Question

Emma was recently hired by Greenpower 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 Emma has a B.S. in accounting from CWU (2015) and passed the CPA exam (2017). She has been in public accounting for several years. During that time she earned an MBA from Seattle U. She would like to be the CFO of a company someday--maybe Greenpower Ltd.-- and this is an opportunity to get onto that career track and to prove her ability As Emma 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 Emma has accumulated so far: The Capital Budgeting Projects She must choose one of the four capital budgeting projects listed below Table 1 A C (17.500,000) (17,900,000 (14,850,000) (16,600,000) 4,500,000 4,500,000 5,660.000 4,680,000 4,500,000 5,560,000 5.660,000 6,780,000 S,820,000 5,200,000 5,200,000 5,900,000 6,800,000 6,500,000 4.600,000 5,800,000 Risk High Average Average 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 Greenpower Ltd. has the following capital structure, which is considered to be optimal: Debt 30% Preferred Equity 10% Common Equity 60% 100% Cost of Capital Emma 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) Greenpower Ltd. has issued a 12% semi-annual coupon bond with 15 years term to maturity. The current trading price is $1,105 (3) The firm has issued some preferred stock which pays an annual 10.5% dividend of S100 par value, and the current market price is $102. (4) The firm's stock is currently selling for $54 per share. Its last dividend (D) was $2.80, and dividends are expected to grow at a constant rate of 7%. The current risk free return offered by Treasury security is 2.5%, and the market portfolio's returm is 10.40%. Greenpower Ltd. has a beta of 1.3. For the bond-yield- plus-risk-premium approach, the firm uses a risk premium of 2.5% (5) The firm adjusts its project WACC for risk by adding 2.0% to the overall WACC for high-risk projects and subtracting 2.1% for low-risk projects Emma knows that Greenpower 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, Emma must finish the analysis and write her report. To help begin, she has formulated the following questions: 1. What is the firm's cost of debt? 2. What is the cost of preferred stock for Greenpower Ltd.? 3. 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? 1. What is the firm's cost of debt? 2. What is the cost of preferred stock for Greenpower Ltd.? 3. 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? 4. What is Greenpower Ltd.'s overall WACC? 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 ABCD WACC NPV IRR MIRR 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 Emma's criterion of choice. 11. Which project should Emma recommend and why? Explain why cach of the projects not chosen was rejected.

Answer 1

Greenpower Ltd.

1.The firm's after-tax cost of debt

Current trading price of the bond=Present Value of all its future coupons+Present Value of the face value to be received at maturity

ie.Price/PV=(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where, Current price is given as $ 1105

Pmt.=Semi-annual $ coupon payments,ie. 1000*12%/2= $ 60

r=   ? --Effective cost to the company to be found out

n=No.of semi-annual coupon pmts. Still to maturity, ie. 15 yrs*2= 30

FV=Face value of the bond= $ 1000

Withthese inputs, we find the before-tax cost as:

1105=(60*(1-(1+r)^-30)/r)+(1000/(1+r)^30)

Solving for r, we get the before-tax semi-annual cost as

5.294%

Annual cost of debt=(1+5.294%)^2-1=10.868%

The after-tax annual cost of debt =BTY*(1-Tax rate)

ie. 10.868%*(1-35%)=

7.06%

2.Cost of Preferred stock

k(ps)=$ annual dividend/Current market price

ie.(10.5%*100)/102=

10.29%

3. Cost of common Equity

Using

i. CAPM approach:

Cost of Equity=RFR+(Beta*Market risk premium)

where, Market Risk Premium=Market return-RFR

ie. Ke=2.5%+(1.3*(10.40%-2.5%))=

12.77%

ii. DCF approach:

Ke=(D1/P0)+g

where D1=D0*(1+g)

ie.Ke=((2.80*(1+7%))/54)+7%

12.55%

iii. Bond-Yield+Risk premium approach:

Ke=Bond Yield as in 1+Equity risk premium

ie. 7.06%+2.5%=

0.0956

4. Final estimate of Cost of equity

is an average of i,ii, &iii in 3 above

ie.((12.77%+12.55%+9.56%))/3=

11.63%

Green power's Overall WACC

WACC= (Wt.d*kd)+(Wt.ps*Kps)+(Wt.eq.*Keq.)

ie.(30%*7.06%)+(10%*10.29%)+(60%*11.63%)=

10.13%

5. NO.

It is logical that cash flows of projects with high risk are discounted at higher WACC than those with comparatively low risk

It is better to have differential rates of WACC , to have a true/more accurate picture of the PVs of the expected cash flows

6&7
Year	A	B	C	D
0	-14850000	-17500000	-16600000	-17900000
1	4500000	4500000	5660000	4680000
2	4500000	5560000	5660000	6780000
3	5200000	5820000	5200000	5900000
4	6800000	6500000	4600000	5800000
Risk	High	Average	Average	Low
Overall WACC	11.63%	11.63%	11.63%	11.63%
Adj. Factor	2.00%	0	0	-2.10%
Risk adj.WACC for each	13.63%	11.63%	11.63%	9.53%
PV of cash flows(yr.1-4)	15068504	16862801	16312917	18444278
NPV(netted with initial inv.)	218504	-637199	-287083	544278
IRR	14.29%	10.00%	10.78%	10.88%
MIRR	14.05%	10.60%	11.14%	10.35%

8. NPV, Pay-back period ,IRR & MIRR are the most commonly used methods to appraise & analyse capital budgeting projects while selecting one among them.

NPV scores over all others because of its more accuracy & inclusion of the cash flow over the entire project-life .

Ranking conflicts arise between these approaches ,mainly because of the difference in magnitude & timing of cash inflows & cash outflows.

10. Ranking as per Emma's criterion (NPV & MIRR)
Ranking (as per NPV)	2	4	3	1
as per MIRR	1	3	2	4

9&11. Emma should recommend Project D for its highest NPV & low risk& also IRR& MIRR>WACC

Project A with next highest NPV is catergorised as a HIGH-risk one & hence to be rejected

Project B& C are to be rejected as they give NEGATIVE NPV s & both IRR&MIRR<WACC

Project -wise Workings for NPV/IRR& MIRR
Year	A	13.63%	PV
0	-14850000	1	-14850000
1	4500000	0.880049283	3960221.8
2	4500000	0.77448674	3485190
3	5200000	0.6815865	3544250
4	6800000	0.599829711	4078842
NPV			218504
IRR			14.29%
MIRR			14.05%
Year	B	11.63%	PV
0	-17500000	1	-17500000
1	4500000	0.895816537	4031174
2	5560000	0.802487268	4461829
3	5820000	0.718881365	4183890
4	6500000	0.643985815	4185908
NPV			-637199
IRR			10.00%
MIRR			10.60%
Year	C	11.63%	PV
0	-16600000	1	-16600000
1	5660000	0.895816537	5070322
2	5660000	0.802487268	4542078
3	5200000	0.718881365	3738183
4	4600000	0.643985815	2962335
NPV			-287083
IRR			10.78%
MIRR			11.14%
Year	D	9.53%	PV
0	-17900000	1	-17900000
1	4680000	0.912991874	4272802
2	6780000	0.833554163	5651497
3	5900000	0.761028177	4490066
4	5800000	0.694812542	4029913
NPV			544278
IRR			10.88%
MIRR			10.35%