Problem Set 8 Delta Corporation has the following capital structure: Cost (after
ID: 1169926 • Letter: P
Question
Problem Set 8
Delta Corporation has the following capital structure:
Cost (after tax)
Weights
Weighted Cost
Debt
9.1%
60%
Preferred stock
10.6%
5%
Common equity (retained earnings)
11.1%
35%
Weighted Average Cost of Capital
Calculate the weighted average cost of capital (WACC) and use it for the cost of capital interest rate for the rest of this problem. In other words, the WACC becomes the discount rate for the net present value calculations.
Assume Delta has three different (mutually exclusive) projects that are being considered. Listed below are the cash flows for the projects.
Project 1
Project 2
Project 3
Initial investment
$50,000
Initial Investment
$48,000
Initial Investment
$62,000
Cash Flow Year 1
$10,000
Cash Flow Year 1
$32,000
Cash Flow Year 1
$15,000
Cash Flow Year 2
$30,000
Cash Flow Year 2
$30,000
Cash Flow Year 2
$15,000
Cash Flow Year 3
$22,000
Cash Flow Year 3
0
Cash Flow Year 3
$15,000
Cash Flow Year 4
$8,000
Cash Flow Year 4
0
Cash Flow Year 4
$15,000
Cash Flow Year 5
$6,000
Cash Flow Year 5
0
Cash Flow Year 5
$2,000
For each of the projects shown above, calculate the Payback Period, Internal Rate of Return (IRR), and Net Present Value (NPV). Make a table in APA format and label it Table 1. In this table show the three projects and the values for payback period, IRR, and NPV. Write a one paragraph explanation of which projects Delta management should choose and why. Explain whether the different calculation methods give you different results on which project(s) should be chosen and why.
*List for years 0-5 for the payback period, IRR and the NPV, Label each clearly.
Cost (after tax)
Weights
Weighted Cost
Debt
9.1%
60%
Preferred stock
10.6%
5%
Common equity (retained earnings)
11.1%
35%
Weighted Average Cost of Capital
Explanation / Answer
Weights
Weighted Cost
Cost (after tax)
Debt
9.10%
60%
5.4600%
Preferred stock
10.60%
5%
0.5300%
Common equity (retained earnings)
11.10%
35%
3.8850%
Weighted Average Cost of Capital
Sum of weight*cost
9.8750%
Project 1
Project 2
Project 3
Year
cash flow
present value of cash flow = cash flow/(1+r)^n r= 9.88%
Year
cash flow
present value of cash flow = cash flow/(1+r)^n r= 9.88%
Year
cash flow
present value of cash flow = cash flow/(1+r)^n r= 9.88%
0
($50,000)
($50,000)
0
($48,000)
($48,000)
0
($62,000)
($62,000)
1
$10,000
$9,100.84
1
$32,000
$29,122.68
1
$15,000
$13,651.26
2
$30,000
$24,847.57
2
$30,000
$24,847.57
2
$15,000
$12,423.79
3
$22,000
$16,583.14
3
$0
$0.00
3
$15,000
$11,306.69
4
$8,000
$5,488.02
4
$0
$0.00
4
$15,000
$10,290.03
5
$6,000
$3,745.92
5
$0
$0.00
5
$2,000
$1,248.64
NPV
sum of present value of cash flow
$9,765
NPV
sum of present value of cash flow
$5,970
NPV
sum of present value of cash flow
($13,080)
IRR
Using IRR function in MS excel =irr(-50000,10000,30000,22000,8000,6000)
18.15%
IRR
Using IRR function in MS excel =irr(-48000,32000,30000,0,0,0)
19.13%
IRR
Using IRR function in MS excel =irr(-62000,15000,15000,15000,15000,15000)
0%
Payback period
Payback period
Payback period
Project 1
Project 2
Project 3
Year
cash flow
cumulative cash flow
Year
cash flow
cumulative cash flow
Year
cash flow
cumulative cash flow
0
($50,000)
0
($48,000)
0
($62,000)
1
$10,000
$10,000
1
$32,000
$32,000
1
$15,000
$15,000
2
$30,000
$40,000
2
$30,000
$18,000
Amount to be recovered
2
$15,000
$30,000
Amount to be recovered
3
$22,000
10000
Amount to be recovered
3
$0
3
$15,000
$45,000
4
$8,000
4
$0
4
$15,000
$60,000
5
$6,000
5
$0
5
$2,000
$62,000
payback period
year before the final recovery+(amount to be recovered/cash flow of final year of recovery
2+(10000/22000)
2.45
payback period
year before the final recovery+(amount to be recovered/cash flow of final year of recovery
1+(18000/30000)
1.6
payback period
Entire amount is recovered in year 5 so Payback period is 5 years
Project
1
2
3
NPV
$9,765
$5,970
($13,080)
Project 1
IRR
18.15%
19.13%
0%
Project 2
Payback period
2.45
1.6
5
Project 2
As per different techniques of capital budgeting NPV suggest that Project 1 should be selected while IRR and PB period suggest Project 2 should be selected so in this situation conflict arise so it is better that Project 1 should be consided for selection as it is the best technique of capital budgeting because IRR takes an assumption of reinvestment of cash flow with the same rate equal to irr which in actual world is not possible and payback period ignores the time value of money so in case of mutual exclusive project project 1 should be selected.
Weights
Weighted Cost
Cost (after tax)
Debt
9.10%
60%
5.4600%
Preferred stock
10.60%
5%
0.5300%
Common equity (retained earnings)
11.10%
35%
3.8850%
Weighted Average Cost of Capital
Sum of weight*cost
9.8750%
Project 1
Project 2
Project 3
Year
cash flow
present value of cash flow = cash flow/(1+r)^n r= 9.88%
Year
cash flow
present value of cash flow = cash flow/(1+r)^n r= 9.88%
Year
cash flow
present value of cash flow = cash flow/(1+r)^n r= 9.88%
0
($50,000)
($50,000)
0
($48,000)
($48,000)
0
($62,000)
($62,000)
1
$10,000
$9,100.84
1
$32,000
$29,122.68
1
$15,000
$13,651.26
2
$30,000
$24,847.57
2
$30,000
$24,847.57
2
$15,000
$12,423.79
3
$22,000
$16,583.14
3
$0
$0.00
3
$15,000
$11,306.69
4
$8,000
$5,488.02
4
$0
$0.00
4
$15,000
$10,290.03
5
$6,000
$3,745.92
5
$0
$0.00
5
$2,000
$1,248.64
NPV
sum of present value of cash flow
$9,765
NPV
sum of present value of cash flow
$5,970
NPV
sum of present value of cash flow
($13,080)
IRR
Using IRR function in MS excel =irr(-50000,10000,30000,22000,8000,6000)
18.15%
IRR
Using IRR function in MS excel =irr(-48000,32000,30000,0,0,0)
19.13%
IRR
Using IRR function in MS excel =irr(-62000,15000,15000,15000,15000,15000)
0%
Payback period
Payback period
Payback period
Project 1
Project 2
Project 3
Year
cash flow
cumulative cash flow
Year
cash flow
cumulative cash flow
Year
cash flow
cumulative cash flow
0
($50,000)
0
($48,000)
0
($62,000)
1
$10,000
$10,000
1
$32,000
$32,000
1
$15,000
$15,000
2
$30,000
$40,000
2
$30,000
$18,000
Amount to be recovered
2
$15,000
$30,000
Amount to be recovered
3
$22,000
10000
Amount to be recovered
3
$0
3
$15,000
$45,000
4
$8,000
4
$0
4
$15,000
$60,000
5
$6,000
5
$0
5
$2,000
$62,000
payback period
year before the final recovery+(amount to be recovered/cash flow of final year of recovery
2+(10000/22000)
2.45
payback period
year before the final recovery+(amount to be recovered/cash flow of final year of recovery
1+(18000/30000)
1.6
payback period
Entire amount is recovered in year 5 so Payback period is 5 years
Project
1
2
3
NPV
$9,765
$5,970
($13,080)
Project 1
IRR
18.15%
19.13%
0%
Project 2
Payback period
2.45
1.6
5
Project 2
As per different techniques of capital budgeting NPV suggest that Project 1 should be selected while IRR and PB period suggest Project 2 should be selected so in this situation conflict arise so it is better that Project 1 should be consided for selection as it is the best technique of capital budgeting because IRR takes an assumption of reinvestment of cash flow with the same rate equal to irr which in actual world is not possible and payback period ignores the time value of money so in case of mutual exclusive project project 1 should be selected.
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