CAPITAL BUDGETING AND THE COST OF CAPITAL |
The table below gives the initial investment and expected cash flows over the next five years for two different projects. Assume that the industry you are in expects a return of 10%, which you use as the discount rate in net present value (NPV) calculations and as the required rate of return for purposes of deciding on projects. Also, assume that management only wants to invest in projects that pay off within four years.
For each project, compute the payback period, NPV, and internal rate of return (IRR). Then explain whether each project should be accepted based on these three criteria.
Project A | Project B | |
Initial Investment | $40,000 | $28,000 |
Year | Cash Flows | |
1 | $10,000 | $10,000 |
2 | $10,000 | $13,000 |
3 | $10,000 | $5,000 |
4 | $10,000 | $5,000 |
5 | $10,000 | $6,000 |
Payback period Project A = Year 4
Payback period Project B = Year 3
NPV Project A = -$2,092.13
NPV Project B = -$2,731.88
IRR Project A = 7.93%
IRR Project B = 14.39%
Both projects are acceptable being that they are within the 4-year payback periods. However, Project B yields the highest rate of return @ 14.39%
Suppose you are planning on becoming a vendor at the arena where your favorite sports team plays. You are trying to decide between opening up a souvenir stand selling T-shirts, caps, etc., with your sports team’s logo or opening up a hot dog and beer stand. It is more expensive to open up the hot dog and beer stand because you need to purchase a license to serve alcohol and you need to spend money to comply with health department regulations. Revenue from the souvenir stand is likely to be unpredictable because fans of your favorite team tend to want to purchase hats and T-shirts only when the team is winning. Revenue from hot dogs and beer seem to be a little more steady since fans want to eat and drink regardless of whether the team is winning.
Below is a table with the initial investment cost of each type of stand and the annual payments you expect over the next five years. The annual payments will be different depending on how well your team does. Therefore, you will estimate how much cash flow you will get depending on whether your team does better than expected (optimistic), the same as the past few years (most likely), and worse than expected (pessimistic). Use a discount rate of 8%.
Souvenir Stand | Hot Dog and Beer Stand | |
Initial Investment | $100,000 | $150,000 |
Annual Cash Inflows (5 Years) | ||
Outcome | ||
Pessimistic | $30,000 | $50,000 |
Most likely | $50,000 | $60,000 |
Optimistic | $70,000 | $70,000 |
Souvenir Stand (In $) | Pessimistic | Most likely | Optimistic |
---|---|---|---|
NPV (b-a) | $19,781 | $99,636 | $179,490 |
Hot Dog and Beer Stand (In $) | Pessimistic | Most likely | Optimistic |
---|---|---|---|
NPV (b-a) | $49,636 | $89,563 | $129,490 |
Suppose you are a corn farmer in your home state. You have to decide between two projects. One project is to purchase new equipment for your farm that will help boost your profits for the next 10 years. You also find out that you can purchase a large banana farm in Brazil for the same price as the equipment, and at the current market price for bananas you will make a lot more profit than you would from purchasing new corn farming equipment.
- Calculate the net present value (NPV) for each type of stand under each of the three scenarios. Calculate the range of possible NPV values for each type of stand.
- Based on your answer to A) above and your own guesses about how well you think your favorite team will do over the next five years, which type of stand would you rather invest in?
- Since we expect that our team will perform optimistically, we will choose Souvenir Stand so that maximum NPV of $ 179,490 can be reached. However, if our team managed to perform “Most likely”, we will be in a better position than Hot Dog and Beer Stand as NPV of Souvenir Stand ($ 99,636) is higher than NPV of Hot Dog and Beer Stand ($ 89,563) in “Most likely” situation.
After asking around, you find out that the standard discount rate for evaluating the NPV of the farming project is 6%. Most farmers in your home state seem to use this rate successfully. However, you don’t know any other banana farmers and you don’t know too much about farming in Brazil, so you have to make a guess on an appropriate discount rate for the Brazilian banana farm. Based on the concepts from the background readings, would you say the Brazilian banana farm will need a lower or higher discount rate? A lot larger or smaller, or only a little?
The discount rate would be higher because in your home state you would know the risks and details of the business much better. Also, you would have more customers. In your home state you would not have to pay for import/customs duties, tariffs, etc... The red tape and other unknown factors will lead to a higher discount rate. Also in US you would have a strong currency, hence exchange rate risk is lower. A country like Brazil (which is my home country by the way) will have a higher political instability resulting in a much higher discount rate than 6 %.
Calculate the following:
Suppose you own a chain of dry cleaners and the WACC you’ve been using to make decisions on new purchases of dry cleaning equipment is a steady 9%. Recently, gambling has been made legal in your home town, so you decide to expand and open up a casino. Should you use the same WACC to evaluate purchases of casino equipment? Why or why not? What are some alternatives to using the same WACC to make decisions on casino equipment? Explain your reasoning and make references to concepts from the background readings.
- The cost of equity if the risk-free rate is 2%, the market risk premium is 8%, and the beta for the company is 1.3.
Cost of Equity = Risk – free Rate + Beta * Market Risk Premium - Cost of Equity = 2% + 1.3 * 8%
- Cost of Equity = 12.40%
- The cost of equity if the company paid a dividend of $2 last year and is expected to grow at a constant rate of 7%. The stock price is currently $40.
Cost of Equity = D0*(1 + g) / P0 + g - Cost of Equity = $2*1.07 / $40 + 0.07
- Cost of Equity = 12.35%
- The weighted average cost of capital (WACC) if the company has a total value of $1 million with a market value of its debt at $600,000 and a market value of its equity at $400,000. Its cost of debt is 6% and its cost of equity is 15%. The tax rate it pays is 25%.
- Weight of Debt = Value of Debt / Value of Firm
- Weight of Debt = $600,000 / $1,000,000
- Weight of Debt = 60%
- Weight of Equity = Value of Equity / Value of Firm
- Weight of Equity = $400,000 / $1,000,000
- Weight of Equity = 40%
- WACC = Weight of Debt * Cost of Debt * (1 – tax) + Weight of Equity * Cost of Equity
- WACC = 60% * 6% * (1 – 0.25) + 40% * 15%
- WACC = 8.70%
- The cost of equity if the company paid a dividend of $2 last year and is expected to grow at a constant rate of 7%. The stock price is currently $40.
The appropriate discount rate on a new project is the minimum expected rate of return an
investment must offer to be attractive. This minimum required return is often called the
cost of capital associated with the investment . If the earnings are less than WACC, then it is better not to go with the investment. Existing WACC can be the benchmark of taking investment decision in a new project, if it can be of the same risk. Here a business wants to invest in the gambling industry. Return here is unknown. It has a very high degree of risk.
A solution can be to Increase WACC rate on the higher side. The increase will cover extra risk from such investment. If after considering this higher WACC, the business is found to have positive present value of cash flows, then it can be a good investment. Or, consider a minimum net present value required from such investment. This positive cut off NPV is minimum required rate of return to cover up gambling risk. Then apply normal WACC and estimate actual net present value. If it is found higher than minimum positive NPV, then accept the project. Otherwise it is not a good investment. This method will also off set extra risk of gambling business and will make the decision a good one.