Question

Lindsey was recently hired by Swift Ltd. as a junior budget analyst. She is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate. She must give her analysis and recommendation to the capital budgeting committee.

Lindsey has a B.S. in accounting from CWU (2007) and passed the CPA exam (2008). She has been in public accounting for 2 years. During that time she earned an MBA from Seattle U. She would like to be the CFO of a company someday--maybe Swift Ltd.-- and this is an opportunity to get onto that career track and to prove her ability.

As Lindsey looks over the financial data collected, she is trying to make sense of it all. She already has the most difficult part of the analysis complete -- the estimation of cash flows. Through some internet research and application of finance theory, she has also determined the firm’s beta.

Here is the information that Lindsey has accumulated so far:

The Capital Budgeting Projects

She must choose one of the four capital budgeting projects listed below:  

Table 1

t	A	B	C	D
0	(22,500,000)	(24,000,000)	(23,000,000)	(21,000,000)
1	9,600,000	7,700,000	8,200,000	7,500,000
2	9,600,000	8,400,000	8,200,000	6,900,000
3	4,500,000	9,800,000	6,500,000	5,400,000
4	4,500,000	4,900,000	5,900,000	4,500,000
Risk	Average	Average	High	Low

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

Swift Ltd. has the following capital structure, which is considered to be optimal:

Debt	30%
Preferred Equity	15%
Common Equity	55%
	100%

   

Cost of Capital

Lindsey 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 35%.

(2) Swift Ltd. has issued a 8% semi-annual coupon bond with 14 years term to maturity. The current trading price is $960.

(3) The firm has issued some preferred stock which pays an annual 8.5% dividend of $50 par value, and the current market price is $52.

(4) The firm’s stock is currently selling for $35 per share. Its last dividend (D₀) was $2.00, and dividends are expected to grow at a constant rate of 5%. The current risk free return offered by Treasury security is 2.8%, and the market portfolio’s return is 10.80%. Swift Ltd. has a beta of 1.1. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 3.5%.

(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.

Lindsey knows that Swift Ltd. executives have favored IRR in the past for making their capital budgeting decisions. Her professor at Seattle U. said NPV was better than IRR. Her textbook says that MIRR is also better than IRR.   She is the new kid on the block and must be prepared to defend her recommendations.

First, however, Lindsey must finish the analysis and write her report. To help begin, she has formulated the following questions:

What is the firm’s cost of debt?

What is the cost of preferred stock for Swift Ltd.?

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 r_s?

What is Swift Ltd.’s overall WACC?

Do you think the firm should use the single overall WACC as the hurdle rate for each of its projects? Explain.

What is the WACC for each project? Place your numerical solutions in Table 2.

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

Comment on the commonly used capital budgeting measures. What is the underlying cause of ranking conflicts? Which criterion is the best one, and why?

Which of the projects are unacceptable and why?

Rank the projects that are acceptable, according to Lindsey’s criterion of choice.

Which project should Lindsey recommend and why? Explain why each of the projects not chosen was rejected.

Answer 1

Since the question is silent on what to be answered, I Lill be answering first 5 sub parts. ů) firm's Cast of Debt = Coupon Rate (1 - tax rate) =*4(1-0.35) = 2.6%. * 47 has been taken as coupon sate because coubon payments are semi Annual = 4) sobre lü) Cast of preferenced Stock Note: Since nothing is mentioned about time pound of preference Shares we take it as irredemable preference shares! =. Preference Dividend Current market price = 50x8.5% Dividend always taken 52 l at por volui? 28.17% Cast of Common Equity. (11) using CAPM approach - RJ + CRm-R8) B. Rg = Risk free rate Rm = Retwen on market portfolio Bz Beto. - 2.8+(10.8-2.8) 11.640 (17) Cost of Common Equity using DCf Approach. I Do - Dividend of 7 Poice of Equity Stock= Docito) po previous podried Tgz growth kez cost of Equity Keg. con 35 = 2(1+0.05) Obnou ke-0.05 35(Ke-0.05)= 2(1.05) Ke- 0.05= 21/1 ... Continued.

... Continued from i I ke=11%. Cost of common equity using bond yield blus disk bromnom'. Ruski premium = Rm- Rp _ 33.5 (given in the question itself) We will use formula for CA PM = Rp+(Rm-RP) B 228 +3.5x11 = 665% Note :-Since equity & Preference. Duidend are paid after tax, so tax. component has not been taken into account OR | Cost of common equity using bond yield plus susk premium can her calculated as Couben Rate + Riski beemium Refer Note & held bond). . 4.23 +3.52 7.73% Note Assuming par value of bond to be 1000 $ & same should be taken as redemption value ... Yield = Coupon + Redemption - Current Valle Price (n of years). Redemption value t Current Price Lesteretet temi annual & 40+ 1000-960 coubon payment 985.)in yeous, but Sami annud. caubon 1427 28 1ooo +960 = 4.23%