Assignment 1: LASA # 2—Capital Budgeting Techniques
Assignment 1: LASA # 2—Capital Budgeting Techniques
As a financial consultant, you have contracted with Wheel Industries to evaluate their procedures
involving the evaluation of long term investment opportunities. You have agreed to provide a
detailed report illustrating the use of several techniques for evaluating capital projects including
the weighted average cost of capital to the firm, the anticipated cash flows for the projects, and
the methods used for project selection. In addition, you have been asked to evaluate two
projects, incorporating risk into the calculations.
You have also agreed to provide an 8-10 page report, in good form, with detailed explanation of
your methodology, findings, and recommendations.
Company Information
Wheel Industries is considering a three-year expansion project, Project A. The project requires
an initial investment of $1.5 million. The project will use the straight-line depreciation method.
The project has no salvage value. It is estimated that the project will generate additional revenues
of $1.2 million per year before tax and has additional annual costs of $600,000. The Marginal
Tax rate is 35%.
Required:
Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a
constant rate of six percent per year forever. If the stock is currently selling for $50 per share
with a 10% flotation cost, what is the cost of new equity for the firm? What are the
advantages and disadvantages of using this type of financing for the firm?
The firm is considering using debt in its capital structure. If the market rate of 5% is
appropriate for debt of this kind, what is the after tax cost of debt for the company? What are
the advantages and disadvantages of using this type of financing for the firm?
The firm has decided on a capital structure consisting of 30% debt and 70% new common
stock. Calculate the WACC and explain how it is used in the capital budgeting process.
Calculate the after tax cash flows for the project for each year. Explain the methods used in
your calculations.
If the discount rate were 6 percent calculate the NPV of the project. Is this an economically
acceptable project to undertake? Why or why not?
Depreciation = Cost of the asset – salvage value
Life of the asset
= 1,500,000/ 3
= 500,000
Calculation of cash flows:
Revenue –
1,200,000
Less Cost –
600,000
Less Depreciation –
500,000
Profit 100,000
Less taxes (35%)
35,000
Profit after taxes
65,000
Add depreciation
Cash flow after taxes
500,000
565,000
NPV = Present value of cash flows – Cash outlay
= 565,000 x PVIFA 6%, 3 years – 1,200,000
= 565,000 x 2.6730 – 1,200,000
= 1,510,245 – 1,200,000
= 310,245
As the NPV is positive the project should be accepted.
Now calculate the IRR for the project. Is this an acceptable project? Why or why not? Is
there a conflict between your answer to part C? Explain why or why not?
Wheel has two other possible investment opportunities, which are mutually exclusive, and
independent of Investment A above. Both investments will cost $120,000 and have a life of 6
years. The after tax cash flows are expected to be the same over the six year life for both
projects, and the probabilities for each year’s after tax cash flow is given in the table below.
Investm
Investment C
ent B
Probability
After
Probability
After
Tax
Tax
Cash
Cash
Flow
Flow
0.25
$20,000
0.30
$22,000
0.50
32,000
0.50
40,000
0.25
40,000
0.20
50,000
What is the expected value of each project’s annual after tax cash flow? Justify your answers
and identify any conflicts between the IRR and the NPV and explain why these conflicts may
occur.
Assuming that the appropriate discount rate for projects of this risk level is 8%, what is the
risk-adjusted NPV for each project? Which project, if either, should be selected? Justify your
conclusions.
Turn in your completed work to the M5: Assignment 1 Dropbox by Saturday, November 10,
2012.
Assignment 1 Grading Criteria
Correctly calculated the cost of new equity and explained the
calculations, as well as the advantages and disadvantages of
using this type of financing for the firm. (CO4)
Correctly calculated the cost of new debt and explained the
calculations, as well as the advantages and disadvantages of
using this type of financing for the firm. (CO4)
Maximum
Points
20
20
Correctly calculated the weighted average cost of capital and
explained how and why it is used in the capital budgeting
process. (CO4)
Correctly calculated the annual cash flows for the projects and
explained the methods used in the calculations. (CO1)
Evaluated the projects using the NPV method and came to the
correct conclusions based on the decision rules for the NPV.
(CO2)
Evaluated the projects using the IRR method and came to the
correct conclusion based on the decision rules for the IRR.
Identified any conflicts between the IRR and the NPV and
explained why these conflicts may occur. (CO 3)
Correctly introduced risk into the evaluation by using the
expected values as the cash flows and evaluated these cash
flows using risk adjusted discounted rates. (CO 5)
Written in a clear, concise, and organized manner;
demonstrated ethical scholarship in accurate representation
and attribution of sources; displayed accurate spelling,
grammar, and punctuation.
Total:
20
44
44
44
44
64
300
