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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
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 + ß(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