Question

Q No. 2 Assume that you are a new analyst hired to evaluate the capital budgeting projects of the company which is considering investing in two CPEC projects, “Expansion Zone North” and “Expansion Zone East”. The initial cost of each project is Rs. 10,000. Company discount all projects based on WACC. Further, all the projects are equally risky projects and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at an interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for next period is $2.0, its expected that they will grow at the constant growth rate of 8%, and the company's common stock sells for $20. The tax rate is 50%. The cash flows of both the projects are given in table below: Time Expansion Zone North Cashflows (amount in Rs.) 10,000 Expansion Zone East Cashflows (amount in Rs.) 10,000 0 1 2. 6,500 3,000 3,000 1,000 3,500 3,500 3,500 3,500 3 4 Carefully analyze the above table and answer the following questions in detail. I. Calculate the weighted average cost of capital for this firm? (2.5 marks) II. Compute each project’s IRR, NPV, payback, MIRR, and discounted payback. (2.5 Marks) III. Which project(s) should be accepted if they are mutually exclusive? Explain (1.5 Marks) IV. Which project(s) should be accepted if they are independent? Explain (1.5 Marks)

Answer 1

I]

WACC = (weight of debt * cost of debt) + (weight of common stock * cost of common stock)

cost of debt = rd * (1 - tax rate) = 10% * (1 - 50%) = 5%

cost of common stock = (expected dividend / current stock price) + growth rate

cost of common stock = ($2 / $20) + 8% = 18%

WACC = (50% * 5%) + (50% * 18%)

WACC = 11.50%

II]

IRR and MIRR are calculated using the respective functions in Excel

Present value of each cash flow = cash flow / (1 + WACC)ⁿ

where n = number of years after which the cash flow occurs.

NPV = sum of present values of all cash flows

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = Last year in which cumulative cash flow is negative + (cash flow required in next year for cumulative cash flows to equal zero / next year cash flow)  

Discounted payback period is the time taken for the cumulative cash flows to equal zero

Discounted payback period = Last year in which cumulative discounted cash flow is negative + (discounted cash flow required in next year for cumulative cash flows to equal zero / next year discounted cash flow)  

The calculations are below :

Discounted payback period is the time taken for the cumulative cash flows to equal zero

Discounted payback period = Last year in which cumulative discounted cash flow is negative + (discounted cash flow required in next year for cumulative cash flows to equal zero / next year discounted cash flow)  

III]

If the projects are mutually exclusive, Project North should be accepted because it has a higher NPV

IV]

If the projects are independent, both Projects should be accepted because both the projects have a positive NPV