Fin Project

FIN 425 – Course Project

CougCoffee Inc.

DCF Project and Company Analysis

Instructions:

Your final report should include a complete set of tables, numerical and written answers to each

part of the assigned questions. Show your computation steps. Your written report for this project

should not exceed 8 pages. There is no minimum page requirement as long as you answer all

questions properly.

If necessary, you can choose to provide additional evidence such as supporting excel calculations,

regressions or data. However, additional evidence is not required and the project report itself

should be self-explanatory.

Additional Requirements

In conducting the analysis and preparing your report, you may use any sources you find helpful:

textbook, public documents, data from various websites, etc. However, the work you submit must

be your own in the sense that it represents your own synthesis and analysis of information

gathered from multiple sources and is written in your own words. Be sure to carefully document

all your sources, calculations, and assumptions.

Moreover, you should perform your own data analysis and estimations, rather than copying

from other available analyst’s report (such as beta, alpha, cost of capital, etc.).

Failure to follow any of the above requirements can result in serious consequence. It can lead

to a failure of this project and this course.

Additional important project Policies and Template will be posted on canvas. It is your

responsibility to read and comply with these policies.

CougCoffee is an American coffee product retailer and manufacturer located in Pullman, WA. The

company president is Jack Ryan, who inherited the company. When the company was founded

over 50 years ago, it originally imported coffee beans from Mexico. The company focused on

roasting and retailing coffee beans to more than 30 states in the US. Over the years, the company

still maintains its original coffee beans retail business, accounting for about 50 percent of its total

revenue. Faced with stiff competition, the company also expanded into the business of

manufacturing coffee machines. You, as a Carson College business majored, are hired by the

company’s finance department to evaluate a new project for the company.

As of now, CougCoffees only coffee maker is named the QuickCofee (QC), and sales have been

excellent. CougCoffees main competitor in the coffee maker market is Stanley Black & Decker,

Inc. (SWK). CougCoffees QC is similar to the SWKs Black & Decker but easier to use. However,

CougCoffee wants to introduce a new version of the coffee maker, the CoffeeMaster (CM), into

their lineup. CougCoffee spent $300,000 to develop the new CM, which can adjust brew

temperature according to different types of coffee beans and brews directly into the included 18-

ounce thermal mug or into any mug or cup of your choice. The company has spent a further

$50,000 on a marketing study to determine the new coffee makers expected sales figures.

CougCoffee can manufacture the new coffee maker for $55 per machine in variable costs. Fixed

costs for the operation are estimated to run $1,500,000 per year. The estimated sales volumes (in

units) are 140,000, 160,000, and 100,000 coffee makers per year for the next three years,

respectively. The unit price of the new coffee maker will be $95. The necessary equipment can be

purchased for $3,000,000 and will be depreciated on a five-year MACRS schedule. It is believed

the value of the equipment in three years will be $1,500,000.

As previously stated, CougCoffee currently manufactures the QC. Production of the existing

product is expecting to be terminated in two years. If CougCoffee does not introduce the new CM

product, sales of the existing product will be 100,000 and 90,000 units per year for the next two

years, respectively. The price of the existing coffee maker, QC is $75 per coffee maker, with

variable costs of $45 each and fixed costs of $900,000 per year. If CougCoffee does introduce the

new coffee maker, sales of the existing one will fall by 50,000 (units) coffee makers per year, and

the price of the existing coffee maker will have to be lowered to $40 per coffee maker.

Net working capital for the new project will be 20 percent of sales and will occur with the timing

of the cash flows for the year; for example, there is no initial outlay for NWC, but changes in NWC

will first occur in Year 1 with the first year’s sales. CougCoffee has a 20 percent corporate tax rate.

The company has a target debt to equity ratio of 0.5 and is currently A rated (according to S&P

500 ratings). The overall cost of capital of CougCoffee is 14 percent.

The finance department of the company has asked you to prepare a report to Jack, the companys

CEO, and the report should answer the following questions.

QUESTIONS

1. Can you prepare the income statement and the total cash flow (CFFA) table for this new

project?

2. Please use these tables to help explain to Jack the relevant and irrelevant cash flows of this

project?

3. The companys CEO, Jack, wants to understand the risk of the coffee maker industry better.

Since CougCoffees main competitor, Stanley Black & Decker Inc (SWK), is a leading

company in this industry, Jack asks you to perform the following analysis on SWK.

a. Using the past N years of data (ending in December 2021), estimate your own beta

and alpha of SWK based on a regression analysis. Document the data sources used.

Also, explain how long a time period (from which year to which year) that you

decide to use to perform your estimation, and explain why?

b. Provide your beta and alpha estimates, as well as the statistical significance (e.g., t

ratio, p-value). Comment briefly.

c. Plot the security characteristic line for this company, and clearly show alpha and

beta on the diagram. Is the company correctly priced, overpriced, or underpriced?

d. From the above analysis, can you explain to Jack the risk characteristics of SWK

and the coffee maker industry using the beta you estimated? Do you think your

estimated beta makes sense given the nature of the company and the industry?

4. Given your understanding of CougCoffee and your analyses so far, can you help Jack to make

the project decision regarding the companys new product CM? That is, please compute the

NPV and IRR of CougCoffees new project? Please show your computation steps clearly

(show your inputs if using financial calculator or excel sheet).

Should Jack take the new project? Why or why not (Please explain using the NPV and IRR

rules separately)? CHAPTER 14

COST OF CAPITAL

Chapter 11

PROJECT ANALYSIS AND

EVALUATION

Lecture slides posted on blackboard

For your own reading, will not be on the

exam

11-2

Chapter 14 Cost of Capital

The Cost of Capital Equity, Debt, and Preferred

(Quick Review of DGM & CAPM)

The Weighted Average Cost of Capital (WACC)

Project Costs of Capital

Flotation Costs and the WACC

14-3

last piece to complete capital budgeting analysis

Cost of Capital

14-4

Banker: The

required return

must be

CFO: Wow,

thats my cost!

Cost of Capital

14-5

required return

(for investors)

Cost of capital

(to the firm)

required return = discount rate = cost of capital

more or less interchangeably

=

Cost of Capital

How do we determine the cost of capital/required return?

14-6

required return = discount rate = cost of capital

more or less interchangeably

Key principle – the return required on some

asset/project depends on the risk of the asset

Key principle – The cost of capital depends primarily on

the use of the funds, not the source of the funds.

14-7

Moscow

The cost of capital depends primarily on the

use of the funds (risk), not the source.

Travel agency

Pullman

Higher risk, higher

cost of capital

Importance of cost of capital

Why is it important to determine Cost of Capital ?

Required return = discount rate = cost of capital

How to determine a firm’s overall cost of capital?

depends on the return required on the firm’s overall assets

14-8

Cost of Equity

Cost of Debt

Capital budgeting decisions (DCF analyses):

We need to know the required return (discount rate) for an

investment before we can compute the NPV and make a decision

about whether or not to take the investment

Corporate policy decisions:

the optimal capital structure (D/E) minimizes the cost of capital

Cost of Equity

The cost of equity (RE)

the return required by equity investors, given the

risk of (the cash flows from) the firm

There are two major methods for determining the

cost of equity

Dividend growth model (DGM)

CAPM (or SML)

14-9

Covered in FIN325

A quick review here

Chapter 13

The Dividend Growth Model Approach Quick

Review

Start with the dividend growth model (DGM)

(with constant growth)

14-10

D1 = D0(1+g)

RE = dividend yield (D1 / P0) + capital gains yield (g)

Rearrange, solve for RE

Example: Dividend Growth Model

Example Suppose that your company is expected

to pay a dividend of $1.50 per share next year.

There has been a steady growth in dividends of

5.1% per year and the market expects that to

continue.

The current price is $25. What is the cost of

equity?

14-11

The Dividend Growth Model Approach

The dividend growth model (DGM) formula

14-12

D1 = D0(1+g)

To use DGM, we need 3 pieces of information: D0 , P0 , and g.

Which one is most difficult to get?

the expected g for dividends, must be estimated.

To estimate g:

Use analysts’ forecasts of future growth rates -available

from a variety of sources, e.g. at yahoo.com, or zacks.com.

Use historical growth rates

Advantages and Disadvantages of Dividend

Growth Model

Advantages and disadvantages of DGM:

Advantage easy to understand and use

Disadvantages ?

Only applicable to companies currently paying

dividends

Not applicable if dividends arent growing at a

reasonably constant rate

Extremely sensitive to the estimated g —

an overestimation of g by 1% an overestimation of RE by 1%

Does not explicitly consider risk

14-13

Chapter 14 Cost of Capital

The Cost of Capital Equity

(Quick Review of DGM & CAPM)

14-14

The CAPM (or SML) Approach

14-15

What is risk premium?

Risk premium = Expected return risk-free rate

E(RE) Rf = E (E(RM) Rf)

CAPM (or SML) Approach: Link Expected Return to Risk

The risk premium on individual assets depends on:

risk premium on the market portfolio (M)

risk the beta coefficient with respect to M

Nobel Prize

Wining Theory

E(RE) = Rf + E (E(RM) Rf)

Expected Return and Risk

According to CAPM, what type risk should matter for E(R)?

Still remember Systematic vs. Unsystematic risk?

Systematic risk inflation, recession, interest rate

Unsystematic risk lighting strike, CEO heart attack, unexpected big order

Systematic !

Unsystematic risk

can be diversified

away, not priced

Recession Lighting strike

Expected Return and Risk

According to CAPM, only Systematic risk matters in

determining E(R), unsystematic risk can be diversified away,

you will not be paid if you hold it.

How to measure systematic risk? by Beta:

i =[COV(ri,rM)] /

2

M

measures: How individual security is correlated with market

portfolio.

An individual securitys total risk (2i) can be partitioned into

systematic and unsystematic risk:

What is the beta of the market? M = ?

2i = sys. risk + unsys. risk

= i

2 M

2 + 2(ei)

M = 1

Expected Return and Risk (Basic Logic)

In equilibrium, return-to-risk ratio should be the same for all

assets.

The ratio of risk premium to beta should be the same for any

two securities, and to that of the market portfolio:

M

fM

i

fi

rrErrE

=

)()(

CAPM

j

j

i

i

risk

Return

risk

Return

=

Systematic

risk ()

Risk

premium

M = 1

Professor William Sharpe, Stanford

University, won the Nobel Prize in 1990

Sample Calculations for SML

x = 1.25

E(rx) =3% + 1.25 (8%) = 13%

y = .6

E(ry) =3% + 0.6 (8%) = 7.8%

Equation of the CAPM

E(ri) = rf + i[E(rM) – rf]

If = 1?

If = 0?

Can we plot the return-risk

relation of these stocks?

E(rm) – rf = 8% – Market risk premium – Return per unit of sys. risk

rf = 3% – Risk-free rate

E(rm) – rf = 8% – Market risk premium (Return per unit of sys. Risk)

E(rm) = 11% – Market return

rf = 3% – Risk-free rate

E(r)

SML

M

1.0

RM=11%

3%

Rx=13%

x

1.25

Ry=7.8%

y

.6

8%

Graph of Sample Calculations

7-20

=0 , ERriskfree=3%

=0.6 , ER=7.8%

=1, ERMkt=11%

=1.25, ER=13%

Market risk premium

Equation of the CAPM

E(ri) = rf + bi [E(rM) – rf]

If all securities are correctly

priced (CAPM), they should plot

on SML.

Question 1

Southern Home Cookin’ just paid its annual dividend

of $0.65 a share. The stock has a market price of $13

and a beta of 1.2. The return on the U.S. Treasury bill

is 2.5 percent and the market return is 10.5 percent.

What is the cost of equity?

A. 9.60 percent

B. 12.10 percent

C. 12.60 percent

D. 15.10 percent

Answer: B Not D

Re = 2.5% + 1.2 (10.5% – 2.5%)

= 12.10 percent

Wrong answer:

Re = 2.5% + 1.2 10.5%

= 2.5% + 12.60% =15.10 percent

Equation of the CAPM

E(ri) = rf + bi [E(rM) – rf]

The CAPM or SML Approach A quick review

14-22

CAPM (or SML) Approach:

The risk premium on individual assets depends on:

risk premium of market

sys. risk ()

Higher beta, higher return

High beta stock? Low beta stock?

E(r)

SML

ERLVS

LVS

2.0

ERMCD

MCD

.38

Graph of Sample Calculations

7-23

Using past 10

years data:

E(R)LVS=28%

E(R)MCD=12%

= +2% Positive is good, Plot above SML

+ gives the buyer a positive abnormal return

E(rE(r))

15%15%

SMLSML

1.01.0

RRmm=11%=11%

rrff=3%=3%

1.251.25

Disequilibrium Example

Suppose a security Q with Q of ____ is

offering an expected return of ____

According to the SML, the E(r) should be

___?__

1.25

15%

Underpriced: too cheap – offers too high of a return for its level of risk

The difference between the actual return and the return required for the risk

level as measured by the CAPM is called the stocks alpha. What is the in

this case?

E(r) = rf + Q [E(rM) rf]

=

Is the security under or overpriced?

13%

7-24

Q

3% + 1.25 (8%) = 13%

Mispricing

More on alpha and beta

E(rM) = 14%

S = 1.5

rf = 5%

Required return(s) = rf + S [E(rM) rf]

=

If you believe the stock will actually provide a return of ____,

what is the implied alpha? Is the stock overpriced or

underpriced?

=

5 + 1.5 [14 5] = 18.5%

17%

17% – 18.5% = 1.5%, the stock is overpriced (too expensive)

A stock with a negative alpha plots below the SML & gives

the buyer a negative abnormal return

Measuring Beta

Concept:

Method

We need to estimate the relationship between the

security and the Market portfolio.

using historical data of excess returns of the

security and the Market portfolio

Use regression analysis to calculate the Security

Characteristic Line (SCL) and estimate beta

How to measure beta?

Security Characteristic Line (SCL)

Excess Returns (i)

.

.

.

..

.

. .

. ..

. .

.

. .

. .

.

.

.

.

. .

. .

.

. .

.

. .

. .

.

. .

.

. .

.

. … .

. .. .

Excess returns

on market (M)

Ri = i + iRM + ei

Slope =

– abnormal return

What should be?

SCL

Dispersion of the points

around the line measures

__________________.Unsys. risk (e)

7-27

SCL equation:

E(ri) – rf = i + i[E(rM) – rf]

Advantages and Disadvantages of

CAPM

Advantages

Explicitly adjusts for systematic risk

Applicable to all companies, even companies that do not pay

dividends! as long as we can estimate beta.

Disadvantages

Have to estimate beta, which also varies over time

Have to estimate the expected market risk premium, which

does vary over time

We are using the past to predict the future, which is not

always reliable

14-28

Advantages and Disadvantages of CAPM

Takeaways or what to do When estimate Beta?

Looking at analyst forecasts may NOT be reliable

especially if you have the skill to estimate beta yourself

If you notice that there are business strategy changes

you probably want to use the most recent data to estimate

beta

On the other hand, if the company has been stable

you should use as long a time period as possible.

Because, statistically, the more the observations, the more

accurate the estimation

Chapter Outline

The Cost of Capital

The Weighted Average Cost of Capital (WACC)

The Cost of Equity

The Costs of Debt and Preferred Stock

Divisional and Project Costs of Capital

Flotation Costs and the WACC

14-30

Cost of Debt Chap 7

The cost of debt required return (YTM) on a

companys debt.

How to estimate Cost of Debt for a company?

Computing the YTM on the existing debt

Use current YTM based on the credit rating

If the firm is rated as BBB, we can find YTM (or the

interest rate) on newly issued BBB bonds.

14-31

Cost of Preferred Stock

Reminders

Preferred stock generally pays a constant dividend each

period forever

Preferred stock is a perpetuity:

RP = D / P0

14-32

perpetuity formula: P0= D / RP ,

rearrange and solve for RP

If a company has preferred stock with an

annual dividend of $3. Current price is

$25, then cost of preferred stock is:

RP = 3 / 25 = 12%

The Weighted Average Cost of Capital

14-33

Cost of

equity

Cost of

debt

Weighted Ave.

Cost of Capital

(WACC)

The weights are determined by

market value of each asset

Capital Structure Weights

Notations

E = market value of equity

= # of outstanding shares x price per share

D = market value of debt

= # of outstanding bonds x bond price

V = market value of the firm

= D + E

Weights (capital structure weights)

wE = E/V = percent financed with equity

wD = D/V = percent financed with debt

14-34

Taxes and the WACC

Effect of taxes

Interest expense (on bonds) reduces firms tax liability, therefore

reduces the cost of debt

After-tax cost of debt = RD(1-TC)

Dividends (on stocks) are not tax deductible, so there is no tax

impact on the cost of equity

Therefore:

WACC = wE RE + wD RD (1-TC)

14-35

Extended Example: WACC

Equity Information

50 million shares

$80 per share

Beta = 1.15

Market risk

premium = 9%

Risk-free rate = 5%

Debt Information

$1 billion in

outstanding debt

(face value)

Current price = 1,100

Coupon rate = 9%,

semiannual coupons

15 years to maturity

Tax rate = 40%

14-36

Extended Example: WACC

What is the cost of equity?

RE = 5 + 1.15(9) = 15.35%

What is the cost of debt?

N = 30; PV = -1,100; PMT = 45;

FV = 1,000;

CPT I/Y = 3.9268

RD = 3.927(2) = 7.854%

What is the after-tax cost of debt?

RD(1-TC) = 7.854(1-40%) = 4.712%

14-37

Equity Information

50 million shares

$80 per share

Beta = 1.15

Market risk premium = 9%

Risk-free rate = 5%

Debt Information

$1 billion in outstanding debt

Current price = 1100

Coupon rate = 9%, semiannual;

15 years to maturity

Tax rate = 40%

Extended Example: WACC

What are the capital structure weights?

E = 50 million ($80) = $4 billion

# of outstanding bonds

=$ 1billion FV/$1,000 =1 mil units of bonds

D = 1 mil x ($1,100) = $1.1 billion

V = 4 billion + 1.1billion = $ 5.1 billion

wE = E/V = 4 / 5.1 = 78.43%

wD = D/V = 1.1 / 5.1 = 21.57%

What is the WACC?

WACC = .7843 x (15.35%) + .2157 x (4.712%) = 13.06%

14-38

Equity Information

50 million shares

$80 per share

Debt Information

$1 billion in outstanding debt

(FV)

Current price = $1100

RE = 15.35%; RD(1-TC) = 4.712%

Practice Question 8

Kelso’s has a debt-equity ratio of 0.55. The firm does not issue

preferred stock. The cost of equity is 14.5 percent and the cost of

debt is 8% and tax rate is 40%. What is the weighted average

cost of capital?

A. 10.46 percent

B. 10.67 percent

C. 11.06 percent

D. 11.38 percent

E. 12.19 percent

Answer – C

D/E=0.55; D=0.55; E=1; V=0.55+1=1.55

E/V =1 / 1.55 =64.52%;

D/V = 0.55 /1.55 =35.48%

WACC= (64.52%) (14.5%) + (35.48%) x 8% x (1-0.4)

= 11.06%

How to estimate WACC

First, Cost of Equity

Go to Yahoo! Finance

to get information on Eastman Chemical (EMN)

Under Profile and Key Statistics, you can find:

# of shares outstanding; Price; Beta

Under analysts estimates:

estimates of earnings growth (g)

The Bonds section : T-bill rate

Use CAPM and DGM to estimate the cost of equity

14-40

Eastman Chemical (EMN)

is an American Fortune 500 company, it

is a global chemical company with

Market cap about 13 billion

A Real Example

WACC

Eastman Chemical (EMN) Cost of Equity

Yahoo.finance

Summary of EMN

Price=85

Beta=1.24

D1=2.04

Find other information

under: statistics and

analysis (such as g,

D/E)

85

1.24

2.04 Forward dividend

EMN

2018-9-14

Estimate beta yourself

Eastman Chemical (EMN) Cost of Equity

Growth

Estimates

EMN Industry Sector S&P 500

Current Qtr. 13.70% N/A N/A 0.34

Next Qtr. 12.10% N/A N/A 0.40

Current Year 10.90% N/A N/A 0.17

Next Year 8.80% N/A N/A 0.12

Next 5 Years

(per annum)

8.00% N/A N/A 0.12

Past 5 Years

(per annum)

4.06% N/A N/A N/A

g=8%

Eastman Chemical (EMN) Cost of Equity

140 D/E=140%

(mrq-most recent Q)

Eastman Chemical Cost of Equity

Use CAPM and DGM to estimate the cost of equity

(1) Use DGM:

RE= D1 / P0 + g

= 2.04/85 + 8%= 2.4%+ 8% =10.4%

(2) Use CAPM:

RE=riskfree +Beta*(RM – riskfree)

RE=1%+1.24* (14% – 1%)=17.12%

14-44

Price = $85

Beta = 1.24

g = 8%

D1= $2.04

Last 3 years, average market return was about 14% (market index, e.g.

S&P500), Risk-free rate 1% (3-month T bill)

Average these two = 13. 76%

Eastman Chemical (EMN) Cost of Debt

14-45

Various websites for bond information:

Government website: FINRA, or morningstar.com

Bloomberg terminal

Enter EMN to find bond information

Note that you may not be able to find information on all bond issues due to

the illiquidity of the bond market

7 bond issues currently outstanding

Do a weighted average YTM of all EMN bonds

Cost of debt = 3.29 %

Eastman Chemical (EMN) WACC

Find the weighted average cost of the debt (WACC)

Use market values if you were able to get the information

Use the book values (only) if market information was not available

They are often very close

Compute Eastman’s WACC (Assuming a tax rate of 35%)

14-46

WACC = 13.76% * 0.42 + 3.29% * (1-T) *0.58 = 7.02 %

Type Percentage

D/E ratio 140%

Debt 58%

Equity 42%

D/E = 140%

D=140; E=100

V= D + E =240

D/V=140/240 = 58%

E/V=100/240 = 42%

Cost of Equity= 13.76%; Cost of Debt = 3.29%; T=35%

find WACC

with just a

Name!

Chapter Outline

The Cost of Capital

The Weighted Average Cost of Capital (WACC)

Flotation Costs and the WACC

Divisional and Project Costs of Capital

14-47

Flotation Costs and WACC

If a company accepts a new project, it may be required to

issue, or float, new bonds and stocks. This means that the

firm will incur some costs, which we call flotation costs.

Flotation costs is NOT included in WACC (i.e. discount rate)

included directly in the Initial Cost of a project.

Basic Approach

Compute the weighted average flotation cost, use it to

adjust the overall initial cost properly

14-48

Example: Flotation costs

The Marcus company uses both debt and equity. The

firms target capital structure is 60 percent equity, 40

percent debt. The flotation costs associated with equity

are 10 percent and with debt are 5 percent.

The firm is contemplating a large-scale, $100 million

expansion of its existing operations, which will be

financed by issuing both debt and equity.

When flotation costs are considered, what is the cost of

the expansion?

Example: Flotation costs

First, the weighted average flotation cost, fA

fA= E/V * fE + D/V *fD

= 60% x 0.1 + 40% x 0.05 = 8%

Important principal

Although we may not know how much equity/debt the firm issued to get the

$100 mil.

We should always use the target capital structure weights because the firm

will issue securities in target weights over the long term

Target capital structure is 60% equity, 40% debt.

The flotation costs of equity are10% and of debt are 5%.

New project costs $100 million and will be financed by issuing both debt

and equity.

When flotation costs are considered, what is the cost of the expansion?

E=60%

D=40%

Example: Flotation costs

The weighted average flotation cost, fA

Incorporate flotation cost in the initial cost:

Amount raised excluding flotation costs = amount needed for the project

Amount raised x (1-8%) = 100 million

Total Amount raised = $100 million/(1 8%)

= $108.7 million.

fA= 8%

Target capital structure is 60% equity, 40% debt.

The flotation costs of equity are10% and of debt are 5%.

New project costs $100 million and will be financed by issuing both debt

and equity.

When flotation costs are considered, what is the cost of the expansion?

Total amount raised including flotation

costs = the true cost of the project

FLOTATION COSTS AND NPV

Suppose the Tripleday Printing Company is currently at its target

debtequity ratio of 100 %. It is considering building a new

$500,000 printing plant in Kansas. This new plant is expected to

generate aftertax cash flows of $73,150 per year forever. The tax

rate is 34 %. There are two financing options:

A $500,000 new issue of common stock: The issuance costs is 10

% of the amount raised. The required return on equity is 20 %.

A $500,000 issue of 30-year bonds: The issuance costs is 2 % of

the proceeds. The company can raise new debt at 10 %.

What is the NPV of the new printing plant?

FLOTATION COSTS AND NPV

What is the NPV of the new printing plant?

The companys cost of capital:

WACC =50% x 20 + 50% x 10 x (1-0.34)

= 13.3%

OCF= $73,150 per year forever:

PV of perpetuity = OCF / WACC

= $73,150/0.133=$550,000

If we ignore flotation costs, the project can

generate:

NPV=$550,000 500,000 = $50,000

common stock: require

return = 20 %

bonds: required return

= 10 %

Tax rate = 34%

D/E=1

Initial cost = 500,000

FLOTATION COSTS AND NPV

What is the NPV of the new printing plant,

considering flotation costs?

Compute weighted average flotation cost:

The true cost (amount raised) including

flotation costs:

Amount raised (1-f)= $500,000

Amount raised = $500,000/(1 fA)

= $500,000/.94 = $531,915.

With flotation costs, the project can generate:

NPV=$550,000 531,915 = $18,085

Without flotation costs,

NPV= $50,000

common stock: The

issuance costs= 10 %

bonds: The issuance

costs = 2 %

D/E=1

Initial cost = 500,000

PV of CFs

=$73,150/0.133

=$550,000

%6%250.0%1050.0

)/()/(

=+=

+=

DEA

fVDfVEf

Divisional and Project Costs of Capital

We use WACC to value the entire firm

For an individual project, can we use

WACC of the firm?

Yes, if it has the same risk as the firms

current operations

If a project does NOT have the same risk as

the firm need to determine the

appropriate discount rate for that project

Same is true for different divisions

company has more than one line of

business.

14-55

Entire Firm

WACC

(discount rate)

Division

(project)

Division

(project)

Cost of

capital

Cost of

capital

14-56

Moscow Travel agency

Smart Cougs !

Offers R=16%

B=1.2

E(R)= 7% +1.2×8% = 16.6%

Offers R=14%

A=0.6

E(R)= 7% +0.6×8% =11.8%

Rf = 7%

RM Rf=8%

14% >11.8%, positive , Accept! 16% < 16.6%, negative , Reject! Pullman Ice Cream & Deli 14-57 Moscow Travel agency Smart Cougs ! Offers R=16% negative & NPV Offers R=14% Positive &NPV Wrong decision! Using WACC for all projects without considering risk: Accept risky projects Reject less risky but profitable projects if the company does this on a consistent basis The firm will become riskier. The overall WACC will increase!Cutoff =15% Pullman Ice Cream & DeliWACC=15% Solutions? The Pure Play Approach Pure Play Approach 14-58 From this example, we learn: Estimate cost of capital for individual project (based on risk) is important! However, in this example, Beta is given: ICE Cream Beta =0.6; Travel agency Beta = 1.2 But, how do we get these? The company has not started the projects yet? No data/information Solutions? The Pure Play Approach Find pure play companies companies that specialize in the product or service that we are considering Use beta & CAPM to find the appropriate required rate of return for each pure play company use for the project were considering Assumption the project has the same risk as the pure play company Disadvantage Often difficult to find pure play companies need to find companies that focus as exclusively as possible on the type of project in which we are interested. 14-59 Solutions? Subjective Approach Subjective approach: Consider the projects risk relative to the firm overall risk If the project risk > the firm, use a discount rate

greater than the WACC

If the project risk < the firm, use a discount rate less than the WACC 14-60 Example - Subjective Approach Category Examples Adjustment Factor Discount Rate High risk New products +6% 20% Moderate risk Expansion of existing lines, cost savings +0 14% Low risk Replacement of existing equipment 4% 10% WACC of the firm = 14% Which one to choose if using WACC=14%? Which one to choose if putting them into proper risk categories? B A A =12% B =16% Correct decision! Example - Subjective Approach Category Examples Adjustment Factor Discount Rate High risk New products +6% 20% Moderate risk Expansion of existing lines, cost savings +0 14% Low risk Replacement of existing equipment 4% 10% WACC of the firm = 14% Summary: Not as precise as CAPM do not compute the exact E(R) But the error rate should be lower than not considering subjective approach at all especially useful when its hard to find pure play companies CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS DCF (Discounted CF Analysis) Jeep is reviving a classic. See the new Grand Wagoneer What went into Jeeps decision to launch its new Grand Wagoneer ? https://www.cnn.com/2021/03/11/success/jeep-grand- wagoneer-reveal/index.html https://www.cnn.com/2021/03/11/success/jeep-grand-wagoneer-reveal/index.html Here's what it's like to drive a new $100,000 Jeep (CNN) Cruising up a highway heading north out of New York City, the bright white Jeep Grand Wagoneer I was driving got the sort of attention usually given to Lamborghinis and Ferraris. Other vehicles maneuvered to get a better look and smartphones were held out through car windows for a shot. I was driving the luxuriously equipped Grand Wagoneer, with a total price of more than $100,000, toward an off-road course on private land. The new Jeep Grand Wagoneer offers a level of luxury not seen in a Jeep before. Here's what it's like to drive a new $100,000 Jeep Features and Competitors: As the heir to an iconic American luxury SUV, the new model - 2022 Grand Wagoneer - has a reputation to live up to. Its available with a 6.4-liter V8 and an eight-speed automatic transmission. The V8 is rated at 471 hp and lets the body-on-frame SUV go 0-60 mph in 6 seconds. But, while the Grand Wagoneer doesnt offer hybrid options like the Range Rover, it does offer standard 4WD with a two-speed transfer case. And with the integrated tow hitch, it can tow up to 9850 pounds. In Rock Mode, the SUV has 10.1 of ground clearance and can wade into water 24 deep. Plus, like the Range Rover, it has independent front and rear suspension. If it were a contest, the Grand Wagoneer makes a strong play for leader in total touchscreen area inside an SUV. There was even a screen just for the front passenger, one each for rear passengers and one in the center between the second row passengers. The Jeep Grand Wagoneer has a surprising level of technology throughout. Its available with driving assistance technologies that help it hold its lane on the highway and maintain a set speed in traffic without driving into vehicles ahead of it.

August 19, 2022

August 19, 2022

August 19, 2022

August 19, 2022