Question

Phil was recently hired by Select Network 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.  

Phil has a B.S. in accounting from CWU (2007) and passed the CPA exam (2008). He has been in public accounting for 2 years. During that time he earned an MBA from Seattle U. He would like to be the CFO of a company someday--maybe Select Network Inc. -- and this is an opportunity to get onto that career track and to prove his ability.

As Phil 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 Phil 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	(13,900,000)	(18,500,000)	(10,500,000)	(16,500,000)
1	5,170,000	3,700,000	2,690,000	3,400,000
2	5,170,000	7,900,000	3,870,000	5,900,000
3	5,170,000	7,250,000	4,760,000	6,800,000
4	5,170,000	6,500,000	3,870,000	6,800,000
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

Select Network Inc. has the following capital structure, which is considered to be optimal:

Debt	44%
Preferred Equity	8%
Common Equity	48%
	100%

   

Cost of Capital

Phil 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) Select Network Inc. has issued a 10% semi-annual coupon bond with 8 years term to maturity. The current trading price is $1,059.

(3) The firm has issued some preferred stock which pays an annual 8.8% dividend of $100 par value, and the current market price is $105.

(4) The firm’s stock is currently selling for $108 per share. Its last dividend (D0) was $3, and dividends are expected to grow at a constant rate of 9%. The current risk free return offered by Treasury security is 3.8%, and the market portfolio’s return is 12%. Select Network Inc. has a beta of 1.08. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 3.5%.

(5) The firm adjusts its project WACC for risk by adding 3% to the overall WACC for high-risk projects and subtracting 2.5% for low-risk projects.

Phil knows that Select Network 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, Phil must finish the analysis and write his report. To help begin, he has formulated the following questions:

What is Select Network Inc.’s overall WACC?

Do you think the firm should use the single overall WACC as the hurdle rate for each of its projects? Explain.

What is the WACC for each project? Place your numerical solutions in Table 2.

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

Comment on the commonly used capital budgeting measures. What is the underlying cause of ranking conflicts? Which criterion is the best one, and why?

Which of the projects are unacceptable and why?

Rank the projects that are acceptable, according to Phil’s criterion of choice.

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

Answer 1

cost of debt	Using rate function in MS excel	rate(nper,pmt,pv,fv,type)	4%	4.48%
Annual rate of cost of debt	4.48*2	8.96
After tax cost of debt	before tax rate*(1-tax rate)	8.96*(1-.4)	5.376
cost of preferred stock	preferred dividend/market price	8.8/105	8.38%
cost of equity	risk free rate+(market return-risk free rate)*beta	3.8+(12-3.8)*1.08	12.66
WACC
source	weight	cost of source	weight*cost of source
debt	0.44	5.38	2.3672
preferred	0.8	8.38	6.704
equity	0.48	12.66	6.0768
WACC in %	sum of weight*cost		15.15
WACC for high risk projects	15.15+3	18.15
WACC for low risk projects	15.15-2.5	12.65
The composite WACC reflects the risk of an average project undertaken by the firm. Different Projects may have different risks. The division’s WACC should be adjusted to reflect the project risk and capital structure
Project	A	B	C	D
WACC	18.15	15.15	12.65	15.15
Project	A	B	C	D
0	-13900000	-18500000	-10500000	-16500000
1	5170000	3700000	2690000	3400000
2	5170000	7900000	3870000	5900000
3	5170000	7250000	4760000	6800000
4	5170000	6500000	3870000	6800000
WACC	18.15	15.148	12.65	15.148
NPV = Using NPV function in MS excel	($2,273,349.71)	($766,486.11)	$595,215.13	($673,591.45)
IRR=Using IRR function in MS excel	18.03%	12.93%	15.47%	13.03%
MIRR =Using MIRR function in MS excel	18.08%	14.86%	16.49%	14.82%
Commonly used Capital budgeting techniques are NPV IRR and MIRR, such techniques often give conflicing results due to size, time and risk involved in the project
NPV is the best criteria as it compares the present value of cash inflows with cash outflows
Project A B and D are unacceptable as NPV IRR and MIRR results are against the acceptance criteria
NPV Is negative in case of project A B & D so all should be rejected and project C Should be selected as it results in Positive NPV
IRR Suggest the selection of Project C as its IRR is greater than WACC and rest Projects IRR is less than WACC
MIRR Suggest the selection of Project C as its MIRR is greater than WACC and rest Projects MIRR is less than WACC
Project C should be choosen as all techniques of capital budgeting favor project C