Spring 2016 FIN 370 AOL ASSIGNMENT

CASE ANALYSIS: The Case of the Junior Analyst

Name:_______________________

Amber was recently hired by Gracious Fashion as a junior budget analyst. She is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate. She must give her analysis and recommendation to the capital budgeting committee on Wednesday, June 1.

Amber has a B.S. in accounting from CWU (2007) and passed the CPA exam (2008). She has been in public accounting for 2 years. During that time she earned an MBA from Seattle U. She would like to be the CFO of a company someday--maybe Gracious Fashion-- and this is an opportunity to get onto that career track and to prove her ability.

As Amber looks over the financial data collected, she is trying to make sense of it all. She already has the most difficult part of the analysis complete -- the estimation of cash flows. Through some internet research and application of finance theory, she has also determined the firm?s beta.

Here is the information that Amber has accumulated so far:

The Capital Budgeting Projects

She must choose one of the four capital budgeting projects listed below:

Table 1

t	A	B	C	D
0	(16,000,000)	(20,000,000)	(19,000,000)	(18,000,000)
1	5,500,000	7,000,000	8,200,000	9,000,000
2	5,500,000	8,000,000	8,200,000	7,000,000
3	7,000,000	8,000,000	5,200,000	6,000,000
4	7,000,000	1,000,000	5,200,000	5,000,000
Risk	Low	Average	High	Average

Table 1 shows the expected after-tax operating cash flows for each project. All projects are expected to have a 4 year life. The projects differ in size (the cost of the initial investment), and their cash flow patterns are different. They also differ in risk as indicated in the above table.

The capital budget is $20 million and the projects are mutually exclusive.

Capital Structures

Gracious Fashion has the following capital structure, which is considered to be optimal:

Debt	40%
Preferred Equity	10%
Common Equity	50%
	100%

Cost of Capital

Amber knows that in order to evaluate the projects she will have to determine the cost of capital for each of them. She has been given the following data, which he believes will be relevant to her task.

(1)The firm?s tax rate is 30%.

(2) Gracious Fashion has issued a 13% semi-annual coupon bond with 10 years term to maturity. The current trading price is $1,206.

(3) The firm has issued some preferred stock which pays an annual 9% dividend of $100 par value, and the current market price is $110.

(4) The firm?s stock is currently selling for $68 per share. Its last dividend (D₀) was $4, and dividends are expected to grow at a constant rate of 8%. The current risk free return offered by Treasury security is 2.5%, and the market portfolio?s return is 10.5%. Gracious Fashion has a beta of 1.5. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4.5%.

(5) The firm adjusts its project WACC for risk by adding 2.5% to the overall WACC for high-risk projects and subtracting 2.5% for low-risk projects.

Amber knows that Gracious Fashion executives have favored IRR in the past for making their capital budgeting decisions. Her professor at Seattle U. said NPV was better than IRR. Her textbook says that MIRR is also better than IRR. She is the new kid on the block and must be prepared to defend her recommendations.

First, however, Amber must finish the analysis and write her report. To help begin, she has formulated the following questions:

1. What is the firm?s cost of debt?

2. What is the cost of preferred stock for Gracious Fashion?

3. Cost of common equity

(1) What is the estimated cost of common equity using the CAPM approach?

(2) What is the estimated cost of common equity using the DCF approach?

(3) What is the estimated cost of common equity using the bond-yield-plus-risk-premium approach?

(4) What is the final estimate for r_s?

4. What is Gracious Fashion?s overall WACC?

5. Do you think the firm should use the single overall WACC as the hurdle rate for each of its projects? Explain.

6. What is the WACC for each project? Place your numerical solutions in Table 2.

7. Calculate all relevant capital budgeting measures for each project, and place your numerical solutions in Table 2.

Table 2

	A	B	C	D
WACC
NPV
IRR
MIRR

8. Comment on the commonly used capital budgeting measures. What is the underlying cause of ranking conflicts? Which criterion is the best one, and why?

9. Which of the projects are unacceptable and why?

10. Rank the projects that are acceptable, according to Amber?s criterion of choice.

11. Which project should Amber recommend and why? Explain why each of the projects not chosen was rejected.

Instructions

1.Your answers should be Word processed (typed and printed out) and attached (stapled) to the original case.

2.Questions 5, 8, 9, and 11 are discussion questions.

3.Place your numerical solutions in Table 2.

**This is what i have so far, i need help with the last half. DUE AT 4PM tonight

1. Cost of debt Tax rate of the firm Coupon rate of bond Cost of debt = Coupon rate of the bond (1-tax rate) Cost of debt = Coupon rate of the bond (1-tax rate) 2. Cost of Preferred Stock Dividend = annual 9% of $100 par value = $9 The current market price = $110 Cost of Preferred stock = Dividend/ current market price 3.aCost of Common Equity Estimated cost of common equity using the CAPM approach Cost of equity = Risk free return + Beta (Market return- risk free return) Risk free return Beta Market return risk free return total 3.b What is the estimated cost of common equity using the DCF approach? The firms stock is currently selling for $76.5 per share. Its last dividend (D0) was $4, and dividends are expected to grow at a constant rate of 8%. So D1 Dividend for next year will be $ ($4 * 1.08). Cost of equity = (D1/ current market price) + Growth rate D0 -$4*8% D1 current market price = (3.01/76.5) + 8% = 3.93% +8% = 14.35% So the estimated cost of common equity using the DCF approach is 14.35% 3.c What is the estimated cost of common equity using the bond-yield-plus-risk-premium approach? Equity's Risk Premium Return on an Equity Bond-Yield-Plus-Risk-Premium 3.d What is the final estimatefor Rs? 4. What is Gracious Fashion's overall WACC? 6. What is the WACC for each project? Place your numerical solutions in Table 2 30% 13% 70% 9.100% $ 9.00 $ 110.00 8.18% 2.5% 1.5 10.5% 2.5% 2.500% $ 68.00 $ 4.00 0.32 $ 4.32 $ 68.00 0.063529 6.35% 10.5% 4.5% 15% 23.853% 7.95%