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    Evaluating Project Risk

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    Evaluating Project Risk
    It's Better to Be Safe Than Sorry!
    "It's amazing how much difference there is in the way proposals are presented at two different firms," said John Woods to his assistant, Pete Madsen, as he pointed to the stack of capital investment proposals piled on his desk. "We sure have our work cut out for us, Pete. I need you to collect some data for me as soon as possible. "
    John Woods, had recently been hired as the Assistant Vice President of Finance of Mid-West Home Products. His past experience included a seven-year stint with another large consumer products firm. His career had been very successful, thus far, as he had gone from being a financial analyst to an Assistant Vice-President of Finance in a little
    over seven years. John, who held an undergraduate degree in Accounting and an MBA in Finance from nationally recognized business schools, preferred to follow a conservative policy when analyzing capital investment projects. Most of the projects that he had analyzed and got approved had turned out to be profitable for his former employers.

    At a recent meeting of the Capital Investment Committee, which was the primary group responsible for approving proposals at Mid-West Home products, the five divisional managers had presented proposals that had cost estimates ranging from $250,000 to $750,000. All five proposals were shown to have positive net present values (NPVs) and fairly high internal rates of return (IRRs). Moreover, the cost and revenue figures seemed to be conservatively arrived at and all five proposals seemed to have good overall strategic value. However, upon careful deliberation and reflection, it was learned that the divisional managers had used the cost of debt as the minimum acceptable rate of return whilst evaluating their respective projects. The company had issued 20-year, 8% bonds, at par, last year and that rate was used as the hurdle rate under the
    assumption that additional funds could be raised at the same rate. There was considerable argument, confusion, and dissent at the meeting, when John brought up the issue of the firm's target capital structure and raised concerns that the hurdle rate for each project could vary depending on the total capital raised by the firm. It was clear that there was a lack of full understanding and consensus about cost of capital issues among the 5 divisional managers, most of whom did not have a finance background. Sensing that the meeting was going nowhere, the Chief Financial Officer, Sean Walker, said, "John, why don't you take these proposals, re-evaluate them based on appropriate discount rates, and present your recommendations at our next week's committee meeting. I'm sure you all will agree with me, that it is better to be safe than sorry!"
    John started his analysis by listing the estimated cost, economic life, and internal rate of return of each proposal as shown in Table 1. He then collected data regarding the current prices, preferred dividend rate, retention ratio, and number of issues outstanding of the firm's bonds, preferred stock, and common stock (see Table 2). For this purpose, John referred to the latest income statement (shown in Table 3), balance sheet
    (see Table 4) and the Internet. A call to the firm's investment banker helped John obtain estimates of flotation costs that would apply based on the type of issue (see Table 5). As he crunched the numbers, John realized that he would need the following estimates:

    1. The firm's expected growth rate of sales, earnings and
    2. The expected return on the market index;
    3. The Treasury bill rate, and
    4. The firm's beta.
    This is the list he passed on to his assistant, Pete.

    Table 1
    Project Information
    Project Cost IRR Estimated Life NPV @ 8%
    A $ 500,000 20% 5 Years $ 346,754.39
    B $ 750,000 12% 4 Years $ 117,437.77
    C $ 250,000 16% 3 Years $ 59,772.39
    D $ 600,000 25% 4 Years $ 476,703.89
    E $ 400,000 15% 3 Years $ 82,927.84

    Table 2
    Market Data Regarding Outstanding Securities
    Type Par Value Current Price Number Outstanding
    10%, 20-Year Bonds $1,000 $900 10,000
    6% Preferred Stock $10 $12 500,000
    Common Stock $1 $25 1,000,000

    Table 3
    Mid-West Home Products
    Last Year's Income Statement
    Revenues 37500
    Cost of Goods Sold 31875
    Gross Profit 5625
    Selling & Administration Expenses 1125
    Depreciation 1000
    Earnings Before Interest and Taxes 3500
    Interest Expenses 887
    Earnings Before Taxes 2613
    Taxes (40%) 1045
    Net Income 1,568
    Preferred Dividends 300
    Income Available for Common 1,268
    Common Stock Dividends 508
    Addition to Retained Earnings 760

    Table 4
    Mid-West Home Products
    Balance Sheet
    Current Assets 10,000 Current Liabilities 3000
    Net Fixed Assets 75,000 Notes Payable 2000

    Long-term Debt
    (10,000 outstanding, Coupon Rate =
    8%, Face Value = $1,000) 10000

    Preferrred Stock
    (500,000 outstanding, Dividend Rate =
    6%, Par Value = $10) 50000

    Common Stock (1,000,000
    outstanding) 20000

    Total Assets 85,000 Total Liabilities & Shareholders' Equity 85000

    Table 5
    Flotation Cost Schedule
    Type of Security Issuance Cost
    Bonds 5%
    Preferred Stock 10%
    Common Stock 15%

    1. What seems to be wrong with the way the NPV of each project has been calculated? Indicate, without any calculations, how Pete and John should go about recalculating the projects' NPVs.

    2. Why does John need to know the retention rate of the firm? What impact will retained earnings have on the calculations?

    3. Why is the target capital structure of concern to John? How should it be determined?

    4. Pete collects the necessary data and prepares the Table 6 (shown below.) Accordingly, calculate the component costs of debt, preferred stock, and common stock. Will these costs be constant irrespective of the amount of capital raised? Please explain.

    Table 6
    Expected Growth Rate of Sales ....................................... 25%
    Expected Growth Rate of Earnings and Dividends .......... 12%
    Expected Return on the Market........................................ 5%
    Treasury bill rate............................................................... 6%
    Expected retention rate .................................................... 60%
    Firm's Equity Beta ............................................................ 1.2

    5. Develop and graph the Marginal Cost of Capital for the intended capital investments. Explain how the values are arrived at.

    6. Using the same graph as in #5, develop an Investment Opportunity Schedule using the data for the 5 proposals and accordingly indicate which combination of projects would be acceptable.

    7. Recalculate the NPVs of the 5 projects using the appropriate hurdle rate. Are the projects still acceptable? Please explain.

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    Solution Summary

    This solution shows step-by-step calculations to determine the proper NPV, retention rate of the firm, target capital structure, components costs of debt, preferred stock and common stock.