Capital Budgeting and the Cost of Capital
Module 3 - CaseCapital Budgeting and the Cost of CapitalAssignment OverviewBefore starting on this assignment, make sure to thoroughly review
the required background materials. Make sure you fully understand both
the basic concepts as well as how to calculate payback period, NPV, IRR,
and WACC. Submit your answers in a Word document. Make sure to show
your work for all quantitative questions and fully explain your answers
using references to the background readings for any conceptual
questions. Questions 1 and 2 will require Excel. Attach an Excel file to
show your computations for Questions 1 and 2. Case AssignmentThe 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
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: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.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 StandHot Dog and Beer StandInitial 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$70,000Suppose 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?Calculate the following: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.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.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%.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? Explain your reasoning, and make references to concepts from
the background readings. Assignment ExpectationsAnswer the assignment questions directly.Stay focused on the precise assignment questions. Do not go off on
tangents or devote a lot of space to summarizing general background
materials.For computational problems, make sure to show your work and explain your steps.For short answer/short essay questions, make sure to reference your
sources of information with both a bibliography and in-text citations.
See the Student Guide to Writing a High-Quality Academic Paper,
including pages 11-14 on in-text citations. Another resource is the
“Writing Style Guide,” which is found under “My Resources” in the TLC
Portal.