Question

poly comes from two hority. In recent years he managing director de hot VCL should con al Park and Herto of VCL's land ou de d to a recent meeting s of Geoff's only 11 Understanding the advantages and disadvantages of using WACC for project evaluation to Verity Cotton Ltd (VCL) operates a large cotton farm near Bullamakanka. Its water supply com sources: rainfall and an annual allocation from the Bullamakanka Water Supply Authority has been difficult to obtain sufficient water to produce a good crop. Geoff Singh, the mange VCL, has recently received a report from the Bullamakanka Tourism Board suggesting that VCI opening a camping ground to serve visitors to the recently opened Bullamakanka National Parl Site, which is located near the farm. Such a development would take about 10 per cent of VCI cotton production. Geoff prepared an NPV analysis of the proposal, which he presented to go the VCi board of directors. At the meeting, there was some disagreement over two aspects of Geol These aspects were: a) Geoff ignored the fact that 10 per cent of the land would no longer be used for cotton productie directors felt that because 10 per cent of the land would no longer be used to produce cotton, the should include a 10 per cent reduction in the net cash flow expected from cotton production b) In his analysis, Geoff had used an estimate of VCL's cost of capital to discount the forecast t he the camping ground project. However, Geoff noted in his analysis that all of the costs of the project be financed by a bank loan. Some directors argued that, in view of this fact, the appropriate discount to use is the interest rate that the bank would charge. As Hank, one of the directors, explained, 'Since of the shareholders' money will be used in the project, we don't need to reward the shareholders: we need to ensure that the cash flows are sufficient to meet the bank's requirements'. 'rovide the board with your advice on each of the two matters raised in (a) and (b). Hon production. Some cotton, the analysis

Answer 1

a)

The board is absolutely correct in stating the fact that 10 percent of the land would no longer be used for cotton production but it fails to see the fact that in the recent years it has been difficult to obtain sufficient water to produce a good crop meaning the production was not at its full capacity due to lack of water supply. Geoff Singh ignored the 10% percent reduction in land available for production, it must be based on the expectation/analysis that the smaller area now available for production will have sufficient water supply and be able to maintain its current level of production. The board ignored the fact that the current production was not optimum due to lack of water supply.

b)

It is true that all of the costs of the project would be financed by a bank loan, but seeing this entire project separately and using the interest rate as the discount rate is not correct. The reason being that the project is still a part of the company and not a separate entity, the project will be using the company's pre-existing assets (the land, manpower, management, etc) for its operation and will also become the part of future financial statements. The appropriate discount rate should be as such that it takes into consideration how the current capital structure of the company changes after the project is initiated to come up with a new estimate of the cost of capital.