CAPITAL BUDGETING AND CAPITAL STRUCTURE

Assignment Overview

Make sure to thoroughly review the required background readings and work through both the concepts and the computational examples. The videos on computing NPV and IRR using Excel along with the sample spreadsheet should also help. If you are unable to figure out how to make the computations in Excel, then you can get partial credit by computing the answers using a calculator and thoroughly explaining your steps. For conceptual questions, make sure to thoroughly explain the reasoning for your answers and to use references from the required background readings.

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Case Assignment

Please download the Case 4 Template. You will type your answers into this document. Save the document with your last name and submit to the dropbox. Note that you will get partial credit if you show your work even if the answers are incorrect.

1.   The table below gives the initial investment (the negative numbers at “Year 0”) for two projects. Compute the payback period, the NPV, and the IRR using Excel. Then rank the two projects based on each of these three criteria, and discuss which projects should be funded based on your computations.

Firm Cost of Capital:

11%

Year

Project A

Project B

0

-100,000

-150,000

1

25,000

30,000

2

25,000

30,000

3

25,000

90,000

4

25,000

20,000

5

25,000

20,000

6

25,000

20,000

2.   The ACME Umbrella Company is deciding between two different umbrella factories. Both factories will cost $500,000 to get started. However, the cash flows for each factory will depend on whether the next five years are rainier than average or sunnier than average. Factory A will have cash flows of $130,000 per year for the next five years if the weather is sunnier than average. But if it is rainier than average the cash flows will be $150,000 per year for the next five years. Factory B will have cash flows of $100,000 per year for the next five years if it is sunnier than average, but if it is rainier than average it will have cash flows of $200,000 per year. ACME has a cost of capital of 9%. Based on this information, calculate the following:

a.  Calculate the NPV for both factories and for both scenarios (rainy versus sunny). What is the range of NPV for each factory based on your scenario analysis?

b.  Based on your answer to a) above, do you think ACME should use the same discount rate of 9% for each factory? Or should they use a risk-adjusted discount rate (RADR)? If so, which factory should have a higher RADR? Explain your answer with references to the background readings.

3.   The Carpet Company’s shareholders require an 11% return on their investment, and stock makes up 50% of the company’s capital structure. The other half of the company’s capital structure consists of debt. The interest rate on this debt is 7%. Assume the corporate tax rate is 21%. What is carpet company’s WACC?

4.   Assume the Carpet Company’s corporate tax rate falls to 0%. The company borrows money to buy back and retire half of its outstanding common stock. What happens to the company’s WACC?

Assignment Expectations

·         Answer the assignment questions directly.

·        Stay focused on the precise assignment questions. Do not go off on tangents or devote a lot of space to summarizing general background materials.

·        For computational problems, make sure to show your work and explain your steps.

·        For short answer/short essay questions, make sure to reference your sources of information with both a bibliography and in-text citations. See the Student Guide to Writing a High-Quality Academic Paper, including pages 11-14 on in-text citations. Another resource is the “Writing Style Guide,” which is found under “My Resources” in the TLC Portal.

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