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Cost of Capital, Capital Structure, and Capital Budgeting Analysis

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Purpose of the project:
In this project, you are supposed to be a financial manager who determines the cost of debt, cost of preferred stock, cost of common equity, capital structure, and the weighted average cost of capital (WACC) for a Phizer (PFE). You will use the estimated WACC as the discount rate to conduct capital budgeting analysis for a hypothetical project (the information given below) that is under consideration by Phizer (PFE), and decide whether the project should be accepted.

(1) Compute Weighted Average Cost of Capital (WACC)
- Estimate the firm's before-tax and after-tax component cost of debt; (Note: If the information about the current corporate tax rate is not available, you need to estimate the tax rate based on the historical tax payments).
- Estimate the firm's component cost of preferred stock;
- Use three approaches (CAPM, DCF, bond-yield-plus-risk-premium) to estimate the component cost of common equity of the firm.
- Calculate the firm's weighted average cost of capital (WACC) using market-based capital weights.

(2) Cash Flow Estimation
- Assume that Phizer (PFE) is considering a new project. The project has 8 years life. This project requires initial investment of $300 million to construct building and purchase equipment, and $20 million for shipping & installation fee. The fixed assets fall in the 7-year MACRS class. The salvage value of the fixed assets is $15 million. The number of units of the new product expected to be sold in the first year is 2,000,000 and the expected annual growth rate is 10%. The sales price is $300 per unit and the variable cost is $220 per unit in the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 2.8%. The required net operating working capital (NOWC) is 12% of sales. Please use the corporate tax rate that you obtained in Step (1) for the project. The project is assumed to have the same risk as the corporation, so you should use the WACC you obtained from prior steps as the discount rate.

- Compute the depreciation basis and annual depreciation of the new project.
- Estimate annual cash flows for the 8 years.
- Draw a time line of the cash flows.

(3) Capital Budgeting Analysis
- Using the WACC you obtained from in Step (1) as the discount rate for this project, apply capital budgeting analysis techniques (NPV, IRR, MIRR, PI, Payback, Discounted Payback) to analyze the new project.
- Perform a sensitivity analysis for the effects of key variables (e.g., sales growth rate, cost of capital, unit costs, sales price) on the estimated NPV or IRR in order to demonstrate the sensitivity of the model. The Scenario analysis of several variables simultaneously is encouraged, but not required.
- Discuss whether the project should be taken and summarize your report.

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Solution Summary

The expert examines the cost of capital, capital structures and the capital budgeting analysis for a project.

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26 Question Multiple Choice MANAGERIAL FINANCE

See attached file.
1. The difference between the market value of an investment and its cost is the:
Net present value
Internal rate of return
Payback Period
Profitability Index

2. The process of valuing an investment by determining the net present value of its future cash flows is called (the):
Constant dividend growth model
Discount cash flow valuation
Expected earnings model
Capital Asset Pricing Model

3. The length of time required for an investment to generate cash flow sufficient to recover its initial cost it the:
Net present value
Internal rate of return
Payback period
Profitability index

4. The discount rate that makes the net present value of an investment exactly equal to zero is the:
Payback period
Internal rate of return
Average accounting return
Profitability index

5. A situation in which taking one investment prevents the taking of another is called:
Net present value profiling
Operational ambiguity
Mutually exclusive investment decisions
Issues of scale
Multiple rates of return

6. The chnages in the firms future cash flows that are a direct consequence of accepting a project are called:
Incremental cash flows
Stand-alone cash flows
Aftertax cash flows
Net present value cash flows
Erosion cash flows

7. A cost that has alread been paid, or the liability to pay has already been incurred is a(n):
Salvage value expense
Net working capital expense
Opportunity cost
Sunk cost
Erosion cost

8. The most valuable investment given up if an alternative investment is chosen is a(n):
Salvage value expense
Net working capital expense
Sunk cost
Opportunity cost
Erosion cost

9. The possibility that errors in projected cash flows can lead to incorrect NPV estimates is called:
Forecasting risk
Projection risk
Scenario risk
Monte Carlo risk
Accounting risk

10. An analysis of what happens to NPV estimates when we ask what-if questions is called:
Forecasing analysis
Scenario analysis
Sensitivity analysis
Simualtion analysis
Break-even analysis

11. An analysis of the relation between sales volume and various measures of profitability is called:
Forecasting analysis
Scenario analysis
Sensitivity analysis
Simulation analysis
Break-evem analysis

12. The return that lender require on their loaned funds to the firm is called the:
Coupon rate
Current yield
Cost of debt
Capital gains yield
Cos of capital

13. The weighted averal of the firm's cost of equity, preferred stock, and after-tax debt is the:
Reward to risk ratio for the firm
Expected capital gains yield of the stock
Expected capital gains yield for the firm
Portfolio beta of the firm
Weighted average cost of capital (WACC)

14. The proportions of the market value of the firm's assets financed via debt, common stock, and preferred stock are called the firms ______________.
Financing costs
portfoliio weights
Beta coefficient
Capital structure weights
Cost of capital

15. The legal document describing details of the issuing corporation and its security offering to potential investors is called the _____________.
Letter of comment
Rights offering
Offering prospectus
Regulation A statement
Tombstone advertisement

16. A public offering of securities offered for sale to the general public on a direct cash basis is called a:
Best efforts offer
Firm commitment offer
General cash offer
Rights offer
Red herring offer

17. The use of personal borrowing to change the overall amount of finanical leverage to which the individual is exposed is called:
Private debt placement
Dividend recapture
Homemade leverage
A privileged subscription offer
The weighted average cost of captial

18. The equity risk derived from the firm's operating activities is called ________ risk.

19. The proposition that the cost of equity is a positive linear function of capital structure is called :
The Capital Asset Pricing Model
M&M Proposition I
M&M Propostion II
The Law of One Price
The Efficient Markets Hypothesis

20. The equity risk derived form the firm's capital structure policy is called ___________ risk.

21. Payments made out of the firm's earning to its owners in the form of cash or stock are called:
Share repurchases
Stock splits

22. Payments made by a firm to its owners from sources other than current or accumulated earings is called:
Share repurchases
Stock splits

23. A cash payment made by a firm to its owners as a result of a one-time event is called a:
Share repurchase
Liquidating dividends
Regular cash dividend
Special dividend
Extra cash dividend

24. The date by which a stockholder must be registered on the firm's roll as having share ownership in order to receive a declared dividend is called the _________.
date of ex-rights
date of ex-dividend
date of record
date of payment
date of declaration

25. The date on which the board of directors passes a resolution authorizing payment of a dividend to the sharholders if the _________ date.

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