(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?
Return on an equity = 4.5%
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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