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 The xxxxxxx requires xx initial xxxxxxxxxx of xxxxxxx The xxxxxxx will xxx the xxxxxxxxxxxxx depreciation xxxxxx The xxxxxxx has xx salvage xxxxx It xx estimated xxxx the xxxxxxx will xxxxxxxx additional xxxxxxxx of xxxxxxx per xxxx before xxx and xxx additional xxxxxx costs xx 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 s xxxxxx capital xxxxxxxxx capability xx the xxxxxxx expands xxxx its xxxxx It xxx borrow xxxx it xxxxx additional xxxxx Dividend xxxxxxx Discretion x company xx not xxxxxxx bound xx pay xxxxxxxx Reduction xx suspension xx possible xx difficult xxxxx Though xxxx is xxx frequent x company xxxxx to xxx dividend xxxxxxxxx Disadvantages xx Equity xxxxxxxxx Equity xxxxxxx is xxxxxxx with xxxx disadvantages xxxxx are xx follows xxxx Higher xxxxxxxxxx cost xx ordinary xxxxxx as xxxxxxxx to xxxx and xxxxxxxxx being xxx tax xxxxxxxxxx Risk xxxxxxxx shares xxx riskier xxxx of xxxxxxx from xxxxxxxx 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 xxxxxxxx per xxxxx reduce xx the xxxxxxx do xxx increase xxxxxxxxxxx in xxxxxxxxxx to xxx increase xx the xxxxxx of xxxxxxxx shares xxxxxxxxx Dilution xxxxxxxx of xxxxxxxxx is xxxxxxxxxx with xxx issue xx new xxxxxxxx shares xxxxxxxx of xxxxxxxxx assumes xxxxx significance xx the xxxx of xxxxxxxxxxxx companies xxx issuance xx ordinary xxxxxx can xxxxxx the xxxxxxxxx B xxx after xxx cost xx debt xxx the xxxxxxx - xxxxx tax xxxx of xxxx The xxxxxxxxxxxx loss xx control- xxxxxxx over xxxxxxxxx is xxxxxx in xxxx financing xxx right xx manage xx oversee xx running xxx business xxx other xxxxxxxx making xxxx with xxx owner xxxx and xxxx not xxxxxx to xxx lender xxxxxx obligations- xxxxxxxxxx involved xx to xxxxx the xxxxx borrowed xx is xxx complex xxxx repaid xxxxxxxx relationship xxxx the xxxxxx ends xxx advantages xxx interest xx loan xx tax xxxxxxxxxx for xxxx business xxxxx implies xxxxxxxxxxx tax xxxxxxx for x number xx small xxxxxxxxxx Predictable xxxxxxxxx With xxxxx the xxxxxxxxx and xxxxxxxx payments xxxx is xxxxxxx and xxxxx planning xx cashflows xxx be xxxx Many xxxxx businesses xxxxxxxxxx this xxxxxxxxxxxxxx The xxxxxxxxxxxxxxxxxx payment xxxxxx The xxxxxxxx money xxxx be xxxx back xxxxxx a xxxxx period xx time xxxxxxxxxx of xxx success xx the xxxxxxxx The xxxxxxxxxxxx can xxxxxx cumbersome xx the xxxxxxxxx of xxx company xxxx flow xxxxxxxxx If xxx much xxxxxxxx is xxxxx on xxxx the xxxxxxx can xxx up xxxx cash xxxx problems xxxx risk xxxxxxxxxxx Companies xxxxxx excessive xxxx are xx their xxxxxxxx are xxxxxx as xxxxx by xxxxxxxxx investors xxxx makes xx difficult xxx your xxxxxxxx to xxxxxxxx potential xxxxxxxxx in xxxxx to xxxxx additional xxxxxxx in xxx future xxxxxxx during xxxxx times xxxxxx recession xx can xx especially xxxxxxxxx to xxxxxxx on xxxx debt xxxxxxxxx as xxx cash xxxx is xxxx likely xx effected xxxxxx these xxxxxxxxxx times xx becomes xxxxxxxxxxxx difficult xx pay xxxx your xxxx with xxx regularity xxxx costs x It xxx be xxxxxxxxx to xxxx a xxxxxxxx that xxxxxxx high xxxx repayment xxxxx It xx because xx the xxxx outflows xxx to xxxx repayment xxxxxxxxx Without xxx ability xx reinvest xxxxxxx many xxxxxxxxxx become xxxxxxxx and xxxx to xxxxxxx their xxxxxxxxx Collateral xxx Personal xxxxxxxxxxxxx security xxxxxxxxxx in xxxxx of xxxxxxxx assets xxx or xxxxxxxxxx guarantee xxx loan xxxxxx money xx lent xxxxxxxxxx guaranteeing xxx loan xx a xxxxx affair x WACC xxx Weighted xxxxxxx Cost xx Capital xxxx is xxx first xxxxxxxxxxx of xxxxxxx budgeting xxx WACC xx the xxxxxx a xxxxxxxx needs xx grow xx its xxxxxxxxxxx every xxxx to xxxxxxxx its xxxxxxx overall xxxxx Businesses xxx raise xxxxxxx required xx two xxxx either xx taking xxxxx or xx issuing xxxxxx and xxxxxxx ownership xx its xxxxxxxx Certain xxxxxx of xxxxxx on xxxxx investment xx expected xx the xxxxxxx of xxxxx instruments xxxxxxx vary xxxxxxx debt xxx equity xxxx different xxxxxxx of xxxx WACC xxxxxxxx these xxxxxxxxx elements xx provide x quot xxxxxx even xxxx point xxxx businesses xxxx to xxxx based xx the xxxxxxxxxxx of xxxx and xxxxxx in xxxxxxx as xxxx as xxx holders xxxxxxxxxxx of xxxxxx It xx the xxxxxxxx of xxxxxxxxxx for xxxxxxxxxx all xxxxxx projects x Year xxxxx - 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 xxxxxxx value xxxx of xxx asset xxxxxxxxxxx of xxxx flows xxxxxxx Less xxxx Less xxxxxxxxxxxx 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 x As xxx NPV xx positive xxx project xxxxxx be xxxxxxxx F xxx - x r x No xx is xxx acceptable xxxxxxx as xxx IRR xx less xxxx the xxxx of xxxxx is xxx hurdle xxxx Yes xxxxx is xxxxxxxx with x as xxx IRR xx less xxxx WACC xxxxx is xxxxxxxx as xxx minimum xxxxxxxx rate xx return xx order xx accept xxx project x Investment x Investment xxxxxxxxxxxx After xxxxxxxxxx d xxxxxxxxxxxxxxx yAfter xxxxxxxxxx d xxxxxxxxx FlowCash xxxx Total xxxxxxxx Value 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 - xxxx Adjusted xxx of x Present xxxxx of xxxx flows x Cash xxxxxx x xxxxx years x As xxx NPV xx project x is xxxxxx among xxx two xxxxxxx C xxxxxx be xxxxxxxxMore Articles From Finance
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