Question.3058 - As a financial consultant, you have contracted with Wheel Industries to evaluate their procedures involving the evaluation of long term investment opportunities. You have agreed to provide a detailed report illustrating the use of several techniques for evaluating capital projects including the weighted average cost of capital to the firm, the anticipated cash flows for the projects, and the methods used for project selection. In addition, you have been asked to evaluate two projects, incorporating risk into the calculations. You have also agreed to provide an 8-10 page report, in good form, with detailed explanation of your methodology, findings, and recommendations. Company Information Wheel Industries is considering a three-year expansion project, Project A. The project requires an initial investment of $1.5 million. The project will use the straight-line depreciation method. The project has no salvage value. It is estimated that the project will generate additional revenues of $1.2 million per year before tax and has additional annual costs of $600,000. The Marginal Tax rate is 35%. Required:A. Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm? A. The firm is considering using debt in its capital structure. If the market rate of 5% is appropriate for debt of this kind, what is the after tax cost of debt for the company? What are the advantages and disadvantages of using this type of financing for the firm? A. The firm has decided on a capital structure consisting of 30% debt and 70% new common stock. Calculate the WACC and explain how it is used in the capital budgeting process. A. Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations. A. If the discount rate were 6 percent calculate the NPV of the project. Is this an economically acceptable project to undertake? Why or why not? A. Now calculate the IRR for the project. Is this an acceptable project? Why or why not? Is there a conflict between your answer to part C? Explain why or why not? Wheel has two other possible investment opportunities, which are mutually exclusive, and independent of Investment A above. Both investments will cost $120,000 and have a life of 6 years. The after tax cash flows are expected to be the same over the six year life for both projects, and the probabilities for each year's after tax cash flow is given in the table below. Investment B Investment C Probability After Tax Cash Flow Probability After Tax Cash Flow 0.25 $20,000 0.30 $22,000 0.50 32,000 0.50 40,000 0.25 40,000 0.20 50,000 G. What is the expected value of each project’s annual after tax cash flow? Justify your answers and identify any conflicts between the IRR and the NPV and explain why these conflicts may occur. G. Assuming that the appropriate discount rate for projects of this risk level is 8%, what is the risk-adjusted NPV for each project? Which project, if either, should be selected? Justify your conclusions.
Answer Below:
Wheel xxxxxxxxxx is xxxxxxxxxxx a xxxxxxxxxx expansion xxxxxxx Project x nbsp xxx project xxxxxxxx an xxxxxxx investment xx million xxx project xxxx use xxx straight-line xxxxxxxxxxxx method xxx project xxx no xxxxxxx value xx is xxxxxxxxx that xxx project xxxx generate xxxxxxxxxx revenues xx million xxx year xxxxxx tax xxx has xxxxxxxxxx annual xxxxx of xxxx The xxxxxxxx Tax xxxx is x The xxxxxxxx cost xx equity xxxxxxx shows xxxxx r x P x f xx - xxxx of xxxxxx Advantages xx Equity xxxxxxxxx Equity xxxxxxx is xxx most xxxxxxx long-term xxxxxx of xxxxxxxxx Following xxx the xxxxxxxxxx of xx Permanent xxxxxxx It xx the xxxxxxxxx form xx capital xxx is xxxxxxxxx to xxx company xxxx its xxxxxxxxx Since xxxxx are xxx redeemable xx cash xxxxxxx associated xxxx its xxxxxxxxxx It xx a xxxxxxxxx capital xxx is xxxxxxxxx for xxx as xxxx as xxx company xxxx Borrowing xxxx It xxxxx the xxxxxxx increase xxx borrowing xxxxx Lenders xxxxxxxxx lend xx ratio xx the xxxxxxx rsquo x equity xxxxxxx Financial xxxxxxxxxx of xxx company xxxxxxx with xxx issue xx can xxxxxx when xx needs xxxxxxxxxx funds xxxxxxxx Payment xxxxxxxxxx A xxxxxxx is xxx legally xxxxx to xxx dividend xxxxxxxxx or xxxxxxxxxx is xxxxxxxx in xxxxxxxxx times xxxxxx this xx not xxxxxxxx a xxxxxxx tries xx pay xxxxxxxx regularly xxxxxxxxxxxxx of xxxxxx Financing xxxxxx capital xx bundled xxxx some xxxxxxxxxxxxx which xxx as xxxxxxx Cost xxxxxx floatation xxxx on xxxxxxxx shares xx compared xx debt xxx dividends xxxxx non xxx deductible xxxx Ordinary xxxxxx are xxxxxxx form xx capital xxxx investor xxxxx s xxxxx of xxxx reasons xxxxx uncertainty xxxxxxxxx dividend xxx capital xxxxx Therefore xxxx demand x rate xx return xxxxx makes xxxxxx capital xx the xxxxxxx cost xxxxxx of xxxxxxx Earnings xxxxxxxx Dilution xx ownership xx associated xxxx the xxxxx of xxx ordinary xxxxxx Shareholders xxxxx earnings xxx share xxxxxx if xxx profits xx not xxxxxxxx immediately xx proportion xx the xxxxxxxx in xxx number xx ordinary xxxxxx Ownership xxxxxxxx Dilution xx ownership xx associated xxxx the xxxxx of xxx ordinary xxxxxx Dilution xx ownership xxxxxxx great xxxxxxxxxxxx in xxx case xx closely-held xxxxxxxxx The xxxxxxxx of xxxxxxxx shares xxx change xxx ownership x the xxxxx tax xxxx of xxxx for xxx company x After xxx cost xx debt xxx AdvantagesNo xxxx of xxxxxxxx Control xxxx ownership xx intact xx debt xxxxxxxxx The xxxxx to xxxxxx or xxxxxxx or xxxxxxx the xxxxxxxx and xxxxx decision xxxxxx lies xxxx the xxxxx only xxx does xxx passes xx the xxxxxx Simple xxxxxxxxxxxx Obligation xxxxxxxx is xx repay xxx money xxxxxxxx It xx not xxxxxxx Once xxxxxx business xxxxxxxxxxxx with xxx lender xxxx Tax xxxxxxxxxx The xxxxxxxx on xxxx is xxx deductible xxx your xxxxxxxx which xxxxxxx significant xxx savings xxx a xxxxxx of xxxxx businesses xxxxxxxxxxx payments- xxxx loans xxx principal xxx interest xxxxxxxx owed xx certain xxx hence xxxxxxxx of xxxxxxxxx can xx done xxxx small xxxxxxxxxx appreciate xxxx predictability xxx DisadvantagesFixed xxxxxxx terms- xxx borrowed xxxxx must xx paid xxxx within x fixed xxxxxx of xxxx regardless xx the xxxxxxx of xxx business xxx installments xxx become xxxxxxxxxx on xxx cashflows xx the xxxxxxx Cash xxxx problems- xx too xxxx reliance xx given xx debt xxx company xxx end xx with xxxx flow xxxxxxxx High xxxx reputation- xxxxxxxxx having xxxxxxxxx debt xxx in xxxxx business xxx viewed xx risky xx potential xxxxxxxxx This xxxxx it xxxxxxxxx for xxxx business xx approach xxxxxxxxx investors xx order xx raise xxxxxxxxxx capital xx the xxxxxx Tougher xxxxxx tough xxxxx During xxxxxxxxx it xxx be xxxxxxxxxx difficult xx survive xx pure xxxx financing xx the xxxx flow xx most xxxxxx be xxxxxxxx during xxxxx vulnerable xxxxx it xxxxxxx increasingly xxxxxxxxx to xxx back xxxx debt xxxx any xxxxxxxxxx High xxxxx - xx can xx difficult xx grow x business xxxx carries xxxx loan xxxxxxxxx costs xx is xxxxxxx of xxx cash xxxxxxxx due xx loan xxxxxxxxx schedules xxxxxxx the xxxxxxx to xxxxxxxx capital xxxx businesses xxxxxx obsolete xxx fail xx realize xxxxx potential xxxxxxxxxx and xxxxxxxx Guarantees-As xxxxxxxx collateral xx terms xx business xxxxxx and xx personally xxxxxxxxx the xxxx before xxxxx is xxxx Personally xxxxxxxxxxxx the xxxx is x risky xxxxxx C xxxx The xxxxxxxx Average xxxx of xxxxxxx WACC xx the xxxxx constituent xx capital xxxxxxxxx The xxxx is xxx amount x business xxxxx to xxxx on xxx investments xxxxx year xx maintain xxx current xxxxxxx value xxxxxxxxxx can xxxxx capital xxxxxxxx in xxx ways xxxxxx by xxxxxx loans xx by xxxxxxx shares xxx parting xxxxxxxxx in xxx business xxxxxxx amount xx return xx their xxxxxxxxxx is xxxxxxxx by xxx holders xx these xxxxxxxxxxx Returns xxxx because xxxx and xxxxxx have xxxxxxxxx degrees xx risk xxxx combines xxxxx different xxxxxxxx to xxxxxxx a xxx quot xxxxxx even xxx quot xxxxx that xxxxxxxxxx need xx make xxxxx on xxx composition xx debt xxx equity xx capital xx well xx the xxxxxxx amp xxxxxxxxxxx of xxxxxx It xx the xxxxxxxx of xxxxxxxxxx for xxxxxxxxxx all xxxxxx projects x Year xxxxx - xxxx nbsp xxxxxxx Op xxxx - x - xxxxxxxxxxxx - x - xx Profit xxxxx - x - xxx Profit xxxx Flows x From xxxxxxxx operating xxxxx are xxxxxxxx and xxxx depreciation xxxxxxxx are xxxxxxxx to xxxxxx at xxxxxxxxx profits xxxx which xxxxxxxxxxxx and xxx is xxxxxxxx to xxxxxx at xxx profit xxxxxxxx at xxx cash xxxx depreciation xx added xxxx because xxxxx has xxxx no xxxx outflow xxxxxxx with xxxxxxxxxxxx Only xxx tax xxxxxxxx depreciation xx deducted x Depreciation xxxx of xxx asset xxxxx salvage xxxxx Life xx the xxxxx Calculation xx cash xxxxx Revenue xxxxx Less xxxx ndash xxxx Depreciation xxxxx Profit x Less xxxxx Profit xxxxx taxes xxx depreciation xxxx flow xxxxx taxes xxx Present xxxxx of xxxx flows x Cash xxxxxx x xxxxx years xxxxx x xxxxx ndash xx the xxx is xxxxxxxx the xxxxxxx should xx accepted x IRR x r x r xx it xx not xxxxxxxxxx project xx the xxx is xxxx than xxx WACC xx Which xx the xxxxxx rate xxx there xx conflict xxxx C xx the xxx is xxxx than xxxx which xx regarded xx the xxxxxxx required xxxx of xxxxxx in xxxxx to xxxxxx any xxxxxxx G xxxxxxxxxx B xxxxxxxxxx CProbability xxxxx TaxExpecte x ValueProbabilit xxxxxx TaxExpecte x ValueCash xxxxxxxx Flow xxxxx Expected xxxxx nbsp xxxx nbsp xxxx nbsp xxxxx comparing xxx projects xxx NPV xxx IRR xxx provide xxxxxxxxxxx results xx may xx so xxxx one xxxxxxx has xxxxxx NPV xxxxx the xxxxx has x higher xxx This xxxxxxxxxx could xxxxx because xx the xxxxxxxxx cash xxxx patterns xx the xxx projects xxxx facing xxxx a xxxxxxxxx the xxxxxxx with x higher xxx should xx chosen xxxxxxx there xx an xxxxxxxxxx reinvestment xxxxxxxxxx There xx an xxxxxxxxxx that xxx cash xxxxx will xx reinvested xx the xxxx discount xxxx at xxxxx they xxx discounted xx the xxx calculation xxx implicit xxxxxxxxxx for xxxxxxxxxxxx rate xx In xxx the xxxxxxxx reinvestment xxxx assumption xx of xx The xxxxxxxxxxxx rate xx or xx IRR xx quite xxxxxxxxxxx compared xx NPV xxxx makes xxx NPV xxxxxxx superior xx the xxx results x Risk xxxxxxxx NPV xx B xxxxxxx value xx cash xxxxx - xxxx outlay x PVIFA xxxxx ndash x Risk xxxxxxxx NPV xx C xxxxxxx value xx cash xxxxx - xxxx outlay x PVIFA xxxxx ndash x As xxx NPV xx project x is xxxxxx among xxx two xxxxxxx C xxxxxx be xxxxxxxxMore Articles From Finance
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