Question

Colin was recently hired by Coleman Electronics 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.

Colin has a B.S. in accounting from XXX (2015) and passed the CPA exam (2017). He has been in public accounting for several years. During that time he earned an MBA from Seattle U. He would like to be the CFO of a company someday--maybe Coleman Electronics-- and this is an opportunity to get onto that career track and to prove his ability.

As Colin 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 Colin 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	(19,000,000)	(20,000,000)	(14,000,000)	(18,000,000)
1	8,000,000	11,000,000	5,700,000	3,600,000
2	8,000,000	10,000,000	5,700,000	7,600,000
3	8,000,000	8,000,000	5,700,000	5,600,000
4	8,000,000	4,000,000	5,700,000	5,600,000
Risk	Average	High	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

Coleman Electronics has the following capital structure, which is considered to be optimal:

Debt	50%
Preferred Equity	10%
Common Equity	40%
	100%

   

Cost of Capital

Colin 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 35%.

(2) Coleman Electronics has issued a 10% semi-annual coupon bond with 8 years term to maturity. The current trading price is $990.

(3) The firm has issued some preferred stock which pays an annual 10% dividend of $100 par value, and the current market price is $105.

(4) The firm’s stock is currently selling for $36 per share. Its last dividend (D₀) was $3, and dividends are expected to grow at a constant rate of 6%. The current risk free return offered by Treasury security is 2.5%, and the market portfolio’s return is 12%. Coleman Electronics has a beta of 1.2. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 3%.

(5) The firm adjusts its project WACC for risk by adding 1.5% to the overall WACC for high-risk projects and subtracting 1.5% for low-risk projects.

Colin knows that Coleman Electronics 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, Colin must finish the analysis and write his report. To help begin, he has formulated the following questions:

1. What is the firm’s cost of debt?

2. What is the cost of preferred stock for Coleman Electronics?

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 Coleman Electronics’s overall WACC?

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

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

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

9. Which of the projects are unacceptable and why?

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

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

Instructions

1.Your answers should be Word processed, submitted via Canvas.

2.Questions 5, 8, 9, and 11 are discussion questions.

3.Place your numerical solutions in Table 2.

4.Show your steps for calculation questions.

Answer 1

Since the question has multiple parts, I have completed all the parts upto the presentation of Table 2 (WACC, NPV, IRR and MIRR).

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Part 1)

The cost of debt can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT =Payment (here, Coupon Payment), PV = Present Value and FV = Future Value (here, Bond Face Value).

Here, Nper = 8*2 = 16, PMT = 1,000*10%*1/2 = $50, PV = $990 and FV = $1,000.

Using these values in the above function/formula for Rate, we get,

After-Tax Cost of Debt = Rate(16,50,-990,1000)*2*(1-35%) = 6.62%

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Part 2)

The cost of preferred stock is determined as below:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100 = (10%*100)/105*100 = 9.52%

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Part 3)

The cost of common equity under each method is calculated as below:

1)

CAPM Approach

Cost of Common Equity = Risk Free Rate + Beta*(Market Rate of Return - Risk Free Rate) = 2.5% + 1.2*(12% - 2.5%) = 13.90%

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DCF Approach

Cost of Common Equity = D0*(1+Growth Rate)/Current Stock Price + Growth Rate = 3*(1+6%)/36 + 6% = 14.83%

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Bond-Yield-Plus-Risk-Premium

Cost of Common Equity = Bond Yield + Risk Premium = Annual Coupon/Current Bond Price*100 + Risk Premium = (1,000*10%)/990 + 3% = 13.10%

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Part 4)

The final estimate for rs is arrived as follows:

rs (Final Estimate) = (Cost of Common Equity (CAPM Approach) + Cost of Common Equity (DCF Approach) + Cost of Common Equity (Bond-Yield-Plus-Risk-Premium))/3 = (13.90% + 14.83% + 13.10%)/3 = 13.94%

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Part 5)

The Coleman Electronics’s overall WACC is calculated as below:

WACC = Proportion of Debt*After-Tax Cost of Debt + Proportion of Preferred Stock*Cost of Preferred Stock + Proportion of Common Equity*Cost of Common Equity

Substituting values in the above formula, we get,

WACC = 50%*6.62% + 10%*9.52% + 40%*13.94% = 9.84%

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Part 6)

No, the firm shouldn't use the single overall WACC as the hurdle rate for each of its projects. It is because different projects carry different risks. WACC indicates the hurdle rate for an average risk project. Therefore, an adjustment may be required to each project's WACC to indicate/measure the risk associated with the project.

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Part 7)

The WACC for each project is determined as below:

WACC (Project A) = WACC + Risk Adjustment = 9.84% + 0 = 9.84%

WACC (Project B) = WACC + Risk Adjustment = 9.84% + 1.5% = 11.34%

WACC (Project C) = WACC + Risk Adjustment = 9.84% - 1.5% = 8.34%

WACC (Project D) = WACC + Risk Adjustment = 9.84% + 0 = 9.84%

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Part 8)

The NPV for each project is calculated as below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Risk-Adjusted WACC)^1 + Cash Flow Year 2/(1+Risk-Adjusted WACC)^2 + Cash Flow Year 3/(1+Risk-Adjusted WACC)^3 + Cash Flow Year 4/(1+Risk-Adjusted WACC)^4

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NPV (Project A) = -19,000,000 + 8,000,000/(1+9.84%)^1 + 8,000,000/(1+9.84%)^2 + 8,000,000/(1+9.84%)^3 + 8,000,000/(1+9.84%)^4 = $6,447,004.51

NPV (Project B) = -20,000,000 + 11,000,000/(1+11.34%)^1 + 10,000,000/(1+11.34%)^2 + 8,000,000/(1+11.34%)^3 + 4,000,000/(1+11.34%)^4 = $6,345,370.84

NPV (Project C) = -14,000,000 + 5,700,000/(1+8.34%)^1 + 5,700,000/(1+8.34%)^2 + 5,700,000/(1+8.34%)^3 + 5,700,000/(1+8.34%)^4 = $4,737,122.51

NPV (Project D) = -18,000,000 + 3,600,000/(1+9.84%)^1 + 7,600,000/(1+9.84%)^2 + 5,600,000/(1+9.84%)^3 + 5,600,000/(1+9.84%)^4 = -$350,215.65

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Part 9)

IRR is the minimum rate of return acceptable from a project. IRR can be calculated with the IRR function/formula of EXCEL. The basic formula for calculating IRR is given as below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4

IRR is calculated with the use of EXCEL as follows:

where:

IRR (Project A) = IRR(B2:B6) = 24.68%

IRR (Project B) = IRR(C2:C6) = 28.01%

IRR (Project C) = IRR(D2:D6) = 22.82%

IRR (Project D) = IRR(E2:E6) = 8.98%

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Part 10)

MIRR is calculated with the use of MIRR function/formula of EXCEL which is MIRR(values,finance_rate,reinvest_rate) as below:

where:

MIRR (Project A) = MIRR(B2:B6,9.84%,9.84%) = 18.16%

MIRR (Project B) = MIRR(C2:C6,11.34%,11.34%) = 19.28%

MIRR (Project C) = MIRR(D2:D6,8.34%,8.34%) = 16.53%

MIRR (Project D) = MIRR(E2:E6,9.84%,9.84%) = 9.30%

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Tabular Representation:

	A	B	C	D
WACC	9.84%	11.34%	8.34%	9.84%
NPV	$6,447,004.51	$6,345,370.84	$4,737,122.51	-$350,215.65
IRR	24.68%	28.01%	22.82%	8.98%
MIRR	18.16%	19.28%	16.53%	9.30%

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Notes:

There can be a difference in final answers for all parts on account of rounding off values.