Its Better to Be Safe Than Sorry

Its amazing how much difference there is in the way proposals are presented at two different firms, said Art Monk to his assistant, Russell Jacobs, as he pointed to the stack of capital investment proposals piled on his desk. We sure have our work cut out for us, Russ. I need you to collect some data for me as soon as possible. Monk had recently been hired as assistant vice president of finance for American Structural Products. His past experience included a seven-year stint with another large consumer-products firm. His career had been very successful thus far, as he had gone from being a financial analyst to assistant VP of finance in a little over seven years. Art, who held an undergraduate degree in accounting and an MBA in finance from nationally recognized business schools, preferred to follow a conservative policy when analyzing capital investment projects. Most of the projects that he had analyzed and got approved had turned out to be profitable for his former employers. At a recent meeting of the Capital Investment Committeethe primary group responsible for approving proposals at American Structural Productsthe five divisional managers had presented proposals that had cost estimates ranging from $250,000 to $750,000. All five proposals were shown to have positive net present values (NPVs) and fairly high internal rates of return (IRRs). Moreover, the cost and revenue figures seemed to be conservatively arrived at, and all five proposals seemed to have good overall strategic value. However, upon careful deliberation and reflection, it was revealed that the divisional managers had used the cost of debt as the minimum acceptable rate of return whilst evaluating their respective projects. The company had issued 20-year, 8% bonds, at par, last year and that rate was used as the hurdle rate under the assumption that additional funds could be raised at the same rate. There was considerable argument, confusion, and dissent at the meeting when Art brought up the issue of the firms target capital structure and raised concerns that the hurdle rate for each project could vary depending on the total capital raised by the firm. It was clear that there was a lack of full understanding and consensus about cost of capital issues among the divisional managers, most of whom did not have a finance background. Sensing that the meeting was going nowhere, the chief financial officer, Tony Bowker, said, Art, why dont you take these proposals, re-evaluate them based on appropriate discount rates, and present your recommendations at our next weeks committee meeting? Im sure you all will agree with me that it is better to be safe than sorry! Art started his analysis by listing the estimated cost, economic life, and IRR of each proposal, as shown in Table 1. He then collected data regarding the current prices, preferred dividend rate, retention ratio, and number of issues outstanding of the firms bonds, preferred stock, and common stock (Table 2). For this purpose, Art referred to the latest income statement (Table 3), balance sheet (Table 4), and the Internet. A call to the firms investment banker helped him obtain estimates of flotation costs that would apply based on the type of issue (Table 5). As he crunched the numbers, Art realized that he would need the following estimates:

1.The firms expected growth rate of sales, earnings and dividends.

2.The expected return on the market index.

3.The Treasury bill rate.

4.The firms beta.

This is the list he passed on to his assistant, Russ.

Table 1 Project Information

Project	Cost	IRR	Estimated Life	NPV @ 8%
A	$500,000	20%	5 Years	$346,754.39
B	$750,000	12%	4 Years	$117,437.77
C	$250,000	16%	3 Years	$59,772.39
D	$600,000	25%	4 Years	$476,703.89
E	$400,000	15%	3 Years	$82,927.84

Table 2 Market Data Regarding Outstanding Securities

Type	Par Value	Current Price	Number Outstanding
10%, 20-Year Bonds	$1,000	$900	10,000
6% Preferred Stock	$10	$12	500,000
Common Stock	$1	$25	1,000,000

Table 3 American Structural Products

Last Years Income Statement (000s)

Revenues	37500
Cost of Goods Sold	31875
Gross Profit	5625
Selling & Administration Expenses	1125
Depreciation	1000
Earnings Before Interest and Taxes	3500
Interest Expenses	887
Earnings Before Taxes	2613
Taxes (40%)	1045
Net Income	1,568
Preferred Dividends	300
Income Available for Common	1,268
Common Stock Dividends	508
Addition to Retained Earnings	760

Table 4 American Structural Products

Balance Sheet (000s)

Current Assets	10,000	Current Liabilities	3,000
Net Fixed Assets	75,000	Notes Payable	2,000
		Long-Term Debt (10,000 Outstanding, Coupon Rate = 8%, Face Value = $1,000)	10,000
		Preferred Stock (500,000 Outstanding, Dividend Rate = 6%, Par Value = $10)	50,000
		Common Stock (1,000,000 Outstanding)	20,000
Total Assets	85,000	Total Liabilities & Shareholders Equity	85,000

Table 5 Flotation Cost Schedule

Type of Security	Issuance Cost
Bonds	5%
Preferred Stock	10%
Common Stock	15%

Table 6

Expected Growth Rate of Sales	25%
Expected Growth Rate of Earnings and Dividends	12%
Expected Return on the Market	15%
Treasury Bill Rate	6%
Expected Retention Rate	60%
Firms Equity Beta 1.2

QUESTION: PLEASE ANSWER ALL OF THE FOLLOWING QUESTION CORRECTLY!!!!!

5.Develop and graph the marginal cost of capital for the intended capital investments. Explain how the values are arrived at.

6.Using the same graph as in #5, develop an investment opportunity schedule using the data for the five proposals, and indicate which combination of projects would be acceptable.

7.Recalculate the NPVs of the five projects using the appropriate hurdle rate. Are the projects still acceptable? Explain.

8.Assume that the cash flows of Project B were 40% less risky than those of the other four projects, which were estimated to be of average risk. How would the evaluation process be affected? What would Art have to do to make the appropriate recommendations?