# Cost of Capital, Capital Structure, and Capital Budgeting Analysis

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.

https://brainmass.com/business/capital-budgeting/cost-capital-capital-structure-capital-budgeting-analysis-470286

#### Solution Summary

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

Cash budget, Capital Budgeting (Payback, NPV and IRR) , Capital Structure (EBIT-EPS analysis) , and Cost of Capital

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QUESTION 1 - CASH BUDGET

Keith Brothers had sales of R87 000 in May and R83 000 in June. Sales for July, August and September are expected to be R74 000; R67 000 and R56 000 respectively. The company has a cash balance of R20 000 on 1 July and wishes to maintain a minimum cash balance of R20 000.

Additional information

(a) Sales are: 15% for cash; 70% collected in the month following sales and 15% collected two months after sales. (No bad debt is experienced.)

(b) The company expects to receive other income of R4 000; R5 000 and R7 000 respectively in July, August and September.

(c) Expected cash purchases by the company are R70 000; R80 000 and R75 000 respectively in July, August and September.

(d) Rent paid amounts to R3 500 per month.

(e) Salaries and wages are 9% of the previous month's sales.

(f) A cash dividend of R3 300 will be paid in August.

(g) Interest of R5 400 will be paid in July.

(h) Equipment of R6 000 will be bought and paid for in September.

(i) Tax of R4 100 is to be paid in August.

Required:

(a) Given the information above, draw up a cash budget for the months of July, August and September.

(b) What is the maximum overdraft facility that must be arranged in order to maintain a good relationship with the bank?

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QUESTION 2 - CAPITAL BUDGETING

Fast Corporation has the opportunity to replace a five year old machine with a brand new one costing R1 000 000. The new machine is expected to last for 10 years. The new machine will require R50 000 in freight and installation charges. Inventory is expected to increase by R40 000; accounts receivable by R20 000, cash by R15 000, accounts payable by R15 000, and accruals by R10 000. The old machine was originally purchased for R800 000 (5 years ago) and can be sold today for R600 000. The original plan was to depreciate the old machine over its expected economic useful life of 10 years, but through good maintenance the machine is expected to last for 5 more years (10 years' useful life remain). The company uses straight-line depreciation and its tax rate is 30%. The new machine is not expected to increase revenues, but it will decrease operating costs from R300 000 to R180 000 per year. The estimated market value of the new machine after 10 years is R100 000.

Required

Do a complete capital budgeting analysis of the incremental cash flows resulting from the renewal. Assume cost of capital = 10%. What is your recommendation? (Hint: use Payback, NPV and IRR and comment on your answers.)

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QUESTION 3 - CAPITAL STRUCTURE

Fine Chemicals is considering two possible capital structures, A and B, shown in the following table. Assume a 40% tax rate.

Source of capital Structure A Structure B

Long-term debt R75 000 at 16% coupon rate R50 000 at 15% coupon rate

Preferred stock R10 000 with an 18% annual dividend R15 000 with an 18% annual dividend

Common stock 8 000 shares 10 000 shares

Required

(a) Calculate two EBIT-EPS coordinates for each proposed capital structure by selecting any two appropriate EBIT values and finding their associated EPS values. (7)

(b) Plot these on a set of EBIT-EPS axes. (3)

(c) Discuss the leverage and risk associated with each of the structures. (3)

(d) Determine the "cross-over" EBIT value, where the two capital structures would give identical EPS values. (3)

(e) Over what range of EBIT is each structure preferred? (2)

(f) Which structure do you recommend if the firm expects its EBIT to be, on average, more than R35 000? Explain. (2)

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QUESTION 4 - COST OF CAPITAL

Anthony Shoe Co. is financed by R80 million long-term debt, R20 million preferred shares and R100 million common equity. The firm can raise debt by selling R1000 par value, 12% coupon rate (coupons paid annually), 10 year bonds at a discount of R30 and has to pay R30 in flotation cost. The firm can also sell 10% preferred shares with a par value of R100 at R80, and has to pay R5 per share in flotation cost. Anthony's common shares are selling at R50 each. A dividend of R5 per share has just been paid, and the annual growth rate of 8% per year is expected to continue in the near future. The company's tax rate is 30%.

Required

Calculate Anthony's Weighted Average Cost of Capital (WACC).

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