Question

FIN 370 AOL ASSIGNMENT

CASE ANALYSIS: The Case of the Junior Analyst

Name:_______________________

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 CWU (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

1.Firm’s after-tax cost of debt

We find this using the formula to find the PV (given -$ 990)of a bond 8*2=16 nos. , $ 1000*10%=100 semi-annual coupons still to maturity

PV=(Coupon*(1-(1+r)^-n)/r)+(Face value/(1+r)^n)

Filling up the values,

990=(100*(1-(1+r)^-16)/r)+(1000/(1+r)^16)

Solving for r, we get the before-tax yield, r=

10.1288%

So, after-tax cost of the bond=Before-tax cost*(1-Tax Rate)

ie.10.1288%*(1-35%)=

6.58%

2.Cost of preferred stock for Coleman Electronics

K(PS)=Annual $ dividend/Current market price

ie.(10%*100)/105=

9.52%

Cost of common equity

1.Estimated cost of common equity using the CAPM approach

Ke=RFR+(Beta*Mkt.risk premium)

ie.Ke=RFR+(Beta*(MktReturn-RFR)

ie.Ke=2.5%+(1.2*(12%-2.5%)

13.9%

(2)Estimated cost of common equity using the DCF approach

Ke=(Next Dividend/Current market price)+Growth rate

ie. Ke=((3*(1+0.06))/36)+0.06=

14.83%

3)Estimated cost of common equity using the bond-yield-plus-risk-premium approach

Ke=After-tax bond cost/yield+Risk premium

ie.6.58%+3%=

9.58%

(4)Final estimate for Ke/ rs

is the average of the above 3 estimates--

Ke=(13.9%+14.83%+9.58%)/3=

12.77%

Coleman Electronics’s overall WACC

Overall WACC=(Wt.d*Kd)+(Wt.PS*K PS)+(Wt. e*Ke)

ie. Ke=(50%*6.58%)+(10%*9.52%)+(40%*12.77%)

9.35%

Use of single overall WACC as the hurdle rate for each of its projects

is not justifiable as

the WACC or the discount rate to discount the cash flows involved, should be higher for the high-risk project and

can be a lower rate for a project carrying comparatively low risk ,

same as WACC for an average risk one.

WACC for each project
Project	A	B	C	D
Risk	Average	High	Low	Average
WACC	9.35%	10.85%(9.35%+1.5%)	7.85% (9.35%-1.5%)	9.35%

Table 1
t	A	B	C	D
0	-19000000	-20000000	-14000000	-18000000
1	8000000	11000000	5700000	3600000
2	8000000	10000000	5700000	7600000
3	8000000	8000000	5700000	5600000
4	8000000	4000000	5700000	5600000
WACC	9.35%	10.85%	7.85%	9.35%
(As per Excel) functions
IRR	25%	28%	23%	9%
NPV	6719893	6584049	4879123	-152463
MIRR	18%	19%	16%	9%

Ranking as per
IRR	2	1	3	4
NPV	1	2	3	4
MIRR	2	1	3	4

Underlying cause of ranking conflicts

is the timing & magnitude of cash flows is different in different projects.

NPV criterion is the best one as

it considers all the cash flows(both inflows & outflows) over the entire life of the project.

considers time value of money

maximises value for the shareholders , when selected based on this criterion.

Projects unacceptable

B,C, D are unaccepatable

as they are ranked only after A in NPV   &

It maximises value for the available $ 20000000 with Colin

Colin should choose Project A for its highest NPV

B is rejected for high-risk & ranking second in NPV

C is rejected as even at 8% discount rate, NPV is less.

D is rejected as IRR< WACC & NPV is NEGATIVE.