Spring 2019 FIN 341 Case Study on Capital Budgeting Hailey juststarted her first job at Whatcom Co. as a junior budget analyst.She is working for the Venture Capital Division and has been givenfor capital budgeting projects to evaluate. She must give heranalysis and recommendation to the capital budgeting committee.Hailey has a B.S. in accounting from WWU (2007) and passed the CPAexam (2008). She has been in public accounting for 2 years. Duringthat time, she earned an MBA from Seattle U. She would like to bethe CFO of a company someday--maybe Whatcom Co. -- and this is anopportunity to get onto that career track and to prove her ability.As Hailey looks over the financial data collected, she is trying tomake 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 hasaccumulated so far: The Capital Budgeting Projects She must chooseone of the four capital budgeting projects listed below: Table 1Table 1 shows the expected after-tax operating cash flows for eachproject. 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 mutually exclusive. Capital Structures WhatcomCo. has the following capital structure, which is considered to beoptimal: Common Equity 50% Preferred Equity 10% Debt 40% 100% Costof Capital Hailey knows that in order to evaluate the projects shewill have to determine the cost of capital for each of them. Shehas been given the following data, which he believes will berelevant to her task.

(1) The firm’s tax rate is 40%.

(2) Whatcom Co. has issued a 12% semi-annual coupon bond with 5years term to maturity. The current trading price is $1080.

(3) The firm has issued some preferred stock which pays anannual 11% dividend of $100 par value, and the current market priceis $104.

(4) The firm’s stock is currently selling for $94 per share. Itslast dividend (D0) was $3, and dividends are expected to grow at aconstant rate of 9%. The current risk-free return offered byTreasury security is 2.5%, and the market portfolio’s return is10%. Whatcom Co. has a beta of 1.3

(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. Hailey knows that Whatcom Co. executives havefavored IRR in the past for making their capital budgetingdecisions.

Her professor at Seattle U. said NPV was better than IRR. She isthe new kid on the block and must be prepared to defend herrecommendations. First, however, Hailey must finish the analysisand write her report. To help begin, she has formulated thefollowing questions:

1.  What is the firm’s cost ofdebt?

2.  What is the cost of preferred stock forWhatcom Co.?

3.  Cost of common equity

(1) What is the estimated cost of common equity usingthe CAPM approach?

(2) What is the estimated cost of common equity usingthe DCF approach?

(3) What is the final estimate for cost ofequity?

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 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.