Finance 221

Problem Set 4 (Practice Problems) Solutions

This problem set is to provide practice for the capital budgeting portion of midterm 2. You will not
be required to submit your answers for credit.

1. Midwest Electric Company (MEC) uses only debt and equity. It can borrow unlimited
amounts at an interest rate of 10 percent as long as it finances at its target capital structure,
which calls for 45 percent debt and 55 percent common equity. Its last dividend was $2, its
expected constant growth rate is 4 percent, and its stock sells at a price of $20. MEC’s tax
rate is 40 percent. Two projects are available: Project A has a rate of return of 13 percent,
while Project B has a rate of return of 10 percent. All of the company’s potential projects
are equally risky and as risky as the firm’s other assets.

(a) What is MEC’s cost of common equity?

Recall that we can use the Gordon Growth Model to solve for the cost of equity is we
have a forecast of expected dividend growth:
D1
re = + E(g).
P0

Here, D0 = $2, so D1 = 2(1.04) = $2.08. So the cost of equity is

2.08
re = + 0.04 = 0.144 =⇒ 14.4%.
20

(b) What is MEC’s WACC?

D E
   
W ACC = rd (1−τc )+ re = (0.45)(10%)(1−0.40)+(0.55)(14.4%) = 10.62%
D+E D+E

(c) Which projects should MEC select?

We compare the firm’s W ACC to the rate of return on the investments (IRR). We see
that Project A’s return exceeds the cost of capital, while Project B offers a return less
than the cost of capital. Hence, we accept Project A and reject Project B.
2. A firm has a capital structure consisting of 35% debt, 45% common stock, and 20% preferred
stock. The preferred stock pays an annual dividend of $3.50, and the current market price
for preferred stock is $50 per share. The company has $20 million in bonds outstanding, each
with a face value of $1,000. The bonds pay an 8% annual coupon and have a maturity of
7 years. The bonds currently have a market price of $850. If the firm issues new debt, it
expects to have the same yield-to-maturity as its outstanding debt. The firm’s common stock
has a beta of 1.25. The risk-free rate is 2% and the market risk premium is 9%. The firm
faces a marginal tax rate of 35%. What is this firm’s WACC?

Recall that the formula for the firm’s (after-tax) W ACC is

D E P
     
W ACC = rd (1 − τc ) + re + rp .
D+E +P D+E+P D+E+P
The fractions of each type of security in the firm’s capital structure are given in the problem,
so we just need to find the cost for each security:

• rd = YTM on marginal debt = 11.20% (1,000 FV -850 PV 80 PMT 7 N → CPT

I/Y ).
• re = 2% + 1.25(9%) = 13.25% (using CAPM).
$3.50
• rp = $50 = 7%.

So the W ACC for this firm turns out to be:

W ACC = (0.35)(11.20%)(1 − 0.35) + (0.45)(13.25%) + (0.20)(7.0%) = 9.91%.

3. Edelman Engineering is considering including two pieces of equipment, a truck and an over-
head pulley system, in this year’s capital budget. The projects are independent. The cash
outlay for the truck is $17,100, and that for the pulley system is $22,430. The firm’s cost
of capital is 14%. After tax cash flows, including depreciation, are included on the table be-
low. Calculate the IRR, NPV, and PI for each project and indicate the correct accept/reject
decision for each.

Year Truck Pulley

0 -$17,200 -$22,430
1 $5,100 $7,500
2 $5,100 $7,500
3 $5,100 $7,500
4 $5,100 $7,500
5 $5,100 $7,500

IRR 14.99% 20.0%

NPV $408.71 $3,318.11
PI 1.024 1.148

We would make the decision to accept both projects if the firm didn’t face a capital rationing
situation. If the firm was capital rationed (and could only choose one project), we would
choose the Pulley.
4. After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation
must decide whether to mine the deposit. The most cost-effective method of mining gold is
sulfuric acid extraction, a process that results in environmental damage. To go ahead with
the extraction, CTC must spend $900,000 for new mining equipment and pay $165,000 for
its installation. The gold mined will net the firm an estimated $350,000 each year over the
5-year life of the vein. CTC’s cost of capital is 14 percent. For the purposes of this problem,
assume that the cash inflows occur at the end of the year.

(a) What is the NPV and IRR of this project?

The net cash flows from the proposed mining project are:

Year CF
0 -$1,065,000
1 350,000
2 350,000
3 350,000
4 350,000
5 350,000

The N P V is $136,578.34 and the IRR is 19.22%.

(b) If we ignore environmental concerns, should this project be undertaken?

Yes, since the NPV > 0 (and the IRR > WACC).

(c) How should environmental effects be considered when evaluating this, or any other,
project? How might these effects change your decision in part (b)?

The analysis in (a) ignores the environmental damage caused by the mining process.
Environmental damage is an example of an externality. The firm should deduct the cost
of the environmental damage from the expected cash flows to get a better estimate of
the marginal benefits and marginal costs of the project. If the environmental costs were
large enough, it might lead the manager to reject the project.
5. A firm with a W ACC of 10 percent is considering the following mutually exclusive projects:

Project A Project B
Year NCF* Cumulative Discounted NCF Cumulative NCF Cumulative Discounted NCF Cumulative
0 -400 -400 -400 -400 -600 -600 -600 -600
1 55 -345 50 -350 300 -300 272.73 -327.27
2 55 -290 45.45 -304.55 300 0 247.93 -79.34
3 55 -235 41.32 -263.22 50 50 37.57 -41.77
4 225 -10 153.68 -109.55 50 100 34.15 -7.62
5 225 215 139.71 30.16 50 150 31.05 23.42
Payback Period: 4.04 Payback Period: 2.00
Discounted Payback Period: 4.78 Discounted Payback Period: 4.25
NPV: $30.16 NPV: $23.42
IRR: 12.21% IRR: 12.28%
*NCF = Net Cash Flows

(a) According to the payback criterion, which project should be accepted?

Project B.
(b) According to the discounted payback criterion, which project should be accepted?

Project B.
(c) According to the NPV criterion, which project should be selected?

Project A.
(d) According to the IRR criterion, which project should be selected?

Project B.
6. Holmes Manufacturing Company is considering the purchase of a new machine for $250,000
that will reduce manufacturing costs by $90,000 annually. Holmes will use the 3-year MACRS
accelerated method to depreciate the machine, and it expects to sell the machine at the end
of its 5-year operating life for $23,000. The applicable depreciation rates are 33%, 45%, 15%,
and 7%. The firm will need to increase net operating working capital by $25,000 when the
machine is installed, but required operating working capital will return to the original level
when the machine is sold after 5 years. Holmes marginal tax rate is 40%, and it uses a 10%
cost of capital to evaluate projects of this nature.

The Cash Flow Analysis looks like this:

Year 0 1 2 3 4 5

Investment outlays
Machine $(250,000)
WC $(25,000)

Operating Cash Flows

Revenue* $90,000 $90,000 $90,000 $90,000 $90,000
Depreciation $82,500 $112,500 $37,500 $17,500 $0
EBIT $7,500 $(22,500) $52,500 $72,500 $90,000
Taxes $3,000 $(9,000) $21,000 $29,000 $36,000
NOPAT $4,500 $(13,500) $31,500 $43,500 $54,000
Depreciation $82,500 $112,500 $37,500 $17,500 $0

Operating Cash Flow $87,000 $99,000 $69,000 $61,000 $54,000

Terminal Cash Flows

Return of WC $25,000
Net Salvage Value $13,800

Net Cash Flow $(275,000) $87,000 $99,000 $69,000 $61,000 $92,800

*Technically these are cost savings, but we can treat them as revenue.

(a) What is the project’s NPV? NPV = $37,035.13

(b) Assume the firm is unsure about the savings to operating costs that will occur with the
new machine’s acquisition. Management believes these savings may deviate from their
base-case value ($90,000) by as much as plus or minus 20%. What is the NPV of the
project under both situations?

Outcome Cost Savings NPV

Low Savings $72,000/year -$3,905.37
Base-Case $90,000/year $29,597.12
High Savings $108,000/year $77,975.63
7. The Harris Company is evaluating the proposed acquisition of a new milling machine. The
machine’s base price is $108,000, and it would cost another $12,500 to modify it for special
use by your firm. The machine falls into the MACRS 3-year class, and it would be sold after
3 years for $65,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The
machine would require an increase in net operating working capital (inventory) of $5,500.
The milling machine would have no effect on revenues, but it is expected to save the firm
$44,000 per year in before-tax operating costs, mainly labor. Harris’s marginal tax rate is
35%.

The cash flow analysis for this project is:

Year 0 1 2 3

Investment outlays
Machine $(108,000.00)
Modifications $(12,500.00)
Increase in WC $(5,500.00)

Operating Cash Flows

Total Costs $(44,000.00) $(44,000.00) $(44,000.00)
Depreciation $39,765.00 $54,225.00 $18,075.00
EBIT $4,235.00 $(10,225.00) $25,925.00
Taxes $1,482.25 $(3,578.75) $9,073.75
NOPAT $2,752.75 $(6,646.25) $16,851.25
Depreciation $39,765.00 $54,225.00 $18,075.00
Operating Cash Flows $42,517.75 $47,578.75 $34,926.25

Terminal Cash Flows

Return of WC $5,500.00
Net Salvage Value $45,202.25

Net Cash Flows $(126,000.00) $42,517.75 $47,578.75 $85,628.50

IRR 16.37%
NPV $10,840.44

=⇒ The IRR exceeds the cost of capital (12%), so the firm should go ahead with this project.
8. ALLIED FOOD PRODUCTS: Capital Budgeting and Cash Flow Estimation (problem 11-12,
p. 449).

(a) Straightforward.
(b) The following table contains the completed standard form for Allied Products:

End of Year 0 1 2 3 4
Investment Outlays

Equipment Cost $(200,000)

Installation $(40,000)
Increase in Inventory $(25,000)
Increase in Accounts payable $5,000
Total Net Investment $(260,000.00)

Operating Cash Flows

Unit Sales 100,000 100,000 100,000 100,000

Price per Unit $2.00 $2.00 $2.00 $2.00
Total Revenues $200,000 $200,000 $200,000 $200,000
Operating Costs (excl. dep) $120,000 $120,000 $120,000 $120,000
Depreciation $79,200 $108,000 $36,000 $16,800
Total Costs $199,200 $228,000 $156,000 $136,800
Operating Income Before Taxes $800 $(28,000) $44,000 $63,200
Taxes on Operating Income $320 $(11,200) $17,600 $25,280
Operating Income After Taxes $480 $(16,800) $26,400 $37,920
Depreciation $79,200 $108,000 $36,000 $16,800
Operating Cash Flow $79,680 $91,200 $62,400 $54,720

Terminal Year Cash Flows

Return of Net Operating WC $20,000

Salvage $25,000
Tax on Salvage Value $10,000
Total Termination Cash Flows $35,000

Net Cash Flows $(260,000) $79,680 $91,200 $62,400 $89,720

Results

NPV = $(4,029.72)
IRR = 9.28%
Payback Period 3.424 years
(c) i. Allied uses debt in its capital structure, so some of the money used to finance the
project will be debt. Given this fact, should the projected cash flows be revised to
show projected interest charges? Explain.

No. The cost of capital already reflects the returns required by all investors in the
firm, including the bondholders. If we subtracted interest charges from revenues, we
would essentially be counting the cost of debt twice.

ii. Suppose you learned that Allied had spent $50,000 to renovate the building last
year, expensing these costs. Should this cost be reflected in the analysis? Explain.

No. The renovation expenses are a sunk cost and should not have any impact on
the decision to invest today.

iii. Now suppose you learn that Allied could lease its building to another party and earn
$25,000 per year. Should that fact be reflected in the analysis? If so, how?

Yes. This is an example of an opportunity cost. The foregone income which could
be obtained from leasing the building should be considered as a real cost.

iv. Now assume that the lemon juice project would take away profitable sales from
Allied’s fresh orange juice business. Should that fact be reflected in your analysis?
If so, how?

Yes. We should decrease the revenues by the same amount as the loss in revenues
from the orange juice business in order to accurately determine the impact of the
project on shareholder wealth.

(d) Disregard all of the assumptions made in part (c), and assume there was no alternative
use for the building over the next 4 years. Now calculate the project’s NPV, IRR and
payback. Do these indicators suggest that the project should be accepted?

Looking at the above analysis, we see that the NPV is negative and the IRR is less than
the cost of capital. This suggests that this project should be rejected.