Case Study

Case study on Cost of Capital of a Firm

1. Star Products Company is a growing manufacturer of automobile
accessories whose stock is actively traded on the over-the-counter
exchange. During 2003, the Dallas-based company experienced sharp
increases in both sales and earnings. Because of this recent growth,
Melissa Jen, the company’s treasurer, wants to make sure that available
funds are being used to their fullest. Management policy is to maintain
the current capital structure proportions of 30% long-term debt, 10%
preferred stock, and 60% common stock equity for at least the next 3
years. The firm is in the 40% tax bracket.
Star’s division and product managers have presented several competing
investment opportunities to Ms. Jen. However, because funds are limited,
choices of which projects to accept must be made. The investment
opportunities schedule (IOS) is shown in the following table.
Investment Opportunities Schedule (IOS)
for Star Products Company
Investment opportunity Internal rate return (IRR) initial investment
A 15% $400,000
B 22 200,000
C 25 700,000
D 23 400,000
E 17 500,000
F 19 600,000
G 14 500,000

To estimate the firm’s weighted average cost of capital (WACC), Ms. Jen
contacted a leading investment banking firm, which provided the financing cost
data as shown below.
Financing Cost Data
 Star Products Company
Long-term debt: The firm can raise $450,000 of additional debt by selling
15-year, $1,000-par-value, 9% coupon interest rate bonds that pay annual
interest. It expects to net $960 per bond after flotation costs. Any debt in excess
of $450,000 will have a before-tax cost, kd, of 13%.
Preferred stock: Preferred stock, regardless of the amount sold, can be issued
with a $70 par value and a 14% annual dividend rate and will net $65 per
share after flotation costs.
Common stock equity: The firm expects dividends and earnings per share to
be $0.96 and $3.20, respectively, in 2004 and to continue to grow at a
constant rate of 11% per year. The firm’s stock currently sells for $12 per
share. Star expects to have $1,500,000 of retained earnings available in the
coming year. Once the retained earnings have been exhausted, the firm can
raise additional funds by selling new common stock, netting $9 per share after
underpricing and flotation costs.
Required
a. Calculate the cost of each source of financing, as specified:
(1) Long-term debt, first $450,000.
(2) Long-term debt, greater than $450,000.
(3) Preferred stock, all amounts.
(4) Common stock equity, first $1,500,000.
(5) Common stock equity, greater than $1,500,000.
b. Find the break points associated with each source of capital, and use them
to specify each of the ranges of total new financing over which the firm’s
weighted average cost of capital (WACC) remains constant.
c. Calculate the weighted average cost of capital (WACC) over each of the
ranges of total new financing specified in part b.
d. Using your findings in part c along with the investment opportunities
schedule (IOS), draw the firm’s weighted marginal cost of capital (WMCC) and
IOS on the same set of axes (total new financing or investment on the x axis
and weighted average cost of capital and IRR on the y axis).
e. Which, if any, of the available investments would you recommend that the
firm accept? Explain your answer.

2. The Marietta Corporation, a large manufacturer of mufflers, tailpipes,

and shock absorbers, is currently carrying out its financial planning for
next year. In about two weeks, at the next meeting of the firm’s board of
directors, Frank Bosworth, vice president of finance, is scheduled to
present his recommendations for next year’s overall financial plan. He
has asked Donna Botello, manager of financial planning, to gather the
necessary information and perform the calculations for the financial
plan. The company’s divisional staffs, together with corporate finance
department personnel, have analyzed several proposed capital
expenditure projects. The following is a summary schedule of acceptable
projects (defined by the company as projects having internal rates of
return greater than 8 percent):
Project Investment Amount (in Millions ) Internal Rate of return
A $10.0 25%
B 20.0 21
C 30.0 18
D 35.0 15
E 40.0
12.4
F 40.0 11.3
G 40.0 10
H 20.0 9

All projects are expected to have one year of negative cash flow followed by
positive cash flows over the remaining years. In addition, next year’s projects
involve modifications and expansion of the company’s existing facilities and
products. As a result, these projects are considered to have approximately the
same degree of risk as the company’s existing assets.
Botello feels that this summary schedule and detailed supporting documents
provide her with the necessary information concerning the possible capital
expenditure projects for next year. She can now direct her attention to
obtaining the data necessary to determine the cost of the capital required to
finance next year’s proposed projects.
The company’s investment bankers indicated to Bosworth in a recent meeting
that they feel the company could issue up to $50 million of 9 percent first-
mortgage bonds at par next year. The investment bankers also feel that any
additional debt would have to be subordinated debentures with a coupon of 10
percent, also to be sold at par. The investment bankers rendered this opinion
after Bosworth gave an approximate estimate of the size of next year’s capital
budget, and after he estimated that approximately $100 million of retained
earnings would be available next year.
Both the company’s financial managers and its investment bankers consider
the present capital structure of the company, shown in the following table, to
be optimal (assume that book and market values are equal):
Debt $ 400,000,000
Stockholders’ equity:
Common stock 150,000,000
Retained earnings 450,000,000
$1,000,000,000

Botello has assembled additional information, as follows:

■ Marietta common stock is currently selling at $21 per share.
■ The investment bankers have also indicated that an additional $75 million in
new common stock could be issued to net the company $19 per share.
■ The company’s present annual dividend is $1.32 per share. However,
Bosworth feels fairly certain that the board will increase it to $1.415 per share
next year.
■ The company’s earnings and dividends have doubled over the past 10 years.
Growth has been fairly steady, and this rate is expected to continue for the
foreseeable future. The company’s marginal tax rate is 40 percent.

Required:
Using the information provided, answer the following questions. (Note:
Disregard depreciation in this case.)
1. Calculate the after-tax cost of each component source of capital.
2. Calculate the marginal cost of capital for the various intervals, or
“packages,” of capital the company can raise next year. Plot the marginal cost
of capital curve.
3. Using the marginal cost of capital curve from question 2, and plotting the
investment opportunity curve, determine the company’s optimal capital budget
for next year.
4. Should Project G be accepted or rejected? Why?
5. What factors do you feel might cause Bosworth to recommend a different
capital budget than the one obtained in question 3?
6. Assume that a sudden rise in interest rates has caused the cost of various
capital components to increase. The pretax cost of first-mortgage bonds has
increased to 11 percent; the pretax cost of subordinated debentures has
increased to 12.5 percent; the company’s common stock price has declined to
$18; and new stock could be sold to net Marietta $16 per share.
a. Recomputed the after-tax cost of the individual component sources of
capital.
b. Recomputed the marginal cost of capital for the various intervals of capital
Marietta can raise next year.
c. Determine the optimal capital budget for next year at the higher cost of
capital.
d. How does the interest rate surge affect Marietta’s optimal capital budget?

A Case Study On Company’s Machine Renewal or Replacement Decision

Bo Humphries, chief financial officer of Clark Upholstery Company, expects the

firm’s net profits after taxes for the next 5 years to be as shown in the following
table.
Year Net profits after taxes
1 $100,000
2 150,000
3 200,000
4 250,000
5 320,000

Bo is beginning to develop the relevant cash flows needed to analyze whether to

renew or replace Clark’s only depreciable asset, a machine that originally cost
$30,000, has a current book value of zero, and can now be sold for $20,000.
(Note: Because the firm’s only depreciable asset is fully depreciated— its book
value is zero—its expected net profits after taxes equal its operating cash
inflows.) He estimates that at the end of 5 years, the existing machine can be
sold to net $2,000 before taxes. Bo plans to use the following information to
develop the relevant cash flows for each of the alternatives.
Alternative 1 Renew the existing machine at a total depreciable cost of
$90,000. The renewed machine would have a 5-year usable life and would be
depreciated under MACRS using a 5-year recovery period. Renewing the
machine would result in the following projected revenues and expenses
(excluding depreciation):
Expenses
Year Revenue (excl. depreciation)
1 $1,000,000 $801,500
2 1,175,000 884,200
3 1,300,000 918,100
4 1,425,000 943,100
5 1,550,000 968,100

The renewed machine would result in an increased investment in net working

capital of $15,000. At the end of 5 years, the machine could be sold to net
$8,000 before taxes.
Alternative 2 Replace the existing machine with a new machine that costs
$100,000 and requires installation costs of $10,000. The new machine would
have a 5-year usable life and would be depreciated under MACRS using a 5-
year recovery period. The firm’s projected revenues and expenses (excluding
depreciation), if it acquires the machine, would be as follows:
Expenses
Year Revenue (excl. depreciation)
1 $1,000,000 $764,500
2 1,175,000 839,800
3 1,300,000 914,900
4 1,425,000 989,900
5 1,550,000 998,900

The new machine would result in an increased investment in net working

capital of $22,000. At the end of 5 years, the new machine could be sold to net
$25,000 before taxes.
The firm is subject to a 40% tax on both ordinary income and capital gains.
As noted, the company uses MACRS depreciation. (See Table 3.2 on page 100
for the applicable depreciation percentages.)
Required
a. Calculate the initial investment associated with each of Clark Upholstery’s
alternatives.
b. Calculate the incremental operating cash inflows associated with each of
Clark’s alternatives. (Note: Be sure to consider the depreciation in year 6.)
c. Calculate the terminal cash flow at the end of year 5 associated with each of
Clark’s alternatives.
d. Use your findings in parts a, b, and c to depict on a time line the relevant
cash flows associated with each of Clark Upholstery’s alternatives.
e. Solely on the basis of your comparison of their relevant cash flows, which
alternative appears to be better? Why?

Case On Capital Budgeting Decisions

First Republic Bancorp is considering the acquisition of a new data processing
and management information system. The system, including computer
hardware and software, will cost $1 million. Delivery and installation of the
system is expected to add $100,000 to this cost. To put this new system in
place, the bank expects to have to make an investment of $50,000 in net
working capital immediately and an additional net working capital investment
of $25,000 at the end of year 1. The system has an expected economic life of 10
years. It will be depreciated as a 7-year asset under MACRS rules. Actual
salvage value at the end of 10 years is expected to be $100,000, and the bank
plans to sell the system for its salvage value at that time.
The new data processing system will save the bank the $190,000 fee per year
that it currently pays to a computer time-sharing company. Operating,
maintenance, and insurance costs for the system are estimated to total
$50,000 during the first year. These costs are expected to increase at a rate of
7 percent per year over the 10-year period.
First Republic plans to sell excess computer time to a number of local firms.
The demand function for this service during year 1 is estimated to be
Q = 20,000 – 200P
where Q = number of units of computer time sold, and P = price per unit of
computer time sold.
Based on an analysis of the local market for computer time, the bank feels that
it can charge $14 per unit of computer time. Although the bank does not
anticipate changing this charge over the 10-year period, it expects the quantity
demanded to decline by 5 percent per year after year 1. It is expected that
these outside sales of computer time will cost the bank an additional $40,000
per year in computer operating costs (including the salary of a computer
services representative to handle the new customers). These additional
operating costs are expected to increase at a rate of 7 percent annually over the
10-year period.
The bank has a marginal ordinary tax rate of 34 percent. This rate is expected
to remain in effect over the life of the project. First Republic uses an after-tax
cost of capital of 15 percent to evaluate projects of this risk. This cost of capital
was computed based upon the current after-tax cost of equity and debt funds
in the bank’s capital structure.
Required:
Based on the information contained in the case, use the NPV approach to
determine if First Republic should acquire the new data processing system.

Case study on capital project Risk

Cherone Equipment, a manufacturer of electronic fitness equipment, wishes
to evaluate two alternative plans for increasing its production capacity to meet
the rapidly growing demand for its key product—the Cardiocycle. After months
of investigation and analysis, the firm has pruned the list of alternatives down
to the following two plans, either of which would allow it to meet the forecast
product demand.
Plan X Use current proven technology to expand the existing plant and
semiautomated production line. This plan is viewed as only slightly more risky
than the firm’s current average level of risk.
Plan Y Install new, just-developed automatic production equipment in the
existing plant to replace the current semiautomated production line.
Because this plan eliminates the need to expand the plant, it is less expensive
than Plan X, but it is believed to be far more risky because of the unproven
nature of the technology.
Cherone, which routinely uses NPV to evaluate capital budgeting projects,
has a cost of capital of 12%. Currently the risk-free rate of interest, RF, is 9%.
The firm has decided to evaluate the two plans over a 5-year time period, at the
end of which each plan would be liquidated. The relevant cash flows associated
with each plan are summarized in the accompanying table.
Plan X Plan Y
Initial investment (CF0) $2,700,000 $2,100,000
Year (t) Cash inflows (CFt)
1 $ 470,000 $ 380,000
2 610,000 700,000
3 950,000 800,000
4 970,000 600,000
5 1,500,000 1,200,000
The firm has determined the risk-adjusted discount rate (RADR) applicable to
each plan.
Risk-adjusted
Plan discount rate (RADR)
X 13%
Y 15%
Required
a. Assuming that the two plans have the same risk as the firm, use the
following capital budgeting techniques and the firm’s cost of capital to evaluate
their acceptability and relative ranking.
(1) Net present value (NPV).
(2) Internal rate of return (IRR).
b. Recognizing the differences in plan risk, use the NPV method, the risk
adjusted discount rates (RADRs), and the data given earlier to evaluate the
acceptability and relative ranking of the two plans.
c. Compare and contrast your finding in parts a and b. Which plan would you
recommend? Did explicit recognition of the risk differences of the plans affect
this recommendation?
d. Would your recommendations in parts a, and b be changed if the firm were
operating under capital rationing? Explain.