Max was recently hired by Imagine Software Inc. as a junior budget analyst. He is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate. He must give his analysis and recommendation to the capital budgeting committee.

Max has a B.S. in accounting from CWU (2015) and passed the CPA exam (2017). He has been in public accounting for several years. During that time he earned an MBA from Seattle U. He would like to be the CFO of a company someday--maybe Imagine Software Inc. -- and this is an opportunity to get onto that career track and to prove his ability.

As Max looks over the financial data collected, he is trying to make sense of it all. He already has the most difficult part of the analysis complete -- the estimation of cash flows. Through some internet research and application of finance theory, he has also determined the firm’s beta.

Here is the information that Max has accumulated so far:

The Capital Budgeting Projects

He must choose one of the four capital budgeting projects listed below:  

Table 1

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

Imagine Software Inc. has the following capital structure, which is considered to be optimal:

Cost of Capital

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

(1)The firm’s tax rate is 40%.

(2) Imagine Software Inc. has issued a 9% semi-annual coupon bond with 7 years term to maturity. The current trading price is $988.

Cost of Preferred Stock is 9.04 %

(3) The firm has issued some preferred stock which pays an annual 8.5% dividend of $100 par value, and the current market price is $94.

Cost of common equity

(1) Estimated cost of common equity using the CAPM approach

(4) The firm’s stock is currently selling for $76.5 per share. Its last dividend (D0) was $2.80, and dividends are expected to grow at a constant rate of 7.5%. The current risk free return offered by Treasury security is 3.1%, and the market portfolio’s return is 10%. Imagine Software Inc. has a beta of 1.25. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 2.8%.

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

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

Max knows that Imagine Software Inc. executives have favored IRR in the past for making their capital budgeting decisions. His professor at Seattle U. said NPV was better than IRR. His textbook says that MIRR is also better than IRR. He is the new kid on the block and must be prepared to defend his recommendations.

First, however, Max must finish the analysis and write his report. To help begin, he has formulated the following questions:

1. What is the firm’s cost of debt?

2. What is the cost of preferred stock for Imagine Software Inc.?

3. Cost of common equity

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

The current risk free return offered by Treasury security is 3.1%, and the market portfolio’s return is 10%. Imagine Software Inc. has a beta of 1.25.

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

The firm’s stock is currently selling for $76.5 per share.

(3) What is the estimated cost of common equity using the bond-yield-plus-risk-premium approach?

Bond yield plus risk premium:

(4) What is the final estimate for rs?

4. What is Imagine Software Inc.’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? Place your numerical solutions in Table 2.

7. Calculate all relevant capital budgeting measures for each project, and place your numerical solutions in Table 2.

Table 2

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 Max’s criterion of choice.

1. Which project should Max recommend and why? Explain why each of the projects not chosen was rejected.

Imagine that you are holding 5,500 shares of stock, currently selling at $50 per share. You are ready to sell the shares but would prefer to put off the sale until next year due to tax reasons. If you continue to hold the shares until January, however, you face the risk that the stock will drop in value before year-end. You decide to use a collar to limit downside risk without laying out a good deal of additional funds. January call options with a strike price of $55 are selling at $2, and January puts with a strike price of $45 are selling at $3. What will be the value of your portfolio in January (net of the proceeds from the options) if the stock price ends up at $41, $50, $61? What will the value of your portfolio be if you simply continued to hold the shares?

Problem 11-06

New-Project Analysis

The Campbell Company is considering adding a robotic paint sprayer to its production line. The sprayer's base price is $1,150,000, and it would cost another $22,000 to install it. The machine falls into the MACRS 3-year class (the applicable MACRS depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%), and it would be sold after 3 years for $660,000. The machine would require an increase in net working capital (inventory) of $16,500. The sprayer would not change revenues, but it is expected to save the firm $456,000 per year in before-tax operating costs, mainly labor. Campbell's marginal tax rate is 35%.

What is the Year 0 net cash flow?

$

What are the net operating cash flows in Years 1, 2, and 3? Do not round intermediate calculations. Round your answers to the nearest dollar.

Year 1 $

Year 2 $

Year 3 $

What is the additional Year 3 cash flow (i.e, the after-tax salvage and the return of working capital)? Do not round intermediate calculations. Round your answer to the nearest dollar.

$

If the project's cost of capital is 12 %, what is the NPV of the project? Do not round intermediate calculations. Round your answer to the nearest dollar.

$

Should the machine be purchased?

p25.)

A firm is considering replacing the existing industrial air conditioning unit. They will pick one of two units. The first, the AC360, costs $26,257.00 to install, $5,170.00 to operate per year for 7 years at which time it will be sold for $7,061.00. The second, RayCool 8, costs $41,293.00 to install, $2,116.00 to operate per year for 5 years at which time it will be sold for $8,997.00. The firm’s cost of capital is 6.55%. What is the equivalent annual cost of the AC360? Assume that there are no taxes.

Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm's EBIT is $13 million, and it faces a 25% federal-plus-state tax rate. The market risk premium is 6%, and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 40% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 11%. BEA has a beta of 0.8.

What are BEA's new beta, cost of equity (Rs), and WACC if it has 40% debt? Do not round intermediate calculations. Round your answers to two decimal places.

European call and put options with a strike price of $50 will expire in one year. The underlying stock is selling for $51 currently and pays no cash dividend during the 1life of the options. The risk-free rate is 5% (continuous compounding). The price of the call option is $5.00. Please answer the following questions:

1. Please calculate the price of the put option under the put-call parity

2. If the actual price of the put is $2.50, is there an arbitrage opportunity? Please explain.

3. If your answer in 2 is yes, please write down the four transactions needed to realize the arbitrage profit.

1. What are the risks and problems of living in subdivided housing units? List and explain four of them.

2. You are offered an annuity that will pay $10,000 a year for ten years (that is, ten payments), but the payments start after five years have elapsed. If you want to earn 8% on your funds, what is the maximum you should pay for this annuity?

Quantitative Problem: Adams Manufacturing Inc. buys $10.8 million of materials (net of discounts) on terms of 2/10, net 50; and it currently pays after 10 days and takes the discounts. Adams plans to expand, which will require additional financing. If Adams decides to forgo discounts, how much additional credit could it obtain? Enter your answer as a positive value. Do not round intermediate calculations. Round your answer to the nearest cent. Use a 365-day year.

$

What would be the nominal and effective cost of such a credit? Do not round intermediate calculations. Round your answers to two decimal places. Use a 365-day year.

Nominal cost: ?

Effective cost?

If the company could receive the funds from a bank at a rate of 8.30%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank loan? Do not round intermediate calculations. Round your answer to two decimal places.

?? %

Should Adams use bank debt or additional trade credit?

​(Alternative dividend policies​)
Final earnings estimates for the Smithfield Meat Packing Company have been prepared for the CFO of the company and are shown in the following​ table:
YEAR   PROFITS AFTER TAXES
1 18,000,000
2 21,000,000
3 19,000,000
4 23,000,000
5 25,000,000
The firm has 7,700,000 shares of common stock outstanding. As assistant to the​ CFO, you are asked to determine the yearly dividend per share to be paid depending on the following possible​ policies:

a. A stable dollar dividend targeted at 50 percent of earnings over a​ 5-year period.

b. A​ small, regular dividend of ​$0.70 per share plus a​ year-end extra when the profits in any year exceed ​$20,000,000. The​ year-end extra dividend will equal 60 percent of profits exceeding ​$20,000,000.

c. A constant dividend payout ratio of 45 percent.

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $70,000, and it would cost another $10,500 to modify the equipment for special use by the firm. The equipment falls into the MACRS 3-year class and would be sold after 3 years for $28,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $13,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $67,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 35%.

a. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest cent.  

b. What are the project's annual cash flows in Years 1, 2, and 3? Do not round intermediate calculations. Round your answers to the nearest cent.

c. If the WACC is 14%, should the spectrometer be purchased?

Wolfson Corporation has decided to purchase a new machine that costs $3.9 million. The machine will be depreciated on a straight-line basis and will be worthless after four years. The corporate tax rate is 23 percent. The Sur Bank has offered Wolfson a four-year loan for $3.9 million. The repayment schedule is four yearly principal repayments of $975,000 and an interest charge of 7 percent on the outstanding balance of the loan at the beginning of each year. Both principal repayments and interest are due at the end of each year. Cal Leasing Corporation offers to lease the same machine to Wolfson. Lease payments of $1,110,000 per year are due at the beginning of each of the four years of the lease.

a. What is the NAL of leasing for Wolfson? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.) b. What is the maximum annual lease Wolfson would be willing to pay?

Lewis Health System Inc. has decided to acquire a new electronic health record system for its Richmond hospital. The system receives clinical data and other patient information from nursing units and other patient care areas, then either displays the information on a screen or stores it for later retrieval by physicians. The system also permits patients to call up their health record on Lewis's website.

The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS three-year class. If the system were purchased, a four-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after four years, and the best estimate of its residual value at that time is $200,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain.   

As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a four-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis's marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions:

a. What is the present value cost of owning the equipment?

b. What is the present value cost of leasing the equipment?                                               

c. What is the net advantage to leasing (NAL)?                                                                                

d. Answer these questions one at a time to see the effect of the change on NAL. That is, starting with the original numbers you used for questions a. and b., what is the NAL if:                                                                                             

    - interest rate increases to 12 percent                                                                                          

    - the tax rate falls to 34 percent                                                                                       

    - maintenance cost increases to $25,000 per year                                                                                   

    - residual value falls to $150,000                                                                                      

    - the system price increases to $1,050,000                                                                                               

e. Do the changes in d. make leasing more or less attractive? Explain.

**Please show all calculations and formulas used to derive the answers**

Your division is considering two projects with the following cash flows (in millions):

1. What are the projects' NPVs assuming the WACC is 5%? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Negative values, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to two decimal places.

   Project A:    $   million

   Project B:    $   million

   What are the projects' NPVs assuming the WACC is 10%? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Negative values, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to two decimal places.

   Project A:  $   million

   Project B:  $   million

   What are the projects' NPVs assuming the WACC is 15%? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Negative values, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to two decimal places.

   Project A:  $   million

   Project B:  $   million

2. What are the projects' IRRs assuming the WACC is 5%? Do not round intermediate calculations. Round your answer to two decimal places.

   Project A:    %

   Project B:    %

   What are the projects' IRRs assuming the WACC is 10%? Do not round intermediate calculations. Round your answer to two decimal places.

   Project A:    %

   Project B:    %

   What are the projects' IRRs assuming the WACC is 15%? Do not round intermediate calculations. Round your answer to two decimal places.

   Project A:    %

   Project B:    %

3. If the WACC was 5% and A and B were mutually exclusive, which project would you choose? (Hint: The crossover rate is 7.81%.)

   -Select-Project AProject BNeither A nor BItem 13

   If the WACC was 10% and A and B were mutually exclusive, which project would you choose? (Hint: The crossover rate is 7.81%.)

   -Select-Project A Project B Neither A nor B Item 14

   If the WACC was 15% and A and B were mutually exclusive, which project would you choose? (Hint: The crossover rate is 7.81%.)

Assume Highline Company has just paid an annual dividend of $ 0.91 Analysts are predicting an 11.7 % per year growth rate in earnings over the next five years. After​ then, Highline's earnings are expected to grow at the current industry average of 5.1 % per year. If​ Highline's equity cost of capital is 7.9 % per year and its dividend payout ratio remains​ constant, for what price does the​ dividend-discount model predict Highline stock should​ sell?