Capital Budgeting project

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

K_d = i (1-T)

K_d = i% (1 - .40)

K_d = i% (.60)

K_d = 6.94%

b. Preferred stock:

K_p = D_p / (P_p – F)

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

K_p = 10.35%

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

CAPM:15.76%

K_j = R_f + β(K_m – R_f)

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:

K_n = D₁ / (P₀ – F) + g

K_n = 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	K_d		69.4835
Preferred stock	K_p		4.4668
Retained earnings	K_e		26.0497
Weighted average cost of capital	K_a

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

		Cost (aftertax)	Weights	Weighted Cost
Debt	K_d
Preferred stock	K_p
New common stock	K_n
Weighted average cost of capital	K_a

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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