CAPITAL BUDGETING

In December 2019, Bob Prescott, the controller for the Blue Ridge Mill, was considering the addition of new on-site long-wood woodyard. The addition would have two primary benefits: to eliminate the need to purchase short-wood from an outside supplier and create the opportunity to sell short-wood on the open market as a new market for Worldwide Paper Company (WPC). The new woodyard would allow the Blue Ridge Mill not only to reduce its operating costs but also to increase its revenues. The proposed woodyard will utilise new technology that allows tree-length logs, called long-wood, to be processed directly, whereas the current process required short-wood, which had to be purchased from the Shenandoah Mill.

This nearby mill, owned by a competitor, has excess capacity that allows it to produce more short-wood than it needs for its own pulp production. The excess is sold to several different mills, including the Blue Ridge Mill. Thus, adding the new long-wood equipment would mean that Prescott would no longer need to use the Shenandoah Mill as a short-wood supplier and that the Blue Ridge Mill would instead compete with the Shenandoah Mill by selling on the short-wood market. The question for Prescott was whether these expected benefits were enough to justify the $18m capital outlay plus the incremental investment in working capital over the six-year life of the investment.

Construction would start within a few months, and the investment outlay would be spent over two calendar years: $16m in 2020 and the remaining $2m in 2021. When the woodyard begins operating in 2021, it would significantly reduce the operating costs of the mill. These operating savings would come mostly from the difference in the cost of producing short-wood on-site versus buying it on the open market and were estimated to be $2m for 2021 and $3.5m per year thereafter.

Prescott also planned on taking advantage of the excess production capacity afforded by the new facility by selling short-wood on the open market as soon as possible. For 2021, he expected to show revenues of approximately $14m, as the facility came on-line and began to break into the new market. He expected shortwood sales to reach $20m in 2022 and continue at the $20m level through 2026. Prescott estimated that the cost of goods sold (before including depreciation expense) would be 75%.

In addition to the capital outlay of $18m, the increased revenues would necessitate higher levels of inventories and accounts receivable. Therefore the amount of working capital investment each year would equal 15% of incremental sales for the year. At the end of the life of the equipment, in 2026, all the networking capital on the books would be recoverable at cost fully.

Taxes would be paid at a 30% rate, and the equipment depreciation is to be calculated on a straight-line basis over the six-year life to zero balance. However, the new equipment is estimated to have a salvage value (scrap value) of $3m at the end of its life. WPC’s accountants have told Prescott that depreciation charges could not begin until 2021, when all the $18m had been spent and the equipment is in service.

WPC has a company policy to use 15% as the hurdle rate for such investment opportunities. The hurdle rate is based on the study of the company’s cost of capital conducted 5 years ago.

Required:

1. Prepare cash flow statement/s and compute the NPV and IRR of the proposed project. Comment on the feasibility of the project.

2. Outline reasons why Prescott may be uneasy using the 15% hurdle rate for a discount rate.

Empire Today Inc. has 10 million shares of common stock outstanding, 300,000 shares of 5% preferred stock outstanding, and 7 million of 6.7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $85 per share and has a beta of 1.15, the preferred stock currently sells for $103 per share, and the bonds have 20 years to maturity and sell for 93% of par. The market risk premium is 11 percent, T-bills are yielding 2.14 %, and the firm's tax rate is 25.7%.

1) Calculate the firm’s Weighted Average Cost of Capital and explain the meaning of WACC using your calculated solution.

2) The CFO is assessing a potential project which will yield an IRR of 9.3%. The project has the firm level risk. Should the CFO accept the project? Provide your explanations.

Define each term in short words and provide an example for each term as well:

1) Seasoned Equity Offering (SEO):

2) Security Market Line (SML):

3) Sinking Fund:

4) Syndicate:

5) Systematic Risk Principle:

6) Tender Offer:

7) Treasury Bond:

8) Treasury Stock:

9) Unsystematic Risk:

The table below is the Monthly return Correlation Coefficients between two stocks:

Required:

a. Which pair of two stocks have the highest and lowest correlations?

b. Suggest some economic reasons to explain the high and low correlation between these stocks. If you were to form a portfolio of two stocks, which ones would you choose to maximise the benefits of diversification? Give reasons for your answer.

The Adams Construction Company is bidding on a project to install alarge flood drainage culvert from Dandridge to a distantlake. The cost and benefits

are shown below. Use the Present Worth conventional and modified Benefit-Cost ration method to make a recommendation.Draw Cash Flow Diagram

Initial investment = $2 million

Right of way maintenance cost = $30,000 per year

Major upkeep every six years = $50,000

Annual benefits to the taxpayers = $135,000 per year

Life of the project = 12 years

MARR = 6%

On 3 May 2019, a speculator buys five July 2019 US Soybeans futures contracts at a price of 842 cents per bushel. The speculator closes out her futures position on 30 May 2019 at a price of 888.88 cent per bushel. The US Soybeans futures contract is written on 5,000 bushels of soybeans and, for a speculator, the initial and maintenance margins are $3,375 and $2,500 per contract respectively. Assume that the speculator does not withdraw any excess out of their margin account.

1. At the time the futures position is established, what is the minimum price movement that will generate a margin call? Report your answer in cents with 2 decimal places (2 dps).
   
2. Construct a table as below to illustrate the daily marking-to-market (and final settlement) of the speculator’s overall futures position.

Table Q2

c. What is the overall profit/loss of the speculator? Decompose the overall profit/loss into two components: (i) total margin calls, and (ii) the change in the margin account balance.

NPVs and IRRs for Mutually Exclusive Projects

Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving materials in its factory. Because both forklifts perform the same function, the firm will choose only one. (They are mutually exclusive investments.) The electric-powered truck will cost more, but it will be less expensive to operate; it will cost $22,000, whereas the gas-powered truck will cost $17,500. The cost of capital that applies to both investments is 12%. The life for both types of truck is estimated to be 6 years, during which time the net cash flows for the electric-powered truck will be $6,290 per year and those for the gas-powered truck will be $5,000 per year. Annual net cash flows include depreciation expenses.

1. Calculate the NPV for each type of truck. Do not round intermediate calculations. Round your answers to the nearest dollar.

   Electric-powered truck	$
   Gas-powered truck	$

2. Calculate the IRR for each type of truck. Do not round intermediate calculations. Round your answers to two decimal places.

   Electric-powered truck	%
   Gas-powered truck	%

   Which type of the truck should the firm purchase?
   -Select-Electric-poweredGas-powered

Bill Clinton reportedly was paid 10 million to write his book My Life. The book took three years to write. In the time he spent writing, Clinton could have been paid to make speeches. Given his popularity, assume that he could earn 8 million per year (paid at the end of the year) speaking instead of writing. Assume his cost of capital is 10% per year.

What is the IRR of agreeing to write the book (ignoring any royalty payments)? Should Clinton agree to write the book (ignoring any royalty payments)? Why?

1) You are US company, 500,000 BP (British Pound) payable to UK in one year. Answer in terms of US$.

Information for Forward Contract:

Forward exchange rate (one yr): 1.54 $/BP

Information for Money Market Instruments (MMI):

Current exchange rate: 1.50 $/BP

Investment return at Aerion Fund Management (in UK): 4% annual

Interest rate of borrowing from Bank of America (in USA): 2% annual

Information you need for Currency Options Contract:

Options premium: 0.015 $/BP

Interest rate of borrowing from Bank of America (USA): 2% annual

Allowed to exercise options at 1.54 $/BP

What are the costs of MMI? (Answer in US$ of course. You are US company!)

2) You are US company, 500,000 BP (British Pound) payable to UK in one year. Answer in terms of US$.

Information for Forward Contract:

Forward exchange rate (one yr): 1.54 $/BP

Information for Money Market Instruments (MMI):

Current exchange rate: 1.50 $/BP

Investment return at Aerion Fund Management (in UK): 4% annual

Interest rate of borrowing from Bank of America (in USA): 2% annual

Information you need for Currency Options Contract:

Options premium: 0.015 $/BP

Interest rate of borrowing from Bank of America (USA): 2% annual

Allowed to exercise options at 1.54 $/BP

If the break-even exchange rate for the Currency Options Contract is 1.46 $/BP, and you believe the exchange rate at the time of the payment would be 1.43 $/BP, should you sign the contract?

The following three stocks are available in the market: E(R) β Stock A 10.5 % 1.27 Stock B 13.7 1.07 Stock C 16.2 1.47 Market 14.1 1.00 Assume the market model is valid. The return on the market is 14.9 percent and there are no unsystematic surprises in the returns. What is the return on each stock? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) Return Stock A % Stock B % Stock C % Assume a portfolio has weights of 20 percent Stock A, 35 percent Stock B, and 45 percent Stock C. The return on the market is 14.9 percent and there are no unsystematic surprises in the returns. What is the return on the portfolio? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) Return on the portfolio %

Robbins Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected.

Reed Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected.

Spence Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the cost of capital or negative, in both cases it will be rejected.

Module 20: Long-Term Financing 1. Why do public organizations use municipal bonds to finance long-term capital projects?

2. A major urban center is planning to issue a $100 million, 20-year, semiannual-interest-paying municipal bond for the construction of a stadium.

a. The interest rate is 5.875%, based on the economic and financial conditions of the city and city government.

b. The design and issuance costs are estimated to be $10 million and 1%, respectively.

c. What is the total interest paid if the city decides to adopt a level debt service structure?

d. How much will the city still owe on this bond at the end of each year?

2. The city administration is considering refurbishing the lighting system of its administration building. After an initial investigation, the city procurement office has narrowed down the choices to the following two options: a. Option 1 is an Ergolight system that costs $500,000 to purchase and install. The energy cost for option 1 is $20,000, and its maintenance cost is $2,000. b. Option 2 is a conventional system that costs $100,000 to purchase and install. The energy cost for option 2 is $50,000, and its maintenance cost is $10,000. Both systems are expected to last for 20 years. Assume that the discount rate is 4% and all future costs are paid at the end of the year. 3. Which lighting system should the city select based on LCC considerations?