Trident FIN501 Module 3 (Case+SLP+Discussion) Latest 2019 January Question # 00597742 Subject: Education Due on: 02/05/2019 Posted On: 02/05/2019 12:50 PM Tutorials: 1 Rating: 4.9/5
FIN501 Corporate
Finance
Module 3 Case
CAPITAL BUDGETING AND THE COST OF CAPITAL
Assignment Overview
Before starting on this assignment, make sure to thoroughly
review the required background materials. Make sure you fully understand both
the basic concepts as well as how to calculate payback period, NPV, IRR, and
WACC. Submit your answers in a Word document. Make sure to show your work for
all quantitative questions and fully explain your answers using references to
the background readings for any conceptual questions. Questions 1 and 2 will
require Excel. Attach an Excel file to show your computations for Questions 1
and 2.
Case Assignment
1. The table
below gives the initial investment and expected cash flows over the next five
years for two different projects. Assume that the industry you are in expects a
return of 10%, which you use as the discount rate in net present value (NPV)
calculations and as the required rate of return for purposes of deciding on
projects. Also, assume that management only wants to invest in projects that
pay off within four years.
For each project, compute the payback period, NPV, and
internal rate of return (IRR). Then explain whether each project should be
accepted based on these three criteria.
Project A Project B
Initial Investment $40,000 $28,000
Year Cash Flows
1 $10,000 $10,000
2 $10,000 $13,000
3 $10,000 $5,000
4 $10,000 $5,000
5 $10,000 $6,000
2. Suppose
you are planning on becoming a vendor at the arena where your favorite sports
team plays. You are trying to decide between opening up a souvenir stand
selling T-shirts, caps, etc., with your sports team’s logo or opening up a hot
dog and beer stand. It is more expensive to open up the hot dog and beer stand
because you need to purchase a license to serve alcohol and you need to spend
money to comply with health department regulations. Revenue from the souvenir
stand is likely to be unpredictable because fans of your favorite team tend to
want to purchase hats and T-shirts only when the team is winning. Revenue from
hot dogs and beer seem to be a little more steady since fans want to eat and
drink regardless of whether the team is winning.
Below is a table with the initial investment cost of each
type of stand and the annual payments you expect over the next five years. The
annual payments will be different depending on how well your team does.
Therefore, you will estimate how much cash flow you will get depending on
whether your team does better than expected (optimistic), the same as the past
few years (most likely), and worse than expected (pessimistic). Use a discount
rate of 8%.
Based on the table below, answer the following items:
A. Calculate
the net present value (NPV) for each type of stand under each of the three
scenarios. Calculate the range of possible NPV values for each type of stand.
B. Based on
your answer to A) above and your own guesses about how well you think your
favorite team will do over the next five years, which type of stand would you
rather invest in?
Souvenir Stand Hot Dog and Beer Stand
Initial Investment $100,000 $150,000
Annual Cash Inflows (5 Years)
Outcome
Pessimistic $30,000 $50,000
Most likely $50,000 $60,000
Optimistic $70,000 $70,000
3. Suppose
you are a corn farmer in your home state. You have to decide between two
projects. One project is to purchase new equipment for your farm that will help
boost your profits for the next 10 years. You also find out that you can
purchase a large banana farm in Brazil for the same price as the equipment, and
at the current market price for bananas you will make a lot more profit than
you would from purchasing new corn farming equipment.
After asking around, you find out that the standard discount
rate for evaluating the NPV of the farming project is 6%. Most farmers in your
home state seem to use this rate successfully. However, you don’t know any
other banana farmers and you don’t know too much about farming in Brazil, so
you have to make a guess on an appropriate discount rate for the Brazilian
banana farm. Based on the concepts from the background readings, would you say
the Brazilian banana farm will need a lower or higher discount rate? A lot
larger or smaller, or only a little?
4. Calculate
the following:
A. The cost
of equity if the risk-free rate is 2%, the market risk premium is 8%, and the
beta for the company is 1.3.
B. The cost
of equity if the company paid a dividend of $2 last year and is expected to
grow at a constant rate of 7%. The stock price is currently $40.
C. The
weighted average cost of capital (WACC) if the company has a total value of $1
million with a market value of its debt at $600,000 and a market value of its
equity at $400,000. Its cost of debt is 6% and its cost of equity is 15%. The
tax rate it pays is 25%.
5. Suppose
you own a chain of dry cleaners and the WACC you’ve been using to make
decisions on new purchases of dry cleaning equipment is a steady 9%. Recently,
gambling has been made legal in your home town so you decide to expand and open
up a casino. Should you use the same WACC to evaluate purchases of casino
equipment? Why or why not? What are some alternatives to using the same WACC to
make decisions on casino equipment? Explain your reasoning, and make references
to concepts from the background readings.
Assignment Expectations
• Answer
the assignment questions directly.
• Stay
focused on the precise assignment questions. Do not go off on tangents or
devote a lot of space to summarizing general background materials.
• For
computational problems, make sure to show your work and explain your steps.
• For short
answer/short essay questions, make sure to reference your sources of information
with both a bibliography and in-text citations. See the Student Guide to
Writing a High-Quality Academic Paper, including pages 11-14 on in-text
citations. Another resource is the “Writing Style Guide,” which is found under
“My Resources” in the TLC Portal.
FIN501 Corporate
Finance
Module 3 SLP
CAPITAL BUDGETING AND THE COST OF CAPITAL
For your Module 3 SLP assignment, continue to do research on
the company that you wrote about for Modules 1 and 2. For this assignment, you
will be estimating the weighted average cost of capital (WACC) for your chosen
company. The final calculation will be fairly straightforward, as it involves
just plugging in some numbers into an equation. However, the more challenging
task will be finding the necessary numbers to plug into the formulas. You will
need information such as the beta for your company, the bond-rating, and
various information from its balance sheet. Links to some suggested Web pages
for finding this kind of information is included in the instructions, but you
might be able to find other sources of information. Go step by step and present
your information for Steps 1-4 below in a Word document. Make sure to show all
of your steps one by one and include the sources of your information:
1. Find out
your chosen company’s credit rating. Rating agencies such as Moody’s and
Standard and Poor’s assign ratings to companies. AAA is high, AA is lower, BBB
is even lower, etc. The higher the rating, the lower the cost of debt capital.
Explain what your company’s credit rating is and the reasons for the high or
low rating based on your research. Also, use the Fidelity Fixed Income Web page
to find out what the current return is for a 30-year bond for a corporation
with the rating that your company has. This yield will be the approximate cost
of debt capital for your company. We will call the cost of debt RD.
2. Now
estimate the cost of equity for your company. First you will need the beta; you
already found this for your Module 1 SLP. You will also need the three-month
treasury bill yield, which we will use as our measure of the risk-free rate.
This rate should be listed on the Fidelity Fixed Income Web page linked above.
Finally, you will need the equity risk premium. You can find estimates of this
on many Web pages including Fidelity Fixed Income or Gutenberg Research. It is
usually around 5%. Once you have this information, you can estimate the cost of
equity as the 30-year treasury bill yield rate plus beta multiplied by the
equity premium:
Cost of Equity = risk-free rate + Beta * (Equity Premium).
Show your calculations. We will call the cost of equity RE.
3. Now find
out how much of the firm’s capital is equity and how much is debt. For the
total value, look at the balance sheet for your company as found on Google
Finance or a similar Web page. The total value of your company will be “total
liabilities and shareholder’s equity.” The proportion of debt will be total
liabilities divided by total value, which we will call D/V. The proportion of
equity will be shareholder’s equity divided by total value, or E/V. If you
calculate them correctly, the proportions will add up to one.
4. Now we
have all the information we need to get at least a rough ballpark estimate of
WACC. Let’s assume a corporate tax rate of 35%. So the formula we will use is WACC
= (E/V)* RE +(D/V)* RD *(1-.35)
Calculate WACC and show your computations. As a “reality
check” on your calculations, the WACC should likely be in the single digits and
positive. Compare what you found to the average WACC in your company’s
industry, which should be available on Web pages such as Cost of Capital by
Sector (US). Note that 35% is the official corporate tax rate, but many
corporations find tax breaks. If your WACC is too low, try computing it with a
lower tax rate such as 25% or 10%.
SLP Assignment Expectations
• Answer
the assignment questions directly.
• Stay
focused on the precise assignment questions. Do not go off on tangents or
devote a lot of space to summarizing general background materials.
• For
computational problems, make sure to show your work and explain your steps.
• For short
answer/short essay questions, make sure to reference your sources of
information with both a bibliography and in-text citations. See the Student
Guide to Writing a High-Quality Academic Paper, including pages 11-14 on
in-text citations. Another resource is the “Writing Style Guide,” which is
found under “My Resources” in the TLC Portal.
Finance
Module 3
Discussion
Reading about Net Present Value (NPV) for this module, you
probably thought of it as a technique used only by corporations. But the
technique may also apply to your own purchases.
You may have heard a salesperson tell you, “This product
pays for itself!” While this is probably rare for most products, sometimes
there are future savings from certain products that will offset some of the
costs. For example, if you buy a newer, more reliable, and more fuel-efficient
car, it may save you on repair bills and gas prices compared with your old car.
If you are a coffee connoisseur, buying a $100 espresso machine might save you
money compared with constantly buying $4 drinks at your local Starbucks.
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Think of a purchase you are planning to make or have
recently made. How much did it cost? How much per year do you think you will
save from this purchase, and for how many years will you get these savings?
Estimate the present value of the savings, and subtract the cost of the
product. Note that it is rare that any purchase will “pay for itself” (e.g.,
have a positive NPV). But are the savings enough that the product becomes a lot
“cheaper” and more worthwhile for you to buy?
