Sophia was recently hired by Great Wall Co. as a junior budget analyst. She is w
ID: 1171216 • Letter: S
Question
Sophia was recently hired by Great Wall Co. as a junior budget analyst. She is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate. She must give her analysis and recommendation to the capital budgeting committee.
Sophia has a B.S. in accounting from WWU (2007) and passed the CPA exam (2008). She has been in public accounting for 2 years. During that time she earned an MBA from Seattle U. She would like to be the CFO of a company someday--maybe Great Wall Co. -- and this is an opportunity to get onto that career track and to prove her ability.
As Sophia looks over the financial data collected, she is trying to make sense of it all. She already has the most difficult part of the analysis complete -- the estimation of cash flows. Through some internet research and application of finance theory, she has also determined the firm’s beta.
Here is the information that Sophia has accumulated so far:
The Capital Budgeting Projects
She must choose one of the four capital budgeting projects listed below:
Table 1
t
A
B
C
D
0
(26,000,000)
(23,500,000)
(19,500,000)
(19,920,000)
1
7,500,000
9,900,000
7,700,000
8,500,000
2
7,500,000
8,200,000
7,700,000
7,500,000
3
7,000,000
7,800,000
6,700,000
6,500,000
4
7,000,000
1,200,000
5,200,000
5,500,000
Risk
Low
Average
Average
High
Table 1 shows the expected after-tax operating cash flows for each project. All projects are expected to have a 4-year life. The projects differ in size (the cost of the initial investment), and their cash flow patterns are different. They also differ in risk as indicated in the above table.
The capital budget is $20 million and the projects are mutually exclusive.
Capital Structures
Great Wall Co. has the following capital structure, which is considered to be optimal?
Debt
40%
Preferred Equity
10%
Common Equity
50%
100%
Cost of Capital
Sophia knows that in order to evaluate the projects she will have to determine the cost of capital for each of them. She has been given the following data, which he believes will be relevant to her task.
The firm’s tax rate is 35%.
(2) Great Wall Co. has issued a 11% semi-annual coupon bond with 15 years term to maturity. The current trading price is $1,180.
(3) The firm has issued some preferred stock which pays an annual 9.5% dividend of $100 par value, and the current market price is $115.
(4) The firm’s stock is currently selling for $128 per share. Its last dividend (D0) was $4.5, and dividends are expected to grow at a constant rate of 8.5%. The current risk-free return offered by Treasury security is 3.5%, and the market portfolio’s return is 10.25%. Great Wall Co. has a beta of 1.35
(5) The firm adjusts its project WACC for risk by adding 2.5% to the overall WACC for high-risk projects and subtracting 2.6% for low-risk projects.
Sophia knows that Great Wall Co. executives have favored IRR in the past for making their capital budgeting decisions. Her professor at Seattle U. said NPV was better than IRR. She is the new kid on the block and must be prepared to defend her recommendations.
First, however, Sophia must finish the analysis and write her report. To help begin, she has formulated the following questions:
1. What is the firm’s cost of debt?
2. What is the cost of preferred stock for Great Wall Co.?
3. Cost of common equity
(1) What is the estimated cost of common equity using the CAPM approach?
(2) What is the estimated cost of common equity using the DCF approach?
(3) What is the final estimate for cost of equity?
4. What is Great Wall Co.’s overall WACC?
5. Do you think the firm should use the single overall WACC as the hurdle rate for each of its projects? Explain.
6. What is the WACC for each project?
7. Calculate all relevant capital budgeting measures for each project, and place your numerical solutions in Table 2.
Table 2
A
B
C
D
NPV
IRR
8. Comment on the commonly used capital budgeting measures. What is the underlying cause of ranking conflicts? Which criterion is the best one, and why?
9. Which of the projects are unacceptable and why?
10. Rank the projects that are acceptable, according to Sophia’s criterion of choice.
t
A
B
C
D
0
(26,000,000)
(23,500,000)
(19,500,000)
(19,920,000)
1
7,500,000
9,900,000
7,700,000
8,500,000
2
7,500,000
8,200,000
7,700,000
7,500,000
3
7,000,000
7,800,000
6,700,000
6,500,000
4
7,000,000
1,200,000
5,200,000
5,500,000
Risk
Low
Average
Average
High
Explanation / Answer
1. Cost of debt is calculated by finding the YTM or Required return with the following inputs into the cash flow discounting equation :
a) PV(present value)=-1180, FV(Future value)=1000, PMT(Coupon)=5.5/100*1000=55, N=30------>This gives I/Y or Req return or YTM as 4.4 %semiannually or 8.8% annually.
This YTM or cost of debt= 8.8%
2. Cost of preffered stock is Annual dividend payment/Market price of stock = ((9.5/100)*100)/115=8.26%
3. 1) Using CAPM cost of equity is = Risk free rate + Beta*(Market Return - Risk free rate)
= 3.5 + 1.35*(10.25-3.5)
= 12.6125 %
2) Using DCF ( Gordon growth) we find that Price of stock = Next period dividend/(Cost of Equity - Growth rate)
128 = 4.5*(1.085)/(R-.085)
Solving for R, we get R= 12.31 %= Cost of Equity
3) Sophia can use either of the results from CAPM and DCF for the cost of equity since they differ slightly. To be more conservative she could use the higher cost of equity ie 12.6 % (Although CAPM has been found to be more accurate as per historical figures.)
4) The overall WACC ( irrespective of risk)= (weight of debt)*Cost of debt *(1-Tax) +(weight of equity)* Cost of Equity + (weight of prefferd equity)* Cost of preffered equity
= 0.4*8.8%*(1-35% ) + 0.5*12.6% + 0.1*8.26%
= 2.288% + 6.3% +0.826%
= 9.414%
5) It is appropriate to add a risk factor to accomodate any additional risk that each individual project may pose. Hence each project may have seperate hurdle rates.
6) WACC for average risk project = WACC=9.414%
WACC for low risk Project = WACC- 2.6%
= 9.414%-2.6%
= 6.814%
WACC for high risk project = WACC + 2.5%
= 9.414% + 2.5%
= 11.914 %
7. A B C D
NPV------- -1283275.3 -809916.4 2712969.35 1806615.738
IRR------- 4.58% 7.45% 16.067% 16.496%
8. Commonly used capital budgeting mesaure are NPV (Net Present Value) & IRR (Internal Rate of Return)
The differences between them are as below:
1.)IRR assumes reinvestment at IRR while NPV does this with the WACC measure. Hence there arises inconsistencies with the measures.
2.) Also IRR cannot be compared across projects having different investment size ( initial cash outflows) since the IRR of 10 % on 1 Million dollar amount would be much better than the same 10% IRR on 100K dollars.
3.) NPVs are highly dependent on timing of cash flows where as IRR doesnt assume this and hence in net effect doesnt take into consideration the timing of cash flows ( which is essential for accurate understanding of profitability).
As such it becomes inconclusive to base selection of a project amongst mutually exclusive project based on IRR measures and in such cases one must always go for NPV measure.
9. Thus based on NPV- Projects A & B are unacceptable accounting for their negative NPV.
10. Rank of the acceptable projects ( based on their NPV )are- 1. C
2. D
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