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# Capital Budgeting

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7) X-treme Vitamin Company is considering two investments, both of which cost \$10,000. The cash flows are as follows:

Year Project A Project B
1 \$12,000 \$10,000
2 8,000 6,000
3 6,000 16,000

a) Which of the two projects should be chosen based on the payback method?

b) Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

c) Should a firm normally have more confidence in answer a or b?

15) The Danforth Tire Company is considering the purchase of a new machine that would increase the speed of manufacturing and save money. The net cost of this machine is \$66,000. The annual cash flows have the following projections:

Year Cash Flow
1 \$21,000
2 29,000
3 36,000
4 16,000
5 8,000

a) If the cost of the capital is 10 percent, what is the net present value?

b) What is the rate of return?

c) Should the project be accepted? Why?

20) Miller Electronics is considering two new investments. Project C calls for the purchase of a coolant recovery system. Project H represents an investment in a heat recovery system. The firm wishes to use a net present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project C Project H
\$25,000 Investment \$25,000 Investment
Year Cash Flow Year Cash Flow
1 \$6,000 1 \$20,000
2 7,000 2 6,000
3 9,000 3 5,000
4 13,000

a) Determine the net present value of the projects based on a zero discount rate.

b) Determine the net present value of the projects based on a 9 percent discount rate.

c) The internal rate of return on Project C is 13.01 percent, and the internal rate of return on Project H is 15.68 percent. Graph a net present value profile for the two investments similar to figure 12-3. (Use a scale up to \$10,000 on the vertical axis, with \$2,000 increments. Use a scale up to 20 percent on the horizontal axis, with 5 percent increments.)

d) If the two projects are not mutually exclusive, what would your acceptance or rejection decision be if the cost of the capital (discount rate) is 8 percent/ (Use the net present value profile for your decision; no actual numbers are necessary.)

e) If the two projects are mutually exclusive (the selection of one precludes the selection of the other), what would your decision be if the cost of capital is (1) 5 percent, (2) 13 percent, (3) 19 percent? Use the net present value profile for your answer.

#### Solution Summary

The solution explains various questions relating to capital budgeting

\$2.19

## Cost of Capital, Capital Budgeting, Capital Structure, Forecasting, and Working Capital Management

Question 1: (Cost of Capital)

You are provided the following information on a company. The total market value is \$38 million. The company's capital structure, shown here, is considered to be optimal.
(see attached file for data)

a. What is the after-tax cost of debt? (assume the company's effective tax rate = 40%)
b. Assuming a \$4 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume floatation costs = \$0.00)
c. Assuming the risk-free rate is 1%, the expected return on the stock market is 7%, and the company's beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)?
d. What is the company's weighted average cost of capital (WACC)?

Question 2: (Capital Budgeting)

It's time to decide how to use the money your firm is expected to make this year. Two investment opportunities are available, with net cash flows as follows:
(See attached file for data)

a. Calculate each project's Net Present Value (NPV), assuming your firm's weighted average cost of capital (WACC) is 7%
b. Calculate each project's Internal rate of Return (IRR).
c. Plot NPV profiles for both projects on a graph).
d. Assuming that your firm's WACC is 7%:
(1) If the projects are independent which one(s) should be accepted?
(2) If the projects are mutually exclusive which one(s) should be accepted?

Question 3: (Capital Structure)

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
(See attached file for data)

The company's tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, Rs. The risk-free rate is 1 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (i.e., its "unlevered beta," bU, equals 1.0.)

On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Question 4: (Forecasting)

A firm has the following balance sheet:
(See attached file for data)

Sales for the year just ended were \$6,000, and fixed assets were used at 80 percent of capacity. Current assets and accounts payable vary directly with sales. Sales are expected to grow by 20 percent next year, the expected net profit margin is 5 percent, and the dividend payout ratio is 80 percent.

How much additional funds (AFN) will be needed next year, if any?

Question 5: Working Capital Management

The Chickman Corporation has an inventory conversion period of 60 days, a receivables collection period of 30 days, and a payables deferral period of 30 days. Its annual credit sales are \$6,000,000, and its annual cost of goods sold (COGS) is 60% of sales.

a. What is the length of the firm's cash conversion cycle?
b. What is the firm's investment in accounts receivable?
c. What is the company's inventory turnover ratio?
d. Identify three ways in which the company could reduce its cash conversion cycle?
e. What are the possible risks of reducing the cash conversion cycle per your recommendations in part d?

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