Lindsey was recently hired by Swift Ltd. as a junior budgetanalyst. She is working for the Venture Capital Division and hasbeen given for capital budgeting projects to evaluate. She mustgive her analysis and recommendation to the capital budgetingcommittee.
Lindsey has a B.S. in accounting from CWU (2014) and passed theCPA exam (2017). She has been in public accounting for severalyears. During that time she earned an MBA from Seattle U. She wouldlike to be the CFO of a company someday--maybe Swift Ltd.-- andthis is an opportunity to get onto that career track and to proveher ability.
As Lindsey looks over the financial data collected, she istrying to make sense of it all. She already has the most difficultpart of the analysis complete -- the estimation of cash flows.Through some internet research and application of finance theory,she has also determined the firm’s beta.
Here is the information that Lindsey 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 | (22,500,000) | (24,000,000) | (23,000,000) | (21,000,000) |
1 | 9,600,000 | 7,700,000 | 8,200,000 | 7,500,000 |
2 | 9,600,000 | 8,400,000 | 8,200,000 | 6,900,000 |
3 | 4,500,000 | 9,800,000 | 6,500,000 | 5,400,000 |
4 | 4,500,000 | 4,900,000 | 5,900,000 | 4,500,000 |
Risk | Average | Average | High | 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
Swift Ltd. has the following capital structure, which isconsidered to be optimal:
Debt | 30% |
Preferred Equity | 15% |
Common Equity | 55% |
| 100% |
Cost of Capital
Lindsey 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) Swift Ltd. has issued a 8% semi-annual coupon bond with 14years term to maturity. The current trading price is $960.
(3) The firm has issued some preferred stock which pays anannual 8.5% dividend of $50 par value, and the current market priceis $52.
(4) The firm’s stock is currently selling for $35 per share. Itslast dividend (D0) was $2.00, and dividends are expectedto grow at a constant rate of 5%. The current risk free returnoffered by Treasury security is 2.8%, and the market portfolio’sreturn is 10.80%. Swift Ltd. has a beta of 1.1. For thebond-yield-plus-risk-premium approach, the firm uses a risk premiumof 3.5%.
(5) The firm adjusts its project WACC for risk by adding 2.5% tothe overall WACC for high-risk projects and subtracting 2.5% forlow-risk projects.
Lindsey knows that Swift Ltd. executives have favored IRR in thepast for making their capital budgeting decisions. Her professor atSeattle U. said NPV was better than IRR. Her textbook says thatMIRR is also better than IRR. She is the new kid on theblock and must be prepared to defend her recommendations.
First, however, Lindsey must finish the analysis and write herreport. To help begin, she has formulated the followingquestions:
- What is the firm’s cost of debt?
- What is the cost of preferred stock for Swift Ltd.?
- 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 estimated cost of common equity using thebond-yield-plus-risk-premium approach?
(4) What is the final estimate for rs?
- What is Swift Ltd.’s overall WACC?
- Do you think the firm should use the single overall WACC as thehurdle rate for each of its projects? Explain.
- What is the WACC for each project? Place your numericalsolutions in Table 2.
- Calculate all relevant capital budgeting measures for eachproject, and place your numerical solutions in Table2.
Table 2
- Comment on the commonly used capital budgeting measures. Whatis the underlying cause of ranking conflicts? Which criterion isthe best one, and why?
- Which of the projects are unacceptable and why?
- Rank the projects that are acceptable, according to Lindsey’scriterion of choice.
- Which project should Lindsey recommend and why? Explain whyeach of the projects not chosen was rejected.
Instructions
1.Your answers should be Word processed, submitted viaCanvas.
2.Questions 5, 8, 9, and 11 are discussionquestions.
3.Place your numerical solutions in Table2.
4.Show your steps for calculationquestions.
