CAPITAL BUDGETING AND THE COST OF CAPITAL

1. The table below gives the initial investment and expected cash flows over the next five years for two different projects. Assume that the industry you are in expects a return of 10%, which you use as the discount rate in net present value (NPV) calculations and as the required rate of return for purposes of deciding on projects. Also, assume that management only wants to invest in projects that pay off within four years. For each project, compute the payback period, NPV, and internal rate of return (IRR). Then explain whether each project should be accepted based on these three criteria. Project A Project B Initial Investment $40,000 $28,000 Year Cash Flows 1 $10,000 $10,000 2 $10,000 $13,000 3 $10,000 $5,000 4 $10,000 $5,000 5 $10,000 $6,000 2. Suppose you are planning on becoming a vendor at the arena where your favorite sports team plays. You are trying to decide between opening up a souvenir stand selling T-shirts, caps, etc., with your sports team’s logo or opening up a hot dog and beer stand. It is more expensive to open up the hot dog and beer stand because you need to purchase a license to serve alcohol and you need to spend money to comply with health department regulations. Revenue from the souvenir stand is likely to be unpredictable because fans of your favorite team tend to want to purchase hats and T-shirts only when the team is winning. Revenue from hot dogs and beer seem to be a little more steady since fans want to eat and drink regardless of whether the team is winning.
Below is a table with the initial investment cost of each type of stand and the annual payments you expect over the next five years. The annual payments will be different depending on how well your team does. Therefore, you will estimate how much cash flow you will get depending on whether your team does better than expected (optimistic), the same as the past few years (most likely), and worse than expected (pessimistic). Use a discount rate of 8%. Based on the table below, answer the following items: A. Calculate the net present value (NPV) for each type of stand under each of the three scenarios. Calculate the range of possible NPV values for each type of stand. B. Based on your answer to A) above and your own guesses about how well you think your favorite team will do over the next five years, which type of stand would you rather invest in? Souvenir Stand Hot Dog and Beer Stand Initial Investment $100,000 $150,000 Annual Cash Inflows (5 Years) Outcome Pessimistic $30,000 $50,000 Most likely $50,000 $60,000 Optimistic $70,000 $70,000

3. Suppose you are a corn farmer in your home state. You have to decide between two projects. One project is to purchase new equipment for your farm that will help boost your profits for the next 10 years. You also find out that you can purchase a large banana farm in Brazil for the same price as the equipment, and at the current market price for bananas you will make a lot more profit than you would from purchasing new corn farming equipment.
After asking around, you find out that the standard discount rate for evaluating the NPV of the farming project is 6%. Most farmers in your home state seem to use this rate successfully. However, you don’t know any other banana farmers and you don’t know too much about farming in Brazil, so you have to make a guess on an appropriate discount rate for the Brazilian banana farm. Based on the concepts from the background readings, would you say the Brazilian banana farm will need a lower or higher discount rate? A lot larger or smaller, or only a little? 4. Calculate the following: A. The cost of equity if the risk-free rate is 2%, the market risk premium is 8%, and the beta for the company is 1.3. B. The cost of equity if the company paid a dividend of $2 last year and is expected to grow at a constant rate of 7%. The stock price is currently $40. C. The weighted average cost of capital (WACC) if the company has a total value of $1 million with a market value of its debt at $600,000 and a market value of its equity at $400,000. Its cost of debt is 6% and its cost of equity is 15%. The tax rate it pays is 25%. 5. Suppose you own a chain of dry cleaners and the WACC you’ve been using to make decisions on new purchases of dry cleaning equipment is a steady 9%. Recently, gambling has been made legal in your home town so you decide to expand and open up a casino. Should you use the same WACC to evaluate purchases of casino equipment? Why or why not? What are some alternatives to using the same WACC to make decisions on casino equipment?

 

 

 

Sample Solution

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