Question

Dundee Co. is considering Project “X” whose cash flows are shown below:

Year 0 1 2 3
CF -$1,200 $600 $550 $300

The company’s capital structure is distributed equally between debt, preferred stock and common stock. It has also the following information:

1- After tax cost of debt: 2%
2- Preferred stocks are selling at $120 per share and pay a dividend of $5 per share
3- Common stocks are selling at $40 per share, pay a year-end dividend of $2 per share and grow at a constant rate of 10%.

The company is also considering another two projects “Y” & “Z” with the following information:

Project Y Z
NPV $96.00 $281.9
MIRR 6.26% 9.24%
IRR 12.41% 10.98%
Payback Period 1.44 years 2.33 Year

7. Assuming that the three projects X, Y & Z are independent, then based on MIRR which project (s) should the company choose: *

A. X, Y & Z

B. X & Z

C. Only X

D. Only Z

E. Reject all projects

8. Assuming that the three projects X, Y & Z are Mutual Exclusive, then based on MIRR which project (s) should the company choose: *

A. X, Y & Z

B. X & Y

C. Only X

D. Only Z

E. Reject all projects

9. If IRR for “X” is 11.00%, and the three project X, Y & Z are Independent, which project (s) should the company choose: *

A. X, Y & Z

B. X & Y

C. Only X

D. Only Y

E. Reject all projects

10. Wilson Co. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,500 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each of the next 4 years. Each project has a WACC of 11%. What is the equivalent annual annuity of the most profitable project? *

A. $1,345.50

B. $1,346.30

C. $1,361.52

D. $1,376.74

E. $1,411.15

Answer 1

Weight of equity=33.33%

Weight of preferred stock=33.33%

Weight of debt=33.33%

WACC=(weight of equity*cost of equity)+(weight of preferred stock*cost of preferred stock)+(weight of debt*after tax cost of debt)

Cost of preferred stock=annual dividend/preferred share price=$5/120=4.17%

Cost of equity=(Dividend next year/sahre price)+growth rate

Dividend next year=$2*(1+10%)=$2.2

Cost of equity=($2.2/40)+10%=15.5%

WACC=(33.33%*15.5%)+(33.33%*4.17%)+(33.33%*2%)=7.22%

=NPV(rate, Year1 to Year3 cashflows)-Year0 cashflow

=NPV(7.22%,Year1 to Year3 cashflows)-Year0 cashflow

NPV=$81.36

=IRR(Values)=IRR(Year0 to Year3 cashflows)

IRR=11.34%

=MIRR(values, finance rate, reinvestment rate)

=MIRR(Year0 to Year3 cashflows,7.22%,7.22%)

MIRR=9.59%

Pay back period is 2.167 years, in which comapny receives its initial cost of investment.

7. if projects are independent, all the projects are accepted (X<Y<Z) because all projects MIRR is greater than WACC

8.Only X should be accepted because of higher MIRR than other projects

9.If projects are independent, all the projects are accepted

10.

	Project X	ProjectB
Year0	-10000	-10000
Year1	6000	4600
Year2	8500	4600
Year3		4600
Year4		4600
NPV	2304.20	4271.25
	$1,345.50	$1,376.74

NPV of X=$2304.20

NPV of Y=$4271.25

Now find equivalent annual annuity using PMT function in EXCEL

=PMT(rate,nper,pv,fv,type)

X=PMT(11%,2,-2304.20,0,0)=$1345.50

Y=PMT(11%,4,-4271.25,0,0)=$1376.74

Project Y has higher EAA. so, it is $1376.74

Option D is correct