1. A&B Enterprises uses a capital rationing approach to capital budgeting. They have established a capital budget cap of $100,000 this year and are considering 2 investments (A&B) with initial costs of $100,000 each. They desire to maintain a 35% debt and 65% equity mix in their capital structure. They are currently not using preferred stock in their capital structure. Their beta is 1.2. Their tax-rate is 30%.Their current common stock price is $63 per share. They will need to pay $3 per share for floatation costs if they issue new shares. Their most recent dividend paid was $4 per share but is expected to increase by 5% for the next dividend. Their assumed long term growth rate is also 5%. They currently have traditional, vanilla bonds outstanding with a coupon rate of 10.5%, par value of $1,000, current price of $1,100, and will mature in 15 years. The cash flows of projects A & B are as follows: (41 points)

Year A B

1 $10,000 $50,000

2 $20,000 $40,000

3 $30,000 $32,000

4 $40,000 0

5 $44,000 0

a. Calculate the WACC (weighted average cost of capital). Use the constant growth dividend valuation model and the use of new stock for the cost of equity.

b. Calculate the 1) payback period, 2) NPV and 3) IRR of projects A & B and indicate which project you would choose for each method. Use your WACC calculation from letter a and round the WACC to the nearest whole number.

c. Briefly describe the pros and cons of each capital budgeting method (payback, NPV, & IRR)

d. Based on your analysis and A&B Enterprises capital budgeting approach, which project(s) would you select and why?

e. If you determined that one of the projects was significantly riskier than the other project, could this change your opinion? Briefly describe 2 methods of quantitatively evaluating this risk?

f. A&B is also considering issuing zero coupon bonds instead of their existing vanilla bonds. Their underwriter informs them that they could issue $1,000 par value, 15 year zero coupon bonds for $209.

1. Calculate the YTM on the zero coupon bonds and then compare to the YTM on the vanilla bonds calculated previously. Which is preferable for A&B to issue based on yields?

2. Why do the YTMs between the 2 types vary?

3. What factor(s) should A&B consider when deciding whether to issue these zero coupon bonds instead of the vanilla bonds?

g. A&B is also considering issuing floating rate bonds instead of their existing vanilla bonds. They could issue these bonds at a 7 % rate. The economy is expected to enter an extended growth and expansion period. Would you recommend that A&B issue floating rate bonds instead of vanilla bonds? Why or why not?