Question

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	C	D
0	(14,850,000)	(17,500,000)	(16,600,000)	(17,900,000)
1	4,500,000	4,500,000	5,660,000	4,680,000
2	4,500,000	5,560,000	5,660,000	6,780,000
3	5,200,000	5,820,000	5,200,000	5,900,000
4	6,800,000	6,500,000	4,600,000	5,800,000
Risk	High	Average	Average	Low

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	60%
Preferred Equity	10%
Debt	30%
	100%

Cost of Capital

Hailey knows that in order to evaluate the projects she will have to determine the cost of capital for each of them. She has been given the following data, which he believes will be relevant to her task.

(1) The firm’s tax rate is 35%.

(2) Whatcom Co. has issued a 12% semi-annual coupon bond with 15 years term to maturity. The current trading price is $1105.

(3) The firm has issued some preferred stock which pays an annual 10.5% dividend of $100 par value, and the current market price is $102.

(4) The firm’s stock is currently selling for $54 per share. Its last dividend (D₀) was $2.8, and dividends are expected to grow at a constant rate of 7%. The current risk-free return offered by Treasury security is 2.5%, and the market portfolio’s return is 10.4%. Whatcom Co. has a beta of 1.3

(5) The firm adjusts its project WACC for risk by adding 2% to the overall WACC for high-risk projects and subtracting 2.1% for low-risk projects.

Hailey knows that Whatcom Co. executives have favored IRR in the past for making their capital budgeting decisions. Her professor at Seattle U. said NPV was better than IRR. She is the new kid on the block and must be prepared to defend her recommendations.

First, however, Hailey must finish the analysis and write her report. To help begin, she has formulated the following questions:

1. What is the firm’s cost of debt?

2. What is the firm’s cost of preferred stock?

3. Cost of common equity

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

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

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

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

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

1. Firm's cost of debt = YTM or Pre-tax cost of debt*(1-tax rate)

Pre-tax cost of debt is its YTM or yield to maturity.

We can use financial calculator for calculation of YTM using below key strokes:

Bond pays semi-annual interest. so maturity will be doubled and interest will be half. face value of the bond is $1,000.

N= maturity = 15*2 = 30; PV = present value = -$1105; PMT = interest = $1,000*12%*1/2 = $60; FV = face value = $1,000 > CPT= compute > I/Y = YTM = 5.29%

YTM of 5.29% is semi-annual. We need to convert it to annual as 5.29%*2 = 10.58%.

Firm's cost of debt = 10.58%*(1-0.35) = 10.58%*0.65 = 6.88%

2. cost of Preferred stock = dividend/current stock price = ($100*10.5%)/$102 = $10.5/$102 = 0.1029 or 10.29%

3. 1. CAPM = Risk-free rate + beta of stock*(market portfolio's return - risk free rate) = 2.5% + 1.3*(10.4% - 2.5%) = 2.5% + 1.3*7.9% = 2.5% + 10.27% = 12.77%

3. 2. DCF approach

Required return = [last dividend*(1+growth rate)/current stock price] + growth rate = [$2.8*(1+0.07)/$54] + 0.07 = ($2.996/$54) + 0.07 = 0.0555 + 0.07 = 12.55%

3. 3. Final estimate of cost of equity is average of (12.77% + 12.55%)/2 = 12.66%. we can also take 12.77% if we want to conservatively analyze the projects.

4. Whatcom Co.’s overall WACC = weight of debt*after-tax cost of debt + weight of Preferred stock*cost of Preferred stock + weight of common equity*cost of common equity

WACC = 0.30*6.88% + 0.10*10.29% + 0.60*12.66% = 2.064% + 1.029% + 7.596% = 10.69%