Q3: Capital budgeting and cost
Q3: Capital budgeting and cost of capital
Reno Co is considering a project that will cost $ 26,000 andresult in the following cash flows:
|
Years |
1 |
2 |
3 |
4 |
|
Project Cash flow |
10,000 |
11,500 |
12,600 |
14,800 |
The views of the directors of Reno Co are that all investmentprojects must be evaluated over four years of operations using netpresent value. You have given the information below to assist youto calculate the appropriate discount rate:
- Reno Co has 1.3 million shares of stock outstanding and thestock currently sell for $20 per share. The market value of thedebt is $4.56 million and cost of debt is 6.061%
- The risk free rate is 3.5588% and the market risk premium is10%
- You have estimated that Reno Co has a beta of 0.75
- Corporate tax rate is 34%
Required:
- Estimate cost of equity using CAPM and define the securitymarket line.
- Estimate the cost of capital.
- Evaluate the investment project using the NPV criteria and costof capital estimated above.
- State clearly any limitations and assumptions that you made inyour calculations.
Answer:
Part a)
Cost of equity by using CAPM = risk free rate + (Beta*Marketrisk premium) = 3.5588% + (0.75*10%) = 3.5588%+7.5% = 11.0588%
The security market line (SML) is the graphical representationof the Capital Asset Pricing Model (CAPM) and gives the expectedreturn of the market at different levels of systematic or marketrisk.
Part b)
Cost of debt after tax = Cost of debt before tax*(1-tax rate) =6.061%*(1-0.34) = 6.061%*0.66 = 4%
| Type | Marketvalue | Proportion(Market value/Σmarket value) | Cost | WACC(Proportion*cost) |
| Equity | 26,000,000 | 85% | 11.0588% | 9.40% |
| Debt | 4,560,000 | 15% | 4% | 0.60% |
| 30,560,000 | 10.00% |
Part c)
| Year | Cashflow | PVF @ 10% | Cost (Cashflow * PVF @10%) |
| 0 | -26,000 | 1/[(1+discounting rate)^year] =1/(1.1^0) = 1 | (26,000.00) |
| 1 | 10,000 | 1/[(1+discounting rate)^year] =1/(1.1^1) = 0.9091 | 9,091.00 |
| 2 | 11,500 | 1/[(1+discounting rate)^year] =1/(1.1^2) = 0.8265 | 9,504.75 |
| 3 | 12,600 | 1/[(1+discounting rate)^year] =1/(1.1^3) = 0.7514 | 9,467.64 |
| 4 | 14,800 | 1/[(1+discounting rate)^year] =1/(1.1^4) = 0.6831 | 10,109.88 |
| 12,173.27 |
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