Capital Budgeting

Case Study 3

Wonder Bars

Submitted by

Maha Rasheed

Registration number

(L1F17BBAM0171)

Submitted to

Prof. Esha Tariq

Submission date

11thJan; 2021

Section

(A)
Q1. What is WB’s Capital Structure?

Total equity

Common stock 75 M

Class b stock 10 M

85 M

Price per share X $35

Total equity 2,975 M

Total debt

Bond outstanding 133 M

Bond outstanding 100 M

Short term interest bearing debt 76 132 M

Total Debt: 309 132 M

Total Capital

Total Equity 2978M

Total Debt 309132M

3284132M

Wdebt= debt/ (debt+equity)

 = 309132 million / 3284.132

= 9.4%

Wequity= equity/ (debt + equity)

= 2975million/ 3284.132million

= 90.6%

Q2. What is WB’s Before – Tax Cost of long term Debt?

Before tax cost of debt for first Bond

= 8.25% x $133 million = $10,972,500

After tax cost of debt: i x (1- tax*)

= 8.25% x (1- 0.3879*) = 0.050498

= $133million x 0.050498

= $6,716,234 before tax cost of debt:

$6,716,234/ (1- 0.3879) = $10,972,445

Q3. What is the firm’s Cost of equity?

Cost of equity = RF + beta x (E (Rm)-Rh).

Beta = 0.95

RF = 12%.

Cost of equity = RF + beta x (E (Rm)-Rh)

=12% + 0.95 * (12.95% – 7%) = 17.6525 %

E(Rm) = Rf + beta* Risk Premium

Risk Premium: Market Rate –Free Rate

=13% - 12%

= 1%

Rh = S&P500- Treasury bill = 12%-5% = 7 %

E (Rm) = 12% + 0.95 x 1% = 12.95 %

Q4. Calculate the cost of Capital for WB.

Cost of total debt:

= (0.05738 + 0.050498 + 0.05019) / 3

= 5.26%

Cost of equity = RF + beta x (E (Rm)-Rh)

=12% + 0.95 * (12.95% – 7%) = 17.6525 %

Cost of Capital

= 17.6525 % + 5.26% = 22.91 %

Q5. If wonder bar uses book value rather than market value to determine its capital
structure, what is the impact of the cost of capital on it budgeting decisions?

The book value is reliable as it is not volatile. Book value is the value of the asset as per the
balance sheet account. For the assets, the value is based on the asset’s original costs. The use of
the Book value instead of the market value will ensure that the budgeting decisions are made as
per the one stipulated on the balance sheet.
Q6. Which is superior, using the book value or the market value of the firm’s capital in the
determination of the cost of capital? Why?

Market Value is considered appropriate because an investor would demand market required rate
of return on the market value of the capital and not on its book value. However, the market value
must be determined and it is critical to analyst since market value has “volatility” Determination
should be based on historical data.

Q7. Wendover apparently believes that WB’s cost of capital can be used as the hurdle rate
required return to evaluate the acquisition of Sonzoni Foods. Under what conditions, if
any, is this appropriate?

In capital budgeting, hurdle rate is the minimum rate that a company expects to earn when
investing in a project. Hence the hurdle rate is also referred to as the company's required rate of
return or target rate. For the acquisition of Sozoni Foods, WB internal rate of return must equal
or exceed the hurdle rate. Wonder Bar can use the cost of capital as the hurdle rate in projects
that are of similar risk. The beta for Sonzoni Food was 0.90. Since it is a similar risk project, the
project can be considered if it will earn better than the cost of capital.

Q8. How can the firm raise $85 million for the acquisition without changing the present
capital structure?

As capital structure encompasses debt and equity so, as not to change the capital structure, debt
and equity should not be touched. Considering the company’s financial position, one way to raise
$85 million is thru working capital reduction. This may be done thru aggressive collection
efforts, reduction in inventory maintained and increasing payables thru negotiation of longer
terms from suppliers. This will help the company in raising the money without changing the
capital structure.

Q9. Assuming an expected net income in 1995 of $182Million, how would you suggest that
the firm finance the acquisition?

This will really depend on the strategy of the management. If the direction of the company is to
aggressively penetrate the market, such that credit terms to customers should be longer and high
inventory levels should be maintained to ensure product availability, we would suggest
additional borrowings to the company. The following are the envisioned benefits to the company
of borrowing:

 The company will establish better track record with its banks.
 The leverage will increase the ROE which may provide a better perception by investors,
thereby providing a good chance of upward movement in the market price of the shares
of the company.
 The net income will be able to absorb the interest expense which will be incurred by the
company.

A combination of these different methods can also be used by the company depending on what
level the company is comfortable with.