Cost of Capital, Capital Structure,and Capital Budgeting Analysis
1. Purpose of the project:In this project, you are supposed to be a financial manager working for a big corporation and you have to apply the knowledge obtained from the financial management (FIN6352) course to determine the cost of debt, cost of preferred stock, cost of common equity, capital structure, and the weighted average cost of capital (WACC) for a publicly-traded company of your choice. You will use the WACC as the discount rate to conduct capital budgeting analysis for a project that the firm is considering and then decide whether it should be accepted or not.
2. Outline for the project:
(1) Executive Summary
- Summarize the results and analysis of the report.
(2) Estimate Capital Structure
- Estimate the firm's weights of debt, preferred stock, and common stock using the firm's balance sheet (book value)
- Estimate the firm's weights of debt, preferred stock, and common stock using the market value of each capital component
(3) Compute Weighted Average Cost of Capital (WACC)
-Estimate the firm's before-tax and after-tax component cost of debt;
-Estimate the firm's component cost of preferred stock;
-Use three approaches (CAPM, DCF, bond-yield-plus-risk-premium) to estimate the component cost of common equity of the firm.
- Calculate the firm's weighted average cost of capital (WACC).
(4) Cash Flow Estimation
- We assume that the company you selected is considering a new project. The project has 10 years' life. This project requires initial investment of $50 million to purchase building and equipment, and $4 million for shipping & installation fee. The fixed assets fall in the 10-year MACRS class. The salvage value of fixed assets is $4 million. The number of units of the new product expected to be sold in the first year is 300,000 and the expected annual growth rate is 10%. The sales price is $60 per unit and the variable cost is $46 per unit in the first year. The fixed costs for the project are $2,000,000 per year. Prices and costs will be adjusted based on the estimated annualized inflation rate of 5%. The required net operating working capital (NOWC) is 15% of sales. Students will estimate the average tax rate in recent years and use it in the calculations. (Average tax rate should be between 15% to 35 %). The project is assumed to have the same risk as the corporation.
- Compute the depreciation basis and annual depreciation of the new project.
(Please refer to table of MACRS allowances in your textbook)
- Estimate annual cash flows for the next10 years.
(5) Capital Budgeting Analysis
- Using the WACC you obtained for the publicly-traded company as discount rate, apply capital budgeting analysis techniques (NPV, IRR, MIRR, PI, Payback) to analyze the new project.
- Perform a sensitivity analysis for the effects of key variables (sales growth rate, cost of capital, unit costs, fixed costs, sales price) on the estimated NPV or IRR in order to demonstrate the sensitivity of the model.
- Discuss whether the project should be taken.
3. Other information regarding the project:
(1) Avoid firms in the financial sector. Their financial statements are not compatible with the type of model we study in this class. Generally, financial firms have 4-digit SIC codes 6000s.
(2) You will inform the instructor of the company you choose in the first 2 weeks of the semester. Students have to choose different companies. If several students want to use the same company, the first student to inform the instructor will have priority; the others will have to pick another company.
(3) Your project should be well-organized and typed in a Word document but you must attach the necessary Excel workbook with your report. The style and organization part of the project account for 10 percent of the grade.
(4) Information obtained in this MP will be used in other mini projects.