Question

Spring 2019 FIN 341 Case Study on Capital Budgeting Hailey just started her first job at Whatcom Co. 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. Hailey has a B.S. in accounting from WWU (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 Whatcom Co. -- and this is an opportunity to get onto that career track and to prove her ability As Hailey 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 Hailey 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 (25,000,000) 7,500,000 7,500,000 7,500,000 (24,600,000) 11,000,000 9,000,000 6,000,000 4,000,000 High (19,000,000) 6,200,000 6,200,000 6,200, 000 (22,000,000) 4,600, 000 1 2 7,600,000 8,800, 000 8,800, 000 3 4 7,500,000 6,200,000 Risk 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 Whatcom Co. has the following capital structure, which is considered to be optimal: Common Equity Preferred Equity 50% 10% 40% Debt 100%

1. What is the firm’s cost of debt?

(Pre tax) Cost of debt, Kd = YTM of the bond = 2 x RATE (Period, PMT, PV, FV) = 2 x RATE (2 x 5, 12%/2 x 1000, -1080, 1000) = 2 x RATE (10, 60, -1080, 1000) = 9.93%

2. What is the cost of preferred stock for Whatcom Co.?

Ks = Annual dividend / Current price = 11% x 100 / 104 = 10.58%

3. Cost of common equity

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

Ke = Rf + Beta x (Rm - Rf) = 2.5% + 1.3 x (10% - 2.5%) = 12.25%

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

Ke = D0 x (1 + g) / P + g = 3 x (1 + 9%) / 94 + 9% = 12.48%

(3) What is the final estimate for cost of equity?

We can take average of the two, Ke = (12.25% + 12.48%) / 2 = 12.36%

4. What is Whatcom Co.’s overall WACC?

WACC = Wd x Kd x (1 - T) + Ws x Ks + We x Ke = 40% x 9.93% x (1 - 40%) + 10% x 10.58% + 50% x 12.36% = 9.62%

Please answer 5-10

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?

7. Calculate all relevant capital budgeting measures for each project and place your numerical solutions in Table 2. Table 2 A B C D NPV IRR

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 Hailey’s criterion of choice.

Answer 1

Answer 5: For Project analysis, each project should have a different hurdle rate, based on the risk involved in the project. Higher Risk is associated with higher expected returns from the capital providers, while lower safer bets are less costly. An average risky project can be assumed to be in line with firms current risky profile, and same WACC may be used.

Answer 6: Determining exact WACC with this information may be difficult, though directionally, we can say

WACC for project A & D = or similar to WACC for Whatcom Co = 9.62%

WACC for project B >> WACC for Whatcom Co= say by an additional risk premium = 9.62+Risk Premium

WACC for project C << WACC for Whatcom Co= say by a low risk discount = 9.62 - Risk Discount

Answer 7:

In Mn
T	0	1	2	3	4	WACC	Risk	NPV	IRR	IRR-WACC
A	(25.0)	7.5	7.5	7.5	7.5	9.62%	Average	($0.94)	7.71%	-1.91%
B	(24.6)	11.0	9.0	6.0	4.0	10.1%	High	$0.02	10.17%	0.05%
C	(19.0)	6.2	6.2	6.2	6.2	9.1%	Low	$0.95	11.58%	2.46%
D	(22.0)	4.6	7.6	8.8	8.8	9.62%	Average	$1.18	12.04%	2.42%
NOTES:
Assumes Risk Premium and Discount of 0.5%
=NPV(rate, Value1, Value2,…)
=IRR(Cash Flow Values…..)

Answer 8: For most part, NPV and IRR are giving similar results in terms of project ranking.

Apparent Rank reversal on projects C and D is due to fact that Project D has higher cash flows in later years, getting discounted at a higher rate vs Project C.

Answer 9: Project A is unacceptable with our current assumptions, as

1. Its having a negative NPV i.e. a value destroying project

2. Projects IRR is also lower than the WACC the hurdle rate for the project.

Answer 10: Given resources are limited, it makes sense to invest in higher NPV project first. If additional funds are available, further projects can be picked in this order.

So project ranking of choice will be - Project D > C > B.

Project A is not a choice at all.