Question

A thumbs Up will be Given:

1.Can you respond to question #5,8,9,10,11 they are written responses

2. Show work for the answers in Table 2

Also below assignment, is the answers for the first half to see the work

Max was recently hired by Imagine Software Inc. as a junior budget analyst. He is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate. He must give his analysis and recommendation to the capital budgeting committee.

Max has a B.S. in accounting from CWU (2015) and passed the CPA exam (2017). He has been in public accounting for several years. During that time he earned an MBA from Seattle U. He would like to be the CFO of a company someday--maybe Imagine Software Inc. -- and this is an opportunity to get onto that career track and to prove his ability.

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

Here is the information that Max has accumulated so far:

The Capital Budgeting Projects

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

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?

Pre-tax cost = 9.236576475%

After-tax cost = 5.541945885%

2. What is the cost of preferred stock for Imagine Software Inc.?

Cost of preferred stock = 9.042553191%

3. Cost of common equity

1. What is the estimated cost of common equity using the CAPM approach?

Cost of common equity using the CAPM approach = 11.725%

2. What is the estimated cost of common equity using the DCF approach?

Cost of common equity using the DCF approach = 11.43464052%

(3) What is the estimated cost of common equity using the bond-yield-plus-risk-premium approach?

Cost of common equity using the bond-yield-plus-risk-premium approach = 12.03657647%

(4) What is the final estimate for r_s?

Final estimate for r=11.73207233%

4. What is Imagine Software Inc.’s overall WACC?

Overall WACC =9.16%

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

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

7. Calculate all relevant capital budgeting measures for each project, and place your numerical solutions in Table 2.

Table 2

	A	B	C	D
WACC	11.1600%	9.1600%	7.1600%	9.1600%
NPV	($137,149.89)	$837,262.71	$650,552.53	$924,143.02
IRR	10.67%	11.55%	8.91%	11.45%
MIRR	10.87%	10.53%	8.27%	10.53%

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

9. Which of the projects are unacceptable and why?

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

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

    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%

Answer 1

Q5. Do you think the firm should use the single overall WACC as the hurdle rate for each of its projects? Explain.

A. Hurdle rate is the minimum rate that a company wants to earn in a project. Though in accounting, WACC is mostly used as a Hurdle rate, i.e., expected return to the capital bearers of the company. But here, for the company Software Inc.WACC should not be used as a Hurdle rate because of the different risk phenomenons associated with each project. That's why that company has given additional 2 % to high risk project and subtracted -2% for low risk projects.

Hurdle rate should also consider risk premium, inflation and interest rates as other factors which WACC does not include.

Q8. Commonly used capital budgeting measures and their ranking conflicts

A. Capital budgeting measures

1. Payback Period. It calculates the time periods to recover the investment made in the project. The period is generally estimated in years and gives an estimate is investment recovering time.

2. Net present value. It is the difference between the cost of project and present value of expected cash flows from the project to bring in.it determines the worthwhile of the money today in present over the future.

3. Internal rate of return. This calculates the return rate at which the investment breaks in. The project whose IRR is higher than the cost of capital is taken into consideration.it is directly related to the profitability of the project.

4. Profitability index. It examines the relationship between cost of project and expected return from it. PI less than 1 indicates lower present value of future revenue than cost of initial investment thereby not worth considering.

Ranking conflicts

The payback method and PI method does not convert the future cash flows into its present value however IRR and NPV does assuming can flows arising from the project can be reinvested at some rate. However NPV and IRR may also give conflicting results because of ft do d us were different cash flow pattern from the project.

Q9. The best criteria is NPV as it can handle multiple discount rates for each year's cash flow respectively without any fuss. It clearly determines that the project will or will not add value to the company.though IRR is also considered as it gives percentage of expected return t from the project.

Q10. Project A it's totally unacceptable because of negative NPV value and its WACC is higher than IRR i.e., more cost for low return.while other projects B, C, AND D have favorable higher return over the investment.

Q11. Max's choice of criteria is MIRR i.e., modified internal rate of return

According to MIRR technique, project D should be favored most as it has higher IRR, MIRR and more NPV value then project B for higher returns and then project C for slightly higher return over the investment made