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COMPREHENSIVE CAPITAL BUDGETING PROJECT    A comprehensive capital budgeting project will be due at the end of this module

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COMPREHENSIVE CAPITAL BUDGETING PROJECT 

 

A comprehensive capital budgeting project will be due at the end of this module.

 

Instructions: This project requires you to apply the concepts and methods learned in the course. This is an individual project. You are not permitted to discuss this project with other class members or with friends or colleagues. Any assistance should be rendered only by the professor. 

 

Assignment: You are interested in proposing a new venture to the management of your company. Pertinent financial information is given below.

 

	BALANCE SHEET
Cash	2,000,000	Accounts Payable and Accruals	18,000,000
Accounts Receivable	28,000,000	Notes Payable	40,000,000
Inventories	42,000,000	Long-Term Debt	60,000,000
		Preferred Stock	10,000,000
Net Fixed Assets	133,000,000	Common Equity	77,000,000

 

 

205,000,000

Total Assets Total Claims

 

 

• Last year’s sales were $225,000,000.

 

• 205,000,000

  The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent semi-annual coupon, and are currently selling for $874.78.

 

• You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a 3.33% per share flotation cost.

 

• The company has 10 million shares of common stock outstanding with a current price of $14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D₀) was $.80. New stock could be sold with flotation costs of 15 percent.

 

• The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 14 percent. Your stock’s beta is 1.22.

 

• Stockholders require a risk premium of 5 percent above the return on the firms bonds.

 

• The firm expects to have additional retained earnings of $10 million in the coming year, and expects depreciation expenses of $35 million.

 

• Your firm does not use notes payable for long-term financing.

 

• The firm considers its current market value capital structure to be optimal, and wishes to maintain that structure. (Hint: Examine the market value of the firm’s capital structure, rather than its book value when determining the weights in the WACC calculations.)

 

• The firm’s management requires a 2% adjustment to the cost of capital for risky projects.

 

• Your firm’s federal + state marginal tax rate is 40%.

 

• The firm has the following investment opportunities currently available in addition to the venture that you are proposing:

 

Project          

      IRR

 

1. 20%
2. 20,000,000           18%
3. 15,000,000           14%
4. 30,000,000           12%
5. 25,000,000           10%

 

Your venture would consist of a new product introduction (You should label your venture as Project I, for “introduction”).  You estimate that your product will have a six-year life span, and the equipment used to manufacture the project falls into the MACRS 5-year class.  Your venture would require a capital investment of $15,000,000 in equipment, plus $2,000,000 in installation costs.  The venture would also require an initial investment in accounts receivable and inventories of $4,000,000.  At the end of the six-year life span of the venture, you estimate that the equipment could be sold at a $4,000,000 salvage value.

 

Your venture, which management considers risky, would increase fixed costs by a constant $1,000,000 per year, while the variable costs of the venture would equal 30 percent of revenues. You are projecting that revenues generated by the project would equal $5,000,000 in year 1, $10,000,000 in year 2, $14,000,000 in year 3, $16,000,000 in year 4, $12,000,000 in year 5, and $8,000,000 in year 6.

The following list of steps provides a structure that you should use in analyzing your new venture.

 

            Note: Carry all final calculations to two decimal places.

 

Phase 1

1. Find the costs of the individual capital components (12 points):
   1. long-term debt
   2. preferred stock
   3. retained earnings (avg. of CAPM, DCF, & bond yield + risk premium approaches)
   4. new common stock
2. Determine the target percentages (weights) for the optimal capital structure. (Carry weights to four decimal places. For example: 0.2973 or 29.73%) (3 points)
3. Compute the retained earnings break point. (3 points)
4. Draw the MCC schedule, including depreciation-generated funds in the schedule. (7 points)

 

Phase 2

5. Compute the Year 0 investment for Project I. (3 points)
6. Compute the annual operating cash flows for years 1-6 of the project. (12 points)
7. Compute the non-operating (end-of-project) cash flows at the end of year 6. (3 points) 8. Draw a timeline that summarizes all of the cash flows for your venture. (3 points) Note:  You may complete #5-8 in an Excel spreadsheet or calculate these manually.

 

Phase 3

9. Compute the IRR and payback period for Project I. (10 points)
10. Draw the IOS schedule, including Project I along with Projects A-E. (4 points)
11. Determine your firm’s corporate cost of capital. (5 points)
12. Compute the discounted payback and NPV for Project I at the risk-adjusted cost of capital for project I.  (10 points)
13. Indicate which projects should be accepted, and why. (10 points)
14. Would your answer be different if the project I was determined to be of average risk? Explain. (5 points)

 

Phase 4

15. Summarize your findings and recommendations in a brief (1-2 page) memo to the President of the firm.  (10 points)
16. Conclude the project with your reflections on what you have learned from this course and how it has affected your view of your own job and career.