Question

The Capital Budgeting Projects

She must choose one of the four capital budgeting projects listed below:  

Table 1

t	A	B	C	D
0	(19,500,000)	(21,000,000)	(16,500,000)	(18,000,000)
1	7,500,000	6,500,000	5,200,000	7,500,000
2	7,500,000	7,200,000	5,200,000	5,800,000
3	5,000,000	8,000,000	6,300,000	4,400,000
4	3,500,000	3,000,000	5,900,000	4,500,000
Risk	Average	Average	High	Low

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 $22 million and the projects are mutually exclusive.

Capital Structures

Happy Mood Food has the following capital structure, which is considered to be optimal:

Debt	30%
Preferred Equity	15%
Common Equity	55%
	100%

   

Cost of Capital

Serena knows that in order to evaluate the projects she will have to determine the cost of capital for each of them. She has been given the following data, which he believes will be relevant to her task.

- The firm’s tax rate is 35%.

- Happy Mood Food has issued a 6% semi-annual coupon bond with 8 years term to maturity. The current trading price is $870.

- The firm has issued some preferred stock which pays an annual 8.8% dividend of $100 par value, and the current market price is $115.

- The firm’s stock is currently selling for $59 per share. Its last dividend (D₀) was $3, and dividends are expected to grow at a constant rate of 6.8%. The current risk free return offered by Treasury security is 2.2%, and the market portfolio’s return is 7.8%. Happy Mood Food has a beta of 1.8. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 3.8%.

- The firm adjusts its project WACC for risk by adding 2.2% to the overall WACC for high-risk projects and subtracting 2% for low-risk projects.

Serena knows that Happy Mood Food executives have favored IRR in the past for making their capital budgeting decisions. Her professor at Seattle U. said NPV was better than IRR. Her textbook says that MIRR is also better than IRR.   She is the new kid on the block and must be prepared to defend her recommendations.

First, however, Serena must finish the analysis and write her report. To help begin, she has formulated the following questions:

Please show calculations as this is what I need to help actually learn and understand the solutions.

1. What is the firm’s cost of debt?

2. What is the cost of preferred stock for Happy Mood Food?

3. Cost of common equity

(1) What is the estimated cost of common equity using the CAPM approach?

(2) What is the estimated cost of common equity using the DCF approach?

(3) What is the estimated cost of common equity using the bond-yield-plus-risk-premium approach?

(4) What is the final estimate for r_s?

4. What is Happy Mood Food’s overall WACC?

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

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

Answer 1

Cost of Debt
before tax cost of debt =using rate function in MS excel	rate(nper,pmt,pv,fv,type) nper =8*2 =16 pmt =1000*6%*1/2 = 30 pv = -870 fv=1000 type =0	RATE(16,30,-870,1000,0)	4.13%
annual before tax bond yield	4.13*2		8.26
after tax cost of debt =before tax cost of debt*(1-tax rate)	4.13*2*(1-.35)		5.369
Cost of preferred stock
cost of preferred stock = preferred dividend/market price	8.8/115		7.65%
cost of equity
cost of equity Using CAPM = risk free rate+(market portfolio return-risk free rate)*beta	2.2+(7.8-2.2)*1.8		12.28
cost of equity using dcf approach =(expected dividend/market price)+growth rate	(3*1.068)/59)+6.08%		11.51
cost of equity using bond yield plus risk premium approach	after tax cost of debt+risk premium	5.369+3.8	9.17
Final estimate of cost of equity	(12.28+11.51+9.17)/2		16.48
Overall WACC
Source	weight	component cost	weight*component cost
debt	0.3	5.369	1.6107
preferred stock	0.15	7.65	1.1475
equity	0.55	16.48	9.064
total
WACC = sum of weight*component cost			11.82
WACC for each project	Overall WACC	risk premium/discount	WACC for each project
High	11.82	2.2	14.02
Average	11.82	0	11.82
Low	11.82	-2	9.82