The Capital Budgeting Projects She must choose one of the four capital budgeting
ID: 2798721 • Letter: T
Question
The Capital Budgeting Projects
She must choose one of the four capital budgeting projects listed below:
Table 1
t
A
B
C
D
0
(16,000,000)
(20,000,000)
(19,000,000)
(18,000,000)
1
5,500,000
7,000,000
8,200,000
9,000,000
2
5,500,000
8,000,000
8,200,000
7,000,000
3
7,000,000
8,000,000
5,200,000
6,000,000
4
7,000,000
1,000,000
5,200,000
5,000,000
Risk
Low
Average
High
Average
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.
(1)The firm’s tax rate is 30%.
(2) Great Wall Co. has issued a 13% semi-annual coupon bond with 10 years term to maturity. The current trading price is $1,206.
(3) The firm has issued some preferred stock which pays an annual 9% dividend of $100 par value, and the current market price is $110.
(4) The firm’s stock is currently selling for $68 per share. Its last dividend (D0) was $4, and dividends are expected to grow at a constant rate of 8%. The current risk free return offered by Treasury security is 2.5%, and the market portfolio’s return is 10.5%. Great Wall Co. has a beta of 1.5.
(5) The firm adjusts its project WACC for risk by adding 2.5% to the overall WACC for high-risk projects and subtracting 2.5% 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?
t
A
B
C
D
0
(16,000,000)
(20,000,000)
(19,000,000)
(18,000,000)
1
5,500,000
7,000,000
8,200,000
9,000,000
2
5,500,000
8,000,000
8,200,000
7,000,000
3
7,000,000
8,000,000
5,200,000
6,000,000
4
7,000,000
1,000,000
5,200,000
5,000,000
Risk
Low
Average
High
Average
Explanation / Answer
1 Face value (FV) $ 1,000 2 Coupon rate 13.00% 3 Number of compounding periods per year 2 1*2/3 Interest per period (PMT) $ 65.00 Bond price (PV) $ (1,206) 4 Number of years to maturity 10 5 = 4*3 Number of compounding periods till maturity (NPER) 20 Bond yield to maturity RATE(NPER,PMT,PV,FV)*2 Bond yield to maturity 9.73% (Pre-tax cost of debt) Bond yield to maturity 6.81% (After-tax cost of debt) 9.73%*(1-30%)