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.

Cengage Learning. (2010). Web extension 12B: The marginal cost of capital and the optimal capital budget. Retrieved from http://academic.cengage.com/resource_uploads/downloads/0324594690_163042.pdf

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

 

 

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