Professional Documents
Culture Documents
Cap Bud Prob Sol
Cap Bud Prob Sol
1. A company is considering a project that requires an initial investment of $24M to build a new
plant and purchase equipment. The investment will be depreciated as a MACRS 7-year class
(see p. 21 in the text) asset. The new plant will be built on some of the company's land
which has a current, after-tax market value of $4.3M. The company will produce units at a
cost of $130 each and will sell them for $420 each. There are annual fixed costs of $0.5M.
Unit sales are expected to be 150,000 each year for the next 6 years, at which time the project
will be abandoned. At that time, the plant and equipment is expected to be worth $8M
(before tax) and the land is expected to be worth $5.4M (after tax). To supplement the
production process, the company will need to purchase $1M worth of inventory. That
inventory will be depleted during the final year of the project. The company has $100M of
debt outstanding with a yield-to-maturity of 8%, and has $150M of equity outstanding with a
beta of 0.9. The expected market return is 13% and the risk-free rate is 5%. The company's
marginal tax rate is 40%. Should the project be accepted?
Solution
WACC:
wd = $100M / $250M = 0.4
kd = 8%
ws = $150M / $250M = 0.6
ks = 5% + 0.9(13% - 5%) = 12.2%
WACC = 0.48%(1-0.4) + 0.612.2% = 9.24%
Capital Expenditure:
-$24M at date 0
NPV = -29.3 + 27.172/ 1.0924 + … + 39.141/1.09246 = $99.37M > 0, so accept the project.
Solution
WACC:
wd = 0
ws = $150 / ($150 + $50) = 0.75
ks = 14.4%
wps = $50 / ($150 + $50) = 0.25
kps = D1/P0 = $2 / $20 = 10%
Capital Expenditure:
-$10.4M at date 0
Change in NWC:
$0
Solution
Capital Expenditure:
-$10M at date 0
IRR: 1.03
reject the project
4. As the director of a firm's capital budgeting department, you have been asked to evaluate a
project. After collecting information from various sources, you have determined the
following. The firm's preferred stock pays a constant annual dividend of $2.25 and is
currently selling for $20. The firm is expected to pay a common stock dividend of $3 in one
year, with anticipated growth of 2% each year thereafter. Currently, the common stock is
selling at a price of $23.75. The firm has 8 year bonds outstanding with a coupon rate of
8.75%, paid annually. The bonds are currently selling at par. The firm is currently being
financed with $10,000,000 of debt, $20,000,000 of common equity, and $5,000,000 of
preferred stock. The project requires the use of equipment valued at $6,200,000. The
equipment currently has a book value of $3,000,000 with two years of straight-line
depreciation (to zero) remaining ($1,500,000 each year). You anticipate that the equipment
can be sold in three years for $2,100,000. Anticipated sales are 1,000,000 units per year
based on a sale price of $11 per unit. The cost of producing each unit is $8.50. If the project
is accepted, the firm will need to hire an additional manager with an annual salary of
$80,000. The product complements another of the firm's products. As a result, you
anticipate increased sales of $700,000 per year for that product. Total research (information
gathering for project analysis) expenses to date are $26,000. If the project is accepted, the
firm will have to forego another project that has a NPV of $584,000. The firm's marginal tax
rate is 40%. Should the project be accepted?
Solution
Notice that the $26,000 research expense does not appear. It is a sunk cost and
therefore should not affect our analysis.
Normally, we would accept the project, but doing so would result in us giving up a
$0.584M project (a net loss of $0.316M). We therefore must reject the project.
5. A company is considering two projects and can only accept one of them. The projected cash
flows are as follows:
The company's WACC is 10%. Compute the payback, NPV, and IRR for each project.
Which project should be chosen? Explain the logic behind your choice.
Solution
The choice is a judgement call. The NPVs are very close, but the IRR for A is a good bit
higher than the IRR for B. Because we might have errors in our projections, I would
tend to favor project A.