6. What is the WACC for each project?

Fall 2017FIN 341 Case Study on Capital Budgeting

Sophia was recently hired by Great Wall Co. as a junior budget analyst.She is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate.She must give her analysis and recommendation to the capital budgeting committee.

Sophia has a B.S. in accounting from WWU (2007) and passed the CPA exam (2008). She has been in public accounting for 2 years.During that time she earned an MBA from Seattle U. She would like to be the CFO of a company someday--maybe Great Wall Co. -- and this is an opportunity to get onto that career track and to prove her ability.

As Sophia looks over the financial data collected, she is trying to make sense of it all.She already has the most difficult part 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 Sophia has accumulated so far:

The Capital Budgeting Projects

She must choose one of the four capital budgeting projects listed below:

Table 1

t

A

B

C

D

0

(16,000,000)

(20,000,000)

(19,000,000)

(18,000,000)

1

5,500,000

7,000,000

8,200,000

9,000,000

2

5,500,000

8,000,000

8,200,000

7,000,000

3

7,000,000

8,000,000

5,200,000

6,000,000

4

7,000,000

1,000,000

5,200,000

5,000,000

Risk

Low

Average

High

Average

Table 1 shows the expected after-tax operating cash flows for each project. All projects are expected to have a 4 year life.The projects differ in size (the cost of the initial investment), and their cash flow patterns are different.They also differ in risk as indicated in the above table.

The capital budget is $20 million and the projects are mutually exclusive.

Capital Structures

Great Wall Co. has the following capital structure, which is considered to be optimal:

Debt

40%

Preferred Equity

10%

Common Equity

50%

100%

Cost of Capital

Sophia knows that in order to evaluate the projects she will have to determine the cost of capital for each of them. She has been given the following data, which he believes will be relevant to her task.

(1)The firm's tax rate is 30%.

(2) Great Wall Co. has issued a 13% semi-annual coupon bond with 10 years term to maturity. The current trading price is $1,206.

(3) The firm has issued some preferred stock which pays an annual 9% dividend of $100 par value, and the current market price is $110.

(4) The firm's stock is currently selling for $68 per share. Its last dividend (D₀) was $4, and dividends are expected to grow at a constant rate of 8%. The current risk free return offered by Treasury security is 2.5%, and the market portfolio's return is 10.5%. Great Wall Co. has a beta of 1.5.

(5) The firm adjusts its project WACC for risk by adding 2.5% to the overall WACC for high-risk projects and subtracting 2.5% for low-risk projects.

Sophia knows that Great Wall Co. executives have favored IRR in the past for making their capital budgeting decisions.Her professor at Seattle U. said NPV was better than IRR.She is the new kid on the block and must be prepared to defend her recommendations.

First, however, Sophia must finish the analysis and write her report.To help begin, she has formulated the following questions: