Question

Ronald was recently hired by Highland Equipment Inc. 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.

Ronald has a B.S. in accounting from CWU (2016) and passed the CPA exam (2018). 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 Highland Equipment Inc.-- and this is an opportunity to get onto that career track and to prove his ability.

As Ronald 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 Ronald 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	5,200,000	6,000,000	5,200,000	7,600,000
2	5,200,000	10,000,000	5,200,000	7,600,000
3	6,800,000	8,000,000	5,200,000	5,600,000
4	6,800,000	4,000,000	5,200,000	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

Highland Equipment Inc. has the following capital structure, which is considered to be optimal:

Debt	40%
Preferred Equity	5%
Common Equity	55%
	100%

   

Cost of Capital

Ronald 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) Highland Equipment Inc. has issued a 12% semi-annual coupon bond with 5 years term to maturity. The current trading price is $1,040.

(3) The firm has issued some preferred stock which pays an annual 11% dividend of $100 par value, and the current market price is $106.

(4) The firm’s stock is currently selling for $95 per share. Its last dividend (D₀) was $5, and dividends are expected to grow at a constant rate of 7%. The current risk free return offered by Treasury security is 1.5%, and the market portfolio’s return is 9.5%. Highland Equipment Inc. has a beta of 1.4. 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 2% to the overall WACC for high-risk projects and subtracting 2% for low-risk projects.

Ronald knows that Highland Equipment Inc. 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.

4. What is Highland Equipment Inc.’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 Ronald’s criterion of choice.

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

Answer 1

1.The firm's after-tax cost of debt

Current trading price of the bond=Present Value of all its future coupons+Present Value of the face value to be received at maturity

ie.Price/PV=(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where, Current price is given as $ 1040

Pmt.=Semi-annual $ coupon payments,ie. 1000*12%/2= $ 60

r=   ? --Effective cost to the company to be found out

n=No.of semi-annual coupon pmts. Still to maturity, ie. 5 yrs*2= 10

FV=Face value of the bond= $ 1000

With these inputs, we find the before-tax cost as:

1040=(60*(1-(1+r)^-10)/r)+(1000/(1+r)^10)

Solving for r, we get the before-tax semi-annual cost as

5.470%

so,Annual before-tax cost of debt=(1+5.47%)^2-1=11.2392%

The annual after-tax cost of debt =BTY*(1-Tax rate)

ie. 11.2392%*(1-35%)=

7.31%

2.Cost of Preferred stock

k(ps)=$ annual dividend/Current market price

ie.(11%*100)/106=

10.38%

3. Cost of common Equity

Using

i. CAPM approach:

Cost of Equity=RFR+(Beta*Market risk premium)

where, Market Risk Premium=Market return-RFR

ie. Ke=1.5%+(1.4*(9.50%-1.5%))=

12.70%

ii. DCF approach:

Ke=(D1/P0)+g

where D1=D0*(1+g)

ie.Ke=((5*(1+7%))/95)+7%

12.63%

iii. Bond-Yield+Risk premium approach:

Ke=Bond Yield as in 1+Equity risk premium

ie. 7.31%+3%=

10.31%

4. Final estimate of Cost of equity

is an average of i,ii, &iii in 3 above

ie.((12.70%+12.63%+10.31%))/3=

11.88%

Highland equipment inc.'s Overall WACC

WACC= (Wt.d*kd)+(Wt.ps*Kps)+(Wt.eq.*Keq.)

ie.(40%*7.31%)+(5%*10.38%)+(55%*11.88%)=

9.98%

5. NO.

It is logical that cash flows of projects with high risk are discounted at higher WACC/hurdle rate than those with comparatively low risk

It is better to have differential rates of WACC , to have a true/more accurate picture of the PVs of the expected cash flows

Year	A	9.98%	PV
0	-19000000	1	-19000000
1	5200000	0.9092562	4728132
2	5200000	0.8267469	4299084
3	6800000	0.7517248	5111728
4	6800000	0.6835104	4647871
NPV			-213185
IRR			9.49%
MIRR			9.67%
Year	B	11.98%	PV
0	-20000000	1	-20000000
1	6000000	0.8930166	5358100
2	10000000	0.7974787	7974787
3	8000000	0.7121617	5697294
4	4000000	0.6359722	2543889
NPV			1574069
IRR			15.84%
MIRR			14.12%
Year	C	7.98%	PV
0	-14000000	1	-14000000
1	5200000	0.9260974	4815707
2	5200000	0.8576564	4459813
3	5200000	0.7942734	4130222
4	5200000	0.7355746	3824988
NPV			3230730
IRR			17.96%
MIRR			13.73%
Year	D	9.98%	PV
0	-18000000	1	-18000000
1	7600000	0.9092562	6910347
2	7600000	0.8267469	6283276
3	5600000	0.7517248	4209659
4	5600000	0.6835104	3827658
NPV			3230941
IRR			18.60%
MIRR			14.61%

Table 2
	A	B	C	D
WACC	9.98%	11.98%	7.98%	9.98%
NPV	-213185	1574069	3230730	3230941
IRR	9.49%	15.84%	17.96%	18.60%
MIRR	9.67%	14.12%	13.73%	14.61%

NPV, Pay-back period ,IRR & MIRR are the most commonly used methods to appraise & analyse capital budgeting projects while selecting one among them.

NPV scores over all others because of its more accuracy & inclusion of the cash flow over the entire project-life .

Ranking conflicts arise between these approaches ,mainly because of the difference in magnitude & timing of cash inflows & cash outflows.

Year	A	B	C	D
0	-19000000	-20000000	-14000000	-18000000
1	5200000	6000000	5200000	7600000
2	5200000	10000000	5200000	7600000
3	6800000	8000000	5200000	5600000
4	6800000	4000000	5200000	5600000
Risk	Average	High	Low	Average
Risk	Average	High	Low	Average
Overall WACC	9.98%	9.98%	9.98%	9.98%
Adj. Factor	0	2.00%	-2.00%	0
Risk Adj.WACC for each	9.98%	11.98%	7.98%	9.98%
PV of cash flows(yr.1-4)	18786815	21574069	17230730	21230941
NPV(netted with initial inv.)	-213185	1574069	3230730	3230941
IRR	9.49%	15.84%	17.96%	18.60%
MIRR	9.67%	14.12%	13.73%	14.61%
Ranking as per Ronald's criterion--NPV & MIRR
as per NPV	4	3	2	1
as per MIRR	4	2	3	1

Ronald should recommend Project D ---Highest NPV & average risk & also IRR&MIRR>WACC

Project A - Unacceptable-- Negative NPV --both IRR& MIRR<WACC

Project B &C --lesser NPV than Project D