Your final assignment as a financial management intern is to apply the knowledge that you acquired while engaging in the cost of capital and capital budgeting discussion you had with your colleagues. In this task, you will be evaluating a capital project using the weighted cost of capital for a firm using the market value rather than the book value of the components and the capital budgeting techniques presented in this phase.
First, recalculate the weighted average cost of capital (WACC) using the market value of equity to determine are more realistic cost of capital. You will need to visit a Web site to get the current value of the common stock price per share and multiply this value times the most recent number of shares of common stock outstanding. In this exercise, you will be ignoring preferred stock because its weight value will most likely be too low to impact the final result. You may use the following table to complete this portion of the task:
|
Company |
Common Stock, price per share |
Number of Common Shares Outstanding |
Market Value of Common Equity |
Now, you can estimate the total market value of the company by adding the book value of total liabilities to the market value of the firm’s common equity and determine their market value weights.
|
Company |
Total Liabilities |
Market Value of Common Equity |
Market Value of the Firm |
| Values | |||
| Weights |
Using the cost of each component as determined in the Phase 4 IP, calculate the firm’s market value WACC.
|
After-Tax Cost of Debt |
Cost of Common Equity |
WACC |
|
|
Unweighted Cost |
|||
|
Market Weight of Component |
|||
|
Market Weighted Cost of Component |
The firm is considering investing in a capital project that will have an initial cost of $12 million. The project is expected to have a productive life of 5 years, and at the end of this period, it is expected to have a salvage value of $2 million. The net value of the project will be depreciated using the straight-line method for the full 5 years. The project is expected to increase the firm’s revenue by $10 million per year, and related expenses (not including depreciation) are expected to increase by about $6.5 million per year.
The first thing you need to do is calculate the annual depreciation. Feel free to use the following table:
| Initial Investment | |
| less Salvage Value | |
| Depreciable Value | |
| Life of Project (years) | |
| Depreciation/year |
Now, you need to calculate the relevant cash flows for the project. You can use the average tax rate that was calculated in Phase 4 to determine the additional taxes the firm will have to pay. The following template may be of some assistance to you:
|
Years |
0 |
1 |
2 |
3 |
4 |
5 |
| Initial Investment (negative) | ||||||
| Increase in Revenue | ||||||
| Less Increase in Operating Expenses | ||||||
| Increase in Operating Income | ||||||
| Less Depreciation/year | ||||||
| Taxable Income | ||||||
| Less Taxes at Average Rate | ||||||
| Net Income | ||||||
| Plus Depreciation/year | ||||||
| Operating Cash Flow | ||||||
| Plus Salvage Value (Year 5) | ||||||
| Relevant Cash Flows (0–5) |
At this point, you are ready to apply the capital budgeting techniques of net present value (NPV) and the internal rate of return (IRR). To calculate the NPV, use the market-value WACC as your discount rate and the required rate of return for IRR.
- After completing the required calculations, explain your results in a Word document, and attach the spreadsheet showing your work. Be sure to explain the following:
- Based on your calculations, would you recommend approving or rejecting the project, and why?
- Why would you expect both NPV and IRR to support the same conclusion to accept or reject the project?
- If you employed a cost of capital of 20%, would you have made the same accept or reject decision, and why?
- What are some of the advantages and disadvantages of the 2 methods (NPV and IRR), and under what circumstances is one more reliable over the other?
- Why is operating cash flow used in capital budgeting and not net income?
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