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(solution) How do I determine the target percentages for the optimal capital


How do I determine the target percentages for the optimal capital structure, and then compute the WACC. (Carry weights to four decimal places. For example: 0.2973 or 29.73%)


APPENDIX B: CAPITAL BUDGETING GROUP PRESENTATION

 

ACMC Inc. is a multinational conglomerate corporation providing a wide range of goods and

 

services to its customers. As part of its budgeting process for the next year, it has three mutually

 

exclusive projects under consideration, and it might decide which project should receive the

 

investment funds for this year.

 

As part of the financial analysis team, it is up to you to determine the appropriate valuation of

 

each project. However, before you can determine the appropriate valuations of these projects,

 

you need to determine the weighted average cost of capital for the firm. Do remember that

 

management has a preference in using the market values of the firm?s capital structure and

 

believes it current structure is optimal. BALANCE SHEET

 

Cash

 

Accounts

 

Receivable

 

Inventories 2,000,000

 

28,000,000

 

42,000,000 Accounts Payable

 

and Accruals

 

Notes Payable 18,000,000 60,000,000

 

10,000,000

 

77,000,000 Net Fixed Assets 133,000,000 Long-Term Debt

 

Preferred Stock

 

Common Equity Total Assets 205,000,000 Total Claims 40,000,000 205,000,000 Market Values of Capital The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity.

 

The bonds carry a 10 percent semi-annual coupon, and are currently selling for $874.78. You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock

 

outstanding. The current market price is $90.00. Any new issues of preferred stock would

 

incur a $3.00 per share flotation cost. The company has 5 million shares of common stock outstanding with a currently price of

 

$14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend

 

(D0) was $.80. New stock could be sold with flotation costs, including market pressure, of 15

 

percent. The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole

 

is 14 percent. Your stock?s beta is 1.22. Your firm does not use notes payable for long-term financing. Your firm?s federal + state marginal tax rate is 40%. Project A:

 

This project requires an initial investment of $20,000,000 in equipment which will cost an

 

additional $3,000,000 to install. The firm will use the attached MACRS depreciation schedule to

 

expense this equipment. Once the equipment is installed, the company will need to increase raw

 

goods inventory by $5,000,000, but it will also see an increase in accounts payable for

 

$1,500,000. With this investment, the project will last 6 years at which time the market value for

 

the equipment will be $1,000,000.

 

The project will project a product with a sales price of $20.00 per unit and the variable cost per

 

unit will be $10.00. It is estimated the sales volume for this project will be 700,000 in year 1,

 

1,000,000 in year 2, 650,000 in year 3, 700,000 in year 4, 650,000 in year 5 and 550,000 in year

 

6. The fixed costs would be $2,000,000 per year. Because this project is very close to current

 

products sold by the business, management has expressed some favoritism towards this project

 

and as allowed for a reduced rate of return of 2 percentage point below its current WACC as the

 

valuation hurdle it must meet or surpass.

 

Project B:

 

This project requires an initial investment of $20,000,000 in equipment which will require

 

additional expense of $1,000,000 to install in the current facility. Consistent with other projects,

 

the equipment will be depreciated using the MACRS Investment Class schedule. Once installed,

 

the firm will need to increase inventory by $6,000,000. The project will last 6 years, but at the

 

end of that period, the equipment will have no salvage value.

 

During the operational period of this project, the product produced will sell for $6.50 per unit.

 

The costs related to this product will be $4.00 per unit in variable cost and the fixed costs each

 

year will be $1,000,000. Management has estimated that the sales volume for this project will be

 

3,500,000 in year 1, 4,000,000 in year 2, 4,250,000 in year 3, 4,500,000 in year 4, 4,300,000 in

 

year 5, and 4,200,000 in year 6. Since the project has been brought under consideration through

 

the normal channels, a discount rate equal to the WACC should be used in the project valuation.

 

Project C:

 

The project is outside of the normal products sold of the firm. The project is a reconsideration of

 

a project proposed two years ago by a former manager. At that time a marketing study costing

 

$200,000 was done; however, the project was not undertaken. Now the firm needs to consider if

 

this project is worth the firm?s capital investment dollars. This project would require investment

 

in equipment of $20,000,000 with an additional cost of $5,000,000 in installation fees. The

 

project will be considered under a 6 year project cycle, but would be depreciated under the 5 year

 

MACRS schedule. At the end of the project, management estimates that the equipment could be

 

sold at a market value of $5,000,000. This project also creates a need to increase raw goods

 

inventory by $6,000,000.

 

During the operational cycle of this project, the product would have a sales price of $90.00 per

 

unit. Costs associated with this project would be $65.00 in variable cost per unit and a fixed cost

 

per year of $5,000,000. Management estimates that the sales volume would be 500,000 units in

 

year 1, 600,000 units in year 2, 700,000 units in year 3, 800,000 units in year 4, 800,000 units in year 5, and 600,000 units in year 6. Because management is uneasy with undertaking a project

 

so far outside of its normal product portfolio, it is imposing a 3 percentage point premium above

 

the WACC as the required rate of return on the project.

 

Modified Accelerated Cost Recovery System (MACRS)

 

Ownership Year

 

1

 

2

 

3

 

4

 

5

 

6 5-Year Investment Class

 

Depreciation Schedule

 

20%

 

32%

 

19%

 

12%

 

11%

 

6%

 

Total = 100% Requirements

 

1. Find the costs of the individual capital components:

 

a. long-term debt (before tax and after tax)

 

b. preferred stock

 

c. average cost of retained earnings (avg. of CAPM and DCF)

 

2. Determine the target percentages for the optimal capital structure, and then compute the

 

WACC. (Carry weights to four decimal places. For example: 0.2973 or 29.73%)

 

3. Create a valuation spreadsheet for each of the projects mentioned above. Evaluate each

 

project according to the following valuation methods:

 

a. Net Present Value of Discounted Cash Flow

 

b. Internal Rate of Return

 

c. Payback Period

 

d. Profitability Index

 

4. Identify the sensitivity of the projects related to a 10% reduction in price and a 10% reduction

 

in sales volume.

 

5. Provide a synopsis evaluation of each project and provide a recommendation of which project

 

management will accept for its capital expenditures budget for the upcoming year.

 


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