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? 
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? 

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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.
   Investment B     Investment C     
Probability

After Tax
                        Cash Flow

Probability

After Tax
                        Cash 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 Monday, October 2, 2017. 
  Assignment 1 Grading Criteria   Maximum Points    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)  20    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)  20    Correctly calculated the  weighted average cost of capital and explained how and why it is used in  the capital budgeting process. (CO4)  20    Correctly calculated the annual cash flows for the projects and explained the methods used in the calculations. (CO1)  44    Evaluated the projects using the NPV method and came to the correct conclusions based on the decision rules for the NPV. (CO2)  44    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)  44    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)  44    Written in a clear,  concise, and organized manner; demonstrated ethical scholarship in  accurate representation and attribution of sources; displayed accurate  spelling, grammar, and punctuation.  64    Total:  300

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