Question
One of the points of discussion between management and its consultants is the choice of the discount rate for this capital budgeting exercise. It was
One of the points of discussion between management and its consultants is the choice of the discount rate for this capital budgeting exercise. It was finally decided that the discount rate would be the companys WACC.
Currently all of Highlands assets are exclusively financed by common equity and long-term debt (bonds).
The companys balance sheet shows the following values:
Bonds: Common Equity:
Paid-in Capital: Retained Earnings:
$100,000,000
$35,000,000 $ 9,000,000
Bonds: In early January 2010, the company issued 100,000 20-year non-callable bonds with an 8% coupon paid semi-annually, at a$1,000 par value. They currently trade at $1,150. This is the only bond issue the company has made to date.
Common equity: Highland Beverages went public in 2005 and issued 1,000,000 shares at $35 each. It has not issued any new stock since then, nor has it repurchased any of its issued stock. The Highland stock currently trades at $54.
Currently, the yield on US Treasury bonds is 3.5%, and the required return for a well-diversified stock portfolio is 9%. Highland Beverages beta is estimated at 1.15.
Highland Beverages marginal tax rate is 40%.
Questions:
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1) What are the relevant cash flows to consider for this project relative to the old plant? (Hint: use a timeline)
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2) What are the relevant cash flows to consider for this project relative to the new plant? (Hint: same as above)
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3) Calculate the proper discount rate to use for this project (2 decimals)?
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4) What are the NPV and IRR of this project as of today, January 1st 2015?
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5) Based on all the assumptions and on your calculations, should the company proceed with the
new plant? Explain.
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6) Aside from projected revenue and expense timing and amounts, tax considerations, or market
data, which assumption could be easily changed that would probably modify your answer in 4) and 5)?
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