Ronald was recently hired by Highland Equipment Inc. as a juniorbudget analyst. He is working for the Venture Capital Division andhas been given for capital budgeting projects to evaluate. He mustgive his analysis and recommendation to the capital budgetingcommittee.

Ronald has a B.S. in accounting from CWU (2016) and passed theCPA exam (2018). He has been in public accounting for severalyears. During that time he earned an MBA from Seattle U. He wouldlike to be the CFO of a company someday--maybe Highland EquipmentInc.-- and this is an opportunity to get onto that career track andto prove his ability.

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

Here is the information that Ronald has accumulated so far:

The Capital Budgeting Projects

He must choose one of the four capital budgeting projects listedbelow:  

Table 1

t	A	B	C	D
0	(19,000,000)	(20,000,000)	(14,000,000)	(18,000,000)
1	5,200,000	6,000,000	5,200,000	7,600,000
2	5,200,000	10,000,000	5,200,000	7,600,000
3	6,800,000	8,000,000	5,200,000	5,600,000
4	6,800,000	4,000,000	5,200,000	5,600,000
Risk	Average	High	Low	Average

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

Highland Equipment Inc. has the following capital structure,which is considered to be optimal:

Debt	40%
Preferred Equity	5%
Common Equity	55%
	100%

   

Cost of Capital

Ronald knows that in order to evaluate the projects he will haveto determine the cost of capital for each of them. He has beengiven the following data, which he believes will be relevant to histask.

(1)The firm’s tax rate is 35%.

(2) Highland Equipment Inc. has issued a 12% semi-annual couponbond with 5 years term to maturity. The current trading price is$1,040.

(3) The firm has issued some preferred stock which pays anannual 11% dividend of $100 par value, and the current market priceis $106.

(4) The firm’s stock is currently selling for $95 per share. Itslast dividend (D₀) was $5, and dividends are expected togrow at a constant rate of 7%. The current risk free return offeredby Treasury security is 1.5%, and the market portfolio’s return is9.5%. Highland Equipment Inc. has a beta of 1.4. For thebond-yield-plus-risk-premium approach, the firm uses a risk premiumof 3%.

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

Ronald knows that Highland Equipment Inc. executives havefavored IRR in the past for making their capital budgetingdecisions. His professor at Seattle U. said NPV was better thanIRR. His textbook says that MIRR is also better than IRR. He is thenew kid on the block and must be prepared to defend hisrecommendations.

4. What is Highland Equipment Inc.’s overall WACC?

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

6. What is the WACC for each project? Place your numericalsolutions in Table 2.

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

Table 2

	A	B	C	D
WACC
NPV
IRR
MIRR

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 Ronald’scriterion of choice.

11. Which project should Ronald recommend and why? Explain why eachof the projects not chosen was rejected.