Capital Budgeting

1. The company has 2 proposed projects. Here are the projects net cash flows (in thousands of dollars). The CFO has determined the weighted average cost of capital to be 10 percent.

Expected Net Cash Flow

Year

Project L

Project S

0

($100)

($100)

1

35

60

2

75

75

3

150

125

4

50

100

1. 1. What is the payback period for projects L & S?
   2. What is the net present value (NPV) of each project?
   3. What is the internal rate of return (IRR) for each project?
   4. What is the modified internal rate of return (MIRR) for each project?
   5. Which method is the best? Why?

2. Suppose you have predicted the following returns for stocks C (Your Company) and T (Your Competitor) in three possible states of nature. What are the expected returns?

State

Probability

C

T

Boom

0.2

0.13

0.30

Normal

0.5

0.12

0.17

Recession

0.3

0.04

0.02

3. Suppose you hold a 2-stock portfolio of the company you picked and the competitor.

a. Compute the rate of return for the 2 stocks for the year.

b. If your portfolio was made up of 40% of the stock you picked and 60% of the stock of the competitor, what was the rate of return on the portfolio for the year 2005?

4. Consider an asset with a beta of 1.2, a risk-free rate of 4.3%, and a market return of 12%.

a. What is the reward-to-risk ratio in equilibrium?

b. What is the expected return on the asset?

5. Using the Dividend Growth Approach, suppose that your company is expected to pay a dividend of $1.25 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $29. What is the cost of equity?

6. Suppose your company has an equity beta of .62 and the current risk-free rate is 4.1%. If the expected market risk premium is 9.6%, what is your cost of equity capital?

7. Your company has preferred stock that has an annual dividend of $2. If the current price is $20, what is the cost of preferred stock?

8. Answer the following questions given the information below:

Equity Information

40 million shares

$100 per share

Beta = 1.15

Market risk premium = 8%

Risk-free rate = 3%

Debt Information

$1 billion in outstanding debt (face value)

YTM = 9%

a. What is the cost of equity?

b. What is the cost of debt?

c. What is the after-tax cost of debt?

d. What are the capital structure weights?

e. What is the WACC?