On January 2, 2016, George Wood, the executive vice president and CFO of Hughes Energy and Transportation Company, was preparing for the January meeting of the Capital Budget Committee (CBC) with Hughes brothers. The CBC is considering 10 projects representing $45 in capital expenditures. Unfortunately, the Hughes brothers have imposed a spending limit on the total investment and have mandated to not exceed the firms internal funds. With the new fiscal year, there was a need to determine which projects best fits the Companys future growth value enhancement. Thus, the challenge for the Committee was to allocate the funds among competing projects efficiently to increase the Companys value.

The Company

Hughes Energy and Transportation Company (Hughes) is managed by the three Hughes brothers, and Gorge Woods, son-in-law of the oldest Hughes brother. Hughes through its two divisions produces and markets coal and mineral primarily to utilities and industrial users and operates as a transportation company that provides truck and carrier services in the United States, Mexico, and Canada.

Its energy division which is mainly in coal and mining produces a range of steam coals with varying sulfur and heat contents. The company operates 10 underground mining complexes in Illinois, Indiana, Kentucky, Maryland, and West Virginia. As of December 31, 2015, it had approximately 1.1 billion tons of proven and probable coal reserves. The company also leases land; and operates a coal loading terminal with a capacity of 8.0 million tons with ground storage of approximately 60,000 to 70,000 tons on the Ohio River at Mt. Vernon, Indiana. In addition, it buys and resells coal; and manufactures and sells rock dust. Further, the company offers various products and services, which comprise the design and installation of underground mine hoists for transporting employees and materials in and out of mines; design of systems for automating and controlling various aspects of industrial and mining environments; and design and sale of mine safety equipment, including its miner and equipment tracking and proximity detection systems.

Its transportation division provides services to automotive, steel, oil and gas, alternative energy, and manufacturing industries, as well as other transportation companies who aggregate loads from various shippers. As of December 31, 2015, its fleet consisted of 2,166 in-service tractors and 6,054 in-service trailers.

Capital Budget Committee and Project Selection

The Capital Budget Committee at Hughes is composed of Hughes brothers and Woods. Typically, Woods solicit investment proposal from managing directors and if the project cost exceeds $500,000, it required the approval of CBC. For this year, the directors have recommended 10 projects which exceeded the capital expenditure limits. Table 1 and 2 provide a brief description of the projects and initial cost and the estimated cash flow of each project (after tax profit plus depreciation) over its estimated life.

Financial Information

At the end of 2015, the Company had net income of $79,893 and total asset was $1,017,032; consisting of $711,922, from to energy segment and $305,110 from transportation services.

On the basis of its net income, Woods wants to know how much money is available for capital investments as shown in Table 2. Its established common stocks dividend payout ratio after the preferred stock dividends payment is 50 percent of the funds. Currently the preferred stock has a 8 percent dividend yield with a par value of $100. A 12 percent cost of capital for funds generated internally has been used in the past, and Woods sees no reason to depart from this figure. Any additional funds used for capital budgeting purposes will have to come from external financing. In discussions with the Hughes brothers, Woods informed them that any additional external funds will have a 14 percent rather than the 12 percent current cost of capital.

Questions:

How much of the internal fund is available for investments?

Which quantitative methods are useful to evaluate the projects?

Discuss the strengths and weaknesses of the quantitative methods you used to select the projects.

Which quantitative ranking results in the highest value to the company?

Are there any conflicts among the rankings of the projects? How do you resolve the conflict in ranking?

What project(s) should the CBC should recommend for the coming year based on 12 and 14 percent cost of capital?

Are there any issues about the projects that CBC did not consider before the recommendation?

The CBC has decided to finance all of the profitable projects based on its market capital structure but was worried that some of the projects have different risk than the firms overall risk. CBC decided to gather public information about its two divisions as shown in tables 5 and 6. The Company has 20 million shares outstanding and its stock price closed at $31.45 per share on the first week of January, 2016.

Preferred stock is trading at a price of $80 per share with a dividend yield of 8 percent. The current debt was financed with 30-year long-term debt with a par value of $1,000 and was issued 10 years ago with a coupon rate of 8%. The current bond is trading at its par value. However the new debt financing will have a 20 year maturity with interest rate based on Treasury bond rate and risk spread of 4.4%.

1. Determine market value of the capital structures.

2. What is the equity cost of capital of each division?

3. What would be the Companys weighted average cost of capital before new financing?

4. What is the equity cost of capital after financing?

5. What is the Companys weighted average cost of capital after new financing?

6. Compare the expected rate of return of each project with each division equity cost of capital. Which projects should CBC recommend?

7. Is there any change in your recommendations if the comparison is made with the Companys weighted average cost of capital?

Table 1- CHARACTERISTICS OF INVESTMENT PROPOSALS
A	Expand mining facilities at the Illinois
B	Alternative plan for the Illinois is the expansion of terminal freight
C	Expand mining facilities at Indiana
D	Special handling equipment for a mining operation in Indiana,
E	Special handling equipment for mining operation in West Virginia
F	Alternative plan for the West Virginia is the purchase of ten new forklift
G	Expand mining facilities at Kentucky
H	Purchase of ten new tractor-trailer for Kentucky operation
I	Purchase of ten new tractor-trailer rigs Maryland operation
J	Expand mining facilities in Maryland

Table 2 Projects	A	B	C	D	E	F	G	H	I	J
Year	Initial Investment
	($4,000,000)	($3,000,000)	($3,000,000)	($4,000,000)	($7,000,000)	($4,000,000)	($5,000,000)	($5,000,000)	($5,000,000)	($5,000,000)
	Cash Flows
1	750,000	1,250,000	550,000	1,250,000	1,500,000	2,000,000	2,250,000	900,000	1,500,000	500,000
2	750,000	975,000	550,000	1,250,000	1,500,000	2,000,000	2,250,000	900,000	1,400,000	650,000
3	750,000	750,000	550,000	1,250,000	1,500,000	1,500,000	2,250,000	900,000	1,300,000	750,000
4	750,000	650,000	550,000	1,000,000	1,500,000			900,000	1,000,000	800,000
5	750,000	500,000	550,000	1,000,000	1,500,000			900,000	750,000	900,000
6	750,000	450,000	550,000	1,000,000	1,500,000			900,000	650,000	1,000,000
7	750,000		550,000		1,500,000			900,000	500,000	1,100,000
8	750,000		550,000		1,500,000			900,000	450,000	1,500,000
9	750,000		550,000					900,000	300,000	1,750,000
10	750,000		550,000					900,000	300,000	2,000,000

Table 3- Balance Sheet (in thousands)	31-Dec-13	31-Dec-14	31-Dec-15
Assets
Current Assets
Cash And Cash Equivalents	$18,177	$18,137	$18,097
Net Receivables	$123,978	$128,933	$133,889
Inventory	$111,169	$116,768	$122,366
Other Current Assets	$34,427	$31,569	$28,710
Total Current Assets	$287,752	$295,407	$303,063
Long Term Investments	$67,302	$72,332	$77,362
Property Plant and Equipment	$619,721	$642,100	$664,479
Goodwill	$10,238	$10,219	$10,200
Accumulated Amortization	($92,636)	($97,785)	($102,933)
Other Assets	$44,739	$54,801	$64,862
Total Assets	$937,115	$977,074	$1,017,032
Liabilities
Current Liabilities
Accounts Payable	$68,350	$74,749	$81,149
Current Long Term Debt due	$9,333	$9,833	$10,333
Total Current Liabilities	$77,683	$84,583	$91,482
Long Term Debt	$99,667	$120,667	$141,667
Other Liabilities	$12,726	$13,339	$13,951
Deferred Long Term Liability Charges	$82,184	$51,102	$20,020
Minority Interest	$1,202	$1,479	$1,756
Total Liabilities	$273,461	$271,168	$268,875
Preferred Stock (par $100, yield 8% and 1.25 million shares)	$125,000	$125,000	$125,000
Stockholders' Equity
Common Stock ( Class A owners,20 million shares)	$98,575	$74,435	$47,318
Retained Earnings	$429,870	$475,818	$524,743
Treasury Stock	$0	$0	$0
Capital Surplus	$128,902	$146,830	$164,758
Other Stockholder Equity	$6,307	$8,822	$11,337
Total Stockholder Equity	$663,654	$705,905	$748,157
Total Liabilities and Equity	$937,116	$977,074	$1,017,032

Table 4- Income Statement (in thousands)	31-Dec-13	31-Dec-14	31-Dec-15
Total Revenue	$1,030,798	$1,083,793	$1,136,788
Cost of Revenue	$550,044	$579,578	$609,112
Gross Profit	$480,754	$504,215	$527,676
Selling General and Administrative	$262,895	$272,787	$282,680
Others	$92,636	$97,785	$102,933
Operating Income or Loss	$125,223	$133,643	$142,063
Total Other Income/Expenses Net	$4,100	$5,055	$6,010
Earnings Before Interest And Taxes	$121,123	$128,588	$136,053
Interest Expense	$648	$789	$930
Income Before Tax	$120,474	$127,798	$135,122
Income Tax Expense	($48,190)	($51,119)	($54,049)
Minority Interest	($898)	($1,039)	($1,180)
Net Income From Continuing Ops	$71,387	$75,640	$79,893
Net Income	$71,387	$75,640	$79,893

Table 5- Trucking Industry Peer group	Stock Symbol	Stock Market Capital	Recent Stock price	Enterprise Value	Total Debt	Equity Beta
		(Mil. $)	($)	(Mil. $)	(Mil. $)
Universal Truckload Services	UACL	838	29	1060	242	1.64
Celadon Group	CGI	529	22.73	804	321	1.35
Covenant Transportation group	CVTI	392	26.18	626	223	1.35
Heartland Express	HTLD	2410	22.47	2240	21	0.47
JB Hunt Transport Services Inc	JBHT	9950	1027	8920	840	0.91
Knight Transportation	KNX	3300	75.43	1870	38	0.81
Landstar System	LSTR	3300	74.53	3280	30	0.7
USA Truck	USAK	268	25.58	350	114	1.75
Werner Enterprises	WERN	225	221	1860	75	0.92
Marten Transport	MRTN	741	22.19	712	25	1.07

Table 6- Energy Industry Peer group	Stock Symbol	Stock Market Capital	Recent Stock Price	Enterprise Value	Total Debt	Equity Beta
		(Mil. $)	($)	(Mil. $)	(Mil. $)
Arch Coal	ACI	982	5	4950	5150	1.97
Alpha Natural Resources	ANR	935	4	3420	3430	0.48
CONSOL Energy	CNX	9340	41	1219	3180	1.13
Cameo Corp	CCJ	8970	23	1064	1410	1.2
Peabody Energy	BTU	4360	16	9840	6000	1.5
Westmoreland Coal	WLB	420	28	695	340	0.11
Alliance Holdings Group LP	AHGP	3650	61	4400	886	0.51
Alliance Resources Partners	ARLP	3080	83	3830	886	0.65
Cloud Peak Energy	CLD	1260	21	1630	720	1.7
Walter Energy Inc.	WALT	463	7	2980	2780	1.56

TABLE 7 Total Annual Returns, 1926-2013

Investment	Average Return	Risk Premium
Large Stocks	11.70%	8.00%
Small Stocks	16.70%	13.00%
Long-term Corporate Bonds	6.20%	2.50%
Long-term Government Bonds	5.90%	2.20%
U.S. Treasury Bills	3.70%	0.00%

Table 8- US Treasury Bonds Rates- December, 2016
Maturity	Yield	Yesterday	Last Week	Last Month
3 Month	0.02	0.02	0.03	0.01
6 Month	0.04	0.05	0.07	0.06
2 Year	0.45	0.4	0.42	0.3
3 Year	0.91	0.89	0.89	0.67
5 Year	1.73	1.69	1.71	1.47
10 Year	2.8	2.68	2.74	2.66
20 Year	3.6	3.53	3.61	3.63