Looking for assistance with the questions concerning, marginal cost of capital, retained earnings breakpoint and WACC up to $14M and over $14MChristine D. Withers

BUSN 320

Mid-term Capital Budgeting project

November 8, 2014

 

 

 

 

1. Find the costs (rate of return under current market conditions) of the individual capital components. 

Long-term debt:

PV = -$874.78, FV = $1,000, PMT = $100, n = 15, i = need to solve for this first

Kd = i (1-T)

Kd = i% (1 - .40)

Kd = i% (.60)

Kd = 6.94%

 

Preferred stock:

Kp = Dp / (Pp – F)

Kp =  Hint: D is *$100 par value times 9%

Kp = 10.35%

 

Retained earnings (avg. of CAPM and bond yield + risk premium approaches):

CAPM:15.76%

 Kj = Rf + β(Km – Rf)

 

Bond yield = 7.09% (calculated above) + 5% risk premium

= 16.56%

Average of two approaches: 15.76 + 16.56 / 2 = 16.16%

 

New common stock:

Kn = D1 / (P0 – F) + g

Kn = 17.40%

 

2. Compute the value of the long-term elements of the capital structure, and determine the target percentages for the optimal capital structure (based on current market value). 

 

Long-term debt:

Market value = # bonds (bond price) = $140,000,000

Preferred stock:

Market value = # shares (share price) = $9,000,000

Common equity (retained earnings):

Market value = # shares (share price) = $52,486,800

 

 

Long-term debt 52,486,800 26.0497%   

Preferred stock 9,000,000 4.4668%   

Common equity 140,000,000 69.4835%   

Total capital (check figure) $201,486,800 100%  

 

Determining the Marginal Cost of Capital:

 

 

Last year’s sales: 225,000,000   

Net profit margin:   

Net earnings:   

Dividend payout ratio: 50%   

New retained earnings in year 0: *  

*The firm also expects $10 million in retained earnings in year 1

 

 

Retained earnings breakpoint:

X = Retained earnings / % of retained earnings in the capital structure

X = 

Weighted Average Cost of Capital for Financing up to $14 million:

 

Cost (aftertax) Weights Weighted Cost   

Debt Kd 69.4835   

Preferred stock Kp 4.4668   

Retained earnings Ke 26.0497   

Weighted average cost of capital Ka  

 

 

Weighted Average Cost of Capital for Financing over $14 million:

 

Cost (aftertax) Weights Weighted Cost   

Debt Kd   

Preferred stock Kp   

New common stock Kn   

Weighted average cost of capital Ka  

 

 

 

3. Compute the Year 0 investment for Project I.

$ (equipment) + $ (installation) + $ (AR/Inventory – Working capital) = 

 

Year 0 Investment = $15,000,000 + $2,000,000 + $4,000,000

Year 0 Investment = $21,000,000

 4. Compute the annual operating cash flows for years 1-6 of the project.

Annual depreciation expense:

 

Year Depreciation Base Percentage Depreciation Annual Depreciation   

1 $17,000,000* .2 3,400,000   

2 17,000,000 .32 5,400,000   

3 17,000,000 .192 3,264,000   

4 17,000,000 .115 1,955,000   

5 17,000,000 .115 1,955,000   

6 17,000,000 .058 986,000   

Total Depreciation 17,000,000$  

*MACRS is calculated with the purchase price as the depreciation base (Block et al., 2011).

Annual operating cash flows generated by the project:

 

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6   

Rev $5,000,000 $10,000,000 $14,000,000 $16,000,000 $12,000,000 $8,000,000   

FC 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000   

VC* 1,500,000 3,000,000 4,200,000 4,800,000 3,600,000 2,400,000   

Depr** 3,400,000 5,400,000 3,264,000 1,955,000 1,955,000 986,000   

EBT (900,000) 560,000 5,536,000 8,245,000 5,445,000 3,614,000   

Taxes‡ 224,000 2,214,4000 3,298,000 2,178,000 1,445,600   

EAT (900,000) 336,000 3,321,600 4,947,000 3,267,000 2,168,400   

+Depr 3,400,000 5,400,000 3,264,000 1,955,000 1,955,000 986,000   

CF 2,500,000 5,776,000 6,585,600 6,902,000 5,222,000 3,154,400  

*Revenues multiplied by 30%

**Calculated above

‡With a 40% tax rate

 

5. Compute the additional non-operating cash flow at the end of year 6.

 

Purchase price of equipment: -17,000,000   

Total depreciation to date: 17,000,000   

Book value: $0.00   

Sales price: $4,000,000   

Gain on sale:     

Tax expense (40%): -1,600,000   

Cash inflow from sale: 2,400,000   

Recovery of working capital:   

Total terminal cash inflow: 6,400,000   

*(Hodges, n.d.).  

 

 

6. Compute the IRR and payback period for Project I.

Payback period:

 

Year Cash Inflows   

1 2,500,000   

2 5,776,000   

3 6,585,600   

Total 14,861,600  

 

 

  

Investment to be recovered: 21,000,000   

Less: Amount recovered by the end of year 3: 14,861,600   

Amount still needed: 6,138,400   

Divided by: Cash flow in year 4: 6,902,000   

Fraction of year 4 needed to recover balance: 3.89  

 

Payback period: = 3.89

 

 

Internal rate of return:

Using a financial calculator as explained on page 327 of our text:

 

CFo (21,000,000)   

CFj-1 2,500,000   

CFj-2 5,776,000   

CFj-3 6,585,600   

CFj-4 6,902,000   

CFj-5 5,222.000   

CFj-6* 9,554,400   

IRR 15.82%  

*Operating cash flow of $3,108,000 + Non-operating cash flow of $6,400,000

 

 

7. Determine your firm’s cost of capital (WACC plus an adjustment for the write up).

Long term debt 6.94%

Common stock 17.40%

Preferred stock  10.35%

 

6.94% x 26.0497% + 17.40% x 69.4835% + 10.35% x 4.4668% = 14.36%

 

8. Compute the NPV for Project I. Should management adopt this project based on your analysis? Explain. Would your answer be different if the project were determined to be of average risk? Explain.

 

Using a financial calculator as explained on page 325 of our text:

 

CFo   

CFj-1   

CFj-2   

CFj-3   

CFj-4   

CFj-5   

CFj-6*   

i   

NPV  

 

 

 

  

CFo   

CFj-1   

CFj-2   

CFj-3   

CFj-4   

CFj-5   

CFj-6*   

i   

NPV  

 

*Operating cash flow of $3,108,000 + Non-operating cash flow of $6,400,000

 

 

Project I 

 

 

 

9. Indicate which of the other projects (A through E) should be accepted and why.

Assuming these projects are not mutually exclusive, the company should accept both Project A and Project B. 

 

 

 

 

 

 

 

 

 

References

Block, B. B., Hirt, G. A., & Danielsen, B. R. (2011). Foundations of financial management (14th ed.). New York, NY: McGraw-Hill/Irwin.

Cengage Learning. (2010). Web extension 12B: The marginal cost of capital and the optimal capital budget. Retrieved from http://academic.cengage.com/resource_uploads/downloads/0324594690_163042.pdf

Hodges, C. W. (n.d.). Relevant capital budgeting cash flows are future. Retrieved from http://www.westga.edu/~chodges/pdf/capbudhint.pdf