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:
A.
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?
B.
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?
C.
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.
D.
Calculate
the after tax cash flows for the project for each year. Explain the methods
used in your calculations.
E.
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?
F.
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?
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 |
|
Investment |
||
|
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 |
G.
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.
H.
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.
