# Capital budgeting

 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