CAPITAL BUDGETING AND CAPITAL STRUCTURE
Required Reading
For chapters in Peterson and Fabozzi’s text, you should read through the following material in this textbook found in the Ebook Central database.
Peterson, P., & Fabozzi, F. J. (2010). The basics of finance: An introduction to financial markets, business finance, and portfolio management. Hoboken, NJ: John Wiley & Sons, Incorporated. ISBN: 978-0-470-60971-2. Available in the Trident Online Library.
Chapter 8: The Corporate Financing Decision
This chapter compares the use of debt and equity and discusses optimal capital structure.
Chapter 12: Cash Flow Analysis
This chapter discusses cost of capital and cash flows.
Chapter 13: Capital Budgeting
This chapter introduces tools, such as net present value and internal rate of return, which are used to make investment decisions.
Case Assignment
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.
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?
