Corporate Finance: CAPM, WACC, NPV

1. You complete an analysis of a new project, and the NPV is $1. You recommend accepting the project. Your coworker from marketing argues that the project should not be accepted because the NPV of $1 isn't enough of a profit. Assuming the discount rate is indeed conservative, how do you respond in the following scenarios? Which project(s) should be accepted or rejected?

a. There are not any other mutually exclusive projects.

b. Your coworker has an idea for another mutual exclusive project. You calculate the NPV of the new project to be $2.

c. Your coworker has an idea for another project. You calculate that the NPV of the new project is $2. The projects are not mutually exclusive.

2. What's the difference between marginal and average tax rates? How can you determine the average tax rate? What's most important for most financial decisions?

3. Describe how the dividend growth model values a stock. Why isn't it a good idea to use the dividend growth model for growth stocks?

4. You've invested in a small, but rapidly growing company that's starting to generate good cash flows and is becoming very profitable. The company is currently 100 percent equity-financed. Using the formula for WACC, explain why it might be a good idea to use at least some debt financing.

5. What happens to bond prices as interest rates increase? Why?

Part B: Answer each of the following questions in a composition of one to two paragraphs, and perform calculations as requested.

6. Recall that the security market line (SML) illustrates the relationship between systematic risk and expected returns. Perhaps the most famous and practical application of the SML is the capital asset pricing model (CAPM), expressed as follows:

E(Ri) = Rf + [E(RM) - Rf] X βi

a. Explain each of the variables.

b. Describe βi in more detail, including its effect on the expected return on the investment. What would a beta of 1.5 suggest?

7. You're a consultant hired by a small company that installs GPS units in semi trucks and school buses. The company is considering investing in a project to manufacture the units themselves (instead of purchasing the new units). It used its weighted average cost of capital (WACC) of 15 percent to determine that the project has a positive NPV of $3,000.

The CFO and the CEO don't agree. The CEO doesn't believe that the WACC is the correct number because the project is risky; it's a brand-new venture. The CFO argues that the WACC already incorporates risk, and the cost of new funds at the source (debt and equity financing) is the only thing that matters.

a. What's WACC? What's the formula? Who is correct? Why?

b. What are two different approaches to determine an appropriate cost of capital that appropriately accounts for the different risk(s)? Walk through the steps on how you would proceed. (Keep in mind there's more than one correct answer.) Then, identify an advantage and disadvantage of each of these approaches. Lastly, how would you determine if this project should be accepted or rejected? (No actual computations are needed).