Question

The following questions are conceptual questions on several topics that we have discussed in the course. In answering the questions, be clear and to-the-point. The motivation of your answer determines the grade.

1. Suppose you have to choose between three projects. All involve production technologies that will be repeated at the end of their economic lives. Relevant project information is summarized below. Your supervisor expects a recommendation consistent with shareholder value maximization (his compensation package is linked to the share price of the firm). Which of the projects would you recommend to him, and how can you explain the difference in project rankings between the different capital budgeting criteria? Motivate your answer.
   

Project	T=0	T=1	T=2	T=3	IRR	NPV@10%	EA
A	-$500,000	$250,000	$250,000	$ 200,000	19.7%	$84,147	$33,837
B	-$1,000,000	$500,000	$750,000	-	15.1%	$74,380	$42,857
C	-$1,500,000	$250.000	$750,000	$1,000,000	13.1%	$98,422	$39,577

1. As part of its efforts to stimulate the economy after the crisis, the Obama administration allowed small businesses to immediately write down capital expenditures for tax purposes. The policy is now being reviewed as part of the discussion on corporate tax reform. One of your colleagues argues that this ultimate form of accelerated depreciation is always beneficial to companies. Another colleague argues that this is not necessarily true, but depends on the salvage value of the asset at the time it is sold. In particular, if a firm sells an asset at a price above book value, accelerated depreciation may be less attractive. A third colleague points out that the depreciation method used by a firm is irrelevant, since depreciation is a non-cash expense, and therefore only affects accounting earnings. Please respond to each of these statements. Who do you agree with and how would you assess the attractiveness of the Obama policy? Motivate your answer.
              
2. American Chemical, a large chemical conglomerate, is planning to buy the Paper division of Du Pont. A Stern student doing an internship at the firm has been asked to identify the correct cost of capital of American Chemical after the acquisition and collected the following firm and financial market information. The student established that all firms in the table pay corporate taxes at a 35% rate, and estimated a market risk premium of 6%. The target capital structure for the acquisition is 50% debt. American Chemical’s target capital structure has 40% debt and Du Pont’s Paper division has 30% debt. Describe clearly how the student should proceed in estimating the correct cost of capital. Motivate your input choices, discuss any additional information you would need and show the steps (You can include any formulas you would use)

Answer 1

i.Net present value is the present value of cash flows occuring over the entire life of a project & the cash flows are discounted at the cost of the funds specifically sourced for the project or a weighted average cost of capital to the user.

This measure is the ultimate decider as it gives time value to all the cash flows ,in entirety.

That said,Project A which returns the highest NPV is recommended for selection.

Also it requires the least initial investment of the three.

ii. A. Immdiate full depreciation.

Immediate depreciation of the capital expenditure creates immediate value to the company, in the form of cash outflow towards tax expense saved to the extent of depreciation amount*Tax rate applicable.

It must mean a lot to the small businesses , when part of the cash out-flow towards capital expenses are saved , at the same time assets /major improvements are made paving some way for probable future profits.

Immediate cash is worth its 100% ,rather than its discounted counter-part.

B.Accelerated depn. & salvage value above book value.

In the case of accelerated depreciation,at the time of salvage (esp.when the asset is sold for more than its carrying value),the more depreciated the asset, the less its carrying value,& hence the more the capital gains on its sale which means more income tax expense on the gains.

Hence, the second argument speaks against accelerated depreciation--as the book value reduces fast.

C.The third argument , does not hold any water ,ab initio, as depreciation, even though a non-cash expense, is allowed under all the generally accepted accounting principles, the world over, as chargeable expense, over the period of the useful lives of the assets , so as not to burden a particular year's income statement with any capital expense.

The depreciation charge , does definitely creates cash flow to the company, in the form of reduced tax cash outflow ,to the extent of the depreciation amount charged, ie. Depn.amt*Tax rate .

That said, Obama's policy seems to b emore attractive for small entrpreneurs, as it creates immeditae cash flow , rather than the second option which reflects about some probable future sale above book value.Even then , tax incidence ,is bound to be less , given the time value of money.

Also the business will have to spare lesser cash outflow towards his capital purchase.

Cost of capital is normally the weighted average cost of all the sources of funds acquired by a company , to specifically fund a project , or its normal funding structure.

So,first, the student needs to know separately, the amount of equity funds & the debt funds ,ie. Their proportion in Dupont's capital structure---that he has ,that is, 70% equity & 30% debt funds

Next , he requires the cost of these funds.

For equity, he needs to calculate the cost of equity or required return for the equity holders , through any one of the common methods such as Capital Asset Pricing model , which links the market expected return & the premium desired over the risk-free rate .It uses the formula, Ke=RFR+(beta*Market risk premium).--where, beta is a measure of market volatility for DuPont's stock

Or, discounting of future dividend cash flows , to the present & finding the cost of equity capital , by fixing it with the currently traded stock price---using the formula- Ke=(D1/P0)+g----where, g is the growth rate of dividends.

As the market risk premium is known to be estimated as 6% ,& we have the latest 10-Year Treasury bill yield as 2.09 --which is the risk-free interest rate.

& if we suppose DuPont's stock beta to be 1.7

so, we can calculate the cost of DuPont's equity as 2.09%+(1.7*6%)= 12.29% ----is the cost of equity

Now, if we again, suppose the interest rate on DuPont's debt as 7/5%, the after-tax cost of debt becomes 7.5%*(1-35%)= 4.88%

As the target capital structure for acquistion is given as 50% debt, we calculate the weighted av.cost of capital as

WACC=(Wt.D*kd)+(Wt.E*ke)

ie.(50%*4.88%)+(50%*12.29%)=

8.59%

So, under the above assumptions,the WACC for DuPont's stock is 8.59%

ie. The American Chemicals will assess all its relevant cash flows associated with acquisition of DuPont , by discounting at this rate of WACC, ie. 8.59%