Amber was recently hired by Gracious Fashion 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.

Amber has a B.S. in accounting from CWU (2015) and passed the CPA exam (2017). She has been in public accounting for several years.During that time she earned an MBA from Seattle U.She would like to be the CFO of a company someday--maybe Gracious Fashion-- and this is an opportunity to get onto that career track and to prove her ability.

As Amber 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 Amber 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

Gracious Fashion has the following capital structure, which is considered to be optimal:

Debt 40%

Preferred Equity 10%

Common Equity50%

100%

Cost of Capital

Amber 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) Gracious Fashion 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%. Gracious Fashion has a beta of 1.5. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4.5%.

(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.

Amber knows that Gracious Fashion executives have favored IRR in the past for making their capital budgeting decisions.Her professor at Seattle U. said NPV was better than IRR.Her textbook says that MIRR is also better than IRR.She is the new kid on the block and must be prepared to defend her recommendations.

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

1-Calculate all relevant capital budgeting measures for each project, and place your numerical solutions inTable 2.

Table 2

A B C D

WACC

NPV

IRR

MIRR

2-Comment on the commonly used capital budgeting measures. What is the underlying cause of ranking conflicts? Which criterion is the best one, and why?

3-Which of the projects are unacceptable and why?

4-Rank the projects that are acceptable, according to Amber's criterion of choice.

5-Which project should Amber recommend and why? Explain why each of the projects not chosen was rejected.

Instructions

Questions 5, 8, 9, and 11 are discussion questions.

Place numerical solutions in Table 2.

Show steps for calculation questions.