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Capital Budgeting, Cost of Capital

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?

Solution Summary

Answers questions on capital budgeting and evaluates why NPV is better than IRR. Calculates cost of equity, preferred stock and debt.

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