Question

Problem Set 8

Delta Corporation has the following capital structure:

	Cost (after tax)	Weights	Weighted Cost
Debt	9.1%	60%
Preferred stock	10.6%	5%
Common equity (retained earnings)	11.1%	35%
Weighted Average Cost of Capital

Calculate the weighted average cost of capital (WACC) and use it for the cost of capital interest rate for the rest of this problem. In other words, the WACC becomes the discount rate for the net present value calculations.

Assume Delta has three different (mutually exclusive) projects that are being considered. Listed below are the cash flows for the projects.

Project 1		Project 2		Project 3
Initial investment	$50,000	Initial Investment	$48,000	Initial Investment	$62,000
Cash Flow Year 1	$10,000	Cash Flow Year 1	$32,000	Cash Flow Year 1	$15,000
Cash Flow Year 2	$30,000	Cash Flow Year 2	$30,000	Cash Flow Year 2	$15,000
Cash Flow Year 3	$22,000	Cash Flow Year 3	0	Cash Flow Year 3	$15,000
Cash Flow Year 4	$8,000	Cash Flow Year 4	0	Cash Flow Year 4	$15,000
Cash Flow Year 5	$6,000	Cash Flow Year 5	0	Cash Flow Year 5	$2,000

For each of the projects shown above, calculate the Payback Period, Internal Rate of Return (IRR), and Net Present Value (NPV). Make a table in APA format and label it Table 1. In this table show the three projects and the values for payback period, IRR, and NPV. Write a one paragraph explanation of which projects Delta management should choose and why. Explain whether the different calculation methods give you different results on which project(s) should be chosen and why.

*List for years 0-5 for the payback period, IRR and the NPV, Label each clearly.

Answer 1

	Weights	Weighted Cost
Cost (after tax)
Debt	9.10%	60%	5.4600%
Preferred stock	10.60%	5%	0.5300%
Common equity (retained earnings)	11.10%	35%	3.8850%
Weighted Average Cost of Capital	Sum of weight*cost		9.8750%
Project 1				Project 2				Project 3
Year	cash flow	present value of cash flow = cash flow/(1+r)^n r= 9.88%		Year	cash flow	present value of cash flow = cash flow/(1+r)^n r= 9.88%		Year	cash flow	present value of cash flow = cash flow/(1+r)^n r= 9.88%
0	($50,000)	($50,000)		0	($48,000)	($48,000)		0	($62,000)	($62,000)
1	$10,000	$9,100.84		1	$32,000	$29,122.68		1	$15,000	$13,651.26
2	$30,000	$24,847.57		2	$30,000	$24,847.57		2	$15,000	$12,423.79
3	$22,000	$16,583.14		3	$0	$0.00		3	$15,000	$11,306.69
4	$8,000	$5,488.02		4	$0	$0.00		4	$15,000	$10,290.03
5	$6,000	$3,745.92		5	$0	$0.00		5	$2,000	$1,248.64
NPV	sum of present value of cash flow	$9,765		NPV	sum of present value of cash flow	$5,970		NPV	sum of present value of cash flow	($13,080)
IRR	Using IRR function in MS excel =irr(-50000,10000,30000,22000,8000,6000)	18.15%		IRR	Using IRR function in MS excel =irr(-48000,32000,30000,0,0,0)	19.13%		IRR	Using IRR function in MS excel =irr(-62000,15000,15000,15000,15000,15000)	0%
Payback period					Payback period				Payback period
Project 1					Project 2				Project 3
Year	cash flow	cumulative cash flow			Year	cash flow	cumulative cash flow		Year	cash flow	cumulative cash flow
0	($50,000)				0	($48,000)			0	($62,000)
1	$10,000	$10,000			1	$32,000	$32,000		1	$15,000	$15,000
2	$30,000	$40,000			2	$30,000	$18,000	Amount to be recovered	2	$15,000	$30,000	Amount to be recovered
3	$22,000	10000	Amount to be recovered		3	$0			3	$15,000	$45,000
4	$8,000				4	$0			4	$15,000	$60,000
5	$6,000				5	$0			5	$2,000	$62,000
payback period	year before the final recovery+(amount to be recovered/cash flow of final year of recovery	2+(10000/22000)	2.45		payback period	year before the final recovery+(amount to be recovered/cash flow of final year of recovery	1+(18000/30000)	1.6	payback period	Entire amount is recovered in year 5 so Payback period is 5 years
	Project	1	2	3
	NPV	$9,765	$5,970	($13,080)	Project 1
	IRR	18.15%	19.13%	0%	Project 2
	Payback period	2.45	1.6	5	Project 2
	As per different techniques of capital budgeting NPV suggest that Project 1 should be selected while IRR and PB period suggest Project 2 should be selected so in this situation conflict arise so it is better that Project 1 should be consided for selection as it is the best technique of capital budgeting because IRR takes an assumption of reinvestment of cash flow with the same rate equal to irr which in actual world is not possible and payback period ignores the time value of money so in case of mutual exclusive project project 1 should be selected.