Question

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

t	A	B	C	D
0	(14,900,000)	(17,900,000)	(16,600,000)	(19,700,000)
1	4,980,000	5,990,000	3,850,000	6,400,000
2	4,980,000	6,210,000	4,990,000	5,880,000
3	4,510,000	6,250,000	6,860,000	6,800,000
4	4,510,000	4,700,000	4,990,000	6,650,000
Risk	High	Average	Low	Average

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:

Debt	35%
Preferred Equity	15%
Common Equity	50%
	100%

  

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

	A	B	C	D
WACC
NPV
IRR
MIRR

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.

Answer 1

1.Firm's cost of debt , kd:

Using the formula to find PV?Price of bonds,

PV/Current market price of bonds=(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where

where PV/mkt.price of the bond is given to be $ 988

Pmt.= the semi-annual coupon pmt.= 9%/2*1000= $ 45

r= semi-annual yield /cost which we need to find--- ??

n= no.of semi-annual coupon periods= 7*2= 14

FV = Face value = $ 1000

So, plugging in the values in the formula,

988=(45*(1-(1+r)^-14)/r)+(1000/(1+r)^14)

& solving for r, we get the semi-annual before-tax yield/cost as

4.618%

Now the annual before-tax cost=(1+4.618%)^2-1=

9.45%

so, the annual after-tax cost=BT cost*(1-Tax Rate)

ie.9.45%*(1-40%)=

5.67%

2.Cost of preferred stock for Imagine Software Inc.:

k ps $ dividend/Current mkt.price

Ie. (100*8.5%)/94

9.04%

3. Cost of commmon equity,ke

i.as per CAPM

ke=RFR+(Beta*(market Return-RFR))

3.1%+(1.25*(10%-3.1%))=

11.73%

ii. Using DCF method

ke=(Next dividend/Current mkt.price)+Growth Rate of dividends

ie.((2.80*(1+0.075))/76.5)+7.5%=

11.43%

iii.Bond-yield-plus-risk-premium approach

After-tax Bond yield as in 1. above=5.67%

Risk premium(given) =2.8%

so, ke=5.67%+2.8%=

8.47%

4. Final estimate of Cost of Equity

can be the average of I,ii & iii

ie.(11.73%+11.43%+8.47%)/3=

10.54%

5.Imagine Software Inc.’s overall WACC:

WACC=(Wt.d*kd)+(Wt. ps*k ps)+(Wt.e*ke)

ie.(35%*5.67%)+(15%*9.04%)+(50%*10.54%)=

8.61%

So, WACC for high-risk projects--- 8.61%+2%=10.61%

WACC for low-risk projects--- 8.61%-2%=6.61%

Table 1
t	A	B	C	D
0	-14,900,000	-17,900,000	-16,600,000	-19,700,000
1	4,980,000	5,990,000	3,850,000	6,400,000
2	4,980,000	6,210,000	4,990,000	5,880,000
3	4,510,000	6,250,000	6,860,000	6,800,000
4	4,510,000	4,700,000	4,990,000	6,650,000
Risk	High	Average	Low	Average
WACC	10.61%	8.61%	6.61%	8.61%
NPV(Excel fn.)	18415	1135587	926042	1264003
IRR(Excel fn.)	11%	12%	9%	11%
MIRR(Excel fn.)	11%	10%	8%	10%
Ranking as per Max's criterion
Acc. To NPV	4	2	3	1
Acc. To MIRR	1	2	4	3
Max should recommend Project D for highest NPV & reject others with lesser NPVs.

Out of the capital budgeting techinques,

NPV stands out as fool proof , as it considers time value of cash flows, occuring over the entire life of a project.

Also, it tells precisely, what is the exact $ value that will be created to the owners , by undertaking a particular project.

IRR does not consider cash flows , for the entire project-period. Also it's results are misleading when there are multiple negative cash flows.

Although MIRR rectifies this defect , to a very great extent, it conflicts with NPV when the timing or magnitude of cash flows differ.

Both the payback methods just indicate when the investment will be recouped & nothing after that.

Selecting projects according to NPV is the most recommended.

Accordingly, Project D is RECOMMENDED with highest NPV.

Also it uses up almost the entire $ 20 mln. Budgeted , to create maximum value to the owners/shareholders.

The other projects are rejected for lesser NPVs , & also the $ 20 mln. Budget will be exceeded.