, which is very unlikely.
Different Methods of appraising projects:
There are many methods to evaluate whether a project is financially worth carrying out or not. The following are considered in this case:
1.Discounted Cash flow Techniques (NPV and IRR).
2.Discounted Payback Period.
3.Return on Capital Employed (ROCE)
1.Discounted Cash flow Techniques (NPV and IRR):
When using discounted cash flow techniques, only relevant costs (costs of investment appraisal including opportunity costs, working capital costs) should be taken into calculations. Non-relevant costs like past costs, sunk costs, committed costs, depreciation and any other fixed overheads that are irrelevant to the project should be ignored.