Hailey just started her first job at Whatcom Co. as a juniorbudget analyst. She is working for the Venture Capital Division andhas been given for capital budgeting projects to evaluate. She mustgive her analysis and recommendation to the capital budgetingcommittee.

Hailey has a B.S. in accounting from WWU (2007) and passed theCPA exam (2008). She has been in public accounting for 2 years.During that time, she earned an MBA from Seattle U. She would liketo be the CFO of a company someday--maybe Whatcom Co. -- and thisis an opportunity to get onto that career track and to prove herability.

As Hailey looks over the financial data collected, she is tryingto make sense of it all. She already has the most difficult part ofthe analysis complete -- the estimation of cash flows. Through someinternet research and application of finance theory, she has alsodetermined the firm’s beta.

Here is the information that Hailey has accumulated so far:

The Capital Budgeting Projects

She must choose one of the four capital budgeting projectslisted below:  

Table 1

t	A	B	C	D
0	(14,850,000)	(17,500,000)	(16,600,000)	(17,900,000)
1	4,500,000	4,500,000	5,660,000	4,680,000
2	4,500,000	5,560,000	5,660,000	6,780,000
3	5,200,000	5,820,000	5,200,000	5,900,000
4	6,800,000	6,500,000	4,600,000	5,800,000
Risk	High	Average	Average	Low

Table 1 shows the expected after-tax operating cash flows foreach project. All projects are expected to have a 4-year life. Theprojects differ in size (the cost of the initial investment), andtheir cash flow patterns are different. They also differ in risk asindicated in the above table.

The capital budget is $20 million, and the projects are mutuallyexclusive.

Capital Structures

Whatcom Co. has the following capital structure, which isconsidered to be optimal:

Common Equity	60%
Preferred Equity	10%
Debt	30%
	100%

Cost of Capital

Hailey knows that in order to evaluate the projects she willhave to determine the cost of capital for each of them. She hasbeen given the following data, which he believes will be relevantto her task.

(1) The firm’s tax rate is 35%.

(2) Whatcom Co. has issued a 12% semi-annual coupon bond with 15years term to maturity. The current trading price is $1105.

(3) The firm has issued some preferred stock which pays anannual 10.5% dividend of $100 par value, and the current marketprice is $102.

(4) The firm’s stock is currently selling for $54 per share. Itslast dividend (D₀) was $2.8, and dividends are expectedto grow at a constant rate of 7%. The current risk-free returnoffered by Treasury security is 2.5%, and the market portfolio’sreturn is 10.4%. Whatcom Co. has a beta of 1.3

(5) The firm adjusts its project WACC for risk by adding 2% tothe overall WACC for high-risk projects and subtracting 2.1% forlow-risk projects.

Hailey knows that Whatcom Co. executives have favored IRR in thepast for making their capital budgeting decisions. Her professor atSeattle U. said NPV was better than IRR. She is the new kid on theblock and must be prepared to defend her recommendations.

First, however, Hailey must finish the analysis and write herreport. To help begin, she has formulated the followingquestions:

1. What is the firm’s cost of debt?

2. What is the firm’s cost of preferred stock?

3. Cost of common equity

(1) What is the estimated cost of common equity using the CAPMapproach?

(2) What is the estimated cost of common equity using the DCFapproach?

(3) What is the final estimate for cost of equity?

4. What is Whatcom Co.’s overall WACC?

5. Do you think the firm should use the single overall WACC asthe hurdle rate for each of its projects? Explain.

6. What is the WACC for each project?

7. Calculate all relevant capital budgeting measures for eachproject and place your numerical solutions in Table2.

Table 2

	A	B	C	D
NPV
IRR

8. Comment on the commonly used capital budgeting measures. Whatis the underlying cause of ranking conflicts? Which criterion isthe best one, and why?

9. Which of the projects are unacceptable and why?

10. Rank the projects that are acceptable, according to Hailey’scriterion of choice.