Question

Company B has three Projects it can choose from: Projects X, Y and Z. The following information is available regarding Project X: Years 0 1 2 3 CF -100 80 60 40

The company’s capital structure is distributed equally between debt and preferred stock and the remaining 40% goes to common stock. It has also the following information: 1- After tax cost of debt: 3%. Tax rate: 40% 2- Preferred stocks are selling at $70 per share and pay a dividend of $7 per share 3- Common stocks are selling at $60 per share, pay a year-end dividend of $4 per share and grow at a constant rate of 8.59%.

The company is also considering another two projects “Y” & “Z” with the following information: Criteria Project Y Project Z NPV $40 $67 MIRR 11% 20% IRR -2.0% 18.7% Regular Payback 2.23 years 1.77 years Note:

This problem is related to questions 1 to 9

1) NPV for Project X is: * a) $80 b) 52.37% c) 70% d) $52.37 e) None of the above 2) MIRR for Project X is: * a) 2.65% b) 26.5% c) 14.7% d) 13.8% e) None of the above 3) The regular payback period for Project X is: * a) 0.67 years b) 1.33 years c) 1.55 years d) 2.55 years e) None of the above 4) The discounted payback period for Project X is: * a) 0.67 years b) 1.33 years c) 1.55 years d) 2.55 years e) None of the above 5) Assuming that the three projects X, Y & Z are independent, which project (s) should the company choose: * a) Project Z b) Projects X and Z c) Projects X, Y and Z d) Projects Y and Z e) Reject all projects 6) Assuming that the three projects X, Y & Z are mutually exclusive, which project (s) should the company choose: * a) Project Z b) Project X c) Projects X, Y and Z d) Project Y e) Reject all projects 7) Assuming that the three projects X, Y & Z are independent, based on MIRR criteria which project (s) should the company choose: * a) Project Z b) Project X c) Projects X, Y and Z d) Project Y e) Reject all projects 8) Assuming that the three projects X, Y & Z are mutually exclusive, based on MIRR criteria which project (s) should the company choose: * a) Project Z b) Project X c) Projects X, Y and Z d) Project Y e) Reject all projects 9) If IRR for Project X is 17.95%, and the three project X, Y & Z are independent, then based on IRR criteria which project (s) should the company choose: * a) Project Z b) Projects X and Z c) Projects X, Y and Z d) Projects Y and Z e) Reject all projects

Answer 1

Cost of Preferred Stock = 7/70= 0.1

Cost of common stock = 4/60+8.59% = 0.152567

After tax Cost of Debt= 3% = 0.03

WACC = 0.3*0.03+0.3*0.1+0.4*0.152567 = 0.100027 or 10%

1. NPV of Project X = -100+80/1.1+60/1.1^2+40/1.1^3 = 52.366 or $52.37 (option d)

2. FV of Cash inflows = 80*(1.1)^2+60*1.1+40 = 202.80

So, MIRR = (202.80/100)^(1/3) -1 = 0.265 or 26.5%(Option b)

3. The Cumulative Cashflows and Discounted Cumulative Cashflows are as shown in table below

Year	CF	Cumulative Cashflows	Discounted CF	Cumulative DCF
0	-100	-100	-100	-100
1	80	-20	72.72727	-27.27273
2	60	40	49.58678	22.31405
3	40	80	30.05259	52.36664

It can be seen that Cumulative Cashflows become positive in Year 2

Hence , the regular payback period =

1 year+ (Cumulative Cashflow in year 1)/ Cashflow in year 2

= 1+20/60

= 1.33 years (Option b)

4)

It can be seen that Discounted Cumulative Cashflows become positive in Year 2

Hence , the Discounted payback period =

1 year+ (Cumulative Discounted Cashflow in year 1)/ Discounted Cashflow in year 2

= 1+27.27/49.59

= 1.55 years (Option c)