Capital budgeting

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Module 12 CT PROBLEMS
COST OF CAPITAL, CAPITAL BUDGETING, AND THE FINANCING MIX
CT 12 – 1
INDIVIDUAL OR COMPONENT COSTS OF CAPITAL
Compute the cost of the following:
A)
A bond that has SAR 1,000 par value (face value) and a contract or coupon interest rate of 9 percent. A new issue would have a flotation cost of 11 percent of the $1,150 market value. The bonds mature in 20 years. The firm’s marginal tax rate is 35 percent.
DATA
face value
coupon interest rate
flotation cost
mrkt value
years
marginal tax rate
Net price =
Cost (interest) =
After-Tax cost =
B)
A new common stock issue that paid a SAR 5.00 dividend last year. The earnings per share have grown at a rate of 4 percent per year. This growth rated is expected to continue into the foreseeable future. The company maintains a constant dividend-earnings ratio of 25 percent. The price of this stock is now SAR 32.00, but 6 percent flotation costs (as a percent of market price) are anticipated.  Calculate the cost of capital for the new stock.
DATA
Div last year 5.00
growth rate 4%
div/earnings 25%
mrkt price 32.00
flotation costs 6%
Cost =
C)
Calculate the cost of internal common equity when the current market price of the common stock is SAR 28.00. The expected dividend this coming year should be SAR 4.25, increasing thereafter at a 4 percent annual growth rate. The corporations’s tax rate is 30 percent.
DATA
mrkt price 28.00
div this yr 4.25
growth rate 4%
tax rate 30%
Cost =
D)
A preferred stock paying a 7 percent dividend on a SAR 100 par value. If a new issue is offered, flotation costs will be 9 percent of the current price of SAR 125.
DATA
dividend 7%
parvalue 100.00
flotation costs 9%
mrkt price 125.00
Cost =
CT 12 – 2
WEIGHTED AVERAGE COST OF CAPITAL
The capital structure for the Saudi Corporation is provded below. The company plans to maintain its debt structure in the future. If the firm has a 5.25 percent after-tax cost of debt, a 13 percent cost of preferred stock, and an 17.5 percent cost of common stock, what is the firms’s weighted average cost of capital given the SAR amounts listed below?
DATA
After-tax cost of debt 5.25%
Cost of preferred stock 13.00%
Cost of common stock 17.50%
Bonds  (SAR)                                    1,500
Preferred stock  (SAR)                                       450
Common stock  (SAR)                                    4,100
Bond weight
Preferred stock weight
Common stock weight
Weighted cost of bonds
Weighted cost of preferred stock
Weighted cost of common stock
WACC
CT 12 – 3
PAYBACK PERIOD, NPV, PI, AND IRR CALCULATIONS
You are considering a project with an initial cash outlay of $250,000 and expected free cash flows of $65,000 at the end of each year for 6 years. The required rate of return for this projcect is 10 percent.
DATA
Initial Outlay
Expected after tax cash flow
Years
Required rate of return
A) What is the project’s pay back period?
Pay back period
     Discounted pay back period
Year Discounted Cash Flow Accumulated Cash Flow
1
2
3
4
5
6
B) What is the project’s NPV?
NPV
C) What is the project’s PI?
PI
D) What is the project’s IRR?
IRR
CT 12 – 4
PAYBACK PERIOD CALCULATIONS
You are considering three independent projects: A, B, and C. Given the folloing free cash flow information, calculate the payback period for each.
DATA
Required rate of return 9.00%
Year Project A Project B Project C
0 (1,000) (9,000) (4,000)
1 300 4,000 1,100
2 400 2,000 1,800
3 250 2,000 2,200
4 125 3,000 2,800
5 125 5,000 3,200
Payback period
If you require a 3-year payback before an investment can be accepted, which project(s) would be accepted?
CT 12 – 5
MUTUALLY EXCLUSIVE PROJECTS AND NPV
You have been assigned the task of evaluating two mutually exclusive projects with the following projected free cash flows:
DATA
Discount rate 10%
A B
Year Cash Flows Cash Flows
0 -165,000 -165,000
1 44,000 0
2 44,000 0
3 44,000 0
4 44,000 0
5 44,000 250,000
NPV
CT 12 – 6
BREAKEVEN POINT AND SELLING PRICE
Tabuk Electronics will manufacture and sell 300,000 units next year. Fixed costs will be SAR 485,000, and variable costs will be 35 percent of sales.
DATA
Sell
Fixed Costs
Variable Costs
A)
The firm wants to achieve a level of earnings before interst and taxes of $250,000. What selling price per unit is necessary to achieve the result?
EBIT
Sales =
Avg selling price =
B)
Set up a pro forma income statement to verify your solution to part a.
Sales
Total VC
Revenue before FC
Total FC
EBIT

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