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Finance: WACC, capital budgeting etc

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~Why is Weighted Average Cost of Capital (WACC) important to an organization?
~What impact does WACC have on capital budgeting and structure?
~What are the risks and uncertainty related to capital budgeting?

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QUESTIONS
1. Why is Weighted Average Cost of Capital (WACC) important to an organization?
2. What impact does WACC have on capital budgeting and structure?
3. What are the risks and uncertainty related to capital budgeting?

TUTORIAL
1.
The Weighted Average cost of capital (WACC) represents the total cost of all forms of financing sourced by a company. The WACC is the cost borne by the company because of it obtaining ...

Solution Summary

The problems deal with issues in finance WACC, capital budgeting, etc. The impact WACC has on capital budgeting and structure is determined.

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Capital Budgeting question for Corporate Finance Class

A U.S. firm, Vanger Inc., is considering expansion of its British subsidiary Albion plc. The cost of the expansion is 60 million British pounds, which must be expanded in the very near future (we will assume at t=0). This capital expenditure will be depreciated straight line for five years.

Revenue in the first year (aggregated at t=1) is 90 million pounds; revenue after that is assumed to grow at 9% per year for the next 5 years (thus revenues at t= 2,3,4,5 and 6 will at grow 9% from the previous years). After that the assumption is revenue will be constant. Expenses are assumed to be 80% of revenues each year for 6 years, and constant after that.

Net working capital is assumed to change with revenue; the changes in net working capital is assumed to be 7.5% of the change in forecasted revenue. Thus the change in t=0 NWC is equal to 0.075 times the difference in revenue at t=1 minus the revenue at t=0. And each year following works like that.

While firms uses six years of forecasted revenues and cash flows (t=1 to 6 plus t=0), the subsidiary project is assumed to continue on indefinitely. Vanger calculates terminal value by assuming cash flows beyond t=6 will equal t=6 earnings after taxes (EBIAT or NOPAT) forever. (Note NOPAT=EBIT-taxes). The no growth assumption implies that there will be no future changes in NWC. Thus terminal value of this project is estimated by applying the no-growth perpetuity formula to t=6 EBIAT.

Exhibit data below presents other economic and project specific data. Note that Vanger uses the government bond yield as its estimate of this risk-free rate.

Dollar Pound
Price inflation 3% 7%
Government Bond Yield 6%
Corporate tax rate 34% 35%
Market Risk Premium 8.60% na
Spot exchange rate ($/£) 1.70

Firm cost of debt 9.40%
Debt to Equity Ratio 0.4
Firm beta 0.9

When analyzing a subsidiary project, Vanger uses earned cash flows in its analysis (whether or not remitted). This means assume 100% repatriation of cash flows.

The firm assumes its corporate capital providers are home country investors, and thus Vanger calculates a home currency WACC and then converts into foreign WACC. It uses the higher of the two tax rates in its WACC calculations and in its cash flow calculations.

It is assumed that the country risks of investing in the UK (versus US) are low and therefore no other adjustment are made to the WACC. (That is, there is no risk premium added to discount rate for the foreign investment.)

1. Please calculate the home currency WACC and the foreign currency WACC. And calculate the project NPV using the home currency approach and the foreign currency approach.

This is a practice question given to us. I 'm having trouble doing it. Please help.
I need the cash flow table, the WACC calculation details, and details of any other calculation done to find the answers.

I have attached a WORD document with the same question if the figures here are not clear.

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