FIN 425 – Course Project

CougCoffee Inc.

Don't use plagiarized sources. Get Your Custom Essay on

top answer: FIN 425 – Course Project
CougCoffee Inc.
DCF Project and Company Analysis
Instructions:

Just from $10/Page

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, CougCoffee’s only coffee maker is named the QuickCofee (QC), and sales have been

excellent. CougCoffee’s main competitor in the coffee maker market is Stanley Black & Decker,

Inc. (SWK). CougCoffee’s QC is similar to the SWK’s 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 company’s

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 company’s CEO, Jack, wants to understand the risk of the coffee maker industry better.

Since CougCoffee’s 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 company’s new product CM? That is, please compute the

NPV and IRR of CougCoffee’s 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 10

MAKING CAPITAL INVESTMENT DECISIONS

– DCF (Discounted CF Analysis)

Jeep is reviving a classic. See the

new Grand Wagoneer

What went into Jeep’s decision to launch its new

Grand Wagoneer ?

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. It’s 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 doesn’t 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. It’s

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.

Here’s what it’s like to drive a new

$100,000 Jeep

Features and Competitors:

•Still, the best things about both the Wagoneer and Grand Wagoneer are built into their

bones. These are, fundamentally, excellent big SUVs that are comfortable, practical and

capable. The more expensive Grand Wagoneer is in a price range with the most opulent

European SUVs, like the BMW X7 and Mercedes-Benz GLS. While they do provide a

more luxurious experience for those who want to ride like royalty, the European SUVs

might not be so good at crawling over rock beds. The Grand Wagoneer and Wagoneer

are clear contenders for king of the mountain among big SUVs.

Pricing

The Grand Wagoneer has a starting price near $90,000, a sizable jump up from

the $60,000 for the two-wheel drive base version of the Wagoneer. The lowest-

price version won’t be available until later, though. The Wagoneer that’s

currently on the market costs nearly $70,000.

Do you think $70,000 starting

price is reasonable?

Any theoretical foundation?

How exactly to set a

competitive price on a new

product?

Here’s what it’s like to drive a new

$100,000 Jeep

What went into Jeep’s decision to launch its new

Grand Wagoneer ?

How would you go about making such a project

decision?

https://www.cnn.com/2021/08/31/success/jeep-grand-

wagoneer-review/

❑ Decision Rules (Ch 9)

❑ Cash flows (Ch10)

❑ Discount rates/Cost of

Capital (Ch14)

Chapter10 Outline

– 2nd Chapter under Capital budgeting

Incremental Cash Flows

Financial Statements and Project Cash Flows

Alternative Definitions of Operating Cash Flow

Some Special Cases of Discounted Cash Flow

(DCF) Analysis

10-7

Relevant Cash Flows

❑ The first and most important step for capital

budgeting decision – is to decide which cash flows

are relevant.

❑ Should be straightforward to determine – But in a

few situations it is easy to make mistakes

10-8

Any and all changes in the firm’s future cash

flows that are a direct consequence of taking the

project ‒ The incremental cash flows

Example

Suppose Hill’s Pet Nutrition Company hires a financial

marketing company to help evaluate whether a line of

new dog treat should be launched. When the consultant

turns in the report, Hill’s pet objects to the analysis

because the consultant did not include the hefty

consulting fee as a cost of the dog treat project.

Should the consulting fee be included in the cost of the

dog treat project?

Sunk Cost

❑ Consulting fee must be paid whether or not the new dog treat

line will be launched. So the consulting fee is a Sunk Cost.

❑ Sunk cost is NOT a relevant cash flow – Not a direct

consequence to accepting the project.

❑ The point is: we should always be careful to exclude sunk

costs (e.g. consulting fee) from our analysis.

10-10

Sunk cost is a cost we have already paid, or

already incurred the liability to pay.

No, exclude consulting fee

Example

A company is thinking of converting an old rustic factory

building (and the associated land) into an upscale office

building. The company bought the old building years

ago for $500,000. If they undertake this project, there

will be no direct cash outflow associated with buying the

old building because they already own it.

For purposes of evaluating the office building project,

should they treat the old building as “free”?

Opportunity Cost

The old factory building is a valuable resource.

Using it for the project has an opportunity cost:

They give up the valuable opportunity of selling it (to build an

office building).

Should they treat the old building as “free”?

The answer is NO!

What is the direct

consequence?

Take the project Use the old factory

building/land

Not take the project Sell it !

No, they should NOT treat the old building as free!

Opportunity Cost

How much should we charge (the office project) for the

use of the old building?

Should we use $500,000, given we paid that much years ago?

No. The fact that we paid $500,000 some years ago is

irrelevant.

Should charge the amount we give up – the opportunity cost

That is what the factory would sell for today – Market value.

The point: Need to pay attention to opportunity costs!

Side effects

❑ It is common for a project to have side, or spillover effects, both

good and bad → the cash flows should be adjusted to reflect these

side effects

❑ Negative impact (Erosion)

➢ Introducing of a new product may have a negative impact on the

cash flows of an existing product.

E.g. Opening an in Pullman ??

❑ Positive impact

➢ HP sells far more printers now than in the 1990s, but the price is

only 1/5 – they sell more cartridges and special papers

will drain customers

from Moscow Applebees.

Common Types of Cash Flows

Other incremental cash flows:

❑ Changes in net working capital

▪ Most projects will require an increase in NWC initially as we build

inventory and receivables. Then, we recover NWC at the end of the

project.

❑ Financing costs – In analyzing a project, we will not include

financing costs such as interest paid, dividends repaid.

▪ Financing cost is included in the required return (cost of capital) –

avoid double counting

▪ finance the entire portfolio of projects at one time, not a single one

at a time.

❑ Taxes – we need to consider cash flows on an after-tax basis.

10-15

Question 3

Suppose that Ford is considering a project to make a

new brand of gas-saving car. In that project, the sales

of the new brand will decrease the sales of existing

brands of cars. This decrease in the sales of existing

brands of cars is an example of:

a. fixed cost

b. sunk cost

c. opportunity cost

d. erosion

Note:

Erosion = negative side effect

Question 4

Which one of the following should NOT be included in the analysis

of a new product?

A. Increase in accounts payable for new product inventory

purchases.

B. Reduction in sales for a current product once the new product

is introduced.

C. Market value of a machine owned by the firm which will be

used to produce the new product.

D. Money already spent for research and development of the

new product.

B – Neg. Side effect: Erosion

C – Opportunity cost

D – Sunk cost

A – changes in NWC

Pro Forma (projected) Statements and Cash

Flow

Capital budgeting relies heavily on pro forma, or

projected, accounting statements, particularly income

statements

Computing cash flows – refresher

▪ Operating Cash Flow (OCF) = EBIT + depreciation – taxes

▪ Cash Flow From Assets (CFFA) =

OCF – net capital spending (NCS) – changes in NWC

10-18

Example – the Project

Suppose we can sell 50,000 cans of shark attractant per year at a price

of $4 per can. It costs us about $2.50 per can to produce, and a new

product like this typically has only a three-year life. We require a 20

percent return on new products.

Fixed costs for the project, including rent on the production facility,

which will run $12,000 per year.

Further, we will need to invest a total of $90,000 in manufacturing

equipment. Assume that this $90,000 will be 100 percent depreciated

over the three year (straight-line). Furthermore, the equipment will be

essentially worthless on a market value basis at the end.

Finally, the project will require an initial $20,000 investment in net

working capital, and the tax rate is 34 percent.

Should we accept the project?

Table 10.1 Pro Forma Income Statement

Sales (50,000 units at

$4.00/unit)

$200,000

Variable Costs ($2.50/unit) 125,000

Gross profit

Fixed costs

Depreciation ($90,000 / 3)

EBIT

Taxes (34%)

Net Income

10-20

Key Information:

•rent on facility,

$12,000 per year.

•Invest $90,000 in

equipment

$75,000

12,000

30,000

$ 33,000

11,220

$ 21,780

OCF = EBIT + depreciation – taxes

Projected Operating Cash Flow

Operating Cash Flow (OCF) = EBIT + depreciation – taxes

Table 10.5 Projected Total Cash Flows

Year

0 1 2 3

OCF $51,780 $51,780 $51,780

Change in

NWC

-$20,000 20,000

NCS -$90,000 0

CFFA -$110,000 $51,780 $51,780 $71,780

10-22

▪ OCF each year = $51,780 ;

▪ Further, we will need to invest a total of $90,000 in manufacturing equipment. the

equipment will be essentially worthless on a market value basis at the end.

▪ Finally, the project will require an initial $20,000 investment in net working capital

Making The Decision

❑ Now that we have the cash flows, required return=20%, we

can apply the techniques that we learned in Chapter 9

❑ Compute NPV &IRR

▪ CF0 = -110,000;

▪ C01 = 51,780; F01 = 2;

▪ C02 = 71,780; F02 = 1;

▪ NPV: I = 20;

▪ CPT NPV = 10,648

▪ CPT IRR = 25.8%

❑ Should we accept or reject the project?

▪ The project creates over $10,000 and should be accepted.

▪ Also, we find that the IRR = 25.8 % > 20%

10-23

0 1 2 3

CFFA -$110,000 $51,780 $51,780 $71,780

Things that affect CFs:

10-24

Things that affect CFs:

❑ Depreciation

❑ Salvage Value

– market value of initial investments (e.g.

equipment) at the end of project

Things that affect CFs: Depreciation

Depreciation itself is a non-cash expense;

▪ it is only relevant because it affects taxes

Depreciation tax shield = D × T

▪ D = depreciation expense

▪ T = marginal tax rate

10-25

OCF = EBIT + depreciation – taxes

Taxes are determined by:

▪ EBIT = S – C – D

▪ the higher D, the lower the taxable income

Computing Depreciation

Straight-line depreciation

➢ Dep. amount is the same each year during the life time of the asset

D = (Initial cost – salvage) / number of years

Salvage – market value of initial investments at the end of project

➢ If the requirement is “straight-line depreciation to 0”, then:

D = (Initial cost – 0) / number of years

➢ Very few assets are depreciated straight-line for tax purposes

Modified Accelerated Cost Recovery System (MACRS)

➢ every asset is assigned to a particular class

D = initial cost x % given in table

➢ The expected salvage value are NOT explicitly considered in the

calculation of depreciation

10-26

MACRS

Class Examples

Three-year Equipment used in research

Five-year Autos, computers

Seven-year Most industrial equipments

TABLE 10.6

Modified ACRS Property Classes

❑ under MACRS, every asset is assigned to a

particular class

You can find the full list in IRS Pub 946.

MACRS

Property Class

Year Three-Year Five-Year Seven-Year

1 33.33% 20.00% 14.29%

2 44.45 32.00 24.49

3 14.81 19.20 17.49

4 7.41 11.52 12.49

5 11.52 8.93

6 5.76 8.92

7 8.93

8 4.46

TABLE 10.7 Modified ACRS Depreciation Allowances

▪ depreciation % are much higher in early years than in later years

o asset is most heavily used when it is new, functional

o Why might firms prefer an accelerated depreciation method (MACRS)?

lower taxes in early years, defer taxes to later periods

❑ After-tax Salvage Value

❑ Sell the equipment at the end, and pay tax

▪ After-tax salvage value affect firms’ cash flows at the end

of project life

❑ After-tax salvage = salvage – T*(salvage – book value)

▪ BV = initial cost – accumulated depreciation

▪ If the salvage value is different from the BV of the asset,

then there is a tax effect

10-29

Things that affect CFs: After-Tax Salvage

Example: Depreciation affets After-tax Salvage

❑ You purchase equipment for $100,000, and it costs $10,000

to have it delivered and installed.

❑ Based on past information, you believe that you can sell the

equipment for $17,000 when you are done with it in 6 years.

❑ The company’s marginal tax rate is 40%.

❑ What is the depreciation expense each year and what is the

after-tax salvage in year 6 for each of the following

situations?

▪ Straight-line depreciation to salvage value

▪ MACRs depreciation

10-30

Case 1: Straight-line to Salvage

D = (Initial cost – salvage) / number of years

❑ D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years

❑ BV in year 6 = 110,000 – 6*(15,500) = 17,000

❑ After-tax salvage = salvage – T*(salvage – book value)

=17,000 – .4 * (17,000 – 17,000)

= 17,000

10-31

Key information:

You purchase equipment for $100,000, and it costs $10,000 to have it delivered and

installed.

you can sell the equipment for $17,000 when you are done with it in 6 years.

Tax rate is 40%.

Before-tax salvage value

Case2: Three-year MACRS

Yr MACRS

percent

D =

initial cost x % dep.

1 .3333 .3333(110,000)

= 36,663

2 .4445 .4445(110,000)

= 48,895

3 .1481 .1481(110,000)

= 16,291

4 .0741 .0741(110,000)

= 8,151

5 0

6 0

BV in year 6 =

110,000 – 36,663 –

48,895 – 16,291 – 8,151

= 0

After-tax salvage

= 17,000 – .40 * (17,000 – 0) = $10,200

Will the effect always be negative?

10-32

No, salvage < BV, positive

Chapter Outline

Incremental Cash Flows

Financial Statements and Project Cash Flows

Alternative Definitions of Operating Cash Flow

Some Special Cases of Discounted Cash Flow (DCF)

Analysis

10-33

Other Methods for Computing OCF

Top-Down Approach

▪ OCF = Sales – Costs – Taxes

▪ Don’t subtract non-cash deductions

Bottom-Up Approach

▪ OCF = NI + depreciation

Tax Shield Approach

▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T

10-34

Traditional Approach:

OCF = EBIT +Depreciation – Taxes

Tax shield

Other Methods for Computing OCF

Top-Down Approach

▪ Start from traditional:

▪ OCF = EBIT + Dep. – Taxes

Since EBIT=Sales – Costs – Dep., if add back Depreciation:

▪ Top-down: OCF = Sales – Costs – Taxes

Examples

▪ Traditional approach

▪ OCF = EBIT + D – T

▪ EBIT = S – C – D

= $1,500 -700 -600 = $200

▪ Taxes = EBIT x T =$200 x 0.34 = $68

▪ OCF = $200 + 600 – 68 = $732

10-35

Top-down Approach

OCF = Sales – Costs – Taxes

= 1,500 – 700 – 68

= $732

Sales = $1,500

Costs=$700

Depreciation =$600

T=34%

Other Methods for Computing OCF

❑ Bottom-Up Approach

▪ OCF = NI + depreciation

▪ The bottom-up approach – start with the accountant’s bottom

line (net income) and add back any noncash deductions such

as depreciation

❑ Example

10-36

.

▪ EBIT= S – C – D

=1500 – 700 – 600 = $200

▪ Taxes=200 x 0.34 = $68

▪ NI = EBIT – Taxes = $200 – 68 =$132

▪ OCF = NI + Dep. = $132 + 600 = $732

Sales = $1,500

Costs=$700

Depreciation =$600

T=34%

▪ NI = Total sales x Profit margin

o profit margin = NI/ Total sales

▪ Profit margin=8.8%,

NI = $1500 x 8.8% = $132

Other Methods for Computing OCF

❑ Tax Shield Approach

❑ OCF = after-tax profit + Dep. Tax shield

= (Sales – Costs)(1 – T) + Depreciation*T

❑ Do we get the same answer?

▪ OCF = ($1,500 – $ 700) x.66 + 600 x 0.34

= $528 + $204 = $732

❑ All 4 methods give us the same OCF.

▪ If we know NI, bottom up is more efficient,

▪ Otherwise we should use top down, or tax shield

approach.

10-37

Sales = $1,500

Costs=$700

Depreciation =$600

T=34%

OCF=$732

Question 6:

The Beach House has sales of $784,000 and a profit margin of

11 percent. The annual depreciation expense is $14,000. What is

the amount of the operating cash flow?

A. $68,760

B. $72,240

C. $86,240

D. $100,240

E. $101,760

Answer – D

▪NI = Total sales x Profit margin

= $784,000 0.11=$86,240

▪Bottom up:

OCF = NI + D

=$86,240 + $14,000

= $100,240

Question 5:

Lily’s Fashions is considering a project that will require $28,000

in net working capital and $87,000 in initial investment in fixed

assets. The project is expected to produce annual sales of

$75,000 with associated costs of $57,000. The project has a 5-

year life. The company uses straight-line depreciation to a zero

book value over the life of the project. Salvage value is zero. The

tax rate is 30 percent. Using tax shield approach, what is the

operating cash flow for this project?

A. -$1,520

B. -$580

C. $420

D. $15,680

E. $17,820

Answer: E

OCF = (Sales – Costs)(1 – T) +Depreciation*T

Depreciation Tax shield = ($87,000/5)*0.30 =$5,220

OCF = ($75,000 – $57,000)(1 – 0.30) + $5,220

= $17,820

Practicing Question 10

You have the following information:

A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year.

Salvage value will be $200,000 at that time.

The project requires $150,000 in additional inventory and will increase

accounts payable by $50,000.

It will generate $207,160 operating cash flows (OCF) each year. The tax rate

is 40%.

What is the incremental cash flow in years 0 and year 6 respectively?

10-40

Year 0 Years1 – 5 Year 6

OCF $207,160 $207,160

Change in NWC -$100,000 +$100,000

NCS

CFFA

❑Changes in NWC = 150,000 – 50,000 = 100,000

Practicing Question 10

You have the following information:

A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year.

Salvage value will be $200,000 at that time.

The project requires $150,000 in additional inventory and will increase

accounts payable by $50,000.

It will generate $207,160 operating cash flows (OCF) each year. The tax rate

is 40%.

What is the incremental cash flow in years 0 and year 6 respectively?

10-41

Year 0 Years1 – 5 Year 6

OCF $207,160 $207,160

Change in NWC -$100,000 +$100,000

NCS -$1,000,000 +$120,000

CFFA

❑After-tax salvage = salvage – (salvage – BV)*T

= 200,000 – (200,000 – 0) * 40% = 120,000

Practicing Question 10

You have the following information:

A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year.

Salvage value will be $200,000 at that time.

The project requires $150,000 in additional inventory and will increase

accounts payable by $50,000.

It will generate $207,160 operating cash flows (OCF) each year. The tax rate

is 40%.

What is the incremental cash flow in years 0 and year 6 respectively?

10-42

Year 0 Years1 – 5 Year 6

OCF $207,160 $207,160

Change in NWC -$100,000 +$100,000

NCS -$1,000,000 +$120,000

CFFA -$1,100,000 $207,160 $427,160

Full-fledged DCF Analysis

10-43

❑ Relevant Cash Flows.

❑ Use financial statements and CF table

▪ Compute OCF and CFFAs

❑ Using decision rules (NPV, IRR) to make the

decision.

Some Special Cases

10-44

1. Investments that are primarily aimed at

improving efficiency and thereby cutting costs.

2. When a firm is involved in submitting

competitive bids.

Case1 – EVALUATING COST-CUTTING

PROPOSALS

Suppose we are considering automating some part of an

existing production process.

The necessary equipment costs $80,000 to buy and install.

The automation will save $22,000 per year (before taxes)

by reducing labor and material costs.

For simplicity, assume that the equipment has a five-year

life and is depreciated to 0 on a straight-line basis over that

period. It will actually be worth $20,000 in five years.

The tax rate is 34 percent, and the discount rate is 10

percent. Should we automate?

Case1 – EVALUATING COST-CUTTING

PROPOSALS

The first step – identify the relevant cash flows (OCF & CFFA)

OCF = EBIT + D – Taxes

❑ EBIT = S – C – D

▪ Do we have sales and costs?

the project’s operating income (gross profit) is NOT in terms of (S

– C), BUT in terms of:

Cost saving = $22,000 each year

▪ D = $80,000/5 = $16,000 per year.

▪ So, EBIT = $22,000 − $16,000 = $6,000.

❑ Taxes = $6,000 × .34 = $2,040.

Basic information

automation will save $22,000 per year (before taxes) by reducing labor and

material costs.

The initial investment in equipment costs $80,000. The equipment has a 5-year

life and is depreciated to 0 on a straight-line basis.

EBIT = Cost saving – D

Case1 – EVALUATING COST-CUTTING

PROPOSALS

Net Capital Spending (NCS):

▪ Initially outflow: – $80,000

▪ After-tax salvage value = $20,000 – $0.34 *($20,000 – 0)

= $13,200

The necessary equipment costs $80,000

the equipment has a 5-year life and is depreciated to 0 on a straight-line

basis over that period. It will actually be worth $20,000 in five years.

❑ At 10 percent, it’s straightforward to verify: NPV = $3,860 > 0

❑ So we should go ahead and automate.

Question 2

The operating cash flow of a cost cutting project:

A. is equal to the depreciation tax shield.

B. is equal to zero because there is no incremental

sales.

C. can only be analyzed by projecting the sales and

costs for a firm’s entire operations.

D. can be positive even though there are no sales.

Answer: D

Normal project: OCF = Aftertax Profit + D*T

Cost cutting: OCF = Aftertax cost saving +D*T

Case 2 – Setting Competitive Bid or

Price

Special Cases

10-49

Case2 – Setting the Bid Price

❑ Imagine we are in the business of buying stripped-down truck

platforms and then modifying them to customer specifications

for resale. A local distributor has requested bids for 5 specially

modified trucks each year for the next 4 years, for a total of 20

trucks in all.

❑ We need to decide what price per truck to bid.

❑ The goal of our analysis is to determine the lowest price we

can profitably charge.

➢ This price should be low enough to maximize our chances of getting

the contract

➢ while guarding against the winner’s curse (that is, too cheap, we will

not earn the required return).

Case2 – Setting the Bid Price

Suppose we can buy the truck platforms for $10,000 each. The

facilities can be leased for $24,000 per year. The labor and

material costs work out to be about $4,000 per truck.

▪ Total cost per year (of 5 trucks) = $24,000 + 5 × (10,000 + 4,000) =

$94,000.

We will need to invest $60,000 in new equipment. This

equipment will be depreciated straight-line to a 0 over the 4

years. It will be worth about $5,000 at the end of that time.

We will also need to invest $40,000 in raw materials inventory

and other working capital items. The relevant tax rate is 39%.

What price per truck should we bid if we require a 20% return

on our investment?

Case2 – Setting the Bid Price

First, the basic intuition:

❑ By logic, what is the lowest possible price we can profitably

charge (at 20%)?

▪ When NPV=0 (at discount rate =20%): → earn exactly

20% !

▪ Set that price (NPV=0) as the optimal bidding price – no

more, no less!

❑ Conclusion: Optimal price (P*) is price at NPV=0

❑ we first determine the CF (or OCF) that the NPV = 0. Then

we can back out the P* from OCF.

That is: the price that maximize our chance of getting the

contract, and also make sure we earn our required return (20%)

Case2 – Setting the Bid Price

Steps to determine Optimal price (P*)

First, Set up Cash Flow Table

Second, solve for OCF* that will make NPV=0 (at

our required return)

Third, backout the Optimal price from OCF*

◼Use OCF formula to back out P*

Case2 – Setting the Bid Price

We can’t determine the OCF just yet because we don’t know

the sales price.

Net Capital spending (NCS):

▪ – $60,000 today for new equipment.

▪ The after-tax salvage =$5,000 – (5,000-0) × .39 = $3,050.

Change in NWC:

▪ invest – $40,000 today in working capital. We will get this back in

four years.

We will need to invest $60,000 in new equipment,

depreciated straight-line to a 0 over the 4 years. Salvage = $5,000 at the end

of that time.

Need to invest $40,000 in raw materials inventory and other WC items

Case2 – Setting the Bid Price

We can’t determine the OCF just yet because we don’t know the

sales price. Thus, here is what our CF table looks like so far:

Net Capital spending (NCS):

▪ – $60,000 today for new equipment.

▪ The after-tax salvage =$5,000 – (5,000-0) × .39 = $3,050.

Change in NWC:

▪ invest +$40,000 today in working capital. We will get this back in

four years.

We will need to invest $60,000 in new equipment,

depreciated straight-line to a 0 over the 4 years. Salvage = $5,000. Need to invest

$40,000 in NWC

Case2 – Setting the Bid Price

❑ Therefore we first need to determine the annual OCF for the

NPV = 0.

– $100,000

+ 43,050/1.24= – $79,239

Case2 – Setting the Bid Price

Now, the OCF is now an annuity amount.

Determine OCF* that makes NPV=0:

▪ PV of OCF = OCF * PVIFA

▪ PV of OCF = OCF * 2.5887 = $79,239

▪ OCF = $79,239/2.5887 = $30,609

Are we finished?

No! need optimal sales price results in an OCF* = $30,609.

The present value interest factor of

annuity (PVIFA) – refresher

PVIFA (r, n) = [1-1/(1+r)n]/r

PVIFA (20%, 4)

= [1-1/(1.20)4]/0.20= 2.5887

This is the OCF* that makes NPV=0

Case2 – Setting the Bid Price

Use OCF formula to back out price

❑ Tax Shield Approach

▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T

▪ $30,609 = (Sales – $94,000) *0.61 +$15,000*0.39

▪ Sales = $134,589

❑ the contract calls for 5 trucks per year

Sale Price = $134,589/5 = $26,918.

Bid about $27,000 per truck.

OCF = $30,609

Costs = $94,000

D= $15,000

T=0.39

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,

that’s 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 aren’t 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)] / σ

2

M

measures: How individual security is correlated with market

portfolio.

❑An individual security’s 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

βx = 1.25

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

βy = .6

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

Equation of the CAPM

E(ri) = rf + βi[E(rM) – rf]

If β = 1?

If β = 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

ß

ßM

1.0

RM=11%

3%

Rx=13%

ßx

1.25

Ry=7.8%

ßy

.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 (β)

Higher beta, higher return

High beta stock? Low beta stock?

E(r)

SML

ß

ERLVS

ßLVS

2.0

ERMCD

ßMCD

.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

ßß

1.01.0

RRmm=11%=11%

rrff=3%=3%

1.251.25

Disequilibrium Example

Suppose a security Q with β 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 stock’s alpha. What is the α in

this case?

E(r) = rf + β 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%

βS = 1.5

rf = 5%

Required return(s) = rf + β 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 + ßiRM + 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 + βi[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

company’s 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

firm’s 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

debt−equity 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 company’s 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 firm’s

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%

βB=1.2

E(R)= 7% +1.2×8% = 16.6%

Offers R=14%

βA=0.6

E(R)= 7% +0.6×8% =11.8%

Rf = 7%

RM – Rf=8%

• 14% >11.8%, positive α, Accept! • 16% < 16.6%, negative α, Reject!

Pullman Ice Cream & Deli

14-57

Moscow Travel agency

Smart Cougs !

Offers R=16%

negative α & NPV

Offers R=14%

Positive α &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 we’re 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 project’s 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 it’s hard to find pure play

companies

The price is based on these factors:

Academic level

Number of pages

Urgency

Basic features

- Free title page and bibliography
- Unlimited revisions
- Plagiarism-free guarantee
- Money-back guarantee
- 24/7 support

On-demand options

- Writer’s samples
- Part-by-part delivery
- Overnight delivery
- Copies of used sources
- Expert Proofreading

Paper format

- 275 words per page
- 12 pt Arial/Times New Roman
- Double line spacing
- Any citation style (APA, MLA, Chicago/Turabian, Harvard)

Delivering a high-quality product at a reasonable price is not enough anymore.

That’s why we have developed 5 beneficial guarantees that will make your experience with our service enjoyable, easy, and safe.

You have to be 100% sure of the quality of your product to give a money-back guarantee. This describes us perfectly. Make sure that this guarantee is totally transparent.

Read moreEach paper is composed from scratch, according to your instructions. It is then checked by our plagiarism-detection software. There is no gap where plagiarism could squeeze in.

Read moreThanks to our free revisions, there is no way for you to be unsatisfied. We will work on your paper until you are completely happy with the result.

Read moreYour email is safe, as we store it according to international data protection rules. Your bank details are secure, as we use only reliable payment systems.

Read moreBy sending us your money, you buy the service we provide. Check out our terms and conditions if you prefer business talks to be laid out in official language.

Read more