# Capital budgeting project | Business & Finance homework help

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1. Find the costs (rate of return under current market conditions) of the individual capital components.

a.       Long-term debt:

PV = -\$874.78, FV = \$1,000, PMT = \$100, n = 15, i = need to solve for this first

Kd = i (1-T)

Kd = i% (1 – .40)

Kd = i% (.60)

Kd = 6.94%

b.      Preferred stock:

Kp = Dp / (Pp – F)

Kp =  Hint: D is *\$100 par value times 9%

Kp = 10.35%

c.       Retained earnings (avg. of CAPM and bond yield + risk premium approaches):

CAPM:15.76%

Kj = Rf + β(Km – Rf)

Bond yield = 7.09% (calculated above) + 5% risk premium

= 16.56%

Average of two approaches: 15.76 + 16.56 / 2 = 16.16%

d.      New common stock:

Kn = D1 / (P0 – F) + g

Kn = 17.40%

2. Compute the value of the long-term elements of the capital structure, and determine the target percentages for the optimal capital structure (based on current market value).

a.       Long-term debt:

Market value = # bonds (bond price) = \$140,000,000

b.      Preferred stock:

Market value = # shares (share price) = \$9,000,000

c.       Common equity (retained earnings):

Market value = # shares (share price) = \$52,486,800

 Long-term debt 52,486,800 26.0497% Preferred stock 9,000,000 4.4668% Common equity 140,000,000 69.4835% Total capital (check figure) \$201,486,800 100%

Determining the Marginal Cost of Capital:

 Last year’s sales: 225,000,000 Net profit margin: Net earnings: Dividend payout ratio: 50% New retained earnings in year 0: *

*The firm also expects \$10 million in retained earnings in year 1

Retained earnings breakpoint:

X = Retained earnings / % of retained earnings in the capital structure

X =

Weighted Average Cost of Capital for Financing up to \$14 million:

 Cost (aftertax) Weights Weighted Cost Debt Kd 69.4835 Preferred stock Kp 4.4668 Retained earnings Ke 26.0497 Weighted average cost of capital Ka

Weighted Average Cost of Capital for Financing over \$14 million:

 Cost (aftertax) Weights Weighted Cost Debt Kd Preferred stock Kp New common stock Kn Weighted average cost of capital Ka

3. Compute the Year 0 investment for Project I.

\$ (equipment) + \$ (installation) + \$ (AR/Inventory – Working capital) =

Year 0 Investment = \$15,000,000 + \$2,000,000 + \$4,000,000

Year 0 Investment = \$21,000,000

4. Compute the annual operating cash flows for years 1-6 of the project.

Annual depreciation expense:

 Year Depreciation Base Percentage Depreciation Annual Depreciation 1 \$17,000,000* .2 3,400,000 2 17,000,000 .32 5,400,000 3 17,000,000 .192 3,264,000 4 17,000,000 .115 1,955,000 5 17,000,000 .115 1,955,000 6 17,000,000 .058 986,000 Total Depreciation 17,000,000\$

*MACRS is calculated with the purchase price as the depreciation base (Block et al., 2011).

Annual operating cash flows generated by the project:

 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Rev \$5,000,000 \$10,000,000 \$14,000,000 \$16,000,000 \$12,000,000 \$8,000,000 FC 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 VC* 1,500,000 3,000,000 4,200,000 4,800,000 3,600,000 2,400,000 Depr** 3,400,000 5,400,000 3,264,000 1,955,000 1,955,000 986,000 EBT (900,000) 560,000 5,536,000 8,245,000 5,445,000 3,614,000 Taxes‡ 224,000 2,214,4000 3,298,000 2,178,000 1,445,600 EAT (900,000) 336,000 3,321,600 4,947,000 3,267,000 2,168,400 +Depr 3,400,000 5,400,000 3,264,000 1,955,000 1,955,000 986,000 CF 2,500,000 5,776,000 6,585,600 6,902,000 5,222,000 3,154,400

*Revenues multiplied by 30%

**Calculated above

‡With a 40% tax rate

5. Compute the additional non-operating cash flow at the end of year 6.

 Purchase price of equipment: -17,000,000 Total depreciation to date: 17,000,000 Book value: \$0.00 Sales price: \$4,000,000 Gain on sale: Tax expense (40%): -1,600,000 Cash inflow from sale: 2,400,000 Recovery of working capital: Total terminal cash inflow: 6,400,000 *(Hodges, n.d.).

6. Compute the IRR and payback period for Project I.

Payback period:

 Year Cash Inflows 1 2,500,000 2 5,776,000 3 6,585,600 Total 14,861,600

 Investment to be recovered: 21,000,000 Less: Amount recovered by the end of year 3: 14,861,600 Amount still needed: 6,138,400 Divided by: Cash flow in year 4: 6,902,000 Fraction of year 4 needed to recover balance: 3.89

Payback period: = 3.89

Internal rate of return:

Using a financial calculator as explained on page 327 of our text:

 CFo (21,000,000) CFj-1 2,500,000 CFj-2 5,776,000 CFj-3 6,585,600 CFj-4 6,902,000 CFj-5 5,222.000 CFj-6* 9,554,400 IRR 15.82%

*Operating cash flow of \$3,108,000 + Non-operating cash flow of \$6,400,000

7. Determine your firm’s cost of capital (WACC plus an adjustment for the write up).

Long term debt 6.94%

Common stock 17.40%

Preferred stock  10.35%

6.94% x 26.0497% + 17.40% x 69.4835% + 10.35% x 4.4668% = 14.36%

8. Compute the NPV for Project I. Should management adopt this project based on your analysis? Explain. Would your answer be different if the project were determined to be of average risk? Explain.

Using a financial calculator as explained on page 325 of our text:

 CFo CFj-1 CFj-2 CFj-3 CFj-4 CFj-5 CFj-6* i NPV

 CFo CFj-1 CFj-2 CFj-3 CFj-4 CFj-5 CFj-6* i NPV

*Operating cash flow of \$3,108,000 + Non-operating cash flow of \$6,400,000

Project I

9. Indicate which of the other projects (A through E) should be accepted and why.

Assuming these projects are not mutually exclusive, the company should accept both Project A and Project B.

References

Block, B. B., Hirt, G. A., & Danielsen, B. R. (2011). Foundations of financial management (14th ed.). New York, NY: McGraw-Hill/Irwin.

Hodges, C. W. (n.d.). Relevant capital budgeting cash flows are future. Retrieved from http://www.westga.edu/~chodges/pdf/capbudhint.pdf

Pages (550 words)
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