1. Find the costs (rate of return under current market conditions) of the individual capital components.
\na. Long-term debt:
\nPV = -$874.78, FV = $1,000, PMT = $100, n = 15, i = need to solve for this first
\nKd = i (1-T)
\nKd = i% (1 – .40)
\nKd = i% (.60)
\nKd = 6.94%<\/p>\n
b. Preferred stock:
\nKp = Dp \/ (Pp \u2013 F)
\nKp = Hint: D is *$100 par value times 9%
\nKp = 10.35%<\/p>\n
c. Retained earnings (avg. of CAPM and bond yield + risk premium approaches):
\nCAPM:15.76%
\nKj = Rf + \u00df(Km \u2013 Rf)<\/p>\n
Bond yield = 7.09% (calculated above) + 5% risk premium
\n= 16.56%
\nAverage of two approaches: 15.76 + 16.56 \/ 2 = 16.16%<\/p>\n
d. New common stock:
\nKn = D1 \/ (P0 \u2013 F) + g
\nKn = 17.40%<\/p>\n
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).<\/p>\n
a. Long-term debt:
\nMarket value = # bonds (bond price) = $140,000,000
\nb. Preferred stock:
\nMarket value = # shares (share price) = $9,000,000
\nc. Common equity (retained earnings):
\nMarket value = # shares (share price) = $52,486,800<\/p>\n
Long-term debt
\n52,486,800
\n26.0497%
\nPreferred stock
\n9,000,000
\n4.4668%
\nCommon equity
\n140,000,000
\n69.4835%
\nTotal capital (check figure)
\n$201,486,800
\n100%<\/p>\n
Determining the Marginal Cost of Capital:<\/p>\n
Last year\u2019s sales:
\n225,000,000
\nNet profit margin:<\/p>\n
Net earnings:<\/p>\n
Dividend payout ratio:
\n50%
\nNew retained earnings in year 0:
\n*
\n*The firm also expects $10 million in retained earnings in year 1<\/p>\n
Retained earnings breakpoint:
\nX = Retained earnings \/ % of retained earnings in the capital structure
\nX =
\nWeighted Average Cost of Capital for Financing up to $14 million:<\/p>\n
Cost (aftertax)
\nWeights
\nWeighted Cost
\nDebt
\nKd<\/p>\n
69.4835<\/p>\n
Preferred stock
\nKp<\/p>\n
4.4668<\/p>\n
Retained earnings
\nKe<\/p>\n
26.0497<\/p>\n
Weighted average cost of capital
\nKa<\/p>\n
Weighted Average Cost of Capital for Financing over $14 million:<\/p>\n
Cost (aftertax)
\nWeights
\nWeighted Cost
\nDebt
\nKd<\/p>\n
Preferred stock
\nKp<\/p>\n
New common stock
\nKn<\/p>\n
Weighted average cost of capital
\nKa<\/p>\n
3. Compute the Year 0 investment for Project I.
\n$ (equipment) + $ (installation) + $ (AR\/Inventory \u2013 Working capital) =<\/p>\n
Year 0 Investment = $15,000,000 + $2,000,000 + $4,000,000
\nYear 0 Investment = $21,000,000<\/p>\n
4. Compute the annual operating cash flows for years 1-6 of the project.
\nAnnual depreciation expense:
\nYear
\nDepreciation Base
\nPercentage Depreciation
\nAnnual Depreciation
\n1
\n$17,000,000*
\n.2
\n3,400,000
\n2
\n17,000,000
\n.32
\n5,400,000
\n3
\n17,000,000
\n.192
\n3,264,000
\n4
\n17,000,000
\n.115
\n1,955,000
\n5
\n17,000,000
\n.115
\n1,955,000
\n6
\n17,000,000
\n.058
\n986,000<\/p>\n
Total Depreciation
\n17,000,000$
\n*MACRS is calculated with the purchase price as the depreciation base (Block et al., 2011).
\nAnnual operating cash flows generated by the project:<\/p>\n
Year 1
\nYear 2
\nYear 3
\nYear 4
\nYear 5
\nYear 6
\nRev
\n$5,000,000
\n$10,000,000
\n$14,000,000
\n$16,000,000
\n$12,000,000
\n$8,000,000
\nFC
\n1,000,000
\n1,000,000
\n1,000,000
\n1,000,000
\n1,000,000
\n1,000,000
\nVC*
\n1,500,000
\n3,000,000
\n4,200,000
\n4,800,000
\n3,600,000
\n2,400,000
\nDepr**
\n3,400,000
\n5,400,000
\n3,264,000
\n1,955,000
\n1,955,000
\n986,000
\nEBT
\n(900,000)
\n560,000
\n5,536,000
\n8,245,000
\n5,445,000
\n3,614,000
\nTaxes\u2021<\/p>\n
224,000
\n2,214,4000
\n3,298,000
\n2,178,000
\n1,445,600
\nEAT
\n(900,000)
\n336,000
\n3,321,600
\n4,947,000
\n3,267,000
\n2,168,400
\n+Depr
\n3,400,000
\n5,400,000
\n3,264,000
\n1,955,000
\n1,955,000
\n986,000
\nCF
\n2,500,000
\n5,776,000
\n6,585,600
\n6,902,000
\n5,222,000
\n3,154,400
\n*Revenues multiplied by 30%
\n**Calculated above
\n\u2021With a 40% tax rate<\/p>\n
5. Compute the additional non-operating cash flow at the end of year 6.
\nPurchase price of equipment: -17,000,000<\/p>\n
Total depreciation to date: 17,000,000<\/p>\n
Book value: $0.00<\/p>\n
Sales price: $4,000,000<\/p>\n
Gain on sale:<\/p>\n
Tax expense (40%): -1,600,000<\/p>\n
Cash inflow from sale: 2,400,000<\/p>\n
Recovery of working capital:<\/p>\n
Total terminal cash inflow: 6,400,000<\/p>\n
*(Hodges, n.d.).<\/p>\n
6. Compute the IRR and payback period for Project I.
\nPayback period:
\nYear
\nCash Inflows
\n1
\n2,500,000
\n2
\n5,776,000
\n3
\n6,585,600
\nTotal
\n14,861,600<\/p>\n
Investment to be recovered: 21,000,000<\/p>\n
Less: Amount recovered by the end of year 3: 14,861,600<\/p>\n
Amount still needed: 6,138,400<\/p>\n
Divided by: Cash flow in year 4: 6,902,000<\/p>\n
Fraction of year 4 needed to recover balance: 3.89<\/p>\n
Payback period: = 3.89<\/p>\n
Internal rate of return:
\nUsing a financial calculator as explained on page 327 of our text:
\nCFo
\n(21,000,000)
\nCFj-1
\n2,500,000
\nCFj-2
\n5,776,000
\nCFj-3
\n6,585,600
\nCFj-4
\n6,902,000
\nCFj-5
\n5,222.000
\nCFj-6*
\n9,554,400
\nIRR
\n15.82%
\n*Operating cash flow of $3,108,000 + Non-operating cash flow of $6,400,000<\/p>\n
7. Determine your firm\u2019s cost of capital (WACC plus an adjustment for the write up).
\nLong term debt 6.94%
\nCommon stock 17.40%
\nPreferred stock 10.35%<\/p>\n
6.94% x 26.0497% + 17.40% x 69.4835% + 10.35% x 4.4668% = 14.36%<\/p>\n
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.<\/p>\n
Using a financial calculator as explained on page 325 of our text:
\nCFo<\/p>\n
CFj-1<\/p>\n
CFj-2<\/p>\n
CFj-3<\/p>\n
CFj-4<\/p>\n
CFj-5<\/p>\n
CFj-6*<\/p>\n
i<\/p>\n
NPV<\/p>\n
CFo<\/p>\n
CFj-1<\/p>\n
CFj-2<\/p>\n
CFj-3<\/p>\n
CFj-4<\/p>\n
CFj-5<\/p>\n
CFj-6*<\/p>\n
i<\/p>\n
NPV<\/p>\n
*Operating cash flow of $3,108,000 + Non-operating cash flow of $6,400,000<\/p>\n
Project I<\/p>\n
9. Indicate which of the other projects (A through E) should be accepted and why.
\nAssuming these projects are not mutually exclusive, the company should accept both Project A and Project B.<\/p>\n
References
\nBlock, B. B., Hirt, G. A., & Danielsen, B. R. (2011). Foundations of financial management (14th ed.). New York, NY: McGraw-Hill\/Irwin.
\nCengage 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
\nHodges, C. W. (n.d.). Relevant capital budgeting cash flows are future. Retrieved from http:\/\/www.westga.edu\/~chodges\/pdf\/capbudhint.pdf<\/p>\n","protected":false},"excerpt":{"rendered":"
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 Read More …<\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[],"tags":[],"class_list":["post-237572","post","type-post","status-publish","format-standard","hentry"],"_links":{"self":[{"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/posts\/237572","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/comments?post=237572"}],"version-history":[{"count":0,"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/posts\/237572\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/media?parent=237572"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/categories?post=237572"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.benedictsol.com\/blogs\/wp-json\/wp\/v2\/tags?post=237572"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}