Module 3 – Case

Capital Budgeting and the Cost of Capital

Assignment Overview

Before starting on this assignment, make sure to thoroughly review
the required background materials. Make sure you fully understand both
the basic concepts as well as how to calculate payback period, NPV, IRR,
and WACC. Submit your answers in a Word document. Make sure to show
your work for all quantitative questions and fully explain your answers
using references to the background readings for any conceptual
questions. Questions 1 and 2 will require Excel. Attach an Excel file to
show your computations for Questions 1 and 2.

Case Assignment

1. 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.

1. 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%.

Based on the table below, answer the following items:

1. 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.
2. 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?

1. 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.

   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?

1. Calculate the following:
   1. 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.
   2. 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.
   3. 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%.
2. 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.

Assignment Expectations

• Answer the assignment questions directly.
• Stay focused on the precise assignment questions. Do not go off on
  tangents or devote a lot of space to summarizing general background
  materials.
• For computational problems, make sure to show your work and explain your steps.
• For short answer/short essay questions, make sure to reference your
  sources of information with both a bibliography and in-text citations.
  See the Student Guide to Writing a High-Quality Academic Paper,
  including pages 11-14 on in-text citations. Another resource is the
  “Writing Style Guide,” which is found under “My Resources” in the TLC
  Portal.