Capital Budgeting and the Cost of Capital

Assignment Overview

Before starting on this assignment, make sure
to thoroughly review the required background materials. Make sure you fully
understand both the basic concepts as well as how to calculate payback period,
NPV, IRR, and WACC. Submit your answers in a Word document. Make sure to show
your work for all quantitative questions and fully explain your answers using
references to the background readings for any conceptual questions. Questions 1
and 2 will require Excel. Attach an Excel file to show your computations for
Questions 1 and 2.

Case Assignment

The table below gives
the initial investment and expected cash flows over the next five years for two
different projects. Assume that the industry you are in expects a return of
10%, which you use as the discount rate in net present value (NPV) calculations
and as the required rate of return for purposes of deciding on projects. Also,
assume that management only wants to invest in projects that pay off within
four years.

For each project, compute the payback period,
NPV, and internal rate of return (IRR). Then explain whether each project
should be accepted based on these three criteria.

Project
A

Project
B

Initial
Investment

$40,000

$28,000

Year

Cash Flows

1

$10,000

$10,000

2

$10,000

$13,000

3

$10,000

$5,000

4

$10,000

$5,000

5

$10,000

$6,000

Suppose you are
planning on becoming a vendor at the arena where your favorite sports team
plays. You are trying to decide between opening up a souvenir stand selling
T-shirts, caps, etc., with your sports team’s logo or opening up a hot dog and
beer stand. It is more expensive to open up the hot dog and beer stand because
you need to purchase a license to serve alcohol and you need to spend money to
comply with health department regulations. Revenue from the souvenir stand is
likely to be unpredictable because fans of your favorite team tend to want to
purchase hats and T-shirts only when the team is winning. Revenue from hot dogs
and beer seem to be a little more steady since fans want to eat and drink
regardless of whether the team is winning.

Below is a table with the initial investment cost of each type of stand and the
annual payments you expect over the next five years. The annual payments will
be different depending on how well your team does. Therefore, you will estimate
how much cash flow you will get depending on whether your team does better than
expected (optimistic), the same as the past few years (most likely), and worse
than expected (pessimistic). Use a discount rate of 8%.

Based on the table below, answer the following
items:

Calculate the net
present value (NPV) for each type of stand under each of the three scenarios.
Calculate the range of possible NPV values for each type of stand.Based on your answer
to A) above and your own guesses about how well you think your favorite team
will do over the next five years, which type of stand would you rather invest
in?

Souvenir
Stand

Hot
Dog and Beer Stand

Initial
Investment

$100,000

$150,000

Annual Cash Inflows (5 Years)

Outcome

Pessimistic

$30,000

$50,000

Most
likely

$50,000

$60,000

Optimistic

$70,000

$70,000

Suppose you are a corn
farmer in your home state. You have to decide between two projects. One project
is to purchase new equipment for your farm that will help boost your profits
for the next 10 years. You also find out that you can purchase a large banana
farm in Brazil for the same price as the equipment, and at the current market
price for bananas you will make a lot more profit than you would from
purchasing new corn farming equipment.

After asking around, you find out that the standard discount rate for
evaluating the NPV of the farming project is 6%. Most farmers in your home
state seem to use this rate successfully. However, you don’t know any other
banana farmers and you don’t know too much about farming in Brazil, so you have
to make a guess on an appropriate discount rate for the Brazilian banana farm.
Based on the concepts from the background readings, would you say the Brazilian
banana farm will need a lower or higher discount rate? A lot larger or smaller,
or only a little?Calculate the
following:The cost of equity if
the risk-free rate is 2%, the market risk premium is 8%, and the beta for the
company is 1.3.The cost of equity if
the company paid a dividend of $2 last year and is expected to grow at a constant
rate of 7%. The stock price is currently $40.The weighted average
cost of capital (WACC) if the company has a total value of $1 million with a
market value of its debt at $600,000 and a market value of its equity at
$400,000. Its cost of debt is 6% and its cost of equity is 15%. The tax rate it
pays is 25%.Suppose you own a
chain of dry cleaners and the WACC you’ve been using to make decisions on new
purchases of dry cleaning equipment is a steady 9%. Recently, gambling has been
made legal in your home town so you decide to expand and open up a casino.
Should you use the same WACC to evaluate purchases of casino equipment? Why or
why not? What are some alternatives to using the same WACC to make decisions on
casino equipment? Explain your reasoning, and make references to concepts from
the background readings.

Assignment Expectations

Answer the assignment
questions directly.Stay focused on the
precise assignment questions. Do not go off on tangents or devote a lot of
space to summarizing general background materials.For computational
problems, make sure to show your work and explain your steps.For short answer/short
essay questions, make sure to reference your sources of information with both a
bibliography and in-text citations. See the Student Guide to Writing a
High-Quality Academic Paper, including pages 11-14 on in-text citations. Another resource
is the “Writing Style Guide,” which is found under “My Resources” in the TLC
Portal.

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