Recommendation of FLIR Systems Commercial company

Based on the analysis below, we don’t recommend investing in the project as it has negative NPV and IRR lower than the cost of capital.The WACC of company is calculated as the weighted average cost of the debt and the equity. For taking the weight we have used the market value of the debt and equity as per the latest financial statement published by the company for the Q2FY18. WACC is the minimum hurdle rate that the project needs to achieve to generate the minimum required return for the company.  Therefore the calculation of WACC is very important aspect in the capital budgeting and need to be evaluated very carefully. For calculating the WACC we need the cost of debt, cost of equity, book value of the debt and equity for calculating the weighted WACC.

WACC is calculated as

WACC = E/V* Re + D/V*Rd*(1-Tc)

Where:

Re = cost of equity

Rd = cost of debt

E = Book value of the firm's equity

D = Book value of the firm's debt

V = E + D = total book value of the firm’s capital

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Tc = corporate tax rate

Cost of equity of FLIR Systems Commercial company

The cost of equity for FLIR is calculated using the CAPM model in which we have the taken the beta, risk free return and an assumed market risk premium of 8%.

The cost of equity using the dividend discount model is calculated as below

Risk free return + beta * market risk premium

3.24% + 0.59*8%

= 7.96%

Cost of debt of FLIR Systems Commercial company

After this we have calculated the cost of debt using the debt figure given in the financial statement of the company. As per that the company has debt outstanding with annual coupon of 3.125% and market value of $421 million.

The cost of debt would be equal to the YTM of the bond outstanding, which can equate the present value of the future payment on the bond equal to the market price of the bond. Therefore using this equation we have calculated the YTM of the bond at 3.125%.

As at this YTM the present value of the future cash flows from the bond is equal to the current market price of the bond.

Also the interest on the debt is tax deductible; therefore we have to take the tax adjusted cost of debt. The average tax rate is calculated as the tax rate paid by the company in its latest financial statement and using the equation

Income tax expense/Pre-tax income

The company average tax rate is approximately 13.7%.

Post tax cost of debt = 3.125%* ( 1- 13.7%) = 2.70%

Therefore after calculating all the cost we can calculate the WACC of the company as given below

As the proportion of equity is higher, therefore the WACC is very close to the cost of equity.

Net Present Value (NPV), Internal Rate of Returns (IRR), Payback Period (PP), MIRR and Profitability index

After the WACC we need to analyze the project cash flows and assess the viability of the project with the project WACC.  For any project to be acceptable the project cash flows need to generate positive NPV and an IRR higher than the WACC and the discounted payback period should be less than the project life so that the project cash flows are recovered well before the project ends.

The project cash flows are as given below

Analysis of FLIR Systems Commercial company

As per the calculation above the project has NPV of ($1997) with the existing capital structure and NPV of ($694) with the target capital structure and in both the cases the IRR and MIRR are lower than the WACC calculated.

However all the method being chosen above has certain drawbacks also, like NPV is based on certain assumptions which include the discount rate, initial investment, sale and cost estimates. Therefore management should spend considerable time in estimating these variables and the future cash flows. Similarly the IRR is based on the assumption that the future cash flows are reinvested at the IRR of the project, which is not possible in certain cases and therefore may be change in the future reinvestment rate and therefore the project IRR will be lower than the estimated IRR. Similarly the payback period doesn’t consider the cash flow beyond the payback period and doesn’t tell about the profitability of the project and how much cash flow will be available after the payback period.

Conclusion of FLIR Systems Commercial company

Based on all above analysis, projected cash flow of the project, we believe that the management should not take this project as it has negative NPV ad lower IRR and this project will not add any value to the company shareholders.