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# Capital budgeting

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See attached file.

UNIT 3 PROFESSIONAL CHALLENGE- INSTRUCTIONS

1. For the WACC, use 7.50%. I fixed the WACC rate for everyone so you will not have to attempt to calculate it from your chosen company. This will save you time. So you will not need to calculate the WACC, only explain it in your paper. You will be calculating 1) Depreciation, 2) Tax Rate, 3) Taxable Income, 4) NOPAT, 5) Net Cash Flow, and the two major calculations- NPV & IRR.

2. You need to find the Net Cash Flows for years 0 thru 5 for Machine A and B. Then find the NPV and IRR of these cash flows. Year 0 thru Year 5 will be the time line for your cash flows.

3. Plug in the given EBITD numbers for the 5 years for each Machine.

4. For Depreciation, use 33% for year 1, 45% for year 2, 15% for year 3, 7% for year 4, and 0% for year 5. You will multiply these percentages by 120,000 for Machine A and 60,000 for Machine B. (Note: Make sure the \$120,000 and \$60,000 are POSITIVE numbers when you multiply the depreciation percentages by them.

5. Taxes for each year will equal (Taxable Income times 40%.)

6. Taxable Income will equal (EBITD minus Depreciation) for each year.

7. Net Operating Profit After Taxes (NOPAT) equals (Taxable Income minus Taxes@40%).

8. To find the Net Cash Flow, negative -\$120,000 will be the year 0 Net Cash Flow for Machine A and negative -\$60,000 will be the year 0 Net Cash Flow for Machine B. (Note: Ignore Salvage Value for Machine A).

9. Net Cash Flow equals (NOPAT + Depreciation). Remember that depreciation is a noncash expense so you add it back to NOPAT.

10. Once you have calculated the Net Cash Flows for Year 0 thru Year 5 for each Machine then you are ready to find the NPV and IRR. Remember, For year 0 for Machine A, you will use the initial cash outlay of -120,000 and -60,000 for Machine B. For the NPV calculation, use the 7.50% WACC as the discount rate.

11. Be sure to use the NPV & IRR formulas in Excel. For the NPV calculations, you want to assume that the cash flows occur at the BEGINNING of each period. So be sure to keep the year 0 cash flow outside and added to the parenthesis of the formula. The Excel Examples spreadsheet that I posted under the Faculty Expectations thread has an example of it.

12. In your Word document, be sure to discuss the following topics. It needs to be approximately two pages in length:

A) After calculating the NPV and IRR for Machine A and Machine B, choose which one you would choose based on being the most profitable.
B) Would an investor choose an investment with the highest NPV or IRR? Justify which one and why.
C) Discuss capital rationing limits firms have and what, if anything they can do,
E) Discuss the WACC.

#### Solution Summary

The solution explains how to calculate the cash flows and determine the WACC, NPV, IRR, EBITD, Depreciation and Taxes

\$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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