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Capital Budgeting Practice Exam

Pertain to the following information about Firms A – G. Firms A, B, C and G operate in Industry 1; Firm D operates in Industry 2; and Firms E and F operate in both Industry 1 and Industry 2. Firms' debt-to-equity ratios (B/S) are shown. None of the firms is taxed. The managements of the seven firms are evaluating capital budgeting projects. Projects in the same industry as the firm are replacement or expansion projects; projects in a different industry than the firm are non-expansion or non-replacement projects. All accepted projects will be financed using the same B/S ratio as the firm’s current B/S ratio.

Firm A Firm B Firm C Firm D Firm E Firm F Firm H

Firm's Industry 1 1 1 2 1, 2 1, 2 1

Firm's B/S 0.0 0.0 0.2 0.2 0.0 0.2 0.5

Project's Industry 1 2 1 1 1, 2 1 1

__D_1. Firm A has a lower asset beta than Firm C.

__A_2. Firm A may appropriately use its own cost of equity as a discount rate for its project but Firm B cannot.

__D_3. Firm B lacks the information needed to compute an appropriate discount rate for its project.

__A_4. Firm E stockholders require a rate of return that lies between the appropriate rates of return for Firm E’s projects.

__A_5. WACC is a more useful metric for Firm C than for Firm F.

__D_6. The goal of corporate finance is to maximize corporate profits.

__D_7. When a firm’s cash flow to stockholders (i.e., Arrow 5) is negative in a given year, the firm’s net income must have been negative.

__D_8. When a project’s internal rate of return (IRR) is greater than the discount rate for project cash flows, the project’s NPV is negative.

__D_9. The payback period is a better metric for making capital budgeting decisions than the profitability index.

1. Cost of Equity (Data for this problem appear in the Excel file that accompanies this practice exam.) New Kids Motor Company (NKMC) went public in March 2013. Management is now considering a major expansion of the company’s factories. To complete its analysis management needs to know NKMC’s cost of equity. The risk- free return, measured by the current yield on 1-year Treasury bills, is now 1% (0.01); the historical market risk premium, RM – RF, is now 7% (0.07). Start-of-month prices for the S&P500, an oft-used stand-in for the market portfolio, and for NKMC stock from 01 April 2013 thru 01 April 2015 appear in the spreadsheet.

Compute NKMC’s cost of equity. Put your answer here: 0.1060 or 10.6% See Excel spreadsheet

2. Weighted Average Cost of Capital (Work in decimal terms; round to 3 decimal places.) (Assume today’s date is November 16, 2020.) The management of Babbitt Laboratories (BL), a pharmaceutical firm, needs to know the firm’s weighted average cost of capital. BL’s most recent balance sheet appears below.

BL has two types of bonds outstanding. Both types have $1,000 par values and have just made semi-annual coupon payments. The bonds due in 2028, 8 years from now, have a 1.5% coupon, paid semiannually, and are priced at $894 per bond. The bonds due in 2048, 28 years from now, have a 2% coupon, paid semiannually, and are priced at $665 per bond. There are 2m bonds of each type outstanding. Babbitt’s (marginal) tax rate is 40%.BL’s common stock has a beta of 1.6. BL common has a par value of $1 per share but a market price of $50 per share. There are 100m common shares outstanding.US Treasury bills currently yield 1% per year. The historical market risk premium is 7% per year. Compute BL’s weighted average cost of capital.

RWACC = RB1 (1–T) (B1 /V) + RB2 (1–T) (B2 /V) + RS (S/V) where V = B1 + B2 + S

RB1, RB2 : Find the yield to maturity on the outstanding bonds. In Excel: Rate = (nper ,pmt, pv, fv)

RB1: = (8x2,15/2,–894,1000)x2; RB1 = 0.03; RB1(1-T) = 0.03 (1-.4) = 0.018 = RB1(1-T)

RB2: = (28x2,20/2,–665,1000)x2; RB2 = 0.04; RB2(1-T) = 0.04 (1-.4) = 0.024 = RB2(1-T)

RS: Use the CAPM. RS = RF + { RM – RF } βS = 0.01 + (0.07)(1.6) = 0.122 = RS

B1 / V, B2 /V, P /V, S/V: use market value amounts.

B1: PB1 NB1 = $894 x 2m = $1,788m B1/V = 0.2203

B2: PB2 NB2 = $665 x 2m = $1,330m B2/V = 0.1638

S: PS NS = $50 x 100m = $5,000m S / V = 0.6159

V = $8,118m V / V = 1.0000

RWACC = (.018)(.2203) + (.024)(.1638) + (.122)(.6159) = RWACC = 0.083 or 8.3%

Project Discount Rate Computation. (Work in decimal terms; round to 3 decimal places.) The managements of Household and Medical Appliances (HMA) and Durable Sporting Goods (DSG) are deciding whether to accept capital budgeting projects.HMA is a leveraged firm with two divisions, one which manufactures household appliances (refrigerators, dishwashers, washers and dryers, etc.) and one which manufactures surgical and diagnostic equipment. Management is considering expansion / replacement projects for both divisions.DSG is a leveraged company which manufactures sporting equipment and apparel. Management is now

considering diversifying the company’s operations by purchasing and operating a chain of restaurants with a sports motif.

Additional data on HMA and DSG appears in the table below. Data on three other companies also appears Precision Medical Instruments, Best Deal Appliances, and North American Restaurants. All firms have a marginal tax rate of 40% (T = 0.4) The risk-free return is 2% per year and the market risk premium is 8.5% per year.

a. Compute appropriate discount rates for HMA’s capital budgeting projects.

b. Compute an appropriate discount rate for DGS’s capital budgeting project.

a. HMA can’t use its own WACC to discount cash flows for the expansion projects because HMA’s cost of equity reflects the reward to bearing the market risk of both household appliance-producing assets and surgical/medical device-producing assets. Cash flows for each project should be discounted using discount rates which reflect the market risk of just one kind of asset. Find pseudo-WACC using Best Deal and Precision Medical Instruments as the proxy firms.

Pseudo-WACC, Household appliance division using Best Deal as the proxy:

1. ?S, X = 1.4

2. ?A = ?S,X / {1 + BX(1-TX) / SX } = 1.4 / { 1 + (0/1)(1–.4) } = 1.4

3. ?S,P = {1 + BP(1-TP) / SP } ?A = { 1 + (.25/.75)(1 – .4) } 1.4 = 1.68

4. RS,P = RF + [ RM – RF ] ?S,P = 0.02 + (0.085) (1.68) = 0.1628

5. R pseudo WACC = RBP (1 – TP) (BP / VP ) + RSP (SP / VP ) = (0.04) (1 – 0.4) (0.25) + ( 0.1628) (0.75) = 0.1281

MBA 520 – Practice Final Exam – Solution – page 4

Pseudo-WACC, Surgical/medical division using Precision Medical Instruments as the proxy:

1. ?S, X = 0.8

2. ?A = ?S,X / {1 + BX(1-TX) / SX } = 0.8 / { 1 + (0/1)(1–.4) } = 0.8

3. ?S,P = {1 + BP(1-TP) / SP } ?A = { 1 + (.25/.75)(1 – .4) } 0.8 = 0.96

4. RS,P = RF + [ RM – RF ] ?S,P = 0.02 + (0.085) (0.96) = 0.1016

5. R pseudo WACC = RBP (1 – TP) (BP / VP ) + RSP (SP / VP ) = (0.04) (1 – 0.4) (0.25) + ( 0.1016) (0.75) = 0.0822

b. DSG is a leveraged firm undertaking a non-expansion, non-replacement project. It cannot use its own WACC as a discount rate for the project because the market risk of DSG’s assets and the project assets are different. North American Restaurants is engaged exclusively in the restaurant business, similar to DSG’s proposed project. NAR’s assets have the appropriate market risk but NAR is also leveraged and leveraged differently than DSG. An appropriate discount rate would be NAR’s WACC but using capital structure weights for DSG.Pseudo WACC for DSG using NAR as the proxy firm is the desired metric.

1. ?S, X = 0.9 market risk of restaurant assets financed like NAR

2. ?A = ?S,X / {1 + BX(1-TX) / SX } = 0.9 / { 1 + (.4/.6)(1–.4) } = 0.6429 market risk of restaurant assets

3. ?S,P = {1 + BP(1-TP) / SP } ?A = { 1 + (.2/.8)(1 – .4) } 0.6429 = 0.7393

market risk of restaurant assets financed like DSG

4. RS,P = RF + [ RM – RF ] ?S,P = 0.02 + (0.085) (0.7393) = 0.0828 pseudo cost of equity

5. R pseudo WACC = RBP (1 – TP) (BP / VP ) + RSP (SP / VP ) = (0.04) (1 – 0.4) (0.2) + ( 0.0828) (0.8) = 0.0710

4. Investment Rules (Round to 3 decimal places.)

The management of a Raleigh-based company is studying a plan to upgrade one of its production lines. Cash flow estimates appear (amounts are thousands of nominal dollars):

Year 0 1 2 3 4 5 6

Project -$100 $15 $30 $45 $45 $45 $55

Project, Cum. -$100 -$85 -$55 $-10 $35 $80 $135

The appropriate discount rate for projects of this type is 12% per year (nominal rate). Also, the company requires that projects earn back their initial cash flows within 3.5 years to be acceptable. Compute the net present value (NPV), internal rate of return (IRR), profitability index (PI), and payback period (PB) for the project. Should the company accept the project judging by each criterion?

NPV: =NPV(.12,15,30,45,45,45,55)-100 NPV = 51.336 > 0 accept

IRR: =IRR(alpha_n:alpha_n+6) where alpha_n:alpha_n+6 are the cells with the seven cash flows

IRR = 25.658% > 12% accept

PI: =NPV(.12,15,30,45,45,45,55)/100 PI = 1.513 > 1 accept

PB: 3 + (10/45) = 3.2222 PB = 3.222 years < 3.5 years accept.