Question

A thumbs up will be given: Table 1 t A B C D 0       (14,900,000)...

A thumbs up will be given:

Table 1

t

A

B

C

D

0

      (14,900,000)

      (17,900,000)

      (16,600,000)

       (19,700,000)

1

         4,980,000

         5,990,000

         3,850,000

          6,400,000

2

         4,980,000

         6,210,000

         4,990,000

          5,880,000

3

         4,510,000

         6,250,000

         6,860,000

          6,800,000

4

         4,510,000

         4,700,000

         4,990,000

          6,650,000

Risk

High

Average

Low

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

Imagine Software Inc. has the following capital structure, which is considered to be optimal:

Debt  

35%

Preferred Equity

15%

Common Equity

50%

100%

   

Cost of Capital

Max knows that in order to evaluate the projects he will have to determine the cost of capital for each of them. He has been given the following data, which he believes will be relevant to his task.

(1)The firm’s tax rate is 40%.

(2) Imagine Software Inc. has issued a 9% semi-annual coupon bond with 7 years term to maturity. The current trading price is $988.

(3) The firm has issued some preferred stock which pays an annual 8.5% dividend of $100 par value, and the current market price is $94.

(4) The firm’s stock is currently selling for $76.5 per share. Its last dividend (D0) was $2.80, and dividends are expected to grow at a constant rate of 7.5%. The current risk free return offered by Treasury security is 3.1%, and the market portfolio’s return is 10%. Imagine Software Inc. has a beta of 1.25. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 2.8%.

(5) The firm adjusts its project WACC for risk by adding 2% to the overall WACC for high-risk projects and subtracting 2% for low-risk projects.

Max knows that Imagine Software Inc. executives have favored IRR in the past for making their capital budgeting decisions. His professor at Seattle U. said NPV was better than IRR. His textbook says that MIRR is also better than IRR. He is the new kid on the block and must be prepared to defend his recommendations.

First, however, Max must finish the analysis and write his report. To help begin, he has formulated the following questions:

  1. What is the firm’s cost of debt?
  1. What is the cost of preferred stock for Imagine Software Inc.?
  1. 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 estimated cost of common equity using the bond-yield-plus-risk-premium approach?

(4) What is the final estimate for rs?

  1. What is Imagine Software Inc.’s overall WACC?
  1. Do you think the firm should use the single overall WACC as the hurdle rate for each of its projects? Explain.
  1. What is the WACC for each project? Place your numerical solutions in Table 2.
  1. Calculate all relevant capital budgeting measures for each project, and place your numerical solutions in Table 2.

Table 2

A

B

C

D

WACC

NPV

IRR

MIRR
  1. Comment on the commonly used capital budgeting measures. What is the underlying cause of ranking conflicts? Which criterion is the best one, and why?
  1. Which of the projects are unacceptable and why?
  1. Rank the projects that are acceptable, according to Max’s criterion of choice.
  1. Which project should Max recommend and why? Explain why each of the projects not chosen was rejected.

Instructions:

Questions 5, 8, 9, and 11 are discussion questions, Place your numerical solutions in Table 2, show all calculation steps

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Homework Answers

Answer #1

What is the firm’s cost of debt?
Pre-tax cost=RATE(7*2,9%*1000/2,-988,1000)*2=9.24%

After-tax cost=RATE(7*2,9%*1000/2,-988,1000)*2*(1-40%)=5.54%

What is the cost of preferred stock for Imagine Software Inc.?
=8.5%*100/94=9.04%

Cost of common equity
(1) What is the estimated cost of common equity using the CAPM approach?
=3.1%+1.25*(10%-3.1%)=11.73%

(2) What is the estimated cost of common equity using the DCF approach?
=2.80*(1+7.5%)/76.5+7.5%=11.43%

(3) What is the estimated cost of common equity using the bond-yield-plus-risk-premium approach?
=RATE(7*2,9%*1000/2,-988,1000)*2+2.8%=12.04%

(4) What is the final estimate for rs?
=(11.73%+11.43%+12.04%)/3=11.73%

What is Imagine Software Inc.’s overall WACC?
=35%*5.54%+15%*9.04%+50%*11.73%=9.16%

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