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Capital Budgeting and Cost of Capital

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1. A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct?

a. The project should be rejected since its return is less than the WACC.
b. The project's internal rate of return is greater than 12 percent.
c. The project's modified internal rate of return is less than 12 percent
d. All of the above answers are correct.
e. None of the above answers is correct.

2. The regular payback method has a number of disadvantages, some of which are listed below. Which of these items is not a disadvantage of this method?
a. Lack of an objective, market-determined benchmark for making decisions
b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.
d. Does not provide any indication regarding a project's liquidity.
e. Does not directly account for differences in risk among projects.

3. Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2.

Question: If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?

4. Which of the following statements is correct?
a. The characteristics line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry.
b. The distance of the plot points from the characteristics line is a measure of the stock's discounted value risk.
c. "Characteristics line" is another name for the Security Market Line.
d. The distance of the plot points from the characteristics line is a measure of the stock's market risk.
e. The slope of the characteristic line is the stock's standard deviation.

5. A share of common stock has just paid a dividend of $2. If the expected long-run growth rate for this stock is 5%, and if investors required rate of return is 10.5%, what is the stock price?

a.$35.39
b.$38.80
c.$37.23
d.$38.18
$39.14

6. Gary Wells Inc. plans to issue perpetual preferred stock with an annual dividend of $6.50 per share. If the required return on this preferred stock is 6.5%, at what price should the stock sell?

a. $90.37
b. $92.69
c. $95.06
d. $97.50
e. $100.00

7. You were hired as a consultant to Kroncke Company, whose target capital structure is 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 6%, the cost of preferred is 7.5%, and the cost of retained earnings is 13.25%. The firm will not be issuing any new stock. What is its WACC?

a. 9.48%
b. 9.78%
c. 10.07%
d. 10.37%
e. 10.68%

8. The Bingo Corporation is in the process of determining which of the following two projects that they may invest in. The details are provided below:
Project Cost of Capital Life of project Annual cash flow Initial cost Salvage Value

A 12% 20 Years $350,000 $1,250,000 $250,000

B 12% 20 Years $400,000 $1,400,000 $110,000

a. What is the payback period?
b. What is the net present value of the two projects?

c. What is the internal rate of return of the two projects?
d. What is the profitability index?
e. Which of the two projects would you choose and which criteria would you use?

9. Sorenson Stores is considering a project that has the following cash flows:

Year Cash Flows (end of period)

1 $2,000

2 $3,000

3 $3,000

4 $1,500

The project has a payback of 2.5 years, and the firm's cost of capital is 12%. What is the project's NPV?

a. $577.68
b. $765.91
c. $1,049.80
d. $2,761.32
e. $3,765.91

10. Thompson Stores is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash Flow
0 ($1,000)
1 $300
2 $295
3 $290
4 $285
5 $270

a. 11.16%
b. 12.40%
c. 13.78%
d. 15.16%
e. 16.68%

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Solution Preview

The solution to the problems is in the file attached.

1. A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct?

a. The project should be rejected since its return is less than the WACC.
b. The project's internal rate of return is greater than 12 percent.
c. The project's modified internal rate of return is less than 12 percent
d. All of the above answers are correct.
e. None of the above answers is correct.

Reason :- IRR is that rate at which NPV is 0. Since NPV is positive, hence IRR got to be greater than WACC.
2. The regular payback method has a number of disadvantages, some of which are listed below. Which of these items is not a disadvantage of this method?
a. Lack of an objective, market-determined benchmark for making decisions
b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.
d. Does not provide any indication regarding a project's liquidity.
e. Does not directly account for differences in risk among projects.

Reason :- Regular payback method provides indication of liquidity through its result. In fact it has a bias towards liquidity. The more liquid an investment be, higher would be its ranking under this method.

3. Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2.

Question: If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?

Solution :-
Expected Rate of Return = 16% = 0.16
Present Value of Dividend at the end of Year 1 = $9.25 (1/(1 + 0.16)) = $7.97
Present Value of Sale Price of Stock at the end of Year 2 = $150 (1/(1 + 0.16)2) = $111.47
Amount you would be willing to pay for the stock today = Present Value of Dividend at the end of Year 1 + Present Value of Sale Price of Stock at the end of Year 2

Amount you would be willing to pay for the stock today =$7.97 + ...

Solution Summary

Capital budgeting and the cost of capital are answered in a Word document. The project's modified internal rate of return is less than 12 percent is examined.

$2.19
See Also This Related BrainMass Solution

Capital Budgeting, Cost of Capital , Cash Flow, Risk

1. Your boss is considering borrowing $10,000 from a bank at 8% for a project. She has determined that the rate of return on the project is expected to be 12%. She comments that since the project is earning more than the cost of the debt, it should definitely be undertaken. You assert that the company's average cost of capital is 13% and the project should not be undertaken. Surprised with your assertiveness she replies, "I don't care about the average cost of capital. I am only using this debt to finance the project. Since this debt only costs 8%, and the project should earn 12%, it will be profitable!!" Defend your assertion that the project should not be undertaken.

2. Why, when comparing mutually exclusive projects, is using the NPV method superior to the IRR decision criteria?

For problems 3 - 8:

Your firm is considering expanding operations into Thailand. The government there has donated land if you build a plant there. The plant would cost roughly 20,000,000 $US. The plant could be depreciated on a 7-yr. MACRS schedule (weights:14.29%, 24.49%, 17.49%, 12.49%, 8.93%, 8.92%, 8.93%, 4.46%). The firm's marginal tax rate is 36%. The operation is expected to generate the following number of units over the coming years:
Year Number of Units
1 150,000
2 220,000
3 320,000
4 350,000

After the fourth year, unit production will be maintained at 350,000 per year. Variable costs are expected to be $28 per unit and the selling price is expected to be $41. Furthermore, production at this plant is expected to save the firm $50,000 per year in pre-tax expenses by producing the product there instead of in their current facilities.

Furthermore, the current stock price for the common shares outstanding is $29. The last dividend paid was $1.65, and has been growing at a constant 12% annually. Preferred shares are trading at $30 and pay a $4 dividend annually. The bonds of the firm are trading at 97.7% of par, have 14 years until maturity and a coupon rate of 12%. The capital structure, with assets financed with 30% debt, 60% common and 10% preferred is deemed optimal, and should remain constant in the future. The firm currently has no retained earnings available. All funds would need to be raised by issuing new common, preferred and debt. After incurring investment banking fees, the firm would receive $980 for each bond (and would mature in 25 years at a coupon set at current market rates for the old bonds), $28.5 on new preferred and $27.50 on new common stock issuance.

3. What is the relevant cost of debt to the firm if they undertake this project?
4. What is the cost of common equity if the project is undertaken?
5. What is the cost of preferred stock if the project is undertaken?
6. What would the appropriate discount rate be for this project - assuming it's risk characteristics were identical to the rest of the firm's assets - and assuming the firm maintains it's capital structure?
7. What are the relevant cash flows for this project?
8. Should the firm invest in the Thailand project? WHY or WHY NOT?

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