PLEASE SHOW WORK AND GIVE FORMULAS IF USED.

Mr. Chad, a recent SU COB graduate, were recently hired to work for Allied Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. He is in charge of capital budgeting and was asked to conduct the following capital budgeting. Mrs. Linda Smith, his boss and chief financial officer (CFO) came in his office and handed him a memo for two proposed projects: Projects L and M. Also, she emphasized that it is not difficult to raise $100 million by issuing corporate bonds and another $100 million dollars by selling new stocks for the proposed projects. She also explained that Allied has a fairly good rating from the Moodys and would end up with a coupon payment of $65 annually per $1,000 face value.

Then, he asked her back about Allieds beta. She paused and added, Well, it depends and varies all the time. Oddly enough, Allieds beta hasnt changed much over the recent years, and it has been around 1.5. She went on to say, the current financialmarkets are out of line and that is, market risk premium runs about 20%, which I have never seen during my tenure here. On the contrary, the interest rate on risk free assets is merely 2.5%. Finally, she went back to her nice clean office. Mr. Chad looked into the memo that she left behind on the two projects.

The following is on the memo. Project L involves adding a new item to the firms ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project M involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects net cash flows (in million dollars):

IN THIS ORDER t=0 t=1 t=2 t=3

Project L -$100 $10 $65 $85 Project M -$100 $70 $50 $20

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The current tax rate for Allied is 26%. The CFO also made subjective risk assessments of each project, and she concluded that both projects have discount rates that are identical to the firms cost of capital of $200 million dollars.

1 (20 points). What is the cost of capital for $200 million to be raised? 2 (25 points). Compute the NPVs of the project L? 3 (25 points). Compute the NPVs of the project M? 4 (10 points). What should his conclusion be on the capital budgeting?