Question

Q3: Capital budgeting and cost of capital

Reno Co is considering a project that will cost $ 26,000 and result in the following cash flows:

Years	1	2	3	4
Project Cash flow	10,000	11,500	12,600	14,800

The views of the directors of Reno Co are that all investment projects must be evaluated over four years of operations using net present value. You have given the information below to assist you to calculate the appropriate discount rate:

• Reno Co has 1.3 million shares of stock outstanding and the stock currently sell for $20 per share. The market value of the debt is $4.56 million and cost of debt is 6.061%
• The risk free rate is 3.5588% and the market risk premium is 10%
• You have estimated that Reno Co has a beta of 0.75
• Corporate tax rate is 34%

Required:

1. Estimate cost of equity using CAPM and define the security market line.
2. Estimate the cost of capital.  
3. Evaluate the investment project using the NPV criteria and cost of capital estimated above.
4. State clearly any limitations and assumptions that you made in your calculations.

Answer 1

Part a)

Cost of equity by using CAPM = risk free rate + (Beta*Market risk premium) = 3.5588% + (0.75*10%) = 3.5588%+7.5% = 11.0588%

The security market line (SML) is the graphical representation of the Capital Asset Pricing Model (CAPM) and gives the expected return of the market at different levels of systematic or market risk.

Part b)

Cost of debt after tax = Cost of debt before tax*(1-tax rate) = 6.061%*(1-0.34) = 6.061%*0.66 = 4%

Type	Market value	Proportion (Market value/Σmarket value)	Cost	WACC (Proportion*cost)
Equity	26,000,000	85%	11.0588%	9.40%
Debt	4,560,000	15%	4%	0.60%
	30,560,000			10.00%

Part c)

Year	Cashflow	PVF @ 10%	Cost (Cashflow * PVF @ 10%)
0	-26,000	1/[(1+discounting rate)^year] = 1/(1.1^0) = 1	(26,000.00)
1	10,000	1/[(1+discounting rate)^year] = 1/(1.1^1) = 0.9091	9,091.00
2	11,500	1/[(1+discounting rate)^year] = 1/(1.1^2) = 0.8265	9,504.75
3	12,600	1/[(1+discounting rate)^year] = 1/(1.1^3) = 0.7514	9,467.64
4	14,800	1/[(1+discounting rate)^year] = 1/(1.1^4) = 0.6831	10,109.88
			12,173.27