you been asked to make recommendations regarding capital budgeting for IDK, Inc.

Question

                    you been asked to make recommendations regarding capital budgeting for IDK, Inc. Specifically,the company has identified 5 projects that it is considering                     undertaking. The projects are independent ofeach other, and if resources allowed, the company would be willing to undertake all projects. However,due to                     resource constraints, the company is able to undertake, at most, projects with a total initialinvestment of $750,000 or less. Expected betas and annual after                     tax cash flows for these projects are                 

Explanation / Answer

1. Here we have to caluclate Expected return Ke = Krf+Beta*(Km-Krf)

This way you calculate Ke for Each project using its beta.

This Ke will be used for NPV & for comparing with IRR

2. WACC = Wd*Kd*(1-T) + We*Ke

Here we use Gordon Model P0 = D0*(1+g)/(Ks-g)

So Ks = D0*(1+g)/P0 + g = 2*(1+6%)/25 + 6% = 14.48%

Debt : Let bond Face value = FV = 1000

CUrrent Bond yield is 9% = Rate

Coupon = 8%*1000 = 80

No of period = 10

So current bond price = PV(Rate,nper,pmt,fv)

= PV(9%,10,80,1000)

= -$936

So Current Bond Value is 93.6% of Face value = 93.6%*50M = $46.80M

Current Value of Stock = $25*3M = $75M

So Total Mkt value = D+E = 46.80+75 = $121.80M

So Wd = 46.80/$121.80 = 38.42%

& We = 75/$121.80 = 61.58%

So WACC = 9%*(1-40%)*38.42% + 14.48%*61.58%

ie WACC = 11%

Now find MIRR as below using Excel MIRR(CFs,Fin rate,Reinvrate)

MIRR for Proj E = MIRR(-275000,90000,95000,105000,105000,85000,11%,11%)

= 16.8%

& so on.

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