FN 310 Module 3Case

Research the topics below as described. Submit a 3-5 page paper that fully addresses all issues and makes appropriate use of charts and graphs to present numerical data. The objective of your paper is to review your firm’s cost of capital and capital structure and how their use of capital affects their investment decisions in order to ultimately make a recommendation regarding their optimal capital structure. I encourage (but do not require) you to consider other capital structure alternatives beyond the four that I have proposed.

Cost of Capital

Estimate your assigned firm’s weighted average cost of capital (WACC) by following the steps below.

  • Estimate what percentage of your firm’s capital comes from long-term debt, preferred stock, and common equity. To do this, you’ll need to pull a balance sheet for your firm. You can find this on Yahoo! Finance.
  • Assume that your firm wants to maintain the same mix of capital that it currently has on its balance sheet. What weights would you use to estimate the WACC?
  • Find your firm’s market capitalization or the market value of its common equity. Using its long-term debt value from the balance sheet (assuming that the market value of the debt equals its book value) and its market capitalization, recalculate the firm’s debt and common equity weights to be used in the WACC equation. These weights are approximations of market value weights.
  • Recall your firm’s cost of equity that you calculated previously. What was it?
  • To calculate your firm’s cost of debt, take the company’s long-term interest expense and divide it by the amount of long-term debt. Alternatively, calculate the average yield of the bonds that you found when you worked on the bond case.
  • Calculate your firm’s WACC.
  • What is your estimate of your firm’s WACC using the book value weights you calculated in question 1a?
  • What is your estimate of your firm’s WACC using the market value weights you calculated in Question 1b?
  • Explain the difference between the two WACC estimates you calculated in questions 4a and 4b. Which estimate do you prefer? Explain.

Capital Budgeting

Assume that your assigned firm is considering a new 4-year project that would require a $1,000,000 initial investment in equipment including shipping and installation. The equipment would be depreciated using 3-year MACRS. 3-year MACRS allows firms to depreciate qualifying assets over four years at rates of 33.33%, 44.45%, 14.81% and 7.41% for years one through four respectively. The equipment can be sold at the end of the project for $250,000. Assume that the project would also require a $100,000 investment in net working capital. Your firm is forecasting that they would sell 10,000 units of the new product at $100 each in the first year and those sales would increase by 30% each year. Cost of goods sold would be 60%. Selling, general and administrative expenses are fixed at $250,000 per year. The firm has a tax rate of 40%. Using your preferred WACC that you calculated, answer the following questions:

1)What is the NPV of this project?

2)What is the IRR of this project?

3)What is the payback of this project?

4)What is the discounted payback of this project?

5)Should the firm accept the project? Explain.

Capital Structure

Assume that your firm is considering the following capital structure alternatives: all equity, 75% equity, 50% equity and 25% equity. They estimate that under those scenarios, their bond rating would be AA, A, BBB, and BB respectively and their before-tax cost of debt would be 5%, 6%, 8.5% and 11% respectively. Based on this information and the values you have researched/calculated previously for total capital, operating income, risk-free rate, market risk premium, implied tax rate, shares outstanding and beta:

  • Calculate the firm’s interest expense, net income and EPS at each proposed capital structure and determine which capital structure maximizes EPS.
  • Calculate your firm’s WACC at each proposed capital structure and determine which capital structure minimizes WACC.
  • Explain what capital structure maximizes shareholder value.
  • Make a recommendation to your firm’s top management team regarding its capital structure.