you must decide which investment project to recommend to the CFO of GCS, Gordon
ID: 2807112 • Letter: Y
Question
you must decide which investment project to recommend to the CFO of GCS, Gordon Brown. In order to make an informed decision, you must take financial risk and capital constraint into account. Select one new project under consideration from Table 6. Compute the required rate of return for the project.
Currently, in the capital budgeting arena, each GCS division has its own method of calculating the cost of capital resulting in different hurdle rates; thus, it leads to non-uniformity with regard to accept/reject decisions on capital investments. GCS feels that in order to maximize shareholder value, it has to come up with company-wide guidelines for calculating its cost of capital and standardize the hurdle rates and accept/reject decisions throughout the company. For the year N+6, GCS is considering the following capital budgeting projects with these projects spread around the globe: Table 6: GCS’s N+6 New Projects Under Consideration Project Net Investment Cost (US$, in millions) Proposed Location Estimated IRR Type of Project 1 $500 Europe 26.3% Existing product, new market 2 $400 USA 13.5% New product, new market 3 $650 Asia 8.6% Expand existing product in existing market 4 $1,500 Asia 23.4% New product, existing market 5 $350 USA 24.6% Replace Equipment 6 $750 Europe 10.2% Expand existing product in existing market 7 $250 Asia 26.7% Existing product, new market 8 $325 Asia 18.8% New product, existing market
Explanation / Answer
Soultion:
Since the company wants to increase share holders value, hence rate of return should be considered as per market value
Using Gordon Model
If using existing funds, then the market value of WACC is 19.47%
Add an allowance for projects without cash inflows 1.00%
add risk premium of 2% to 4% depending on the country and the degree of political risk, exchange rate risk, etc.
Risk types of projects (ROR Based on Market-Value weights)
Type of Project
Degree of Risk
Suggested
Required
Risk
Rate
of
Premium
Return
Routine replacement of equipment
Minimal
0.00%
20.47%
Cost reduction
Low
1.00%
21.47%
Expand existing products in existing markets
Moderate
2.00%
22.47%
Add new products in existing markets
Moderate-High
3.00%
23.47%
Expand existing products in new markets
Moderate-High
5.00%
25.47%
Add new products in new markets
High
6.00%
26.47%
GCS’s N+6 New Projects Under Consideration (ROR Based on Market-Value weights)
Project
Net Investment
Proposed
Estimated
Type of Project
Internatio
Required Rate of
DECISION
Cost (US$, in
Location
IRR
nal Risk
Return (RRR)
millions)
Premium
1
$500
Europe
26.30%
Existing product, new
27.47%
REJECT
market
2%
2
$400
USA
13.50%
New
product, new
26.47%
REJECT
market
0%
3
$650
Asia
8.60%
Expand
existing
25.47%
REJECT
product
in
existing
market
3%
4
$1,500
Asia
23.40%
New product, existing
26.47%
REJECT
market
3%
ACCEPT
5
$350
USA
24.60%
Replace Equipment
0%
20.47%
6
$750
Europe
10.20%
Expand
existing
24.47%
REJECT
product
in
existing
market
2%
7
$250
Asia
26.70%
Existing product, new
28.47%
REJECT
market
3%
8
$325
Asia
18.80%
New product, existing
26.47%
REJECT
market
3%
Finally, company should focus over US market
Type of Project
Degree of Risk
Suggested
Required
Risk
Rate
of
Premium
Return
Routine replacement of equipment
Minimal
0.00%
20.47%
Cost reduction
Low
1.00%
21.47%
Expand existing products in existing markets
Moderate
2.00%
22.47%
Add new products in existing markets
Moderate-High
3.00%
23.47%
Expand existing products in new markets
Moderate-High
5.00%
25.47%
Add new products in new markets
High
6.00%
26.47%
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