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** (Solved) FIN341 Case Study Winter 2017 FIN 341 Case Study on Capital Budgeting Sophia was recently hired by Great Wall Co. as a junior budget analyst. She is...**

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FIN341 Case Study Winter 2017 FIN 341 Case Study on Capital Budgeting

Sophia was recently hired by Great Wall Co. as a junior budget analyst. She is

working for the Venture Capital Division and has been given for capital budgeting

projects to evaluate. She must give her analysis and recommendation to the capital

budgeting committee.

Sophia has a B.S. in accounting from WWU (2007) and passed the CPA exam (2008).

She has been in public accounting for 2 years. During that time she earned an MBA

from Seattle U. She would like to be the CFO of a company someday--maybe Great

Wall Co. -- and this is an opportunity to get onto that career track and to prove her

ability.

As Sophia looks over the financial data collected, she is trying to make sense of it all.

She already has the most difficult part of the analysis complete -- the estimation of

cash flows. Through some internet research and application of finance theory, she

has also determined the firmâ€™s beta.

Here is the information that Sophia has accumulated so far:

The Capital Budgeting Projects

She must choose one of the four capital budgeting projects listed below: t

0

1

2

3

4

Risk A

(16,000,000

)

5,500,000

5,500,000

7,000,000

7,000,000

Low Table 1

B

(20,000,000

)

7,000,000

8,000,000

8,000,000

1,000,000

Average C

(19,000,000

)

8,200,000

8,200,000

5,200,000

5,200,000

High D

(18,000,000)

9,000,000

7,000,000

6,000,000

5,000,000

Average Table 1 shows the expected after-tax operating cash flows for each project. All

projects are expected to have a 4 year life. The projects differ in size (the cost of the

initial investment), and their cash flow patterns are different. They also differ in risk

as indicated in the above table.

The capital budget is $20 million and the projects are mutually exclusive.

Capital Structures

Great Wall Co. has the following capital structure, which is considered to be optimal:

Debt

Preferred Equity 40%

10%

1 FIN341 Case Study Common Equity 50%

100% Cost of Capital

Sophia knows that in order to evaluate the projects she will have to determine the

cost of capital for each of them. She has been given the following data, which he

believes will be relevant to her task.

(1)The firmâ€™s tax rate is 30%.

(2) Great Wall Co. has issued a 13% semi-annual coupon bond with 10 years term to

maturity. The current trading price is $1,206.

(3) The firm has issued some preferred stock which pays an annual 9% dividend of

$100 par value, and the current market price is $110.

(4) The firmâ€™s stock is currently selling for $68 per share. Its last dividend (D 0) was

$4, and dividends are expected to grow at a constant rate of 8%. The current risk

free return offered by Treasury security is 2.5%, and the market portfolioâ€™s return is

10.5%. Great Wall Co. has a beta of 1.5. For the bond-yield-plus-risk-premium

approach, the firm uses a risk premium of 4.5%.

(5) The firm adjusts its project WACC for risk by adding 2.5% to the overall WACC for

high-risk projects and subtracting 2.5% for low-risk projects.

Sophia knows that Great Wall Co. executives have favored IRR in the past for making

their capital budgeting decisions. Her professor at Seattle U. said NPV was better

than IRR. She is the new kid on the block and must be prepared to defend her

recommendations.

First, however, Sophia must finish the analysis and write her report. To help begin,

she has formulated the following questions:

1. What is the firmâ€™s cost of debt? Cost of debt = Coupon rate of the bond (1-tax rate)

Tax rate of firm = 30%

(1-30%) = 70%

Firmâ€™s cost of debt = 70%

Coupon rate of bond = 13%

Cost of Debt*Coupon rate = 9.100%

2. What is the cost of preferred stock for Great Wall Co.? Dividend = annual 9% of $100 par value = $9

The current market price = $110

2 FIN341 Case Study Cost of Preferred stock = Dividend/ current market price

$9.00/$110.00 = 8.18% 3. Cost of common equity

(1) What is the estimated cost of common equity using the CAPM approach? Cost of equity = Risk free return + Beta (Market return- risk

free return)

Risk free return = 2.5%

Beta = 1.5

Market Return = 10.5%

Cost of equity = 2.5% + 1.5 (10.5%-2.5%)

(2) What is the estimated cost of common equity using the DCF approach? The firms stock is currently selling for $76.5 per share.

Its last dividend (D0) was $4, and dividends are expected to

grow at a constant rate of 8%. So D1 Dividend for next year

will

be $ ($4 * 1.08).

Cost of equity = (D1/ current market price) + Growth rate

D0 -$4*8%

D1 = 4.32

Current market price = $68.00

= (3.01/76.5) + 8%

= 3.93% +8%

= 14.35%

So the estimated cost of common equity using the DCF

approach is 14.35%

(3) What is the final estimate for cost of equity?

Equityâ€™s Risk premium = 10.5%

Return on an equity = 4.5%

Bond-Yield-Plus-Risk-Premium = 15%

4. What is Great Wall Co.â€™s overall WACC?

5. Do you think the firm should use the single overall WACC as the hurdle rate for

each of its projects? Explain.

6. What is the WACC for each project? Place your numerical solutions in Table 2. 30%

3 FIN341 Case Study 13%

70%

9.100% $ 9.00

$ 110.00

8.18% 2.5%

1.5

10.5%

2.5%

2.500% $ 68.00

$ 4.00 0.32

$ 4.32

$ 68.00

0.063529

6.35% 10.5%

4.5%

15% 23.853%

7.95%

7. Calculate all relevant capital budgeting measures for each project, and place your

numerical solutions in Table 2. WACC A Table 2

B C D NPV

IRR

8. Comment on the commonly used capital budgeting measures. What is the

underlying cause of ranking conflicts? Which criterion is the best one, and why?

9. Which of the projects are unacceptable and why?

10. Rank the projects that are acceptable, according to Sophiaâ€™s criterion of choice.

11. Which project should Sophia recommend and why? Explain why each of the

projects not chosen was rejected. Instructions

4 FIN341 Case Study 1.Your answers should be Word processed, submitted via Canvas.

2.Questions 5, 8, 9, and 11 are discussion questions.

3.Place your numerical solutions in Table 2.

4.Show your steps for calculation questions.

5.The Case Study is due on Wednesday midnight March 8, 2017. 5

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